The NZVIF programme was set-up to catalyse a venture capital industry in New Zealand. It’s had some successes and had some misses. Is the next phase of development for the industry going to be to leverage this public asset to support the creation of one big fund? Is such an intervention needed? Who’s going to manage it?
The government has made it clear that it is not going to continue with NZVIF as we knew it and has asked NZVIF management for options for how it might exit direct management of the asset. We don’t know what is being proposed but one of the options, that appears to be under consideration, is leveraging the VIF asset as a cornerstone investor in the creation a new $300M fund. Such a fund, we presume, would need to be supported by capital raised from other private, institutional or corporate sources.
The comments that follow come from a biased position. We are an existing VIF manager and, in the past, we were reliant on the VIF programme to do what we did. In a small part, the future opportunity for VIF is dependent on how we perform.
That said, our view is:
- Let’s debate and evaluate the alternatives for how investment in the sector can be stimulated and sustained long-term without direct government involvement.
- We love the aspirational shift in the debate to stretching for Kiwi funds of a meaningful and sustainable size.
- We should take this opportunity to ensure we have a sustainable venture investment sector underpinned by several funds of reasonable size and not place all our chips on one big bet. Such an approach is good for competition, good for entrepreneurs and good for the sustainability of the sector.
- We should make sure that these funds are right-sized for the market opportunity and for ensuring success for the fund’s investors.
- International best practise should be applied to the selection of the managers. Who’s best placed to do this?
NZVIF has played a critical role in the development of Movac
Our historical engagement with the NZVIF programme has been critical to the growth and maturing of Movac as a professional investment firm able to attract private and institutional capital. Institutional capital is critical to building a fund of meaningful and economic scale. The VIF programme educated us on what the industry looks for and how it judges managers – it opened our eyes. The VIF programme has had its flaws in design and flexibility but aspects of it have worked, at least for us.
We first engaged with the VIF programme when we launched Movac Fund 3 in 2011. Prior to 2011, we had been active angel investors and had invested more than $15M of our own money in tech start-ups. At the time, there was a complete absence of venture or growth capital in New Zealand and this was greatly inhibiting our ability to grow the companies we were involved in. We put down the failure of the New Zealand Venture industry at that time to:
- The lack of an eco-system. Venture funds, under NZVIF, were created before the Angel sector existed. Most of the first funds invested in high tech, start-ups, that did not have fully developed products and still required significant investment in R&D.
- The focus on science commercialisation. The NZVIF mandate has a strong focus on science commercialisation and rewards funds with additional capital if their strategy is to invest early. Investments in these sorts of opportunities take a very long time to commercialise, are capitally intensive and are notoriously difficult to predict the outcome.
- Sub-optimal fund size. The funds established were too small, invested too early, by design, and there were no sources of follow-on funding to support the companies invested in if they proved themselves.
- Timing. The funds matured coincidentally with the global financial crisis making exits and securing follow-on capital difficult.
These elements combined to make delivering returns from these funds extremely difficult.
Co-incidentally the Australian Venture market, established under a similar design, had also seriously stalled around the same time.
After very deliberate consideration we made the decision to engage with government through NZVIF in launching our first formal fund. We were very cautious when we did this, we live in Wellington and understand that government policy can and does change and that any future change had the potential to put our plans and capital at risk.
In 2011, we launched Movac Fund 3. Between the founding Movac partners and our management team, we personally committed $10M to this Fund. NZVIF committed $17M and we raised a further $15M privately. Movac Fund 3 would not have got up without the NZVIF programme as there were no other institutional investors in the market prepared to back the early stage tech market. We wouldn’t and couldn’t have done it. The buyback option offered by NZVIF was not our driver in launching the fund and was a minor drawcard to investors. Our driver and core purpose has always been:
to create jobs and wealth for New Zealanders by
investing in and supporting the next wave of iconic kiwi tech companies.
Fund 3 is now fully invested and we’re satisfied with how that fund is positioned. At times it’s been tough and we’ve had to dig deep but we’re expecting this fund to bear fruit over the next two to three years. We’ve made mistakes in Fund 3 and the early stage investment sector has continued to mature around us. The lessons we’ve learnt and the more developed state of the market have informed our strategy for Fund 4.
We’re thrilled to be back in the market with a $110M fund thanks to the support of the likes of NZ Super, Ngai Tahu and the other 80+ talented entrepreneurs that are working with us. NZVIF have invested at a smaller but still useful level in Fund 4.
