Opinion: The state of play for New Zealand's venture capital industry
The question of the future of the NZ Venture Investment Fund is the trigger for one of the most important questions right now in New Zealand – how early stage venture capital in R&D, innovation and technology is funded and managed.
It goes beyond the question of NZVIF, which is a legacy institution and served a different purpose in the past. NZVIF is, in effect two institutions – an investor of the $50 million Seed Coinvestment Fund co-investing alongside angel investors to date in over 230 seed and VC stage companies and manager of 11 secondary stakes in established funds. It has a team of just five investment managers, which is small relative to the number of investments. Profit maximisation of these holdings for the government by the existing team is possible with many different options.
The more relevant questions are what is needed in New Zealand now for supporting VC investments, why is it needed, what is the investment strategy or premise, what size capital is required, who should manage this capital, and how should it be funded.
An additional topic raised by some parties concerned NZVIF will morph into a larger government-funded VC fund making direct investments or that corporate investors form a fund, is an industry standard investment strategy and the independence of the fund management team to make investment decisions. Anything less is not workable or good for venture capital in New Zealand as it could provide unfair competition in the market, trigger conflicts of interest or is not commercial for potential and future co-investor VCs. My argument is for the independent and profit-incentivised management of such a fund based on an agreed and fixed strategy.
After interviewing many people, I've found there is a gap in New Zealand in capital and expert investment fund management teams in the early stages of growing innovation, private and public sector research, productivity investments, development funding, seed funding and commercialisation ahead of what is called the growth stage. Research is funded by dedicated government and university-funded programmes. Angel funding and crowd funding are very active but often tap out at management resources and follow-on capital and lack a consistent investment strategy., As many people have observed growth equity in NZ is well supported by multiple funds and family offices.
NZ VC is not the same as that in US or Israel in that it is still earlier in its development, NZ is a small island based market, it is still building a track record (but there are now many examples of NZ companies that have been grown and funded by VC, albeit mostly non-domestic VC or angel VC), it lacks dedicated VC investment management teams in the $10 -20 mil investment range with track records and only one NZ company has ever listed on Nasdaq. It can still benefit from Government support through co-investment to reach critical size although there is growing interest from the private corporate sector.
The VC investment driver expressed by the NZ Innovation mission to Israel of low R&D as a percentage of GDP is just a number but the key issue is what the objective of increased spend in R&D is and if it is research or development that is lagging. There are other measures that are also critical to New Zealand including benchmarking productivity as this is key to competitive exports, a defensive domestic market and using rather than reacting to disruptive technologies such as AI, cloud computing and big data. Increasing productivity is not just about investment capital but also needs better public awareness, skills training and up-scaling. The Strategic Insights Panel is also looking at key sectors which could boost New Zealand's GDP where these could also be targeted sectors for VC investment.
Role of government
The government typically funds 100% of early stage research through institutions using grants or budgets. Sector research (automotive and aerospace in the UK for example) is often done with dual funding from government and industry groups and private companies. The government, in effect, subsidises the investments by the private sector but also leverages the use of university and specialist research teams.
The next stage of funding (venture capital) is supported in the early stages of its development or in new sectors by government sponsorship of private VC teams based on carefully reviewed strategies and the expertise of the team. The team will seek to raise private capital alongside the government funding, which is normally up to 25% of the total. The government invests as an LP, the management team is privately held and the fund invests based on a commercial strategy. In very few situations are the returns of the government as an investor capped or able to be bought out (as in NZVIF), Government typically invests pari passu as an LP alongside other LPs but may carry specific LP termination rights as well as the right to be an observer to the Investment Committee.
What is needed now?
1. Early stage:
* Callaghan, the universities and other supported groups are covering research funding, which is 100% government funded as grants or loans.
* The private sector has the opportunity to further increase its use of the research capabilities – in some countries such as the UK there are specific sector industry-government research initiatives. In New Zealand, there could be opportunities in low carbon emissions, construction technology, earthquake design, food processing, sustainable tourism, energy efficiency etc.
* Callaghan and the universities should have strong links to VC private capital to bring co-investment and know-how to the commercialisation and development of research projects. Joining up the ecosystem is a clear objective in what is a small market to leverage its success.
* NZVIF has been providing capped funding for early stage investments to a large number of direct and co-investments but these often need larger capital commitments to follow the investment through to growth stage as well as deeper and far more active VC management skill sets and networks. NZVIF’s management team compared to private sector teams may not be 100% aligned with these investments in terms of profit share, exit strategy and as an active co-investor. It holds the investments but does not appear to be under pressure to force exits or sell on the stakes.
