Today, the Australian Venture Capital (VC) industry appears relatively strong, but that has not always been the case. Its history is a chequered one with a number of false starts.
Venture capital is a relatively new concept.
Most commentators consider the world’s first VC firm to be American Research and Development Corporation (ARDC). Although founded in 1946, it wasn’t until 1957 that it made its move into true venture investments. That year, it invested into Digital Equipment Corporation, which was developing microcomputers. It was a resounding success. By the time of ARDC’s exit 14 year later, they had returned more than 5,000 times their original investment and more than $350 million (around $4 billion adjusted for inflation).
Others took notice.
In 1970, around the time that ARDC was cashing out, the first recognised Australian venture firm was established. Bill Ferris founded International Venture Corporation (IVC) with $500K of initial capital ($6 million in 2017 dollars). A short time later, he raised a further $2m from Hill Samuel, a predecessor to Macquarie Bank.
A small number of other venture firms followed with modest raisings. Their fundraising efforts were bolstered by the early 1970’s property boom in Australia, which generated substantial wealth for many investors and emboldened them to take further risks. It was a similar story globally. At the start of 1973, Barron’s summed up the attitude of professional investors with the headline ‘Not a Bear Among Them’.
The good times didn’t last for long.
By October 1974, global asset prices had collapsed and most of the world was in recession. US Dow Industrials had fallen 45%. US inflation was running at 12.3% from 3.4% just 18 months earlier.
Interest rates. Central banks were worried about inflation, and to fight it, they resorted to the only tool in their arsenal: lifting rates. The US Fed rate was 5.5% in March 1972. By April 1973 it was 7.25%. By August 1973, it was 11%, double the rate less than 18 months earlier. In Australia, rates lifted from 5.5% in March 1972 to 9.3% by September 1973. They peaked at an incredible 21.75% in May 1974, before declining again to 10% by the end of that year.
Leverage (debt) plays a role in most asset price booms. When interest rates are low and asset prices are increasing, debt greatly amplifies investor returns. When interest rates increase and asset prices decrease, the reverse is true.
The real trigger for inflation occurred in October 1973, the month that Egypt and Syria launched a surprise attack on Israel. When the USA responded with support for Israel, the Organisation of Arab Petroleum Exporting Countries (OAPEC) cut oil production and put in place an embargo on certain countries. In the subsequent six months, global oil prices quadrupled. The cost of oil impacts the price of just about everything. This dramatic cost increase helped fuel inflation.
There were other things, too. For instance, the Watergate scandal in the US was playing out, ultimately leading to the resignation of President Nixon in August 1974. In the two months following his resignation, the US Dow fell 27%. An article from Newsweek asked ‘Is there no bottom?’
In Australia, share price and property price falls led to substantial investor losses. Companies involved in the boom such as Cambridge Credit and a number of property developers collapsed. Banks and other deposit holders were subject to runs (i.e. customers demanding their deposits back), and only narrowly avoided a collapse following government and central bank intervention.
The recession and resulting investor pullback chocked off the fledgling Australian venture capital sector. New funds weren’t able to raise capital, and the lack of access to follow-on capital starved off the startup sector. The government was aware of the problem and the need to encourage investors back into the space. It finally took action in 1983 with the introduction of the Management and Investment Company (MIC) program, modelled on the Small Business Investment Company (SBIC) program in the USA.
An MIC fund had to invest at least 70% of its capital into at least 5 local companies that were small, growing, innovative and export-oriented. Investors into these funds were offered substantial incentives, including a 100% deduction on their contributed capital.
There was one other problem that had plagued the sector: exit opportunities.
Venture investors have finite investment timeframes, and hence a company that raises venture capital must generally either be acquired or go public for an investor to realise a return. In the 1970’s, neither of these avenues were viable. There was little appetite from Australian (or foreign) companies to acquire small technology businesses, and up until the early 1980’s there was no stock market suitable for listing them.
Around the same time the MIC scheme was introduced, a number of smaller secondary stock markets opened in Australia. This was helped by the relatively strong recent performance of equity markets. Once again, investors were flush with cash and had found their risk appetites.
Australian VC boomed.
By June 1987, there were 11 MIC funds managing $353m of capital ($850m in 2017 dollars). There were a further 4 independent non-MIC venture funds and 25 other funds that invested in venture deals (these funds were owned by a mixture of public companies, merchant banks and stockbrokers).
