Business and Industry. Evaluation of ERDF Supported Venture Capital and Loan Funds

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Evaluation of ERDF Supported

Venture Capital and Loan Funds

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EVALUATION OF ERDF SUPPORTED VENTURE

CAPITAL AND LOAN FUNDS

Scottish Government Social Research

2008

Centre for

Strategy & Evaluation

Services

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This report is available on the Scottish Government Social Research website only www.scotland.gov.uk/socialresearch.

© Crown Copyright 2008

Limited extracts from the text may be produced provided the source is acknowledged. For more extensive reproduction, please write to

the Chief Researcher at Office of Chief Researcher, 4th Floor West Rear, St Andrew’s House, Edinburgh EH1 3DG

The views expressed in this report are those of the researchers and do not necessarily represent those of the Directorate or

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CONTENTS

SUMMARY 1 CHAPTER ONE: INTRODUCTION

Study aims

Structure of the report

10 10 10 CHAPTER TWO: METHODOLOGY

Approach Interview Programme Evaluation Framework 12 12 13 13 CHAPTER THREE: OVERVIEW OF FUNDS

Policy Background EU Policy Developments

Developments in Scotland

Fund Covered by this Evaluation

Geographical Coverage and Objectives of currently operating VCLFs Fund Investment Policy

Financial Resources 14 14 14 15 16 16 17 20 CHAPTER FOUR: THE MARKET FOR FUNDS

Market for Venture Capital The Market for Loans

Sources of Funding for Companies

Market Failure New Funds 22 22 22 23 23 25 CHAPTER FIVE: INVESTMENT PERFORMANCE – LOAN FUNDS Rates of Investment of Funds

Sectoral Analysis of Investments

Non-Performing Loans

28 28 29 30 CHAPTER SIX: INVESTMENT PERFORMANCE EQUITY FUNDS

Rates of Investment

Cash Resources

Sectoral Analysis of Investments Fund Financial Performance

Benchmarking Fund Returns

32 32 33 34 35 35 CHAPTER SEVEN: OPERATIONAL COSTS

Loan Funds

Venture Capital Funds

38 38 38 CHAPTER EIGHT: ECONOMIC EFFECT

ERDF Performance Measures

Investment per Job or Unit of Turnover

39 39 40

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Costs per Job or Unit of Turnover

Venture Capital Effect on Investee Companies Loan Fund Effect on Companies

41 42 44 CHAPTER NINE: ADDITIONALITY AND DISPLACEMENT

Approach

Additionality – Loan Funds

Additionality – Scottish Co-Investment Fund Additionality – Other Venture Capital Funds Displacement

SCF Investment Partners

Displacement between Funds

46 46 46 48 49 49 50 50 CHAPTER TEN: CONCLUSIONS AND RECOMMENDATIONS

Conclusions

Recommendations

52 52 56

ANNEX A: FUND PROFILE – SCOTTISH CO-INVESTMENT FUND ANNEX B: FUND PROFILE – SIGMA INNOVATION

ANNEX C: FUND PROFILE – SIGMA SUSTAINABLE ENERGIES ANNEX D: FUND PROFILE – GENOMIA

ANNEX E: FUND PROFILE – WEST OF SCOTLAND LOAN FUND

ANNEX F: FUND PROFILE – WEST OF SCOTLAND REGENERATION FUND ANNEX G: FUND PROFILE – SOUTH OF SCOTLAND LOAN SCHEME ANNEX H: FUND PROFILE – MICRO CREDIT EAST

ANNEX I: FUND PROFILE – PSYBT ANNEX J: INTERVIEW LIST

ANNEX K: SCF INVESTMENT PARTNERS ANNEX L: INVESTMENT READINESS ANNEX M: ERDF APPLICATIONS

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LIST OF TABLES / CHARTS

Figure 2.1 – Overview of Methodological Approach/Work Plan Table 2.1 – Survey Results

Figure 2.2 – Evaluation framework Figure 3.1 – SME financing stages

Figure 3.2 – VCLFs included in this Evaluation Table 3.1 – Overview of VCLFs

Table 3.4 - Fund Resources during life of ERDF Programming Period, £’000 Table 4.1 – Venture capital investments in Scotland (£m)

Table 4.2 – What sources of funding were used in your business before applying to SCF?

