Innovation and investment – time to think wider than VC

Language is important. When it comes to talking about innovation and investment in the same sentence the focus invariably turns to venture capital.

Long term asset owners have had a mixed experience with venture capital to the point that CALPERS, the Californian public sector fund, has decided to no longer allocate to VC.

But innovation is not just about venture capital. The Oxford Dictionary defines the word innovate as to ‘make changes in something.’ The key word here is change.

Change is fundamental to investment. It is a beast that is hard to control, and much of the investment processes we use are designed to strip out different elements of change in an attempt to tame them.

The one thing that is certain is that the world does not sit still. In fact the pace of change is such that I struggle how to answer my kids’ questions. The olden days – that mystical time that used to refer to knights and castles, now goes all the way back to the era before the ipad was invented – yes, all the way back to before 2010. Our kids are growing up in a world where they think rapid change is normal. The last question I had was ‘Dad, did you have electricity when you were a kid?’

One of the anxieties that Australians have is that we are somehow not an innovative society. We worry endlessly about whether we can create a venture capital industry to rival Silicon Valley.

I think it is time we got rid of this innovation anxiety. Venture capital is at the end of the day just a structure. There is a very good question as to whether it is the best structure for long term investors. VC returns are volatile, which doesn’t suit a system that is measured on short term performance. VC funds are also illiquid and have high due diligence costs. The model of exiting an investment just as it starts to get started is also questionable for long term investors.

If we do want a VC industry in Australia then we need to look at different structures. We can’t ignore the ASX, which provides the governance and daily pricing that superannuation funds need. What we need to see is a series of listed innovation companies that build a portfolio of growing businesses.

Rather than selling a successful business once it reaches the first stage of maturity we need to be keeping these businesses and taking them to the second stage of development. It will only be in this way that we will develop the next generation of large cap Australian companies operating globally.

Investing in innovation through capital markets aligns to a superannuation system that has restrictions on liquidity, but which is rapidly outgrowing the investable opportunities within the ASX. The pathway forward is for start-up companies to collaborate to establish larger innovation companies. The sharing of governance, human resources and debt makes a lot of sense and is likely to be attractive to superannuation funds that have strong taxation and currency incentives to invest in Australia.

The good news is that there is no need for innovation anxiety – except when it comes to explaining the olden days to your kids.

Governments should nudge, not spend

Governments can use ‘nudges’ instead of spending to drive economic growth. An example is using regulation to expand ASX’s trial Equity Research Scheme that provides broker research for a selected number of small cap companies in order to support institutional investment in this market.

We are entering a new global phase where governments will not have the same fiscal power they once had. Governments can use ‘nudges’ to influence economic and social outcomes instead of traditional government spending on programs.

Over the last 100 years governments across the world started making promises they are now struggling to keep.

The first universal age pension promises were made by German chancellor Otto Von Bismark in 1889. The German Government promised to pay pension at the age of 70, dropping to 65 in 1916.

Bismark was a conservative who was the right hand man of Germany’s Kaiser Wilhelm. Bismark’s was motivated, not to address poverty amongst the aged, but to reduce the attractiveness of the emerging socialist party, which he attacked politically, including by passing the Anti-Socialist Law on 19 October 1878.

Bismark’s legacy has grown over the last 120 years as governments have added to their social contracts, establishing universal health schemes.

The problem that governments’ today face is that previous governments never fully funded their pension their promises at the time. Instead of putting away funds to cover future commitments politicians relied on the ability of future generations to fund pensions, age care and health services.

Life expectancy, which was 72 years when Bismark promised the old age pension at 70 is now 81.9 years at birth for the total population (males 79.48 and females 84.45). The funding requirement for government has expanded from 2 years to 16.9 years.

The ability to finance these commitments had one fundamental flaw. It relied on the structure of society to remain the same, that is, that the numbers of beneficiaries of age pensions and health services would be able to be supported by a larger proportion of the population that was in the workforce.

World War 2 produced demographic distortions that are as pronounced as at any time in human history. The effect was twofold. Firstly 50-70 million people were casualties of the War itself. Secondly following the end of the War soldiers de-mobbed. In Australia almost 600,000 Australians were demobilised in a process that commenced from 1 October 1945. The babies that were born over the next 15 or so years created an unprecedented demographic bulge. For many years this demographic bulge acted in our favour, providing nations with productive workers with an associated appetite to consume and drive economic activity.

The baby boomers are now rapidly approaching retirement. The first are now eligible for the age pension. Over the next 15 years baby boomers will progressively leave the labour force.

Within the decade however a significant proportion will retire. Age pension costs are just one bill governments will pay. Health costs rise with age. Age care costs will also increase significantly, although not as quickly as pension and health costs as the first period of retirement for baby-boomers is a period of relative good health.