In the preceding twelve months, Australian venture firms invested $259m across more than 200 businesses. MIC’s alone invested $51m across 48 businesses. There was also substantial direct government investment, especially from the Australian Industry Development Corporation (a federal body) and the Victorian Investment Corporation, which together invested $53m over the period.
As we will shortly write about, there were some success stories over this period, including Vision Systems (founded in 1987), Zenyth Therapeutics (1986) and Cochlear (1979). Unfortunately, the failures far outweighed the successes.
The surge in venture investment in Austrlalia proved brief.
In October 1987, the world’s stock markets crashed. The US and UK markets fell close to 25%. Hong Kong markets fell 46%. Australian and New Zealand markets fell 42% and 60% respectively.
Despite a brief recovery driven by a property boom, Australia—along with most of the developed world—was in recession by 1990. The Reserve Bank cash rate reached 17.5% as it tried to combat inflation. As the asset price bubble unwound and unemployment almost doubled, a number of domestic financial institutions failed, including the State Bank of Victoria, the State Bank of South Australia, and the (rather aptly named) Pyramid Building Society.
In the aftermath, the secondary boards that had provided liquidity to early stage companies shut down and investors lost their risk appetites. MIC funds suffered heavy losses as a number of early stage companies went bankrupt. The restriction on MIC funds investing more than 20% of their capital into a single company, along with their small size, compounded the pressure. Many funds were not able to support their most promising investee companies with follow-on capital.
By 1991, things looked very grim for venture capital and Australian startups. Activity by MICs fell more than 90%, recording just two deals worth $11 million. A study by Cornelius and Hargreaves in that year concluded that ‘the industry is close to extinction’. AVCAL data records only 3 deals totalling $18m invested in 1993.
In 1992, the government replaced the MIC scheme with Pooled Development Funds (PDFs). PDFs were designed to be more flexible, although the tax benefits to investors were whittled back. Instead of a full deduction worth up to 47c of each dollar (the top income tax rate at the time), all earnings from PDFs were taxed at 15%. This benefit was theoretically worth up to 32c on the dollar for an investor in the top income tax bracket, although the true benefit was typically closer to 15-20c given that capital gains tax rates were adjusted for inflation.
After an extended hiatus, signs of life returned to the Australian venture industry in the mid-1990’s. By then the domestic and global economies were once again growing strongly. Interest rates had declined sharply from their early 1990’s peaks, helping to support an ongoing surge in asset prices.
The real kicker was the growth of the internet.
Although the infrastructure that underlies the internet had been developing since the late 1960’s, it was primarily used exclusively by government agencies and computer enthusiasts. In 1990, Tim Berners-Lee invented what was called the World Wide Web, a more intuitive method of accessing online data through websites and hyperlinks. Then, in October 1994, Netscape launched what was arugably the first user-friendly internet browser and helped kickstart the internet revolution.
Startup creation and venture investment surged in tandem as the internet enabled new business opportunities. As excitement built, valuations and exit opportunities increased. Early stage investors made substantial returns, encouraging more capital and more startups in a virtuous circle. This surge in technology startups and venture capital happened earlier and more dramatically in the USA, but the excitement soon spread to other countries including Australia.
In 1997, the Australian Government launched the Innovation Investment Fund (IIF) program, modelled on similar schemes in the UK and USA. The purpose of the program was to help develop the institutional venture capital market in Australia by providing an incentive to investors in these funds.
Under the program, the government awarded a set number of licenses to venture capital managers, and provided them with matching capital against each dollar of private capital raised. The government capital contribution was structured to favour the private investors. This is best shown with an example. For instance if a fund raised $50m comprising $25m government and $25m private capital, and returned $150m (i.e. $100m in profits or a 3x return on capital), the distributions were as follows:
Round 1 of the program closed in 1998, providing $197.4m funding ($130m government, $67.4m private sector) to 5 managers. Four of these fund managers were new: Allen & Buckeridge, GBS Venture Partners (then Rothschild Bioscience Managers), Coates Myer and Company (later CM Capital), and Momentum Funds Management. One of these funds, AMWIN, was a joint venture between CHAMP, a local fund, and the US-based Walden Group. All of the funds were between $31-43m in size.
Australian venture investment and fund raisings rose substantially in the next few years. Although accurate industry data is sparse, we estimate that around $180m was invested by VC firms in the six years to 1998, an average of just $30m per year. In the following 3 years to June 2001, total investment exceeded $1bn, an average of just over $330m per year. In the June 2001 year alone, investment exceed $600m, more than three times the total of Australian venture investment over the six year period to 1998.
