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Smart money

By Rebecca Macfie

Thursday 29th December 2005

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Venture capital remains an undeveloped segment of New Zealand's innovation system.

Innovation drives growth, and venture capital is an important driver of innovation. That's the lesson from around the world, and particularly the US, according to a wide-ranging report on New Zealand's fledgling venture capital industry.

The evidence suggests a dollar of venture capital appears to be three or four times more potent in stimulating patenting than a dollar of traditional corporate R&D spending, says the report, prepared by consulting group LECG for the Ministry of Research Science and Tech-nology. Although venture capital averaged only 3% of corporate R&D in the US from 1983 to 1992, it was responsible for around 10% of US industrial innovations over this period.

"The venture capital revolution served as the driving force behind the transformation of the US economy in the late 20th century," claim the authors, Josh Lerner, David Moore and Stuart Shepherd.

A vibrant venture capital market in New Zealand could bolster this country's ability to commercialise innovation and convert these new ideas into economic growth. But, despite recent growth in the sector, it still "under-serves the New Zealand innovation system" in terms of the amount of capital available from local funds and the scope of services provided by fund managers.

The authors nevertheless praise the government's attempts to develop the sector by setting up the $100 million Venture Investment Fund in 2002. It regards the VIF fund as well designed and likely to play a "catalytic" role in promoting the sector. The VIF fund invests in selected private venture capital funds at a ratio of $1 for every $2 of private capital.

Direct government involvement in the sector is consistent with experience worldwide, which shows that venture capital markets don't tend to develop spontaneously. "All venture capital markets of which we are aware were initiated with government support."

Prior to the VIF fund there was little formal venture capital activity in New Zealand, and since its inception there has been a significant increase in the capital available for investment. So far the fund has attracted $120 million in private capital.

However, since the scheme began there has been no new venture capital fund established without VIF backing, suggesting the industry is still a long way from being self-sufficient. And institutional investors - whose support for the sector is critical long term - have so far failed to back the VIF funds. The local venture capital market's small size and lack of track record appear to be key reasons for their reluctance.

And, although one of the VIF goals is to encourage the commercialisation of research from universities and Crown research institutes, progress is slow on this front. The report says only 6.5% of deals flowing through to venture capital investors have come from these institutions.

New Zealand's venture capital market remains very small by international standards, with early-stage and seed investment amounting to just 0.01% of GDP, or $15.5 million in the 2004 year.

Overall, the authors regard the VIF structure as "sound", and approve of the way it distances commercial decision-making from the political process, requires private investors to match govern-ment funding and supports the development of a market with private investor participation.

However the report says the initial $100 million programme appears to have been established as a one-off commitment. Some $35 million of that total remains uncommitted, and the authors say the scheme will need to be extended if the government wants to ensure a sustainable venture capital industry emerges. It suggests a three- to five-year plan, although it says it's "difficult to be precise" as to the amount of extra capital required.

The government also needs to align the VIF and other government funding programmes. The report says there are several government grant schemes that effectively substitute venture capital, providing capital at low or zero cost but without the commercial rigour applied by venture fund managers. These are likely to displace rather than enhance the development of a venture capital market, and the authors suggest shifting funds from these schemes to the VIF programme.

Refinements to the tax and regulatory environment are also necessary to aid the sector's development, including implementing limited partnership arrangements, removing tax impediments on trans-Tasman capital flows and ensuring investment in venture capital is not tax disadvantaged compared with other investment options. Tax losses generated in the early stages of a business's development should be able to be offset against future income even if the shareholders change, and the sale of patents should be taxed in a way that's consistent with the sale of other capital assets.

And most of all, the authors caution that, when it comes to developing a self-sufficient venture capital market, patience is needed. "The historical record suggests that ... public sector initiatives take a long time to bear fruit."

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