Private equity in Australia – recent developments

Early stage private equity investment in Australia may now be more attractive to foreign investors

by Andrew Lind, Partner and Zmarak Zhouand, Associate, Gadens Lawyers, Sydney

Private equity is making headlines in Australia, as it is around the world.  Recent developments in Australia include:

·                     a Senate enquiry into private equity and its effects; and

·                     new legislation in relation to venture capital limited partnerships.

It is not expected that the Senate enquiry will result in any changes affecting private equity transactions, but the recent amendments to legislation affecting venture capital limited partnerships should make the use of these vehicles more attractive to local and foreign investors for early stage private equity investment in Australia.

Senate enquiry into private equity and its effects

On 29 March 2007 the Australian Government referred to the Senate Standing Committee on Economics (the Committee) an inquiry into private equity and its effects on the Australian economy and capital markets.

The Committee has been directed to assess:

·                     domestic and international trends in private equity;

·                     whether private equity could be a matter of concern for the Australian economy if ownership, debt/equity ratios and risk profiles of Australian businesses were significantly altered;

·                     the long term effects of private equity debt structuring on government revenue;

·                     whether the current laws are sufficient to deal with any attack on national economic or strategic interests by private equity and, if not, what laws should be implemented; and

·                     what, if any, laws should be brought in to deal with private equity.

The Committee's terms of reference and the assumptions underlying the terms of reference have been questioned by numerous stakeholders in submissions to the Committee.

With few exceptions, the general view in Australia is that private equity, within the current legislative framework, has had a positive impact on Australia's capital markets, government revenue and general economic performance and will continue to do so if not over-regulated by government.

A concern held by some stakeholders is that the Committee's report could lead to legislation regulating private equity activity which could potentially slow the growth of private equity activity in Australia.

The Committee has scheduled hearings for late July 2007 and its report is expected in September 2007.

Venture capital limited partnerships

Early stage venture capital activity in Australia has not experienced the same level of growth as the general private equity market. 

One reason attributed to this is that the Venture Capital Limited Partnership (VCLP), introduced in Australia in 2002 to promote foreign venture capital, was too restrictive.

The aim of the VCLP was to provide a flow through entity for tax purposes and capital gains tax exemptions for foreign investors only.  However, the taxation benefits were subject to the satisfaction of certain conditions. 

On 1 July 2007 legislation came into effect which:

·                     removed some of the restrictions that applied to VCLPs; and

·                     introduced a new vehicle to promote venture capital investment, the Early Stage Venture Capital Limited Partnership (ESVCLP).

Removal of restrictions on VCLPs

As a result of the recent legislative changes:

·                     a VCLP can now hold up to 20% of its capital in investee companies that are not Australian residents;

·                     the minimum committed capital has been reduced from A$20m to A$10m;

·                     capital gains tax is no longer payable on most assets disposed of by non-residents;

·                     a VCLP can be established in Australia or with any country with which it has a double taxation treaty;

·                     a general partner can be a resident of any country with which Australia has a double taxation treaty; and

·                     investment can now also be made through convertible notes and in unit trusts.

Introduction of ESVCLPs

The new legislation also introduces ESVCLPs.  ESVCLPs are intended to encourage investment in start up enterprises, allowing smaller organisations to seek capital to fund future activities.

An ESVCLP must have the following features:

·                     the maximum size of the investee entity must not exceed A$50m (at the time of investment);

·                     the fund administered by the ESVCLP must have a minimum size of at least A$10m and a maximum size of A$100m;

·                     an investment must be divested when it exceeds A$250m;

·                     the maximum contribution by an investor (unless the investor is a bank, life office, superannuation fund or an investor approved by the Venture Capital Review Board) must not exceed 30%;

·                     the maximum percentage of committed capital of the ESVCLP for each investment must not exceed 30%;

·                     an ESVCLP must have a minimum life of 5 years, and a maximum life of 15 years;

·                     an investment must be for a minimum period of one year; and

·                     an ESVCLP must report quarterly to the Venture Capital Review Board on the implementation of its investment plan.

Prohibited features include:

·                     the entity in which capital is invested must not be listed on the Australian Stock Exchange (at the time of the investment);

·                     an ESVCLP cannot acquire a pre-owned investment from a third party, unless it had a pre-existing interest in that investment, and has made a further significant new investment; and

·                     an ESVCLP must not invest in property development, some financial services, insurance, construction, infrastructure and passive income investments.

Advantages of ESVCLPs include:

·                     income and capital gains will not be taxed under the ESVCLP, but will flow through to the general and limited partners (although any losses from investing in the ESVCLP will not be deductible); and

·                     benefits will extend to domestic investors, as well as foreign investors.

Disadvantages of ESVCLPs include:

·                     ESVCLPs cannot be used to acquire mature businesses from third parties (investments must be early stage);

·                     investment in certain industries is restricted; and

·                     the investment must be divested when it exceeds A$250m.

As the ESVCLP tax concessions are designed to stimulate Australia's early stage venture capital sector, the tax concessions are not available where "pre-owned" investments are acquired.  That is, the focus is on providing new investment, not providing an exit for those that made the early investment.

An investment is "pre-owned" if it was issued or allotted to an entity other than the ESVCLP (other than to an underwriter or another person for the purpose of being offered for sale).  This would include shares or units in an entity owned by a third party.

An ESVCLP can only invest in pre-owned shares/units if:

·                     the ESVCLP already owns shares or units in the entity or it makes other investments in shares or units in the entity, some or all of which are not pre-owned; and

·                     the value of the pre-owned shares/units, combined with the other investments in that (pre-owned) entity, does not exceed 20% of the ESVCLP's committed capital.

Overlaying this are other ESVCLP requirements, including the requirement for the ESVCLP to have an investment plan approved by the Venture Capital Registration Board (VCRB).  The VCRB, in approving an investment plan, is likely to take into account the extent to which the plan focuses on early stage venture capital.  Ongoing reporting by the ESVCLP to the VCRB on the implementation of the investment plan is required.  An ESVCLP's registration (and the tax concessions that go with it) can be revoked by the VCRB if the ESVCLP does not comply with the ESVCLP requirements.

Conclusion

So, whilst the general legislative landscape for private equity in Australia is unlikely to change as a result of the Senate enquiry, the recent changes to VCLP requirements and the introduction of ESVCLPs may encourage both local and foreign early stage private equity investment in Australia.