The 2003 Pre-Budget Report, issued by the UK Government on 10 December 2003, contained some interesting developments to improve the financing of small businesses. In particular the Government has confirmed its proposals for a new fund vehicle, to be called an Enterprise Capital Fund (ECF), based on the US Small Business Investment Company (SBIC) model. These vehicles will use "soft" loans from Government to leverage private capital.
This announcement follows the publication, in April 2003, of a Government consultation paper entitled "Bridging the Finance Gap: a consultation on improving access to growth capital for small companies". The follow-up report gives an overview of responses to the earlier consultation and looks at the way forward.
Background to ECFs
The April 2003 consultation paper identified the so-called equity gap as the main problem facing small growth businesses. According to Government research, business angels tend to concentrate their investment in businesses seeking less than £250,000 of equity finance. A combination of high fixed transaction costs, a shortage of available exit options and a perceived risk in investing in early stage companies, means that private equity houses are usually unwilling to invest anything less than £2m. The purpose of ECFs is to provide funding to cover this equity gap between £250,000 and £2m.
Other mechanisms which are aimed at overcoming the equity gap include:
The government has recognised that investment in the EIS and VCTs has fallen dramatically in the last 2 years, so in order to revive investor interest, the government has suggested some temporary enhancements to apply for a period of two years from 6 April 2004. Instead of a capital gains tax deferral relief for investment in VCTs, income tax relief (currently given at 20%) will be increased to 40%, with the extra 20% relief being paid directly to the VCT. Additionally, for both VCTs and the EIS, the maximum investment limit for any financial year is to be increased from £100,000 to £200,000. While these measures may provide a boost in the medium term, they are likely to mean that little investment in these vehicles will be made between now and 6 April 2004 when the enhancements are introduced, with the danger that investment will reduce again when the two year period comes to an end in 2006.
The Government also proposes to launch a consultation in January 2004 on the regulatory regime in the Financial Services and Markets Act, with the aim of relaxing the regulations on financial promotions to sophisticated investors. This is a very welcome and long overdue development.
What are ECFs?
ECFs will be privately owned and managed funds which supplement private money with public money borrowed at low rates of interest from the Government. ECFs will invest this mix of public and private sector capital in UK companies which have growth potential but which are currently affected by the equity gap. There will be no specific tax reliefs attached to ECFs (unlike VCTs and the EIS), but it is hoped that the underwriting of them with public funds will create a sufficient reduction in risk to make them attractive to investors.
The criteria discussed below are the criteria to be used for a "pathfinder round" of ECFs in Spring 2004. The Government intends to glean from this pathfinder round, taking into account market developments, the most effective structure which will then be used for future ECFs. These will be managed by managers at arm's length from Government rather than by the Government itself. It is intended that ECFs will be self financing over the medium term.
Applying for ECF leverage
Fund managers wishing to manage a pathfinder ECF will have to apply to the Government. The choice of structure of an ECF fund will be left to the fund operator. Most are likely to opt for a limited partnership. Some business angels investing via ECFs may prefer a corporate structure.
The overriding criterion for applicants to manage ECFs will be the capacity to manage a portfolio of investments successfully and to deliver value for public money. Applicants will have to submit a full business plan. In particular, for the pathfinder round, it is likely that this business plan will have to include details of:
There will not be a minimum fund size at the pathfinder stage but the size of the proposed fund will be considered when assessing the viability of the applicant's proposal.
Drawing down leverage
ECFs must secure commitments for the amount of private capital agreed at the application stage before being entitled to draw down public funds.
Interest will be charged at or close to gilt rate. However repayment of interest will be deferred until the ECF has sufficient cashflow (see Realizing investor funds below).
The amount of leverage that can be drawn down will be subject to a maximum leverage ratio agreed at the application stage. Pathfinder ECFs will not be able to apply for a ratio higher than 2:1. The maximum leverage ratio is just that, a maximum, and ECFs can draw down as little leverage as they chose.
Investing in SMEs
The pathfinder ECFs will be able to invest in companies which:
The main restriction is a upper limit on investment in any one company. Where an ECF invests with a syndicate the total amount of investment is taken into account rather than just the ECF's contribution. This upper limit is aimed at ensuring that investment is targeted at companies affected by the equity gap. It is also intended to prevent any competition between ECFs and the existing venture capital industry.
