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Australia Venture Capital Industry Review

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                    Submission to the

                  Federal Government’s

Australia Venture Capital Industry Review


           Momentum Funds Management Pty Ltd

                       June 2005
Name of Individual/Organisation:   Momentum Funds Management Pty Ltd

Contact Name/Position:             Dr Ergad Gold, Director

Address:                           Suite 2, Level 1, 230 Balaclava Road
                                   Caulfield, VIC 3162

Telephone:                         03 9508 9333

Fax:                               03 9508 9343

This submission to the Federal Government’s Venture Capital Review has been prepared by
Momentum Funds Management Pty Ltd (“Momentum”).

Momentum is a venture capital manager based in Melbourne and was one of five successful
licensees in the first round of the Government’s Innovation Investment Fund (“IIF”) Program.
As a result, Momentum had the opportunity to manage a $30 million fund focussing on seed,
start-up and early expansion Australian technology innovations. The fund commenced
considering investments in January 1999 and completed its investment program around the
end of 2002. Since that time, Momentum has been actively managing its portfolio, which is
exhibiting significant hallmarks of success, but has not yet realised any of its investments.

Since 2002, Momentum has been keen to raise a follow-on fund and build on its venture
capital management experience and provide a much needed source of professionally
managed venture capital to Australian entrepreneurs. However, the relevant private sector
asset advisors and fund managers have repeatedly informed Momentum that it would not be
able to raise additional funds until 2-3 of its current investments had been profitably exited.
This implies that, under current policies, a second Momentum fund will most likely not be up
and running until 2007 at the earliest.

Venture Capital vs. Private Equity
Momentum considers that much of the debate and analysis of venture capital in Australia has
been confused and misguided as a result of a blurring between two very different investment
classes: venture capital and private equity.

Venture capital and private equity are vastly different in almost all respects (see below).
Allowing these vital differences to be blurred has lead to a succession of erroneous
Government policies and programs which have provided assistance where no market failure
exists, and at the same time have inadequately addressed key infrastructure deficiencies in
areas of undeniable market failure.

Below we briefly set out the fundamental distinctions between venture capital and private
equity in the hope that the present Venture Capital Review, and any Government response,
avoids the confusion of the past.

Venture Capital & VC Managers
      Internationally, the term “venture capital” is almost universally employed to denote
      investment in early stage, technology-based ventures.

     This directly gives rise to three associated concepts:
     • Intellectual property - such as patents and technical know-how arising from the
        underlying novel technologies. This is crucial for providing a period of quasi-
        monopoly to allow commercial returns to be achieved.
     • Global market potential - to give rise to substantial commercial returns,
        commensurate with the underlying investment in R&D and commercialisation
     • Early stage venture – venture capital is almost inevitably dealing with small, early
        stage ventures which may be at their formation stage or a little beyond. As a result,
        they tend to have management structures which are incomplete, often being lead
        by the founding entrepreneur(s) until sufficient scale and market acceptance is
      achieved to justify the salary structures expected by experienced professional

   Debt finance is not usually open to early stage technology companies due to the lack of
   tradeable assets, ie “bricks and mortar”. It follows that venture capital, including funding
   raised from family, friends and angel investors, is almost always the only possible
   source of funding for technology start-ups.

   Typical funding requirements depends on the nature of the technology, its stage of
   development, the time to market, etc but for the sake of illustration can be taken as
   $0.5 – 5.0 million for the initial funding round. Within this broad range, seed/start-up
   ventures attract relatively smaller initial investments, with only more established start-
   up/early expansion opportunities, often those seeking B and C round investment,
   justifying investments at the higher end. A related point is that very early stage
   ventures, which have not yet addressed fundamental technical, commercial,
   management and financial risks, are unlikely to command substantial pre-money
   valuations, leading to heavy dilution for the founders if excessive capital is raised at
   that stage.

   A classic venture capital fund will invest in 10-15 investments corresponding to a total
   fund size of around $50-100 million allowing for initial commitments and follow-on
   funding rounds. Funds much bigger than $100 million are very difficult to deploy in
   Australia due to the relative lack of more mature technology ventures, ie ones that have
   generally already demonstrated some interim success based on A/B funding rounds
   and can justify valuations in excess of $15-20 million.