Table 4.3 – What sources of funding were used in your business before applying to WSLF?

Table 4.4 – Reasons for applying for funding (loan funds) Table 4.5 – Reasons for applying for funding (SCF) Table 5.1 – Rate of investment of ERDF loan funds Table 5.2 – Cash resources of loan funds (£’000)

Table 5.3 – WSLF sectoral analysis of investments (larger sectors only) Table 5.4 – WSRF sectoral analysis of investments (larger sectors only) Table 5.5 – Fund financial performance

Table 6.1 – Equity fund investments Table 6.2 – Analysis of SCF investments

Table 6.3 – Sectoral analysis of SCF investments

Table 6.4 – Sectoral analysis of Sigma Innovation investments

Table 6.5 – Pooled IRRs of European Venture Capital and Private Equity Funds

Table 6.6 – J curve effect showing relationship of IRR to period of investment Table 7.1 – SCF Management Costs

Table 8.1 – ERDF performance measures

Table 8.2 – Investment per job or unit of turnover

Table 8.3 – Changes in turnover/employee numbers since SCF invested in business

Table 8.4 – What has been the impact of this funding on the operation of your business?

Table 9.1 – DSL’s survey of customers for additionality Table 9.2 – WSLF’s survey of customers for additionality

Table 9.3 – Why did you decide to apply for funding from the WSLF?

Table 9.4 – What would have happened if funding from this fund had not been available?

Table 9.5 – SoSLS – effect of not obtaining finance Table 9.6 – PSYBT – effect of not obtaining finance

Table 9.7 – SCF - Why did you decide to apply for funding from this fund? Table 9.8 – SCF - What would have happened if funding from this fund had not been available?

11 11 12 13 15 15 19 21 22 22 23 23 27 28 28 29 29 31 32 33 33 34 35 38 39 40 41 43 45 46 46 46 46 47 47 48

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LIST OF ABBREVIATIONS

BVCA British Venture Capital Association

DSL Developing Strathclyde Limited

ERDF European Regional Development Fund

ESEP East of Scotland European Partnership

PSYBT Prince’s Scottish Youth Business Trust

SCF Scottish Co-Investment Fund

SE Scottish Enterprise

SEP Strathclyde European Partnership

SOSEP South of Scotland European Partnership

SoSLS South of Scotland Loan Scheme

VCLF Venture Capital and Loan funds

WSLF West of Scotland Loan Fund

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SUMMARY

1. This study is an evaluation of ERFD supported venture capital and loan funds in Scotland, including the Scottish Co-Investment fund. The study provides a fund level performance appraisal, and information on the effect on companies in which the fund has invested. It also considers the economic effect of the funds and the affect on the market for finance in Scotland.

2. The study is based on surveys and interviews mainly carried out in 2006, although certain data in the main report has been updated during 2007.

The policy background

3. Access to risk finance is important to the development of SMEs, but early stage financing is often less attractive to commercial investors for a number of reasons. For example, a bank may be unwilling to provide finance to an SME because of a lack of a track record, inadequate security, breach of a standard threshold limit, or a credit rating outside an acceptable range. In addition, as the size of investments falls, so the costs of administering investments become relatively more significant. There is therefore a potential failure of the market to provide for the financing needs of SMEs at an early stage.

4. The policy response at both EU and national level has been to seek to develop of cost-effective means of addressing this potential market failure. The development of measures such as revolving loan funds and venture capital funds has been encouraged at both a national level and by the European Commission as an alternative to grants. Across the EU, during the 1994-99 ERDF programming period, VCLF measures accounted for some €570m and this had doubled to an estimated €1,256m in the 2000-06 period. The Regulations for the current (2007-13) Structural Fund programming period continue this emphasis. In addition, there are specific arrangements for VCLFs to be managed by the European Investment Fund (EIF) in the current programming period if Managing Authorities so request.