None of this is news. Around 250,000 baby boomers turned 65 last year.

It is worth remembering that the first Intergenerational Report in 2002 projected that by 2042 the nation would face an annual budget deficit of $87 billion. One of the report’s central scenarios suggested that spending pressures will begin to rise from around 2017. But indications are that the demographic time bomb is coming early in the form of pressure on the health system.

The pressure on the hospital system is consistent with reports from the National Health and Hospitals Reform Commission who have noted that the two major drivers of demand for health services are an ageing population and higher rates of chronic disease, and that both these demand drivers are expected to accelerate over time, adding pressure across the entire health system.

The last Intergenerational Report in 2010 projected that by 2049-50 net debt would be around 20 per cent of GDP with the Budget in a deficit position of 3¾ per cent of GDP. Deloitte Access Economics has also considered the impacts on State Budgets, which are responsible for most health costs. They model that the State shortfall is almost 2½% of GDP by 2050, meaning that the total shortfall in national fiscal finances by 2050 would be just over 5% of GDP.

The key issue for both Federal and State governments is that no matter who is in power we can expect to see continued Budget pressure due to increases costs associated with the ageing of the population.

The pressure to produce Budgets surpluses is likely to lead to a year by year battle to reduce expenditure and increase revenues in order to pay the mounting pension and health costs. Considered over a medium term period such as 15 years – the period of time in which baby-boomers will transition to retirement – we are likely to see political parties make cuts consistent with their own priorities. This will result in what could be considered a jagged approach to cuts. Coalition Governments will seek to make cuts to welfare expenditure, whereas Labor Governments are likely to seek to pull back wealth concessions including for superannuation.

Overtime fiscal tightening and revenue raising can only go so far.

The question for progressive political parties, both here in Australia and globally is whether there are alternatives to this doom and gloom story. The answer is there is.

The challenge for progressive politics is to firstly understand that the power of governments to spend in order to address social, environment and economics issues will be reduced. Instead of proposing government spending as a solution, progressive politicians need to consider alternatives that produce the same outcomes. This is easier said than done and will require a fundamental change of both policy thinking and structures such as think tanks that can debate alternative approaches.

What may be called ‘Nudge Economics’ represents an alternative way of thinking around stimulating economic activity.

Cass Sunstein and Richard Thaler’s 2008 book Nudge proposed how governments could influence health, wellbeing and happiness through ‘nudges’ that would influence behaviour.

Whilst the book was focused on individuals, it is possible to utilise the nudge framework more widely for governments to ‘nudge’ economic activity.

One example of a ‘nudge’ is that governments could support the development of small cap companies by supporting broker research. Currently the debate on encouraging the development of small business focuses on different incentives that can be provided to entrepreneurs.

One alternative is to support the ability of capital markets to develop small cap listed companies.

There are currently around 2,200 companies that are listed on the ASX. The challenge that Australia’s capital markets face is that there are a large number of companies that are of insufficient size to attract investment from institutional investors. The lack of institutional investment interest in turns means that many companies are not liquid which in turn discourages brokers from providing research as broker research is paid for out of the revenues from share trading.

Academic research has demonstrated that there is a link between broker research and company valuations. Companies with increased valuations find it is easier to raise corporate finance and are likely to have stronger growth prospects.

In order to address the lack of broker research of small cap companies the ASX has established an Equity Research Scheme that provides broker research for a number of selected small and medium cap companies. The ASX Equity Research Scheme trial has the potential to be expanded to cover the whole market with in-depth, regular reports.

There are a number of potential ways that the funding for a small cap broker program can be raised.

State Governments may have an interest in paying broker research for small cap companies listed in their home state. It would certainly be cheaper to finance brokerage research than previous schemes where State Governments have competed for a company head office to be located in a particular city.

Alternatively the Federal Government could use regulation to require ASX to establish a broader scheme. The costs of the program could easily be paid for by the top listed companies in the ASX. Whilst it is difficult in a market environment for ASX to require larger companies to pay for the brokerage of smaller companies, since the program would benefit the overall health of the market there is a justification in regulation being used to require listed companies to support the scheme as part of their listing fees.

Having a program that supported brokerage of small cap companies would create an environment that would encourage small cap companies to list in Australia. It would improve the quality and depth of liquidity of small cap companies which in turn would support increased valuations and the growth of smaller companies.

Over the course of 2015 I will write about more potential ‘economic nudges’ that can drive economic activity.


ASX Equity Research Scheme

Carole Comerton-Forde, David R. Gallagher, Joyce Lai and Terry S. Walter, University of Melbourne – Department of Finance , UNSW Business School , University of New South Wales and University of Sydney, Broker Recommendations and Australian Small-Cap Equity

Pension and Superannuation Fund Investment in Innovation

Superannuation Fund Investment in Innovation

Melbourne Financial Services Symposium

Thursday 7 March 2013

Today I wanted to talk about why it is important that the superannuation industry work collaboratively to address the challenges that we currently have investing in what may be called innovation assets.

