Episode 8 of the Curious Kiwi Capitalist Podcast

28 January 2020

My guest for this show is Simeon Burnett of Snowball Effect, a crowd funding platform and private equity marketplace.

We discuss the crowd funding and equity raising landscape. Snowball Effect tends to work in the post-earnings post start-up stage of companies rather than the start-up and rewards part of crowd funding.

Simeon walks through how Snowball Effect helps connect entrepreneurs to investors. We get into the weeds with their process including screening, wholesale investors, documentation and the like.

We finish off with his career in corporate finance at Fonterra before he started Snowball Effect.

Show Notes

About

Simeon held a number of different corporate finance roles at Fonterra, before cofounding Snowball Effect.

Links

* Snowball Effect

* Episode Show Notes

Transcript: Crowd Funding with Simeon Burnett of Snowball Effect

Transcript to come.

Episode 8 of the Curious Kiwi Capitalist Podcast

28 January 2020

My guest for this show is Simeon Burnett of Snowball Effect, a crowd funding platform and private equity marketplace.

We discuss the crowd funding and equity raising landscape. Snowball Effect tends to work in the post-earnings post start-up stage of companies rather than the start-up and rewards part of crowd funding.

Simeon walks through how Snowball Effect helps connect entrepreneurs to investors. We get into the weeds with their process including screening, wholesale investors, documentation and the like.

We finish off with his career in corporate finance at Fonterra before he started Snowball Effect.

Show NotesAbout

Simeon held a number of different corporate finance roles at Fonterra, before cofounding Snowball Effect.

Links

• Snowball Effect
• Episode Show Notes

Transcript: Crowd Funding with Simeon Burnett of Snowball Effect

Transcript to come.

The post Crowd Funding with Simeon Burnett of Snowball Effect appeared first on .

Episode 7 of the Curious Kiwi Capitalist Podcast

12th December 2019

My guest for this episode is Lance Wiggs, Manager of the Punakaiki Fund, a Venture Capital fund.

We discuss the New Zealand venture capital landscape and how a venture capital firm operates. Lance takes a different approach to most VCs in how he has structured the LP side of the Punakaiki Fund  with capital raising from wholesale and retail investors over time rather than a smaller number of instituional investors up front. This is partly due to the shortage of NZ venture capital investors

something we also discuss.

We finish off with his career path including assisting TradeMe with valuation and his time at Yale.

Show Notes

About

Lance Wiggs is a Principal of Lance Wiggs Capital Management, the Manager of the Punakaiki Fund. In 2013 he co-founded this $50M VC fund for investing in high growth technology companies in NZ. It is an innovative approach to the venture capital gap in New Zealand. He is a director of many companies, most/all of which are fund investments.

He has launched Pacific Fibre, advised TradeMe on valuation on the Fairfax sale, and has worked at McKinsey in Washington DC  amongst a wide range of roles he has undertaken overseas.

Links

* Lance Wiggs

* Punakaiki Fund

* Episode Show Notes

Transcript: Venture Capital with Lance Wiggs

Coming in January 2020.

Episode 7 of the Curious Kiwi Capitalist Podcast

12th December 2019

My guest for this episode is Lance Wiggs, Manager of the Punakaiki Fund, a Venture Capital fund.

We discuss the New Zealand venture capital landscape and how a venture capital firm operates. Lance takes a different approach to most VCs in how he has structured the LP side of the Punakaiki Fund  with capital raising from wholesale and retail investors over time rather than a smaller number of instituional investors up front. This is partly due to the shortage of NZ venture capital investors
something we also discuss.

We finish off with his career path including assisting TradeMe with valuation and his time at Yale.

Show NotesAbout

Lance Wiggs is a Principal of Lance Wiggs Capital Management, the Manager of the Punakaiki Fund. In 2013 he co-founded this $50M VC fund for investing in high growth technology companies in NZ. It is an innovative approach to the venture capital gap in New Zealand. He is a director of many companies, most/all of which are fund investments.

He has launched Pacific Fibre, advised TradeMe on valuation on the Fairfax sale, and has worked at McKinsey in Washington DC  amongst a wide range of roles he has undertaken overseas.

Links

• Lance Wiggs
• Punakaiki Fund
• Episode Show Notes

Transcript: Venture Capital with Lance Wiggs

Coming soon.

The post Venture Capital with Lance Wiggs appeared first on .

Episode 6 of the Curious Kiwi Capitalist Podcast

25 September 2019

My guest for this show is John Shewan—former chair of PWC, and serving Adjunct Professor of Victoria University and independent director.

In this episode we discuss:

* Why the Capital Gains Tax (CGT) 2019 recommendation failed

* Lessons from tax reform through the decades including:

* --the rebellion against Muldoon's tax rates,

* --wide support and importance of the broad-base / low-rate approach,

* --always talk about tax in terms of tradeoffs and how taxpayers will be no worse off e.g. Sir John Key selling the GST and income tax rate changes together,

* --unless there is a crisis then incremental tax change with compromises is the best approach,

* --the government needs to actively sell their tax changes or others will take over messaging.

* The strengths of a land tax especially if accompanied by decreased income tax and increased entitlements (super & WfFTC)

* Government and demographic spending requirements putting extreme pressure on personal tax rates—bracket creep is now resulting in low income levels paying a 30% rate.

* Either income tax or GST rates will need to increase within 10 years unless the tax base is broadened e.g. through a land tax or investment property CGT.

Show Notes

About

John Shewan has had a long career in accounting, business and now academia. He is an independant company director, former chair of PWC and serves as an Adjunct Professor at Victoria University.

He sat on the Buckle Tax Working Group in 2010 ("A Tax System for New Zealand’s Future", Victoria University of Wellington) and has been a tax practitioner throughout his career.

He is a past Chair of the Tax Education Office and the National Tax Committee of the New Zealand Institute of Chartered Accountants. He was awarded the CNZM in 2010.

He is truly not just NZ's top tax expert but also brings intellectual firepower together with practical shrewdness to our business community.

Links

* LinkedIn

* Appointment as Adjunct Professor at Victoria University

* Episode Show Notes

Transcript: Tax Reform including Capital Gains Tax with John Shewan

Bruce: What are we trying to do with taxs here in New Zealand?

John: There's really three major objectives with taxes aren't there. The first one and the primary one is to raise the revenue that government needs to run the country, and to put it in context in the year to 30 June 2019 government's expecting to collect around $84 billion in both Direct Tax and GST and other indirect taxes and another $5.8 billion and ACC, fire service levies and fines and other revenue.

So that's the primary focus, but two other really important aspects of text redistribution of wealth tax does have a role in that the primary means of redistributing wealth is through the wealth transfer system, but obviously progressive tax rates achieve that as well and then thirdly an increasingly there's a focus on corrective and behavioral taxes. Things like taxes on tobacco and alcohol and now we're looking at taxes around environmental waste etc. So those are the three primary objectives and one of the most important messages I try and convey on tax policy is let's work out what aspect of that we're talking about before we start talking about the text tool that might be best to achieve it.

Bruce: And it seems that the increase in taxs is expected to rapidly increase over the coming years..

Episode 6 of the Curious Kiwi Capitalist Podcast

25 September 2019

My guest for this show is John Shewan—former chair of PWC, and serving Adjunct Professor of Victoria University and independent director.

In this episode we discuss:

• Why the Capital Gains Tax (CGT) 2019 recommendation failed
• Lessons from tax reform through the decades including:
  • the rebellion against Muldoon’s tax rates,
  • wide support and importance of the broad-base / low-rate approach,
  • always talk about tax in terms of tradeoffs and how taxpayers will be no worse off e.g. Sir John Key selling the GST and income tax rate changes together,
  • unless there is a crisis then incremental tax change with compromises is the best approach,
  • the government needs to actively sell their tax changes or others will take over messaging.
• The strengths of a land tax especially if accompanied by decreased income tax and increased entitlements (super & WfFTC)
• Government and demographic spending requirements putting extreme pressure on personal tax rates—bracket creep is now resulting in low income levels paying a 30% rate.
• Either income tax or GST rates will need to increase within 10 years unless the tax base is broadened e.g. through a land tax or investment property CGT.

Show NotesAbout

John Shewan has had a long career in accounting, business and now academia. He is an independant company director, former chair of PWC and serves as an Adjunct Professor at Victoria University.

He sat on the Buckle Tax Working Group in 2010 (“A Tax System for New Zealand’s Future”, Victoria University of Wellington) and has been a tax practitioner throughout his career.

He is a past Chair of the Tax Education Office and the National Tax Committee of the New Zealand Institute of Chartered Accountants. He was awarded the CNZM in 2010.

He is truly not just NZ’s top tax expert but also brings intellectual firepower together with practical shrewdness to our business community.

Links

• LinkedIn
• Appointment as Adjunct Professor at Victoria University
• Episode Show Notes

