State your case

Real Deals, 24 April 2003

Government-backed venture funds are becoming more important across Europe, especially for early-stage investment. But what should the state's role be?

Bridges Community Ventures seems like a typical creation of the UK's New Labour government. With a £40m fund raised from big name VCs with matched funding from the Treasury, its aim is to create good commercial returns while doing the good work of regenerating the nation's poorest areas.

But the scheme is being run on a hardheaded commercial basis (see below). The government's intent is to use its money and its very visible support to encourage the private sector into areas they currently avoid, and not to just chuck more public money into areas that aren't so much economic blackspots as black holes for regeneration funding.

"The government seems to me to very much recognise its role in supporting entrepreneurs is to catalyse rather than to directly provide services," says Michele Giddens, executive director at Bridges. "From the government perspective, if we can achieve a financial return that makes it attractive to the private sector to invest in future funds and to have a genuine impact on some of the most deprived communities in the country, it's a win-win for the government."

The Bridges fund is just one example of a raft of initiatives by the UK government to put public money to work in private equity. New Labour has sought to exploit partnerships with the industry since Tony Blair addressed the BVCA annual conference in 1999. There followed the Myners report urging more commitment from the pension fund industry, and the Social Investment Task Force, chaired by Ronald Cohen of Apax Partners, which laid the foundations for the Bridges fund.

"The government have taken on board that their role is to be enablers rather than investors," says Cohen. "With Bridges, they provide matching funding but all investment decisions are made by an independent team. We do not need now a series of government bodies, as used to be the fashion, actually investing government money in the marketplace. I much prefer them to provide incentives to the private sector to get things done, so you don't create dependencies on the government to do these things."

The government strategy is focused on addressing perceived gaps in the market, particularly for technology companies and SMEs seeking sums of funding below the radar of most providers.

"The availability of capital for ventures has fallen very considerably," notes David Cooksey, chairman of Advent Venture Partners and of the Small Business Investment Taskforce (SBIT), the quango advising the government on its VC programmes. "I don't think what government is doing by any means fills the gap but it is a step in the right direction."

Filling the gap
Among the funds advised by SBIT is the UK High Technology Fund, launched in 2000. "An area where there's been a real problem is getting enough money into the technology end of the venture market, and I think that is where the High Technology scheme has actually fulfilled quite a considerable need and has stimulated quite a lot of money into that marketplace," says Cooksey.

The cornerstone of the fund is a £20m government investment which has leveraged in a further £106m from pension funds and other institutional investors. The fund is managed as a fund-of-funds by Westport Private Equity, investing in existing VC funds with a hi-tech focus.

"The rationale for it was there were some good UK-based technology investing teams who were struggling to raise money, and a number of UK institutions who had turned their back on the technology sector since the mid-80s," says Rory Earley, fund manager at Westport. "The government money was a signal to the pension funds that this is something worth considering. The deciding factor was not the level of subordination, which was fairly minimal, but that here was a vehicle to allow institutions to invest in early stage technology, and the government was signalling that this was a good thing to do and was prepared to put its money where its mouth was."

Reaction from commercial VCs has been enthusiastic. "The way they went about that has been very successful," says Anne Glover, managing director of technology specialists Amadeus Capital Partners. "Being seeded by the government helped the fund manager to turn to pension funds and get them into the industry for the first time. It has a catalysing effect and glues the industry together. That was a very good initiative but very indirect."

This indirect approach was also taken in the Regional Venture Capital Funds, a programme to provide risk capital to SMEs through separately managed funds in each of the nine English regions. With around half of their money from the national government and the European Investment Fund, the funds range from £15m in the North East Seed Capital Fund managed by Northern Enterprises; to £50m in the Capital Fund managed by London Fund Managers, a division of Yorkshire Fund Managers.

The funds are limited to deals up to £250,000, even in co-investments, so that they stay rooted in the lower end of the equity gap. The government money has a capped return, and will act as "first loss" if the capital base is eroded.

Before joining Westport, Earley was an SME policy advisor at the Department of Trade and Industry (DTI) and helped design the regional funds. "I think that model is a good model because the government is not out of line with other investors," he says. "It does cap its returns so it generates a bit of gearing for other investors - if these funds are successful the other investors gain from that leverage, but it's not significant because the government is always a minority investor."