In my presentation I will be specifically focusing on the role that the ASX plays in providing opportunities for superannuation funds to invest in innovation companies. Young, start-up companies in areas such as Biotech, Clean Technology and Technology already look to the ASX as a means to raise capital.

To start let’s have a look at where the superannuation system is currently at.
According to the APRA December Quarter statistics the system has $1.51 trillion.

What is of particular interest is the rate growth. Over the last twelve months the value of superannuation investments has increased by $192.2 billion. In the last quarter alone we have seen we have seen $21.9 billion contributed to APRA regulated funds. Total contributions in 2012 were $92.2 billion up from $83.8 billion in 2011.

We can expect that the system will continue to grow. Deloitte estimates that by 2028 the system will have $7 trillion in assets.

I want to look at what this may mean for future asset allocation by superannuation funds.
In particular I want to look at the ASX where super funds invest a significant portion of new monies. The market cap of the ASX is around $1.38 trillion.

There are 2,183 companies in the ASX but 95% of the value of the market is in the ASX 200.
Superannuation funds roughly allocate 95% of their investments in ASX to the ASX 200.
The 5% that super funds do invest outside the ASX 200 is still significant, making up over $21 billion.

But here is the problem. The superannuation industry is rapidly outgrowing the ASX 200.
The continued strong cash flows each month into superannuation mean that funds must invest.
If we assume around $80-90 billion of annual contributions on a typical asset allocation we could expect that funds will invest up to an additional $20 billion into the ASX each year.

This equates to 20 $1 billion companies. Given that 92% of the market is made up of companies with a market cap less than $1 billion this indicates the size of the challenge.

There are already a number of implications of our growing size. Super funds for instance are increasingly drawn to dark pools because the size of some of the larger funds in particular means that it can be hard to execute in the lit market without moving the market.

But the more significant question is where does the super industry turn to for future investment?
The challenge that we have is that outside of the ASX 200 the market is illiquid and concentrated.
While liquidity is largely a function of size there are very good reasons why outside the ASX 200 more than half the market is mining and resources related.

We may think this is due to the all the ore that we have in the ground but in reality it is due to the regulation of the market, in particular the Joint Ore Reserves Committee that has meant that Australia has become an attractive place to list for international mining and resources companies.
There are over 200 ASX companies that solely work in Africa. We also have 15 mining companies based in Mongolia. One of the reasons we have such presence is that ASX has actively sought listings by putting people on the ground in Mongolia to recruit companies.

One option of course is for superannuation funds to seek investments outside of the ASX – and this is happening already. However it makes sense for the superannuation industry to consider how the whole of the ASX could be made a better place for future investments.

There are a number of ways the superannuation industry can work together to create more opportunities in the ASX.

The first thing is to understand that markets are a regulatory construct. The codes that have been developed for the mining industry have supported the development of mining and resources companies. The question is can we use similar codes in other areas to support the development of other sectors. One example is the Code of Best Practice For Reporting by Life Science Companies which is currently being reviewed. We know that there are US biotech companies that are now attracted to list on the ASX because of this Code. Are there ways that this could be further supported?
The second area we can concentrate is for the superannuation industry to collaborate to explore how we can support the development of the ASX. This could take a number of forms including establishing a working group that explicitly focus on this end of the market.

The size – and continued growth – of the superannuation system means that it is in our best interests to address the challenges in the ASX.

To finish it is worth asking the question does this is all matter. Is it a problem if super funds simply increase their allocations to global markets and diversify away from ASX?

It is worth delving for a moment into the economic history of one of the great economic empires of the modern era – the Netherlands. Kevin Phillips in his polemic book Wealth and Democracy examined the decline of the Netherlands which had been a significant merchant power in the 1600’s but by the 1740’s consisted of a divided society with a wealthy Dutch upper class and growing unemployment in towns that had once been thriving places for industrial production. Phillips attributes the decline of the Dutch empire in part to the fact that the Dutch upper class preferred to invest in economies other than their own, a fact that was not seen to be a significant issue at the time. In fact there were elements of Dutch society that advocated that the increased size of the finance sector that grew to service the Dutch upper class would more than compensate for the loss of domestic industries. This did not prove to be the case and the Dutch empire gradually faded, its demise accelerated by numerous wars.

Whilst things may have moved on over the last three hundred years the reality is that the superannuation industry and the economy are interlinked. Our contributions come from millions of Australians who rely on a strong economy for their future work. For that reason alone we have a responsibility to do what we can to make the ASX are better place for future investment.