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Inside Private Equity

Thrills, Spills and Lessons from the Author of Nothing Ventured, Nothing Gained

Allen & Unwin

PART ONE: Venture capital, good and bad

I am on the deck of a 16.5-metre Robert Ladd–designed ketch, sailing down the coast of Turkey with my wife. The crew has just served us an aubergine and lemon salad with a side dish of yoghurt and olives. We are washing this down with a cool Bordeaux. The temperature is 27ºC, the wind is from the north at about 15 knots apparent and we are making 7 or 8 knots, heading from Bodrum down to Simi. Indeed, we are hoping to arrive in time for dinner on that beautiful island, which used to boast the world's premier shipbuilding industry in the days when the ancient Greeks were all-conquering.

I am part way through a well-earned sabbatical: three months of relaxation and exploration, together with work on the first edition of this book.

After 30 years in the venture capital business I had begun to wonder whether my investing experiences, successful and unsuccessful, would be interesting and even instructive for others, especially those contemplating a career in this most exciting and creative segment of the capitalist system. Finally I decided they might be. So, let me take you now on a sort of picaresque journey replete with venture capital adventures. Hopefully the stories will convey various lessons, some amusing and others sobering. For reasons that will become clear, in a few cases the names of individuals and companies are codenames.

Introduction

Since founding Australia's first venture capital company in 1970, I have been intrigued by the sector, with what it stands for and what it has and will achieve. Since those early days, the venture capital sector has grown in fits and starts, in recent years maturing into a better organised but still under-resourced segment of the capital markets with approximately $1 billion presently under management.

Unlike its private equity buy-out cousin, the subject of Part Two, the VC segment is still struggling to demonstrate credible financial returns for its investors. As a result, VC has not yet reached the scale or momentum that will be needed if Australia is to meaningfully capitalise on the inventiveness of its people.

During the 1990s, the venture capital activities of my firm Australian Mezzanine Investments Pty Limited (AMIL) assisted in the creation of more than 50 millionaires throughout the country. In doing so we played a role in the creation of many thousands of jobs and the generation of hundreds of millions of dollars in exports and taxes. We enjoyed many wins and some losses. Always interesting and often exhilarating for those of us involved, the venture capital business is quite different from any other capital-investing activity. Yet this venture capital process has rarely been analysed as compared to the other segments of the capital markets.

What is venture capital? As the name implies, it is capital ventured by investors willing to take, and capable of taking, the risks associated with young and rapidly expanding businesses. Venture capital is provided by professionally staffed and managed venture capital funds that typically take an equity (a shareholding) position in their 'investees', the entrepreneurial companies. This form of investing clearly differs from that of banks and other institutions, which lend their funds and expect their clients to return the loans with interest. In terms of security, lenders rank ahead of the shareholders; in the event that a company is unsuccessful, the lender may still recover all or most of its loan, but the venture capital equity investor is likely to lose all. Venture capital is thus the essential risk capital required by entrepreneurs seeking to start new companies, expand existing businesses or try out new technologies or products.

The major suppliers of venture capital in Australia have been a mix of large Australian superannuation funds, high net-worth investors, and government-funded initiatives called Innovation Investment Funds (IIF). In return for the extra risk involved in early stage companies, these investors expect to earn above average returns, never less than 5 to 10 per cent per annum above what they might expect from simply investing in listed stock exchange securities. Since the impacts of the 2008 global financial crisis, institutional investors in Australia have withdrawn from the VC market, unconvinced that potential returns justify the risks they see ahead. In Part Four, I reflect on this 'capital strike' ... does it constitute a continuing market failure or is it a rational and inevitable supply-side response? And does it matter for Australia anyway?

The venture capital process is a quintessential blend of art and science in commerce. It is art in that it involves judgement of people (the entrepreneurs and their team executives) along with assessment of their integrity, their drive, and their thirst for financial and product success. And it is also art in the sense of timing — is the tide of economic and other events right for this innovation, or is the whole project premature, and swimming against an ebbing flow?

It is science in the sense of analysing what it is that is truly distinctive and competitive about each project. Is there innovation in product or service? If so, is it sustainable and, in any case, will consumers pay for the difference? And what else is coming out of the laboratories in California or Tel Aviv or Perth that can blow this apparent competitive advantage away?

