Provision Of Growth Capital To Uk Sm Es Report


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Provision Of Growth Capital To Uk Sm Es Report

  1. 1. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 23 November 2009
  2. 2. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 23 November 2009 London: TSO
  3. 3. Published by TSO (The Stationery Office) and available from: Online Mail, Telephone, Fax & E-mail TSO PO Box 29, Norwich, NR3 1GN Telephone orders/General enquiries: 0870 600 5522 Fax orders: 0870 600 5533 E-mail: Textphone 0870 240 3701 TSO@Blackwell and other Accredited Agents Customers can also order publications from: TSO Ireland 16 Arthur Street, Belfast BT1 4GD Tel 028 9023 8451 Fax 028 9023 5401 Published with the permission of the Department for Business Innovation and Skills on behalf of the Controller of Her Majesty’s Stationery Office. © Crown Copyright 2009 All rights reserved. Copyright in the typographical arrangement and design is vested in The Stationery Office Limited. Applications for reproduction should be made in writing in the first instance to the Office of Public Sector Information, Information Policy Team, Kew, Richmond, Surrey, TW9 4DU. First published 2009 ISBN 9780115155253 Printed in the United Kingdom for The Stationery Office. P002336539 c5 11/09 ii
  4. 4. Contents Foreword from Chris Rowlands .................................................................................. 1 Panel Members............................................................................................................. 2 1 Executive Summary .................................................................................................. 3 2 UK Economy and Growth Capital............................................................................ 7 3 Causes of the Gap in SME Growth Capital........................................................... 14 4 Design Factors ........................................................................................................ 18 5 High Level Options for Intervention ....................................................................... 21 6 Conclusion ............................................................................................................... 26 7 Annexes.................................................................................................................... 27 Annex A: Review Terms of Reference and Methodology ....................................... 28 Annex B: SMEs and Economic Growth.................................................................... 30 Annex C: SME Venture Capital Market..................................................................... 32 Annex D: Balance Sheet Characteristics ................................................................. 35 Annex E: Existing Government Interventions .......................................................... 36 Annex F: Executive Summary of the Literature Review and history of 3i ............. 38 iii
  5. 5. iv The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  6. 6. Foreword from Chris Rowlands I was delighted to be asked to lead this review. With a 36 year career spent lending to, investing in and advising UK SMEs on their capital raising I have a thorough working knowledge of the issues. Nineteen years at 3i instilled a passion for the subject. The basic question of adequacy of access to capital for SMEs is not a new one and a conclusion of a market gap in provision is unlikely to be controversial. However, the Government was right to ask for an urgent update of the analysis and arguments. Our economy cannot afford the dynamic SME segment to be constrained in its growth and competitiveness, especially with recovery ahead. The review concludes that this market gap is permanent, not just short term and cyclical, and exacerbated by recession. The easy availability of bank lending in recent years served to obscure an underlying lack of capital provision. So, an intervention from Government is required and I hope one that might have the lasting impact of attracting private sector capital on a large scale and enduring basis. A legacy we could all be proud of. This review has required an intense effort over a short period to gather and analyse contemporary data, consult widely with interested parties and develop a relevant range of options for consideration. My sincere thanks to the team at the Department for Business, Innovation and Skills, this review's Advisory Panel for their wise councel and Ministers for prioritising their time. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 1
  7. 7. Panel Members Chris Rowlands (chair) Enterprise Directorate and is a member of Chris Rowlands retired in March 2009 when the government’s Expert Group on Access he was a member of 3i’s executive team, to Finance (BERR). He has also advised the group investment committee and Chairman European Commission on the financing of high of 3i Asia. He worked at Barclays Bank for 11 growth young firms and was a founder member years, Andersen for 6 years and ICFC/3i for 19 (2000-2006) of the Professional Chamber of years. During his time at 3i he led their growth the Enterprise Policy Group (DG Enterprise) as capital business and developed 3i in Asia. well as having served on the Risk Capital and He is currently non-executive director of The Gazelle Expert Groups (DGs Enterprise and Principality Building Society. Research). From 2008, he has been appointed to the newly formed Research Advisory Board James Caan of the British Venture Capital Association. He is currently involved in the formal evaluation of the James Caan is CEO of private equity firm Finnish National Innovation Strategy 2008, and Hamilton Bradshaw and has been building providing analysis for a review of ‘hybrid’ (public and selling businesses since 1985, including and privately joint financed) VC funds for the UK’s the Alexander Mann Group and Humana National Audit Office. International. In 2001 James was awarded the 'BT Enterprise of the Year' award and was named PricewaterhouseCoopers 'Entrepreneur Ray Perman of the Year' 2003. That same year, having Ray Perman chairs the Access to Finance Expert successfully graduated from the Advanced Group for the Department of Business Innovation Management Program at Harvard Business and Skills. He is also a board member at Scottish School, Caan also won the Entrepreneur of Enterprise and chair of Social Investment the Year in the Asian Jewel Awards. In 2005 Scotland, which lends money to social economy he was voted one of the 100 most influential organisations. Previously a journalist, he founded Asian people in the UK by Asian Power 100. and built up a magazine publishing business. 