We liken our journey with NZVIF to a graduation programme. The programme gave us an opportunity, some decent structure and solid advice and we’ve progressed to the next level.
Where are the gaps in the New Zealand funding market?
The figure below is our attempt at providing a “heat map” for where funding does and doesn’t exist in the New Zealand ecosystem.
ICT sector – Overall we see the ICT sector as well-served by New Zealand and offshore sources of capital. The investment/return story in this sector is emerging but some high-profile failures and stalled progress with a couple of others have held back recent New Zealand enthusiasm, offset by a buoyant Australian investment community.
Biotech sector – There is some capital for med-tech opportunities but they need to be reasonably advanced along the commercialisation path to access $5M+ investment rounds. If they get into this phase then capital can be accessed but we see many opportunities stalled in-between. Investment appetite for companies researching or developing new drugs is practically non-existent in New Zealand, there is some limited appetite with specialised Australian funds. The investment/return story for this market is developing slowly.
Food and beverage sector – This sector is predominantly privately funded through the early stages. It’s not a sector that has been attractive to the early-growth and venture industry but is proving popular with crowd funding. The industry does, however, see frequent private equity investment when companies reach adequate scale. We see very little in food-tech that is well enough advanced to warrant a meaningful investment.
Science/IP sector – We use this as a catch-all for the diverse range of opportunities we see in New Zealand attempting to commercialise opportunities reliant on deep science or other intellectual property. We see two or three of these a year that look really interesting but require significant funding before they are ready to commercialise. The best ones attract corporate development funding and offshore venture funding, but there is really no funds in New Zealand investing in this category. There’s a great story emerging of the potential here but the returns have not yet been delivered.
Agri-tech sector – Somewhat surprisingly we see very few opportunities in this sector. In the last 24-months considerable effort has gone into seeding and shining a torch on this market and we’d expect that this will start to bear some fruit over the coming years. For now, the investment/return story has not emerged.
Niche manufacturing sector – New Zealand has a few hidden gems in this sector but there is no organised capital, that we are aware, of focusing on this sector. Private equity occasionally gets involved when these businesses have matured.
So, there are clearly gaps in the market. In some cases, these gaps are being filled by specialised off-shore funds, those funds that have the expertise that enables them to assess and add value to these opportunities. Arguably, when you look at the investment/return stories in these sectors, the market is acting rationally in how it is allocating capital at the moment.
$300M – great goal but too big for now.
The primary considerations in fund design are: how much capital can be deployed, in what sectors, in businesses of a certain stage (risk), to deliver an appropriate risk-adjusted return over an acceptable time period.
New managers generally adopt a more conservative approach to portfolio construction to enable them to start building a track-record of returns earlier, rather than later. The danger in New Zealand venture is you end up overweight with high risk, early stage investments. This is what happened with the first wave of NZVIF funds.
The aggregate demand for capital greatly exceeds supply in New Zealand. However, digging under this some of the gaps are in industries where the New Zealand success story has not yet emerged and will struggle to attract capital and in other industries, we still see many opportunities that have not yet matured to the level required to access capital. They need to be able to demonstrate product/market fit, growing revenues, a proven ability to execute and a clear strategy and plan to deploy the capital.
So, in our view quality demand, in industries where the track-record has been established, is significantly smaller than the absolute numbers. In this space, the good opportunities do not have problems accessing capital and we find ourselves one of several suitors at the table.
In our last capital raise our institutional investors challenged us on what we thought the scale of the opportunity was to deploy capital well over the next 3-years. Our answer was $100M to $150M. This was based on our assessment of the deal flow we have seen in the market over the last 15-years and in particular over the last 18-months. Crucial to this, from our point of view, was to make sure that we invested this money in high-quality opportunities that would deliver meaningful returns over the next 10-years. Investing more, which we could do, would require us to invest in pre-revenue opportunities and require a higher risk, investment strategy.
We’re not saying that the capital needs of the New Zealand market are addressed by Movac Fund 4. We have a specific strategy we’re investing against which rules us out of many early stage ventures and science-based ventures that look compelling.
What we are saying though is that, in our view,
The optimal fund size in the New Zealand market today is between $100M and $150M.
At this size, managers should be able to “invest well” and deliver investors the right level of return.