Thus venture capitalists have to be both artist and scientist. Once they have made an investment, the other two ingredients required during the life of the investment are hard work and a measure of luck.

The venture capitalist will normally require a seat on the board of directors of each investee company. This enables the investor to closely monitor the operating performance of the business and, importantly, to contribute as an involved partner to the actions of that business. The venture capitalist will often act as an objective sounding board for the entrepreneur chief executive on issues such as salary levels, recruitment of key personnel and strategy development. This can sometimes simply take the form of good listening and handholding skills on a range of issues that the CEO may feel are too sensitive or inappropriate for discussion with his or her own employees. At other times it will involve the venture capitalist in a detailed understanding and analysis of the company's strengths and weaknesses, of acquisition and divestiture opportunities. The venture capitalist may arrange a refinancing, and may often ultimately find a buyer for the business. The venture capital investor may also occasionally need to step in to run the company, replacing an under-performing chief executive. The venture capitalist's role is obviously a very hands-on one from time to time during the life of each investment.

In my experience, throughout 40 years or so as a practising venture capitalist, hard work helps to avoid losses but luck is probably more important in generating truly exceptional profits. The stories that make up Part One of this book illustrate this experience and perhaps provide a guide for others seeking to enter the world of professional venture capital.

In the case descriptions that follow I make repeated reference to three key components of investment analysis that venture capitalists typically focus on:

• Core proposition: What is the core proposition of the deal? Why can we expect to make exceptional returns from this investment? What is so different or superior about this product or service that ensures above average profits and a sustainable competitive position? Is there protectable intellectual property? (Each core proposition must be capable of articulation in less than one page.)

• Key people: Who are the key executives who will make all this happen? Do they have their lives on the line for this? What experience, contacts and existing business opportunities do they bring to the table? Are they people of integrity?

• Numbers: What do the numbers look like and are they credible? If the core proposition is exciting and the people check out, just how good are the numbers anyway? If everything goes to plan, what are the likely financial returns? And how disastrous will they be if things go badly? How do these various upside and downside cases or scenarios correlate with the nature of the risks involved? In other words, does the risk/reward profile really warrant the exposure of time and money?

In the following case descriptions, each of these three components are examined with the clinical benefit of hindsight. Success or failure can usually be sheeted home to the degree to which the pre-analysis of the critical components actually applied in practice — always acknowledging that luck invariably plays a key role too, sometimes wonderfully and sometimes horribly. In every case, nothing ventured, nothing gained.

Some deals that went badly wrong

Associated Bitumen Sprayers

It seems so long ago — an investment in the early 1970s — but it offers some wonderful lessons in what not to do. I can't remember the exact amount of money involved — about $200 000 — but I do remember that we lost the lot! And in fairly quick time, too.

I had just returned to Australia in 1970 having obtained my MBA from the Harvard Business School. I had become fascinated by the venture business in the United States and had decided to start my own, and Australia's first, venture capital company. I remember receiving lots of advice (in retrospect, I now realise, very good advice) from people such as Rod Carnegie and Bryan Kelman, who said that I should work for a US venture firm for some years prior to starting an enterprise of that sort in Australia. Sir Roderick was then head of McKinsey's practice in Australia and later the chairman of CRA; Bryan ran CSR's concrete and quarrying businesses and subsequently became CEO of the overall group.

I was 25 years of age, impatient and genuinely fearful that if I did not then launch out on my own I would never do so. I feared that I would go to Wall Street and never emerge from that wondrous jungle. I decided to return to Australia since the prospect of pioneering venture capital in my own country was irresistible: perhaps it was a case of heart over head.

From my pre-Harvard days of working as Bryan Kelman's assistant at CSR, I knew a bit about the road aggregates contracting business. Peter Nagle had been referred to me by someone in the industry and he presented me with his plan to commence a 'renegade' road aggregates and bitumen spraying business in New South Wales and in Fiji. Why Fiji, you ask? Well, I will come to that soon.

The road surfacing business in those days 'belonged' to just a few companies: Boral, Shell, Mobil and Blue Metal Industries (BMI). There was no Australian Competition and Consumer Commission in those days, otherwise its chairman Alan Fels would have had them all for lunch, so widespread and blatant were the arrangements for geographic sharing and pricing. These circumstances made it interesting for a renegade operator to enter the market.