2007 saw James joining the panel of BBC2’s He is an angel investor and chairs three small Dragons’ Den, investing his own capital in companies. start‐ups on national television. In 2008 Caan scooped the prestigious 'Man of the Year' at David Quysner CBE the GG2 Leadership and Diversity Awards at David Quysner began his career at ICFC London's Grosvenor Hotel, coupled with being (latterly 3i). He is currently Chairman of Capital named ‘Asian Business Man of the Year’ in quick for Enterprise Limited, which manages the succession. James most recently was appointed government’s equity funds and loan guarantee the new co‐chair on the Ethnic Minority Business schemes for SMEs. He is also Chairman of Taskforce, which supports over 280,000 Abingworth, a venture capital and growth equity businesses, contributing in excess of £20 billion investor in life sciences and a Director of other a year to the UK economy. companies investing in technology. Christina McComb Danny Truell Christina Mccomb is a director of partnerships Danny Truell is the Chief Investment Officer and a UK plc, where she is responsible for investment member of the Executive Board of the Wellcome activities, and was previously a director at 3i. She Trust, the largest charitable foundation in Europe has over 20 years experience investing in venture with assets exceeding £12 billion invested in companies and SMEs. She currently sits on the a broad range of investments including public Boards of several early stage businesses. equities, private equities, property, venture capital and hedge funds. Gordon Murray Gordon Murray holds a Chair of Management (Entrepreneurship) at the University of Exeter Business School. Since 1989, he has researched, lectured and consulted internationally in the two related areas of New Technology-based Firms and the international development of the formal and informal Venture Capital Industry. Dr. Murray is a senior adviser on policy related issues concerning the financing and growth of high potential young firms to the UK government’s 2 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  8. 8. 1 Executive Summary 1.1 Small and medium sized businesses Demand for and problems in (SMEs) are vital to the UK for jobs and wealth and a dynamic, growing SME accessing growth capital sector is likely to contribute significantly 1.6 Gaps in current data and analysis make to future growth and productivity. To it difficult to draw any firm conclusions on maximise their contribution, it will be the existence of a permanent gap in the important that the financing needs of provision of growth capital. However, the viable SMEs which want to grow are fully underlying market issues, together with met. anecdotal evidence suggest that a gap currently exits. In addition, we can say with 1.2 This review was asked to consider some confidence that unmet demand whether and in what form intervention for growth capital is likely to increase as might help increase the supply of long recessionary effects weaken balance sheets term growth capital to SMEs. In particular, and reduce the capacity to take on debt. the review was asked to examine the evidence of market failure and, should 1.7 Drawing on two separate data sources, we there be a case for intervention, to develop estimate that there are 25,000 - 32,000 proposals for Government to consider UK businesses that are growing and/ on: (i) the focus, size and scale of any or restructuring and with characteristics new intervention and (ii) the level (if any) of that may make them suitable for growth public support. capital. Our analysis suggests that up to 5,000 of these firms per annum will be The nature of growth capital viable SMEs which are likely to experience significant problems in accessing capital 1.3 Growth capital is a broad term used to as the economy emerges from recession. describe funding that enables established It is likely that those SMEs which are firms to expand. It is often used by SMEs seeking to access growth capital in for a range of expansion activities from amounts above £2million – the current investing in new plant or equipment to upper limit of public/private provision – and engaging in marketing or hiring a new below £10million – the minimum level at team. Growth capital thus forms a vital which private equity providers will fund – part of the “funding escalator” that allows will face particular difficulties. companies to meet their financing needs at different stages of their development. Reasons for unmet demand 1.4 The nature of growth capital for SMEs 1.8 There are a number of reasons why the varies in its structure or product form. gap in the supply of growth capital to It exists both as term debt, often from SMEs exists. They fall into a number of traditional sources such as banks and categories: structural market failures which in the form of equity or equity type are well documented and apply more investments - typically from venture capital widely to the supply of capital to SMEs; or private equity providers. It also exists market issues that apply specifically to the to a limited degree as mezzanine finance – supply of growth capital; and finally, the term lending, with less security than bank impact of the recent financial crisis and debt but at a higher cost, often through recession. a final “kicker” payment or share in the company’s equity. Structural market failures 1.9 That a growth capital market does not 1.5 What differentiates growth capital from exist is not a market failure per se. If this other types of investment is the level of is because there is not enough economic risk. It is positioned between the two value from such transactions when extremes of high risk -high return pure compared against alternative opportunities equity investment and lower risk, usually this is in fact a market working efficiently. fully secured, bank lending. Growth However, it is widely recognised that the capital involves moderate risk with some market for all types of risk capital suffers security and, as a result, providers expect from failures associated with imperfect a moderate return. It is for this reason that information. This is where both SMEs and demand for growth capital may be met investors have insufficient information to through mezzanine finance products. make optimal investment decisions. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 3
  9. 9. 1.10 On the supply side, this leads to a lack Impact of recent events of investor appetite for growth capital to 1.14 There are reasons to believe that recent SMEs for two reasons: changes in financial markets have • The costs of researching information are intensified the structural market failure similar for small and large businesses. in the provision of growth capital as the Investors therefore tend to prefer larger overall supply of capital has become deals involving larger businesses where constrained. Until recently, banks were the transaction costs are a smaller willing to fill at least some of the demand proportion of the investment made. for growth capital. Competition for market • There is little performance measurement share and low cost of capital led banks to data, in other words track record, on extend traditional short term or working investing in SME growth capital. This capital debt finance for an increased may make investors more risk averse and range of purposes; effectively substituting can result in higher levels of return being the growth capital market, with readily required or lower levels of investment available funding that did not necessarily being committed. match the return for which it was risked. 