The IIF program spurred this along, although just as important was the building global hysteria around technology investments.
The NASDAQ (a US stock market index weighted towards technology companies) increased 400% over 1995-2000. It rose an incredible 86% in 1999 alone. On the first day of trading, it was not uncommon for a company’s share price to increase more than 500%. The media was full of stories about people with no prior investing experience quitting their day jobs to pursue a career in stock trading from home. It all seemed too easy.
The index hit its peak of 5,049 on 10 March 2000.
It wobbled for a few weeks. Then, in the week of April 14, it fell 25%. By year end, the index was down more than 70%, a decline of nearly two trillion dollars. More than half the stocks in the Bloomberg Internet Index fell more than 80%, and half of these fell more than 90%. Many companies entered bankruptcy. Many fortunes evaporated. The market didn’t bottom until 9 October 2002, by which point it had fallen nearly 80% from its peak.
Venture investment and fundraising fell dramatically. US Venture capital firms had raised over $150 billion in the four years preceding the market peak, including $70 billion of capital in the final twelve months. They raised just $10 billion per year over the next two years, a decline from the peak of 85%. Similar stories were repeated globally.
The Australian decline was initially less dramatic. This was partly because there had been fewer internet-related IPOs in Australia and comparatively less exuberance from public market investors.
There were approximately 440 internet IPOs in the USA in the two years prior to the crash, raising a total of US$41bn. Furthermore, there was an acquisition frenzy: in those same two years, almost $320 billion of US technology-related Mergers and Acquisitions (M&A) were completed. In Australia, there were closer to 55 IPOs raising a total of about US$850m and a fraction of the M&A activity.
In both countries, many poor companies (in hindsight) were funded. In the USA, however, there were also many exits of these companies (either through IPOs or acquisitions), generating strong returns for their early investors and leaving others holding the bag. In Australia, there were far fewer exits before the music stopped. Most early stage investors hadn’t been able to pass the bag on in time.
Still, the wheels didn’t fall off the venture industry wagon. Not yet. For one, neither the Australian economy nor the Australian share market crashed. Although there were bankruptcies and significant devaluations for many technology stocks, the overall ASX index—unlike its US counterpart—barely moved.
In addition, Round 2 of the IIF program was about to get underway.
IIF Round 2 commenced in 2001. The $157m commitment ($91m public, $66m private investors) was allocated across four new venture funds. These were Stone Ridge (Foundation Management), Four Hats Capital (Nanyang Innovation), Neo Technology Ventures and Start-up Australia Ventures (Bioventures Australia Partnership). These funds ultimately invested $115m across 38 companies (the difference went to management fees).
In addition, a handful of funds were raised without IIF support. For instance, Technology Venture Partners raised $144m, which was the largest Australian VC fund to date. Allen & Buckeridge raised two funds for $150m in total. GBS (an IIF round one graduate) raised a second $64.5m Biotechnology fund without government support. Starfish Ventures was founded and raised its first fund, a $24m pre-seed fund that closed in January 2002.
What about investment performance?
There were some success stories over the period including LookSmart, Gekko Systems and SEEK (all from the IIF-backed AMWIN fund), Pharmaxis (GBS Ventures, IIF-backed), eServGlobal, Vintela and Hitwise (Allen & Buckeridge) and RESMED (JAFCO, later Starfish Ventures). LookSmart was by far the biggest success, returning its private investors 110x over 18 months, after AMWIN timed its exit in February 2000 (following a US NASDAQ listing) to perfection.
Unfortunately, the failures outweighed the successes.
It can take a number of years before fund investors can judge performance, given the early stage nature of venture investments. In the early 2000’s, it became apparent that (once again) a large majority of Australian venture funds had performed poorly. For instance, according to AVCAL data, the average Internal Rate of Return1 (IRR) reported by all Australian VC’s over 1985-2006 was minus 4%, and the top quartile (i.e. the top 25% of all funds) returned just 5.3%. To put this in context, surveys of typical venture capital investors indicate they target overall returns of at least 20%.
Even the IIF-subsidised venture funds largely dissapointed.
Of the IIF round I funds, AMWIN returned its private investors a 2014% IRR (thanks to LookSmart) and Allen & Buckeridge returned 12.8% IRR. The other three funds returned -2.1%, -4.8% and -12.3%. Of the IIF round II funds, Nanyang Innovation / Four Hats Capital was the only fund to return a positive IRR (8.8%). The remaining funds returned -4.5%, -14.1% and -32.4%.
