Australian venture capitalists face commercialization obstacles

These are frustrating times for Australian venture capitalists. The country's reputation for technological expertise is well established but innovations all too often wither in their infancy, starved of capital and commercial knowhow. There are few solutions in sight.

Only three new venture funds were raised in the fiscal year ended June 30, 2011, collecting a meager A$120 million, according to the Australian Private Equity and Venture Capital Association (AVCAL). This is the lowest level seen seven years. Investment hit a five-year low, with A$120.6 million committed to 76 companies. VC firms are largely relying on relatively old-vintage vehicles to support existing portfolio companies as LPs stay on the sidelines, saying that track records are too sparse to justify investment.

Poor timing

Many of the problems can be traced back to Australian venture capital emerging in the right place but at the wrong time. The industry only got started in 1998, just after more mature players in the US and Europe were making investments that soared during the dotcom boom. It created platform for stellar exits that still mark the high point on most entrepreneurs' resumes. Australia, meanwhile, had nothing.

"When you look at the established offshore players, they invested during some very strong vintage years; many older funds delivered an IRR of 40% from their 1995-7 funds," says Brigitte Smith, managing director of GBS Venture Partners in Australia. "But Australian managers did not have funds during those prime vintage years as the industry didn't exist here at that time."

Given that it took the US venture capital industry about 50 years to mature, having emerged in the years following World War Two, the Australian market, at 15-years-old, is still a relative youngster. It has yet to build an established ecosystem of experienced entrepreneurs, GPs and service providers who have been through several cycles in the startup chain.

According to Malcolm Thornton, investment director at Starfish Ventures, the ideal scale for a VC fund in Australia is currently A$100-250 million. This is likely to be on the small side for local LPs. Starfish, for example, closed its most recent fund at A$185 million and typically targets deals of A$5-10 million.

"The superannuation funds and large intuitional LPs are increasingly looking to make larger commitments," Thornton tells AVCJ. "Maintaining our average deal size, and hence overall fund size, allows us to find the best quality investment opportunities. Solving the gap between our workable fund size and the interests of the local LPs is an ongoing challenge."

In a difficult environment, venture capital investors have little choice but to try and ride out the storm, hoping that LPs will eventually return to the market.

"The technology investment industry may have reached a cyclical low point and in these conditions we must be patient," says Charles Gillies, managing partner at Jolimont Capital. "Ostur strategy is to put value into our portfolio companies and make sure we exit at the right moment because the track record will speak for itself when the appetite from LPs comes back."

Sectors of interest

In an article published in mid-January, Katherine Woodthorpe, CEO of AVCAL, noted that while life sciences received the majority of venture capital investment in 2011, 37% of spending targeted the information communication and technology sector (ICT). Both sectors strike a chord with local VC players - but not necessarily at the same time.

As a company that is heavily geared towards technology, Gillies tells AVCJ that Jolimont Capital does not invest in life-sciences. He sees the specialist skills and large capital requirements as too much of an obstacle. The longer investment timeframe is also unsuited to most mid-cap venture capital investors, he adds.

GBS Venture Partners still sees executable opportunities and focuses on human healthcare, biotechnology product development and life science start-ups. In order to cope with the sector's capital-hungry tendencies, the firm either simply pursues smaller deals or co-invests alongside strategic players through a structured syndicate.

"We are doing some smaller deals around the A$10 million mark and we hope to exit in the A$100-200 million range," GBS' Smith says. "If we target these smaller deals, we can ensure our exit from the company without needing to bring more money from outside investors."

Regarding larger investments, the syndicate in which GBS participates typically commits A$40 million in Series A funding and up to A$100 million in total, working towards an exit value of A$400-500 million. Still, steps are taken to protect against the downside. Rather than doing the Series A on the assumption that new investors will come in at later stages, GBS looks to partner with other GPs from the very beginning, to make sure the syndicate has enough money to support the company through to a natural exit.

Chris Nave, managing director of Brandon Capital, which also focuses on healthcare deals, agrees that in recent years financial risk has been one of the greatest challenges for VC investors. "We now need to have sufficient capital available around the table to take a technology through an exit, rather than relying on attracting investors to new funding rounds," he says.

In order to compensate for the lack of VC capital, Nave has seen more corporate interest and activity, with pharmaceutical companies emerging as strategic investors.

The financing round in mid-February of Celladon Corporation, a biopharmaceutical company specializing in the discovery and development of innovative treatments for cardiovascular diseases, is a case in point. In addition to receiving commitments from VC firms such as GBS Venture Partners, H&Q Healthcare/Life Sciences and Novartis Venture Funds, Johnson & Johnson and several pharmaceutical companies also participated.

Both GBS' Smith and Brandon's Nave would like to see more GPs enter the market as co-investors. "When we consider the deal flow, it can still support many multiples of the funds under management we have today," Smith adds.

The venture capital industry's role as an innovation enabler sits well with governments the world over, and the Australian authorities have noted that entrepreneurs are struggling for capital. As a result, various incentives programs have been unrolled to support the industry. For example, the Australian government spends around $8 billion every year on research with the aim to enhance productivity through new innovation. Businesses able to prove that they use research and development as an investment for future growth also qualify for a 45% refundable tax credit.

The level of support, however, is far from enough. The $8 billion dedicated to research must be shared by a wide variety of applicants, ranging from universities to units of larger companies. There is no guarantee that it government funding will end up in the hands of startups and enable them to commercialize their technologies.

"Whilst the industry has benefited from government support, the level of support remains a small fraction of the annual research budget, and since the purpose of the research must ultimately be its translation for use by society, there appears to be a disconnect in the innovation continuum" says Nave. "Even 1% of the research budget allocated to the sector would make enormous difference."

Jolimont's Gillies shares a similar view. He adds that policies in Australia have been more favorable to mining, agriculture, and manufacturing, while there is not much focus on technology. "There is a gap between what VC firms like and what government supports. The current incentives from the government are not enough to make the VC industry sustainable."

Goodbye, golden goose

Furthermore, venture capitalists face even greater headwinds this year because one government initiative that has helped, the Innovation Investment Fund Program (IIF), is due to come to an end. Founded in 1998, the program allows government to become a cornerstone LP for a number of first time managers and assist early-stage companies in commercializing innovations. There has been no information as to whether IIF will be extended or replaced by another entity.

"Worryingly, there is no appetite to extend it in any form despite a very positive independent review and the government's own praise for the program," AVCAL's Woodthorpe wrote. "This leaves the massive taxpayer funded expenditure into research and development without any adequate commercialization mechanism."

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• Topics
• Australasia
• Venture
• Fundraising
• Technology
• Healthcare
• Venture
• TMT
• healthcare
• AVCAL
• Australia
• GBS Venture Partners
• Starfish Ventures