5. ERDF supported VCLF instruments have been made available in Scotland during both earlier Structural Fund programming periods and continue into the 2007-13 period. Based on an assessment in 1995/96 that there was a continuing market failure in the supply of debt funding up to a level of £250,000, three funds were established. And an evaluation carried out in 2002 found that they “had facilitated better business propositions and ensured larger turnovers than would otherwise have been achieved”.

Fund Covered by this Evaluation

6. During the 2000-06 programming period, a number of new funds were established and it is mainly these funds that are the subject of this evaluation (although some funds, like WSLF and DSL were established earlier). The funds include both loan and equity funds. Equity funds, in turn, include both directly managed funds, where the fund is under the control of a professional investment manager, and a co-investment fund, where the fund appoints private sector partners who introduce deals.

7. The table below summarises the objectives, type of investment (equity or loan), the maximum fund investment level, and the geographical coverage (highlighted) of each of the VCLFs covered by the evaluation.

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Overview of VCLFs

Geographical coverage

Fund Objective Max fund

investment East West South

Equity funds (co-investment)

SCF Growth companies £500,000

Equity funds (managed) Sigma

Innovation

Innovation and early stage (not seed or pre-seed) companies with high growth potential and capacity for job creation

£300,000

Sigma Sustainable Energy

Early and development stage in sustainable or renewable energy technologies in East of Scotland

£500,000

Early stage risk capital (managed) Genomia To commercialise university research, support

spin-outs and creation of IP at Public Sector Research Establishments (PSREs) in animal health and the life sciences.

£250,000

General loan funds

WSLF All qualifying sectors £50,000

WSRF All qualifying sectors, with a concentration on start up companies

£1,000 to £30,000 (first loan)

SoSLS Growth companies £50,000

Loans - Micro credit Micro Credit

East

All qualifying sectors (now through ESF) £5,000 Loans - Younger applicants

PSYBT All qualifying sectors, applicant under 31 £25,000

In addition, there are several other funds which do not take on new business because they have been revolved into one of the above funds.

The market for finance

8. The four ERDF-supported venture capital funds (the top four in the table above) 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), compared to annual venture capital investments in Scotland which vary between £100m and £400m, depending on economic conditions. 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 commissioned by Scottish Enterprise has confirmed their importance.

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9. 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.

Conclusions

10. We now summarise the main conclusions of the evaluation under the headings of relevance, effectiveness, coherence and synergies, impact and added value and sustainability. A brief explanation of each of these issues is also shown.

Relevance (The extent to which the fund objectives are relevant to economic development in Scotland given policy priorities and the key issues relating to the prevailing economic and financial environment generally).

11 Most VCLFs undertook an assessment of the market in the areas they intended

to operate in, as part of their set up process. 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.

12 The research we have carried out confirms the view that ERDF-supported

VCLFs have addressed areas of continuing market failure. Discussions with the financial community, and with the investment partners of SCF, suggest 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 have talked to consider 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. The recent launch of the Scottish Venture fund provides such a vehicle.

13 It is clear that the co-investment fund model helps develop the local financial

community. Discussions with investment partners include the major business angel

syndicates who commented on the beneficial effect of SCF on their operation. The availability of public sector match funding increased the deal capacity of syndicates. Coupled with other public assistance in the running of syndicates, the result has been a strong syndicate network, particularly in the East of Scotland, with newer developments in the West. And some of the investment partners of SCF were not previously involved in company finance in Scotland.

