Focus: Private Equity – May 2006
The impact of the Federal Budget on the venture capital sector
In brief: The Federal Budget announced this month included a package of measures to increase activity in the venture capital sector. Partner Steve Clifford(view CV) and Lawyer Jonathan de Ridder discuss the new measures and give background to the legal structures already in place for venture capitalists.
- Summary of the announcements
- Background
- Relaxing qualification requirements for VCLPs
- Establishment of ESVCLPs
- Further investment in the IIF program
- Conclusion
Summary of the announcements
The new measures were announced by the Minister for Industry, Ian Macfarlane. Three packages of reform are mentioned in the announcement:
- Some of the requirements that must be satisfied in order to establish a Venture Capital Limited Partnership (VCLP) will be relaxed.
- A new investment vehicle called the Early Stage Venture Capital Limited Partnership (ESVCLP) will be established. Qualifying ESVCLPs will be exempt from Australian income and capital gains taxes.
- The Federal Government will commit a further $200 million of funding to the Innovation Investment Fund (IIF).
We discuss these changes in more detail below, first giving some background to the legal regime that is already in place to encourage venture capital investments as well as the process that has culminated in these reforms.
Background
Venture capitalists and limited partnerships
The limited partnership is the preferred form of business association for venture capital investors internationally for two principal reasons. First, they allow the liability of investors to be limited. Second, unlike corporations, income from limited partnerships can 'flow through' to the partners. (This second advantage did not apply to Australian limited partnerships until 2002 as discussed below.)
Unlike normal partnerships, a limited partnership has two kinds of partners: general partners and limited partners. The general partners are just like the partners of a normal partnership: they take part in the management of the limited partnership and have unlimited personal liability for the limited partnership's financial obligations. The limited partners, on the other hand, have their liability for the financial obligations of the partnership limited to the extent of their capital contribution to the partnership. In this respect, limited partners are like shareholders in a company. However, if the limited partners take part in the management of the limited partnership, they may lose their limited liability status.
Venture Capital Limited Partnerships
In 2002, the Federal Government enacted the Venture Capital Act 2002 and the Taxation Laws Amendment (Venture Capital) Act 2002. The effect of these laws was to allow certain limited partnerships to be registered as a VCLP.
Qualifying VCLPs receive a number of tax concessions, two being particularly important:
- Income from a VCLP was allowed to flow-through to the partners, in line with international practice. Previously, limited partnerships were treated as companies for tax purposes. Income earned by limited partnerships was taxed at the source, so a limited partnership had to pay tax on any income earned in Australia before it made a distribution to the partners.
- A capital gains tax exemption is available for certain non-resident investors in a VCLP. To qualify for the exemption, the foreign investor must be registered with the Pooled Development Funds Registration Board (the body responsible for considering applications for the registration of VCLPs). The capital gains tax exemption is thought to be particularly attractive to venture capitalists, who usually hope to make most of their earnings from capital appreciation.
VCLPs must satisfy several requirements to qualify for these tax concessions. Some of the key requirements are outlined below in the context of the Government's plans to relax the requirements for VCLP registration.
Review of the venture capital industry
The Federal Government conducted a review of the venture capital industry last year. The review's terms of reference included the requirement that it:
'[c]onsider the appropriateness and efficiency of existing Australian Government support for the venture capital and later stage private equity investment ... including venture capital limited partnerships.'
The review was conducted under the supervision of Melbourne businessman, Brian Watson. Mr Watson delivered his report to the Government in December last year. The Government has stated that the recently announced initiatives addressed the key findings of the Watson Report, although the report has not been made public.
Relaxing qualification requirements for VCLPs
VCLPs are currently subject to a number of restrictions, including in relation to the industry sectors and types of legal structures in which they may invest, the country of residence of the investors, the value of the assets owned by the investee entity, and the location of the assets and employees of the investee entity.
The Australian Private Equity and Venture Capital Association Limited (AVCAL) has long argued that the current restrictions on VCLPs render the vehicle uncompetitive in comparison to equivalent investment vehicles available in foreign jurisdictions, and that this has contributed to a shortage of early-stage capital in Australia. 1
The minister's Budget announcement states the qualification requirements for VCLPs would be relaxed by:
- removing restrictions on the investor's country of residence;
- allowing VCLPs to invest in unit trusts and convertible notes (previously they had been restricted to investing in shares in unlisted Australian companies, listed companies that are to de-list within six-months of the acquisition/investment and, in certain circumstances, other Australian VCLPs);
- reducing the minimum partnership capital required for registration from $20 million to $10 million;
- allowing the appointment of auditors to be delayed until the end of the financial year of the investment; and
- 'relaxing' (in a yet-to-be-specified way) the 'Australian nexus' test, which currently requires 50 per cent of the assets and employees of the investee entity to be located in Australia for 12 months following the investment.
