Is NZVIF directionally correct?

The New Zealand Venture Investment Fund was set up 14 years ago with the best intentions – to foster an early stage investment sector in New Zealand by being a fund of funds. It's had $250 million for VC and PE funds but only $129.7 million of that had been invested to June 2015 and $100 million of it is an underwrite facility.

NZVIF later added the now $50 million Seed Co-Investment Fund (SCIF) which co-invests alongside accredited angel investors. As at June 2016 it had placed $38.2 million of that.

It's been a long while since NZVIF was formed but, even with time, the results to date for the fund itself are pretty unspectacular. When I was at McKinsey there was a phrase – "directional correct" – which meant that someone had tried to do the right thing but ended up down the wrong path. Is NZVIF directionally correct?

The latest investment report to June 2015 has just been released. (As an aside it is months late versus the June 2014 report, which was released in November 2014.) Back in 2014 Jamie Ball at NBR wrote a scathing summary and this year gives little to cheer about again.

Let's look at the two parts of the business, the fees on fees, the road ahead and some comments about whether this is personal.

1: NZ-VIF VC Fund of Funds
The VC fund portfolio reported $120 million invested into funds and a net asset value of $93.2 million as at June 2014. In June 2015, that was $129.7 million invested into funds and a value of $99.8 million. That means they added $9.97 million in cash but lost $5.17 million asset value, for an average rate of return of (1.74%) – or negative 1.74% – per year.

In comparison Punakaiki Fund has raised $12 million and has a net asset value of more than $16 million, as we did this in less than two years. We use the same IPEV standards for valuation and our IRR for the original April 2014 investors was over 50% per year when we last officially released data in November 2015. It's quite remarkable to think that Punakaiki Fund's value today is already a sixth of the value of NZVIF's VC fund as at June 2015, and we have not received any funds from the NZVIF fund of funds nor had over 12 years of investing returns for the fund.

NZVIF accepts that the early performance was poor, and breaks down its VC investments by vintage. The latest report shows the original investments from 2003 to 2005 saw an annualised return of (5.47%), and a loss of 30% overall to June 2015. Looking at the two reports, however, I see that in 2014 NZVIF reported $65 million was invested in 2003 to 2005 but in 2015 that historical figure has climbed to $67 million. The return was reported as a loss of 35% in 2014, so things are improving.

But that's a lousy result overall. In 2003, for comparison, I was trying to buy shares in Trade Me, and Xero launched in 2006. I wonder if the conversation with Trade Me would have been different if I'd had access to a $10 million fund.

The second wave of investments, was from 2007 to 2012 (2014 report) of 2007-2014 (2015 report). There were five funds in this cohort in 2014, and six in 2015. The annualised returns for NZVIF were 8% in 2014 and dropped to 4.36% in 2015. Neither of these are acceptable for early stage investors, and what's happened is that NZVIF, under its mandate, had limited its upside by allowing funds to buy out the best investments for near the investment value.

So, for the rather late-stage investment in Xero by Valar, for example, the NZVIF money was essentially a free extension of their funds for a few years. Valar didn't need extra cash to make a return, a great return, but it sure was nice that NZVIF was there to support this offshore fund. NZVIF, unfortunately, gets essentially no return from the deal, which is why I use the "buy-out adjusted" returns to the NZVIF fund rather than its unadjusted returns. Those unadjusted returns for the period were reported at 26% a year in 2014 but fell to 12.67% per annum in 2015. That was a 2.11 return as at June 2014 and a 1.46x return as at June 2015, remembering that this is funny money, not reality.

As good as that sounds, it's not great for early stage investing.

For comparison during the first 2007 to 2012 period I invested in Define Instruments (solid), 200Square (still selling houses), Pocketsmith (growing well over the years), Vend (over 600% returns, including more cash out than invested), Valuecruncher (failed), Lingopal (in quiet mode), and Pacific Fibre (we tried), as well as some sweat-equity firms like My Tours (doing very well), Groupy Deals (exited to Yellow), Powerkiwi (2nd in Deloitte Fast 50, contract bought out by Powershop), AllAboutTheStory (closed) and others. Later on, I invested in Syft (4x cashed out return), and then Punakaiki Fund (52% up so far). I just took a very brutal ruler to those investments and valuing rather harshly the unrealised investments I still see over 400% or 500% return on investment (one company valuation could drive that a lot higher). Of the more than $900,000 that I invested only $150,000 can be deemed a failure, and some of that is still being worked out.

