Beyond the starting blocks

Corporate Financier, September 2005
This story, in a slightly different form, was shortlisted for the BVCA Private Equity & Venture Capital Journalist Of The Year Awards 2005.

The government-backed regional venture capital funds have now been running for three years, but are they succeeding in their aim of filling the equity gap for SMEs? Tim Chapman investigates

Small businesses with big plans for growth often find a serious pitfall when they try to raise the equity finance they need. It's relatively easy to raise 100,000 or so from a friendly business angel to get you started, while a more established business can attract a few million from a commercial venture capitalist. It's when they need to raise something in between that a promising business can take a tumble. Welcome to the equity gap.

In 2002, the DTI launched a brave new scheme to help close this gap, with funding from the UK government, the European Investment Fund and various banks, pension funds and other commercial investors. The nine regional venture capital funds (RVCFs), one for each English region, can invest up to 500,000 in promising companies. As well as increasing the funds available, they are also intended to demonstrate to commercial VCs that this small end of the market can be a profitable place to invest.

The RVCFs are just part of an armoury of government-supported VC schemes intended to plug holes in the commercial market (see below). But now that they are three years into their ten-year lifetimes, are they achieving their aims? And can a government-funded scheme really make a difference in the tooth-and-nail world of venture capital?

Regional assistance
The Advantage Growth Fund is the RVCF for the West Midlands. The region itself is a microcosm of the national economy – its once-mighty manufacturing industries have been largely, though by no means entirely, replaced by the service, ICT and financial sectors.

The Advantage fund has to date invested in 24 businesses, in areas ranging from specialist polymers for the healthcare sector to broadband access for trains.The fund has invested 5.3m from its 20m pot, with a total of 38 funding rounds. Under the RVCF rules, the funds can invest just 250,000 in each of a first and second round. They can invest up to 1.5m extra in subsequent rounds, but only to avoid dilution of their stake.

Investments have tended to be at an earlier stage of the company's life than was originally envisaged. "We thought it would be more of a mix of early stage development capital and management buy-outs, but in reality we've found very few MBOs to do," says the fund's manager, John O'Neill of Birmingham-based Midven. "We're doing more ICT investments than we envisaged. We thought it would be far more of a mix of industries."

The fund's investment limits mean than it can be of much more use to some sectors than others. "If you're a virgin greenfield manufacturing operation, it wouldn't be a lot of money," says O'Neill. "In a lot of service businesses or ICT businesses, where essentially it's just a collection of people with an office, it's a tidy sum to get them up to a level where they can become viable. It's not brilliant, but it's not bad."

Midven also provides active support to its investees. "It's part and parcel of the job, because they're all small companies, they don't have all the management skills necessary because they just can't afford them," O'Neill notes. "We've very structured in our approach to corporate governance – we try to get all the companies we invest in to think like big companies and start off with all the right procedures."

In the traditionally wealthier South East, the story is broadly similar. The South East Growth Fund has backed 26 companies in around 60 rounds, investing 11m of its 30m pot. "We are broadly on target," says fund manager Derek King. "We've slipped a bit slower over the past 12 months, particularly in terms of new companies, because the quality just hasn't been there."

ICT and early-stage technology companies have again dominated. King sees around 40-50 proposals a month at present, three-fifths of which are very early stage. About two-fifths of the proposals come direct from entrepreneurs, but these tend to be of a poorer quality.

"Often they can be off the wall enquiries, or companies that just aren't right or prepared for equity," says King. "The best quality comes from corporate financiers and other VCs, business angels, non-executive directors or entrepreneurs working with the companies – companies that have put a bit more around their infrastructure in terms of the management team or have gone a bit more down the track." On average, just 2% of applications received by an RVCF will win funding, a slightly higher hit rate than that of conventional VCs.

A question of quality
The North West Equity Fund has meanwhile backed 25 companies in 46 rounds, investing 7.7m of its 35m fund. Fund manager John Hardcastle acknowledges that the numbers are below initial targets. "Our original expectation was that most of the money would be invested by the end of 2006, with a proportion put aside to allow us to do follow-on investments," he says. "Although the initial investment period runs to 2008, we do need to be investing at close to 6m per annum if we are to be fully invested. Based on our experiences in the last three years that is a challenging target, particularly when we are limited to an initial investment of 250,000 and a usual maximum of 500,000. Actual investment rates are a function of investment limits and the number of quality investment opportunities we come across."

