Australian LPs and domestic VC: Toe in the water

Domestic venture capital is no longer toxic to Australian superannuation funds, it would appear. Having pared their exposure to the asset class in the wake of the global financial crisis, there are early signs that these institutions are making their way back, with Blackbird Ventures and Brandon Capital the beneficiaries.

Blackbird closed its second fund at A$200 million ($143 million) last month, with First State Super and HOSTPLUS contributing A$110 million and A$35 million, respectively. This followed Brandon Capital's Medical research Commercialization Fund 3, also A$200 million in size, which received commitments from existing investors AustralianSuper and Statewide Super as well as HESTA and HOSTPLUS.

The two funds share two key characteristics: they are big enough to accommodate the super funds' relatively large check sizes; and they offer flexibility in structure that suits these investors' appetite for later-stage co-investment.

We are still going to invest in seed to Series A rounds. But with the bigger fund, we're able to support the founders of these companies for longer periods

"If they can follow companies as they become real assets and put in increasing amounts of money then it can make a difference," Chris Nave, managing director at Brandon, told AVCJ earlier this year. "Success for this fund may not be just the returns. If we create a company and they get to fund it through the co-investment mandate, it might end up receiving investment from their expansion and listed funds."

Blackbird and Brandon's fundraising success raises the question of whether other venture capital firms could or should follow their approach. Snaring a super fund means a sizeable capital commitment, but can managers handle the changes in structure and economics that these arrangements involve?

The disenchanted

The fundraising record of Australian VC has been patchy in recent years. According to AVCJ Research, VC firms raised $326 million and $168 million in 2010 and 2011, respectively. The total soared to $466 million the following year, but slipped back to S426 million in 2013 and to $183 million 12 months later. Thanks to Brandon and Blackbird, the 2015 total stands at $394 million.

HESTA is typical of many super funds in that it relied on fund-of-funds to get exposure to venture capital from the late 1990s to the mid-2000s. However, as the domestic buyout opportunity grew, these fund-of-funds began to tilt towards private equity. In 2007, HESTA committed to a fund-of-funds that focused specifically on life sciences venture capital. When the investment period for that mandate expired in 2011, it was not renewed, mainly because of poor performance across the VC portfolio.

"Fundamentally, we would like to support innovation in Australia because it provides a way that we can maintain a competitive advantage economically by using our knowledge and intellectual capacity. However, a super fund needs to generate returns for its members, and it is difficult to justify ongoing investment in venture capital based on the relatively poor track record of the sector to date," says Andrew Major, general manager for unlisted assets at HESTA.

HOSTPLUS also scaled back its VC exposure through fund-of-funds in 2011 due to unsatisfactory performance. Neil Stanford, private equity investment manager at HOSPLUS, attributes this problem to old-style venture capital with small funds. As soon as these vehicles were tapped out, managers had to find strategic partners or exit. Even if a company did well, a VC firm's holding would end up so diluted there would be little in terms of return.

"That's the old venture funding model and we don't want to do any more of that - the returns are patchy at best," says Stanford. "The new style, however, allows us to take small early stakes and then follow the investment over time before deciding whether to make further commitments through a follow-on fund or pro-rata co-investment rights. This suits our embryonic co-investment program by taking small steps initially and then being prepared to scale rapidly thereafter."

It also means HOSTPLUS isn't presenting new co-investments "out of the blue" to its board.

In the absence of super funds, Australian VC firms relied on LP contributes from family offices, US venture capital players, and high net worth individuals (HNWIs). There was also various forms of government support, such as the Early Stage Venture Capital Limited Partnership (ESVLP) - introduced in 2004 and offer tax breaks to new funds - and the Innovation Investment Fund.

Blackbird was set up three years ago and its debut fund was an ESVLP. It closed last year well above target at A$30 million, with Australian entrepreneurs and Silicon Valley investors accounting for the bulk of LP commitments. The GP advocates having successful entrepreneurs, such as Atlassian founders Mike Cannon-Brookes and Scott Farquhar, connect with new start-ups in order to offer advices and access to their industry networks.

The IIF program, under which the government matches private sector commitments to VC funds, was terminated last year, although Brandon succeeded in getting support for its second vehicle. The first two iterations of the Medical Research Commercialization Fund closed at A$11 million and A$40 million in 2007 and 2011, respectively. AustralianSuper and Statewide Super also backed Fund II.

The overwhelming majority of Brandon's investments have come through a network of 52 Australian medical research institutes and research hospitals - essentially pipelines for the early-stage development and commercialization of technologies. The VC firm meets with its partners every six weeks and inspects the pipeline of innovations. It has first right of refusal on opportunities presented.

Flexibility first

The flexibility of Fund III appealed to LPs because it allows varied levels of exposure. Up to A$50 million of the corpus is earmarked for very early-stage investments and the remaining A$150 million is reserved for the technology commercialization. There is also a co-investment vehicle through which LPs can effectively double-down on select portfolio companies.

Blackbird has a similar approach. The fund comprises two vehicles: a A$75 million main fund that is used for seed and Series A rounds and a A$125 million vehicle for follow-on investments in companies that are managing to achieve scale.

There is also greater confidence among LPs that they will see meaningful co-investment deal flow, with Stanford of HOSTPLUS observing that there has been a marked improvement in the quality of opportunities. Part of this is global - the costs of starting a business have fallen dramatically, while modern communications allow collaboration irrespective of distance and location - but some elements are Australian.