14 In respect of SCF, additionality can be considered both from the point of view of

the enterprise in which the investment is made, and from the point of view of the investment partner. Investment partners of SCF only bring to SCF the share of those deals which they cannot finance themselves. The reason for bringing deals to SCF is often a lack of financial capacity to meet the whole of the deal, or a desire to spread risks. Such reasons imply additionality – the deals would not be entered into fully if SCF was not there. From the point of view of the enterprise, the structure of SCF makes it more difficult to measure additionality using normal techniques. This is because the enterprise will typically approach a number of private sector funders and from its point of view the effect of SCF is to improve the demand side, rather than to provide a “lender of last resort”.

15 The survey evidence suggests high additionality from SCF. Our survey of investee

companies showed that no other funding was available (28%) or that whilst some other funding was available more was needed (64%). In most cases companies said that their

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investment could not have gone ahead without funding (25%) or would have gone ahead on a smaller scale (70%). The number of investments in the other equity funds is small but the survey evidence on additionality, based on the small numbers, shows a similar position.

16 Loan funds seek to operate on a lender of last resort principle. Their application

procedures include a requirement that the lender should demonstrate that they have sought commercial funding and have not obtained such funding. To this extent, the additionality of investments by loan funds should be high because the funds are making loans which would not otherwise be made. Most previous evaluations of the various loan funds have shown high levels of additionality, although a small survey of SoSLS investee companies showed lower additionality. For example, an external evaluation of WSLF suggesting that additionality exceeded 70% and high levels of additionality were also supported by our surveys. For example a small survey of PSYBT showed full and partial additionality in 13 out of 14 cases.

17 The issue for the loan funds is to find investments which are of sufficiently high

quality so that they are likely to be able to meet repayments, but not so high as to include enterprises which could be financed commercially. Most loan funds take security (even if it is just a floating charge) and their terms are marginally better than commercial lenders. The loan funds could increase additionality by taking on worse risks – but this may be at the expense of the sustainability of the fund. Additionality, by itself, may not be a good measure without an understanding of the investment policy of the fund.

18 All VCLFs have explicitly addressed the issue of displacement in their ERDF

funding applications to demonstrate how they comply with state aid rules. Displacement can take place at various levels. The setting up of ERDF supported VCLFs may displace existing providers of such funds and the provision of public funding to enterprises may displace competitors who do not receive such funding. The latter point is, however, covered by EU state aid rules.

19 The structure of the venture capital funds set up under ERDF funding means

that it is unlikely that significant displacement effects will occur. SCF, for example, is likely to enhance the market rather than to displace other providers because it only invests in deals that are brought to it by other venture capitalists. Indeed, if SCF is financially successful, it may have a demonstration effect which could encourage venture capital firms to return to the Scottish market. A similar position exists for the other larger funds, in particular the Sigma funds, which are invested in conjunction with existing providers.

20 In respect of loan funds, the policy is to concentrate on lenders who have not

been able to obtain funding from any other source. As indicated above, it is a specific requirement of these funds that the applicant is able to demonstrate that he has not been able to obtain funds elsewhere. As a result, it is unlikely that there will be significant displacement effects towards other loan providers since those other providers obtain a chance of the more attractive deals on a commercial basis.

21 At a company level there is more likelihood of displacement by loan funds than

equity funds. Most of the equity funds invest in early stage businesses, generally in new markets. In such circumstances there is less likelihood of displacement at the company level, because markets are growing. On the other hand, the loan funds often lend to established businesses, later in their life cycle. For these investments, the likelihood of displacement of a competitor is higher. But we do not have evidence on actual levels of displacement.

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Effectiveness (The extent to which the funds are achieving their targets. There are a number of critical factors in this respect – the quality and quantity of resources, the extent to which outcomes are relevant (see above), how effectively the funds meet their objectives).

22 The VCLFs all have targets for the rate at which they invest funds, in particular

ERDF funding where there are time constraints. The rate of investment of SCF is lower in the West of Scotland than in the East. Because ERDF funding has been provided to SCF for venture capital purposes, it cannot be decommitted. If the investment allocated to SCF is not utilised by the end of 2008, then there is a danger that some ERDF funding may be lost. In the South of Scotland, the planned funding to be allocated to SCF was reduced from £2 million to £1.5 million, but in the West of Scotland the commitment has taken place and cannot be reversed.

