Venture capital: will Australia follow US?

Recent tax proposals have thrown the spotlight on venture capital investments. But Australia has a lot of catching up to do, say Stephen White and Sam Armstrong.

Recent tax proposals have thrown the spotlight on venture capital investments. But Australia has a lot of catching up to do, say Stephen White and Sam Armstrong.

This year has been an important year for private equity. It is emerging as an asset class with growing popularity for both retail and institutional investors in Australia.

The names used to refer to the asset class that comprises unlisted companies vary, including terms like venture capital, management buy-ins (MBIs), management buy-outs (MBOs) and development capital. At Macquarie, we refer to investments in unlisted businesses as private equity.

There are two compelling reasons for people to consider the opportunities of a private equity investment. The first is investors are becoming increasingly comfortable with the notion of unlisted equity investments.

The second is that the intended cuts to capital gains tax resulting from the recent Ralph recommendations are adding to the attraction of ventures with a high capital growth component to their returns. Due to favourable capital gains tax treatment and long investment time frames, superannuation funds (both institutional and retail) are likely to be drawn to the growing number of private equity offerings.

The recent proliferation of private equity funds in Australia demonstrates fund managers’ confidence in the public’s continuing appetite for higher risk-return investment propositions.

At Macquarie, we have found that private equity as an asset class is in its fledgling stage, with about $365 million committed to various Macquarie Bank funds since the start of the year. Almost a third of this amount has come from retail investors.

Yet private equity as an asset class has been largely overlooked by Australian investors until recently.

The US phenomenon

Conventional wisdom preaches that high returns are the reward for investing in the private equity sector. Some individual investors might even make the mistake of planning to get rich overnight by short-term exposure.

In contrast, Macquarie’s research shows that year-on-year returns in the US from 1945 to 1997 were 3 — 4 per cent ahead of the listed sharemarket. Compounding this outperformance provides a very impressive long-term outcome. Over 25 years, a stake in private equity could be worth double the value of a similar initial investment in listed shares (see table 1). So it is reasonable to conclude that private equity is an ideal asset class for superannuation funds, including the self managed variety.

Over the past 50 years American pension funds have allocated a large portion of their assets to private equity investments in order to achieve long term and tax advantaged capital gains. Despite some high quality local opportunities over the past 20 years, only 2 per cent of Australian superannuation assets in Australian super funds have been allocated to private equity since. In the United States the comparable figure is as high as 25 per cent.

In 1998, global private equity commitments in the US was $118 billion, of which $88 billion was US-sourced. In the same year, Australians committed a mere $430 million into private equity.

Risky business?

There are also some interesting lessons from the US on the risk of investing in private equity. In the US, there is far greater risk of disappointment due to the wider range and quality of private equity opportunities. In the US private equity market, there has been a 17 per cent spread between returns achieved by top quartile and bottom quartile private equity managers, compared to 8 per cent in Australia. The lesson here is that just because a market is big does not mean it has become more efficient and is providing investors with greater certainty about returns.

The probability of the risk growing with the size of the market is illustrated by the sheer volume of new offerings available to fund of fund style private equity managers in the US. Each US-based fund of fund is approached by an average of 800 fresh investment partnerships every year (partnership is the term commonly used in the US to describe fund managers seeking to raise money to invest in private equity). About half these new US offerings are by fund managers totally new to the market. The rest are from existing private equity funds.

In Australia, the very few managers of fund of fund products have about 30 fresh opportunities to assess each year, of which about a third are offerings by new promoters of private equity fund-raising vehicles.

Taxing times

The tax changes proposed by the Government’s response to Ralph should encourage more money from offshore into the Australian private equity market. It will also attract greater expertise and experience to the local market. This will be as important as the tax incentives.

Overseas companies may not open up offices in Australia. Rather, their influence will be felt through joint venture arrangements with local players. For example, Australian Mezzanine Investments recently formed an alliance with the Walden Group. This is the group that backed LookSmart, one of the great private equity success stories of recent years.

The capital gains tax rollover relief will be a huge boost for the industry. Many smaller companies grow through acquisition. For example, Signature Security has grown through 60 acquisitions. Many such roll-up strategies have been hampered to date by the lack of any rollover relief. The rollover relief will help accelerate industry rationalisation.

The CGT exemption proposed for international superannuation funds investing in qualifying private equity investments is favourable, but there will inevitably be devil in the detail. The only detail we have to date is that the gross assets of the underlying investee companies cannot exceed $50 million. This is small.

The private equity industry is also going to be affected by the move to tax closely held trusts as companies.

International fund-of-fund providers will now be encouraged to come to Australia. This won't happen overnight because many are still achieving amazing returns from investing in their local markets.

But when they start coming to Australia, it will benefit everybody. Superannuation funds will be offered a wider variety of international private equity funds. Meanwhile, local private equity managers will have alternative funding sources.

However, creating a vibrant private equity industry requires a culture change. There has to be an appetite for risk taking; more awareness of the availability of risk capital; more service providers willing to share risk; and appropriate rewards for risk takers. We are observing the beginnings of this culture in Australia.

Stephen White and Sam Armstrong are division directors of Macquarie Investment Management and fund managers for the Macquarie Private Equity Multifund.

Private equity in Australia and the US

US MARKET AUSTRALIAN MARKET IMPLICATIONS

Long term (1945 to 1997) private equity (PE) sector returns in the US have been about 3 to 4 per cent ahead of listed shares. Australian long-term returns (1982 to 1995) from the private equity sector similarly offer 3 t o 4 per cent ahead of listed shares.

If you assume over the next 25 years that listed equities return 11 per cent and private equities return 14 per cent, then assets invested in PE will be worth twice as much the listed equities. Superannuation investors with long time frames and low liquidity requirements (private equity is illiquid) should have an exposure to private equity.

Typical private equity allocations are high. State pension funds have between 2 and 5 per cent, corporate pension funds between 5 and 7 per cent and university endowment funds up to 25 per cent. Private equity allocations in Australia are low with total superannuation allocation estimated at about 2 per cent of assets and concentrated in larger funds. Australian superannuation investors are underexposed to private equit