Equities – Let the big adventure begin...

Venture capital has long been a staple of super funds in Australia and a standard investment sector for sophisticated US investors. Gareth Cosslett explores the possibility of the sector becoming a must for advisers with high net worth clients.

Strictly speaking, venture capitalists are the high-risk, high-earning prospectors willing to put their money where their mouth is and invest in promising businesses starting up from scratch. So that's venture as in 'adventure' and also 'vent your' anger after losing your shirt.

The risks are taken as read, but so are the rewards. This sector is often seen as the domain of the high rollers of the finance world and some of their jargon reflects this: a 'ten-bagger' is a company that returns a ten-fold increase on the initial investment within a year.

In the US, venture capitalists are rife in areas such as Silicon Valley and the industry is booming, with around $US10 billion invested every year and some superannuation funds committing up to 40 per cent of their portfolios in the sector.

In Australia, progress has been slower with less than 1 per cent of the country's total cash flow being poured into venture capital and private equity schemes. And most of that tiny proportion is contributed by a few superannuation fund managers willing and able to invest the standard minimum $500,000 into a wholesale private equity fund. But commitment levels are still relatively small: super funds invest between 3 and 5 per cent of total funds there.

However, a new scheme from Macquarie Direct Investment is aiming to build grassroots awareness of private equity funds by opening up a wholesale institutional fund to retail investors for the first time. Although retail investors can already play the investment game indirectly through master trusts and there are also other existing retail opportunities, Macquarie is hoping that the kudos and proven track record of its wholesale funds will pull the punters.

Macquarie Investment Trust III hopes to secure $50 million from retail investors willing to spend the minimum $30,000 - the first instalment of $12,300 must be paid by May 14, followed by $12,000 two years later and a final instalment of $6,000 expected between one and three years after that. The wholesale side is expected to provide the other $150 million, taking the overall fund to $200 million.

The fund's exclusively wholesale predecessors, MIT and MIT II, have shown internal rates of return of 25 per cent after fees and 18 per cent respectively on smaller funds of $50 million and $100 million.

Sandy Lockhart, managing director of Macquarie Direct Investment, is "pretty confident" the $50 million target will be achieved.

"A third of the allocation was filled up in two weeks after the launch," he says.

The scheme has proven popular with individuals channelling their investments through super funds - a natural choice due to the fund's illiquidity and the fact that only 15 per cent tax is payable on capital gains in super.

Tim Farrelly, executive director of Macquarie Investment Management, expects about 75 per cent of the retail investment to be channelled through financial planners. "Around 95 per cent of researchers have recommended the product," he says.

Michael Shaw, managing director of Victorian Venture Capital Managers, the private equity arm of Melbourne-based investment bank Bristow Shaw & Company, says Macquarie's initiative will be good for the industry as a whole.

"It's an astute move. And it's important for people to realise that this area will be a major creator of jobs."

Currently, the top 100 Australian companies grow jobs by about 2 per cent per year whereas venture-based companies grow at 20 per cent.

Shaw also believes it will be a useful tool for educating financial planners.

"I suspect the awareness of private equity schemes is not as high as it ought to be. Maybe they're worried they can't look up the share price and see how their investment is doing."

There are also obvious concerns over illiquidity and yield. Typically, investors need to give themselves an eight-year window before returning their investment. MIT III is therefore targeted at retail investors with more than $250,000 in their portfolio.

But one of Macquarie's competitors poured scorn on the idea.

"There's no shortage of investors out there. So this is either because they cannot raise the money from wholesale - unlikely - or they just want to charge more lucrative retail fees," says the source, who asked to remain anonymous.

Macquarie charges 1.25 per cent fees over and above wholesale on the retail product. The source also says his company receives many requests from private clients on how they can get more involved in venture capital, but there are "product-specific issues that need to be solved" due to the illiquidity.

"You can find yourself in court pretty quickly with a client asking for his money back unless you're careful," he says.

Industry pundits believe the real art of the venture capitalist is in knowing before investing how to get the money out. Investors can realise their assets in various ways, but they all basically amount to selling the business. A management buy-out or management buy in, trade sale or IPO (initial public offering) for those companies with a net market value of equity of $20 million on flotation, will all liquidate the fund.

Most companies have a three to five year window under the fund before selling out but, as managers gradually invest in companies, most funds last about 10 years before they are completely liquidated. In the wholesale end, capital gains tend to be paid as and when they are made, but many retail products give investors the safety blanket of regular dividends.

As divisional director of Macquarie Investment Management's institutional funds division, Sam Armstrong is not forced to invest in MIT III, but he will as "just another fund sponsor".

His Macquarie Alternative Investment Trust (MAIT) fund spreads the risk by investing in a pool of eight venture capital products controlled by seven managers. He says he "has no problem going in with retail investors" but hopes "they are entering the market sufficiently well educated as to the risk".

Armstrong believes the potential for the industry is enormous.

"Private unlisted companies account for 50 per cent of the economy by any measure - sales or employment. But Australia is undergoing a huge generation change and family businesses are selling out as there is no-one to pass them down to.

"Most super trustees participated in the Telstra float, but they were buying into a company with a price/earnings ratio of over 20. In the private market the p/e ratio is around four to seven. Maybe it could be time to cash in those chips. If investors are doing the wise thing they are selling their listed stocks at the top of the market." However, as the industry is still in a relatively young stage, there are concerns there could be a shortfall in venture capitalists if investors chose to exit the stock market en masse.

"There's more funding than good quality transactions at the moment. Current estimates say around $4 billion has been invested in Australia out of a total $6 billion - meaning there's around $2 billion of undrawn capital," says Victorian Venture Capital Managers' Michael Shaw.

So raising money is one thing, but finding the investment directors and suitable companies to spend it is another. Macquarie says it receives about 150 business proposals per year, from which it will typically invest in two or three companies.

Steve Baldwin, director of Hambro-Grantham, says the standard of applications from private business has improved. "Compared with five years ago, the general education has improved greatly. Back then, a lot of the applications we received were not even close to ready."

He says there is also an increasing number of intermediaries actively sourcing potential companies.

"There's more managers in the market and a wider selection of funds to choose from," says Victor Bivell, editor and publisher of Australian Venture Capital Journal. "The industry has been growing pretty rapidly since 1992 and as a financial service it's getting bigger." But it also requires hands-on commitment.

"It's not something you can do part time. Once you start to manage other people's money, it's a full-time job," Bivell says.

This view is echoed by Michael Shaw. "It shouldn't be treated as an investment that can be put in the bottom draw. Any evolving business has growing pains and some lurch from crisis to crisis. They require active management," he says.

And picking the right business can be an arduous task. "As a venture capitalist, you're trying to return levels of 20 per cent internally. Those kinds of businesses don't just pop out and walk up the street. Fund managers are very risk averse and the entrepreneur with the business usually doesn't see you as a business partner rather a money lender at first," Shaw says.

He estimates that in a typical portfolio of 10 companies, two would only return what he puts in, two would make a fairly healthy profit, two a modest loss, two a "complete loss", leaving the way for the couple of "hero companies" that make the whole exercise worthwhile. Current best practice guidelines say directors should not invest in companies more than two or three hours from where they live, meaning the industry is becoming increasingly regionalised, and should have around six to eight companies under their wing.

So what makes a really good venture capitalist? Macquarie's Sam Armstrong confirms that this really is a game for the high rollers.

"I'd rather have a lucky one than a good one. The key thing is that he has a good deal flow and gets to see the good companies first. Word soon gets round among the entrepreneurs, so the best managers attract the best entrepreneurs."