4.3  Capital Market Failure

Limited access to capital is often blamed for the problems of New Zealand business. This section looks at the issues around the formal capital market[17] and finds little evidence that this is an issue. New Zealand capital markets seem to show signs of improvement over recent years. The key issues appear to be expertise and information rather than simple finance.

What is capital market failure? In theory it is the inability to access finance for an economically valuable purpose. In practise it is very difficult to demonstrate. The possible causes of capital market failure are varied – lack of information, poor judgements or even discrimination. Several studies have been conducted on small business finance in New Zealand and the picture is complex. Many of these past studies have been summarised in Cameron and Massey (1999), while some more recent studies also have some perspectives on the issue. All of these studies are drawn on here.

It is important to begin with a few definitions of different types of capital. Debt finance is given in return for interest payments. It is usually in the form of a loan from a bank, backed up by collateral from the borrower. Equity finance is given in return for a portion of the ownership of the business. This includes a right to future profits. Seed capital is money needed to get a new venture off the ground. Venture capital on the other hand would become involved once a product is established and is starting to be sold. Venture capital is given in exchange for equity, whereas seed capital may be funded by debt or equity.

4.3.1  Debt Finance

There is strong evidence of a statistical difference between interest rates on loans to businesses of different sizes in Australia, and some evidence of similar circumstances here in New Zealand. Cameron and Massey (1999) argue that this is related to the higher administrative costs and risks of lending to small businesses. Small businesses seem to have difficulties providing business plans, accurate information and security for the loan. However, banks are becoming more flexible with regards to the security that is offered.

Financial deregulation appears to have improved the ability and desire of banks to lend to business. This increased flexibility has led to a much greater use of debt financing by business, especially by larger companies.

4.3.2  Venture Capital

On the demand side of venture capital (businesses seeking venture capital), some common stories come through. Similar to debt finance, small businesses seem to have a poor idea of what is needed to get people to invest in their business (i.e. business plans). However recent increases in access to specialist services (such as business mentoring) should help in this regard.

Entrepreneurs also reportedly have problems with the idea of giving up equity, and consequently favour debt. Similar stories are not uncommon overseas, so it is difficult to tell to what degree New Zealand is unusual in this respect.

On the supply side (companies supplying venture capital), New Zealand’s venture capital market may have come under more criticism than is justifiable.

Campbell-Hunt and CANZ (2001) questions the adequacy of New Zealand’s venture capital markets, not only in their ability to provide finance, but also to provide expertise and advice. The focus of this study is on global leaders, especially the phase of going global with a new product simultaneously in many markets. Campbell-Hunt and CANZ (2001) note that many of the exemplar firms that they investigated in this category had received contributions from the Development Finance Corporation[18] (DFC) during this critical move into exporting. According to Wally and Brian Smaill of Criterion “The DFC for us is the reason we are here.” The difficulty with the Campbell-Hunt and CANZ (2001) conclusions is that they come from studying companies that are quite old. As such this work has limited application when drawing conclusions about today’s capital market.

In terms of finance New Zealand’s venture capital market seems to be showing encouraging signs. Watt (1999) argues that a fledgling venture capital industry developed in New Zealand in the 1980’s, partly encouraged by the involvement of the Development Finance Corporation (DFC). The venture capital market suffered a huge set-back in 1987, with the high-risk enterprises involving venture capital being wiped out in the stock market crash. Cameron and Massey (1999) claim that the venture capital industry in New Zealand has not yet recovered from this setback. There are, however, some signs that this recovery is starting to happen. New Zealand is now spawning a few true venture capital firms.

On the other hand, the provision of information, networks and expertise to firms may be a real problem for the New Zealand venture capital market. This role is as important as providing finance. Unavoidably some knowledge about the industry is needed to make a positive impact (often in the form of expertise and networks). In the United States, venture capital firms (and the analysts within them) are focussed on certain industries (Watt, 2000). Given the small size of most New Zealand businesses and the diverse nature of their products, New Zealand venture capital firms cannot afford to do this. Some New Zealand entrepreneurs complain that as a result they cannot get the information they need from venture capitalists. New Zealand may therefore be a comparatively difficult place for a venture capital market to function perfectly.

This information/expertise/networks issue may link to the ongoing hurdle to exporting. If New Zealand firms cannot find home grown sources of expertise and networks (and specialised tacit knowledge is an important issue in their industry), perhaps they need to look to offshore partners or buyers in the same industry. This information/ expertise issue is worthy of further research, as it is consistent with the observation that New Zealand firms tend to look to foreign firms in the same industry to acquire distribution economies.