Academics and angels
The government also backs a clutch of specialist funds, including the University Challenge programme, which has distributed £45m seed funding among 15 university consortia; and the Carbon Trust, part of the UK's Climate Change Programme.

"There's almost too many initiatives, and it would be better if some were a bit more consolidated and a bit more visible," comments Glover.

The latest addition to the risk capital armoury is the Early Growth Funding scheme. Launched in December by the DTI's Small Business Service, the scheme will invest around £50m in a network of funds to support initiatives across England.

The first such fund is the London Seed Capital Fund, managed by a subsidiary of Greater London Enterprise, the economic development company jointly owned by the city's local authorities. The fund is backed by £2.65m from the DTI plus £150,000 from the investment panel and managers.

The aims of the fund are very similar to those of the Regional VC Funds, says investment manager Andrew Cavaghan. "We're both trying to make a capital gain for shareholders and seeking to invest in the equity gap below £500,000 where there's currently not much competition from VC's," he says. "But in terms of how we operate, there are distinctions - we exclusively co-invest with lead business angels. It gives us great comfort when our board representative has also invested £50,000-100,000 of his or her own money alongside us. One of the outputs of our business model is that the London business angel market is going to be stimulated."

Prospective investments include more later-stage companies than traditionally associated with the business angel market, Cavaghan notes, a trend he attributes to changes in the mainstream VC industry. "Our aim is to prove there's money to be made at this end of the market, and to raise further funds from commercial sources," he adds.

Celtic tigers
Many funds also receive backing from various European Union sources, taking the issue of government involvement up another level. The £20m equity fund managed by Welsh Finance, a subsidiary of the Welsh Development Agency, is funded by the Objective One programme which provides pots of match funding for the most deprived regions of Europe, and Barclays.

"We're looking to make investments in SMEs and are really trying to stimulate the equity climate in Wales," says fund manager Gary Partridge. "This kind of venture capital has not been available in Wales for a number of years, particularly after 3i moved out of Cardiff. We're trying to get our message out there and remind people what equity investment can provide."

Finance Wales aims to make 20 or more investments a year, from seedcorn funding of around £50,000 to syndicated deals of up to £1.5m. "We are syndicating alongside some fairly well known VC names, such as 3i and ABN Amro," Partridge says. "If we can help to be part of that funding package, it leverages these bigger names into Wales, and we can also be the eyes and ears on the ground and lead the monitoring and development of the investment."

Across the water, Enterprise Ireland has been active in backing both homegrown businesses and VCs. Since 1988, it has provided around Euro220m direct investment in Irish businesses, with successes including Iona Technologies. "The terms attaching to our equity will be the same as for the private sector," says Denis Marnane, manager of the agency's equity and VC unit. "In all cases the money will be matched by the private sector. We're not just putting in soft money."

In 1994, Enterprise Ireland launched its six-year Seed & Venture Capital Programme, backed with Euro43.9m from the EU, sparking the creation of new firms and new partnership funds. In the first phase of the programme, 15 funds invested over E110m in over 120 companies.

"We put up half the money in the 1994 programme to encourage the private sector to increase capital to early stage technology companies and to increase the knowledge of VC investors and fund managers," says Marnane. "It's been more than successful because it has helped to grow the VC market in Ireland from a base of three to something like 15-20, with a lot more professionals operating in the space now."

The second phase, the Seed & Venture Capital Fund Scheme 2001-2006, is backed with Euro 95m of government money to continue to develop the indigenous VC industry. The scheme features 15 new funds targeted at areas such as early-stage SMEs and biotech, and with a greater regional emphasis.

"If you don't have a strong indigenous Irish VC profession, you will not get overseas VCs to invest here," Marnane notes. "If there is market failure, as a development agency we see it's our role to address those gaps and bring the market forward."

Euro catalyst
The biggest state-backed player in the private equity market is the European Investment Fund (EIF), a joint venture between the European Commission, the European Investment Bank (EIB), and national banks and financial institutions. It has over Euro2.45bn invested in 184 funds supporting SMEs across the continent, including a handful of funds in the accession countries. In 2002 alone, it invested E472m in 36 new funds, ranging from the pan-European Merlin Biosciences III to the Italian regional Mezzogiorno 2001 fund.