Again, the best prospects are those introduced to the fund by other VCs. "Although the VC community doesn't really introduce many opportunities to us, those that it does do are far more likely to result in a deal being done, because they've already been through the mill to get their initial VC money from a seedcorn fund," Hardcastle notes.

While the RVCFs are intended to address the supply side of the funding equation, questions remain over the demand side. Are there really that many quality businesses with an unmet need for equity finance in this range? Several players suspect not, and privately admit that fully half or more of the total 250m in the RVCFs will not be invested by the end of the programme's life. It may be the case that the programme is still building up momentum, however. "Start-up has been pretty slow just because the market has been starved of this sort of fund for so long that most entrepreneurs just don't bother looking for equity funding at this level," says Clive Brook, corporate finance partner at PKF.

The wrong gap?
A common criticism of the RVCFs since their inception is that they are simply not addressing the actual funding gap. A limit of 250,000 in a single round barely scratches the real shortage of finance up to 3m or higher. Even though many commercial VCs claim to invest down to 1m or so, few do in practice for the simple reason that it's as much work to do a deal worth 2m as one worth 20m.

The problem is particularly acute with management buy-outs, which were expected to form a key part of the programme. Relatively small MBOs are now more often funded wholly by banks offering structured finance deals or, if equity investment is required, by the VCT market. This could leave RVCF portfolios dangerously over-weighted with more risky early-stage investments.

The investment ceiling could also put companies at risk if they accept the 250,000 round on the table when they really need more to take them to the next stage. Many RVCFs are investing in follow-up rounds as part of a syndicate with specialist VCs or business angels. The programme rules do not allow this in an RVCF's initial investment in a company, but the funds can syndicate in the second and subsequent rounds.

It's widely agreed that the real equity gap extends far above the RVCFs' upper limits, but there's also the question of where it starts. Business angels, acting alone or in syndicates or networks, are increasingly confident in investing several hundreds of thousands in promising companies. "I think business angel activity is far far better than it was previously. That's a sign that we are a richer country than we were 10 years ago," says O'Neill.

Several RVCF managers say they have lost deals to the angel market. While this is an encouraging sign for the health of the investment market around 250,000, it's a further indication that the RVCF initiative is targeting the wrong gap.

The private angel market does not necessarily see the RVCFs as competition, however. "As the market is maturing, people are saying let's cooperate on this and put private angel money alongside RVCF money," says Modwenna Rees-Mogg, editor-in-chief of Angel News, an online news service for early stage companies and investors. "I think there's plenty of capacity, there's plenty of good companies out there over the 10-year life of the funds. In several years, I'm sure it will grow the market further and they will invest in companies that come back to private funds."

The next stage
The RVCFs have successfully exited from a handful of their companies, through Ofex or Aim floats or by trade sale. The Capital Fund made a 30% IRR from selling internet provider UK Explorer, while the Yorkshire & Humber Equity Fund received a 3.5x money multiple from the sale of specialist printers Harlands of Hull.

But for most, the challenge is to raise the next round of funding, a problem exacerbated by the low ceiling on RVCF investment. A typical burn rate of 20,000-30,000 per month for a new technology company means that 250,000 or 500,000 doesn't last that long, and the business will need to find the next round before its had really had a chance to prove what it can do.

Finding follow-on funders in the 500,000-2m gap is a major challenge for the funds. For the fund managers, concentrating on meeting the funding needs of current investments is likely to further slow the rate of new investments. Some are also reluctantly turning promising companies away because they can't provide as much funding as they actually need. Several managers say they would like the RVCF limits relaxed to allow them to invest larger amounts. This would both help ensure the continuing success of their investees, and help them to fully invest their funds.