1.11 On the demand side, information failures 1.15 Since the onset of the credit crunch, include: lack of ‘investment readiness’ by lending by banks has declined for a entrepreneurs; lack of knowledge amongst number of reasons including retreating into SMEs on the nature and availability of more traditional lending practices possibly equity finance; and a perception by SMEs’ reflecting increased risk aversion; these owner-managers (and their advisors) that changes are unlikely to be reversed soon. debt finance is the only form of finance Banks are therefore unlikely to provide suitable for their business. This is a belief sufficient and appropriate capital to fund that may have been encouraged by the SME growth plans over the next few years. plentiful supply of cheap debt finance in the recent past. 1.16 For all of these reasons, and despite lack of absolute certainty on the precise level of 1.12 There is also a significant body of evidence unmet demand amongst viable SMEs for that business owners may not be willing growth capital, there is evidence to point to concede a stake in their business to to a permanent gap in the provision of attract professional investors, preferring growth capital. This situation is potentially to sacrifice potential growth for assured exacerbated by the recession. The review autonomy. This is likely to lead to a believes that this constitutes a strong relatively lower level of demand for equity rationale for Government intervention. finance. It is also likely to constrain the growth of companies not accepting Building an escalator of finance professional resources. 1.17 Government has recognised the existence of the market failures around the supply Other market issues of finance to SMEs for many years. It has 1.13 The review believes that further market provided significant investment in recent issues exist that restrict the supply of years into a range of early stage equity growth capital to SMEs: funds and programmes as well as through • A preference in private equity for larger Government guarantee schemes. Many of transactions where risk is easier to these schemes have been successful in calibrate and returns have been historically promoting the productivity and profitability highly attractive; of companies in which they invest and • Financial incentives for fund managers, they have also attracted private sector which encourage investment in larger capital and capable management teams transactions; and into the equity gap at this level. However, they have been primarily focussed on • Lack of an established channel for growth debt finance for start-ups and young capital and the fact that institutions businesses and on early stage equity for allocate a limited percentage of funds high growth, innovative businesses, not on to “alternative assets”, a category that the supply of growth capital to established includes the whole spectrum of private firms with medium to high growth equity and venture capital investment. potential. Allocations to larger buy-outs and secondary purchases have crowded out 1.18 Government needs to ensure that other segments of the market. interventions are sufficiently flexible to meet the needs of business at many different stages of development. It should consider carefully: the optimal size of 4 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  10. 10. funds; their ability to provide follow-on 1.23 In consulting a wide range of stakeholders funding; the size of individual investments; and drawing lessons from the experience and their sector/geographical focus. of previous government interventions in Although a small number of the publicly- the early stage equity market, the review supported early stage funds have the believes that the design of any intervention flexibility to provide mezzanine type should address the following key points: funding, they are often restricted in size • Private funding: Any intervention should and scope. seek to draw in private funding to the maximum extent possible. 1.19 In order to build an effective escalator • Scale: The aspiration should be to have of finance within the finance gap, a large total fund size. This would capture Government needs to intervene to ensure economies of scale; allow the intervention that businesses can access finance to to make a significant impact on the gap; start, expand and grow. It must also provide money for follow on investment; ensure sufficient sector/geographical focus and provide regional coverage. and overcome the current restrictions of scale. The size of current equity funds • Commerciality: Private sector capital will ranges from as little as £2m up to £46m, be maximised if the intervention operates with the size of investment for many funds with entirely commercial objectives and limited to a maximum of £2m. strategies aimed at maximising returns. • Long term: An intervention must be 1.20 In mapping current government able to avoid the pressure for early exit interventions, the review has concluded from investments and provide long term that the current landscape would benefit support to SMEs. from simplification. Any new intervention to increase the supply of growth capital 1.24 The final chapter of this report considers should be part of an integrated solution to the merits and drawbacks of the three the financing problems of businesses in broad options against these points, addition to providing a credible source of but does not offer a final view on which follow-on funding for growing SMEs. should be pursued. This would be for Government to consider in the broader Options for intervention context of what institutions and delivery bodies already exist. 1.21 The review concludes that it is unlikely that the financing gap for growth capital can be resolved without targeted Government Conclusion intervention. An initial level of government 1.25 In summary, the Review has reached the support is likely to be required to initiate following seven key conclusions and urges activity, in particular to overcome barriers Government to take considered action to in terms of scale and distribution and to address the gap in growth capital facing give investors confidence to invest in the SMEs. area. It concludes that a mezzanine type product is well positioned to address • A vibrant SME sector displaying the particular risk/return characteristics strong growth is vital for overall of growth capital and can be structured economic growth, leading to increased to mitigate the impact of various SME competition and innovation, and demand-side barriers and support improved productivity. Government attractive returns for investors. should strive to ensure that adequate growth capital is available across the 1.22 A number of broad distribution options SME growth cycle. exist for the way in which Government can deliver such a mezzanine product to the • A gap exists for companies looking market: for between £2m and £10m in growth capital. Neither bank lending nor equity • a standalone, full scale and commercial investors are likely to fill this gap in the institution to raise, manage and directly foreseeable future. distribute growth capital • A mezzanine product would be best • a “thin” commercial institution to raise suited to fill this gap. It would help and manage capital but with distribution address demand side aversion to through existing private sector providers pure equity, and provide a return • a “thin” commercial institution to raise above regular bank lending to reward capital and deliver investment through investors. A well designed intervention a co-investment model with approved could offer a risk/return profile that private sector partners would attract capital to the sector. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 5
