Scottish Government

CHAPTER FOUR THE MARKET FOR FUNDS

4.1 This chapter considers the overall market for funds and the role played by the venture capital and loan funds. It also reviews the extent of any market failure.

Market for Venture Capital

4.2 In respect of venture capital, the British Venture Capital Association publishes statistics of the amounts of venture capital invested by BVCA members. What is clear is that there is a large variation in the total amount of lending year by year as economic conditions change.

Table 4.1 - Venture capital investments in Scotland (£m)

Source: BVCA

4.3 By comparison, the four ERDF-supported venture capital funds have total public sector resources of just over £50 million for the current programming period. On the assumption that these are invested over a 3 or 4 year period, average annual public sector input is in the region of £13 million to £17 million (clearly, in some years the amount is higher).

4.4 The ERDF-supported funds therefore play a relatively small part in the market overall. However, they play a significant role in early stage financing and an analysis of deals ¹⁰ commissioned by Scottish Enterprise has confirmed their importance. One of the key findings of this analysis was that:

"The Business Growth Fund and the Scottish Co-investment Fund accounted for 7% of total monies invested in Scottish young companies during 2004, yet were represented in 55% of all deals recorded, an increase from 4% of the capital in 44% of all deals recorded in 2003."(Don et Harrison, 2006)

The Market for Loans

4.5 There are no clear statistics on the size of the market for loan finance in Scotland. For the UK as a whole, bank lending to small and medium sized enterprises amounted to £44.3 billion ¹¹, of which £9.1 billion was on overdraft. In addition, it is widely accepted that some bank lending to personal customers is used for business. However, bank lending statistics cover secured and unsecured lending and tell us little about the market for loans for start ups and early stage businesses where there may be a gap in funding. To help such businesses, there is a loan guarantee scheme on a UK wide basis. This scheme provides a guarantee for young companies for 75% of loans up to £250,000 in qualifying sectors, at an annual cost of 2% per annum of the loan. Across the UK as a whole, the loan guarantee scheme provides support for about £250 million ¹² of loans per year.

4.6 In comparison, the loan funds covered in this evaluation can lend approximately £4 million per annum. These funds are small in relation to the market as a whole and are therefore unlikely to displace other lenders.

Sources of Funding for Companies

4.7 Venture capital and loan funds obviously provide only one part of the funding for start up companies. As an example of the diverse sources of funding used by start up companies, our surveys of SCF and WSLF investee companies showed the following results.

Table 4.2 - What sources of funding were used in your business before applying to SCF? (Please tick all that apply)

Source: CSES survey of SCF companies

Table 4.3 - What sources of funding were used in your business before applying to WSLF? (Please tick all that apply)

Source: CSES survey of WSLF companies

Market Failure

4.8 In Scotland, most VCLFs undertook an assessment of the market in the areas they intended to operate in as part of the set up process. The market assessment findings of PSYBT and SCF are particularly interesting. PSYBT carried out market research in 2001 ¹³ which demonstrated that potential businesses were unable to raise funding because of lack of track record, lack of security and the risk profile of the projects. The same research also identified issues relating to the investment readiness of the businesses themselves, which we return to later in this report. The SCF business plan contained information on the market failure which SCF seeks to address. It said that:

"There are a number of market failures present in the equity funding market in Scotland that need to be addressed. In total, it is estimated that there are only about 150-200 deals concluded per year in Scotland vs. around 5,000 propositions for investment." ( SCF Business Plan, 2003).

4.9 The conclusion of these assessments was that a market failure existed and that some public intervention was necessary to ensure a supply of loans or risk capital to enterprises in Scotland. There was evidence of market failure in respect of the supply of small scale loans and risk capital, and a market failure in the supply of venture capital.

4.10 This evaluation provides evidence of market failure both through surveys of investee companies, and through interviews with the financial sector.

Survey of Investee Companies

4.11 In respect of the loan funds, about two thirds of companies reported that no other source of funding was available, or that where other funding existed, more opportunities were nevertheless needed.

Table 4.4 - Reasons for applying for funding (loan funds)
Why did you decide to apply for funding from this fund?

Source: CSES survey of WSLF and PSYBT companies

4.12 There was a greater response from companies in which SCF had invested, with almost all companies reporting that no other source of funding was available, or that where it existed, more was needed.

Table 4.5 - Reasons for applying for funding ( SCF)
Why did you decide to apply for funding from this fund?

Source: CSES survey of SCF companies

4.13 The implication of these responses is that both the loan funds and SCF fill a gap which is not met by other sources including commercial sources. Surveys of the other VCLFs, with smaller numbers of responses, as reported in the fund profiles in the appendices, also support this view.

4.14 An evaluation of WSLF identified why companies approach WSLF for funding. The main reasons identified were that companies did not have collateral (28%), were unable or unwilling to give personal guarantees (25%), were at the limit of their available finance (20%), or did not have a track record (16%).

Interviews with Financial Sector

4.15 As part of the evaluation we carried out a series of telephone interviews with investment partners of the SCF and also with others in the financial sector. The telephone survey of partners gave two principal reasons for bringing the deal to SCF.

4.16 One reason related to the size of deals. Where partners had a limit on their financing available, they wished to participate with SCF in larger deals, thus extending their financial scope. This was the most common reason given by partners. For example, a business angel syndicate commented that for deals above £0.75 million to £1 million it may be more difficult to put together a group of investors. Another investor commented that they normally had an upper limit of £0.5 million. For such investors, the participation of SCF allows the size of deals to be increased.

4.17 A second reason relates to the desire to spread risk. One investment partner said that when it had deals which were not in the sectors it usually operated in, an option it sometimes took was to part finance the deal through SCF. This course of action allows it to limit its exposure to the sector to a level consistent with its policy.

4.18 The discussions with the financial community, and in particular with the investment partners of SCF, suggested that the decline in availability of venture capital in Scotland arising from the effects of the 'dotcom bubble' continues. The investment partners of SCF whom we talked to considered that there is a market failure above the level at which SCF now operates. Most partners said that the investment limit of SCF should be increased, possibly to £5 million, or another vehicle put in place to cover that part of the market. For example, a major investment angel syndicate pointed to lack of capacity to undertake larger deals. The discussions we had are consistent with the detailed market assessment carried out on behalf of Scottish Enterprise by Queens University Belfast and referred to earlier.

New Funds

4.19 At the time of the fieldwork for this evaluation, Scottish Enterprise launched a new fund to address market failures for smaller amounts of loans and risk capital. The 'Scottish Seed Fund', launched in September 2006, provides loans and equity investments from £20,000 to £100,000 to early stage businesses keen to grow and which meet various criteria relating to their size and commercial viability. In October 2006, to address the market failure in larger funds, Scottish Enterprise launched the Scottish Venture Fund, a co-investment fund to provide risk capital for growth oriented companies. The fund provides up to £2 million per transaction for deals between £2 million and £5 million, the remainder coming from co-investment partners.

Summary:

The principal findings of this chapter are that:

• The publicly supported venture capital and loan funds represent a relatively small share of the Scottish market for finance for SMEs, but are important particularly in the area of start ups and high technology developments.
• All the funds carried out an assessment of market failure when they were set up.
• To the extent that this study has been able to address the continuation of market failures, the information we have obtained suggests a market failure both in respect of smaller amounts of funding, and up to £5 million for some types of companies.