Literature Review Of Australian Private Equity And Capitaly
Private Equity has been considered as a fast developing investment which offers investors a high return because it is focusing on investments in high growth potential companies. By providing financial and management aid, Private Equity increases the value of the firm; followed by an exiting process, a high investment return is achieved.
The Venture Capital investment is one kind of Private Equity investment which focuses on investing in the company which is in the seed and early stage. This literature review focuses on the academic articles which are specifically research on Australian Private Equity and Venture Capital market and mainly analysis about the topics of: benchmarks and historical performance; investment characteristics; roles in portfolio management and the broader economic effects of PE and VC.
The latest academic researches on private equity and venture capital in Australia combined with some data that is generated from Australia Bureau and Statistics show the private equity and venture capital market has been developed rapidly in pervious years. Based on 27 academic articles, 4 reports from AVCAL and 2 reports from ABS, this literature review have been done which focus on the 4 topics including main issues in alternative investments portfolio management. Researches which are done by the AVCAL (The Australian private equity and venture capital association limited) and ABS also provides some information to help the investor understand more about the PE and VC market in Australia.
Benchmarks and historical performance of Private Equity and Venture Capital:
Private equity and venture capital form a multi billion dollar industry in Australia and is a significant part of the economy. According to the report ‘Value Capital: The Evolution of Venture Capital and Private Equity in Australia’, venture capital industry has performed to the scale where it can be compared with any other country venture capital industry. It mentions about the boom in the private equity market between 2003 and 2005. As at 30 June 2008 the amount of capital employed is more than $10.6 billion in venture capital and private equity. The report states that the Australian private equity has performed well and is one of the best when it comes to improving the value of the investment. Buyout and later stage PE funds formed from 1985-2007 gave an IRR of 9.9% as at 30 June 2008. The overall IRR of the Private Equity funds was 8.5% over a 20 year time period. The recent crisis adversely affected the investment in private equity. Venture capital has also performed well so far. The survey performed by Ernst and Young in 2008 showed that PE grew by 21% against the publicly listed companies which grew by 11%.
Source: ABS, Venture Capital and Later Stage Private Equity
Source: Thomson/AVCAL Yearbook 2008
A Brief Summary Of the history of Private Equity and Venture Capital:
In 1970 the first VC fund was formed. In 1984 the government came up with the idea of MIC program in which there were investment vehicles. In 1987 the first PE fund was formed and in 1992 large corporate investors started coming in. Also AVCAL was formed with 17 funds. The Australian Technology Group was formed to invest in emerging IT companies. In 1997, the government formed an Investment Innovation Fund and AVCAL reported the growth of funds to 40 with $2.7 billion. In 1999, the government introduced a program to fund early stage growth firms and gave various tax concessions to US and pension funds. In 2006 high profile PE deals such as the acquisition of Brambles Cleanaway and Seven Network were done. In 2008 it was observed that over $1.68 billion of PE deals were done in Australia which is more than China and Japan. In 2009 the government has provided the IIF with $83 million of follow on fund.
In the late 1980s VC got hit by the recession and was growing very slowly. In the 1990s especially in the later years there was IT boom which helped in VC growing faster with some of the deals reaping huge returns. In 2002 the VC got affected with the flow of cash in the funds because of the bursting of the IT bubble. The VC capital investments have increased from $1 billion in about 300 companies in 2000 to $2.7 billion in 700 companies in 2008.The Australian VC funds have not been able to attract the Super investments which prefer US venture capital investments despite the fact that they give competitive returns too.
Source: ABS, Venture Capital and Later Stage Private Equity
Started in 1987 AMIT raised $30 million and Byvest raising $95.5 million. Since the inception of superannuation funds was made compulsory, it increased the amount of capital investment from the domestic market. This helped in increase in employment and quality of investments was better. Australia had a very good PE infrastructure and was giving record returns in 2002. The Asian market was not performing as per the investor’s expectations, so as a result PE market was in boom in Australia. The number of PE deals had increased and included acquisition of high profile brands such as MYER by TPG. This led to investor confidence in the market and the share prices were increasing. With the recession coming in 2007 the PE deals got hit and there was a decline. By 2008 the amount of funds invested in PE had decreased to $6 billion from $11 billion in 2007.