  11. 11. • Any intervention would need scale and a centralised asset allocation and risk management function, perhaps through an institution, which would also set the overall strategic direction of the investment strategy and ensure that there was not "mandate creep." • Evidence points to a need for the ability to find, assess, and manage investment opportunities in the regions. • Investments should be made on a commercial basis in order to attract private capital into the asset class, to attract talented investment managers who work on a commercial basis and to avoid distorting the market and crowding out private initiatives. • The existing landscape of government intervention would benefit from simplification. Any new intervention should not add to, but be part of a solution to resolve these problems, as well as providing a credible source of follow-on funding for growing SMEs. 6 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  12. 12. 2 UK Economy and Growth Capital This chapter defines growth capital and sets out the role and importance of growth capital for SMEs in the UK. SMEs access a variety of forms of external finance and this chapter considers how debt and pure equity finance are unlikely to be suitable products for SMEs needing growth finance. The chapter closes by making an assessment of the level of potential demand for growth capital, and estimates the structural gap in its provision of and how this may change as the economy recovers. Role of SMEs in UK Economy The Market for Growth Capital 2.1 Small and medium sized enterprises play 2.4 The term ‘Growth Capital’ is usually a vital role in the economy. They employ applied to funding that enables established 13.7 million people, about 59% of the companies to expand their activities, and total private sector workforce. SMEs also is a vital part of the ‘funding escalator’ that contribute as much as large businesses allows companies to move from start-up, to UK output. The SME sector has seen expansion, and growth into a larger firm. It strong growth recently with over a million can be used for a wide range of activities more businesses at the start of 2008 than from investing in new plant or equipment in 2000 and employment growth of 13% to engaging in marketing or building over the same period. customer support capability. While the boundaries are blurred, it is usually seen 2.2 In addition, a vibrant SME sector is an as different from working capital, which is important driver of economic growth. used to fund day to day activities. In terms Through the process of economic of investment, it is differentiated from seed churn, new businesses enter the market or start-up and the very large amounts of and displace less efficient established capital invested in management buy outs/ businesses. SMEs also bring forward buy ins. innovation in products and business processes. 2.5 Capital available to SMEs is priced to reflect the risks inherent in the activities 2.3 SMEs are likely to be critical to driving that it funds and the downside protection and sustaining the return to economic afforded by security. In general terms, growth across the economy. As economic the higher the risk of capital loss the conditions stabilise SMEs will have greater the return required by the lender opportunities to expand and grow to meet or investor. Growth capital requires a level higher demand, to address new export of return below that for Venture Capital/ opportunities and to serve new customers. Private Equity but in excess of what would It is also likely that vibrant SMEs will look be appropriate for debt finance on normal to take on business from competitors terms. Figure 1 maps the different types that did not emerge from the recession of finance against their expected return as successfully. Whilst this growth will profile. require additional levels of working capital, some of which may be financed through appropriate short term debt, it is likely that finance will be needed to support long term development and structural growth. It is important that the UK’s SMEs are supported with the investment to grow and optimise their performance and help drive the economic recovery. Annex B looks in more detail at the links between SMEs and productivity and the impact on business investment and economic recovery through a lack of finance. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 7
  13. 13. Figure 1: SME Finance types: Illustrative mapping of expected return profile against amount sought 50% Business Angels Early Stage Venture Private Equity 40% Capital Government supported venture Public Markets capital funds Risk/Return 30% 20% Grants Mezzanine and Lending Finance informal guarantee 10% lending schemes Bank Finance 0% £0.01m £0.05m £0.1m £0.5m £1m £2m £5m £10m £30m+ Amount of Finance Sought 2.6 Defining the growth capital funding gap • The assessment of whether to offer a in terms of amount sought by SMEs is loan is highly influenced by the security difficult to do with any precision. However, available to support it. The lending it is possible to locate a gap at between is based on a credit decision not an £2 million and £10 million. Analysis of the investment decision, which would require growth capital deals within the growth looking at the future prospects of the and restructuring population provides a company for growth from which to repay median deal size of £3 to 5million further the loan. As such, above a low level, loans substantiating that it is within this range are usually secured against assets that can that growth capital deals are sought and be sold to repay the lender. Therefore the made. This reflects the £2 million ceiling of value of an SME’s assets against which existing government interventions (below to secure finance will be essential to their which start-ups or early stage funds are ability to secure finance, rather than the focused) and the £10 million threshold fundamental strength of their below which private equity and venture business plan. capital rarely invest owing to the structure • Bank finance to SMEs can be relatively of their business model. short term. Overdrafts are repayable on demand and are therefore not an “Serious consideration should be appropriate form of long-term finance. given to introducing regionally focused Term loans are usually less than 10 years and frequently repaid well ahead of development capital funds that fill the maturity.1 Bank finance may also have current gap of about £2m to £10m.” – restrictive covenants that may impede Partner, Commercial Law Practice the performance of the business if market conditions change. 2.7 The next sections set out the suitability of • Bank lending will typically yield a small debt and equity finance to meet growth margin over the Bank of England base capital needs. rate to the lender and will usually only be advanced where the lender views there Growth Capital and Bank Debt to be a very low risk of capital loss. Under 2.8 Bank Finance is the primary form normal terms it is uncommon for debt to of external finance for SMEs, most deliver returns over 10% IRR. Banks are commonly in the form of overdraft and generally unwilling to take the higher risk term loans. However, whilst bank finance associated with financing long term growth is an important source of funding for or, if they are, the price of the debt finance most businesses, including SMEs, it is can be prohibitive for the SME. not always an appropriate form of growth capital, for a number of reasons: There is therefore potentially a gap in the provision of finance that is long term, flexible and structured to accurately reflect 1. BIS SME banking data 2009 8 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  14. 