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. iv The Provision of Growth Capital to UK Small and Medium Sized Enterprises
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. 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. 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. 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. 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. • 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. 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. 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. 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. 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. 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. 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. 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. 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. “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. 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
