Dr John H Howard, 13 September, 2024
One critical issue often overlooked in the conversation about reaching Australia's 3% R&D target is the difficulty that medium-sized growth firms (MSGFs) face in accessing the capital market for expansion capital.
This limitation has pushed many firms towards foreign takeovers, often viewed as an inevitable growth pathway.
But, foreign ownership frequently results in the absorption of intellectual property (IP), followed by the closure of Australian operations. This recurring pattern stifles long-term innovation in Australia and contributes to the erosion of the country’s technology and R&D base.
MSGFs typically have proven technology, strong leadership, competent management, and market-ready products. However, they must invest significantly in research, development, innovation, and marketing to seize market opportunities. While some businesses grow slowly by accumulating revenues or securing lucrative deals, this method alone is insufficient for firms needing to scale.
These companies require capital to invest in new facilities, testing equipment, production machinery, and advanced software systems integrated with enterprise technologies.
The Capital Imperative for MSGFs
Access to capital is essential for MSGFs, particularly for technology-intensive firms. These companies frequently operate with high upfront costs and must endure extended periods before generating positive cash flows. To bridge the gap, they rely on a mix of personal resources, family networks, government grants, and partnerships with universities and research institutions.
This ad hoc approach often falls short. The rapid pace of technological change requires sustained capital investments to fund R&D and stay competitive by constantly innovating and updating product offerings.
Emerging sectors such as artificial intelligence, renewable energy, biotechnology, and advanced manufacturing are evolving at a breakneck pace. Participation in these industries demands substantial investment, but Australian MSGFs frequently find themselves disadvantaged due to insufficient access to capital.
This leaves them unable to compete globally, ultimately limiting Australia’s contribution to high-growth, high-tech sectors.
The Reality of Capital Market Failure
The core issue is a fundamental failure in Australia’s capital market—the inability of MSGFs to raise sufficient capital for growth, expansion, and R&D investment.
Several factors contribute to this failure, notably the dominance of Australia’s "Big Four" banks, which control a significant portion of the lending market but focus on low-risk sectors such as real estate or well-established businesses with predictable cash flows.
MSGFs, especially those in the tech sector, often lack tangible assets and operate with uncertain future cash flows, disqualifying them from traditional bank loans. The concentration of lending power in a few institutions reduces competitive pressure to innovate in lending products that cater to high-growth, high-risk firms. In comparison, markets like the U.S. and U.K. offer a broader range of specialised lenders and more diverse financial products for high-growth companies.
The dismantling of public-sector development banks, such as the Australian Industry Development Corporation (AIDC), exacerbated the problem. These institutions provided long-term capital for strategic industries, including technology, but their absence has left a gap that commercial banks are unwilling to fill.
Structural Challenges in Private Equity and Public Markets
Private equity is another capital source that remains underdeveloped for MSGFs in Australia. While private equity investments have increased, they predominantly focus on large buyouts or early-stage startups, leaving growth-stage firms underserved. Australia’s private equity firms tend to direct their capital toward established businesses, limiting MSGFs’ access to capital.
The Australian Securities Exchange (ASX) presents its own set of challenges. The ASX is dominated by mining, finance, and real estate industries, with institutional investors prioritising sectors offering stable, short-term returns.
As a result, technology stocks receive relatively little attention. Out of the ASX 200, only 14 companies are technology-focused, which reflects the lack of institutional appetite for tech-intensive firms.
Financial analysts who rely on traditional valuation models, such as price-to-earnings ratios, reinforce this bias. These models are not well-suited to evaluating high-growth, technology-driven firms with long pathways to profitability.
Consequently, even listed technology firms often experience depressed share prices, making it more difficult to raise additional capital. Unsurprisingly, some of Australia’s most successful tech companies, such as Atlassian, have listed on NASDAQ, bypassing the ASX altogether.
Prudential Regulations and Risk Perception
Australia’s prudential regulatory framework, overseen by the Australian Prudential Regulation Authority (APRA), further complicates access to capital. Based on the Basel III framework, APRA's capital adequacy rules require banks to hold higher capital levels against high-risk loans.
Since technology firms typically have intangible assets and volatile cash flows, they are classified as high-risk borrowers, increasing the capital cost for banks to lend to them. As a result, banks naturally prefer lending to sectors with lower risk weightings, such as housing and real estate.
In contrast, countries like the U.S. and U.K. have more flexible regulatory frameworks that support lending to high-growth sectors. For instance, the U.S. Small Business Administration (SBA) provides government-backed loan guarantees that reduce the risk burden for banks. Similar initiatives in Australia could make a significant difference in encouraging banks to lend to high-growth technology firms.
Addressing Capital Market Failures
Addressing this capital market failure requires targeted interventions to create a more supportive environment for growth-oriented firms. Among the potential solutions are:
A dedicated exchange or a technology-specific segment within the ASX could help attract more capital for tech-driven firms. Lower listing costs, streamlined regulations, and investor incentives could foster a more conducive environment for innovation-intensive firms.
Reintroducing a public development bank focused on providing patient capital to high-growth sectors like technology could help fill the funding gap left by traditional banks. This institution could provide long-term, stable funding to MSGFs that need it.
Expanding access to venture debt or revenue-based financing to give MSGFs more options for raising capital without diluting equity or relying on traditional bank loans.
Conclusion
Australia’s capital market failure is an increasing barrier to the growth and success of medium-sized technology firms. The overreliance on foreign takeovers and the lack of domestic capital make it difficult for these firms to scale and innovate.
With targeted policy reforms, a more vibrant capital market, and better regulatory frameworks, Australia can provide its technology firms with the support they need to succeed globally. The time to act is now––before another generation of innovation is lost to foreign ownership.
A summary of this Paper appeared in auManufacturiing.com.au on 13 September 2024.
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A more detailed version of this paper is at ….
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