14. the risk of capital loss and to capture 2.13 For larger and ambitious firms seeking adequate returns should the firm perform equity finance to expand, there is also well. the opportunity to float on the London Stock Exchange Alternative Investment Growth Capital and Private equity/ Market (AIM). However, this will not suit venture capital the majority of businesses looking to grow. 2.9 Equity finance provides an injection of Annex C provides more detailed overview capital into an SME in return for a share of the market for equity finance for SMEs. of ownership of the business. Equity finance needs to command a high level of Growth Capital as ‘mezzanine’ return due to its subordinate position to 2.14 This mismatch between the main types debt holders. In the event of the business of finance instrument – debt and equity performing well, equity holders will get a – and the finance needs of moderate share of that return. However, in the event growth SMEs has led to the development of liquidation, ordinary shareholders are of mezzanine finance services. Mezzanine the most vulnerable finance providers as finance is particularly suited to SME they are only entitled to the residual value growth because it occupies the middle once creditors and debt holders have ground between the lower risk and return been paid. of bank debt and the higher risk and return of equity investment. It shares features of 2.10 This form of capital is not secured against debt, but typically provides compensation any asset and does not normally receive for greater risk taking on the part of the a guaranteed yield. Typically the potential investor, through a small equity component returns are many multiples of the initial or redemption premium. investment and target returns for individual investments may be set at returns 2.15 However, evidence collected when in excess of 40% so that successful compiling this report indicates that activity investments can compensate for losses in this range is limited, with existing that will inevitably arise on others. mezzanine providers in the market focusing on investments above £10 2.11 Given the requirement for relatively high million, often as part of large scale private returns, equity finance may not be suitable equity deals, and the previous existence as the sole source of growth finance of relatively cheap bank debt crowding out for the majority of SMEs for at least two provision below £10m. reasons. Firstly, the anticipated modest growth of many of these firms would not “From 1997 to 2007 Banks were the be sufficient to support such high returns. key competitors to Mezzanine finance; Secondly, as due diligence costs tend to rise only moderately as firm size increases, the cheap debt effectively killed the investment costs for SMEs make a larger Mezzanine product [below £10million]” negative impact on net returns for these – Partner, Mezzanine provider firms than for larger firms. 2.12 The potential to reap higher returns at the Demand for Growth Capital larger end of the market has, together 2.16 During the course of the Review the team with the relatively high costs of making have encountered substantial anecdotal equity investments, driven investors evidence of small businesses wanting towards larger businesses. Over time this long term growth capital that they cannot has meant that equity investment has at present access through banks or the become focussed on the high risk/high venture capital markets. Quantification return segment of the market. In addition, of this need however comes with a high the aversion that exists within the SME degree of uncertainty. Much of the data community to equity finance means that is necessarily based on demand for this is not always a suitable instrument. products similar to but not necessarily identical to those any intervention aimed at “There are great opportunities to the growth capital market would employ. Furthermore, the market issues identified expand… [I looked into] venture capital later affect the level and type of demand but they wanted too much. There has and not merely the supply of growth got to be something in it for me and if capital. I dilute my share any further I see little point continuing” – Business Owner The Provision of Growth Capital to UK Small and Medium Sized Enterprises 9
  15. 15. 2.17 Rather than making assumptions about 2.19 Analysis of the characteristics of firms the type of firms looking for growth capital, undertaking growth capital deals this review has assessed the market (specifically in terms of sales and for growth capital by identifying what employment growth over time) highlights criteria mark out firms that seek and find three key segments with a differing it. Work carried out for this review by incidence of deals: pH Group identified the most common characteristics of those companies that • The highest incidence of growth capital have previously undertaken growth capital deals occurs amongst firms growing in deals2: both employment and turnover with the • The analysis (see figure 2) identified around greatest incidence among those firms with 170,000 SMEs with a turnover between growth of at least 25% per annum in both. £1-£25m, and which were over 3 years • An above average incidence of growth old. This formed the population that was capital deals appear to be undertaken by subsequently analysed. firms ‘restructuring’ – defined as where • The more employees a firm had, the either employment or turnover increases more likely it was to do a growth capital whilst the other declines, or where both deal. The likelihood of doing a deal was are declining. highest for those companies with an • Finally the lowest incidence of deals annual turnover between £5m-£10m, is found among a cohort of stable whilst lowest for those companies with a companies. This fits with anecdotal turnover around £1m. evidence that suggests that there are • In terms of sector, there is no significant a number of small companies which skew towards one over the other but are moderately successful but whose there is a greater representation of management have limited ambition to manufacturing and business services. grow further. 2.18 Within this defined market it is possible 2. Data on deals from to identify companies undertaking CorpFin, part of ‘growth capital’ deals.3 This allows the Experian Ltd pH group. Corpfin claims identification and analysis of the key to capture 95% of all characteristics of companies prior to the deals over £500,000. receipt of development capital. Thus it is For the analysis, growth possible to quantify the relative importance capital deals included: of certain financial and non-financial a) Development Capital drivers to deals, as well as the natural deals; b) Reconstruction territory of development capital.4 deals; c) Minority stake deals; and d) reverse takeover deals. It does not Figure 2: Incidence of growth capital deals by industry and size include e) acquisition; or f) Management Average number of companies by year buyouts (MBOs) as not Total number of deals considered relevant. Number of employees 3. Those companies for N/A 1-2 3-4 5-9 10-19 20-49 50-99 100-199 200-249 250+ Industry whom, at any point, growth capital may be Agri. 1% 1% appropriate. Deal logged Min., Energ. 