23 SCF recognises the need to increase the deal flow in the West of Scotland and

commissioned a study to consider the reasons for the low deal flow. An important recommendation was that investment readiness of companies should be improved, and that in particular links between advisers and SCF should be improved so that there is a larger and better deal flow from the advisers.

24 The West of Scotland based loan funds have generally met their investment

targets, although the targets increase over time and substantial funds remain to be

invested. Updated information suggests that for WSLF, commitments are failing to meet

these increasing targets.

25 In the South of Scotland, there has been some decommitment of money made

available to loan funds and it is understood that a further decommitment is planned. As noted below, the main loan fund now operating, SEBSED, has a substantial cash balance. We consider separately the economic effects of the funds later in this section.

Economy and Efficiency (The costs of managing, administering and operating the funds and whether the resources used to operate the funds could be used more efficiently to produce similar results at lower costs).

26 The operational costs of the loan schemes appear at first sight much higher than

those of the venture capital schemes. The loan schemes’ direct costs are in the region of 10% to 15% of gross new loans and in addition some external support is provided by local authorities and Business Gateways. The deal size of loans is, of course, much less than that of the venture capital funds.

27 The direct annual costs of the venture capital funds are in the region of 3% to

6% of gross investment. Costs for SCF are higher in the initial stages because of the fee of 2.5% or 3.5% paid to partners. As the fund is fully invested, costs should drop. For Sigma managed funds, it must be appreciated that these costs will continue over the life of the investment. An annual fee of 3% will amount to approximately 20% of gross investment for an investment held for (say) six years. The SCF model appears to be cost-effective from a management point of view.

Coherence and synergies (From an internal perspective, how funds relate to other public sector and private initiatives. Externally, the question is the extent to which there is overlap between funds, or the degree to which particular markets are not met by them).

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28 The portfolio of VCLFs supported by ERDF funding includes the provision of risk capital through equity funding:

• Equity funding, up to a deal size of £2 million, throughout Scotland

• Risk capital funding, at start-up or proof of concept stage, in the East of Scotland

• Loan funds, directed at existing and new businesses, in the West of Scotland

• Loan funds directed at growing businesses, in the South of Scotland

• Specialist funds, including Micro credit in the East of Scotland and a small element of finance for young people.

29 It is clear that there are gaps in the funds that are being offered. When we

carried out our fieldwork in 2006, the gaps included equity funding above the £2 million deal size level. This gap has of course been addressed to a large extent with the launch of new funds at the end of 2006. There are also geographical gaps in the provision of general loan funding in the East of Scotland, and micro finance, although our work did not provide evidence of unmet demand for general loan funds or micro finance.

30 In terms of the coherence of the various funds, it is necessary to consider

whether there is any displacement effect between the funds, for example between some of the loan funds and the venture capital funds or between loan funds. There is clearly some overlap between WSLF and WSRF, although there appears to be adequate demand for their loans. To consider a possible overlap between WSLF and SCF, we looked at the sectors in which each invests and the size of the investments. This analysis did not suggest any significant overlap.

Impact and added value (What effect the funds have overall on the Scottish economy).

31 The ERDF-supported funds play a relatively small part in the Scottish market

overall, both in respect of loan financing and equity financing. However, they play a significant role in early stage equity financing, where the total market in Scotland has averaged about £20m per year in the period covered by this evaluation. In that context, SCF’s total public sector resources of £43m (not all early stage) are significant.