Transcript: Tax Reform including Capital Gains Tax with John Shewan

Bruce: What are we trying to do with taxs here in New Zealand?
John: There’s really three major objectives with taxes aren’t there. The first one and the primary one is to raise the revenue that government needs to run the country, and to put it in context in the year to 30 June 2019 government’s expecting to collect around $84 billion in both Direct Tax and GST and other indirect taxes and another $5.8 billion and ACC, fire service levies and fines and other revenue.
So that’s the primary focus, but two other really important aspects of text redistribution of wealth tax does have a role in that the primary means of redistributing wealth is through the wealth transfer system, but obviously progressive tax rates achieve that as well and then thirdly an increasingly there’s a focus on corrective and behavioral taxes. Things like taxes on tobacco and alcohol and now we’re looking at taxes around environmental waste etc. So those are the three primary objectives and one of the most important messages I try and convey on tax policy is let’s work out what aspect of that we’re talking about before we start talking about the text tool that might be best to achieve it.
Bruce: And it seems that the increase in taxs is expected to rapidly increase over the coming years..
John: Yes so the New Zealand tax system has performed extremely well over the last 30 to 40 years, its served successive governments well. We’ve basically got a sound system and the power of that can be seen in the 2019 budget where there’s a projection of tax going up by about 25% over the next four years. Which is quite a significant amount obviously and that’s driven off the strong bases of GST and also personal and company income tax. That kind of increase though is useful from a government perspective. However, We have to be cautious that we don’t bake in spending that equals that exactly and then find that if there’s a dip in the economy and the tax goes down. You’ve got a sudden budget imbalance. So that’s a significant issue for the Minister of Finance.
Bruce: Yes. So that’s the context if you like right now and going forward a little bit. What about let’s go back to the 70s. I remember my father used to turn on the radio and listen them to the Muldoon budgets. The household was silent as we listen to what was going to happen to us the next day. What what was the tax system back then in the seventies?
John: Well, I fell into tax by mistake studying it at Victoria University in a postgraduate course in 1976 and at that time New Zealand was in really a pretty tough spot. Britain had just joined the European Union. Ironically. We had the energy crisis. We had a significant downturn on exports and we were facing significant budget deficits and the Muldoon response was increasingly with interventionist. And at the time to me as a student that scene entirely logical. Let’s introduce tax incentives that will incentivize investment or incentivize people behaving in particular ways, but it really grew on top of itself far too much and by 1981 there were about 70 specific tax incentives which were gobbling up 42% of the tax take so to put that in context, today we’re collecting about 84 billion a year in direct tax and GST. If you used 42% of that to incentivize Behavior, you have a real problem and that’s exactly what Mr Muldoon as he was then called struck.
So by 1981 the tax system was in real strife because of the amount that was being spent. The response to that to bridge that gap was to put up tax rates and the top rate went up to 66% in 1982. And again at I that stage I was just starting working in tax policy or had been in it for about three years, I began to realize that actually a lot of these incentives were doing an enormous amount of damage and it really came home to roost once when Mr. Trotter subsequently Sir Ron Trotter who was head of Wrightson NMA as it was called in those days part of the Challenge Corporation group, chastised me for doing something which I thought he should be pleased about it. And that was that we had identified as his Auditors that his company right since was eligible for various very generous tax incentives on new grain silo installations, and they had not realized that and they got quite a substantial refund and I was asked I was requested to go meet with Sir Ron Trotter, which was pretty pretty traumatizing for a young graduate, and he was a big man. I remember walking to his office expecting to be congratulated and he was quite gruff and he said I hear you’ve saved some money, but I think this is just completely wrong. And I asked why and he said look as a board we made the decision to build those new silos some 5 or 8 years ago it had nothing to do with these incentives. This is a misuse of crown funds. And it was a very telling moment in my career because it made me realize actually that when you are as a government using item strong policy tool like the tax system to incentivize behavior, you really have to make sure you’re doing it in a targeted way that doesn’t result in wastage.
So I began to change my views and then as the 66 percent tax rate began to bite another kind of dramatic impact for myself and other tax advisors was that basically there was civil unrest. Entirely law-abiding citizens basically said I won’t work 2/3 of the day for the government and they reacted very strongly by investing into a whole lot of farm ventures and film ventures and some mad things like the deer running all over the hills Peru, which probably the dear probably never existed in the first place, but my gosh, they generate significant tax losses. And people were basically refusing to pay the 66%. So the whole the whole tax system was coming down under its own weight and of course literally the country was in a state of a virtual bankruptcy by 1984 when the the significant changes began to occur following the change of government.
Bruce: So in the seventies the country was slowly being broken through a number of things economic and tax, perhaps other things as well, by ’84 it in essence broke. And the Lange government came in what did the now Sir Roger and David Lange do over the coming years?
John: Well, the first dramatic change was not long after they were elected they announced of course that they had to bring in a GST and that was stunning.
Suddenly we had a government that had been elected. Had not campaign on a significant tax change but they announced they’re going to do that and it heralded just a completely different approach. But whilst they announced that they also made it very clear that they were going to consult and I recall those involved with what was then called the society of accountants tax committee.
We had never been consulted by the government and we’ve been brought up to kind of oppose. So whatever Muldoon proposed would kind of oppose but I particular reason other than the fact that generally speaking we didn’t agree with what the tax measures were doing. Sir Roger Douglas on the other hand announced that he would be coming and visiting our committee at our officers which was kind of stunning and it was again for me a real line in the sand because it marked the start of a tax policy reform process, which has endured to this day in a certain New Zealand really well.
But he genuinely said look, I don’t want to debate with you guys the principle of GST because we’re going to do it but I absolutely want detailed input as to how it should be designed and and of course that model has been picked up by subsequent governments and lives on today. So it was a very very dramatic change and it took quite a while for us to get used to and that’s of course applied across all extras s fix the economy whether it be banking capital markets tax the whole reform agenda, but it was a period of enormous consultation enormous controversy, but was made much easier I think by the fact that because the country was on its knees financially everybody whether you be working in a supermarket or whether you be chief executive of one of New Zealand’s largest companies everyone knew that we couldn’t stay as we were. So it demonstrated to me at least that never waste a good crisis. And Sir Roger and David Lange didn’t waste a good crisis they were able to achieve enormous change in a very short space of time.
Bruce: What were the key things that they did in your opinion?
John: Well, they go well beyond tax, of curse, ultimately a complete Reformation the economy,
Bruce: Just on tax…
John: If I focus on tax, the really biggest change was recognition by the government that taxes have a distortionary effect and therefore you need to go back to basics and work out what are the least distortionary taxes. All taxes create distortions one of the basic principles of tax policy is in the context of efficiency and growth. You want to make sure the taxes do the least damage possible. In a perfect world you’d have no tax, but of course can’t work because you need to run though the government.
So they very quickly referred to the research done globally that demonstrated that the most distortionary taxes are taxes on salaries and wages and company profits. And so the rates were ridiculously high 66 percent for individuals top rate 48 percent for companies. They had to come down. So they very quickly reduced those rates and funded that by the GST, which was brought in from 1 October ’86 at a rate of 10%. And then they also abolished all the incentives so that the 70 incentives that were gobbling up about 42 percent of the tax state, they disappeared within the space of about 12 months which caused enormous pain for some operations, particularly, obviously Farmers, but, and there is a real issue in this, they sold it very cleaverly by the trade-offs. That for everybody who was paying more tax than previously in a particular area in other areas they were receiving some form of discount or credit. And by and large there was general acceptance by the business community that these measures whilst painful were necessary and the fact that they haven’t been reversed, you know, you hear about the failed policies of the 80s, which is complete nonsense because in successive governments have stuck with those policies and the been endorsed strongly by the likes of the OECD and the IMF and the World Bank.
Bruce: Perhaps a key lesson is the trade-offs that you’re talking about. So never talk about a tax by itself, if you looking at a large tax reform package, but always as the the trade-offs from one tax versus a another type of of tax.
John: Yes trade-offs that crucial. If you look at more recent history, I think the one of the reasons in my view why the 2019 tax working group’s recommendation of a capital gains tax in the end didn’t proceed was because it was it was put up in a way really didn’t deliver trade-offs other than in areas like the revenue from that capital gains tax would likely have been used to fund additional benefits or tax cuts at the very low end. Now that that’s fine as a policy objective, but when you’re asking one group to fund such a significant change for another group with no other compensating trade-offs that is a very hard message to sell. And so it proved.
If you look at what John Key managed to do in 2010 when the GST went up from 12 and a half to 15% but the trade-off was quite a significant drop in personal tax rates across the board and also an increase in working for families.
So those trade-offs are crucial in history if you look at the really big reforms that have come in tax over the last 40 years the ones that have been sold and have succeeded are the ones that have involved significant compensating trade-offs. And that’s a really important I think a political lesson, but also it’s a message for those wanting to advocate for tax policy reforms.
You got to present both sides of the equation.
Bruce: Just as an aside, did the Lange government ever look at some form of tax on capital.
John: Yes, so in the late 80s, they set up a group to in design a capital gains tax and ironically is seems to always happen in New Zealand when we set up groups to examine capital gains tax in the end it did not proceed because that particular group concluded that there were a number of other design features of the NZ tax system that needed to be solved first. By the time those were being addressed with had a change of National came in and the the capital gains tax didn’t actually proceed. But they definitely looked at and I think to this day Sir Roger Douglas would say that’s that’s unfinished business as he would arge there are many other areas he would argue those unfinished business. The “cup of tea” in 1989 I think it was took care of that.
Bruce: Wasn’t there a book called “Unfinished Business” , Prebble?
John: Yes Sir Roger Douglas.
But I don’t want to give the impression that everything was was smelling of roses in the 1980s. The Douglas era did not cover all the bases. And one example would be when they deregulated the foreign exchange markets they didn’t simultaneously bring in tax measures to deal with the taxation of profits that might arise from money being moved off to these offshore jurisdictions, which often have much lower tax rates than New Zealand. That that loophole was closed in the late 80s, but there were two or three years where it was open and there was quite a significant outflow of funds and tax lost as a result. Another example would be the delay in bringing in things like fringe benefit tax where that resulted in in some loss of revenue.
So they dealt with the really big issues. But you know, it was like drinking out of a fire hose. There was so much going on. So perhaps not surprising that some of those matters around the edges were not dealt with as expeditiously as they should have been.
Bruce: Do you remember, so right if now we’re at about an 84 billion tax take, do you remember what the text take was nominal dollars back in the and then the 80s.
John: No, I can’t recall those figures but it obviously was a fraction of that but it was also very concentrated on on individuals and companies and of course very high sales taxes. But the strength of, what’s been the, what’s turbo charged the New Zealand tax system is the GST. It’s an enormously powerful instrument as other jurisdictions are found as well. And it’s relatively less distortionary and that’s been hugely successful. And I think it’s not surprising that John Key resorted to the GST in 2010 when he wanted to implement a further rebalancing of the tech system.
Bruce: Okay, so that’s the 80s and then we have the new Bolger government. What approach did they take?
John: Well the Bulger Richardson era largely in tax terms continued the Douglas era, continued with the reform program. It was it was more granular in the sense that some of the big ticket items will be dealt with and so they were dealing with some of the more detailed matter.
But the most significant change that occurred in the Bolger era and the Richardson era was the introduction of what what sounds really boring but it was really important, which was the generic tax policy process. What that is, and it was designed by Sir Ivor Richardson former President of the Court of Appeal and a tax specialist. But it arose because the Bolger government identified, as did Sir Roger Douglas actually that when you are designing tax policy, you will benefit a lot from private sector input. You need to have contestable advice so officials and this country like other Commonwealth countries at least have enormous power because they have access to the politicians and they provide the advice. Sir Roger Douglas and subsequently, Mr Bolger and Ruth Richardson recognized though the power of private sector input. So the the generic text policy process formalized what Sir Roger had started by requiring Treasury and Inland Revenue to involve the private sector in in-depth consultation around tax policy. And that came in a 1984 and this again the success of subsequent reforms, reforms subsequent to ’84 in large part, I think is attributable to the success of that process.
I think it’s quite tough on officials because they have to deal with private sector input. It’s not so much these days but in the 90s and early 2000s, there were private sector people seconded the ministerial offices the Minister of Finance and the minister of Revenue had private sector people in their offices, and that was extremely valuable in terms of robust debate and getting a really good conclusion.
Unfortunately to some extent that processes is not as wholesome as it used to be., We seem to be reversing a little bit the old days of the officials doing 90% of the work or 95%, and that’s one area where I have some nervousness about the way the tax policy process is going now. I think we need to go back and freshen up the generic tax policy process or we risk going back into some of falling back into some of the traps of the past.
Bruce: One of those traps being the tax incentives for business and we seem to be having more and more, and perhaps this was in the Key government as well, I’m not sure but, more and more business tax incentives thereby putting holes in that broad base low rate system that I think you’re a strong advocate
John: I fear that the broad base flow rate system is under real threat because there’s very high expectations today in relation to what the tax system might be able to achieve. And I think we have to, and Sir Robert McLeod who chaired the 2001 tax review coined the phrase we must proceed with Extreme Caution before tasking the tax system with functions for which it’s ill-equipped to deliver, or words to that effect. That I absolutely endorse his comments and yet these days not helped by the kind of one-liners across social media which then become headlines in the mainstream media, many people with the best intentions view taxes being a logical and easy way to deliver changes which will incentivize behavior. And it ranges from business tax incentives, like strong focus on lets incentivize research and development and I’ll come back to that right through to whether it be sugar or red meat or other sort of evils that are seen as causing and they do cause problems in society, let’s use the tax system to fix them and I think we have to be really careful. There has to be a very high burden of proof in my view before you resort to tax. And like if I take sugar as an example, and it’s a very ill defined debate at the moment and quite rightly the 2019 tax working group on sugar said to the government you go away and tell us what you actually want to achieve from a policy perspective with sugar. Because if we want sugar consumption to drop dramatically, well let’s regulate for that or ban it or not ban it completely obviously but you put in restrictions on the amount you can have. It’s unlikely that the text system will be able to achieve that and
tobacco tax is a huge revenue earner. And yet it’s a contradiction because actually if we’re serious about wanting to reduce tobacco consumption to Zero by it’s a 2030 then you’d want to wipe out the several hundred million that’s collected each year from that source. And yet we know what the excise tax on cigarettes do they result in actually the poorer into society being subjected to very very high rates of tax.
So I think we have to be careful. If I come back to the business tax incentives research and development incentive personally. I don’t support I argued against it in the early 2000s when the then labor government bought it in and the subsequent national government repealed. It is now coming back in it will without doubt have some positive effects, but you’ve also got I evaluate to what extent is that subsidizing activity which would carry on in any event at quite substantial cost. So I have real reservations over that and I keep in my top drawer at home the 1981 tax information bulletin which which is a really good illustration of once you start down the slippery slope of tax incentives then you start with the research and development and it’s very easy to end up with about 60 or 70 others and a very narrow base and that comes at a cost. That means everybody else is cross subsidizing and you’ll have tax rate inevitably will go back up and that’s my biggest fear. I think the outlook is for a narrowing of the text base and an inevitable increase in both personal and company tax rates.
Bruce: I almost wonder if it a board level people are saying, this is not right of course, but it illustrates the point, they are saying shall we spend some dudget on a lobbyist or shall we spend some budget on an export manager or a overseas distribution channel. And it feels as we increase the level of incentives offered to government either direct cash or tax that decision is going more towards the lobbyists and towards being the normal business growth decision.
John: I hope that’s not right certainly the organizations I’m involved in we don’t spend anything on lobbyists, but I’ve always had the view that are actually have got a coherent policy objective, NZ is a country where you can get access to the decision-makers, it’s one of the great features of New Zealand without going through a lobbyist who probably doesn’t understand the technical detail on any event.
Bruce: So then in 2010, you were part of the Victoria University tax working group and your work led to Sir John, delivering some increases in GST and decreases in personal tax rate.
But you also recommended a land tax as well. Perhaps talk a bit about that working group and end where you came from in terms of the land tax.
John: So the 2010 tax working group was interesting because if we look we have these tax reviews around about every ten years typically at the start of a new government.
So we had back in 1982 McCaw report, Valabh group in the late 80s, had Sir Robert Macleod tax review in 2001, those ones were all government appointed. The 2010 one was actually a Victoria University initiative which arose from a major tax conference the university had had in 2009, but it attracted the interest of the government and including Sir John Key.
And so he was very supportive of the idea of a university-based working group, but the big advantage that we had relative to those other working groups and also to the 2019 tax we can group is that we were completely independent of the government point one. Point two, we had no terms of reference. It was fascinating. I remember sitting down at our first meeting and we literally had a plain sheet of paper.
Where do we go? Whereas the 2019 group had quite prescriptive and restrictive terms of reference. So we decided that we would focus primarily on. Revenue raising taxes rather than the behavioral taxes and at an early stage and Bob Buckle Professor Bob Buckle, dean of the business school at Victoria University at that time was chair, and did a fantastic job. With the research that we had from the University assisted by Treasury and some input from The Reserve Bank, our group at an early stage reached the view that the system tax system in 2010 was suffering from some of three major problems.
Firstly it very heavily reliant on the most growth distorting taxes being taxes on individuals and companies and there were some dangers ahead with demographic changes etc.
Secondly, we concluded there was a gap in the in the in the taxation of capital.
And thirdly we concluded that there are a number of other distortions caused by different entities been taxed at different rates. And so, you know, if you operated through a company, you paid a much different rate than if you operate it as an individual etc.
So those are the three primary areas and we concluded that the system basically wasn’t sustainable. But what unlike some working groups where we took with the viewers taken that you shouldn’t get involved in politics. We concluded that to present a package that was saleable, we had to accept that I’d be very hard politically to make major changes in things like GST or capital gains taxes or land taxes. So we had to produce a package that would come up with trade-offs, which is what the 2010 report does. And I think by and large it was a well thought through set of alternative proposals that were put to the government and just before Christmas 2009 and which ultimately found a way through into the 2010 budget.
Bruce: One of those things was the land tax. Perhaps talk through the the land tax proposal.
John: The land tax proposal came as part of the overall discussion round the taxation of capital. So this was the subject where our working group had the most debate and the greatest disparity of views.
And it’s interesting if you look at history, that’s what’s happened to every one of the four tax working groups in the last 40 years. We’re all the most recent three: the McLeod one, the Victoria University one, the 2019 one, have all recommended to the government some form of increase in the level of taxation on capital. And ironically in all three cases the government has rejected the recommendation. So you have to sit back and say why is it that we’ve got these working groups which by and large comprise people got a fair bit of experience come up with these recommendations and governments, successive governments of all colors, are saying no and I think it comes down basically to politics and to the fact that the politicians want to be re-elected and you have to sympathise with that.
If I focus specifically on the land tax proposal, our group could not agree on a capital gains tax. We will split I think it was split something like five-three or five-four against a comprehensive capital gains tax for basically exactly the same reasons as the minority view in the 2019 group were against it. That is in the overall scheme of tax policy if you carve out the family home, which which almost certainly have to do politically then what you’re left with is a much narrower base and our view back in 2010, I think it was right, is that the net downside of bringing in a comprehensive capital gains tax in terms of impact on coherent sufficiency fairness those core principles was not outweighed by the upside.
However, we thought there was a gap and because in the taxation of capital and the biggest component of capital by a large margin in New Zealand, biggest component of untaxed capital, relates to land and our view was that unless you are bold enough to bring in land that is underneath people’s own houses, you may as well forget it. Which is basically what the current government’s decided to do, but back in 2010 we went further and said we think you could bring in a very very low level land tax think we’re looking about 0.5% and that would have applied to all land and you may have had some exceptions for and variations for Maori land and some aspect to Farmland.
But certainly a lion’s share of land would be caught but the revenue from that was potentially extremely significant it was around a billion dollars at a point five percent rate and we were able to put up a package that had compensating tax reductions and other benefits going up. So the top rate would have been about of tax would have been 23% and most people would have been paying about 12% or 13%. So it was a very powerful package. But the justification for it was that it’s a very efficient tax land tax, you can’t avoid land tax. We didn’t think it was as hard to sell as some people suggest because local authority rates are basically a land tax so there’s already a precedent and it’s reasonably easy to collect.
So that was the that was the basis for our conclusions. But again, it was a split decision, but the majority recommend it and to this day it surprises me that it didn’t receive more profile than it did. There was very little attention paid to it. Sir John Key of course wasn’t prepared to go that far. He was prepared to go with the GST.
And it was fascinating I recall we had a really useful debate with the then prime minister just before Christmas in 2009 giving him a heads-up as direction of travel and initially he didn’t seem at all comfortable with either a GST increase or the land tax and we basically argued in response if you want to reform the tax system you’re going to have to do something that’s got real grunt to it and is justified from a policy perspective. And I think he bought that argument but saw the GST as being something he could sell which but he did very well actually, but he thought the land tax was not something that he would either want to sell or could sell and you know, I have to respect his political judgment. Maybe he’s right. I don’t know but I’d to this day believe that sooner or later New Zealand’s going to have to tackle this issue. Ironically. It’s been kicked out of the park. Now, the black caps will be proud of the the whack that the Prime Minister gave this one it’s it’s a 6 and we’re not going to have this debate for another 10 years, which I think is unfortunate.
Bruce: I’ve always wondered whether you have a land tax combined up with the rates. So there is a rate that the central government collects, land tax of course, and then central government hands out money to local government and also put some various restrictions around the quality of spending that local government puts in place but I suspect that is equally difficult in terms of the politics.
John: But I think there’s an argument for that kind of reform whether the sharing of land tax revenue, which is basically local authority rates equivalent, between central and local government. Of course in Australia they share the GST is paid to the states and that seems to have caused an enormous amount of stress over there and it perhaps as one precedent you need to look at very carefully, but I think there is a case for reform of the funding of local authorities.
And I think there is a package there that you could look at wrapping it up with an enhanced land tax. But you’ve got to solve the trade-offs and the trade-offs would be a permanent reduction in personal tax rates. The reason I say permanent and this is a real challenge is that the public will be rightly skeptical that they’ll get the tax rate reduction now but sooner or later I subsequent government will increase personal rates again, and you end up with the worst of all worlds. And that is a challenge. And you course Parliament is sovereign you can never bind and future governments. So you need to be conscious of that problem
Bruce: In terms of retired people who don’t have high income but own a large as it being their family house. I guess you’d increase their super to make up for the increase in the the rate or the land Tex.
John: Yes. I’m in dealing with transitional provisions like that is important. So retired people you’d need to look after them one way of doing it is increasing super, another would be that this text might only apply to people who buy land after a certain date, another another might be for people who quite rightly say I don’t have the cash flow to fund those kind of tax that it be built into effectively a loan from the government and paid at the time that the property is sold. So there are and these are all big challenges now, I don’t want to underestimate them. But there is a I’m convinced that a package there, you know, the irony is it’ll probably take a financial crisis to actually provide the rocket to put this deal into. Because that’s what happened with GST back in ’84 ’85 and we don’t want to predict the future financial crisis for New Zealand, of course, but I think it’s not until the going gets really tough that, actually if you don’t want to bring in those really substantive reforms, that it’s easier to get people on side.
Bruce: This is a podcast about the capital markets and one of the things that keeps coming up as the extent to which people have invested in land residential land rather than into to growth assets such as private businesses and the stock market. I like the idea of a land tax because of the way it and incentivises capital to go towards growth assets rather than what I see as being a consumption, being the family home?
John: I think that’s right. I think there’s a real real issue here and some very good analysis in the 2019 text working group report, which I would recommend for anyone interested in capital markets around risk capital and the principles of taxing risk capital and the circumstances under which government may not wish to be too active in the taxation of risk capital because by definition of they’re doing that they’re also picking up their share of the losses that arise from that risk capital. So there is an argument and this is how this risk free rate of return principle that that is now applied to tax overseas investments from a New Zealand portfolio and business perspective. That’s where that that mechanism had its genesis and the 2019 working group research makes it very clear that the biggest area of unproductive and undertaxed capital is in that area of land without doubt. And so although you can point to certain other areas. I think you deal with 80% of the problem if you were able to tackle the land issue. That’s the easy part.
The hard part is that there’s the particularly the issue of farms and Maori land very very hard to deal with that and to what extent should you have exemptions etc, but I say again, I think there is a package there. And the productivity commission’s report around productivity in New Zealand and the impact of tax on productivity and the kind of assets that we should be taxing more lightly versus those that we should be taxing more heavily all point to doing something around land.
And we get so emotional over it for some reason that we run away. And again, it’s the politicians that have to sell it and I can appreciate how hard it is, but sooner or later it will happen whether it’s in a lifetime, I don’t know.
Bruce: In terms of the the Maori land I understand there’s Treaty of Waitangi negotiations that have gone on and when we don’t want to disrupt those. In terms of farming land, how would that be handled?
John: Well, the issue with farming land is clearly. It’s part of the business of farms the if you impose the tax on it would result in a significant burden on farming which would further erode profitability of a sector which at the moment at least in many aspects of farming is not generating an acceptable return on capital now. So quite rightly this would cause significant pressure. However, you do have to question why is it, why are why do we have all this these assets tied up and not producing an adequate rate of return. So that’s a much broader set of economic questions there. I think though that until until there’s transformation on that sector if you were to bring on an tax, you’d have to have some very concessionary provisions around farmland and you could do that. You can justify it. What I’ve learned from tax policy over the years is that you can be reasonably generous and a transition because the decades quickly take care of it so you can grandfather things. But if you get those principles in place and people know where they’re headed going forward they can plan accordingly.
And again the lion share of land in New Zealand is residential land and that’s the area where you could make some real progress I think.
Bruce: I suspect the line here is Auckland residential land where the heart of the median voter lies and therefore causes the most political difficulty.
John: Yes, but that again comes back to trade-offs.
Bruce: Right so you said this before, so you increase you have a land tax and you drop your rates your tax your income tax rates down to 23% I think.
John: In 2010 with the modeling we were doing in the 2010 working group at that point I top rate of 23% was feasible. It’s interesting. I think if you took an average Auckland household and you went out with a package along the lines of, whether this modeling works today, I’d had that obviously verifed, but went out with a package of a point five percent land tax which might result in a tax burden of say eighteen hundred dollars a year on typical Auckland house.
But the conversation was their top tax rate was going to be lets say 23% and the scale down accordingly as a package. That’s something I think people would be pretty interested in having a look at. And again coming back to the impact of taxes on incomes versus taxes on land and consumption.
We know from an economic perspective the taxes on consumption and land are going to be less damaging than the taxes on income.
Bruce: And the land tax is on land, its not on the improvements to the land or the housing on the land. So it’s just the the land. That’s interesting. Shame that this was lost in the tax political wilderness.
Some good work was done there and then the 2019 tax working group was set up. Perhaps review that and the lessons that came out of that.
John: The 2019 tax working group is a really interesting exercise to look back on and I think they’ll be books written about it in the future maybe not best sellers but these books. And the reason I say that is that it was very clear when it was set up that the government had a absolutely genuine desire to improve the fairness of the New Zealand tax system and to obtain advice on how they could better structure the tax system to deal with poverty, housing affordability, environmental issues and social issues. And the terms of reference were very very specific and and gave very clear guidance.
My own view is that they were too restrictive and I think some on that working group share that view that they would have found it easier to have had more room to come up with packages because some of the trade-offs that they may have wanted to offer they couldn’t because of the restrictions. We have to bear in mind that it had a very bumpy political birth because initially it was suggested as part of the 2017 election campaign from Labour where they were going to setup this committee after they were elected into government and that resulting people saying we’ll hang on I’ll be electing a government or a committee. And then the labor committed to well, we’ll set up a committee, but we will not legislate but we will not introduce any measures that have effect before the 2020 election.
So that’s the way they dealt with that criticism, but it didn’t mean that they’d already committed to any significant changes being taken to the electorate. Contrast that with 2010 and back to the Roger Douglas days where they weren’t taking these substantive matters out to the electorate.
So the group was chaired by Sir Michael Cullen. I thought that was an inspired choice in the sense that very very able man and someone who I thought would be able to sell very well the arguments for expanding the tax base to include some kind of tax on capital which was clearly one of the government’s objectives, and they’ve been pretty open about that.
With the benefit of hindsight, although I think Sir Michael did a very very good job in terms of the way he did articulate things, I had underestimated though the effect of him being a former obviously very senior politician Deputy Prime Minister Minister of Finance, that I think resulted in some in the public seeing him as an extension of the government.
So caused some skepticism as to the independence of the group. So the lesson I think for me from that is that actually you probably best to keep these groups as independent as possible from government. That in no way is a criticusm of Sir Michael I have enormous respect for him, but I think that the history there is interesting.
The other interesting development there, of course was it was apparent from an early point that with the particular mix on that group which was more diverse than earlier tax working groups, and I can understand the reasons for that, so your people particular expertise in social policy and Maoridom and so on, environmental issues, but the more diverse there was perhaps less focused by some on the economic principles of tax policy. And that resulted in a likelihood that there was going to be a disparity of opinion and indeed that’s of course what happened. When you got a minority of three came out with a report which disagreed with the primary recommendation of the group which was to bring in a comprehensive capital gains tax. And I think that was always going to be difficult for the government to handle.
The other really interesting development with the 2019 working group which I think is a lesson for future governments and future working groups is that they produce their final report in I think February of 2019 and then there was quite a delay whilst the government decided what they wanted to do. And the government finally responded in mid-April to the working groups recommendations. And in the meantime that gap was filled by, all manner of well-meaning commentators and perhaps some who are not so well meaning some who are deliberately trying to undermine the process. And particularly around the capital gains tax which completely dominated the whole media debate there was some very very strong criticism. And I could sense of the public was getting unsettled because although they’ve been told that if a capital gains tax came in it would only impact, remember the Prime Minister saying four percent of New Zealanders and it was going to be in a straightforward ecetera. And the reality was it was it was not straightforward and we began to get examples of what happens if Grandma dies and the house is held for a while and then sold and what about the holiday house and what about all these valuations that will have to occur… And so the public began to get very very edgy and it’s interesting history tells you that you underestimate the public at your peril. And I gave a public address in March of 2019 where I said to quite a big group this package doesn’t have a bolters show of been accepted by the government or the public. Because it was simply too too scary and and it lacked the trade-offs and that’s exactly what has happened.
And it’s I think in many respects unfortunate that direction it did but there are many lessons to be taken out at it. However, there’s some really good material on their report and there’s a number of others. It’s interesting. There are 99 recommendations. If you ask the public I dealt with other people would get beyond the capital gains tax one.
So the other 98, of course the kind of wallowing in the sea somewhere. There will be some I think response from government of already committed to researching a number of those ideas and and things like environmental taxation I think we will see some reforms that are based on this working groups work, but unfortunately it will always be known the capital gains tax that didn’t ever proceed.
Bruce: So true that dominated the agenda for so long and it was just the CGT the capital gains tax. It’s interesting how it was almost more of a PR disaster than a working group disaster.
John: I think it demonstrates the need for and it’s hard for a government in receipt of a report to give a prompt response but it demonstrates the need for there to be immediate political leadership which they gave but they gave I think with great respect to the government some weeks too late. And therefore they lost you know, someone else was driving the debate and the results speak for themselves. I think there’s a real lesson in
that.
Bruce: As I said before we started recording, I remember hearing the announcement that they were going to put a CGT on the sales of business and and thinking by golly there’s going to be a lot of work there for valuing businesses. It’s not good for for clients, but boy, is there a revenue stream that I think every lawyer and an accountant, anyone involved with the capital markets saw a huge stream of these in felt and embarrased, bad, that such a fee would be made from what would be such a difficult tax to be applied to to the client base.
John: Yes, the the package was so comprehensive that the consultants would have made a fortune. Again the government said that’s not it’s not the case it’s going to be really simple but it was that was completely contrary to the facts. I think the taxation of business in a capital tax regime is hugely complicated. The big one of the big issues in New Zealand of courses with imputation, you’ve got one layer of tax and it was easy to demonstrate that a capital gains tax that taxes again on what’s basically the discounted cash flow of future profits. There’s an element of double tax and how do you eliminate that so immediately you had all these very technical issues which caused people’s eyes to glaze, of course the consultants to smile, but the worst aspect I was it caused business uncertainty and you saw the impact on the share price of certain entities that you know, they were beginning to wobble a bit as people were unclear about what almost would mean. So that was unfortunate and I think at the end of the day that the whole regime was far too ambitious. It was much broader to have a non inflation-adjusted capital gains tax, with no grandfathered assets applied basically all business assets with very little in the way of concessions to deal with some of those complex issues we touched on. Very very very very ambitious and as I said earlier, it was never going to sell.
Bruce: And what many business owners probably don’t understand is that valuing a business has a wide range an incredibly wide range depending on the assumptions behind that report or that valuation and likewise what could happen is the IRD could choose one number your lawyer can choose the other and the person that will decide would be the Supreme Court. The people that were designed by the Supreme Court in the end it would have been a litigation feast.
John: Yes and that points to violation of one of the fundamental principles of good tax policy is compliance administration costs.
And the cost would have been enormous. Now, you have to trade those off against the benefits but like Minority Report made a very strong cogent argument, it’s only nine nine or 10 pages, but the primary driver of that I think was probably Robin Oliver who is, one of, if not, the most respected tax policy people in New Zealand was Deputy Commissioner of Inland Revenue and head of policy for many many years used to be also on tax policy and Treasury.
And Robin Oliver has an uncanny knack of expressing in very clear terms matters that have been troubling the public for a long time. And so I recall on a couple of radio interviews he basically ditched the capital gains tax. I think his his impact was very very significant. He argues and I think I agree with him that you can take the incremental approach on something like this and that we are better off with the under taxed areas in particular residential housing and rental housing, which do appear to be undertaxed you can deal with those in different ways. You don’t need to bring in this enormous reform which sort of blows holes in other parts of the tax system and causes lots of business uncertainty and also grief to to private individuals.
So, you know, it’s not we shouldn’t say this debate is over, it’s not, and the Minority Report I think gives a very good framework to move forward on. Although interestingly the government has kind of rejected that and that’s what took everybody by surprise the fact that they didn’t only say we might go ahead with the immediate proposal just don’t come back and talk about it in the foreseeable future, which is a big surprise.
Bruce: So in terms of the future in terms of tax policy in the future, what’s going to happen? You know, there’s an issue there with bracket creep and an issue there with more and more spending or tax breaks. What’s going to happen in the future and how do we avoid another disaster like we had 1984? Though perhaps that was such a disaster will never ever go back to those days.
John: I do think we’ve got some real challenges ahead on the tax front because the the impact of inflation lowers it is has meant that we now have. The thirty percent tax rate cutting in at an incredibly low level $48,000 and the top rates only 33 percent so it’s not really that much different and that comes in at 70,000.
And successive governments have left it at that level and now it means that a very significant number of kiwis are on either the top rate or very very close to it. Now it’s expensive to change that. Once you get everyone paying those rates as soon as you move the brackets that obviously cost a lot of money and at the same time we’ve got what looks to be an economic downturn coming as you would expect driven by global and domestic events and yet we’re forecasting a 25% increase in tax over the next four years. I can’t see that 25% been collected. I may be wrong, but I hope I am wrong, but I just think if we look at the global trajectory and we mirror that locally to say that we’re going to get a an increase in tax of about 4- 5% a year of economic growth being 2.8. I don’t quite understand how that can be the case.
So that means I think that we’re going to have pressure on for rate increases and also means we’re really not in a good position to deal with some of the other anomalies that the tax working group in 2019 identified such as no tax relief on seismic expenditure, which is a major issue, especially in the Wellington area, the inability to depreciate buildings, even in circumstances where clearly they do depreciate that’s an expensive problem to fix.
So the number of areas where the tax system requires reform but both officials and politicians seem quite quick a dealing with matters of reform that raise money, but not so quick at dealing with matters of reform that result in a revenue reduction and I understand that but sooner or later that catches up with you.
So I looking ahead would be surprised if we don’t face a scenario in say 2023, which is the four year out year period from the 2019 budget where tax rates and GST don’t increase. And you know GST increased to say seventeen and a half or eighteen and a half percent or increases in personal tax rates must be a possibility. Again I hope I’m wrong.
But we have to be really careful because we have the tax system has been managed extremely well over the last 30-40 years almost we have to be careful not to lose those gains and yet some of the design features now that are coming through a putting real pressure on.
Bruce: I suspect that if we are forecasting that the tax take will increase to I think it was a hundred and five billion in 2023 the government expenditure will naturally match that 105 billion even if it not forecast right now. And if there’s an economic recession even a mild one the government expenditure will be even higher than a hundred five billion unemployment benefit for example, and the tax take will be much lower and we’ll start to have an exaggerated and increase in deficits compared to what would happen if we didn’t have that.
John: I agree was that I’m Bill English coined the phrase in his valedictory speech “beware the dangerous complacency of good intentions”, and there is a risk that you build in well-meaning and many respects justified increases in spending to deal with some of the social problems that the country faces, some of the environmental challenges we face, and you hard bake in that expenditure and then the revenue falls away.
So you got one variable that’s highly volatile in one sense and as is quite possible it drops quite significantly. Whereas the other tends once it’s baked and it’s very hard to roll it back. So I think that that is a challenge. That’s not lost on Grant Robertson, you know, he’s clearly across these issues but it’s a hard hard equation to balance and there are some months there are some clouds out there.
Bruce: Any final thoughts about tax reform and the way forward.
John: I think the key when I look back on what’s now about a 45 year career in tax policy, I first thing I’m very proud of what NZ has achieved. That I think when you look at the cot case we were in the early 80s and the position we’re in now with the tax system, I think we should be proud of what’s been achieved. But I think we need to preserve that. You know sooner or later someone will do something like provide an exemption from GST shouldn’t be imposed on bananas or something ludicrous like that and that will be the slippery slope that will begin to unravel one aspect of reforms that have been so successful.
And I think we need to learn from history as we’ve talked about in there are many really good things things are going well things are not going so well, so let’s listen from that.
And I’m really pleased that the current government is committed to the broad-based low-rate as a non-negotiable strategy and I think hopefully that will survive because that’s been hugely important to our success.
And the final message does say it history makes it very clear that major reforms will only succeed if the timings absolutely right point one. If you’ve got a really strong Communicator point two. And point three, if you take the public with you. Politicians underestimate the public at their peril, and the biggest tax reform failures in my term in the game have been driven by politicians who underestimated the public and then did a really poor job trying to explain what they were trying to achieve in the first place.
Bruce: Thank you, John. Much appreciated.
John: Thank you.