0% 1% on the Corpfin database Man. dur. 10% 14% that captures all deals over £500,000, claiming Man. non-dur. 7% 6% 95% coverage. Constr. 11% 1% W-sale 12% 6% 4. It is important to bear Retail 12% 8% in mind that the overall number of deals is Transp. PTT 6% 4% low, and they do not Bus. Serv. 23% 32% represent demand Fin., Ins. 4% 9% for growth capital but Property 5% 6% development capital deals in the existing Pers. Serv. 4% 4% market. It is possible Public 4% 5% however to develop 36% 1% 1% 5% 11% 23% 13% 7% 2% 2% 160014 some conclusions about 15% 1% 2% 3% 8% 20% 21% 16% 4% 12% 548 what type of firms will by looking for this sort of finance. Source: pH Group 2009. Blue filled circles = no. of deals, black rings = no. of firms 10 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  16. 16. Figure 3: Incidence of growth capital deals } Strong (25%) increase in both criteria Some growth (1-25%) in both criteria Growing Growth in one criteria the other stable Growth in one criteria contracting in other Contracting in both criteria } Restructuring Stable in both criteria Stable in one criteria contracting in other* } Stable -100% 0% 100% 200% 300% 400% 500% 600% 700% *inc. where data is N/A 100% = normal incidence of deals Source: pH analysis 2.20 Evidence collected from the consultation proportions experiencing problems in interviews confirmed the first two groups obtaining any finance. as the hotspots for growth capital deals. As well as identifying businesses exhibiting 2.23 To estimate the structural gap in the growth, the interviews suggested that provision of growth capital it is necessary those that have hit a plateau through lack to draw on survey data from prior to the of funding or who are unable to secure beginning of the credit crunch. The BIS a second round after initial early stage Annual Small Business Survey 2007/08 investment would be suitable targets for found that of the 35 percent of growth growth capital. Further analysis is shown businesses seeking finance, only 21 per at Annex D. cent had problems raising finance from the first source approached and 4 per cent Estimating the scale of the unmet were unable to access any finance from demand for growth capital any source. 2.21 The previous analysis illustrates that deficiencies in current data make it difficult 2.24 Applying these percentages to the mid to estimate with any degree of precision point (28,500) of the estimated range the number of SMEs that might benefit (25,000-32,000), produces a figure of from a growth capital injection. However, between a few hundred (400) and a few the analysis of two data sources – pH data thousand (2,100) businesses experiencing and the Business Structures Database, problems raising finance. Given both the provides an indication of the broad orders problems with survey data and precisely of magnitude using the pH analysis. estimating the number of firms which It estimated that of the circa 170,000 might benefit from an injection of growth companies there are approximately 25,000 capital, these figures should only be to 32,000 SMEs in the growing and viewed as indicative of the scale of the restructuring bracket with characteristics problem. that may make them suitable for growth capital finance. This is supported by 2.25 Table 1 illustrates the impact of two analysis of the Business Structures plausible scenarios on the scale of unmet database (based on VAT returns and demand for growth capital over the next employee numbers) which gives a figure few years. of circa 25,000 for growth firms within • Both supply and demand continue to the same parameters.5 Only a smaller be subdued relative to pre-recession proportion of these SMEs will be seeking conditions. Under this scenario the scale finance at any one time. of unmet demand could rise to between 1,300 and 2,100 businesses per year. Unmet demand prior to the recession • Demand for finance amongst SMEs 2.22 Although data does not exist directly on returns to its pre-recession level as the scale of unmet demand, surveys of recovery accelerates but the supply of small businesses before the recession finance remains constrained at current 5. pH analysis showed provide figures both for the number of levels. This scenario of supply remaining circa 20,000 “growing” businesses seeking finance, and the constrained is entirely plausible, as for firms and circa 12,000 “restructuring”. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 11
  17. 17. instance banks react to the anticipation 2.28 Experience of previous recessions indicates of regulatory changes to both capital that it could take several years before & liquidity requirements, and the trend the supply, and possibly the demand for of reduced foreign lending looks set to finance, returns to pre-recession levels. continue. Under this scenario, the scale This is important, as research has shown of unmet demand could rise to between that the ability to fund growth internally is 2,700 and 4,400 businesses. directly linked to the extent to which a firm is financially constrained.6 Capital structure, 2.26 Depending on the medium term trends specifically levels of debt and interest cover in both demand and supply of finance, are good indicators of how financially we estimate that up to 5,000 SMEs per constrained SMEs are. annum seeking growth capital could experience problems raising this capital. 2.29 The data depicted in Figure 4 suggests Again, given the number of other factors that in aggregate UK businesses entered that might influence the demand for this recession with both considerably more growth capital, inadequacies in data and debt and cash than they did historically. the uncertainty about how the financial This is reflected at the very small end of markets will adjust as the recovery the market in companies with turnover accelerates, these estimates should only less than £1m and to a lesser extent in be taken as indicative of the possible scale our target SMEs with turnover above of unmet demand. this. However, growth companies have traditionally borrowed more and more Impact of recession on number of often and are now overleveraged. SMEs financially constrained 2.27 There are strong reasons to believe that “We are already seeing businesses problems faced by some SMEs in raising which need to invest to meet forecast growth capital will have been accentuated by the recent events in financial markets. increases in demand but which find Business surveys since the recession have themselves unable to raise bank found that whilst there has been a fall in finance to assist” – Fund Manager, demand for finance by SMEs, there has Private Equity Firm also been an increase in the proportion of SMEs facing difficulties accessing it. For 2.30 Analysis of historic data across the SME example, the June 2009 BIS Barometer population also shows that although found that of the 17 per cent of all SMEs since 1999 there are a declining number seeking finance, 44 per cent had problems of businesses borrowing, those that are raising finance from the first source doing so borrow more and are likely to approached and 27 per cent of all SMEs have low levels of interest coverage: 44% seeking finance were unable to access any of businesses that borrowed in 2008 had finance from any source. less than 2 times interest cover.7 Historical precedent suggests that profitability could deteriorate before it gets better, and may also struggle to recover even when GDP growth does. Table 1: Estimation of potential unmet demand for finance Population of Businesses Number of Number of businesses Seeking external businesses businesses suitable for finance unable to raise having problems growth capital finance from any raising finance source from first source approached Pre-recession 28,500 10,000 400 2,100 demand and 6. D. Harhoff, “Are supply There Financing Recession 28,500 4,800 1,300 2,100 Constraints for R&D and demand and Investment in German supply Manufacturing Firms?”, Annales d’Economie et Demand at pre- 28,500 10,000 2,700 4,400 de Statistique, 1998 recession levels, 7. pH Group 2009. supply at current Analysis completed on behalf of the Rowlands levels Review. 