   Thus a venture capital fund needs to manage a portfolio of 10-15 investments in early
   stage technology ventures with relatively embryonic management. Venture capital
   investment is inherently “active” with managers often being involved with investees on
   an almost daily basis to assist the entrepreneurs with day-to-day business matters
   such as recruitment, sales/marketing, patents, R&D, etc as well as longer term issues
   such as strategic planning and capital raising. Venture capital managers need to have
   a broad range of experience in business, technology, etc as well as personal qualities
   which enable them to enhance, foster and complement the skills of the entrepreneurs,
   while avoiding the natural temptation to take over. While venture capital managers act
   as Directors of their investees, this role constitutes a relatively small proportion of the
   time allocated to each investee.

   A professionally managed venture capital fund is one which:
   • Applies venture capital best practice in terms of portfolio structuring, investment
      methodology, hands-on value added investment style, etc
   • Has adequate scale and critical mass to ensure that venture capital management is
      the sole activity undertaken by the team, both to ensure focus, and to avoid conflict
      of interest with investment banking or advisory work which would otherwise be
      carried out to support operations. Given typical fee structures, the criticality
      requirement translates to minimum funds under management of around $50 million.

Private Equity & PE Managers
   Private equity denotes the general class of investments in unlisted entities generally in
   cases where:
   • A profitable company has growth opportunities which require additional capital to be
       realised. These opportunities are generally for “more of the same”, eg acquisition of
         synergistic businesses, extending the existing business model into new territories,
     •   An entity with a relatively secure future earnings stream is established.
         Infrastructure investments, such as for new toll roads, often fit this model.
     •   An arbitrage opportunity allows the purchase of a successful operating business at
         a perceived discount. This may occur when major corporations divest themselves
         of non-strategic, but otherwise successful businesses, or on occasions when listed
         companies are temporarily out of favour with the market.

     Statistically, private equity is dominated by the very large investments in infrastructure
     and MBO/MBIs, but also includes mezzanine and developmental funding of growth

     Private equity investments tend to be far larger than venture capital investments,
     typically ranging from $10-50 million - individual private equity investments may even
     exceed the total size of a venture capital fund. Investees have fully formed
     management structures and investments almost always involve profitable companies
     with, particularly in large deals, the total funding requirement being met with substantial
     additional debt funding, with security and interest cover being met by the investee’s
     Balance Sheet assets and operating revenue.

     Private equity managers are largely financial analysts and investment bankers since
     the nature of the task is largely transactional. There is little need for private equity
     managers to provide hands-on business assistance to investee companies since, as a
     pre-condition for funding, they are required to have highly credentialed management
     already in place. Private equity managers sit as Directors of their investee companies,
     but have little involvement in business operations, since experienced management is in
     place to run the company day to day.

     One final distinction is that private equity is largely focused on the domestic market, for
     example by acquiring and de-listing an ASX-listed entity, tightening its operations,
     acquiring synergistic businesses, and re-listing under more favourable market
     conditions, thus benefiting from both the general market turn-around as well as the
     productivity gains made in the business.

The Australian Private Equity Industry
In the private equity sector, there are a substantial number of conventional funds, such as
CHAMP Ventures, GS Capital, Catalyst, Hastings, etc, as well as a growing number of listed
and unlisted “cash box” companies such as Babcock & Brown, Investec, Allco, etc. There
may even be arguments that the market may be over-investing in private equity and that the
dealflow will be inadequate to sustain the weight of money now available in this sector.

The adequate supply of private equity does not appear to be directly related to any recent
Government initiative but to the investment returns eventually produced by some of the
earliest private equity managers (eg Catalyst, Macquarie Direct, CHAMP then known as
Australian Mezzanine Investments, etc). Interestingly, many of Australia’s pace-setting
private equity managers were initially drawn into the sector by the Government’s MIC
program of the mid-1980s and sustained through the intervening years by large financial
institutions such as Westpac, Macquarie, St George, etc.
The Australian Venture Capital Industry
The Australian venture capital industry is miniscule, both in absolute numbers of professional
venture capital management teams, and relative to the range and level of demand for
venture capital from Australia’s entrepreneurs, research institutions, etc.

