Investment in early stage Australian life sciences: fund structures and the portfolio model

A commercial fund investing in early stage life sciences companies in Australia operates in accordance with a fairly limited framework.

Typically, the fund would be a closed end fund.  A closed end fund means that the fund has a set term of existence (say 10 to 12 years) and needs to exit all of its investments by the end of its term.

The fund would usually be established as one of two vehicles:  either as an Australian unit trust or as an Early Stage Venture Capital Limited Partnership (ESVCLP).

Each vehicle has different potential benefits.  In particular, an ESVCLP has a number of tax benefits including a 10% tax offset when capital is invested and is tax free on income and capital account.  However, it comes with certain restrictions on the amount of capital that can be invested in each asset and on the types of investment that can be made.  A unit trust provides significantly more freedom in investment choices.

Funds in this space usually invest in accordance with the portfolio model commonly used by venture capital funds.

Venture capital funds typically invest in companies which have the potential for significant capital growth but with a higher degree of risk, including the potential failure to grow adequately and the potential for loss of investor capital.  Venture capital inherently involves a higher degree of risk than other asset classes (such as cash, fixed interest, listed domestic and international equities and property) but it also has the potential to generate higher levels of capital growth than those asset classes. Typically, the investment horizon is over a number of years and the prospects of success of the investee company only becomes clear over time.

As success or failure can be difficult to predict in a venture capital company when an investment is first made, venture capital funds may invest in a portfolio of companies with the expectation that the significant growth in value of one or more of the companies (typically many multiples of the original investment) will offset the capital losses made in the companies that do not perform.

It is critical in maximising returns for a fund under this model to recognise quickly when a portfolio company will fail.  The less capital the fund deploys in a company with low prospects of success, the more that can be deployed in companies with a higher probability of success.

Venture capital requires that portfolio companies are actively managed and decisions are made to preferentially deploy capital over time to the better performing companies in the portfolio.  This can be done on the basis of commercially relevant milestones including, for example and without limitation, successful reproducing critical experimental assay results in an independent laboratory and demonstration of activity of a proposed drug in animal models.

Furthermore, as the portfolio matures, such funds may provide the opportunity for co-investment by individual Investors in later funding rounds with reduced fee arrangements. This may allow individual Investors to invest more of their own capital in the companies with the greatest prospects of providing positive returns.  As the co-investment is later in the life cycle of the company, the time to obtaining a return from an exit will likely be shorter.

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