Benjamin Thornley, Investor Weekly, 22 November 1999
FOR Rothschild, it was a telling mistake. Through its recently-launched venture capital vehicle, the Arrow Development Fund, the manager took a position in unlisted car battery producer, Apollo Batteries. Seven years later and Apollo has been suspended from trading on the Australian Stock Exchange for the past 18 months.
While according to sources Rothschild looks like returning its stakeholders an average 10 per cent per annum when the fund winds up around 2002, the result is a far cry from the 15-25 per cent expected from most development capital investments.
Not that Rothschild's story is unusual.
As superannuation funds increasingly look to add value through alternative investments, the venture capital industry - estimated at $3.8 billion including infrastructure investments - has become one of the fastest-growing segments of the market. While most investors are aware of the high returns the sector can produce, Rothschild's experience serves as a reminder of the potential risks involved.
And although sources were hesitant to discuss specific unsuccessful development capital funds, for fear of damaging the sector's credibility, they confirmed some funds had done a "lot worse than Rothschild."
Of the 10 to 20 investments a typical development capital fund will make over its lifespan, at least one is usually expected to lose money, according to Gresham Private Equity Limited director, Les Fallick.
"In a typical $100 million, you're expecting one or two investments to
do nothing," he says, "you're expecting one or two investments to really
shoot the lights out, and one investment you'll probably get nothing back from."
"In the middle there'll be six or seven investments where you get an average
25 to 30 per cent internal rate of return. They are the real determinants of whether
the fund is spectacularly good or average," he argues.
One of Australia's oldest-running venture capital companies, BCR Asset Management, can vouch for just such a scenario.
Executive director of BCR, David Ciracovitch, confirms that in the 10 years from 1984 when its Enterprise Development Fund was run out of Adelaide, the manager "had some failures."
However investors, including primarily the South Australian state government, were paid out in 1994 to the tune of a 14 per cent average annual return over the entire period.
"They were pretty happy with 14," he says. "Investors would argue that's an acceptable return."
Like Fallick, Ciracovitch suggests that out of 10 investments, two will probably be great successes, two might go "belly up", and the rest might earn average returns.
"There can be no bones about it. Venture capital is at the high-risk end of the investment spectrum. Investors are still only starting to put their toes in the water," he says.
According to Fallick, a development capital fund can run into problems for three main reasons. First, it can simply be bad luck; second, it can be a function of inadequate processes, and; finally, it can be the result of an unexpected major market downturn or recession.
"You can't do anything about the first and third," he says, "but
you can do some due diligence that tells you about the second."
"You can examine the processes a manager uses for deal selection, deal due
diligence, and deal management."
Which leads Fallick to the importance of people.
"You're investing in people at two levels," he says, "the guys that do the investing, and through them company management teams."
Although Rothschild declined to comment for this report - saying it first wanted to brief its investors before showing Investor Weekly its latest Arrow Development Fund annual report - it is understood one of the main problems for the manager was that some of its team walked out after just a couple of years managing the fund.
"You need to make sure the investment team has their incentive linked to your incentive and receives rewards when the fund liquidates," Fallick says.
"You also need to do some due diligence about whether the people have human skills," he argues.
"There's not a formula in development capital, it's a judgement call."
BCR's Ciracovitch agrees: "Whether we like it or not we're in the business
of picking winners. You're relying on the calibre of managers. You need to pick
your manager carefully and at least have someone with a track record."
Interestingly, in the US, according to chief executive officer of the Development Australia Fund, Ian Court, where managers of listed equities "tend to have ups and downs," in private equity the best managers often remain in the top quartile for 10 to 15 years."
"It's partly to do with the fact the manager puts together a top quality team and they stick together," he says.