Almost all of the existing have come about through some form of government initiative (IIF,
ATG, etc) but the support was unfortunately piecemeal and inefficient, thus failing to make
best use of the built-up experience.

Only two groups have had the opportunity to sustain their investment activities continuously
for 10 years or more. Starfish operated within Nomura Jafco for many years and has realised
several investments from that period. GBS operated within Rothschild for many years and
has also had time to achieve some successful exits.

While several VC funds (A&B, TVP, etc) were raised during the dotcom period, this appears
to reflect the aberrant market conditions of the time. Only two management teams, Starfish
and GBS, have successfully raised venture funds in recent years.

To our knowledge, the sum total of the professional venture capital industry in Australia is:

                                Incubated     Investing
            VC Manager                                                            Comments
                                 by Govt      Currently
        ROUND 1 IIF
         A&B                       NO*           NO        Origin in CP Ventures (Govt’s MIC Program)
         AMWIN / CHAMP             YES           NO        Origin is private equity group Aus Mezz
         CM Capital                YES           NO
         GBS / Rothschild          YES           YES       Origin within Rothschild
         Momentum                  YES           NO

        ROUND 2 IIF
         Foundation                YES           YES
         Nanyang                   YES           YES       Origin within private equity group St George
         Neo / Newport             YES           YES
         Start-up                  YES           YES       Origin is Govt’s Aust Technology Group
         REEF (IIF equiv)          YES           YES

         Innovation Capital        NO            YES       Only non-incubated, non-Govt VC manager
         QBF                       YES           YES       Launched by Queensland Govt via QIC
         Starfish                  NO            YES       Origin within Nomura Jafco
         TVP                       YES           YES       Origin is Govt’s Aust Technology Group
         Uniseed                   YES           YES       Founded by, and invests in UniMelb and UQ spinouts

          The Macquarie VC fund no longer operates as a standalone entity but the bank occasionally makes
          direct VC investments. New Zealand VC funds occasionally invest in Australia. The ASX-listed
          entity Biotech Capital previously made VC investments but now appears inactive.

          We consider professional fund managers to be those solely focused on VC management, ie they
          have no need to undertake investment banking or other income generating activities due to
          adequate fees generated from VC fund management.

Market Failure
The free market appears to be adequately supporting the provision of private equity. While
recent Government initiatives, such as the introduction of Venture Capital Limited
Partnerships and Capital Gains Tax exemptions may have assisted at the margin, there does
not, in our view, appear to be any further rationale for Government assistance to the private
equity sector given the level of support by the free market.
However by contrast, the provision of venture capital to support early stage technology
ventures can only be characterised as market failure. The inadequate allocation of venture
capital by the free market has persisted since venture capital first came to be discussed in
Australia in the 1980s, and despite a series of government initiatives (see below) that were
intended to catalyse a self-sustaining Australian venture capital industry.