We would not put our hands up to invest our own capital or time in a New Zealand focused $300M venture fund.
At $150M do we run the risk of under-capitalising our companies? Potentially, but syndication is a common practise in early-stage growth and venture deals. In Movac Fund 3, a $42M fund, we’ve co-invested every deal we’ve been involved in. Co-investors have been a mix of New Zealand private investors, Venture Funds and Corporate Venture funds from the US, Asia and Australia. For three of these companies, we have lead rounds that now total upwards of $30M each. There are plenty of other examples in New Zealand of companies that have raised more than this. Co-investment is a very common practice in this industry, it provides validation of the opportunity and broadens the resources and networks that can be brought to bear to ensure the success of a company and the investment.
Current market conditions are the best that we’ve ever seen for co-investment. The Australian funds are particularly active in New Zealand. If anything, this is putting pressure on making our initial investment cheques smaller, rather than bigger.
Who would manage a $300M fund in New Zealand?
A fund of this size must be institutional class to attract the other capital needed. In our experience becoming an institutional class investment team doesn’t happen overnight. You earn the right across successive fund cycles. Do it well and your cornerstone investors stick with you, stuff it up and you lose your ticket to the next fund.
So, what are the characteristics of an institutional class manager? The list below illustrates the sorts of criteria that institutional investors and their advisors apply in selecting fund managers.
- Delivers returns to its investors – this goes without saying, but any fund only exists long-term in the market based on its ability to consistently generate returns for its investors. It takes a long time to build a return story when you’re investing funds of 10+ year duration. Fund managers can get away with robustly developed internal valuations up to a point, after that point absolute, cash returns are paramount.
- Has a clearly articulated investment thesis – the thesis describes what sort of investments the fund will make in what sectors and at what stage. Institutional investors select funds on this basis and seek to avoid making allocations to funds executing the same strategies. The investment thesis must match the capability and experience of the manager.
- Has strong economic alignment with investors – the managers put their own cash at risk and don’t earn the majority of their return from the salaries they draw as the manager. The benchmarks we’ve seen are between 3% and 5% of the overall fund size that is expected to come from the manager. In Fund 3 we were 23% of the Fund. In Fund 4 we’re around 5%.
- Has a stable team that has worked across multiple fund-cycles – being a fund manager in the early investment market is a tough gig, the toughest I’ve ever been involved in. Companies regularly run out of money, under-perform and changes in leadership teams and boards sometimes have to be made. None of this part of the business is fun and this is 90% of what we do. Institutional investors understand this and seek investment teams that have shown the ability to support each other and work together across multiple fund cycles.
- Has a demonstrable track-record of accessing deals – the manager is embedded and respected in the sector that it operates in and can demonstrate its ability to access and execute good deals.
- Has a demonstrable ability to work with and add value to portfolio companies – the management team brings additional capability and networks to the companies that they invest in. This helps ensure success and de-risks returns for investors.
- Can operate on an economic basis – the fund is appropriately sized and the fee base adequate to deliver on the investment plan. We have a history in New Zealand of creating funds that are sub-economic in size. Our own assessment is that the economics for the manager start to work at around $80m+ in funds under management, on a 2% fee structure. Under that is very tough. We made Movac 3 work by taking significantly below market salaries.
- Can deploy the amount of capital the investor is looking to deploy – institutional investors have got bigger and bigger across New Zealand and Australia. If you aim for the Super funds it can be a real challenge to create a strategy that will put enough capital to work for them to bother. The minimum investment commitment for some of these is $50M – $100M and if you start at one end of the spectrum they expect you to scale bigger on the next fund. There are smaller Super funds and other sources of institutional, corporate and private capital.
The above represents a high hurdle, it’s hard to wave a wand and create new managers that can cross these quickly. Most managers build track-record by starting small and earning the right to manage larger pools of capital. There are many professional advisors, such as Cambridge Asscoiates, who have been in the market a long time and have tremendous experience that can be drawn on to help vet and select potential managers.
What’s our North Star? What’s our vision for the New Zealand Venture investment sector?
One of the great things coming out of the sector at the moment is the shifting in the aspiration for the size and type of funds New Zealand needs. This was started by Simon Moutter from Spark last year and has been picked up Richard Dellabarca from NZVIF this year. We’ve been bumbling along with sub-optimally sized funds for too long. Let’s:
Create an industry, underpinned by a diverse group of investment managers that:
a) represents the spectrum of opportunities in New Zealand, and
b) delivers value to both the companies they invest in and the investors that they represent.