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Episode 5 of the Curious Kiwi Capitalist Podcast

13th September 2019

My guest for this show is Ian Frame, retired CEO of Rangatira Investments, a long-term private equity firm.

In this episode we discuss

* what is a private equity firm, what's their fees, investors and strategy

* the difference between classic private equity (PE) firms and long-term PE firms

* what sort of investments they're after and their investment horizon

* stock market crashes, investor cynicism and regulation

* venture capital and angel investing

* and much more..

Show Notes

About

Ian Frame was the CEO of Rangatira, a long-term private equity company, for 11 years up to his retirement in 2014. Rangitira was one of the earliest private equity firms and Ian was one of a line of extraordinarily talented CEOs who have made it one of the most successful PE investors in NZ.

Originally an engineer, he was one of the first New Zealanders to get an MBA and worked at DFC duing the '70s before joinging Downer in an international role. He worked for investment companies often in a CEO change management role. He has retired in Taranaki but still is involved in angel investing.

Links

Ian Frame (LinkedIn)

Rangatira Investments

"Long-Term Private Equity with Ian Frame" show notes

Transcript: Long-Term Private Equity with Ian Frame

Bruce: Firstly, what is private equity?

Ian: Well in New Zealand private equity really falls into probably three categories actually. The first there are a number of private equity firms that go and raise capital from superannuation funds and other large institutional parties and they will invest that money on their behalf of the institutions. The private equity firms take a management fee.

And usually they have to pay the funds back to the institutions within five or seven or ten years. The second category are those that invest similarly but they have their own equity and I'm talking about the likes of Rangatira, Todd Capital and similar family funds. Most of them will have maybe up to 200 million of funds to invest and they invest longer term. Because they don't have to repay the money they can afford to hold on to their investments and ride out the cycles.

The third category in New Zealand comprises a large number of family businesses, includeing virtually all of the farming sector, that run businesses based on capital provided by the family and the money they have accumulated from those businesses over the years.

Bruce: In the case of the first category the what I'd call perhaps erroneously as a classic private equity firm, they would have the limited partners: the superannuation funds, the endowments perhaps, wealthy families and individuals and they would invest that money into a fund and then the private equity firm would get a management fee and a performance fee. What's the management fee and performance fees that they tend to get?

Ian: Well they vary but generally speaking they would take a 2% fee per annum on the funds invested and then they will take a percentage like 20% of the gain over and above a fixed return.

The fixed return maybe eight percent per annum so they have to achieve that over the life of the investment and then if there's a surplus above that then they'll take 20% of that surplus. So that's what's known as a 2 plus 20 arrangement. There have been times when that's been common and other times when it's been under pressure.

Where it sits today, I'm not a hundred percent sure, but it it's probably around that 2 plus 20 level.

Bruce: And those classic private equity firms will have different funds,

Episode 5 of the Curious Kiwi Capitalist Podcast

13th September 2019

My guest for this show is Ian Frame, retired CEO of Rangatira Investments, a long-term private equity firm.

In this episode we discuss

• what is a private equity firm, what’s their fees, investors and strategy
• the difference between classic private equity (PE) firms and long-term PE firms
• what sort of investments they’re after and their investment horizon
• stock market crashes, investor cynicism and regulation
• venture capital and angel investing
• and much more..

Show NotesAbout

Ian Frame was the CEO of Rangatira, a long-term private equity company, for 11 years up to his retirement in 2014. Rangitira was one of the earliest private equity firms and Ian was one of a line of extraordinarily talented CEOs who have made it one of the most successful PE investors in NZ.

Originally an engineer, he was one of the first New Zealanders to get an MBA and worked at DFC duing the ’70s before joinging Downer in an international role. He worked for investment companies often in a CEO change management role. He has retired in Taranaki but still is involved in angel investing.

Links

Ian Frame (LinkedIn)