Following submissions made by the BVCA in response to the April 2003 consultation paper, the Government has conceded that it is essential that ECFs have the ability to follow on where the initial investment into a company is successful - if the successful company seeks alternative sources of funding, the ECF's share will be diluted or if it is not able to find alternative funding, the company's growth will be curtailed and the original investment could be wasted. The Government intends to allow pathfinder ECFs to participate in follow-on investments which exceed the upper limit. The only constraint will be an upper limit, set in line with normal commercial practice, on the proportion of an ECF's fund that may be invested in any one company.
Investments in companies by pathfinder ECFs will have to include some equity or equity related securities (which includes debt instruments with options to convert to equity). Provided pathfinder ECFs comply with this requirement, they can structure deals with investee companies in whatever way they choose.
Realising successful investments
The April 2003 consultation paper envisaged that any UK variant of the US SBIC model should have a rigid structure for the distribution of the proceeds of the investments by the fund: once a fund had suitable cashflow, the Government loans and the interest on them would be repaid in priority to the repayment of the private investors' capital, then the private investors and the Government would receive a share in the profits.
The December 2003 report acknowledges the dissatisfaction of respondents with such a proposed rigid structure and suggests that applicants for ECFs specify in their bids the method of distributing the proceeds of successful investments. The one overriding principle is that the risk to public funds must not be greater than the level of risk to which the private investor's capital is exposed.
The April 2003 consultation paper proposed that the Government be able to liquidate under-performing funds to re-claim loans. This was not welcomed by the private equity industry as it would be unacceptable to investors.
This subject is not broached in the December 2003 report and it may be that the Government has decided to analyse the outcome of the pathfinder round of ECFs before making specific proposals on this point.
Comparison with SBICs
As discussed, ECFs are adapted from the US SBIC participating securities model. SBICs have been around since 1958. They were overhauled in 1994 - giving SBICs the option of applying for leverage in the form of participating securities, usually preferred limited partnership interests, as well as the traditional debenture interests. SBICs have been particularly successful since this overhaul and are said to have financed around 90,000 US businesses.
Some of the differences between the SBIC regime and the proposals for the pathfinder round of ECFs are highlighted below.
As well as wealthy individual investors, for US regulatory reasons, banks and other institutional investors find it advantageous to invest in SBICs. ECFs are aimed at wealthy individuals.
The criteria for applicant management teams for SBICs are very much based on the past performance of the individuals' funds. Applicants for pathfinder ECFs will not be so strictly assessed on past fund performance - the December 2003 report suggests that for ECFs the emphasis is on the viability of the business plan and the past experience of the fund managers will be an indicator of viability.
Two types of leverage are available to SBICs - debenture leverage and participating securities leverage. Participating securities leverage is only available to funds structured as limited partnerships, the participating securities taking the form of a preferred limited partner's interest. Before 1994 only debenture leverage was available. The structure of the leverage for pathfinder ECFs will be determined by the fund managers in their application.
There is a regulatory capital requirement for SBICs - they must have a certain level of capital commitments from private investors to obtain SBIC status. Currently an SBIC using debentures must have a regulatory capital of at least $5m and an SBIC using participating securities must have a regulatory capital of at least $10m. The pathfinder ECFs will not be subject to such a requirement but the amount of private investor commitments may affect whether a pathfinder ECF application is successful.
SBICs may only invest in "small businesses" (with net worth of less than $18m and average after tax income of less than $6m) and 20% of their total investments must be in "smaller enterprises" (with net worth of less than $6m and average after tax income of less than $2m). Also where the SBIC uses more than $90m leverage, the excess must be invested in smaller enterprises. There are no such guidelines for ECFs. Instead restrictions focus on the amount that can be invested in any one company by an ECF.
An SBIC must follow certain deal structures when investing in companies. Pathfinder ECFs, on the other hand, will be able to structure deals as they wish providing there is an equity element to the deal. However the deal structure will be one of the factors taken into account when the pathfinder ECF application is assessed.
Further details are expected in early 2004. The pathfinder bidding process is due to be launched in Spring 2004 if EU state aid approval is obtained and the Government has also promised an update of the progress and a clarification of the tax treatment of ECFs at the same time.
SJ Berwin is planning a seminar in February or March 2004 on the proposals, aimed at those who may wish to consider bidding in the Spring. This will include perspectives from the US on the SBIC model. If you are interested in attending please let them know.
For further information please call your usual contact at SJ Berwin or Simon Witney on +44 (0)20 7533 2222 or email him at email@example.com. Warning: This bulletin is not intended to offer professional advice and you should not act upon the matters referred to within it without taking specific advice. Copyright 2003 SJ Berwin. All rights reserved.