4.3.3  Seed Capital

Cameron and Massey (1999) state that “there will always be a gap in the supply of such capital in New Zealand for amounts less than about $250,000.” Their arguments are basically that professional venture capital is run as a high margin, low volume business. Before investing, venture capitalists undertake research into the company’s status and prospects (due diligence). As this process is a fixed cost, venture capital companies often cannot afford to look at small start-up companies. Instead they “tend to limit their resources to funding established businesses and large projects such as management buyouts” (Cameron & Massey (1999)). Start-up finance is also unlikely to come from banks (due to the risks of an undeveloped product) unless security is given. Traditionally this early finance area has in the past come from friends, family and networks of business “angel” investors.

The Government’s Venture Investment Fund[19] (VIF) is intervening in this area attempting to improve the access to capital for start-ups. By providing matching funds for venture capitalists to engage in this area, the aim is that private sector expertise in dealing with these firms will grow, and a seed capital industry will be spawned. It will be interesting to see if the skills emerge and the seed capital market proves to be viable, or if Cameron and Massey’s (1999) view on fixed costs prove correct and the area is unable to yield returns.

4.3.4  Public Listing

Commentators consistently make the following observation about the use of the sharemarket to obtain capital in New Zealand. Even companies with growth ambitions tend to have high dividend policies, relying on debt for expansion. This leaves the companies exposed to increased risk when things go wrong.

4.3.5  Conclusion

Overall, the evidence on capital market imperfections is inconclusive. There is little evidence that the capital market in New Zealand functions less effectively than anywhere else. This is an area with considerable profile - much of it negative - without a lot of substantive evidence to back it up. Two factors about New Zealand appear to make the job of capital markets more difficult in New Zealand than overseas. Firstly, the high proportion of small firms may cause difficulties for the capital market. Capital markets all over the world do not finance many small firms due to the fixed costs and risk involved. Small firms traditionally rely on owner or angel capital. This point is consistent with the high proportion of angel financing in New Zealand shown by the GEM report (2001). Secondly, the small domestic market may lead to a lack of specialised expertise in the New Zealand venture capital market rather than lack of capital per se. This may be a contributing factor behind firms turning to foreign purchasers in the same industry for expertise and networks.

4.4  Exchange Rate Fluctuations Are A Persistent Issue

A consistent issue raised by business in past years of the Infometrics survey is the exchange rate. The exchange rate level is not the key issue per se, it is the amount of fluctuation. These findings are backed by a survey in Grimes, Holmes and Bowden (2000). Their survey showed that the average level of the exchange rate in the 1990’s favoured some groups and disadvantaged others, overall producing a largely neutral effect. According to that survey, exchange rate fluctuations caused adverse conditions for the majority of firms (80%) surveyed.

Another interesting result from the Grimes, Holmes and Bowden (2000) survey is that firms with 11-20 employees seem to favour currency union most strongly. The authors argue this is because these firms are on the brink of exporting, but do not yet have the size to afford hedging against exchange rate fluctuations. They point to a few key facts to back up this up. Recalling Table 2 in Section 2.2, there seems to be an increase in exporting activity after the firm grows beyond 20 employees. The survey also shows that only 20% of firms with less than 25 employees and significant exports have some hedging, compared to 93% of firms with over 50 employees. This lack of take-up may be related to relatively high fixed costs of hedging for small firms. In short, exchange rate fluctuations, along with the other costs and risks of moving into exporting discussed previously, may well impinge on SMEs the most.

The 1990’s were a period of considerable exchange rate movements in New Zealand, both real and on a nominal basis. Figure 7 shows how New Zealand’s real exchange rate (weighed according to our trading partners) moved proportionately more than Australia’s over the entire period of the 1990’s.

Figure 7: New Zealand and Australia Real Exchange Rates (Jan 1990=100)

Source: IMF New Zealand and Australia trade weighted real exchange rates, both indexed to 100 for 1990.[20]

Between the New Zealand dollar’s high in March 1997 and low in October 2000, the real exchange rate lost 33% of its value. It is difficult to hedge for fluctuations of this size over this timeframe. In comparison the Australian dollar lost 27% of its value over a much longer timeframe – September 1990 to March 2001.

The exchange rate may be an easy scapegoat for exporters and may therefore get undue levels of attention. However, any factor that can move costs (through imports) and revenues by up to 33% over a period of 3½ years can potentially alter a firm’s export strategy.

Source; Campbell-Hunt and CANZ (2001)

In short, a fluctuating exchange rate has the potential to cause considerable problems, especially for small firms. It increases the risks of moving into exporting, and provides ongoing risks for exporting firms. The risks and costs associated with hedging are also likely to be proportionately greater for the smaller firm. This complements the analysis on the first hurdle to exporting by compounding the risks faced by small firms in this move.