Source: ABS, Venture Capital and Later Stage Private Equity
On the other hand, one of the article mentions about Australian funds being very small, the reason is that there is no limited partnership funds but pooled investment funds.Venture capital and private equity contracting: an international perspective
Another article talks about the review taken by the Australian government in 2004 of the venture capital industry and the impact of the government programmes. The review found that the venture capital industry was underdeveloped. There were low levels of investments, inadequate of capital formation and lack of investment managers with a proven track record. It was underdeveloped in contrast to the country’s Research and Development activity and in comparison with other nations.
Josh Lerner and Brian Watson (2007) found that, The underdeveloped venture capital market was accompanied by robust LBO market. For venture capital industry, there were very few reliable sources of data. The venture capital in Australia is much below US and UK and even lags behind the new and growing venture capital markets of Korea, etc. It is lowest among the developing countries along with Austria. After the review of 2005, the Australian government took various initiatives to boost the venture capital market such as the establishment of Early Stage Investment Vehicle which was tax free to investors. Innovation Investment Fund programme was continued.
An article ‘Journal of Industrial Relations’ contains information about the Private equity in Australia and its growth in the last two decades. The volume of assets in the managed funds was $263,974 million in 1993 which has increased to $1,363,108 million. The share of the pension funds was 84% which declined to 59% in 2007(ABS, 2007).Nevertheless private equity forms a very small proportion of the total capital funds in the market but it has increased in value over a period of time. The number of transactions related to it is not much in number but a considerable increase from $2 billion to $14 billion has been seen over the period of 5 years till 2006.
The reasons for high returns on private equity are as follows:
Because the private equity sector is non transparent, the returns are high. If a company is publicly listed, the information can be analysed and forecasting can be done to a certain extent. In the case of private equity the information is not easily accessible for such purposes.
It is beneficial as it gives diversification to an investment portfolio. The investment is appraised according to independent valuation and it shows the fundamental value of the investment. The returns of private equity does have a direct correlation with the equity market, but is affected by the changes in the market. An initial boost in the IPO’s can give a boost to the private equity sector which ensures that the IPO’s go at relatively good prices. This has ensured that the private equity fund that used to hold an investment for 5 years now holds it for only 3 years.
Although there is a secondary market globally, but in Australia it is still low. One of the benchmark used to measure the size of private equity is the ratio of the private equity commitments to the GDP of the economy. As compared to US and UK which have 2.7% and 4.8% of private equity commitments to the GDP respectively, Australia has only 0.9% which shows that there is a scope for expansion.
What does an investor anticipate when entering the Australian private equity market? Predictable return, limited risk, transparent laws, tax benefits? How attractive the Australian equity market, for both local and international investors?
The Equity market in Australia is relatively new, yet it is growing fast and well diversified across different investment types, stages, industries and ownership types. On the flipside the Australian market overall is relatively small and the percentage of the private equity in the market is small too comparing with USA and West Europe, this leads to illiquidity and volatile returns. All that in addition to the lack of information, characterise these investments with a high risk prospect.
The Australian Government shows throughout the years support for Private Equity and Venture Capital market in Australia. By providing different tax concession and creating different tools that encourage investors to enter this market.
The Australian federal government created in 1992 what is called Pooled Development funds (PDF), which is a tool aims to help improve private equity access of small and medium sized firms by offering registered PDFs tax concession and other incentives.
In 1994 change in tax regulation helped PDF program by allowing the distribution of dividends to be either tax exempt or by applying dividend imputation system, which resulted in a rapid growth in PDF capital investments, however this did not help in attracting overseas investors as they cannot benefit from the new tax regulations.