For us this means, at least 3 Venture Funds of $100M to $150M, of slightly different vintages, that are sustainable over a long-term basis.
Such an industry, coupled with the resurgent Australian industry and increasing interest from funds from other countries, will ensure an appropriate balance of collaboration and competition – something that is clearly in the interests of both our entrepreneurs and investors. It would also manage risk by creating 3 investment teams of up to 8 people in each team. This would be 24 people or roughly double or triple what we have operating in the sector today.
It would seem like a missed opportunity if the VIF asset was concentrated in a way that supported only the creation of one new $300M Fund. What sort of an industry will we be left with if that Fund fails?
What are the alternatives?
The current discussion has focussed on what to do about VIF and how that asset could be re-deployed. VIF was created for two reasons:
- The lack of institutional capital prepared to invest in Venture.
- The need to develop managers capable of investing in Venture.
Some things have changed. Some things have stayed the same.
Institutional pools of capital have grown significantly over the last 15 years. Some have started to dip their toes in parts of the Venture market. Some have been bitten and won’t go back until the return story is fully developed. Some parts of the market have structural inefficiencies built in that has stopped capital flowing into “illiquid investments”. But, that said we’re getting close but not there yet. I expect Movac Fund 5 to have more institutional New Zealand investors than Movac Fund 4. In our last capital raise, it was clear we were close to moving these pools of capital.
The management talent pool remains thin on the ground in New Zealand, especially those managers that have invested together in anger over 10+ years. But capability does exist and is gaining more experience and becoming more connected every year.
The challenge, however, is still motivating the more institutional investment market to support New Zealand venture funds. We don’t believe that international capital will flock to New Zealand by simply marketing a larger fund, underpinned by government support. We’ve marketed our funds across the world and New Zealand is just too small and too far away for most large investors to consider. We get lumped in with Australia and Asia who have tickets in front of us in the queue. There is very little foreign capital in our very successful private equity funds in New Zealand. The fact that Peter Thiel’s Valar fund no longer has feet on the ground in New Zealand demonstrates that international investors see New Zealand as a nice stopover, not a place to put down roots.
So, we need to stimulate the New Zealand investor market and continue to deepen the return story. If done well we remove the need for government to have a direct role.
Specific stimulus we could look at includes:
- Tax incentives – exploring the tax incentive models that have been so effective over the last 24-months in Australia and the United Kingdom.
- Wealthy migrant incentives – providing stronger incentives in the wealthy migrant programme to tip investment towards productive assets rather than government bonds and property.
- Fixing Kiwi Saver – exploring the flaws in the Kiwi Saver settings that are causing these funds to not invest in New Zealand’s best performing assets class, Private Equity.
If the VIF asset is to be recycled back into the sector consider:
- Perpetual management – allowing established managers, like Movac, to recycle the VIF assets it manages today in perpetuity, subject to performance and raising a minimum fund size.
- Contestible management – opening up the management of the VIF assets to other established private sector managers.
If you made it this far, well done! This is a complex debate and it’s not easy to cover all the issues in a digestible form. In summary, our biased 2c worth is:
- This is a great opportunity to debate and potentially create a step change in the New Zealand venture industry.
- If the VIF asset is to be leveraged let’s see it leveraged to support multiple managers, not limited to one new manager.
- Let’s make sure the managers are world class and we avoid the mistakes of the past.
- Let’s consider the alternative approaches that could be used to create a sustainable industry that removes the requirement for direct government support.
Other links you might be interested related to this discussion include:
- NZ Innovation Inc. – Are we there yet – Phil McCaw
- The best reform for NZVIF? Scrap it in favour of tax write-offs for investors – Ralph Shale, NBR.
- Opinion: The state of play for New Zealand’s venture capital industry – Michael White, NBR.
- The fix for New Zealand’s Series A funding crunch – Jenny Morel.
- Government would seek ‘commercial return’ if NZVIF reinvented – Stuff.
- Venture capitalists could be crowded out by Crown company, industry body says – Stuff.
- Does the Size of a VC Fund Matter? Mark Suster
- “We have met the enemy…and he is us” Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience – Kauffman Foundation
- Right-sizing the U.S. Venture Capital industry – Kauffman Foundation.