Tuesday, July 5th, 2011 - Machel Advisory Services
Early stage venture capital limited partnership: Have they lived up to the expectations?

Trawling through the Ausindustry website, one will notice that there are only a handful of fully registered early stage venture capital limited partnerships (“ESVCLPs”) with some additional ESVCLPs having been granted conditional registration on the proviso that they do manage to raise the necessary capital. The ESVCLP regime has been introduced four years now, yet the take-up of ESVCLPs has been poor so far in comparison to its predecessor (the Pooled Development Fund regime, now grandfathered, had 126 registered entities at its peak). Is it a matter of bad timing, a lack of funding appetite in an area that is underserviced in the Australian investment landscape or the wrong incentive offerings? Arguably, it is a combination of all the above i.e. the global financial crisis, lack of familiarity by Australian investors with the ESVCLP model, a certain bias towards a unit trust model by the funds management industry and certain regulatory and legal constraints imposed on ESVCLPs.

The ESVCLP regime was introduced by the Australian Government with the aim to attract both domestic and foreign investment flows in risky startups. With a partnership structure, ESVCLPs were seen as the most appropriate vehicle to attract offshore venture capital investors given that the latter would already be familiar with this type of investment structure. However, as alluded above, there has not been a flurry of investors to get the momentum going and increase the level of investment activity in the early stage venture sector.

By way of background, ESVCLPs are transparent vehicles for Australian tax purposes and there are significant and generous tax incentives for both domestic and foreign investors. Essentially, any income (essentially distributions from investee firms) and the gains from the disposal of the investee firms flowing from the ESVCLP to both domestic and offshore investors are exempt from Australian tax (save for the return on carry interest). The flip side is that losses generated from an investment cannot be utilised by the investors. This is a natural outcome to a large extent. However, there is a certain imbalance between the tax incentives and the wastage of losses. Early stage ventures are high risk in nature and the likelihood of realising a gain on an investment is fairly lower compared to crystallising a loss. Also, the likelihood that investors receive a distribution from an early stage venture is virtually inexistent. This means that the tax incentives are of limited benefits; this view can be supported by the fact that the Government expected to have a loss in revenue of only $16m in the 2010-11 financial year when it first introduced the ESVCLP regime back in June 2007. Given the lack of take-up, presumably this forecast has gone south.

Notwithstanding the above, we are not of the view that losses should flow to investors; investors cannot have it both ways (tax free gains and use of tax losses). An option would be to allow the losses to flow to a special purpose vehicle (“SPV”) set-up to hold ventures that have been spun off from the ESVCLP; such spin off would be necessary due to either the venture having exceeded the ceiling asset threshold level or to allow future reinvestment(s) in new publicly listed ventures. The SPV is not afforded the same concessional tax treatment as an ESVCLP and therefore allowing the use of losses in that instance is more ‘palatable’.

Investment restrictions imposed on ESVCLPs have been a deterrent for fund managers. There is a requirement for ESVCLPs to divest out of an investee firm once the ceiling asset threshold, being $250m, has been breached. In addition, 1) ESVCLPs are not allowed to hold investments in publicly listed companies (save for pre-IPO investments) and 2) the activities of the underlying investee firms are broadly confined to non-financial and non-property related active businesses. Whilst the above may seem restrictive, ESVCLP was not meant to be a one size fits all investment vehicle. The inherent nature of early stage ventures meant that some restrictions should be imposed to align the investment activities of ESVCLPs to the policy intent. If an investment is no longer an early stage venture, it is a matter of divesting it to an associated SPV. It is not uncommon for funds managers to be managing stapled funds or ‘sister’ funds. As part of the divestment, any profit made will be tax free (save for the return on carry interest) and the SPV will benefit from a step-up in the cost base of the investment on transfer.

Another major roadblock is the fact that an existing tax carve-out for Pooled Development Funds has not been replicated for ESVCLPs. This simply restricts the ability of fund managers to invest in ESVCLPs via an interposed trust structure because this would mean that the tax free concession of the ESVCLP regime would effectively be lost.

The ESVCLP, in its current form, should not be discarded as an investment vehicle. The regime is flexible enough to cater for early stage ventures and ventures in expansionary stage. With the Board of Taxation expected to submit a review of the whole venture capital limited partnership regime in the near future, there is an expectation that some of the above impediments will be addressed to increase the attractiveness of ESVCLP.

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Machel Advisory Services


Machel Advisory Services is a boutique advisory firm with focus on capital raising, exit planning and tax advisory for start-ups and growing businesses. For a tabular comparaison between an ESVCLP and a unit trust structure and their respective operations, please email us at [email protected]


Yanese Chellapen
P: (03) 8635 1987
W: www.macheladvisory.com.au

Keywords

Venture capital, ESVCLP, early stage venture capital limited partnership, capital raising, VC

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