In 1998, another amendment of PDF Act took a place, the Government allows for the first time share buy-backs, which significantly increase the liquidity in the market. Also the Government allows superannuation funds to fully hold PDFs, as a step to encourage super funds locally and internationally invest in this market, before that they were only allowed to hold up to 30%. Also the Government allows PDFs to offer loans up to 20% of their capital. And finally the Government allow PDFs to merge under certain circumstances.
In 1999, more amendments took a place to make the investment atmosphere in Australia more attractive. The legislation was improved to facilitate the direct access of international superannuation funds into small and medium firms in Australia. Furthermore, the government improved the income tax assessment Act 1997 to provide more tax concession for investing in PDFs. (Australia chooses venture)
Return and Risk
Private Equity and Venture Capital returns have been difficult to study empirically because of the confidentiality of the information and the reticence of this type of investments to give out the return data on all of the involved investments in the portfolio. Investment bodies provide information on the overall performance of the industry without details on individual investments. Most of the available information about the returns of private equity firms is provided by studies about the required rate of returns of venture capital. (Manigart et al. 1997, 2002). These studies basically found that the required rate of return is highly correlated with:
Activity of the firm, such as syndication, exit strategy or value added
The experience of the venture capitalist
Whether or not the firm is specialized.
Different risk controlling, based on the investment stage; early, expansion or buyout.
Being captive or owner managed
In sum the return on private equity is related to the ability of the investment to generate added value.
Captive and owner managed VC
Bruno (1986) believes captive venture capital firms seek diversification in income streams, while all of manigret and struyf 1997, Riyanto and Schwienbacher 2002 and Hellmann 2002 belleve that captive venture capital seek strategic and competitive advantages and access to new technology or markets. As a result the required rate of return on captive venture capital firms can be lower as they satisfy other business goals. Conversely owner managed firms and insurance and superannuation investments are seeking capital gain (Gompers and Lerner 1996).
Specialized and non-specialized VC
Based on the standard portfolio theory, the required rate of return of specialized venture capital firms is higher than other venture capital firms; this is because of their lower diversification level by nature. Which leads to higher unsystematic risk as the companies in the portfolio will be in the same sector or stage. At the same time other venture capital firms can reduce the unsystematic risk by diversifying their portfolio (Norton and Tenenbaum 1993 and manigart at al. 2002 ).
On contrast, based on the resource-based theories; the required rate of return of specialized venture capital firms is lower than other venture capital firms because specialized firms have more experience and ability to estimate the risks related to each investment in their area of specialty whether it is an industry or a stage of the investment life. (Manigart et al. 2002)
Manigart et al. 2002 argue that some specialized venture capital requires higher rate of return when investing in other areas than its specialty. Whereas Amit et al. 1998 argue private equity and venture capital only invest (buy, monitor and add value) where they can create Alfa profits over and above the normal returns. Thus accumulating information and knowledge build up in specialized venture capital firm, which allows them to take better decisions and better indentify the risks. Ljungqvist and Richardson 2003 they support, as they argue that the more experienced the private equity investors are the better their choices are, with regard of greater returns and lower risks.
Roles in the portfolio management
Over here we are talking about what roles private equity and venture capital investments play in a portfolio or an overall portfolio management. When we refer to a portfolio in financial terms we mean the collection of assets. One should also know that portfolio has been defined in various ways by different persons. Summarising it would tell us that all inside and outside resources and assets and anything owned by a company would be included in its portfolio. Now we are going to see the importance of private equity and venture capital in a company’s portfolio.
The private equity market came up in Australia 1970s and therefore is an older form of investment. The venture capital investment is still fresh which started in early 1990s. The Australian government formed a programme to help the Australian businesses with venture capital and private equity in 1997 known as the innovation investment fund (IIF). Now there are nine IIFs.