The state and current direction of the market can best be gauged by considering some
recent, specific pointers:
     • Since the dotcom period, only two venture funds, Starfish and GBS, have been
          successfully raised in Australia, despite several fund managers, including
          Momentum, actively seeking to raise follow-on funds.
     • This “drought” period roughly corresponds to 3 years which is approximately one
          investment cycle in a conventional 10 year venture fund. Thus it can be considered
          that Australia has almost completely missed out on one investment cycle over the
          past 3 years.
     • In the period 1998-2002, several venture funds were launched, largely as a result
          of the 9 IIF funds, as well as other funds (eg J B Were, Blue Peak, Biotech Capital,
          Tinshed, ESCOR, etc) which came into existence because of the widespread
          interest in venture capital during the dotcom period.
     • The Starfish and GBS groups have had the longest sustained investing opportunity
          in Australia, as a result of their earlier existence within the major financial
          institutions, Nomura Jafco and Rothschild. Each of them have had over 10 years of
          almost continuous availability of funds available for commitment as well a sustained
          management infrastructure. Accordingly, they are the only Australian venture
          capital managers to have had a real opportunity to build experience and develop a
          track record of success – no other fund manager has had equivalent longevity.
     • The AMWIN IIF fund obtained a spectacular, early return due to the Looksmart
          investment, but has also achieved 2-3 other respectable exits from other, more
          conventional investments. Despite this, AMWIN (now called CHAMP) has not been
          able to raise a follow-on venture fund and was only able to raise a “development
          capital” (ie private equity) fund on condition it did not invest in technology ventures.
          The net effect is that an experienced and successful venture capital manager is
          effectively now out of the industry.
     • The ING Fund of Funds, which has in the past been a strong backer of venture
          capital managers, has been prevented from downloading funds to the sector for its
          latest fund.

The failure of the market is not even in contention – it is widely agreed by governments, all
sectors of industry, universities, etc. Paradoxically, it is even the view of the investor
community, largely the superannuation funds and their asset advisors, even though their
views may sometimes be expressed as “…the jury is still out in regards to venture capital in

In reality, this is based on the fact that almost no Australian venture capital managers have
demonstrated a successful track record of generating significant cash returns to their
investors at this point in time. Given that most current funds date from 1998-99 or more
recently, ie six years old at most, it is hardly surprising that funds established as 10 year
entities, providing patient capital to start-ups, and which in addition have had to contend with
the global downturn of the tech-wreck period, have had inadequate time to establish a track
record of success. It is generally conceded that most managers have constructed portfolios
that give every indication of eventual success, but this early promise is understandably an
inadequate basis for additional commitment of venture capital by the free market.
The market is perfectly entitled to be hard-nosed and rational and to wait for 2-3 more years
for individual managers to complete some successful realisations. However, we contend that
Australia does not have this luxury.

The balance of this submission will be solely concerned with venture capital since, only in the
case of venture capital is there:
• Clear evidence of market failure, and
• Major potential benefits commensurate with venture capital’s importance as modern
     economic infrastructure
providing a clear rationale for government intervention to stimulate the creation of a
sustainable venture capital industry. In contrast, given the absence of any evident market
failure, we cannot identify any rationale for further stimuli for the private equity sector.

Government Initiatives
The Government has recognised the deficiency of venture capital in Australia over a period
of approximately twenty years. A range of initiatives have been instituted but, at least until
the creation of the Innovation Investment Fund (“IIF”) program in 1996-7, no attempt was
made to identify, adapt and apply world’s best practice to the creation of a venture capital
industry in Australia. We briefly summarise the most notable past Government initiatives as

     Policy/Program                       Strengths                                   Deficiencies
MIC Program              - First experience for VC managers           - Short term focus based on tax issues
                         - No. of current VCs emerged from MICs       - Wrong investor class attracted
                                                                      - Timing issues (Oct 1987, Second
PDF Program              - Additional experience in tech start-ups    - More focused on mining than
                                                                      - Investors largely tax driven
                                                                      - Corporate structural constraints
                                                                      - Some management fee manipulations
Aust Technology Group    - Strong team attracted and trained          - One fund only - lack of critical mass
                         - Gave rise to TVC & Startup Aust            - Not catalytic - no private sector funds
                                                                      - One-off: Govt interest not sustained
IIF & REEF Programs      - Based on international experiences         - One-off investment cycles
                         - Manager selection via industry norms       - Long wait for follow-on funds
                         - Right signals/incentives for super funds   - Misguided belief in IIF roll-over
                         - Extensive experience for managers
                         - Some emerging investment success
VCLP/CGT                 - Potentially benefits Fund-of-funds         - Largely irrelevant for VCs
                                                                      - Most benefit to large private equity
                                                                      - Focus on O/S funds marginal for VCs

The Government also implemented the BITS and Pre-Seed Programs focused on meeting
the need for pre-seed funding. However, pre-seed funds need to be aligned to the wider
venture capital infrastructure since the success of funds providing small amounts ($0.1-1.0
million) of pre-seed finance is generally dependent on their investees being able to raise later
rounds of venture capital.