So, while I was making four or more times the money invested, the NZVIF fund of funds was actually losing money operating in the same space. And, meanwhile, other early stage investors with larger amounts at their disposal did extraordinarily well. Take a look at the shareholder registers for Xero or Vend.

Meanwhile, NZVIF stated on page 3 of the 2015 investment report that "no private venture capital funds have been established over the past 15 years without NZVIF’s involvement." At LWCM, the manager of Punakaiki Fund, we were somewhat incredulous to read this claim. We have not exactly been hiding under a (flat or otherwise) rock.

2: SCIF
The SCIF fund, which operates deal by deal, had invested $29.7 million to June 2014, and $38.2 million to June 2015. That's an increase of $8.5 million year on year. Punakaiki Fund invested, for comparison, about $10 million in the 21 months since launch in April 2014.

SCIF is not self-limited by the same clawback mechanism, and neither, as I understand it, are the new NZVIF VC investments. That's good.

The average SCIF investment per company was $310,000 in June 2015. That's a lot lower than us at Punakaiki Fund, which is averaging near $700,000 invested and $1 million in asset value per company.

The SCIF returns are fairly sad though, with NZVIF reporting just 1.04% annualised return in June 2015. That's even lower than bank debt, but at least it is positive. The SCIF investments vary by partner – they have 15 or 17 (depends how you count) and only eight are delivering positive returns. I suspect one or two of those will be very successful, and the rest marginal.

Overall NZVIF estimates that the SCIF portfolio returns on investment will be between 0.8 and 1.5 times the money invested, by 2026. Read that again. SCIF is saying that after 10 years it is promising, at best, an annualised rate of return of 4.1%. This is not successful early stage investing.

3: The Fees on Fees
The returns from both parts of the fund are lousy – and I accept that NZVIF is trying as hard as it can to downplay the value of its investments and there should be plenty more upside. If its approach to valuation is, as it states, "conservative" and it is carrying assets at lower values than its co-investors then everyone needs to re-read the IPEV guidelines, which are pretty clear on using fair values. (We use them at Punakaiki Fund, too.) The accountants and auditors (Audit New Zealand) for NZVIF should have strong fairness opinions about the valuation methodology and the individual valuations.

However you cut it, the reported returns from NZVIF's VC Fund of Funds and SCIF are unacceptably low for early stage investing.

But we have not yet mentioned fees. NZVIF's 2014 and 2015 annual reports show that NZVIF received $2.33 million from the government in 2013, 2014 and 2015, and it spent $4.4 million, $4.6 million and $5.3 million in expenses in those three years respectively. A significant part of that, $1.9 million in 2013 and 2014 and $2.6 million in 2015, was for "fund management fees and costs paid to fund managers." I don't know what that means - was this for external people to manage their fund of funds? Or was it paid to the funds it has have invested in? Either way it doesn't appear to be matched in the revenue line. Is it taken from the investment principal?

With $137,500 spent on directors fees, $1.33 million on employee benefits, $1.0 million on "other administrative expenses" and $120k on auditors, the basic costs to run NZVIF (excluding the "fund management fees and some other items) was $2.58 million. That represents 1.9% of the funds under management, while the full $5.3 million of expenses represents 3.9% of the fund under management. I am not sure how this works, but I suspect (and hope) the 3.9% represents both layers of fees - those incurred directly by NZVIF and those paid to its VC fund managers.

NZVIF is a fund of funds, and even the SCIF part relies on others to do the work. The VC funds that it invests in and the angel clubs and small funds that it invests alongside with SCIF charge their own fees beyond those above. The end result is that the overall fees to the investor (us taxpayers) are very high.

Investors don't mind high fees when the returns are great, but, in this case, it's tough to take. NZVIF is charging a lot more than a funds on funds investor should, and while it would argue that it performs a lot more services than just funding, it's hard not to point at the tepid results and ask questions.

I feel frustration that NZVIF is accepting and promulgating these low returns and high fees as acceptable for early stage investing. I understand its need to justify its mandate, but it's arguably creating a chilling effect for newer funds, like Punakaiki Fund, to convince larger investors the asset class is amazing. And it is amazing.

4: The road ahead
The good news is that some of the NZVIF investments are going better as at the end of 2015 but it's unclear what the "buy-out adjusted" returns were at that stage.

