As the effects of the global credit crunch begin to take their toll on the private equity investment model, the industry is starting to explore alternate methods of capital raising and investment so as not to miss the opportunities which the current equity market affords.
Of the strategies being considered by private equity players, investment in small and medium sized enterprises (SMEs) with strong growth potential may prove to be one of the more attractive. This will be particularly so given recent changes to the way early stage venture capital investments are incentivised by the federal government, namely through the implementation of the Early Stage Venture Capital Limited Partnership (ESVCLP) program. The program is aimed at stimulating Australia’s venture capital sector by allowing generous tax concessions for funds meeting the registration criteria and conducting their investment activities in accordance with specified guidelines.
From pooled development funds to ESVCLPs
The Pooled Development Fund Act 1992 (PDF Act) was introduced to develop and demonstrate the potential of the market for providing patient equity capital (including venture capital) to small and medium Australian enterprises that carry on eligible businesses.
The PDF Act introduced the concept of the Pooled Development Fund (PDF) as an investment vehicle whose main advantage was its concessional tax rate of 15 per cent. In order to be eligible for the concessional tax rate, PDFs needed to be registered with the PDF Board and comply with the investment rules contained in the Act.
As a result of amendments to the Venture Capital Act 2002 (Act), applications for registration of PDFs were no longer accepted after 31 December 2006 with the PDF model being replaced by ESVCLPs.
What is an ESVCLP?
An ESVCLP is a venture capital fund, legally structured as a limited partnership and registered with Innovation Australia in accordance with the Act.
Limited partnerships are generally seen as an attractive structure for venture capital investors internationally because of the flexibility of the ‘flow-through’ taxation position and the limited liability of investors.
The benefits of ESVCLPs
Unlike PDFs, a venture capital fund registered as an ESVCLP will have flow-through tax treatment - that is the ESVCLP will not be taxed at the partnership level. In addition, income and capital gains earned by the ESVCLP will be exempt from tax in Australia and this tax exemption is available to both domestic and foreign partners.
Tax losses by ESVCLPs, however, will not flow through to nor be deductible by partners.
The taxation exemption is a significant legislative incentive which has the potential to considerably increase a fund’s internal rate of return.
Things to be aware of
ESVCLPs must be registered with Innovation Australia and have their investment plan approved before they commence their investment activities. There are also a number of legislative requirements which restrict both the financial structure of ESVCLP investments and the nature of the investee entities. Among those requirements are:
- ESVCLPs must not invest in entities whose value exceeds $50 million.
- ESVCLPs may only invest in entities whose pre-dominant activity is in relation to eligible activities. Activities which are not eligible include property development, land ownership, banking, providing capital to others, leasing, factoring, securitisation, insurance, construction, acquisition of infrastructure or related facilities and making investments directed at deriving income in the nature of interest, rents, dividends, royalties or lease payments.
- The size of the ESVCLP fund must be at least $10 million (and not greater than $100 million).
- No single partner’s interest in an ESVCLP may exceed 30% of the total committed capital.
In addition, ESVCLPs are required to lodge quarterly and annual reports with Innovation Australia.
Where investment decisions are able to be brought within the criteria, however, the taxation advantage is substantial.
What types of securities can an ESVCLP acquire?
In making an investment an ESVCLP may acquire the following kinds of securities:
- shares in a company
- units in a unit trust
- options (including warrants), and
- convertible notes, provided they are not debt interests.
How much can a partnership invest in one group?
The total amount a partnership invests in interests (including debt & equity interests) of a company/unit trust and any associate or other member of the same wholly owned group of that company/unit trust must not exceed 30 per cent of its committed capital.
Limitations on the size of an investee entity
ESVCLPs cannot hold investments in an investee entity whose assets together with the assets of an associate of, or a member of the same wholly owned group as, the investee entity exceeds $250 million.
Once this limit is exceeded, the partnership must dispose of the investment within 6 months of the end of the partnership’s income year in which the limit was exceeded. Innovation Australia may extend the divestiture period by an additional 3 months on request of the general partner.
Conclusion
Despite certain market criticisms of the restrictions inherent in the ESVCLP as an investment vehicle, the program still represents a compelling proposition for funds prepared to focus on early stage investment opportunities with high growth potential in eligible activities.
For further information, please contact your usual PricewaterhouseCoopers adviser or:
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Craig Lawn, Partner
PricewaterhouseCoopers Legal
Corporate and Commercial
Tel +61 7 3257 5672 |
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Steven Maarbani, Associate
PricewaterhouseCoopers Legal
Corporate and Commercial
Tel +61 2 8266 6843 |