The article that we are now going to talk about is Venture Capital Returns in Australia by Grant Fleming. He tells us how venture capital returns turned the face of various economies around the world. There was a decline in these investments and now again a rise can be seen. He started his research in Australia by taking portfolios of 129 companies and how venture capital investments have helped them. A company’s portfolio is largely dependent on its venture capital investments. The nature of investment is largely a presentation of the venture capitalist. VC investors can reduce additional cost of the portfolio company with their level of skill. Grant says about Cumming and MacIntosh (2001) where they say that value of venture capital declines with the portfolio over a period of time. Venture capital investments will add higher value to the portfolios of higher growth industries like the IT industry.
We now come across the private equity investments in Australia. He talks about the stages of private equity and how it has added value considering Australia as one portfolio. There was a major increase in these investments from the year 1992 to 2001. There was a decline in 2002. Balanced funds have played a major in Australian private equity compared to buy outs and expansion. When comparing LBO transactions of Australia to the world, Australia stands only at 2.5 percent till 2007  . This leads us to the institutions which help in managing the portfolios of various companies in Australia like Macquirie group, Wilson HTM investment group and Biard Capital Partners etc.
We also come across an article which talks about the benefits that the Australian firms receive in its portfolio management by going private. This article is “What motivates going private: An Analysis of Australian Firms” which has been written by Peter E Heddy, Kin Wai Lee and Stephen N Taylor. We see one company buying another and then converting it to a private based company. Some of the values that it adds to the company’s portfolio are that it reduces its agency costs to a large extent. Going private resulting in delisting which helps the companies reduce their costs like registration costs. Their criteria for disclosure changes as well which helps them save some of the vital information which a public listed company have to disclose. Secondly it created a channel for wealth distribution in the form of tax deduction, transfer in the wealth of employees and share holders and debt holders. It is worth mentioning the three major tax benefits which are
The tax deductibility of interest payments on debt used to finance the typical going private transaction
Increased depreciation deductions with respect to acquired assets and
The tax advantage of share acquisition through employee share ownership.
Another very interesting aspect of going private which adds value to the portfolio management is the way information travels. Once a company goes private it has information about its valuation and the values of listed companies. This gives them an opportunity to decide on their investments and to work on potential changes as their disclosure to the public changes as well.
Going private helps in controlling the free cash flow and reduced agency cost. The conflicts between the shareholders and managers are wiped of resulting in a control on the cash flow. Whereas a public organisation will have to distribute cash to shareholders if there are high free cash flow. This adds value to the overall portfolio of the company.
Now we come across a different type of venture capital investment known as “Angel Investors”. This article is known as “Private Capital for Private Companies” by Christine Kaine. It talks about the functioning of banks and financial institutions in Australia which according to the author were very reserve and orthodox in nature. She says that the Australians are not high risk takers. They believe in low investment and higher returns. AVCAL has played a major role in Australia by noticing the capital requirements and making investments in Australian business.
One of the main reasons as to why private equity and venture capital investments have not been taken up as compared to the USA and European countries are because most Australian businesses are SMFE in nature which account for 70 percent of the total businesses in Australia. Research shows that most of them are unprepared or ill equipped for PE investors. The literacy among them has to be increased with regards to PE and VC investments. The authors also say that in most cases PE investments have resulted in higher profits and efficiency. But somewhere down the line PE and VC investments are yet far behind in the Australian context and needs to grow.
The broader economic effects of Private Equity or Venture Capital investment
The Private Equity sector is having a growing impact on the Australian economy as a whole. The funds which are invested in companies, both in the initial stage as well as the later stages of development and expansion, has given rise to many positive outcomes in the economy. Some of the effects of the PE sector on the economy are a rise in employment opportunities, some social benefits, diversification and expansion of businesses, etc. We will now discuss some of these effects in detail.