The EIF is primarily funded from the EIB, with further contributions from the European Commission under various start-up and seed capital programmes. It aims to play a catalytic role in the VC industry by taking minority positions and encouraging investment from a wide range of investors.

"We follow the underlying development objective of the EU, but there's another requirement which is an adequate return on capital which makes it different from a number of publicly funded investors," says Francis Carpenter, chief executive of the EIF.

The EIF is currently considering expanding its activities beyond its traditional market of SMEs and indirect participation, playing a bigger role in the 10 accession states, and is also preparing to offer advisory services to the general market.

"The advisory services are basically an add-on to what we're doing already," says Carpenter. "A lot of this is done in conjunction with the European Commission and we've been providing some financial engineering in major regions taking EU funding. Since our own experience is based on a very broad view of what's happening in Europe, of what best practice is, we can do quite a bit of cross-fertilisation and help people with that."

Different strokes
Elsewhere in Europe, state-backed programmes offer a host of approaches for different markets. The French innovation agency Anvar provides financial support to potential high-growth companies in exchange for equity warrants - as of end of 2002, Anvar had backed 58 SMEs with equity warrant subscriptions worth E23.4m.

In Germany, state intervention is primarily delivered through KfW, the promotional bank owned by the federal and LŠnder governments. KfW concentrates its efforts on refinancing approved investment partners on a deal-by-deal basis.

"Our most important goal is to increase access for SMEs and innovative young companies to equity," says Marc Brugger, senior project manager at KfW's venture capital division. "We refinance the equity partner in the deal - it's always a loan agreement between the equity partner and KfW, and must be an equity commitment from the partner to the target company."

Support is delivered through a string of programmes at different stages of the business life cycle. At the start-up and seed level, the KfW/BMWA Technology Participation Programme (generally known as BTU) offers up to Euro1.4m in one or more rounds, taking up to 50% of equity. As well as drawing on its own funds, KfW receives extra support from the government for BTU.

Germany's federal government has invested heavily in equity support for start-up companies, both through KfW-BTU and TBG-BTU, an initiative managed by SME promotional agency DtA. Since these two initiatives began in 1989, more than 2000 companies have been backed with over EUR 2bn.

KfW's ERP Participation Programme for later stage innovative companies takes a similar strategy but with less stringent conditions, with loans of Euro3-5m. And at the top end, KfW is rolling out a new Private Equity Programme, replacing the former KfW Risk Capital programme which offered guarantees for firms taking over risk on certain equity commitments. The new programme offers both the guarantee and a new loan variant, which is basically the same as in the BTU and ERP programmes. "The focus is pretty wide open, and the pricing is not fixed so we do have to consider a pricing agreement on every deal," says Brugger.

KfW also operates a handful of fund financing programmes, in which the bank enters a framework agreement with a private sector partner to operate a co-investment vehicle. The partners are generally VCs with whom KfW has worked on deal-by-deal refinancing.

The commercial market tends to be more critical of direct intervention on a deal-by-deal basis, however. "If you're giving guarantees on individual investments, are they going to make the right decision, or say they've got a guarantee so why not take a bigger chance?" says Westport's Rory Earley. "If you move public support back the chain, you minimise the risk of distorting individual investment decisions."

Earley is currently working with a new programme in Greece, which again aims to catalyse the development of a market where there is currently just 10 funds operating. "The Greek government is very keen to stimulate the VC industry - they have created a whole new infrastructure to do this," he says.

The New Economy Development Fund (TANEO) is raising a first round of Euro150m, including a Euro45m cornerstone investment from the Greek government. TANEO will operate as a fund-of-funds, providing up to half of SME or early-stage fund alongside the private sector. "I think it's a brilliant model for European governments to stimulate their VC industries, because it gets the money raised then finds professional venture managers to invest it," says Earley.


Building Bridges
Launched in May 2002 with £20m backing from the UK government, the Bridges Community Development Venture Fund is intended to kickstart the development of a new sector for UK venture capital - investment with a social mission and commercial returns.

The fund is targeted at backing entrepreneurs in the most deprived 25% of wards in England, with eligible communities scattered across the country.