Not surprisingly, investors reduced their allocations to venture capital in search of better returns. Australian VC raised just $300m in total (i.e. $100m per year) over the 2002-2004 period. This was a sharp fall from the years leading up to 2001, when firms were investing $300m every year.
Whilst VC firms were struggling, the Private Equity (PE) industry in Australia was taking off. Although the distinction with VC can sometimes be grey, PE firms typically invest larger sums in more mature (usually profitable) companies, make use of leverage, and either fully or partially control the companies they invest in.
Prior to 1998, PE was almost non-existent in Australia. Two large funds set up that year: Pacific Equity Partners and Archer Capital, raising about A$200m in total. After that, PE exploded. Over the 2000-2007 period, more than $20bn was raised (an average of $2.3bn per year) and a similar amount invested.
We will cover the history of Australian PE in a future post. Let’s return to the venture capital scene.
Tax changes in 2001-2002, including the introduction of the Venture Capital Limited Partnership (VCLP) structure, made it easier and more attractive for foreign investors to invest in Australian funds. Among other things, it allowed foreign investors to be exempt from capital gains tax in certain scenarios.
Up until that point, foreign investment in venture capital was no more than a rounding error. It was hoped that the VCLP changes would attract more capital. However, although the changes benefited PE funds substantially, it wasn’t until the end of 2004 that the benefit flowed through to VC.
By that time, asset prices globally were picking up. In Australia, after a prolonged stagnation, the ASX 200 index increased at 20% p.a. over 2003-2005 (and continued at that rate until its October 2007 peak). As tends to happen in a rising market, investors regained their risk appetites.
Starfish Ventures raised its second fund (and the first VCLP) in November 2004, the $123m Technology Fund I. Along with a number of Australian institutional investors, Starfish managed to attract significant offshore investment, primarily Japanese-based Mitsui. That same year, GBS raised the largest ever Australian biotechnology fund, the $145m GBS BioVentures III.
Over 2005-2008, venture firms in Australia raised an average of $300m per year—triple the average during the preceding 3 year dark age—for a total $1.2bn. Besides Starfish and GBS (which accounted for $268m), other large funds over this period included the $154m CM Capital Fund, the $51m Innovation Capital Fund, the $40m Netus Fund (backed by News Corporation), the $50m Brandon Capital BBFI Fund, the $50m Cleantech Australia fund, and the $35m Bioscience Managers Australian Bioscience Fund I.
Round three of the IIF program started in late 2007. In order to smooth out funding, the program set out to invest $170m ($80m government, $90m private investors) in 10 funds over a 5 year period, nominally 2 per year. The fund made its first investments in the $50m Cleantech Australia Fund (September 2007) and the $50m Brandon Capital BBF1 Partnership (January 2008).
Just as the Australian venture industry was once again building momentum, it was disrupted by another global economic event, the 2008 Global Financial Crisis (GFC).
In the years leading up to 2008, individuals, companies and investors had taken on increasingly large risks, including levels of debt that were in hindsight unsustainable. There were a number of warning signs, including in early 2017 when a series of lenders and funds that had invested in structured mortgage debt collapsed. Most commentators attribute the apex of the crisis to the September 2008 collapse of Lehman Brothers, one of the largest investment banks in the world.
The collapse was dramatic. In the US, the Dow Jones sharemarket index fell 54% over the 17 month period to March 2009. The national housing market fell by one third. The unemployment rate more than doubled to 10%. Similar effects were felt around the world.
In Australia, the local share market fell 59% from peak to trough. The unemployment rate rose 50%, from 4% to 6%. A number of companies went bankrupt, including the asset manager Babcock and Brown, which at its 2007 peak had a market capitalisation of more than A$10 billion.
Although the Australian economy recovered faster than global peers, largely thanks to government stimulus and an ongoing surge in Chinese commodity exports, the global reduction in risk appetite was still felt. Scarred from losses, investors became skeptical of early stage companies, reducing valuations and exit opportunities. Fundraising dried up.
The Australian venture scene entered another dark age.
Thanks for reading. Part 2 of our history of the Australian venture capital industry, following the early recovery post the crisis, and the current comparative boom in venture investment, will be released shortly.
1 An IRR is essentially an annualised (i.e. per annum) return, weighted by the average amount of capital outstanding. Yes, it is more complex than that.