Of course, the same observation can be made about angel investors; while to our knowledge
there has to date been no specific Government initiative in regards to fostering angel
investment in Australia, this is often suggested by various sources. In our view, angels can
play a very useful role, but are also reliant on the availability of follow-on venture capital.
In summary, we submit that of all Government initiatives to date, only the IIF Program was
well informed by overseas experiences, and came closest to achieving the objective of
establishing a sustainable venture capital industry in Australia. The main shortcoming of the
IIF Program was its short-termism, ie its lack of recognition of the long timeframes which are
required to for managers to demonstrate a “bankable” track record.

Our recommendations to this Venture Capital Review (see below) reflect our observation of,
and direct involvement in the venture capital for almost all of its history in Australia, and
reflects our understanding of the strengths and deficiencies of previous policy initiatives.

This submission’s key observations can be briefly summarised as:

•   Venture capital in Australia is characterised by long-standing, debilitating market failure
    and consequently is fragmented, under-developed and sub-critical.
•   As a result, Australia lacks a critical element of economic infrastructure: a depth of
    professionally managed capital for the commercialisation of technology-based
    innovations. This infrastructure is essential for modern, innovative, diversified economies
    and its lack of development in Australia results in a wide range of well documented
    deficiencies such as the low level of business R&D, low levels of patenting relative to
    scientific publication, low levels of commercialisation by universities, CSIRO, the CRCs,
•   The immaturity of the venture capital industry in Australia is largely due to the drastic
    shortage of management teams who have had adequate time to demonstrate a track
    record of successful investment and divestment.
•   Shortage of qualified venture capital management teams places a far more significant
    constraint on the Australian venture capital industry than the oft-cited apparent shortage
    of capital prepared to invest in venture capital funds.
•   Demonstrating a track record typically requires approximately one full fund management
    cycle of almost 10 years, ie 2-3 years of investment, 3-5 years of investee management,
    and 3-5 years of divestment. However, paradoxically, unless a team is continuously
    undertaking all fund management processes, by being allowed to manage 2-3 successive
    funds, the growth of its experience and expertise will be drastically held back by the stop-
    go investment/management/divestment phases.
•   There are strong economic grounds for Government intervention:
       • Venture capital has been a persistent area of market failure for 20+ years
       • In modern economies, venture capital provides critical economic infrastructure for
           innovation, R&D commercialisation, etc. Like other forms of infrastructure, it is not
           easily provided by the free market until its viability as an asset class has been
•   If the Government wishes to address the scarcity of venture capital in Australia, the most
    critical need is to foster the establishment of sustainable venture capital management

Accordingly, we recommend that:

Venture Capital vs. Private Equity
    That the Government carefully distinguish between the terms “private equity” and
    “venture capital” in its policies and programs, including the present Venture Capital

    That the term “venture capital” be used solely in relation to investment by professional
    fund managers into early stage (ie seed, start-up and early expansion stage)
    technology based ventures.

Economic infrastructure

    That the Government recognise that venture capital is a key element of the economic
    infrastructure required to underpin a modern, innovative, globally focused economy.

Market failure

    That the Government recognise that venture capital has been, and continues to be, an
    area of persistent market failure in Australia.

    NOTE: This market failure only applies to venture capital as defined above. There is
    ample evidence that market failure does not extend to private equity which appears to
    be adequately supported by the market.

Facilitate VC sustainability

    That in the light of this market failure, the Government recognise the imperative to
    implement effective policies to foster a sustainable venture capital industry in

    That the Government recognise that the critical impediment to the emergence of a
    sustainable venture capital industry in Australia is the availability of a critical mass of
    venture capital management teams with a consistent, successful record of investment.

    NOTE: Most previous discussions have tended to focus on the supply of capital to the
    sector. We contend that the appropriate capital is abundantly available in Australia and
    that the core impediment is the supply of management teams which are “backable” by
    the free market.