2. VC funding – private teams
* There is a gap in New Zealand for one or more large Series A, B VC funds that are significantly larger than the capital provided by NZVIF and which can invest up to $5-15 million per investment. These funds could offer co-investment rights to investors to enable larger investments. The size of this fund should be determined by the investment strategy of the management team raising the fund based on a robust and well-researched strategy. It could be $150 million as a first-time fund to establish a track record and so raise follow-on funds. Fund size is not typically linked to returns unless the fund is subscale and cannot support a full team or invest based on market opportunities (in terms of million dollars). The argument is for one of the more larger VC funds rather than smaller and capital constrained funds.
* The scope of the new VC fund is to invest enough capital to take selected and screened companies through the process to attract the best management team, build a commercial product or business model and launch the business to a stage where it would be eligible for larger growth capital investments. Typically, after the first rounds of a VC fund, international and larger VC funds support the next stages as required but this decision is often not based on just capital but on the value brought by the VCs.
* The number of investments should be eight to 10 so that the team can manage them actively.
* The fund management company should be independent, privately owned preferably by the management team and so accountable to the investors based on their track record, investment skills, resources, investment strategy, value-added strategy and exit plans.
3. Government support for VC
* Governments in most countries typically support the development in the early stages of VC of new teams, new sectors or new strategies. This is done through selected investments in private funds up to 25% or tax incentives for VC investors.
* Government support for such a new VC fund in New Zealand should be based on a discussion of what the investment strategy is, what the expertise of the team or teams is, what the returns are, what sectors should be the focus of the strategy and why.
* This is a topic many existing VC and growth fund managers and institutions in NZ can contribute to as well as others that appear to now be active in the market including the Strategics Insight Panel and the New Zealand mission to Israel.
4. Alternative models, funding for VC funds, NZVIF
* To address this opportunity now, there is also a discussion of whether funds could mix VC and growth and also invest outside New Zealand to provide follow-on for New Zealand investments – these restrictions are often set by investors.
* NZ Super Fund has recently invested in the three most mature of the PE and growth sector funds but also makes direct investments in VC internationally and domestically (LanzaTech $60 million). There is, therefore, an argument that is could allocate funding to a diversified New Zealand early stage VC fund. Such an investment could at least match the LanzaTech single investment. The same potential exists for the KiwiSaver funds. While citing liquidity as the reason for short-term investments, the liquidity churn for these funds is small allowing a real commitment to longer-dated investment in the VC sector – “aggressive fund” allocations.
* What happens to NZVIF is, in fact, independent of this discussion as there are two topics – how the government wants to manage the legacy of NZVIF and maximise the value of its holdings and how or if it wishes to support a new VC fund with its own private team. Mixing the two does not explore all options or open it up to private consultation. Profit maximisation under the first topic is a separate business strategy from the second.
* However, if there is a new VC fund or a restructuring of NZVIF, it should be privately owned and managed, have an investment strategy that is aligned with potential larger US/Asian/ Australian or corporate VCs (as co-investors), have an institutionally robust strategy and compete for investments on the same terms as existing VC and PE funds.
5. Drivers for VC funding
* Early stage New Zealand companies lacking capital of size cannot grow to their potential; they will either stay small, be selectively acquired (cherry-picked) by large international VCs, list on the stock market prematurely or fail. It is imperative there is a domestic VC market to build this sector in New Zealand.
* New Zealand is successful in innovation but it needs to always build exports and to improve the performance and productivity of its domestic companies – to do this funding should be available at the right size from early stage through to growth and later stage.
* The ecosystem in New Zealand from research, angel, seed and VC to the later stage should be highly visible, easily accessible and known to all companies as well as potential foreign investors. It should not have gaps to be fully supportive.
* VC funding should be large enough to support the business plan of those businesses that are most likely to achieve globally competitive scale. This amount is also of a size the investment management team can justify the people, resources and time to actively manage the investment. In New Zealand, this is believed to be in the range of $5-15 million over a total of 10+ investments. The track record of 10 investments would allow the fund management team to create a track record and raise successor funds (as New Zealand growth funds have done)
Options for NZVIF
Many options exist for the NZVIF building on its experience as an active investor in early stage VC in New Zealand. If NZVIF were divided into two parts, the funds of fund shares in the various PE/VC funds could be sold as secondary sales with the proceeds to the government or they could be managed under contract to the existing team with a clear exit strategy. The question of the early stage SCIF stakes is more complex as the optimal strategy would be that there is a business plan agreed with the government for these stakes taking into account follow-on funding, active management and team and then the full potential of the investments could be realised.
Taking NZVIF private and/or the management and realisation of the government investments are all possible depending on the business plans of the management team and the policies and objectives of the government.
If the successor to NZVIF were to enter the market as a larger VC investor, it should be as a privately held and managed fund with private capital invested alongside any government commitment and targeting institutional investment returns competitive with the market.
Michael White is a Europe-based expatriate who, since 1996, has raised and managed four pioneer independent venture capital funds totalling over €260 million, the first VC fund for central Europe, and the first renewable energy fund for central Europe.