Growth in the past years affecting the economy:
The private equity industry grew rapidly in the years 1999-2001 after which it slowed down up to 2006. In 2006, the Private equity funds committed was at the highest at 416 million Australian dollars. This has increased the amount invested in the Australian economy as the number of companies being funded by private equity reached nearly 900 in 2006. More than half the amount invested by the private equity funds was related to consumer related businesses, the health and technology sectors receiving more than quarter of the funds. Most of the funds (nearly 90%) were invested in Victoria, New South Wales, Queensland and ACT where almost 80% of Australians reside, whereas only around 6% of PE funds were invested in other non-capital cities. Relative to GDP, the level of Australian PE is around three quarters of that in the UK. As compare to other countries like the United States of America and Israel, the Australian Private Equity sector is only one third the size of theirs. Hence it can be seen that Australia has the potential to grow its PE sector furthermore, like countries with more developed economies and proper financial markets.
PE sector generates employment and provides training of staff:
According to the report by PricewaterhouseCoopers, the PE sector funded companies has generated over 650,000 jobs in the private sector, which contributes to almost 8% of total employment in the private sector. Also, considering that the PE sector has huge potential to grow in the years to come, it can be said with fair confidence that there will be greater generation of jobs in the coming years. Private Equity companies themselves provide employment opportunities and are known to provide training and internships for their staff. According to the survey conducted by PricewaterhouseCoopers, nearly 21% of the companies which were surveyed provide internships and almost 82% give training on the job.
PE accelerates the growth of companies:
PE funds help the growth of companies which in turn help the growth of the economy. The increase in post-PE investment allows more funds for companies to diversify and expand their businesses. PE investment has a positive effect on investee companies’ innovation, which has resulted in large firms spending more on research and development.
The respondents of the survey carried out by PricewaterhouseCoopers and AVACAL 2006 were from a wide array of businesses ranging from start-ups to established firms, thus indicating that private equity not only effects companies in their initial stage but even companies which are established benefit from it. A majority of the firms that were surveyed were positive of going public in the coming few years which shows the positive impact of private equity on companies.
The PE funded companies have shown to develop Australia’s human capital as the figures indicate below.
As seen from the figure above, 21% of the respondents offer apprenticeships, 82% of them offer technical training and 43% of them offer soft skills training. When it comes to offering external training the survey found that 14% of respondents offered training to management, 4% of the firms offered training to non-management employees and 39% of the respondents offered training to all staff. With the majority of firms offering training in some or the other form, the investee companies are responsible for improving the productivity of employees and ongoing Australian Research and Development. Also a majority of the firms share their wealth with their employees, with 79% of the respondents having share options.
As the need for alternative fuels and environmentally friendly products are in the rise, PE companies are funding research and development of companies involved in such production which is good for the environment in general. Therefore it can be said that the economic growth is well balanced by the corporate social responsibility projects and initiatives taken by them.
Investee companies benefit from the expertise and experience of the PE managers. There is improved cost management, more efficiency in production and workforce, new and innovative strategies and implementations and other such benefits passed on from the PE managers. This has caused an improvement in Australia’s workforce and productivity overall. Investee companies also have strong corporate governance as the PE managers work closely with these companies and provide risk management and strategic oversight.
PE investments have helped many companies sustain their operation and not end up going bankrupt or selling their business. Many surveys suggest that quite a few companies would have sold their business or cut down on production if it weren’t supported by PE funding. This has an impact on the economy as a whole. Companies shutting down and seizing production is a bad indicator of the economy and would affect people in general as jobs would reduce, spending power of the public would go down and other adverse economic effects would come into existence. Many of the big technological and medicine firms in existence today are a product of either venture capital or private equity. These companies are responsible for new age technologies, medicines, etc. which are of great importance in the modern world. These PE backed companies are also responsible for generating millions of jobs worldwide and a considerable new amount of jobs in Australia. They are also a key factor in the improved standard of living we see now-a-days due to the improved R&D departments funded by PE.
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