12 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  18. 18. Figure 4: Trends in borrowing and deposits of SMEs 60 2.5 50 2.0 Liquidity Ratio 40 1.5 £bn 30 1.0 20 0.5 0 0.0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Borrowing Deposits Liquidity ratio 2.31 In addition, analysis of the two types of business identified in paragraph 2.19 as being more likely to require growth capital – growing and restructuring firms – show signs of their being more financially stretched than the wider SME population. 2.32 Growing SMEs are more likely to borrow; on average over the past three years 42% of growing SMEs borrowed compared to 36% of the wider SME population. In addition, both growing and restructuring SMEs are less likely to have substantial interest coverage on existing debt than the wider population; 48% of growing SMEs have interest cover of less than two times. Amongst restructuring SMEs the situation is even more pronounced with 78% in this position. This could be particularly problematic as in 2008 17% of SMEs across both groups were geared over 200%.8 2.33 Despite the estimation difficulties, for the reasons explored in this chapter, the possibility that several thousand SMEs with growth potential face difficulties in raising appropriate finance to fund their growth plans constitutes a strong rationale for intervention. The next stage in the analysis, assessing whether there are market failures leading to this under allocation and whether they can be effectively addressed, are considered in the next chapters. 8. pH Group 2009. Analysis completed on behalf of the Rowlands Review. The Provision of Growth Capital to UK Small and Medium Sized Enterprises 13
  19. 19. 3 Causes of the Gap in SME Growth Capital This chapter explores the reasons for the apparent under provision of growth capital to SMEs. The review has found that a number of issues have led to the gap in SME growth capital, namely: • Permanent market failures affecting both supply and demand sides; • A number of other market issues that have an adverse impact on the supply of growth capital including methods of risk reduction in private equity, remuneration of fund managers and the lack of an established channel for growth capital; • The impact of the recent financial crisis and the economic downturn on bank financing of growth Market failures those institutional investors not investing in venture capital significantly underestimated 3.1 The reasons why some viable SMEs with the returns achieved by this asset class, growth potential can experience problems whilst those that did invest generally had in raising capital is well documented, and more accurate perceptions.10 If investors is, at least in part, the result of a number have incorrect expectations, this will result of market failures. These market failures in a sub-optimal allocation of capital. relate to imperfect information and other structural issues on the demand and Potential market failures affecting the supply side that have resulted in fund demand side are: managers making fewer, larger and later stage equity investments. The supply side Lack of investment readiness market failures identified by the review are: 3.4 This leads to SMEs lacking the ability to present themselves as investable Cost structure of growth capital deals opportunities, for instance due to 3.2 The prohibitive cost of identifying, poor business plans or inadequate transacting with and exiting from smaller management skills, constraining the ability growth capital deals has been commonly of the business to obtain investment. cited by fund managers and investment firms.9 Consensus suggests that deal SME aversion to equity structuring and due diligence on a ‘typical’ 3.5 Research estimates that up to 20% of deal can take about 3 months. For a incorporated SMEs consider equity finance technically complex company, the costs to fund growth although the numbers that can easily account for 10% or more of the actually use this form of finance is much investment. Thus for smaller deals the due lower at 1%.11 There are a number of diligence can represent a larger proportion reasons why equity is not well favoured; of the deal. This issue particularly affects lack of understanding and reluctance to SMEs as relatively more information cede ownership are most commonly cited is obtainable with regard to larger 9. Respondents to the with 35% of SMEs stating they do not businesses. Review’s ‘Call for want to cede control of their business as Evidence’ and 80 + a reason for not taking equity finance.12 stakeholder interviews Track record However, research also suggests that SME 3.3 Data on returns from growth capital owners and managers can lack the skills 10. British Venture Capital investment is limited, as only a limited or knowledge to understand and secure Association, Institutional number of growth funds exist. Lack of the most appropriate type of investment. Investor Attitudes to track record is likely to make investors Venture Capital in the In addition, lack of information about the more risk averse when investing in supply of finance, differences in valuation UK, 1999. this sector, and as a result demand a of businesses, and a tendency on the part 11. CBR SME Financing higher level of return as compensation. of SMEs to put off growth plans if they do Survey, 2008 Anecdotally this is supported by not secure a favoured form of finance are evidence from the British Venture Capital also common. 12. Annual Small Business Association (BVCA), which shows that Survey, 2008 14 The Provision of Growth Capital to UK Small and Medium Sized Enterprises