Rangatira Investments

“Long-Term Private Equity with Ian Frame” show notes

Transcript: Long-Term Private Equity with Ian Frame

Bruce: Firstly, what is private equity?
Ian: Well in New Zealand private equity really falls into probably three categories actually. The first there are a number of private equity firms that go and raise capital from superannuation funds and other large institutional parties and they will invest that money on their behalf of the institutions. The private equity firms take a management fee.
And usually they have to pay the funds back to the institutions within five or seven or ten years. The second category are those that invest similarly but they have their own equity and I’m talking about the likes of Rangatira, Todd Capital and similar family funds. Most of them will have maybe up to 200 million of funds to invest and they invest longer term. Because they don’t have to repay the money they can afford to hold on to their investments and ride out the cycles.
The third category in New Zealand comprises a large number of family businesses, includeing virtually all of the farming sector, that run businesses based on capital provided by the family and the money they have accumulated from those businesses over the years.
Bruce: In the case of the first category the what I’d call perhaps erroneously as a classic private equity firm, they would have the limited partners: the superannuation funds, the endowments perhaps, wealthy families and individuals and they would invest that money into a fund and then the private equity firm would get a management fee and a performance fee. What’s the management fee and performance fees that they tend to get?
Ian: Well they vary but generally speaking they would take a 2% fee per annum on the funds invested and then they will take a percentage like 20% of the gain over and above a fixed return.
The fixed return maybe eight percent per annum so they have to achieve that over the life of the investment and then if there’s a surplus above that then they’ll take 20% of that surplus. So that’s what’s known as a 2 plus 20 arrangement. There have been times when that’s been common and other times when it’s been under pressure.
Where it sits today, I’m not a hundred percent sure, but it it’s probably around that 2 plus 20 level.
Bruce: And those classic private equity firms will have different funds, how long do those funds tend to last?
Ian: Well, they raise them on the basis that they have to be repaid within a certain period of time and that period of time will invariably be longer than five years, but less than or at a maximum of 10 years.
Bruce: So if they invest in a company in year zero/one they need to sell their company by year 10.
Ian: Yes, so they raise the money first and then look to invest those funds. It may take them two or three years to find something to invest in. So often they are having to sell within seven years maximum because it’s taken them three years to find the right businesses to invest in.
Bruce: Now, we’ll get to some more permanent capital soon rather than the limited life of a of the fund. But once they’ve raised funds, let’s call it Fund one and they’ve deployed all that capital, do they then go and raise Fund two?
Ian: Oh yes, the successful ones do, but it depends on the success of their Fund because the more successful they are the easier it is for them to raise more money. Often they’ll raise money for Fund two from the investors that invested in Fund one because if they are happy investors then they will put more money in. So yes, they will continue and that’s how they operate – they will probably start a new Fund every two or three years. Maybe longer than that just depending on how successful they are and what the markets are doing.
Bruce: And those investors that are investing into most types of private equity including the classic PE firm, what are they looking? They can invest in bonds and the stock market, why are they investing in this risky private equity thing?
Ian: Well, it depends on the on the investor but in the case of the large superannuation funds and institutional funds such as insurance companies, they like to have a portfolio of investments. They probably mark 2% or 5% of their portfolio for higher-risk higher-return investments. Private equity wouldn’t be the highest risk/return class but it is certainly more towards that end of the scale.
Bruce: What’s the difference between shorter term classic private equity firms and longer term private equity firms?
Ian: The short term private equity firms get their money from institutions and they invest on their behalf. So they act a bit like a broker in that they are making the investment decisions within the bounds of some agreed parameters. So they are investing on behalf of somebody else.
The long-term private equity investors, like Rangatira, are investing their own funds, essentially their own equity, so they don’t have to worry about looking after external investors – they are investing their own money and can invest for as long as they like. Rangatira, for example, has one company I’m aware of that they’ve been invested in for the best part of 50 years. They usually co-invest with someone that knows how to run the business. So those long-term funds often will often take only a 50% share maximum with the other 50% to be held by those that know how to run the business.
Also when Rangatira invests, it doesn’t need to have an exit strategy. That’s a key difference between the long term private equity investors and short to medium term ones.
Bruce: Going back to the classic private equity firm, when they’ve reached the end of their Fund, what options do they have? They obviously keep going through a normal m&a process to find other other buyers.
Do they have other options outside of just selling out of the company?
Ian: Yeah, well, basically they’ve got to sell even though they may be starting new funds every two or three years. It is a possibility for them to sell an investment that may not be mature yet into the next fund but they have to be very careful in doing that.
Usually they would need to bring in some Independent party to audit that process including valuation. Usually there isn’t any transfer of assets between Funds because they set out to have an exit strategy from day one and they will work continuously on that exit strategy throughout the investment period.
Bruce: When you’re looking at the longer-term private equity companies.
What sort of turnover of investments do they tend to have if it’s up to 10 years for a classic private equity firm and it’s more longer term for the Rangatiras of the world, how long on average has longer term?
Ian: Okay, the the long-term private equity firms in New Zealand are generally what I would call in the emerging growth sector. So they invest in businesses that are probably turning over a minimum of say 10 or 12 million dollars per annum – that’s about a million dollars per month of sales revenue and they look to grow them to fifty or a hundred million or a hundred and fifty million dollars of turnover.
In some cases they may be able to achieve that in 5 to 10 years in some cases it takes longer. Because they do not have to sell, they do not need to have an exit strategy. They just believe that by continually adding value to the business, sooner or later there will be an exit opportunity for them if needed.
In essence, they don’t have to sell because they’ve invested their own equity, so they can continue to hold. Generally, when they do sell they always sell well because they never have to sell at any particular point in time and they can wait until they have added as much value as they possibly can to that business. Also, they can wait until the market conditions are right – when there are plenty of interested buyers and they can play the market. Usually they do very well on exits. The short term private equity firms are often forced to sell at a certain point in time, so they have to work hard to make sure that they have suitable strategic buyers lined up well in advance.
And there are cases where they just have to cut their losses and get out because they’ve got to realize their funds. They haven’t had time to achieve what they expected to achieve and they’re under pressure to exit at an inconvenient time in the market.
Bruce: During the time that the classic films are holding the investments those investments would be probably distributing dividends. In the case of longer-term private equity firms who are holding those Investments for 20, 30, 40 years they are taking those dividends. In the case of Rangatira how did they distribute the dividends because Rangatira is actually “Unlisted” so to speak?
Ian: Yes, Rangatira acts very much as if it is a listed company. Its shares do actually trade on the Unlisted platform which, while it’s called “Unlisted” it is actually a listed platform, but it doesn’t have all the formal compliance requirements of the main Stock Exchange. Rangatira declares and pays dividends to its shareholders every six months. And traditionally those dividends have been quite good because Rangatira is about two-thirds owned by charitable trusts and many of those trusts are dependent on the income that comes from Rangatira’s dividends. So in many ways it’s like a superannuation fund that pays a steady, or steadily increasing, dividend to its shareholders. To do that, it needs to receive cash from its investments in the form of dividend and, from time to time, it does sell some of its investments and receives cash from that.
Bruce: So Rangatira, if you have a look at it if its balance sheet is actually at the moment pretty flush with cash. No problem with paying dividends.
I don’t suppose it would do an extraordinary dividend payout based off that cash or getting into the internal machinations of the company here or must it invest it in companies.
Ian: Theoretically they probably should but practically when you’ve got charitable trusts holding two thirds of your shares you really want to provide them with steady income. They don’t know how to handle large dollops of additional income.
So there’s a bit of a practical issue there with Rangatira itself. But they tend to manage that by paying higher dividends than they may otherwise do and keeping them steady or steadily increasing year on year.
Bruce: What other companies like Rangatira are in New Zealand? It stands out because it’s on the Unlisted board and therefore there is public information about it, including the annual report. We don’t know much about Todd Capital and there are other family firms that I guess are private equity in structure. Do we know of many others that are other long-term firms.
Ian: No, we when I was running Rangatira we didn’t come across too many that were in the same category. Todd Capital was there, K1W1 which is Tindall family company is quite active, but generally speaking there were no others so that we came across on a regular basis. The parties we did come across where the what you call classic PE firms, the ones who get their funds from others and invest on that basis. Some of the Maori trusts are getting into this space and the Ngai Tahu Trust is one of those.
Bruce: Going back to when you were first involved in the whole private equity sector what changes have you seen from your early knowledge of the sector through to when you exited.
Ian: Oh, that’s a massive question because it changes, it changes all the time. Every year the markets are different and every decade Rangatira has basically had a different strategy. And it’s been going for 70 probably closer to 80 years now. So it’s probably in its lifetime had eight different major strategies.
What causes that is when I first got involved with Rangatira it was about 2004 and that was a good time to acquire companies. We were looking to acquire 50% of what I call by New Zealand standards medium-sized businesses turning over 20, 30, 40 million dollars and then growing those to be much larger.
Investing in private equity is not too different from investing in a rental property in the in the suburbs. You’ve got to buy right. You got to develop it right. And ultimately you’ve got to sell it right. And if you don’t do the first one right, like buy right and you pay too much for it you’ll never make money on the second two steps.
So you have to be able to buy private equity at the right price. At the moment the private equity market prices being paid are what I would call high and that does make it difficult for the long-term players. The short-term players can be in and out and still make a dollar but you wouldn’t want to be caught with an in and out strategy if there’s a major downturn in the markets such as the global financial crisis and you are forced to sell.
Bruce: The price of our business is often expressed a lot by multiple, of course multiple of probably EBITDA and if we’re at the height of the market right now or back in 2007, back when you were at Rangatira, you are the height of the market back then again 12 years for before what might be the peak now who really knows… a new world I guess every day. What were the multiples that you were being offered at the height of the market versus the bottom of the market.
Ian: It depends on the sector that you’re in, but if we’re talking about companies turning over say 15 or 20 million dollars then generally you’re not paying a premium for size and they probably haven’t got a really strong market presence, so there’s plenty of room to develop the business further and you could perhaps pick them up at the right multiple, say 4 times EBITDA, maybe three-and-a-half to four and a half.
At the peak of the market those figures will be doubled that – seven, eight, nine times EBITDA and there’s a lot of downside risk at those sorts of multiples.
When you pay a high multiple you’ve got to work really hard and do a whole lot more than just buy and modify and sell. You’ve got to have a major growth strategy to go with it and that usually involves pulling a number of different companies together to create a much larger business.
I recently saw a company change hands that was turning over about 15 million dollars and the acquirers paid a very high multiple. The acquirer had a major strategy to use this acquisition as a core business for accumulation of a lot of other companies in the same sector. So you’ve got to have major growth strategies like that if you want to be playing in the shorter-term private equity game. Of course, when the multiples are high the longer-term players can afford to sit on their money and wait for the right opportunity to come along.
They aren’t under the same pressure to go out and invest in the market at its peak. So there are quite significant differences in many ways between those two categories of private equity players. Of course, when they come head-to-head the more aggressive shorter-term players will often win because they will be prepared to pay a higher acquisition price. So the longer term players have to work on other factors such as there maybe a family that doesn’t want to commit to an exit strategy. They’re just happy to sell half the business and have a long-term growth strategy for the next generation.
Bruce: So we have 3 factors of buying low and selling high, being one and three I guess, and the second factor being growing the profitability and size of the company. You talked about one strategy there of a rollup I’d call it. Or having a the first platform company and bolting on an additional perhaps more perhaps same size companies to that to grow it. What other growth strategies are there that you
Ian: Well, if you’ve got a consumer brand, for example, and it’s not well known and you can make it famous throughout New Zealand and perhaps Australia, or maybe global then you can increase your multiple a lot. So, if you’re increasing EBITDA and you’re increasing the multiple because you’re creating brand value, you can get a double whammy on growth and that’s when you really make money in private equity.
Bruce: And some of the shorter-term firms focus on export markets and that’s where they want to take New Zealand firms international. So that’s I guess that’s a core part of their growth strategy.
Ian: Yes and there’s also the strategic aspect because a lot of the technology companies are trying to develop SaaS business models and develop strategic value that a large player offshore would want to acquire.
But to attract the attention of large offshore players you have to achieve a strong market position. Trademe was a good example and Xero is a good example of as well. Trademe basically made themselves so well known that somebody had to pay a high price to acquire them. And with Xero, their market position and growth prospects underpinned their value in an IPO.
Bruce: And in the case of Xero especially it had international venture capital underpining its early years.
Ian: Yes, they were able to attract that once they had got to the point where they had demonstrated their strategic importance and global appeal. I think the strategic importance came first. I think Rod Drury saw that there was a market for turning these accounting packages in to a SaaS product and he stole a march on the other players such as MYOB and QuickBooks. He stole a march on them and that then gave him a really good strategic value and it was at that point that the Americans started to invest in it. But he had to prove that strategic value first.
Bruce: Talked before about a size premium and that the mid-market firms didn’t have a large size premium, what, in the case of New Zealand, where does company size start to increase the value of the company.
Ian: Depends a bit on sector that you’re in but generally speaking I would call anything under 15 million dollars of turnover a small company in New Zealand, 15 million to a hundred million of turnover, maybe a bit less, would be medium and anything over that over a hundred million of turnover is a large company by New Zealand standards. I think those boundaries are appropriate for New Zealand, and don’t forget if you convert New Zealand dollars to US dollars those figures are all smaller again. I don’t think in the United States they would have the same categories, the numbers would be much higher, you know a large company in the US is going to be a lot more than 60 million US dollars of turnover.
What I find very interesting from a private equity perspective is whether they treat themselves and manage themselves as a small or medium or large size company.
I mean take Gallagher in New Zealand. I don’t know what their turnover would be but it would be certainly in the large company category, and they probably still run themselves as a small to medium-sized company.
So that’s important I think in New Zealand because if you run as a large corporate in New Zealand, it doesn’t it doesn’t work that well. New Zealand companies generally aren’t managed on a large corporate basis very well. Often they import the Chief Executives from offshore who know how to run a large companies in a corporate sort of way and that doesn’t work all that well. You pay a massive salaries to them and you don’t necessarily get success. The most successful stories in New Zealand companies in the private equity sector are companies that think big but operate on a small to medium-sized company basis.
Bruce: The growth of private equity seems to mirror the decline of the number of listings on the stock market as well. We’re seeing this all around the world, especially in the US, but the ability for fast-growing companies to stay in the private sector for much longer than they used to and there’s a lot of angst there seems to be with the NZX participants about the lack of IPOs and what they are doing wrong. I’ll look at that review that they’re doing with a great deal of interest, but I wonder if they’re doing anything wrong at all. It’s just the market the markets change.
Ian: New Zealanders like to have control of their Investments. It’s interesting. You know, we’ve had some terrible stories in New Zealand in the finance sector large amounts of money have been lost both through publicly listed shares and non-bank finance companies.
Over the years there have been some terrible stories and even through to private investor advice, Ponzi schemes and there has developed a lot of distrust of financial advisers. So it’s not surprising that New Zealanders are very cany about where they put their money. That actually leads to a lot of people to investing in property. They feel they can manage their own property their bank’s more comfortable lending to people on property because its bricks and mortar and they can take personal guarantees to secure those loans, etc.
So, with that mentality it does make it difficult for players in the private equity market. If people are going to invest into it they often prefer to either control the business themselves or know the person that controls it or be involved in the governance so they have some direct control themselves. And when they do that, they find that it operates pretty well and they would prefer to keep it privately owned.
Why would they want to go to the market and have other people dictating how they manage and operate their investment. It’s just a quirk of the New Zealand market.
Bruce: The extent of our residential property investment certainly is a heck of a quirk to have too the amount of money that’s been diverted away from the productive sector into selling houses to each other seems to be one of the tragedies of the capital markets.
Ian: Well it is, but the capital markets in New Zealand can only blame themselves or maybe they can blame the politicians being too weak terms of legislating.
The scandals that have occurred in the in the finance sector and in the share market I mean 1987 there were a lot of very unsubstantial companies that were trading at very high prices all on hype.
And of course when the crash came those companies were exposed for what they were, and the people behind them weree exposed for what they were, but how many people went to jail for it? I think there might have been one and a lot of the other cowboys came back into the market within the next 10 years and everyone forgot about it.
We also have had the global financial crisis recently and through that period the non-bank financial sector, 67 finance companies, went under, I don’t think any substantial second tier finance companies in New Zealand survived that.
And government finally put some legislation in place after that which hopefully has solved that problem, but you can’t blame the vast majority of New Zealanders feeling nervous about giving their money to somebody else to invest on their behalf.
They would much prefer to invest in themselves and directly in their own name. And the best way to do that is to buy property. So unfortunately because the vast majority of New Zealand private equity is gone into property we have got property prices at probably what is an unsustainable level. I’d like to think it’s sustainable, but I’m sure that as soon as interest rates go back up property prices will come down. And that’s going to create problems of its own. It would be nice if New Zealanders became more confident, no it would be nice if the New Zealand private equity markets became much more reliable and people gain confidence in them and started to invest in productive enterprise.
Bruce: Let’s talk about one area that has grown and then that is Angel Investing. I’m not sure how long Angel Investing has actually been around, no doubt it has been around for many years and many decades with a different term used, but it’s shown remarkable growth and you’ve had something to do with this early stage investing as well I think Ian.
Ian: Yes, since I left Rangatira five years ago I have been involved in angel investing in New Zealand and that sector is developing well. The reality of what it is though is it’s a group of people who get together and they are prepared to perhaps put 5% of their portfolios into higher-risk higher-return investments.
They get together in angel groups because that way they can share the collective knowledge of other people in the group and can combine their funds to co-invest with these other people. So Angel Investing is filling a gap in the New Zealand market. It’s certainly at a much earlier stage – it’s really a stage or two before investing then private equity.
And yeah, that is taking off pretty well
Bruce: Angel Investing has certainly taken off and in the recent budget, we’re recording this in July 2019, so the May 19 budget, filled a gap a “funding gap” they called it, or they said they’re going to fill a funding gap it in Venture capital. I’ve heard this a number of times that Angel Investing is reasonably strong certainly compared to how it used to be, private equity is strong. Is Venture Capital a stage in between Angel and Private Equity? Where are we at with venture capital side of things?
Ian: Yes, venture capital is that stage in between and it’s not strong in New Zealand. It’s strong in the United States. It’s pretty strong, probably very strong actually, in Australia, but in New Zealand it just hasn’t taken off. And I think it’s because there isn’t the expertise or capital to undertake it. In many ways it is even more risky than Angel Investing and certainly more risky than private equity investment. The reason for that is simply the amount of money that’s required for venture capital.
With Angel Investing, individuals can put up tens of thousands of dollars and that’s not a large amount of money for a lot of people to risk. Whereas with Venture capital each investment usually requires several millions of dollars, sometimes tens of millions of dollars.
And that money isn’t easily raised in New Zealand. You can get it from institutions, but they’re increasingly concerned about the criteria under which their money is invested and you can get it from some very wealthy private individuals but they are wary that venture capital is probably the riskiest part of the whole cycle because the companies are still high risks while the amount of money required is much higher than for angel investing.
Bruce: And that’s the big difference, angel investing is what I would call seed, the very early stages a good idea and a good person who’s implementing that idea well enough to get you Angel Investors. The big change in risk, as you say, is the level of money a company requires to help it achieve its growth objectives. It seems we need to get to the bottom of why we don’t have so many Venture capital firms.
I mean Jenny Morel at No 8 Wire seemed to be doing well there and closed out it’s Fund and she hasn’t raised another Fund but continues to help out companies through her MoreGo meetings conferences. We’ve got Stephen Tyndall. We’ve got Movac in Wellington. We’ve got Lance Wiggs Punakaiki Fund… I struggle after that.
Ian: Yes, and it’s debatable whether any of those are really venture capital firms. I think the reason why we don’t have many venture capital funds in New Zealand is because takes a lot of expertise to run them and I don’t believe that we have that expertise in New Zealand. I think we’re very thin on the ground. But if you go to Australia, there are a number of people there that have gained their experience perhaps offshore and are living in Australia now or they’ve learned their expertise in Australia. In New Zealand there probably only a handful of people that know how to do it.
Bruce: Its almost a horse and cart thing I guess you need to either have worked for a venture capital firm or you’ve developed and grown a company and you’ve exited the company and now you have capital.
Both those cases you have the experience or knowledge and so you can start a VC firm with confidence. But without a large group of companies, a large group of entrepreneurs who have exited their companies, we don’t have a large group of people who can start up VC firms.
Ian: No, and often people that have started their own firms and develop them and successfully sold out don’t actually have the skills to go and run venture capital activities which cross a much wider market sector. People that have started their own firms often know that industry, know that sector, got lucky with some people they brought on board so they had a great team, and can’t repeat it elsewhere.
It’s one of the reasons why I have enormous respect for Richard Branson. He’s one of the few people that seems to have been able to be successful in one sector and go to another. But venture capital is like an early form of private equity. It’s transitioning those companies that have gone beyond seed capital and Angel Investment. It’s picking up the ones that have really good prospects and then developing them into strong private equity companies. And that takes a complete range of skills, across a complete range of Industry sectors. And when I say a complete range of skills, you’ve got to have Financial skills. You’ve got to have people skills. You’ve got to have market knowledge. And you’ve got to know how to add value and know strategically what adds value. And in my working career have seen very few people that have been able to do that in the New Zealand market.
Bruce: Let’s talk about a bit about you. Before you joined Rangatira, what was your career path? Where did you start and how did you get into private equity?
Ian: I originally graduated in civil engineering. I liked engineering but I found it two dimensional and I wanted to get into management which I saw is three-dimensional. So, when I was in the in my mid-twenties, I was in the United Kingdom and I went and did an MBA back before anyone in New Zealand had heard of MBAs. Then I came back to New Zealand and people were very suspicious of anyone with two degrees, so I had to work my way back up through the system. I got into back into Management in the construction industry and did a lot of large projects around the Pacific and in New Zealand and managed those. I was happy because I was managing rather than doing pure engineering and every project I managed was like managing your own medium sized business.
An opportunity then came up to join the Development Finance Corporation. And that was back when they were doing a very good job. They were set up by Rob Muldoon and the National government to fill a Gap. The Gap being that the banks would not lend any capital or any funds where the capital was at risk.
And it needed some party to come step in and plug that gap. And DFC plugged the gap very well, despite the fact it got criticized a bit for acting too much like a banker and taking too much security on everything. They did actually fulfill a very much-needed service. And a lot of people that came out of the DFC did interesting things after that. I was there at the beginning of the 1980s and through the 1980s there was a lot of major restructuring that took place after Rogernomics, or was part of Rogernomics, a lot of those DFC people were playing very active roles in terms of transitioning the New Zealand economy.
So after that, I got involved into change management. From the mid-80s through to the year 2000 there was an enormous amount of restructuring took place in the New Zealand market. I’m talking about restructuring of businesses because they were largely asset-based and largely cost focused – their pricing policies were all Cost Plus.
They needed to learn how to be market focused and price on a market basis rather than cost-plus. So there was a lot of corporate restructuring and took place and I participated in much of that through to the early 2000s when I went to Rangatira. Rangatira was a dream job for me really because I was putting all my previous experience together and running a private equity firm.
Part of the corporate restructuring I had done was with Renouf Corporation and Hellaby Holdings at the time. We would buy into companies that were struggling as a result of Rogernomics and we would close down what had to be closed down. We would realize assets where we needed to strengthen the balance sheets but we would pick the best parts of the business that had a future and rebuild the company based on that. A lot of those companies are still trading very strongly to this day. So yeah, it was a very interesting and very satisfying period because New Zealand needed that level of corporate restructuring and would not be the vibrant free market economy that it is today if it hadn’t done all that major restructuring from 1985 to 2000.
Bruce: Well, we’re sitting in your beautiful Taranaki house looking down over rolling farmland towards the sea. After Rangatira you moved up here I think? Is that right or have I missed out a section.
Ian: Yes, it took me a couple of years to get here. But I knew Taranaki was good. I love looking out the window and seeing green productive Farmland. It does my heart good. A lot of my friends have gone to live in Central Otago where you look out the window and it’s barren, barren, barren.
Bruce: Rabbits rabbits rabbits…
Ian: And rabbits running around, I look out here and see beautiful green pasture and dairy cows fattening by the day.
Bruce: Thank you very much for your time.
Ian: You’re welcome
Bruce: Much appreciated very, very interesting and I look forward to getting this one out.
Thanks so much.
Ian: Yeah, that’s great Bruce.