It's also great to see some new funds coming on line, with Chintaka Ranatunga looking to close GD1 II soon, and the ICEAngels closing a fund between $5 and $10 million, and others circling. But we are still hundreds of million short - at Punakaiki Fund we are overwhelmed with deals and could place $50 million easily within three months, if we had it.

NZVIF itself is in transition, and with a new CEO yet to be announced there is an ideal chance to make a solid change in structure and mandate.

Last year I commented to NBR that I'd like to see five things:

Equality: Invest on equal terms to other investors into funds - with no buy-back provision. My understanding is that this has now happened.

Simplicity and speed: Impose no conditions on the funds, such as contract criteria, fund structure, investment process, etc. (The VIF conditions were dreadful.). Invest or don't invest based on the offer, and make decisions quickly. My understanding is that the terms are a lot better these days, but it's still dreadfully slow for VC funds to raise money from all investors.

Quantity: Have a strong bias to invest at least something into any local fund which is investing in the target markets/stages. Not done – we are still waiting for a call. I suspect this article will delay it further.

Performance-led: Invest small amounts at first into many funds, and reinvest progressively larger amounts into funds that perform. Not done - the GP/LP structure used by funds means VIF can only invest in lumps when new funds are raised. This can take years.

Reporting: Commission outside experts to deliver reporting on the overall early and growth-stage funding markets in NZ, placing the NZVIF funds in the list next to private investors and non-aligned funds. Not done, but it is good to see the second investment report from NZVIF. I expect the numbers will get better.

And a bonus 6th: Report NZVIF progress to the public on a deal-by-deal and fund-by-fund basis, with ability to do so as a prerequisite for any investment in a fund. Not done – and to be fair this is hard as companies don't like releasing results.

To those I would add three new suggestions:

Lower the management costs for NZVIF to say 0.5% or 1% of assets under management, more normal for a fund of funds. Ask the leadership to restructure accordingly. That means an annual budget of $650k to $1.3 million, well under the $4.6 million today; or

Pass the entire fund to an existing government-owned professional fund manager, and if the government wants to invest in more funds or deals then the fund manager can allocate the funds. The Superfund is the perfect vehicle for this (ACC is an alternative), but the asset class is very small for either shop. One option is to move say two people from NZVIF into Superfund and have them managed there; or

Run a tender to ask for proposals to run the fund and pass the fund to the private sector. Select the manager based on the response in costs and evidence that new ownership would drive higher returns for the fund.

The final alternative is to keep going, but it should be clear by now that more of the same is not necessarily the best course.

5: It's not personal
I commend everyone inside NZVIF and in the funds it has invested into. Everybody works hard to change NZ's investment climate and to deliver returns for investors and founders. Some people in the ecosystem have gone well above and beyond.

This is an attack on a dated mandate for NZVIF, a structure that is unwieldy (though getting better) and in an ecosystem that has marched far ahead.

As investors, advisers and taxpayers we should be unafraid to call out when we perceive there may be an issue, in this case with a business. It can make things tough when people don't understand that this elephant hunting is never personal, but over time essentially everyone respects that things do need to be called out, and an intervention is better than no intervention.

In this case I'd really like NZVIF to succeed, and I'd really like to see a lot more funds in our ecosystem – we need them. But at the same time we need to broaden the ecosystem away from NZVIF. Punakaiki Fund has shown that it can be done from the ground up, as have many high net worth investors, while Milford Asset Management has done the same as a larger investor top down.

The high growth investing ecosystem still needs to earn the right to have the major brokers and banks get behind the space, and the only way we will do that is to show consistent and strong returns, resetting the standard for what proficient early stage investing can achieve.

I love it when investors in our ecosystem make great returns. Here's to the early investors in Diligent, the folks who backed Xero pre-IPO, the few and the brave behind Adherium and the countless quiet investors who back the thousands of companies we never hear about. Let's keep investing into great companies.

And let's hear it for the founders – all of this energy is focused on helping founders start and accelerate the growth of companies. We have an abundance of founders and great companies in New Zealand – we need to get on with giving them what they need.

Lance Wiggs is the founder of Punakaiki Fund, which invests in high growth NZ based companies. He is a member of two Return on Science investment committees, and has helped more than 40 companies as an independent practioner through NZTE’s Better by Capital program. He writes at Lancewiggs.com

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