"Our catchline is backing entrepreneurs to make a difference," says Michele Giddens, executive director at Bridges Community Ventures. "It's important for these areas to have a thriving growth enterprise sector, so we're seeking exciting growth businesses in these areas and backing them with equity capital and quite a lot of additional assistance, and helping them to grow."

Bridges has made three investments to date - £800,000 in DJ talent industry TrusttheDJ and £125,000 in energy services company Simply Energy (£125,000), both based in London; and £500,000 in Touch'n'Glo, a Coventry-based developer of intelligent light switches.

The £40m fund is backed by Apax, 3i and Doughty Hanson, plus banks and a number of high-profile entrepreneurs, with match funding from the government. Giddens says reaction from the VC sector was "extremely welcoming, but curious".

"The government having catalysed it with matching investment was crucial in raising the first fund," she says. "The unknown nature of the idea and the unknown risks and financial return would have been too difficult for the private sector to risk without government backing."

The fund will be run on tough commercial criteria, Giddens insists. Management costs will be high, thanks to the relatively small investments - typically £1m - and the need to spend more time providing value-added support.

"The returns are unknown because this is uncertain territory," Giddens says. "We haven't led the investors to expect market level of return but we need to aim for a return that's enough to raise further funds."

Community development venture (CDV) funds were one of the five main recommendations of the government-commissioned Social Investment Task Force, headed by Ronald Cohen of Apax Partners. Some inspiration came from the CDV scene in the US, where there are 87 such organisations managing an estimated $525m.

The Bridges model is however substantially different in its emphasis on commercial targets. "The US funds were a mixture of philanthropy and investor money, and their objectives were a double bottom line of social and financial which makes it very difficult to judge how they perform," says Cohen. "Our model is an easier base from which to build a substantial industry as the management team has clear objectives. That is something of a breakthrough in unlocking institutional money. We've got an array of institutions that have a fiduciary responsibility to deliver a return - it's very different to taking philanthropic money."

Cohen is currently lobbying the government to approve match funding for further funds - the SITF report proposed that the government provide up to £100m match funding for CDV funds. "My concern is to make sure there's sufficient number of professional teams working in the area that the success of the sector is judged by looking at a number of funds and not just Bridges. It's like a retail venture - you don't test it out with one location only," he says. They second generation of CDV funds, without direct investment from government, could follow in three to four years, he suggests.


State aid - the full Monti
Possibly the harshest and certainly the most effective critic of government involvement in venture capital sits at the heart of the European establishment. The European Commission takes a notoriously dim view of anything that can be perceived as state aid with the potential to distort the workings of the free market.

Competition Commissioner Mario Monti summed up the argument in the VC market when grudgingly approving the UK High Technology Fund in 2000: "Where state aid is involved then there is at least a risk of competition being distorted. At worst, there is a danger that state aid can crowd out private investment, actually discouraging the emergence of the kind of vibrant risk capital markets which Europe needs to develop."

The English Regional Venture Capital Funds were held up by competition scrutiny for eight months, eventually winning approval two weeks after the adoption of a new strategy on risk capital and state aid.

"The delays in Europe were because it was something novel," says Rory Earley of Westport Private Equity, who as SME policy advisor at the DTI worked closely on establishing the regional funds. "What the people in the European Commission needed to do was understand what was happening and why it was happening, and create a framework to allow member states to become involved with venture capital. The state aid framework is very closely based on what's happening in the UK."

The new approach aims to reconcile the rules on state aid with the aims of the Lisbon Strategy - a ten-year programme launched in 2000 to make the EU the world's most dynamic and competitive economy. While risk capital measures could not be found compatible on the basis of existing guidelines, the EC now recognises "a role for public funding of risk capital measures limited to addressing identifiable market failures".

In short, the EC allows state aid in risk capital only where there is a definite gap in the market, particularly with regards to young, hi-tech firms with high growth potential; and only when any market distortion, such as favourable terms for private co-investors, is kept to the absolute minimum. Exact terms, exemptions and criteria are detailed in a nine-page Communication.

The new rules don't necessarily mean quicker approval however - the Commission still took eight months to approve the Bridges Community Development Venture Fund. But there are signs of greater flexibility - in March 2003, the Commission approved the UK government's plans for CDC Group, which provides risk capital investment in poorer developing countries. The EC granted CDC the tax status of an investment company for an initial period of 20 years, an exceptional length of time for such approval.