The New Philanthropy: The Push For A Renewable Capital Innovation Fund

The New Philanthropy

This post is a collaboration between BROSO™ and Tom Spencer, and was originally posted on Truth Has No Temperature.

Why is the Australian venture capital industry almost non-existent and irrelevant on a global scale?

Three reasons:

  1. A massive misallocation of capital, particularly when it comes to Australia’s $1.7 trillion superannuation bolstered capital pool, the fourth largest capital pool in the world.
  2. An attitude of risk-lethargy that impedes any real innovation from happening within Australia.
  3. An ingrained fear of failure that extends to the commercial world and business start-ups, to the point where in Australia there is a very negative attitude towards anyone who declares bankruptcy, the net result of which is less risk-takers, less innovators, less venture capitalists, and most importantly less GDP growth and a diminished tax base.

Many of the start-up opportunities for venture capital exist in the digital or online space, and these ventures by their very nature belong in an international market. Failure of Australia to play in this global sandpit means that Australia is experiencing a flight of human and intellectual capital.

In order to have a functional venture capital industry you need quality start-ups.

So where do these come from, exactly? Generally in the US and Europe it is from within high-quality University programs.

So where are the incentives to start new ventures in Australia’s vibrant University culture? Perhaps the answer is that Australia has a much too generous University and accompanying welfare system that fosters a sense of entitlement and robs young Australians of the desire to create, or take on any risk.

Why does this matter?

With the level of imagination, commercial creativity and desire to innovate in Australia there are all the ingredients for a thriving startup culture and venture capital industry.

But of course there’s the other side to the coin: capital. This is where the Australian venture capital industry has bordered upon impotence.

They simply can’t seem to raise serious capital.

Here are the facts:

  • Total venture capital investment in Australia in 2013 was barely AU$150 million; and
  • Total venture capital investment in Australia in 2014 increased significantly but still only amounted to AU$516 million.

Compare this with the total venture capital investment in Europe and the US:

  • Total venture capital investment in Europe in 2013 was AU$9.5 billion (63 times the amount of Australian venture capital investment over the same period); and
  • Total venture capital investment in the US in 2013 was AU$42.3 billion (282 times the amount of Australian venture capital investment over the same period).

An interesting comparison is to consider the total investment by Chinese Investors in Australian residential property:

  • Chinese investors pumped AU$5.9 billion into Australian residential property in 2013 (40 times the amount of Australian venture capital investment over the same period); and
  • Chinese investors pumped AU$12.4 billion into Australian residential property in 2014 (24 times the amount of Australian venture capital investment over the same period).

But a lack of capital is absolutely NOT the problem. It’s where Australia is deploying that capital.

Australia has one of the largest wealth markets in the world. Australia’s capital pool has grown at an annual compound growth rate of 12% p.a. since 1992.

The unprecedented growth in Australia’s capital pool has obviously been underpinned by its superannuation system which requires a portion of all Australian workers’ incomes to be contributed to a retirement pension fund.

Are there unintended consequences of the private and public sector both ignoring venture capital as an asset class in Australia?

One of the unintended consequences of ignoring the venture capital industry in Australia is human capital flight. What we mean by this is that if the money is not available to invest in new initiatives and to enable young entrepreneurs to start and grow their ventures in Australia then many of these people will simply leave the country. If the government invests in 13 years of school education and then 3 to 5 years of university education only to see the best people leave the country, then this is a huge gift to the rest of the world and represents both lost opportunity and a huge drain on the Australian economy.

A lack of venture capital money means that it will be difficult for innovative young Australians to launch new ventures and manage to survive long enough to reach profitability.

Consider the enormous tax losses suffered by the ATO and the general reduction of the Australian tax base as a result of losing an entire multi-billion dollar asset class to another hemisphere.

Australia could realistically expect to have a $5 billion a year VC industry.

Now let’s make some assumptions about income tax, corporate tax, and GST.

Assuming there are 250 investee companies and on average each of them generates revenues of $20 million per year that equates to $5 billion in annual revenues overall. If the average company has 20% net margins, then this would produce earnings of $2.4 million and the government could hope to collect $180 million in corporate tax revenues. The government would also pocket $500 million in GST revenues (more than what the VC industry invested in Australia in 2013).

Assuming that salary and wages for each company represents 30% of gross revenues and that the blended income tax rate is 28% then this would also mean that the 250 investee companies would produce $420 million in income tax revenues.

All in all, the government is missing out on a potential $1.1 billion in tax revenues per year.

What are the problems with the ingrained culture of the Australian venture capital industry?

American VC funds are willing to invest serious money in early stage ventures because they know how profitable it can be.

The US sees more exits, at higher valuations, and the success of American VC funds has attracted more VC players, more money, and more entrepreneurial ventures.

Part of the problem in Australia is that there is less money available, which means that it is harder for Australian startup founders to get meetings with investors and harder for them to secure investment.

But lack of money is only part of the problem. Another problem is that startup founders typically have to work harder and wait longer to secure investment. At the early stage of a venture where every day counts, delays in securing funding can mean the difference between success and failure, and distract founders from the vital task of growing the business.

Lack of money and longer waiting times are not the only problems though. The main problem is that the Australian VC industry lacks the visionary mind set required to grow successful new companies in Australia.