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Episode 4 of the Curious Kiwi Capitalist Podcast

27th August 2019

My guest for this show is Richard Higham. Richard is one of the top business academic practitioners in New Zealand history. He has not only experienced but researched and studied entrepreneurship. He has run his own firm, consulted to corporates about entrepreneurship, and saw the start of venture capital in NZ before “venture capital” was even really a word.

Now in his eighties, he is still going strong, as you’ll see he is the master of the rhetorical question and pretty much ran this interview himself!

In this show, we’ll discuss entrepreneurship and the early days of venture capital in New Zealand including:

• The king, the castle and le entrepreneur

Otago University rugby Blooz Nooz.

Show NotesAbout

Richard Higham still lectures at Otago University. The lectures are run at the same speed you hear in the episode, always a sprint, but always time for a student. I believe he was a pathfinder for many New Zealand entrepreneurs, not the least being Graeme Hart.

He studied at Oxford, as a young man worked at Imperial Chemical Industries, went to London Business School as a Sloan scholar, and worked at various times in the Auckland and Otago MBA programs, and consulted far and wide.

Richard Higham was my master’s thesis supervisor at Otago University as well as my favourite lecturer. Indeed, of the 8 courses I took, he ran three of them, all of them practical and useful today in representing or investing in high growth companies.

Richard has played rugby, and also has been heavily involved in coaching and leading the Otago University Rugby Club. If you played rugby at Otago then you will want to subscribe to his newsletter about Otago Univeristy rugby, the popular Blooz Nooz.

Links

Richard Higham at Otago University

Blooz Nooz Otago University Rugby Club newsletter, subscribe by emailing Richard: [email protected]

