Lifting the VC logjam

By John Bowie

Tuesday 1st October 2002

Last month, something important happened for New Zealand's small, potential high-growth companies. After a year of waiting, the last Ts were crossed on five "term sheets" - contracts between the government and venture capital companies. The laborious process of handing out $300 million of start-up funding through the Venture Investment Fund (VIF) could begin.

Hooray for that. But the belated signing of the VIF deals has a wider significance. Industry players are hoping it will go a long way towards relieving an impasse in New Zealand's venture capital sector that has seen VC funding all but dry up over the past 12 months; an impasse in which - ironically - VIF was a significant factor.

The problem was perhaps inevitable, and probably unavoidable. The government previewed back in its May 2001 budget that it would put up $100 million of capital for "early stage businesses developing brilliant, innovative ideas with high growth potential" under the proviso its money was matched two for one by $200 million from the private sector. VIF was set up exactly a year ago, in October 2001. Trouble was, once the announcement was made, the VC market stopped. $300 million is a significant sum in the relatively small New Zealand venture capital scene and virtually everyone, whether venture capital fund, company needing capital or even investor, held off doing their deals until they knew the outcome of the VIF negotiations.

"There have been very few early stage deals done this year," says Jenny Morel of No.8 Ventures, one of VIF's chosen six (lately reduced to five) fund managers. She says the VIF process has taken longer than anticipated and there has been a significant deal slowdown to the point where things have virtually reverted to the industry's "early days". "We have been telling people for a year we aren't in investment mode and I can only think of a couple of other deals being done."

It isn't all VIF, of course. The venture capital industry has been hit by external factors; noticeably a worldwide VC downturn since the US market deflated last year. In Australia, the latest Australian Venture Capital Journal/PricewaterhouseCoopers VC survey reveals a collapse of investment from over $600 million in the December quarter 2001 to a paltry $76 million in the March 2002 quarter.

New Zealand's own tech-wreck saw investors like Strathmore and IT Capital all but depart the fledgling VC market. AMP Henderson, an early retiree from the VIF management process, has stopped early stage funding. Martin Turner, AMP's head of private capital, points to factors such as the US downturn, businesses like his busying themselves with existing investments, and general investor nervousness.

VIF and the government are hardly to blame for the worldwide wallet-closing on VC deals, but local industry participants say the seemingly endless road towards VIF's managers signing contracts has seen local deals dropping as fast as Air New Zealand wing parts. Take Howard Paterson's Quest Ventures - one of the funds chosen for VIF funding. Quest pulled out at the final stage because the long-term investment focus of its NZ Biotech No 1 fund didn't suit the government's decision that it would sell down its stakes within six years. Still, the VIF sign-off process and other factors meant Quest pretty much "closed up shop" in the months before the pullout, says managing director Stuart McKenzie.

Morel isn't the only one talking about slower-than-expected government processes, both before and after the selection decision. At the office of Research, Science and Technology Minister Pete Hodgson, spokesman Graeme Speden insists VIF is not a bureaucratic model and the process has been quicker than similar initiatives overseas. But frustrated managers - used to shorter lead times - say the VIF term sheet negotiations were delayed by unrealistic conditions being stubbornly adhered to, including, for example, a desire to tie managers into 10-year terms. There was also insistence from VIF on various operational processes and definition requirements.

VIF's desire to set the rules by which VC investment is made in New Zealand, regardless of investment type, has also created problems for the fund managers. VIF's stated objective is to "align and standardise the New Zealand venture capital market with standard international practice". This one-size-fits-all approach to the New Zealand market begs this question, argued one industry source: "How come VIF knows more about venture capital investing than the experienced managers it has appointed?"

VIF's board also caused delays, as did political considerations. Just one example: VIF manager Ian McInnes of the IO Fund, a joint venture between investment company Infratil and electricity network company Orion, says various VIF definitions could not be resolved during the election because ministerial approval was required.

VIF general manager Franceska Banga didn't comment on any criticisms about delays, instead referring Unlimited to a press release confirming the signing of term sheets with the five managers. She says complex issues with the managers have now been resolved and the documentation will move ahead "with due speed".

What now?

Although the investment logjam will break with the signing of the managers' contracts, the process is far from over, with many of our capital-starved companies likely to wait up to 24 months for funds. First, complex legal documentation needs to be drawn up, which managers worry could take some time. Then the chosen managers must secure institutional investment for VIF funds. Tony Bishop of iGlobe Treasury Fund and other VIF managers talk about low local institutional investor interest in the VC market due to the delays, the global equity market downturn and the tech wreck, although the fund managers all seem optimistic they can raise money. Once they have the money, all five funds have to find target companies for the money and finalise deals. While there may be a trickle of money going out before the end of the year - certainly Pete Hodgson will be looking for that - it is likely to be two or even three years from now before the full $300 million is used - if it is all spent. (Whether the money goes to the high-potential, high-risk seed and start-up companies it is aimed at, or ends up in the lower risk, expansion phase end of the market is another moot point: see Unlimited July 2002. And then there's the question of whether you can even spend $300 million on seed and start-up ventures ...)

Morel says she hopes to be able to raise the first $20 million of investor capital by November, at which time the government will release $10 million of the $15 million of VIF funds No.8 will get. She expects three or four investments in the first year.

IO, which will receive $20 million funding, expects to launch its $60 million fund in October.

The good news

So development of a start-up venture capital industry in New Zealand is delayed for 12 to 18 months? Does it matter? In some ways it does. There's little enough money around for start-ups as it is, and every month wasted means a greater likelihood overseas rivals will beat our New Zealand companies to major markets. But the frustration in the market is tempered by optimism.

"It's a pity it's been slow," says Morel, "but already VIF has done some positive things for the venture capital market in New Zealand." For example, VIF brought out advisers from Wiltshire Associates, a US-based investment company with $10 billion in assets. "We learnt a lot from them," Morel says. "Plus they did a fair amount of going round to visit institutional investors to teach them about investing in venture capital." VIF has given the sector more profile, more respectability and more excitement, Morel says.

TMT head Ross George is unconcerned about the delays, saying it's all part of the process. Deals have been held in limbo but now there will be no shortage for those who have the money. "Previously, there was a lot of silly money that went into silly things," he says. Now sensible deals can be done in a more price-realistic market.

At the minister's office, Speden is still enthusiastic. "There has been a hiatus of a few months where a lot of activity was focused round the fund and so there was a fall off in activity elsewhere. But I don't think that matters. Once it's started, people will get back to business buoyed by the pulse of the new money and the new excitement in the market."

He may just be right.

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