Precise details as to how the above changes will be implemented have not been released at this stage. Significant restrictions on VCLPs will remain, the key ones being:
- target investees must have less than $250 million in assets (a restriction generally not imposed in other jurisdictions); and
- investments in certain fields are precluded, including property development, insurance, infrastructure and certain financial services.
AVCAL had lobbied the Government particularly hard to remove the $250 million cap, as well as the limitations on investing in the financial sector and the limitations on offshore investors, arguing that these restrictions contributed significantly towards making the VCLP an uncompetitive vehicle internationally. It is notable that the Government has not responded to these calls from the industry. AVCAL has, however, been successful in convincing the Government to allow VCLPs to invest in unit trusts and to relax the Australian nexus test, although it remains to be seen how this test will be reformed in practice.
Establishment of ESVCLPs
ESVCLPs will progressively replace the existing Pooled Development Funds (PDFs) from 1 July 2006, with PDFs being closed to new registrations after 31 December 2006.
PDFs are companies established to raise capital and make equity investments in Australian small and medium-sized enterprises (SMEs). As with VCLPs, companies must apply to the Pooled Development Funds Registration Board to be registered as a PDF, and must satisfy certain requirements and follow prescribed investment rules. PDFs are taxed at 15 per cent on the income and gains derived from equity investments in Australian SMEs.
ESVCLPs will be tax flow-through vehicles (like VCLPs) however income and capital gains earned by ESVCLPs will be exempt from any Australian tax. This exemption will apply to both residents and non-residents.
This is a significant concession, both in comparison to VCLPs and PDFs. However, the attractiveness of these concessions must be measured against the following restrictions that will apply to ESVCLPs:
- the maximum size of the fund administered by an ESVCLP is $100 million;
- ESVCLPs will not be able to invest in investee entities having total assets exceeding $50 million (this restriction already applies to PDFs);
- once the total assets of an entity invested in by an ESVCLP exceeds $250 million, the ESVCLP must divest itself of that entity (a significant and onerous requirement that may prove to make ESVCLPs unattractive vehicles for private equity, despite the tax concessions); and
- losses from ESVCLPs will not be deductible by the partners (the justification given by the Government being that, as revenue and capital gains are not taxable, losses should not be deductible).
Further investment in the IIF program
The IIF program was first announced in 1997. Under the program, funds are established with joint investments by the Government and the private sector. The fund manager provides equity financing and managerial advice to investee companies. Different funds are established with different investment focus areas. For example, an IIF called Neo specialises in information and communications technology, IIFs called GBS and Start-up are dedicated to the bioscience sector and an IIF called CM Capital combines information technology and life science expertise.
IIFs invest at the seed, start-up and early expansion stages in companies in targeted industry areas satisfying certain operating requirements. Profits of investee companies are first distributed to the Commonwealth investor and private sector investors to return their subscribed capital and interest on that capital. Further amounts are then split 10 per cent to 90 per cent between the Commonwealth and the private investors (with the private sector component shared with the fund manager as an incentive).
The minister's Budget announcement states that a further $200 million would be contributed to the IIF program. Up to two new fund managers will be appointed each year for five successive years with $40 million per annum available for successful fund managers. The Government's contribution will be matched dollar-for-dollar with funds from the private sector.
Conclusion
It is difficult to definitively assess the impact of the new measures, given that the precise form of the legislative changes that will implement them have not yet been released. The devil may well be in the detail. This is particularly the case in relation to the relaxation of the Australian nexus test for VCLPs, the proposal for which is notably vague at this stage.
While welcoming the initiatives as a step forward, AVCAL has criticised the proposals, stating:
'[u]nfortunately, the government does not yet get the message that private equity drives productivity growth in services and manufacturing, drives economic modernisation and reform and delivers higher returns to domestic super funds.'
The negative reception is not surprising given that two of AVCAL's key suggestions for VCLP reform – removing the $250 million cap and ending the prohibition on investment in financial services – have been ignored. Nevertheless, with these initiatives the Government has moved somewhat closer to establishing an internationally competitive regime for encouraging venture capital investment in Australia.
Footnotes
For further information, please contact:
- Jon WebsterPartner,
Melbourne
Ph: +61 3 9613 8832
Jon.Webster@aar.com.au - David WengerPartner,
Sydney
Ph: +61 2 9230 4680
David.Wenger@aar.com.au