  20. 20. “I would rather retire than give up and a minimum rate of return, or “hurdle”. The carried interest represents a significant control or ownership of my businesses” financial incentive and can be maximised – SME Business Owner through closing larger leveraged deals. Preference for debt finance “There is not a lot of commercial logic 3.6 SMEs have become accustomed to the availability of relatively cheap debt finance investing in growth capital at this and this may have contributed to the level when viewed against high end culture of equity aversion, despite debt Private Equity and their returns”. –Fund not being the most appropriate form of Manager, Private Equity Firm finance, particularly for long-term growth. Selecting the wrong type of finance may constrain future growth, for instance, Lack of channel to growth capital covenants in loan agreements could be 3.11 Over the past decade institutional too restrictive if business circumstances investors have increasingly allocated change. capital to the alternative investment asset class where growth capital resides. However within this asset class funds “Too many SMEs “max out” on the have not been directed to growth capital cheapest, most available and easiest investments. Instead capital has been sources of finance. Short term finance invested by fund managers in higher risk and return investments such as large scale is often used to fund long term assets” private equity. – Fund Manager, Private Equity “Many institutions place their money Other Market Issues with fund of funds which tend to look at 3.7 The review believes that there are further larger international funds as offering the permanent market issues are constraining the supply of growth capital to SMEs: best return and greater diversity of risk” – Fund Manager, Private Equity Firm Methods of risk reduction in private equity 3.12 When allocating capital institutional investors make a series of trade offs. 3.8 The private equity/venture capital industry Among others, they balance the illiquidity has, over the years, sought to limit its of their investments with the prospect exposure to risk in a number of ways. of either a high capital gain return or if Firstly, through a greater focus on buyout available, an acceptable level of annual and secondary purchase investments, yield. Private equity and venture capital which tend to be larger and are perceived equity investments are generally illiquid, to hold less uncertainty and risk. Secondly, do not provide annual yield and rely on an through a focus on a smaller number exit event to release large capital gains. of investments with majority control, Historically fund managers have been able giving the fund manager direct influence to generate significant returns of above over business operations and strategic 25% per annum14 for these investments decisions. which have proved high enough to attract institutional capital into this area. 3.9 In the past five to ten years large buy out investments have delivered significantly 3.13 Partly driven by the lack of performance higher returns than growth capital for data, institutional investors currently investors.13 Available and cheap debt perceive the levels of risk and illiquidity combined with large deals has helped that growth capital offers not to be contribute to these extraordinary returns to compensated by the returns available. be made with very high leverage. 3.14 In addition to returns, scale of fund 13. G. Murray and J. Lott, Remuneration of fund managers is critical to establishing an effective “Have UK Venture 3.10 Later stage and buyout deals have also investment channel. A fund needs to be Capitalists a Bias provided better returns to fund managers Against Investment in of a size to allow institutional investors New Technology Based themselves. Personal remuneration to make their minimum investment Firms”, Research and can be maximised through successfully commitment without going over 10% Policy 24, 1995 managing a larger fund. Fund managers allocation of the total fund size. Currently have historically received a management there are no funds of this size established, 14. British Venture fee each year of c.2% plus a profit share and therefore a credible channel, to attract Capital Association referred to as “carried interest”. This is significant amounts of private sector Performance typically 20% of the capital gain after Management Survey capital into UK growth capital. 2008 investors have had their capital returned The Provision of Growth Capital to UK Small and Medium Sized Enterprises 15
  21. 21. 3.15 These structural issues have contributed “The crucial issue is that currently and to fund managers migrating away from arguably for some time, there has been investing in growth capital towards making fewer, larger and later stage investments. no long-term capital for steady growth Fund managers increasingly specialise available except where there is assured in specific investment types and do not security” – Fund Manager, Private typically invest in SMEs ‘from cradle to grave’. This results in an exclusive focus Equity Firm on a single funding round creating barriers between successive rounds of funding. “‘Normal’ banking activity will return This is problematic for UK SMEs seeking to those £25m+ turnover firms sooner multiple rounds of investment to fund ongoing growth. Provision of adequate than those below £25m turnover…this follow-on funding requires ability to make is due to high costs of distribution and large individual investments from a fund realisation that you can not make these with the capacity not to be restricted lending decisions via ‘scorecards’” – by over exposure to a single firm in the portfolio. Head of UK Corporate and Commercial Bank 3.16 This suggests that UK SMEs suffer from a ‘drip feed’ of capital, which is most 3.18 In the past 24 months there have been acute in the ‘growth phase’. Research notable changes in both the capacity of has explicitly pointed out the importance the lending market and attitudes of banks of follow-on finance for the commercial to lending. UK banks lending criteria were expansion of an SME once the available relaxed as competition for borrowers resources from its early stage investor are increased and significant growth in lending exhausted.15 occurred. As the economy entered recession a significant reduction in the Impact of recent events capacity of UK bank lending has taken place. This has reduced any ‘substitute’ 3.17 In the decade to 2007, banks increasingly effect where debt finance has been used, operated outside their traditional risk perhaps inappropriately, as a source of profiles, lending money to finance growth capital for growth. By the end of 2008 at low cost and through short term and foreign lenders dwindled to only 10% working capital instruments, such as of growth as the overall rate of growth overdrafts. For loans between £1m-£20m declined.18 demand significantly increased from late 2005 and through 2006, with a smaller 3.19 The current reduction in credit mirrors increase being reflected in marketing trends seen in past recessions (see figure loans of less than £1m albeit to a lesser 5). Historically, lending to businesses falls extent.16 This was a function of both price during periods of recession and takes and availability of loans and the fact that some time to recover. Following the the UK lending marketplace was very 1990s recession, net lending to public competitive. Evidence suggests that bank non-financial companies (PNFCs) did lending substituted a proportion of growth not recover until 1995, by which time the capital investment, in areas they would economy had been growing for some time. not traditionally lend.17 Fund managers offering equity or mezzanine investments in SMEs found their terms undercut by 15. G. Murray, “The Second banks seeking to gain market share. Equity Gap: Exit Problems for Seed and Early Stage Venture “Banks have exacerbated the troubles Capitalists and Their we now face; they have provided equity Investee Companies”, International Small priced as debt; relaxed lending criteria, Business Journal 12, increasing leverage and loan multiples 1994 whilst keeping rates low” – Head of UK 16. Bank of England Corporate and Business Bank Lending Reports 2009 17. Rowlands Review Call for Evidence responses, 2009 18. Bank of England Lending Report 16 The Provision of Growth Capital to UK Small and Medium Sized Enterprises