"The entrepreneurs we're seeing are much better - they're thinking globally from day one in terms of their ideas and businesses," Stanford says. "Equally important is the new breed of venture managers who have created wider ‘ecosystems' to support their investments."

This is apparent in many of Blackbird's investments. Portfolio companies must develop solutions for the international market, which could in theory create opportunities for cross-border expansion and larger funding rounds. Last week, crowd-based design outsourcing platform Canva raised $15 million in Series A funding led by US-based Felicis Ventures. Blackbird re-upped and no longer has to stop at Series B.

"We are still going to invest in seed to Series A rounds," explains Rick Baker, co-founder of Blackbird. "But with the bigger fund, we're able to support the founders of these companies for longer periods."

Brandon has enjoyed some bumper life sciences exits, generating a 60x return from the sale of Fibrotech last year. It also shared $200 million in cash - plus the possibility of unspecified earn-outs - with GBS Ventures and other investors as Novartis acquired Spinifex Pharmaceuticals. These sorts of companies may not need to be exited so early if super funds are willing to provide the additional capital required to get drugs through clinical trials.

Major of HESTA adds that Brandon was also willing to be flexible around the proposed commitment structure and fee arrangements. "In particular, we agreed an annual budget approach to manage remuneration, rather than the traditional fee on committed capital which inflates investment management cost in the early years of a fund's life," he says.

Co-investment is a reasonably well-established concept in Australian private equity and Brandon and Blackbird aren't alone in offering it in venture capital.

OneVentures is currently raising $100 million for its second fund, most of which will come from HNWIs and financial institutions. There is a co-investment structure intended to reduce fee burdens and allow LPs to come in at a later stage, and OneVentures' six existing co-investment vehicle are running at an IRR of 99%. But the firm refrains from offering this to super funds that write large checks on a one-off basis.

"If the fee break is on incremental funding into the same deal that can work," says Michelle Deaker, managing director and CEO at OneVentures. "If, however, the manager is trying to manage or place $200 million with a 1% fee, the fee structure is difficult. From our perspective, we could not adequately resource our firm to put the work into the portfolio that we would normally put in. And we believe this work drives performance and consequently returns".

Moreover, some VC investors suggest that the super funds' renewed interest in venture capital is opportunistic and cannot be counted on for the long term. Deaker observes that while US LPs invest across cycles, super funds tend to step in and out, and often fail to pick the right moment.

"They left the Australian VC market during the global financial crisis and have only just shown signs of returning. They therefore did not have exposure to what are arguably strong VC vintage years," she says, noting that funds from 2009-2010 were able to enter deals at better valuations than today and are consequently showing strong above-market returns.

Capital shortage

It remains to be seen whether the Brandon and Blackbird fundraises are a precursor to more super fund activity in the domestic VC space. As it stands, most industry participants complain about a dearth of capital in the market, which makes it hard for start-ups that want to raise Series B and C rounds. Usually they have little option but to seek funding offshore.

"For companies looking to raise A$3-5 million it's really a challenge in Australia, because that space has historically been filled by traditional venture capital firms. There is just not enough capital available at the moment," says John Dyson, co-founder of Starfish Ventures.

With initiatives such as the IIF now defunct, earlier this year the government sought to close the funding gap through changes to the significant investor visa (SIV) program. Overseas business people can become eligible for permanent residence in Australia after four years conditional on deploying at least A$5 million into approved local assets, including at least $500,000 in a venture capital or growth private equity fund.

It estimated about A$150 million in additional capital could flow into the VC funds each year, but investors are uncertain as to how much difference it will make. "I think it will be a long, long time before you will see meaningful flows of capital into venture," says Craig Blair, co-founder and partner at AirTree Ventures. "The challenge is making sure good managers get funded and those business people probably aren't interested in investing in venture capital. They're doing it because they have to."

Rather, the gap will be closed by changes within the venture capital ecosystem. The likes of AirTree, which is looking to upsize from a $60 million to a $150 million fund, are relying on their traditional family office and HNWI LPs to write bigger checks. However, there is an element of flexibility in the approach: the new fund will be split, Blackbird-style, into one vehicle for Series A investments and another for later rounds.

Blue Sky Venture Capital is also considering an top-up fund raised from existing LPs to support portfolio companies as they get larger. The firm closed its first VC fund at A$10 million last year and is looking to raise for its first VC fund last year and is looking to raise A$30 million for Fund II.

If there is any chance of getting a super fund involved, the vehicle would have to be larger - minimum check sizes tend to be A$50-100 million for most of these LPs - but size is only one of the considerations.

"The Blackbird and Brandon funds show that superannuation funds are happy to re-invest into domestic venture capital market, but I think they are doing it cautiously," says Elaine Stead, Blue Sky Venture's investment director. "They invested in fund managers who have proven track records, which is the difficult part. Australian venture is a relatively immature industry if you compare it into the US. It takes time for fund managers to develop those track records."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Venture
• Fundraising
• Technology
• Healthcare
• Australasia
• Early-stage
• LPs
• Venture
• Australia
• Blackbird Ventures
• Brandon Capital
• Technology
• healthcare
• LPs
• HESTA
• HOSTPLUS
• Starfish Ventures
• Blue Sky Private Equity