DTI invites bids for US-style SBIC funds with a £200m pot

The UK government has released further details on the structure and bidding guidelines for the much awaited Enterprise Capital Funds (ECF), designed to bridge the early stage equity gap that The Chilli has long been campaigning for. We examine the underlying structure and bidding guidelines to see if this will meet the needs of high-technology start-ups (HTSUs).

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The ECF will provide government match funding on a ratio of two to one, which is better than we expected. So for every one pound an angel or a HNWI puts in the ECF, the government will put in two pounds, which will result in a net available fund of three pounds, excluding fund management expenses. The scheme will restrict the amount invested in any one company to £2 million, but may allow this rule to be broken when the ECF equity stake is severely diluted, in which case the ECF will be allowed to invest a maximum of 10% of its fund.

Up to £200 million in government contributions will be made available via ECFs, which are designed to be run on a normal commercial basis, investing a combination of private and public money in small high-growth businesses. There is no theoretical limit on any of the funds, although the government will only put in a maximum amount of £25 million in any one fund, suggesting that the number of pathfinder funds will be between three and five.

The ECF proposals are based on a variant of the Small Business Investment Company (SBIC) programme that has operated in the United States for the past 45 years. As highlighted in many articles in The Chilli, the US SBIC programme has supported the early growth stage of companies such as FedEx, Apple, Intel and AOL.

The ECFs will operate on a normal commercial venture capital funds basis, with the objective of investing in enterprises that are expected to make positive financial returns. It is envisaged that if successful, the government will launch further such funds in the future.

Prospective ECF fund managers have eight weeks to prepare detailed bids, showing their investment strategies and how they will target their activities towards small and medium sized businesses in filling the equity gap. They will also need to demonstrate their skill and experience in identifying and helping such companies.

Prospective bidders are advised that they have until 16 September 2005 to submit their bid and the winners will be announced before year end, with detailed due diligence complete by summer of 2006. First investments in SMEs will not take place prior to this.

Bids will be assessed by the Capital for Enterprise Board, an independent body of industry experts appointed by the Small Business Service, who will make recommendations to the government.

The industry minister Mr. Alan Johnson said, “Successful bidders will be able to use the government scheme to attract private capital. The government will provide up to twice the amount of private money committed to each fund, taking a modest share of the profit.”

David Quysner, chairman of the Capital for Enterprise Board said, “A great deal of consultation and groundwork has gone into developing this initiative. ECFs will fulfil a genuine need by addressing a market gap in the availability of equity finance. I am pleased to be involved at an early stage in this innovative programme, which I am confident can make an important contribution to the availability of funding for SMEs.”

The Chilli perspective:
Entrepreneurs will have to wait until summer of 2006
The ECF scheme has been dragging on since the April 2003 publication of ‘Bridging the finance gap: a consultation on improving access to growth capital’. The new scheme follows the required European Union state aid clearance, which was granted by the EU's competition authorities on 3 May 2005.

The bidding guidelines for ECF expect applicants to decide on the investment strategy, as to whether it will focus on early stage, or a particular sector or region. This is disappointing, as we expected the government to take a lead role and provide direction towards the high growth technology sectors, where there is severe drought of early stage funding. Lack of direction may mean that ECF funds could end up funding pizza parlours and retail outlets, hardly a way of encouraging high growth technology companies and the subsequent rise in productivity.

Lack of specific prohibition may mean that public funds will be used for possible management buyouts in the SME sector, as opposed to funding early stage high growth technology companies. The MBO sector doesn’t need any public support, as that part of the private equity market is well served already.

The proposed ECF has no specific tax incentives, as the government doesn’t want to re-direct tax incentivised funds away from VCT and EIS schemes. Whether this will discourage or motivate many angels and HNWIs remains to be seen. The government will not entertain propositions from funds that have already raised sufficient capital and can operate as commercially viable funds.

The ECF funds will not be evergreen, and will have a lifespan of 10 years. The funds will return any exit gains back to the investors, according to an agreed formula, and will not re-invest the money back into the fund.

As for returns, the government expects to take the first bite of any returns, by charging all outstanding interest rate. In the second bite, all original capital is returned back to both private and public investors; after that, minimum hurdle rates are paid out before any carry (remaining profit after all the previous amounts are paid up) is spread between the government, private investors and fund mangers.

The government is asking bidders to propose how this remaining carry will be split amongst the parties. This will present bidders with great difficulties, as there is no previous precedence, although the small business website (SBS) has some illustrative examples which may or may not act as guide.

The government keeps highlighting the need for getting a good return on its portion of the ECF, but it should also bear in mind that it is precisely this position by existing funds that has created the market failure in the first place. It should look at wider non IRR benefits as well.

All in all, giving due consideration to the points highlighted above and the time taken, there is a great urgency to fixing the market failures of early stage technology funds. We hope that the selection committee will bear this in mind, and not worry too much about protecting vested interests from a bit of real competition.

The SBS has published detailed guidance to assist those wishing to bid for these funds. Interested parties can download the guidance from http://www.sbs.gov.uk/financegap.

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