Superannuation funds in Australia are not known for making daring investment choices. But a few of them are increasingly starting to go against their investment DNA: instead of seeking out large, illiquid investments into assets such as infrastructure, or easily understood equity portfolios, they are seeking small investments in early-stage start-up companies.
A few, including Hostplus and First State Super, are taking it a step further. They are proclaiming the benefits of embracing early-stage risk in order to foster innovation in Australia’s technology industry.
The fact that not every start-up lives to reach maturity doesn’t worry Sam Sicilia, chief investment officer of Hostplus. “We have over A$1 billion in VC [venture capital] and most of this is allocated to Australian managers,” he told AsianInvestor.
Indeed, the A$33 billion Hostplus has the largest exposure to venture capital of all superannuation funds. Its investments include Square Peg Capital, Blackbird Ventures, Carthona Capital, MH Carnegie & Co, Roc Capital, Brandon Capital Main Sequence Ventures and Artesian.
For the most part these funds play in the minnow end of the market, funding companies that are often only months old and have spent their seed money.
Not content to invest via VC funds alone, Hostplus has also begun adding exposure to start-ups through co-investment. One example took place in July this year, when it invested A$10 million directly in Culture Amp, a Melbourne-based provider of human resources software. Its allocation was part of Culture Amp’s Series D funding round and was done alongside Blackbird Ventures, which made the introduction.
Sicilia said co-investing gives Hostplus the chance to reap the rewards when a company starts to take off. “The superannuation pool is enormous and if funds like Hostplus are not there to provide later-stage funding, local start-ups will do what they have always done and go offshore,” he said.“We already had exposure to Culture Amp through Blackbird’s involvement in earlier funding rounds and we liked the company’s progress,” said Sicilia. “Blackbird has a seat on the board and we wanted to empower Blackbird to use their influence and take the company to the next level.”
First State Super is also exploring start-up co-investing, having struck three such deals in the past five years and evaluated many more. All-told, about 10% of First State Super’s A$3 billion private equity programme in venture capital and most of this in early-stage businesses.
Jenny Newmarch, who manages the A$90 billion fund’s private equity portfolio, said co-investments give it more control over how to allocate capital.
“Venture co-investments usually occur when a company is raising Series B or C funding and after we have been observing them for a number of years,” he told AsianInvestor. “We have been able to observe them meet certain milestones so we make our co-investment decisions with a high level of conviction.”
Newmarch said the co-investments can be small – as low as A$5 million. The opportunities often arise when the VC funds have reached prudential limits on individual exposure to a particular company.
“Sometimes we have contractual rights to co-invest written into our investment management agreements,” he noted.
The pension fund prefers to target early-stage companies with follow-on allocations rather than assigning capital to late-stage venture funds. “We are cautious about that part of the market because valuations are pretty hot at the moment,” Newmarch said.
Hostplus and First State Super both say investing in early-stage businesses is a good match for their membership bases, which include a large number of young people working in hospitality and healthcare. “Our members want us to be investing in innovative businesses that are focused on the future,” Sicilia said.
WALKING THE LINE
Hostplus and First State Super are among the most aggressive super funds, but they are unlikely to be the only increasingly interested players in the VC space.
That offers an opportunity, but also a potential challenge. Super funds boast a A$2.7 trillion asset pool. The local market walks a fine line between unlocking enough funds to grow the industry and being flooded with money – causing investment prices to spiral, along with risk. But it’s still early days. Daniel Petre, founding partner at VC fund AirTree Ventures, believes many funds have yet to make an allocation to early-stage ventures.
“Some say they want to be able to write cheques of A$200 million to A$300 million or it isn’t worth their time to do the leg work,” he said. “This attitude isn’t helpful. Pension funds in other markets like the US see the value in writing smaller cheques, and there are third-party advisors such as Greenspring and Hatchstone that can do the due diligence work.”
Petre warns superannuation funds against trying to shape the industry by seeking veto power over investments. Similarly, he advises start-ups not to accept direct capital from super funds unless it makes strategic sense.
Newmarch at First State Super agrees. “If another investor can add more value than we can – by giving the company access to offshore markets, for example – then we would strongly recommend the founders make a choice based on strategy and growth potential. However, when we co-invest into these companies we are doing so through our VC managers who own the relationship with the company and who bring strategic value.”
And the super funds do not want a role in the day-to-day management of start-ups, nor do they want a board seat.
“We leave this expertise to the venture capitalists,” Sicilia said. “We sit on the advisory boards of some of our VC funds to ensure that our interests remain aligned and they stick to their knitting.”
Sicilia hopes some of the companies Hostplus is investing in decide to stay private for longer.
“The traditional path for founders is to exit via trade sale or IPO after a few years, but we envisage a future where there is enough capital coming from the superannuation market to give entrepreneurs the option of staying private.” He said one of the factors that made Culture Amp appealing was the long-term vision of founder Didier Elzinga.
He told AsianInvestor’s sister publication FinanceAsia that having an investor like Hostplus on board is a “nice antidote to the frantic pace that typifies this industry”, and said he isn’t looking for a quick exit from Culture Amp.
As the VC industry develops in Australia, the role played by super funds could expand. There is already talk of superannuation funds providing working capital to start-ups and funding convertible note programmes. The next step would be to offer venture debt.
Rick Baker, a co-founder at Blackbird Ventures, said there is also the potential for super funds to act as secondary buyers of existing equity stakes in later-stage ventures.
“At the moment the buyers of secondaries are usually the big global growth funds. There is an opportunity for Australian super funds to play in this space if they are adequately resourced and can move quickly to evaluate these later stage rounds, which are often highly competitive,” he noted.
First State Super’s Newmarch said she would consider a secondary buyout, provided the price is in line with the fund’s return objectives. “Our target is to beat listed equities by 6% net of fees, which is a high bar. It might not be possible to meet ROI (return on investment) hurdles in some late stage secondary rounds.”
Instead, the super fund’s preferred path is to remain aligned with its VC managers on exits. Plus, “if one of our constituent companies decided to IPO and we wanted to stay engaged we have the option of rolling over our holding into our listed equities portfolio,” Newmarch said.
For Australian superannuation players with long investment horizons, local VC investments remain at the borders of traditional investment plans. But while bite-sized, they’re potentially high growth. That combination could tempt others – especially if First State Super and Hostplus begin notching up notable successes.
This article was adapted from a feature that originally appeared in AsianInvestor December 2018/January 2019 magazine.