There is a mixed reaction to the imminent debut of the government-backed Enterprise Capital Funds (see below). Some RVCF managers would rather see their own rules relaxed rather than introduce a new model to an already confused market. Others see than as a valuable addition to the market which should help in securing follow-on funding for RVCF-backed companies.

"I'm glad they've finally been sorted out from the state aid perspective, and I would be delighted if an ECF turned up in the North West of England," says Hardcastle. "Given the basis of why they're being put together, to provide equity funding of up to 2m, they should be a natural home for a number of our portfolio companies seeking further funding"

Proof of the pudding
The financial success of the RVCF programme can't realistically be judged for another four or five years, when there should be more hard evidence for the funds' internal rates of return. The government's stake in the funds is subordinated, meaning that private sector partners will enjoy enhanced returns. "This subordination was the bait dangled in front of commercial investors in an area of the market where historically venture capital has not generated significant IRRs," notes Brook.

This generation of RVCFs are unlikely to provide enough hard evidence to persuade the more sceptical commercial investors that this market is a profitable place to invest. If the current fund managers want to raise further funds to maintain their momentum, they are likely to face problems. "If they go out and raise the next fund, investors aren't going to know by then how the results are going to pan out on the first one," says Brook. "Investors will have a good idea of which are the poorly performing funds, but it will take time for the rest to prove they are successful, as losses are taken early but profits take longer to generate."

The fund managers are unlikely to seek a straight rerun of the RVCFs, however. "We're confident that we will make a financial return in time, and that will give us as a management company a sufficient track record to raise further funds, but it's highly unlikely that we'll want to raise a fund with a similar limited focus," says King.

The parallel goal of the RVCF programme to demonstrate to the wider VC community that commercial returns can be made by investing in the "equity gap" is also looking doubtful. At worst, if the RVCFs are substantially under-invested at the end of their lives or see too many investees fail because they can't secure the next round of funding, they will only serve to reinforce the belief of commercial VCs that they were right to abandon the small end of the market.

To change that belief is likely to require even more government intervention. "My view is the government will have to go on supporting this area for some time to come," says O'Neill. "The idea that the Brits are going to start acting in the same way as the Americans in terms of pumping sums of money into young companies - I haven't seen it yet, and I don't believe it's going to happen in the short term, because the investors have got to feel that more things are going to work out than fail. My guess would be there's probably more fingers burnt than successes."


Public money, private equity

The RVCF programme is just one of a host of venture capital schemes backed and funded by regional, national and European government bodies with the aim of helping fill the equity gap for small growing businesses.

The Early Growth Funding scheme was launched in December 2002 and backed, like the RVCFs, by the DTI's Small Business Service. The scheme now includes four regionally-focused and three England-wide funds, backed with a total 50m funding from the DTI. Each fund is allowed to invest up to 100,000 in small businesses in the early stages of growth, but the investment must be matched with commercial funding. The funds typically work in partnership with regional or specialist business angel networks.

Bridges Community Ventures, a 40m fund backed by the Treasury, meanwhile aims to help regenerate the poorest parts of England by backing growth businesses. It typically invests 150,000-2m in companies based in the most deprived 25% of areas in England.

Wales, Scotland and Northern Ireland have their own range of funds, coordinated by economic development agencies such as Finance Wales, Scottish Enterprise and Invest Northern Ireland. Finance Wales, for instance, offers a range of funding from seedcorn of around 50,000 to syndicated deals of up to 1.5m, with backing from the European Objective One programme. The Objective One programme also backs investment funds in South Yorkshire, Merseyside and Cornwall, which also meet its criteria for economic under-performance.

The latest initiative is the Enterprise Capital Funds, a UK-wide programme targeting a larger equity gap than the RVCFs. The ECFs will invest a total pot of up to 200m in rounds of up to 2m. The SBS is currently considering bids from VC firms to manage the pilot phase of funds, each of which will be backed with up to 25m of government money. The ECF programme is based on the US Small Business Investment Company model, in which the government has first claim on returned capital, albeit at a capped rate. Many potential private sector co-investors have questioned the attractiveness of this.

Like all government-backed VC schemes, the ECFs had to win approval from the European Commission, which takes a tough line on state aid for industry. The EC allows such schemes 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.