    That the Government recognise that venture capital managers can only establish the
    required record of consistency and success through a period of at least 8-10 years of
    continuous investment.
    NOTE: Given conventional fund structures and investment timelines, this requires fund
    managers to operate at least 3 consecutive funds in order to allow time for the earliest
    portfolio to begin to demonstrate commercial success.

Target no. of managers

    That the Government target having at least 20 professional managers actively
    investing in Australian venture capital opportunities at any time.

    NOTE: Allowing for fund specialisation (eg IT, biotech, renewable energy, etc), critical
    mass must be considered in relation to the range of innovative ventures seeking
    funding, aiming to ensure that the most promising ventures are able to access at least
    3-4 actively investing managers prepared to consider investments in their field. The
    needs for investment are not uniform with, for example, far greater demand for IT
    funding, so it is best to define the initial need in terms of a total availability of at least 20
    fund managers actively investing venture capital funds at any time.

    That the Government recognise that achieving the above target number of managers
    can, in the short-medium term only be achieved by a dual approach of:
    (1) Sustaining and building on Australia’s existing base of experienced venture capital
    management teams
    (2) Catalysing the formation of new venture capital management teams

Mechanism: IIF Licences

    That the Government recognise that the IIF program is the only substantially proven
    mechanism for facilitating professionally managed venture funds in Australia.

    That the Government recognise that achieving the target number of managers can, in
    the short-medium term only be achieved by instituting two dual IIF-based programs:
    (1) A Sustaining IIF Licence Program aimed at sustaining and building on
    Australia’s existing base of experienced venture capital management teams
    (2) A New IIF Licence Program aimed at attracting new venture capital management
    teams into the industry

          New IIF Licence Program

    That the Government award 20 new IIF licences via four rounds of five licensees
    each. IIF rounds should take place every two years commencing in 2005/06.

    NOTE: For ease of facilitating the sourcing of matching private capital, the new IIF
    licences should follow the original 2:1 leverage mechanism rather than the messier
    “reverse auction” formula used in the second IIF round which seemed to add little value
    but added greatly to delays.
    That new IIF licences come with an entitlement for each licensed manager to raise up
    to three consecutive IIF funds provided the manager remains in good standing and is
    able to meet the requirement for 1:2 private sector funding.

   NOTE: In seeking to foster the build-up of new venture capital management teams, it is
   essential that the IIF Licence arrangements reflect past lessons and ensure that the
   licensed managers be given adequate time and investment experience to build up the
   track record required by the private markets. This enhancement would also bring the
   IIF Program more closely into line with the US SBIC Program (which partly
   underpinned the initial concept of the IIF Program) where there is no limit to the
   number of consecutive SBIC Licences that a manager can obtain.

         Sustaining IIF Licence Program

    That each existing Round 1 and 2 IIF manager who remains in good standing be
    immediately licensed to raise two more consecutive IIF funds.

   NOTE: This one-off initiative is designed to retain and build on the existing base of
   venture capital managers, as well as ensuring equity and continuity with the above new
   IIF licensees. It could be argued that a separate Sustaining IIF Licence Program is
   unnecessary since existing IIF licensees could apply for new IIF licences. However, we
   contend that it is best to consider the New IIF Licence Program as the main
   mechanism for attracting new management teams into the industry, thus gradually
   lifting the base of experienced venture capital managers to the desired target. If the
   New IIF Licence Program is “contaminated” with existing managers, their greater
   experience may tend to crowd out new applicants and there is likely to be a loss of
   focus on the intended outcome, ie the need to gradually build up the number of active
   venture capital managers.

Monitoring & Reporting

    That in its statistical analysis of the venture capital industry, the Government put
    greater emphasis on reporting on the number of professional venture capital
    managers rather than the current focus on the level of funds under management.
    Reporting should specifically distinguish between managers who are actively investing
    in new opportunities, as well as those managers who are managing existing portfolios
    but not in a position to make new investments.

   Submitted by Momentum Funds Management Pty Ltd

   Ergad Gold (Dr)
10 June 2005

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