Peter Nagle's business proposition was as follows. His new company, Associated Bitumen Sprayers (ABS), would bid on New South Wales country town road contracts at prices approximately 20 per cent below the majors. ABS would win some of these and complete them profitably, given its much lower overhead cost structure; it would then threaten to enter the big city markets where the majors made most of their monopolistic profits. Nagle's CORE PROPOSITION was that not only would the majors be unable to meet ABS's prices on contracts bid by ABS, but they would also have to drop their prices on all tenders. Otherwise ABS would easily win a predatory pricing action in the courts and the majors would be fined big-time and suffer public humiliation to boot.

Thus ABS's entry might well cost the industry 20 per cent across the board — many millions of dollars each year. The idea was to cause enough havoc that one or other of the majors would bid to take over ABS at a massive profit to Nagle and his financial partners.

I was attracted to this core proposition. In my concrete and quarrying days, I had seen similar successful sorties with entrepreneurs enjoying takeouts by big ready-mix concrete groups like CSR, BMI, Boral and Pioneer. Each of these corporations had invested heavily in the infrastructure of quarries, crushing plants and fleets of delivery vehicles. Steady pricing was critical to the bottom line; an upstart operator with a secondhand truck and a source of river gravel and sand could cause havoc. Such upstarts were invariably run out or bought out. I had participated on the heavyweight side of this game and had seen some of the renegade operators' profits at firsthand.

The ABS game plan fitted this experience. In other words, I was happy that the core proposition made sense.

Next, checking the KEY PEOPLE. Nagle had worked as a fairly senior sales executive with one of the major oil companies. He therefore had a reasonably good knowledge of the industry players and dynamics — the 'mud map', if you will. We had satisfactory industry references, although, when I now look back on the checking process, there's no way that Peter could get through our screening today. He had no track record of money making; he was a sales guy, not an operations executive; and we were aware of reports of alcohol abuse in years gone by. But leopards can change their spots, can't they?

At least we had enough sense to immediately supplement the management team in the New South Wales business with a competent young financial accountant.

Turning to the third component of the venture capitalist's trilogy, the NUMBERS looked pretty good. It was a high-risk game plan requiring enough firepower to seriously take on the majors for at least a couple of years until a takeover offer might be forthcoming. The upside case reasonably suggested three times our money back in two years and maybe a lot more if we could cause enough damage to the market.

What happened? It was a great, swashbuckling adventure. ABS won several tenders and managed to break even on most of them. This was in spite of the efforts of the majors to bully some of the suppliers into delaying deliveries to ABS. These efforts reached farcical proportions when one morning ABS found all its spraying equipment vehicles with flat tyres, including the foreman's utility.

Well into the second year it was clear that our CEO was not an operations man. Costs were uncontrolled, tenders were badly priced, man-hours never properly measured and so on. We were still burning cash — at about $10 000 per month. The company had leased most of its equipment and we had invested about $150 000 in cash as the 'firepower' working capital needed to sustain the campaign.

I calculated that ABS had maybe another 60 days before it ran out of cash. Still no takeover offer in sight. Through the trade press, Nagle announced ABS's ambitions to expand its activities into the metropolitan centres of Sydney and Melbourne and a joint venture with a CSR subsidiary for similar activities in Fiji. Still no response from anyone! So, at fifteen days before D-day, my good friend and co-director at the time Rodney O'Neil (from the famous O'Neil Hymix concrete empire), rang Sir Elton Griffin to make an appointment for me to visit.

Sir Elton had a formidable reputation in Australian business circles as a tough, driving bull of a man. He had breathed life and then fire into Boral, building it entrepreneurially into a well- respected industrial enterprise across Australia. Sir Elton was a hands-on, no-nonsense operations man. He was not an MBA yuppie like me. His office was austere and, from memory, rather bare. He sat on his side of a large desk and leered down at Rodney O'Neil and me in our lower seats. His eyes fixed discerningly on me and seemed to anticipate my words even before I uttered them.

Nonetheless, he gave me a fair hearing as I explained the wonderful opportunity ABS had in Fiji and that we were presently weighing up whether to invest more heavily into the New South Wales business or move everything into Fiji. I thought that, given his experience, he might have some advice, some ideas ...

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Excerpted from Inside Private Equity by Bill Ferris. Copyright © 2013 Bill Ferris. Excerpted by permission of Allen & Unwin.
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