“Entrepreneurship & Early Venture Capital in NZ with Richard Higham” show notes

Transcript: Entrepreneurship and early Venture Capital in NZ with Richard Higham

Bruce: Thanks Richard for coming along to this episode about entrepreneurship. Perhaps a little bit about the history of venture capital. I remember my time fondly here at Otago University in the courses that that you taught. Let’s kick it off by asking you about entrepreneurship. What is entrepreneurship?
Richard: What is entrepreneurship?
Well, it started off years and years and years and years ago in France. Where the entrepreneur built castles for the king and the King said I want a castle and someone came along and said I know how to get a castle for you and it’ll cost you so much. So this was really a demand-side initiative the king wanted something and an entrepreneur in France le entrepreneur provided it.
And this went on bring the fashion in France for generation after generation after generation until things changed because what happened was that people started not responding to demand but by taking initiatives they started something themselves. And some people who started things were accused of being against the law.
You can’t do this. You can’t simply change things like this and one chappie wrote an article about it way back in the 1720s in which he maintained that the entrepreneur on the demand side was equally the same as the entrepreneur on the supply side. Someone supplying something new was just as justified in the economy as someone responding to someone who wanted something new and this was the birth of the supply-side entrepreneur the person who takes the initiative does something new pursues it to the ultimate that they can trying to find customers a totally different routine from responding to the king who wants the castle.
Now this went home for year after year after year with studies being undertaken in Austria. The Austrian professors wanted to know why it was that people in Austria were initiating things and other people were not and they wrote pamphlets and books about the supply-side entrepreneur and refined the theory of them.
And one chap who sat at the feet of the professor’s with a man called Joseph Schumpeter and he was an ideal student. He got As in everything and he absorbed all the things that these Austrian Vienna based professors talked about entrepreneurship and years later when he done his PhD in 1910 he wrote a book about it and it came out in 1933. And he said what we want is for people taking initiatives in the economy.
Look at the way that we’re facing a terrible depression. The depression would be solved if people just did some new things and had some more people to do more new things. And if they did that we would have a depression no longer. But the theory by the economist of the time was that the economy would solve itself. If there was a depression people would price their labor so low that others would take it up and make something out of it, but it wasn’t happening. It was not happening and Schumpeter saw it not happening and he was exasperated by it. And he said we want more initiatives on the supply side and people simply laughed at him.
And they went on laughing and they went on laughing for year after year after year. His theories were simply abandoned as being ridiculous. In 1970 I was at the London Business School as a student. And no less than the Austrian-Hungarian communist-run regime asked the business school for a deputation to go along and advise them on how to make the economy better and I was part of that deputation going over. We went over to the heartland of Schumpeterian economists. We went there and you know, we had never heard of Schumpeter and I tell you the truth nor had they. This was the place where he wrote. This is the pastry countless theories. Faith never well, I realize now that they’ve never heard of him.
They had no idea about supply-side entrepreneurship, which was what they needed and we went there and we pounched about telling them all about Capital big Capital communist Capital. But when the communists ran things they ran things for the sake of the peoples being employed. You couldn’t be unemployed in that place.
If you were unemployed you simply had to go along get a job at the local Ironworks and when you went there and they said, what is your skill? I’m a peasant. Oh, well, you better grow some flowers then and the gardens at these Iron Works in a place that we visited called Misconch[?] were enormous in fact that Ironworks employed 1500 gardeners and 500 iron workers.
This is true and we met the board there and they had one man who was supposed to know about entrepreneurship who’d been a grocer before the war. It employed two people in his grocery shop and at the end of the war they’d imprisoned him for three years for employing himself and two others in small business entrepreneuring and it was illegal in communist countries. So they put him in prison now, they brought him back and said advise us about how to run this place better and all he knew about was being a grocer.
We came back to London thinking we’ve done a good job. Where in fact, we had absolutely totally 100% a thousand percent missed the bus. We had no idea what we were talking about.
Years later. In fact 13 years later, things changed. A man called Drucker. You know where he came from Austria
Bruce:
I was thinking America but not it was Austria.
Richard: No, no, he came from Austria has chucked out by the communist and he went to America and he started writing about guess what entrepreneurship and you wrote a book called Innovation and Entrepreneurship and it came out in 1983 and he wrote about not what it did for the economy so much although he had theories about that, of course, but how to do it.
Others read his book and they thought another sounds interesting and by 1986 three years later a whole cycle of books that come out about initiatives on the supply side entrepreneurship as a way to get the economy moving the replacement of jobs and Michael Birch came out Birch came out with his measurement of how many jobs were created by various sectors in the economy.
And when he looked at it he thought that’s funny the small business getting all these jobs and he discovered it wasn’t the small business. It was a small business entrepreneurs growing. So he published his stuff about the new theory of job creation. The entrepreneur on the supply side is the person who launches something.
Maybe it’s difficult. Take some time. Starts getting employment hiring people and grows fast. And Entrepreneurship became the study of fast growth risk-taking, innovation New Ventures all these things that we now know all about because people have discovered entrepreneurship for what it is. So in 1983 to 1986 out came books, book by Brandt, book by Christensen, book by Drucker, book by Birch, book by many other people talking about what entrepreneurship actually meant in the economy.
Now, I went back to London Business School in 1986 to teach entrepreneurship and I tell you what, I still had absolutely no idea what it was. I stood up in front of the MBA class at London Business School to talk about entrepreneurship and I started off talking about small businesses. But the director of what they actually called the Small Business Center because they still believe that entrepreneurship is small business evening in ’86.
He had got some people who call themselves venture investors to come and talk to the class. Who were these people? I’ll tell you. They were people who been employed in large organizations and they had been on the finance side. Seen people coming up with new ideas in large corporations and not getting any help and being turned down and one or two of them said there’s money to be made in this if we get it right and they had left the large corporation and they’d gone to the marketplace privately and said give us a few million and we’ll back new ventures and see if we can make some money. And they came to the business school in London to tell us what they were doing now, they weren’t yet successful. But they had a routine and they learned the routine from the Americans.
What about poor old New Zealand? What about poor little New Zealand not skittled up by the most forces time the skittled out because we didn’t have those sorts of venture investors. We didn’t have them. Well, someone thought that we should have them and that was a man basically in the Development Finance Corporation Called Graham Croackam[?].
And he was dead set on developing the Development Finance Corporation, which was a government-run bank for backing business to back new business. And he persuaded his bosses in Auckland to send him to a place called Harvard. Now Harvard is in America and at Harvard you do the MBA and he went there to do the MBA. When he got there somebody came to the business school there and talked about Venture investing just the same as when I was at London Business School the same year. He was at Harvard listening to the same stuff. And then he came back to New Zealand.
Now by the time that happened I had another job to come back to because I’m afraid being entrepreneurial, I’d had to leave the large corporation known as o-ta-go university to go and teach at London Business School.
They thought it was a silly idea. I’d had to leave I had to resign so when I left the London business school after year teaching there was a contract for year. I had no job. But I was entrepreneurial and a man at Auckland University heard about what I’ve been doing at London. His name is Professor Brian Henshaw, and he sent me an e-mail.
He was Sloan fellow they called it at Harvard Business School. I was a Sloan fellow, this is a studies program at London Business School. And so he knew me and I knew him vaguelly and he sent me a note saying come to Auckland. We need you to come and talk about Venture investing. And so I came back to Auckland and also came back Graham Croackcam[?] from Harvard and he was persuaded by Henshaw to come along and do a lecture at the Auckland University on what he’s learned about Venture investing in Harvard and what I had learned about Venture investing in London.
What have we learned? What we learned was this. Venture investing for new independent initiatives is tricky. What it requires is persons with money disposable cash to go in and buy shares. Can they buy shares and pick winners? No, you cannot pick winners among entrepreneurs. What you have to do is to invest in a portfolio of 5 10 15 companies. What happens then when you’ve invested in 5 say 10 say 10 companies doing your very best and in fact looking at 300 plans. Refining them down to 30 proposals and investing in 10 it is so risky that out of those 10 the best you can expect is 2 surge and make a fortune for you; 2 go belly-up in the first three years; and the other six putter along and should end up a small companies. The Great rule is 2-6-2, 2-6-2, 2 make a fortune, 2 go belly-up and six putter along and make nothing for you.
And the two that make a fortune, compensate for all the others and if you get it right then you’ll expect to make 30% on your Capital where the best at that time shareholders were make perhaps fifteen percent on their capital and everyone else made 5-10-8 percent on their loans. That was about the way it went.
So 2-6-2. Now then will you made the deal with those entrepreneurs who were seeking to expand fast what could you what should you look for? Well. These were Financial people and they were not looking so much as the likelihood of it succeeding in the marketplace because no one could tell them that what they were looking for was a very very good plan, well drawn up and well criticized which offered to make not 30 percent on your money, but seventy percent on your money. If you found 10 of those then those would end up by making overall 30% with 2-6-2. So you had to buy shares in firms that promise to make a very substantial return on that investment–bank money and shareholder money.
Now how many of them actually made it? Well as I say 2-6-2 but out of those 70 %ers you hope to invest in the 10 very best ones and make money. What else did you look for you? Look for the character of the entrepreneur. They had to have good technology. They had to have a overarching determination to make the thing succeed and to make money for themselves. They were driven by the returns are going to make and they had to be Innovative. They had to think of something new not just the same old stuff. You then put your money in you watch them you help them as much as you possibly could and in the end you had to sell out.
Now how many of the shares in the company would you expect to be able to buy? You can’t buy them all.
I mean the Venture investor can buy some of them not all of them because the person who started the firm wants to do own the firm. So that routine was buy about 30 to 35 percent with the promise, this was was just an initial investment and that 30-35 percent would be very very helpful to the person to get going but they would run into difficulties. They would run into cash flow problems and you would be able to invest more perhaps another 20% you’re getting down to 50 perhaps 25% you’re getting 55 and technically you could be in charge of the company.
And so the routine for the Venture investor by the best advice from the America basically Harvard, but also, of course the California experience was that by the time you’ve got to owning 50 55 60 percent of the company you had to so-call syndicate. What syndicating was find another venture investor to come in as a second party and he’d buy or she’d buy the second 25% adding up to 55% You’d have 30 he’d have or should have twenty five, fifty five percent. Then the third round Finance you might find another one to come in and by syndication these Venture investors could the word is not pxx in each other’s pockets but that’s what they did. They helped each other to get the best ones shared out. And this was a sort of a syndication move by Venture investors in California who are very successful at it and he became the fashion to be done elsewhere.
When it came to selling the shares this is when you made your money, it might be after three years, hopefully, but it was usually after five six or seven and when you stole the shares you expect to make six or seven times what you’d put in but over the years this would make you 30% on your investment.
Now who was going to do it? Who’s going to do it? I’ll have to tell you who is going to do it, Professor Henshaw[?] Professor Henshaw initiated when Crowkam[?] came back he initiated a small Venture Capital fund. And it was called Pacific venture capital and it was invented by him and by a student who came, in fact from this University of Otago with an MBA forgotten his name, but he used to work for Air New Zealand, I could recognize his face in the street immediately.
And they to set up Pacific Venture Capital. It wasn’t very big. It was three million dollars it was pathetically small but it started things and they would bring people to the university with ideas. They were not just think to invest in them, but they get them to explain to the classes what they were trying to do as entrepreneurs. And this was a very very small start-up in New Zealand
Bruce: Richard. This was 1980…
Richard: 1986. 86 86 or 87 when I came back from London Business School. And at the same time there was a very very wealthy man who happened to be visiting the country on a sort of trade mission and he was the king from Saudi Arabia.
And what did he do? He thought this is a place here in New Zealand is rather fun. I might drop a bit of money in here and he left three million dollars three million dollars, that’s not much. But then when he went back to Saudi Arabia and he heard about venture capital and doing new things in oil and so forth he wrote back to his friends here and said make this Saudi Corp call it Saudi Corp and start investing and raising money and I’ll put some more in and he put in more millions and more millions and Saudi Corp found a very very capable accountant trained man called Owen McShane, and he’d been talking venture investing for some years before this he thought about it and learned about it and he became the manager of Saudi Corp. Saudi Corp launched big in New Zealand and they followed the right routines. They made money for the prince in Saud they made money for their shareholders were those for wide-ranging by the time they finished.
And he gave way after two or three years to another man, Bob Wilton now Bob Wilson was an accountant. He was a very skilled financier. He came into Saudi Corp and expanded dramatically and ended up as a professor of Finance at the University of Auckland and taught Venture investing. So it all became part of the routine. It became part of the routine.
Well who was out there actually bring new ideas to the marketplace? Now, I’m not thinking of persons who are Financial engineers, and I’m fighting for a name here for the richest man in New Zealand who came to do the MBA here. Oh Hart, now Graeme Hart, I met Graeme Hart and he was a very very clever Financial Wizard and I thought to myself this guy is a potential Venture investor.
But his routine was quite different what he did was. He didn’t go into new situations. He went into existing situations, which hadn’t yet learned about entrepreneuring and were dying on their feet and he bid for their shares and got the shares and then he went as an entrepreneur. The result, would fire all the managers who are bloody useless get rid of all the people who are deadbeat put in my own team so that the total amount of money spent on running the company went like that.
That was what he could earn for his pocket know for his return on shares and of course you then sell the company very well run and make a lot of money and expanded expanded expanded and in fact, it was a venture routine. An entrepreneurial venture routine vision and he went on he came to the MBA down here and I came down from Aukland University to teach entrepreneurship here with him in the class.
He was an extraordinary example of the skill in that kind of financial engineering entrepreneurship, but that’s not real entrepreneurship the way that the innovators go. They are the sort of man who sitting in the back blocks that somewhere in a large company who’s developing something totally new. The sort of inventiveness of large organizations engineers is absolutely legendary and I’ll have to tell you that before all this happened with me I worked in a company called Imperial Chemical Industries. First job after my University Oxford University with Imperial chemical Industries. They made a fool of themselves by going to China and putting up a stand at an exhibition there in which they translated Imperial Chemical Industries as Imperialist Chemical Industries, a disaster for them.
But that firm in the 1920s and 1930s had been the innovators in the chemical industry. They’d been the entrepreneurial venture which started off in the 1925 s with Bruno Mound[?] and so forth and they expanded and expanded expanded and when I joined them they were still at the last gasp of the entrepreneurship. And they were telling each other we don’t need to do this anymore, we don’t need to be inventive anymore. We’ve done it all. We can survive on what we know and they survived on what they knew. And I was in a bit which had been in fact a new Venture some years before and it was still you venturing on. I’ll tell you how clever these Engineers were, what we did was we made plastic film. We made it by a process called the bubble process. Up in the sky somewhere 40 meters up in the air you extruded a tube of plastic. Polypropylene, which what we did polythene would be the other one. that was big. Polypropylene was new and we had to work out how to do it, but they worked out how to do it they extruded this plastic tube and they put hot air inside and outside and more inside than out. So it went and they hit it with heat and it bubbled out into a great shimmering 30 meters across bubble of film. It came out of the sky falling molton as came down it the hardened and they realed it off.
Now then this was polypropylene film which in my early career in ICI, I went out on the road selling as a way of packaging biscuits. What a thought my look I loved doing it, but it was there was just what a stage in ones career but…in America there was a company which was making polypropylene film. Not like that, but by a flatbed process and they could make it far faster far better far thinner far everything than we could. And we were being caught up by these people launching the stuff into the UK where I was working and beating us in the marketplace on price and the ICI bosses turn to the engineers up on the plant and said we need to make this thing cheaper.
And the engineers said. Okay, so what do they do? They blew a double bubble two cubes coming down one inside the other, slit as they fell round off one way and the other way and double the size of the plant in three months. How about that? That was incredible. I mean the technology is all new.
Now this was process innovation. Process Innovation is making the process work better. Product innovation is doing something entirely new with it. And at the same time in 1986 there was Abernathy and Clark who were looking at the two sorts of innovation and claiming process Innovation is fine for the big guys, but don’t think it’ll last forever because someone will come along with something entirely new and bowl you over. Product Innovation and process Innovation have to go together and they were like Schumpeter they were laughed at but they were right.
They were right and if you look now at Imperial chemical Industries, I have to tell you the name is still there. It’s owned by a Dutch company and the original company which I worked for the biggest chemical company in the world when I was there is dead. D-E-A-D. Gone. Finished. Over. No longer. Same with Kodak. Same with a lot of large companies. Why? Because having invented something and having got it going they thought this was the name of the game and it was. But it wasn’t forever and the people who like the engineers are able to do some new things with that plastic they were think what why don’t we do the why don’t we print it in situ? Why don’t we line it with something else, why don’t we do two together like silver inside to make it even…and they were told no we make polypropylene film. That’s what we’re here for–as it was a god-given right to exist and what you did so they left came back to haunt the company.
How long did it take the large firms to realize that they had to be both. process and product Innovative. Well, many of them still don’t know they still don’t realize it but the ones who do realize it, what now, here’s a problem once you’ve realized it, what can you do? Because what you’re asking yourself is to employ some people on Innovation and Entrepreneurship who previously been employed on making things better not different. So but they’re they’re hiding in the Woodwork there somewhere. They’re all they’re trying to find something entirely new. So you have to find them you have to ask them what they can do. You have to back them to a certain extent not too much. Not too much just a bit get them going little cells little cells little Innovative cells in a large organization and that has become the name of the game for the large corporate.
Corporate Innovation is finding the innovators and backing the right ones. And the other ones who maybe their ideas are a little bit too extreme, well they can go outside and do it outside there. And so you’ve got the Venture investor who leaves and requires venture capital from outside. And you’ve got the Venture investor inside who is there to develop something entirely new inside the firm. And well, you’re going to you’re going to eat yourself aren’t you because once this thing works is going to replace what you do already now.
I have the pleasure of going out and inviting some of New Zealand’s largest companies on how to do this and the struggle and the strain to get that corporate culture to change from within I mean, even the people who own the shop floor, they love the company. They love what they’re doing.
The University of otago is like that it loves what it’s doing try to infuse some change into it and you’re fighting you’re fighting uphill. How do you do it? What what you do is you discover people who can be incubated and that’s the word were trying to find before the incubator is where you put the oddballs not everyone or all the time, but you put them in there and you get them to start thinking of doing something different. Fifty sixty seventy percent of your time doing what you’re doing already and the rest of it doing something which entirely new and you foster them and you help them but they’re only a small cell and you explain to everyone else why they’re there and why it’s important that they’re there and they’ll struggle to to accommodate it because they think that what we do already is fine. But then they’ll get going and they’ll come back and they’ll haunt the company with something new then gradually. It’ll it’ll find it find its feet and get going. Now it isn’t just a large corporates and the world…
Bruce: Just to jump in there too Richard. Westpac, for example, I know has a venture capital company they’ve set up, I think in Australia, outside of Westpac thats owned wholly by Westpac. That is, as I understand it, I don’t know it well, is there to be a standalone Venture Capital company that actually invests in fintech companies including one here in Dunedin that I know of. So it seems like they are they are trying to get both the inside and the outside approach.
Richard: If you try to get things going inside it is so very difficult that you have on occasions to say well we simply can’t do that. What we have to do is invent ourselves outside put the people in there and then possibly bring them back later and when they come back later, they’ll come in with all their new ideas, but the idea of separation. It has to be separate even if its right bang within it has to be in a building somewhere just over there where they’re doing all this magic new things.
It doesn’t have to be bang inside the corporate and if it is they’ll be watching it carefully. The corporate immune system is what it is called. It is called the corporate immune, Brandt called it the corporate immune system. What happens is they will gobble up and try to get rid of them because they’re different.
Now lot of firms have incubators now, but universities are really there because inside the university you’ve got this clever scientists who are thinking of new things. Previously, they would have to go outside the university to try to find some backing and they will regard as a bit odd, I mean the professor going outside and finding money to get a business going as, remember the professor of chemistry did that and his building a just down the road there, and I remember his name if I really try to, went and invented something new in chemistry, and he ran that while the same time being the professor of chemistry and the university I think of the time thought my goodness what is happening here?
Well, what should have happened would be that he should be encouraged inside in an incubator and here the University of Otago, and other universities just the same, we have an incubator glass building of magnificent proportion with wonderful facilities and who gathers inside there, a director and he encourages people who have new ideas from the University and some from outside it to come into the place have a room share their views with others and see how to get going. See what the problems are going to be and see what the possibilities are.
And this is where they come against two big factors 1. Death Valley 2. Up the S-Curve.
Now I’ll talk about Death Valley first of all, because it’s a really favorite expression of mine Death Valley. What happened was,besides Graham Croakham going over to Harvard and learning about new venturing just before that, others from the Development Finance Corporation that government-run bank in New Zealand went over to America to learn about investment, investment in not just new ideas, but old ideas as well. And they came up with the American expression, particularly in California, of Death Valley.
What is Death Valley? Death Valley is when you start off with $100,000 and expect to make sales and profits to cover your borrowing of $100,000. What happens is that the $100,000 becomes 80 thousand dollars then sixty thousand dollars then and it goes down you use it. And it hits the 0 line and when I hit the 0 line, you should stop or get some more money, but you go on to the bank and say we just ran out of that original one.
Can we have a lot more they going to say what have you done with it? Well, we spent it on getting going. Well have you got going? No. Why not? I don’t know just haven’t. Well you can’t have any more money. So you’re going to go into overdraft. Down into Death Valley and Death Valley is a long curved down which in the end turns and comes back up again.
There are two Death Valleys is actually. One is Death Valley of profitability. You start making money and so the Death Valley starts to turn but because you’re financing debtors and stock and all that sort of stuff the Death Valley cash goes on down and then it turns. Does it turn? Does it turn? I’ve seen people with worried front brows pondering over is it going to turn?
The truth is Death Valley according to your plan will be so assummed as $100,000 Death Valley in reality will be twice as far out twice as far down: two hundred thousand dollars in a year rather than $100,000 in the first six months of the bottom of the pit.
What can you do about it? What can you do about it? You can’t do anything about it is going to be there. You’re going to have a Death Valley. What you have to do is to persuade the shareholders not the bank the shareholders for a second round and a third round of finance and that remembers where the Venture investor comes in and starts a Syndicate and they will see syndicate if they think is going to turn and come back up again.
Let’s go back to the Development Finance Corporation going to America and coming back with Death Valley and I think in the nineteen eighty one, two, three, all we heard about from the Development Finance Corporation was watch out for Death Valley. Watch out for Death Valley. We’re all trying to avoid Death Valley. First of all by not spending money and secondly by trying to find some more money, but the Development Finance Corporation itself borrowed money in Japan at five percent and then lent it on at 12% and then the interest rates turned against them and the interest rates charged by the Japanese lenders went up to 15%. And guess who died in Death Valley having pronounced death in Death Valley is the worst thing for a company a Development Financial Corporation itself died in Death Valley.
It died down there. It was down the bottom there. It couldn’t get itself out of Death Valley
Bruce: Borrowed short and lent long.
Richard: That’s right by our dear dear that’s right and of course bankers know about this, but it was there for the government to invest in in Ventures existing Ventures and then new Ventures and they did a wonderful job, but unfortunately, they miscalculated and their Death Valley overwhelmed them.
So we invite others not to go into Death Valley or if you get in to get out as fast you can they themselves died there.
What is the other thing you’re going to have a Death Valley? You’re also going to have an S curve.
What is this S curve? Well, people estimate how many people are going to buy from them and obviously because they’re in love with their product they reckon it’s going to be a lot.
And unless they’ve been to University and learned about Death Valley or if the Development Finance Corporation was still there at from the or from the bank and learned about not Death Valley about S-curves.
When they’ve learned about it they will realize why it is. What is it? When you go out and try to sell something you’ll go to 10 people and get one who’s interested and they’ll buy something, you expect five you hope for eight, and you get one, so you’re starting to build up the ready for the for the expansion of the firm and unfortunately, not many people are buying so the stock goes up the cash goes down and the people don’t buy.
The geometric progression of purchasing is 1-3-8-15-50 and that’s how it goes, one person buys, persuades 2 friends and they buy 3, then he goes to 5 of people thinking about it.
Then he goes up and up at 50 and just when you think is never going to go up its soars. So you need more stock, now in Death Valley and the S-cruve is the worst possible slow acceleration of sales then a huge surge that you’d ever expect from the point of view of your need for cash, but it’s real. Look it may be that it’s not real if it doesn’t take off at all.
And you really wan that S-cruve because you need to have the sales but they’re going to confound you with more stock more debt has more everything you require the company more finance therefore to finance growth.
Bruce: And in the case of technology, perhaps more customer services staff, more engineers, probably less of the stock but certainly more of the headcount perhaps even marketing costs.
Richard: Let’s look at an example, years ago a company in New Zealand sold fertilizer. Ravensdown Cooperative. Ravensdown sold fertilizer up and down the country. They were very successful and then they persuaded themselves the new general manager that they ought to look at other forms of service to the farmer. What forms of service to the farmer? Well nowadays when they put the fertilizer on the ground they can tell you where they put it they can tell you how much has gone on they can tell you what it’s done.
They can tell you it isn’t going into the hopefully not into the rivers because they haven’t put it down. They have automatic feeders out of airplanes to put the right amount on the right place at the right time and all this is totally new. Noone knew about it before. Now can you imagine the amount of effort it takes first of all, to think that we ought to do it and then actually to do it means a whole new division and then you’re going to go out and persuade the farmers its useful have to have this extra service and may cost a bit more money.
So it’s slow to take off. But once it takes to of is like an airplane soared into the sky and they have I don’t know their figures, but they have a substantial investment now in these in these things new. And it costs and it’s slow to get going but once it gets going then you’re on the gravy train and it needs controlling.
How fast from the company grow? Some companies grow at a hell of a fast rate.
They need second round financing a third run Finance. They need possibly corporate finance. And of course, the culprits are all looking around for possibilities. To avoid being overtaken by them and they would go along there would say look we are big you are small you are growing. We think we may be able to help you and they were putting their thoughts together in how to invest in the company by way of buying more shares.
But of course buy more shares means milking the company’s directors of their shares because if you’re going to put a whole lot more money in and you’re going to get up to 80 or 90% of the firm leaving 10%, what they will say is listen, the old corporate venturing thing, listen 10% of an elephant is better than 90% of a mouse, and it is it is but that leaves 10% in your hands and your small fry now and where the company goes. And the corporate really owns you or the Venture investor who done the deal owns you with ninety percent of the shares and then of course, they’ll sell out and you get a whole new owner and the corporate world buy you and you’ve got three percent of the shares or you cleaned out all together.
That’s the way that the innovator will make money though but of course they lose the company and they very often they have to take all their money put in the bank and then retire to place it like Cromwell or Queenstown and relaxed up there and enjoy themselves and have an easy life. Not always though.
Can I just go back to these incubators?
Why would the integrator be a good idea what the Venture investor lacks is companionship. They’ve got a whole of advisors on board. Some of them know what they’re talking about and many don’t. But what they don’t have is other people in the same boat as they are facing the same problems as they face the same marketing problems the same pricing problems. And being in an incubator mean to say you can share the ideas out and talk about it over lunch time and and see what other people have thought should be done.
And then of course the incubator received expertise from outside. If it’s in a University from within the university if it’s outside entirely friends, if it’s a bank one, then from others in the bank and so forth and you’ll learn more about some of these tricky bits.
What do I think the real nasty tricky bit is as you expand. What is this? It is going into another place. Why? Because you have developed something, which is super for here. Then you think we’ll make some sales by going to and many companies in New Zealand would think Australia first step. What they don’t realize is that Australia is a totally it really is a totally different place.
It’s bigger scale. It’s more competition, is different people. They think of the kiwis as johnny-come-lately you go over and tell them what you’ve got and they say, oh, yes, we’ve got that, they haven’t got it, but they tell you that they have, you have to take the stuff there and that means take it by a boat or by Aeroplane.
You have to sell it there, which means you can have someone on the ground. Agents, do you have an agent you appoint an agent? What do you do? How do you price it? Now years and years ago pricing and overseas market was very simple. You only had to make a contribution. margin. What you had to do was to cover your cost and made a bit extra and you may have been extra, so it’s only 10% extra but that went straight to the profit. You covered your costs. There were overheads, you cover the overhead little bit of overhead as well. But the rest of it straight to the profit so it was a very profitable thing to do pop overseas and sell at the margin plus a bit.
And if you’re successful, of course it grew and it grew it became a bit problematical. And the dictum was when you go to an overseas market and sell at the margin, this is the old-fashioned way of thinking about it, what you have to do is get to about a quarter of your sales, maybe the third of your sales, you know, so a third of your cells are going over to overseas market now and then you’ve got to have a totally different strategy because now it’s so big in your portfolio you have to change.
You have to start to think of higher pricing getting out. A much better return on your on your sales and that’s not easy. So starting off low price ending up having to be high-priced if you’re successful is a terribly difficult thing to do. Now people do it but very often what they find is they need a friend over there maybe even a corporate who’s going to bring the stuff in and handle the selling and handle the difficulties and that’s probably one of the better ways to go but it’s not easy.
It’s not easy. I’ve seen companies that are going into overseas markets with very very high hopes and great success. Yucca themselves because they get the fundamental equations wrong. They did the balance of what they’re doing here and what they’re doing over there completely wrong.
Now there is another way that people expand in another territory and that is by franchising and franchising is a very very very solid routine for come to the producers something that can be produced here here here here even in manufacturing.
Franchising is a good man a good way to go. But you have to be very canny with your franchises. What you don’t want is someone who knows more about it than you do in your first Branch. Can you imagine appointing someone who knows all about what you do is even a competitor of yours set themselves up as not telling you what to do.
And it can be horrible tension. What you want is someone who’s a trained business person but not perhaps necessarily in that particular routine, right? So they have to learn as they go.
How big can you go with a franchise? The sky’s the limit absolutely the limit but get to 30 franchises and you’ve got to have a franchisor arrangement agreement with them all you have to bring them all together and discuss how you’re going to go.
Some people are very successful at it. All the companies find it very difficult, but I always think franchising, I like franchising because what it does it it releases all the small business initiative, although sometimes the entrepreneur initiative it releases all that under control. And that’s a very it’s a very good balance between what you’re doing here and what you can be doing somewhere else and franchises go overseas with great success as well.
Bruce: And you have your distributor or reseller actually funding your company.
Richard: That’s right, and they will go to the bank and they’ll say I’m operating a franchise with this company from New Zealand and I need to have so much capital to get going. What do you think and they’ll look at the plan is think it’s successful New Zealand. Let’s have a look at it in Australia. It looks like it could be successfully run by an Australian. And when we go through, yes, you can you can raise more finance that way. It’s very good. Very good.
Excellent. Why do I teach the MBA?
Bruce: Before we go there though…
Richard: You don’t want to know about that.
Bruce: We’ll come back to that thought for sure, but we were going down and track of different ways to fund your fast growth and we certainly covered exporting and perhaps finding an agent that way, we talked about franchising.
We talked a bit about Venture Capital venture capitalist coming in, did we finish that conversation though? Because the there you are you’ve got this Death Valley, you’re staring down into it. Cash flow and perhaps net profit. You don’t know where the end is you talk to someone who’s willing to invest through that Venture Capital that that Death Valley poor cash flow process, what comes out the side?
Richard: After the launch of the Venture Capital industry in New Zealand with those two small ones both growing, things change really quite dramatically.
Because what happened was it was an entrepreneurial initiative itself in the Venture industry which got Venture Capital going. It wasn’t necessarily the big banks saying we ought to put some money into Venture investing. It was necessary to finance houses doing. I’m thinking of people who would override our offer loans on purchases of equipment that kind of thing.
They weren’t necessarily the right people in their own view to start venturing into to start investing in small new Fast growth Ventures. So how could it be done? Well, sometimes an overseas company would come along with a branch in here in a couple of American branches were founded quite early on I don’t know the details of that, but I do know that they exist.
But after that it became the property of entrepreneurial investors themselves to raise money among their friends, friendship capital you might say, and it was a formal arrangement within the firm but it wasn’t part of a large organization. And and that’s the way it got going down in Wellington. I remember Wellingotn people investing all through one of the one of the entrepreneurs there who got things going.
And then friendship capital, people funded, crowdfunding came in and you could launch things on a stock market, launch things on a on the market by going to Facebook… and sayingtwho wants to invest in This brilliant new Venture and along with come some people who probably weren’t very well advised in Venture investing. In fact, they weren’t advised at all, but they had a bit of spare money and they put it in by way of a friendship investment and that got going.
I don’t know that anyone knows exactly the proportions now of financing in New Zealand. The formal Venture Capital industry is not that large if you were to put 300 million on it something like that it would be about that as a limit, but there’s lots and lots of other ways that people starting off with family finance getting friends to put some money in associate to put some money in and then launching with their friends to raise more money and and that’s become a routine its success or otherwise of it I don’t think anyone has figures for that.
Bruce: Sure and the Angel Investing side as well perhaps we’ve got the seed and New Zealand Venture Investment Fund.
Richard: Yes, of course lead the government’s is very very keen to get continue to get more Ventures going. Let’s just look for a second at the dynamics here.
How many people in a normal place like New Zealand normal place like New Zealand? Okay, abnormally normal and New Zealand how many people would be imbued with the initiative and the intention of doing something new? I wouldn’t put it any higher than 8 to 10% of the population.
How many of those will actually do something new? Well the biggest you’d expect will be a total of three percent. So three out of ten will actually have a go.
How many of those will succeed 2-6-2 out of 30, six, they will succeed.
What is the result in the economy? Well that job turnaround rate as a result of the entrepreneurs getting going is reckoned to be about 10% of the population every year that is the amount of it.
Why is it like this? It’s like this because the large firms process innovating are losing jobs in proportion to their output. They’re saving on their investment in people by putting in new technology. And that’s an entrepreneurial thing.
How fast are they losing? Well reckon to be about 10% lose every year and this is a massive amount. I mean, is it the whole thing turns around and about 10 to 15 years, you know, it doesn’t actually turn around that that because they’re also hiring more people and but the decline rate in jobs is, Birch, about 10%. Where the new jobs come from? They come from inside and outside entrepreneurship, but the numbers are small the numbers are small because the numbers of people who succeed a small but it takes a lot of effort to get going to replace the jobs.
Are the numbers of jobs in New Zealand increasing? Yes, does that mean to say that when entrepreneurial nation? Yes. Does it mean to say were also saving on the large firms? Also yes. We’re just I think we’re perfectly in balance, but we do need those entrepreneurs to be doing things and the result is going to be a 10% change every year. Jobs. Job, circulating like this and the person who work all that out was a man an interesting round man called Birch in the nineteen eighties who went round and asked the questions in America after questions of how many people to employ now how many two years ago how many five years ago me 10 years ago and he developed this thesis of the declining job numbers in large firms, which is what they have to do to survive replaced by new initiatives either inside or outside.
Very tantalizing small resource to see
Bruce: You’re talking about the University, what are you doing here now? What’s the MBA…
Richard: What happened was the University of Otago decided it was going to be like other universities overseas and have a master’s degree in Business Administration.
When did the master degree in Business operations start? About 1900 and in Harvard in America. When I did the Sloan Fellowship course, which was a post MBA course, London Business School. They had been in the business of offering MBA since about nineteen hundred and sixty-seven that’s when they started off offering the MBA when I was there, London Business School in 1970. There were besides us 20 Sloan fellows. There were about a hundred MBA students. When I went back to lecture 1986 there were 600 MBA students and I bet there are more now, it became the fashionable degree to do in business.
What happened in Otago? 1979. The professor management a man called Philip Russell, who was actually Read International Paper he’d been a very big wig in that in the human resource side came here as a professor of management. He persuaded the university that we ought to have this MBA and in 1979, it started with six students and guess who did a lecture on the opening day of the first MBA taught in diversity of otago a fellow called Richard Higham.
And what did he talk about? I talked about an experience that we’ve had with a company in Otago McSkimming Industries. What a wonderful company that was, was, was, no longer exists.
Why was it wonderful? It had perfected a very difficult routine making lavatory pans not easy because you’ve got two parts and they got two fit together and you do them in one effort and the pouring of that liquid stuff in to form the lavatory pan was an art form beyond belief. It was McSkimming Industries had learnt it and they got it, right and they did it right. Unfortunately overseas people are doing the same sort of thing with equal success, but huge huge organizations and flooding the marketplace here with cheapo lavatory pans and this in the drove poor McSkimming Industries broke. But when we did the case study lecture they were still going strong and I talked about what it was to organize production for something which is extremely difficult and complex to make and then market it throughout New Zealand. 1979. Well after that I lectured on the MBA for each year. I was covering entrepreneurship innovation is as far as I knew it, but it was all small business at the start.
How the small business survived with the, you can remember people used to say, did you realize that what it fifty percent of small businesses fail in the first five years? 80% 80% of small businesses failed in the first five years. Did you realize that eighty percent of small businesses startups fail after five years and this one why why did they fail or they ran out of money or they ran out of market or they did that. Was that the other.
What should we do about it? We should train them. Huge effort in training small businesses how to be good small business people was initiated by the government and that’s why they found a thing I belong to the business development center and that was to help small businesses because they were seedbed of all the good things in the in the economy. What was actually happening was the decline rate of 80% was not just people going broke, 30%. It was people combining with others. Being taken over. It was people who started off with two partners who couldn’t stand each other and so they’d stop and one person would take over and start again. So it was a stop but it was a restart immediately with the same one of the two people starting.
And of the 80% failure 30 actually went broke. Of that only about 15 were in the of courts, and the rest of them was still there, but under a different name or different format or they belong to someone else and so forth.
It was completely falsoe statistic. It was completely wrong and it led to enormous efforts to help the small firm and there I was teaching how to do it because I was a small firm expert I’d run my own small firm after I see ICI. 1983-86 changed all that when we realize the entrepreneur was the name of the game.
And so we started teaching on the MBA here entrepreneurship and I remember Auckland University and coming down to teach the entrepreneurship classes at the MBA in this University as well as in Auckland and we had a case study of a fast growth firm from Invercargill which had gone in for making components little bits of wood that would end up in chairs and they made components for the industry and they, couple of brothers, anyway, they started their company, I think that father started the company and they went whoosh like that and were handling that fast growth. They may still be there.
Bruce: Up the S-curve
I think we this is the one that I did?
It was over two classes, right?
Richard: That’s right, and but not now. No longer taught. We teach the importance of being entrepreneurial. And how to get the entrepreneur going and how to finance the entrepreneur and how to control the rest of them so they understand that entrepreneurship is important, but the actual technology I don’t think it’s taught in the University anymore of actually handling fast actually handling fast growth actually getting the money together. I don’t think that’s taught.
Bruce: And that was the Master of Entrepreneurship I think,
which is what I did.
Richard: Well the Master of Entrepreneurship started off as a marvelous marvelous investment in people’s time. It was terrific and I was lecturing on the MBA on the master entrepreneurship as you remember for many years using the case study to show the sort of things that actually happened in a firm like that. Then the directorship of the entrepreneurship changed and it became something completely different and they didn’t want me anymore and I was shoved out, but I was still doing the MBA classes teaching people how important entrepreneurship was the in the large firm and how to handle it but not teaching how to actually be this fast growth entrepreneur very sadly because that was a good good case study.
That was it was good case towards real to, real gosh scary
Bruce: And now you’re writing the Blooz
Richard: Nooz.
No the Bloose Nooz ws is completely different. What happened was the University of Oxford
Bruce: Otago University…
Richard: What happened at Oxford was this I went to Oxford to study Greats.
Greats is called Greats because it’s was the Great course. It was the Great course going back into the fifteen and sixteen hundreds of Classical Languages literature philosophy history and so forth and if you went to Oxford you did what was call on moderations [?], which is all the languages stuff and then you did Greats and I did Greats. At Cambridge you went there to study mathematics.
The mathematics classes there ended up with people doing the examination seated on a three-legged stool called a tripos and they still call their degree the tripos, you take the tripos at Cambridge, and you argued with the professors and the senior wrangler was the person who got the top first and my uncle was senior wrangler for Cambridge meant he got the top first and got a three-legged stool way back in 1920.
At Oxford you did Greats and I did the Greats course and I love doing that doing. But there was also a thing called Rugby Football. And four of us thought ourselves capable of playing in the second row for the Oxford University in the annual match against Cambridge and of these four I was one of them two played for Scotland in the end one played for England in the end and I played for Bedford Rugby Club.
And so I was technically the least capable but I was the one who never got injured. What a difference. They would go on the field. They would star star for 35 minutes and then suddenly their leg would give way and they be off the field. Sadly and they come back, and then I’d take over you see, and then they come back three weeks later. They do a wonderful job, but in scoring the final winning try again somewhere other they would break their nose and could no longer play the following week. So it just happened that the pattern of injuries to these other three compared with me got me in and I went to a place called Twickenham with the Oxford University Rugby Football side in nineteen fifty-nine sixty years ago, and we knocked the stuffing out of Cambridge and we won by three penalties to one and I was part of it.
So when I came to this University, I then afterwards played for a club,.Er, but when I came to this University this university has a fantastic record in producing good rugby players. We boast. We don’t boast anymore because our friends in Ponsonby and we have got an agreement that we don’t actually claim to have more All Blacks than anyone else has but we have, but don’t tell them, but they think of as many as we have actually played for the club at that time. Since our players have to leave the university after three or four years and join a club we’ve got that number equal to Ponsonby, but the same again, playing a year later for a club so we count them all
Bruce: Clearly much better than Ponsonby,
much better
Richard: So we count them all. Now three years ago, now when I came here I coached the Colts and then the Blues then I was such a bloody hopeless. I was a hopeless coach becuase all I did was to say enjoy yourselves. And so I was the club Captain then the club president and all the rest of it and I went on being that until I went off to London Business School in Auckland.
When I came back here in 2000 two things happened. First of all, I went to a concert and I met a lady who’d been at Auckland University managing the MBA who come down here to manage the MBA down here and he said what are you doing here?
And I said I’ve retired, no you haven’t she said, 2001 this is, no you haven’t come and meet the director. So I went to meet the director fella called John Burke director of the MBA and he put me lecturing the MBA. So I was back in to lecture in the MBA here. And he was the president of the University of Otago Rugby Football Club.
So he said come along to the club. So I went to the club and variously I enjoyed helping at the club and doing and behind the bar and also a staff until three years ago when I put out a one-page summary of what we’ve done this week with the A’s and the B’s and the Colts and the women and so forth one page with a few pictures.
Unfortunately, I sent it to people who replied if I simply filed it somewhere it would have been safe but I sent to people and the list was 50, then he went to a hundred. And it grew and then they started replying and sending in I remember what happened in 1954. Do you remember you remember well all sorts of players like Kirk the chap who captained the All Blacks in the World Cup this out the sort of thing David Kirk and and so on
And well I knew him you see cause when he came here to University I was the club captain and we are tell you something we had a trial at which someone didn’t like him very much and they hit him and flattened him and he was lifted off, I didn’t lift him off but I supervise had been lent up against a fence over here. Like this and he’s sitting on a jersey and you completely gaga it was concussion of the worst sort and at the end of the trial everyone left to went away and I was leaving with my pad here and there he was still so went over to him and said are you okay, and he said I think so sir, and I was sure he just came from school. That was David Kirk captain of the All Blacks and winning the World Cup. That was David Kirk.
Bruce: Okay, so I’ll have a link in the show notes talk about this later perhaps how you can get onto that list.
Richard. Thank you so much for your time.
That was very interesting. Thank you, sir.
Richard: Pleasure pleasure real pleasure. Great fun.