In the States, the VC industry is enthusiastic about investing in early stage ventures, whereas the mood in Australia is sceptical and hesitant. American VC investors look for passion and market potential, and know that asking for financial forecasts from a seed stage company is pointless. Down under it is a different story. Australian investors typically require a full blown business model with financial forecasts, which is genuinely impossible to provide if the venture hasn’t proven its business model and doesn’t yet have any customers.

What is the New Philanthropy?

Philanthropy is defined by the Merriam-Webster Dictionary as the practice of giving money and time to help make life better for other people.

The push for a more significant, better funded venture capital industry in Australian can be framed as a type of New Philanthropy.

We believe business is about solving problems and delighting people, and this becomes viable when businesses manage to do this in a financially sustainable way.

In any case, the New Philanthropy is not a new concept: this is basically what Richard Branson already does when he says he believes in supporting new entrepreneurial ventures and to our knowledge he signed Bill Gates’ giving pledge on that basis, which means he is not conforming to the way that most people would delineate business and philanthropy/charity.

Australia requires the New Philanthropy, and the push for a Renewable Capital Innovation Fund.

By Benjamin S. Broso B.Bus LL.B (Hons) and Thomas D. Spencer B.Com LL.B (Hons) (Sydney) MSc Financial Economics (Oxon).
Tom Spencer Ben Broso

Bank Bailouts and other Moral Hazards

In the previous post on Moral Hazard, we learnt that Moral Hazard refers to any situation where a person is not fully responsible for the consequences of their actions. As a result, they may take greater risks than they would have otherwise.

Here are 6 examples of situations where Moral Hazards arise in practice.

1. Insurance

The provision of insurance is the most common example of Moral Hazard.

For example, if you have comprehensive private health insurance you’ll be more likely to visit the doctor. You may also engage in more risk taking activities because you are not responsible for paying the medical costs if things go badly e.g. you go bungy jumping and throw your back out.

Malcolm Gladwell provides the amusing example of Universal Pepsi Insurance:

“Moral hazard” is the term economists use to describe the fact that insurance can change the behavior of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you’ll drink more Pepsi than you would have otherwise.

2. Mortgage Securitisation

Mortgage securitisation is an insidious and often misunderstood example of Moral Hazard.

The US government, motivated by a desire to expand home ownership, has for many years actively encouraged bankers to make loans to people with poor credit ratings. Fannie Mae and Freddie Mac, two large government sponsored enterprises, have carried out this policy through a process known as “mortgage securitisation”. Mortgage securitisation involves:

  1. purchasing mortgages from banks and mortgage brokers;
  2. grouping these mortgages together into large pools; and then
  3. selling “shares” in these mortgage pools to investors.

Moral Hazard exists because the banks and mortgage brokers who originate the loans do not pay the cost if lenders default. As a result, they have an incentive to make as many loans as possible, even to people with extremely poor credit ratings. These loans are often referred to as NINJA loans because they are made to people with No Income, No Job and No Assets.

3. The Greenspan Put

The Greenspan Put is another example of Moral Hazard.

Since the late 1980’s the Federal Reserve has followed a policy of significantly lowering interest rates in the wake each financial crisis (this policy is often referred to as the Greenspan Put). Lowering interest rates has the effect of increasing the amount of money available to the economy which prevents the economy from deteriorating further and stops asset prices from falling. As a result, this policy encourages investors to take excessive risks because they know that the Fed will lower interest rates if things go badly.

4. Bank Bailouts

Following on from mortgage securitisation and the Greenspan Put, we arrive at bank bailouts.

The provision of bank bailouts by government is perhaps the most topical example of Moral Hazard. In 2008, in the wake of the sub-prime mortgage crisis, the US government created a US$700 billion Troubled Asset Relief Program (known as TARP) to buy financial assets from banks and other financial institutions. The bailout was intended to stabilise financial markets, make sure that credit markets remained liquid and to prevent a repeat of the great depression. A worthy goal, however one small problem with TARP is that it creates a big Moral Hazard. If banks know that government will bail them out, then they will continue to engage in excessive risk taking.

Bailouts are now even being provided to sovereign states. In May 2010, the EU and IMF agreed to provide Greece with bailout money to the tune of €110 billion.

We can expect more financial instability to come.

5. Private Equity

Private equity vehicles, popular until around mid-2007, are another example of Moral Hazard.

Let’s assume that investors give a private equity firm $100 million to invest. If the private equity fund makes a profit of $20 million after one year then the fund managers might take 20%, or $4 million. If the fund loses $20 million after one year then the investors lose $20 million and the fund managers pay nothing. Since the managers are not fully responsible for the consequences of their investment decisions they have an incentive to take excessive risk.

6. The Limited Liability Company

The limited liability company presents an often overlooked form of Moral Hazard (props to Stella Szeto for pointing this out).

A company will often link the amount that its executives get paid with the company’s performance on the stock market. The reason for doing this is to align the interests of the executives with the interests of shareholders, which makes sense on one level (see Principal-Agent problem).

If the company performs well and its stock price rises strongly then shareholders are happy and executives will get a bonus in the form of cash, shares and/or options. However, if the company performs poorly then shareholders lose, while executives still receive their base salary and are not required to compensate shareholders. As a result, executives have an incentive to take excessive risks in an attempt to inflate the company’s short term stock price.