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Episode 3 of the Curious Kiwi Capitalist Podcast

15th August 2019

My guest for this show is Alexander Simmons. Alex is the founder of Voyager Equity a search fund. Search funds are completely new to New Zealand with no fund yet launched but with some interest from Kiwi searchers overseas. In Australia they have gained traction in the last couple of years with at least two funds succesfully acquiring businesses. Alex is the first Australian search fund to get investment for “search capital”, the traditional first tranche of investment in a fund. The other two funds self-funded their search and then got “acquisition capital” the second tranche of investment.

I have to admit I am very intrigued with this type of investment fund and have been involved with encouraging prospective Kiwi searchers in 2019. My hope for young searchers and retiring mid-market business owners is that this investment type takes off over the coming decade.

In this show we’ll discuss search funds in New Zealand and Australia including:

• what is a search fund?

search fund accelerators and business schools

Show NotesAbout Alexander

Alexander Simmons founded Voyager Equity earlier in the year, and it is the first search fund that has raised “search capital” in Australasia. Others have raised acquisition capital, an achievement in its own right, but no one till Alex had raised the first part of a traditional search fund. This makes Alex a real trail blazer in Australasian search funds.

Alex is English, who started his career at Bestport Ventures LLP a UK private equity firm that invests in growth capital and small buyout opportunities in the UK. He moved to Australia where he worked for Partners in Performance to get hands-on operational experience including in New Zealand. He started up his search fund Voyager Equity in 2019.

He has an MBA from INSEAD and a BA from Oxford. INSEAD has one of only a few search fund courses in the world.

Links

“Search Fund Primer 2016”, Stanford Graduate School of Business.
“International Search Funds – 2016 Selected Observations”, IESE, June 2016 in IESE Search Funds
Search Funds in New Zealand: what are they and a way forward (my views in a previous article)

Relay Investments
Harvard Business School Jim Sharpe, who I know is a supporter of Kiwi Harvard grads doing search funds.
Search Fund Accelerator (Timothy Bovard, Boston)

“Perspectives on Search Funds“. A podcast series featuring all things related to search funds and entrepreneurship through acquisition. Hosted by Brian O’Connor, Adjunct Professor of Entrepreneurship at the University of Chicago’s Booth School of Business and Managing Partner of NextGen Growth Partners.

“Search Funds in Australasia with Alexander Simmons” show notes.

Transcript: Search Funds with Alex Simmons

Bruce: What’s a search fund?
Alex: Morning Bruce, quite simply it’s a vehicle a company, whereby an individual such as myself raises some money from investors, that money essentially pays a modest salary to me and provide some some headroom for expenses while I go for a period of time typically two two and a half years to look for a company to buy.
So it’s really something to facilitate the acquisition of a company which would be an existing company that’s had a long operational history. And the seller is looking to retire or transition out of the business and then I would I would come along and buy
Bruce: We’re sitting here in your offices in George Street in Sydney. You are the first person who’s raised search capital, as we call it, in Australasia. Congratulations on that and that search capital as you say pays for your the salary these offices your traveling expenses anything else that the search capital component
Alex: You got your basic administrative expenses that you would incur such as CRM software and and other software that you might use for analysis and research you’ve mentioned travel and accommodations so visiting companies that might be interested in buying you typically want some cash to have for due diligence.
And generally that would be paid for out of the proceeds of the deal. So when your investors fund an acquisition they will actually cover the expenses in that but you need the cash. For two reasons, one you might be asked to pay before closing the deal so say accountants would generally want that.
But equally if you you proceed with a deal which doesn’t complete then you’re going to owe some people some money. So you need to make them whole.
Bruce: Of course. So you’ve raised the search capital you’re now certain will get into each of these stages more soon…you’ll find a target company, l you’ll do your due diligence you’ll like the company you’ll think it makes good financial sense and then you’ll go back to those investors and others to raise acquisition capital. What’s that?
Alex: So those investors that have invested in the first stage, the search phase, they get the essentially the right of first refusal to fund that acquisition. So say I find a company we all like that they get the right to fund that it would generally not then be possible for someone external to fund that if they wish to take the whole deal themselves in the event that perhaps they fill 80% of it then someone else can come in and take the rest. So it’s designed for them to be able to provide the full funding throughout the life of the investment rather than I don’t expect a different group of people, you know in Phase 2 as opposed to today.
Bruce: Right, we should get into the general terms, but the the we can talk to us about the the standard terms, they called standard Stanford terms aren’t they, of the step-up that the search capital investors get if they then proceeded into the acquisition capital. What do the general terms suggest of a step up and what does a step up?
Alex: So, I mean, I guess they are Stanford terms you probably wouldn’t hear them called that necessarily because I think broadly speaking and most of search moment happens in the US the terms of pretty fixed. So the standard search terms are pretty ubiquitous and generally it works works like this. An investor will provide that initial capital small amount of capital to fund the search phase the looking.
Typically you’d have somewhere in the region of 10 to 15 maybe 20 investors at that point some of the US searches tend to have more as we’ve said they get the preferred right to invest in in the second stage, which would be the acquisition of a target company, For taking the risk in that first phase, so say they write a check for 25 or 50 thousand today that will get increased in value by 50% on acquiring a company so that 50k would get turned into 75k of shares in in the Target company. No cash would change hands for that. They’re already paid for that option then like it’s turned into shares.
So it’s really a drag on the Searcher on the individual on your ultimate returns, but that’s the compensation that those investors get for taking the earlier risk.
That’s what search capital is, let’s come back to the search process. We’ve talked about the acquisition capital. Or how the search capitol steps up into acquisition capital and that fresh acquisition capital can come in if required.
Let’s go through the process a bit more. So you’ve you’ve raised the search capital. What did you say to investors? What how did you explain search to them?
Yes, a good question and certainly outside of the US and outside of business school graduates, this is relatively Niche and unknown.
What I will say about my investor group is that the vast majority of them have invested in search funds for a long time. So about half of my investors are in the US, about a third are in Australia. They were the ones who didn’t know the search model, didn’t necessarily know me.
So that was you know, there was this two parts to that was an education piece and there’s also the the fundraising pitch new saley peice which, which is more about you know, selling kind of me and my vision as opposed to the model. Whereas speaking to investors that know search funds very well that they know the model they get it so it’s really about you know, am I credible person to do this?
Bruce: Yes.
Alex: So it was actually very, you know, it was tough and interesting at the same time to to raise the local investment. You’ve got people who don’t know the model. So need to be taught it, I think generally investors see it and they like it. It’s not an accident that search funds are doing what they’re doing at the moment and and generally, you know, more and more popping up outside of the US because it is an attractive investment model for the investor but then, you know the risk of a new model and the risk of an individual that perhaps they don’t know or this sounds some way novel was a challenge. So I mean really you have to sell yourself fundamentally.
Bruce: You’re really a bit of a trailblazer really, or pathfinder … trailblazer.. not sure which military analogy is best but
Alex: Not sure either is that appropriate!
Bruce: It’s enough finding a good target company at a reasonable investment level but also to raise search capital under a new model is certainly difficult. So you went to them and said this is what I’m doing. This is what a search fund. Looks like you raised capital from them. What did you talk about in terms of the process you would follow and what they should expect out of it out of the other end.
Alex: Yeah. So I mean I think and very helpfully, there are materials like the standard materials on the website that talk about search in all its constituent parts and
Bruce: I’ll put them in the file notes
Alex: …the returns studies which I think happened every two years. So it’s quite easy to point to the metrics and say here’s you know, what investors in this asset class typically would expect.
And the process and and this is really driven by searchers in the US where the market is quite, not saturated, but very well serviced both from intermediaries with businesses that are selling and people who want to buy them, is that they need to be quite differentiated and do quite deep analysis on the industries that they want or think would be the most likely to bear fruit.
And so when you talk to investors about process because fundamentally what you’re coming to them where there’s a process here is a process. Whereby I’m going to identify a good acquisition and you know, you’re going to fund it. We’re going to buy it together and I’m going to run it and so the process is very much one of developing relationships with intermediaries in part probably 20 to 30 percent of your time spent doing that but the vast majority would be picking industries, which you think are attractive that have certain characteristics, which will probably get into. Identifying companies within those Industries and basically approaching the sellers and saying hey you interested in in striking a relationship and potentially selling your business?
You know, I liken it to is like knocking on doors to go and buy a house, right you pick a neighborhood that you like and knock on the doors and say you want to help me your house. Right?
And that, too a lot of people, is is a very strange notion. I think people are less emotionally tied to their businesses than they are their houses and you know, it’s not as clean a process for them to sell their businesses as it would be a house.
Bruce: It’s a very honest process though. If you look at private equity, they have their their fees that they get from committed capital from the limited partners and those fees pay for them to do the same thing. Albeit, I mean, I might throw that over to you.
What’s the difference between private equity and search fund?
Alex: Yeah. I mean, I think there is quite a big difference. I used to work in private equity and we’ll probably get into my story a little bit later on but what’s interesting for me searching is that I’m now interested in pretty much exactly the deals and the businesses that I wouldn’t have been interested in before.
So if you look at private equity typically. One they’re looking to assemble a portfolio. So they’ve been given capital by their LPs. They want to assemble a portfolio that might have some theme or other it might not but generally you talking four six eight companies in that portfolio, your whole period is they talk about three to five years most funds are ten years in life.
And when you look at search we’re talking about one business, we’re talking about me going in and running it.Private equity, usually they don’t do that, but some some are more hands-on than others
Bruce: They sit on the board, but not
Alex: Yeah, and some do put in operating partners, generally the bigger ones in the smaller end of the market that is unusual. So I’m going to go in run this business. It’s a one shot thing. I don’t get to assemble a portfolio of businesses. I’m going to run one. Private Equity would look to assemble a portfolio.
And then the type of transaction I think is fundamentally quite different. I mean if you think about what I’m looking for is that succession someone is retiring they need to pass on their business. They want to realize a sale. Private Equity generally wants management in place not always but generally till usually want management with a vision that they can provide capital for. So unless it’s a trade sale or PE buy and build which is really a trade sale of a different name then you know the not going to huge overlap.
Bruce: The other thing I note is that you have a lot of very high quality businesses that come on the market that might have an EBITDA of even up to five million dollars and especially in Australia, less so in New Zealand where the PE firms are bit smaller, they’re just they’re just not interested.
You’ve got a quality mature business there that that is proven itself through that high level of EBITDA and it can’t include financial buyers in its buyers list. And that’s why I think search funds are an exciting addition to the landscape of Australasian capital markets.
Alex: I totally agree and I think as well given the that mix of…
It’s different in the UK said private equity plays lower in the UK, but here certainly you’re right that like 5 million is getting towards the lower end of what they’ll do but the demographics pretty obvious, right? You’ve got a lot of businesses that are owned by essentially Baby Boomers who will be retiring in the next few years and generally those sales aren’t “I need to sell the business now”.
But over that five or ten year time period a lot of these businesses will have to change hands.
Bruce: And I’m not going to dive into exit planning and Baby Boomers because I think that’s a whole topic and of itself. Okay, so you have the right to search capital. You’ve found the target company you’ve acquired it. You’ve run it you’ve added value to it. What’s the next stage?
Alex: Its a good question. And I think it’s in many ways how I think about it to have a predetermined notion of what the end looks like is difficult because it fundamentally, it relies quite heavily on the characteristics of that business and the industry it’s in.
Certainly, the investors do want to realize liquidity at some point and you know an exit of some sort, you know, there are ways and means of achieving that without actually selling the business. So you could in the US for example, some of the businesses there have done recapitalizations where they take on more debt, pay out some of the shareholders and continue.
And certainly what is true is that the biggest success stories in search have the longest hold periods? Far more often than not so investors who some of them have held things for 20-25 years still hold them.
Bruce: Sounds like a transition to permanent capital rather than than a normal search fund modeled to me.
Alex: Yeah speaking to one of my investors in the night. He said that really it’s only after about four or five years that the Searcher who is now the CEO of the company then starts to really add value in a very accreative way. So you buy this business within the first couple of years you really stay on an even keel learning the business and then you start to become this this all around and well develop CEO and from year 4 onwards is when you start to make the changes and feel confident to make the big changes that can really change the outcome.
And so you’re not going to realize that in three to five years.
Bruce: Yeah I you though in your case you might extend that period of time for heck even a lifetime, you end up adding further businesses to your platform to use PE- speak. But what would a standard searcher do in the US, they would hold it up for on average four or five years. I can’t remember the the term and then they’d…
Alex: Yeah, its a good question, I don’t I can’t remember the median time to exit and probably given the the growth of such funds over the last five or ten years the stats aren’t going to be that great either because we’re still in the whole period for most of the more recent acquisitions.
What is more common in the US is the ability I think to refinance and take out or return capital to investors and they will still hold an equity stake in the upside. But then there’s less pressure to achieve some exit if you’d had your capital back, you’ve got a stake in this business you very happy to watch it grow for any length of time.
Whereas I think in other geographies that there may well be a push to try and exit after five eight ten years.
Bruce: And we don’t mirror the US in Australasia, but we rhyme with it don’t we. I don’t know how we’ll rhyme in the future, but I here on the permanent..that longer term holding of search funds.
I think in the US 3-7 years is the average holding period and having made improvements whether that’s at the end of the day, it’s either an increase in the in the earnings and or an increase in the multiple with pay downs of debt, the Searcher would then exit hopefully at a good IRR perhaps even 28 30 33 percent and the research is not showing us what the variance is other than on a very summarized level so we can’t do a Sharpe ratio comparison here of of search funds versus the funds or VC! But there’s I’m sure if you look at the Stanford research, which will link to, there is a large variance that you can see there. Okay. So talk, let’s go back to the parameters.
Alex: So as regards the the characteristics of the Target business
Bruce: That’s right and industries etc.
Alex: So typically there are what I would describe as hard criteria. So size would be an obvious one. And so I’m looking for a business in the two to five million dollar ebitda range. That’s fairly broad church.
But equally they’re not too small and one of the the risks around buying a smaller business is there isn’t enough management capacity within the business to actually, you know, you end up doing everything essentially on your own.
Bruce: And this key main risk, the owner dissapears, adn the value disappears.
Alex: That’s right and all the relationships will be held by the exiting owner which you don’t really want. And the second reason is I like to describe it as it keeps the wolf from the door and if you got earnings and stable earnings of two three million dollars EBITDA there’s a margin of safety there. And really all the characteristics that I’ll go on to describe is more about margin of safety.
And the correlation in the statistics and the research that Stanford and others have done is generally with a lack of failure rather than a success. So the characteristics that investors like such as high recurring Revenue low customer concentration growing industry. The correlation is stronger with not failing than it is with.
Succeeding which is it is nuanced. Right but essentially what it’s saying is it keeps you in the game to get you through that period when you’re learning the business and if you can basically make it through that then the longer hold periods are those that are most often do well.
What else do we have as regards the industry low low capex so high cash generation within the business.
Industry margins again. This is a margin of safety type thing. But if you’ve got needed a margin of 20 25 percent, that’s much healthier than 5 or 10%.
As regards the company itself. What you really want is we’ve talked about that there is Management in place. Everything’s not going to fall over as soon as the owner leaves.
That it’s a simple business to understand. It’s not if we have to talk about servers and things like that. I’m not comfortable doing that and you know wouldn’t for see me running a business where the daily talk is about things to do with servers and widgets and and I see that’s not really me.
The ownership structure needs to be reasonably clean. Otherwise, it gets very messy to do the deal and it’s very expensive to do the deal.
So I think those are the main ones and really the most important ones I’ll come back to are the industry criteria. So growing industry. High cash generation. High recurring Revenue. Low customer concentration those sorts of things.
Bruce: Some people would say that thetTarget business should also be reasonably simple to run. If it’s too complex whether it’s from a technology point of view or industry process point of view then the searcher…and you’re you’re you’re not not a young MBA by any means Alex you’re an experienced operator, but one of the ways, one of the types of people that run search funds are graduates who are only two years out of an MBA School Stanford Harvard or Insead are the big search fund universities it seems.
You’re hiring a very enthusiastic extremely smart person, you’re not hiring you’re investing into this person, and the business owner is super experienced and knows the industry very well, but perhaps doesn’t have the enthusiasm and dare I say it the super smarts of the person coming into it.
And so despite being an incredibly smart the searcher still needs to very quickly understand the business the business is to complex, it’s not for a searcher or at least that’s my impression reading the research.
Alex: Yeah, I think that’s right to point. I think it was too simple and I suppose I don’t have hard evidence on this but speaking to investors and my own observations are that anecdotally the businesses that are bought by self-funded such as and I know we haven’t talked about that yet and and but these are people who have not raised capital and essentially use their own capital to go out and find something to buy, they would find generally slightly simpler businesses.
The problem there is that it’s probably harder to create value, it’s overly simple, and these tend to be the businesses that very cheap. So if you’ve got a quality business high recurring revenue, it must be providing some value to customers that is unique to a point and therefore it ain’t going to be dead simple. There’s got to be something that business is doing that is in some way complex
Bruce: The intangible asset part of the business price. People are always surprised how small tangible assets are of any business sale. But as you say the value is in the intangible components behind the the business processes etc.
So yeah, I don’t think we covered that. You have a self-funded Searcher and a searcher who has raised search capital and seems I think in Australasia, it’s more likely to be a self-funded searcher. I know of you and perhaps one other who has raised search capital, but I think we should assume that the searcher will go out to investors get commitment for the acquisition capital, well not commitment but strong interest in the acquisition capital, and then have to fund the search themselves.
Okay. Let’s go through the vesting process. How do you see the vesting process?
Alex: So the Searcher incentive is I guess I would call it so what happens is it’s agreed upfront as part of the model e the incentive for the searcher or searchers because often search funds are done as a pair rather than as an individual and this is fairly standard pretty straightforward an individual in the Stanford standard search fund terms can earn up to 25 percent of the upside that’s generated. So you might call it similar to a carry in private equity. If you buy business for ten keeping them the simple everything that you sell it for above 10, you can get 25% of and that is vested over three different tranches of shares the first third of the 25 is done on acquisition. So we close the acquisition and then immediately the shares 8.3% is is granted straight away. The middle chunk vests over time so typically over a four-year period in a month by month, you get more shares up to the the eight and eight point three percent there.
And the final tranche is performance-related. What is fairly common again is that is done on an IRR basis of 20 to 35% the sliding scale. So if investors realized 25 percent overall on their investment, then you get that fraction so 5 over 15 percent, so a third of your allocation for that final tranch of shares. For a pair of searchers that would be 30 percent instead of 25 percent.
Bruce: And during that time you’ve been paid a CEO or general manager salary. So that’s probably market rates if not slightly less the market rates .
Alex: I hope so. Hope its market rates
Bruce: So you are getting a salary you’re not just doing this all for free with hope of just vested shares.
So Alex, when you talk to other searches, what are the things that you talk about the most?
Alex: I think that splits into two. One is established searchers who are looking for businesses. We will compare notes and talk about this practice.
I think for prospective searchers and I do get a lot of. calls with prospective searchers who are perhaps looking to raise their own search fund. We spend a lot of time on the industry and the characteristics that we’ve spoken about but also a lot of time on the type of search fund that they might the route they might go down and there isn’t just one flavor of search funds, you know, there are different ways you can do it. So for example, I’ve raised funds from investors, I’ve raised the capital at the start. So to an extent have committed investors throughout the process. Others with briefly alluded to earlier essentially go it alone. They use their own funds. Maybe they’ve got a husband or wife who’s is working and can support them through that period while they’re not earning a salary so they will use their own funds and potentially then engage investors when they’re looking for acquisition capital.
And a third route, which is starting to become more common across the world I think, is the accelerator model which is different again. So this is a bit more like a PE fund that would raise capital from investors and then they they look to recruit searches and they will fund their search and then we’ll have arrange the investment for the follow-on for the acquisition.
You know, there’s no right answer to to which route to go down. I think they’ve all got the challenges that will got the positive aspects but in those conversations with searchers, I think it’s a very personal decision but also very important decision and typically one that they will spend their time thinking about.
Bruce: Related to accelerator, which is there is an accelerator program that started up in Australia, there is the what I call the search fund of funds which are just another investor really, but they’ve professionalized the the search fund investor approach. There’s a number of large ones out of the US. They’ve done it very well and I understand provide very good support. There is the issue that they require a certain size. And so if you’re looking on the smaller side of search funds they are probably not for you. If you looking on the larger side of search funds, and you might be coming up against private equity funds if you are, then these guys certainly are for you and I’d certainly recommend the US search fund of funds.
Alex: Yet. They’re all you know, I know most of them have spoken to most of them and have one of the the recognized international investors Relay Investments as one of my investors. They have extensive experience both of investing in search fund transactions but also how you do a search. And I think it’s quite good to have that mix of institutional and individual investors.
But you’re absolutely right, they’ve got a dedicated fund that invests solely in searches and in search fund acquisitions i.e. the acquisition phase of the search fund. But there is this delicate balance then between the checks that they want to put to work In deals and you’re running up against private equity here. So the reason I’ve chosen 2 to 5 is that range to me feels big enough at the lower end and three is probably where I want to end up big enough at the lower end yet not so big that you run into either run into private equity or you’re looking at what I’d consider a little bit of a ridiculous situation where I’m taking of her business that has 700 employees and you know, I’m not sure that I’m totally qualified to do that.

Bruce: Let’s talk about you. So how did you get into search funds? What was the journey.
Alex: So I I did an MBA at Insead. There is a course there.
At many of the Business Schools they run a course on ETA entrepreneurship through acquisition, which is a search fund course and I was taught by a guy called Timothy Bovard who who didn’t actually do a search fund himself, but he now runs the search fund accelerator in Boston, he built up a business in France and did extremely well.
He taught me the course. I thought this is a great model. Previously, I’d spent five years in lower mid-market private equity in London. So similar size of business 20 to 30 million Sterling enterprise value type businesses. There we were looking to provide growth capital but I liked working with smaller business never really wanted to go and work for a big business did an MBA with a view to being more hands-on learning how to run businesses, because in private equity it’s I’d liken it to its a bit like owning a football team you sit in the stand and you can make more money available for new players and change the management and all this stuff, but you’re not really on the pitch and so I went to business school to transition to roles or a role that would bring me closer to the pitch and I think I see the CEO as being someone who’s the coach in the dugout that is directing the action on the pitch and masterminds it but doesn’t necessarily score the goals as it were. So that was the intention of going to business school and discovered search funds through this course at Insead and then really decided that, you know, I wanted to do that some point in the future.
Bruce: As far as I can tell, and please correct me if I’m wrong, the three headlines schools that are pushing entrepreneurship through acquisition “ETA” or search funds are Harvard, Stanford and Insead. A New Zealander that I’ve spoken to has just come out of Insead and got very interested in search funds and we’ll see if he sets one up in New Zealand a talented young man.
I don’t have his permission to give you as name but he’s one of many another person, who I will give his name is Johnson Wang who came to the Harvard ETA course and he has set up a search fund searching here in Australasia based out of Melbourne. And so there are there are some strong connections there back to those schools from within New Zealand.
Funny enough I called up my–I did Entrepreneurship Masters many years ago–so I called up my old Professor and said have you heard of this and he is a gray-haired old fellow. He said no, I’ve never heard of this what the heck is it, so even for business academics here in New Zealand. It’s a it’s a new thing.
Right. So you have your view you went through private equity did your MBA at Insead? And after that you said this is me I’m going to come to Australia and set up a search fund.
Alex: Well not exactly I mean, just to jump in, I think IESE in Madrid sorry not in Madrid in Barcelona Spanish geography’s let me down there, they’re quite heavily into search funds and they co-author the Stanford study for the international i.e. non-US. So IESE in Barcelona, Insead and then generally yes Harvard, Stanford and I think Columbia and Booth and Chicago
Bruce: Booth in Chicago which has an excellent podcast on search funds and I’ll link to that in the show notes.
Alex: So yeah and look it is becoming more, it’s growing in popularity, but it’s not surprising that people haven’t heard of it, especially in this part of the world. So I took a job in essentially in management consulting but really heavily hands on operational consulting. So doing maintenance shift starts at 6 a.m. in New Zealand actually and and you know, Dairy and Airlines and all these things really to learn what it’s like to be in a business and what running a business looks like. And then through about a year into that I was like hey, I think you know, I think Australia is actually a really great geography to do a search because the market is not saturated at all. I think the demographics are very similar to the US and you know, I think there’s this massive opportunity here for for that succession good businesses private equity doesn’t play too too low down in the in the Enterprise Value space.
Bruce: It’s funny, I see a parallel between investment strategy whre your home market has to be Australia and New Zealand in the case of New Zealand investors in the public stock markets through portfolio building up their portfolios because there isn’t sufficient diversification in the New Zealand stock markets. And so you build your home portfolio, so to speak, in Australia New Zealand. It seems to me to be the same thing will apply with search funds. New Zealand isn’t sufficiently big enough to do a search fund just in New Zealand. You have to include Australia or for the Australians listing will just do Australia rather than in a small geography and indeed if you’re looking to build out your target company, you may need to start in New Zealand and build out until into Australia is one potential growth strategy.
Alex: I mean did speak to someone in New Zealand and they made a very interesting point about why startups in New Zealand the ones that are successful tend to be really successful is you have to build the business to scale internationally because you don’t have a choice. Your home market isn’t big enough to support the growth that you need or that you want. Whereas in Australia is just about big enough. So in New Zealand, you’ve got to say we’re going International very early sort of Xero did any did very well.
Bruce: True any final thoughts.

Alex: I think it’s a very interesting time for search funds in the region. There’s a lot of activity. Yes I raised the first funded search here, but I think a lot of that was that my timing was very good for the first time in my life who graduated in 2009 from University. That wasn’t a great time to get a job. So I think my timing was good. but at the same time raising the funds really is just about building the car and getting it to the start line. You haven’t actually started the race yet. And the searching is very much the make or break activity. So there is a fairly constant pressure that goes with that.
It’s not a stressful pressure but it’s an acknowledgement that the clock is ticking and you know, there’s something out there that I need to find but I don’t necessarily know where it is. So it’s there is that pressure but I think it’s a good it focuses the mind and that’s not a bad thing. I

Bruce: I think it’s the way of the future and it’s been a pleasure interviewing you about search funds.
I think this is the way that that we’ll build out those businesses that baby boomers are exiting through younger people taking them over in vehicles like such funds and I think you’ve described the search fund process really well. Thanks Alex. Best of luck.
Alex: My pleasure and hope has been been helpful. Thank you.

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