32 Overall, the funds considered in this evaluation have invested in more than 350 new businesses, 700 existing businesses and created more than 5300 new jobs. But as indicated above, a more important long term effect is likely to be the development of the financial community, particularly the development of angel syndicates and the encouragement of new lenders to enter the Scottish market

33 All funds which are supported by ERDF funding have a series of targets which

correspond with the requirements of the ERDF. These targets include various measures related to the horizontal themes in ERDF funding for the current programming period, for example equal opportunities. They also include more general targets, in particular targets such as the number of new businesses receiving support, existing businesses receiving support, number of jobs created, number of jobs saved and increases in turnover of businesses. However, these targets are not necessarily appropriate to fund investing for the long term in hi-tech companies.

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34 It appears that the equity funds have a greater effect on turnover and the loan funds have a greater immediate effect on jobs. This result would be consistent with the targets set for the different types of fund. At this stage it is not possible to estimate a cost per job or unit of turnover. However, for the equity funds, to the extent that they are profitable, such a calculation is meaningless because there is no ‘cost’. The loan funds have made estimates of investment per job, in the region of £6,000 - £7,000 for WSLF. Again, because of the recycling effect, the cost will be nil or small.

Sustainability (Whether the funds are likely to be self-sustaining in the longer term without the need for continuing public support, or with lower amounts of public support. Given the relatively early stage of development of some funds it may be difficult to arrive at conclusions in this area at this stage).

35 One of the principles underlying the creation of loan and risk capital funds using

ERDF money is to create sustainable funds. Several of the loan funds – in particular the WSLF and SEBSED have substantial cash balances. It appears that those cash balances are sufficient for the funds to operate for some considerable time without further public funding.

36 Other funds are at an earlier stage and it is not yet clear from outcomes when or

whether they will be self-sustaining. The target rates of return for SCF of 20% would strongly suggest that this fund should become self-sustaining in the long term. However, it is too early in the fund’s life to know whether this will in fact occur. The fund has incurred losses on some initial investments and at the beginning of August 2006 seven companies had ceased trading, representing some 6% of SCF investments to date. Such a rate of loss is not unexpected at this stage and not yet out of line with the results of other funds.

37 SCF is under-committed in the West of Scotland until the end of 2008 (the issue

is the availability of deals), so it will not need immediate new funds from the next programming period in those areas. Typically, realisations from the initial investments might provide cash flow 6 to 10 years after investment. So there is a period during which SCF is likely to require some further support from the next round of ERDF financing to sustain its planned rate of operation.

38 Many early stage funds, and micro loan funds, are less likely to be self-sustaining

because of the relatively high cost of administration relative to the sums invested. A recent survey by DG ECFIN at the European Commission showed that over 10 years, European early stage funds had an IRR of only 1.3% (the figure over 20 years was 1.9% and in earlier years it was negative). It is likely that such funds will require further support to continue.

Recommendations

39 Our recommendations are divided into policy recommendations, in respect of the future of the VCLFs, and more specific recommendations relating to the operation and management of the funds.

Policy recommendations

40 We suggest that the primary focus of future funding should be directed at the

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• Providing funding for the continuing operation of SCF, or alternative venture capital funds, subject to satisfactory financial performance which should be monitored as shown below. If the fund meets its targets it should become self-sustaining after the 2007-2012 period of ERDF funding.

• Providing funding, subject to other priorities, to cover the gap between the £2 million and £5 million deal size levels (during the period of our work, another planned fund in this area was launched).

• Continue to provide finance to special groups such as PSYBT, where results appear good.

41 To allow funding to be concentrated on good prospects which are likely to help

the Scottish economy, geographical restraints on the allocation of funding should be removed. We understand that this is consistent with the proposals of the next period of the regional funds programming.

42 A lower priority should be given to the provision of further money into loan

funds. These loan funds have, in several cases, now reached the stage where they appear to be self-sustaining. Should the funds cease to be self-sustaining, the issue should be looked at again and a comparison made of their costs against alternatives.

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CHAPTER ONE

INTRODUCTION

Study Aims

1.1 The objectives of the study, as set out in the terms of reference, were to:

• Undertake a fund level performance appraisal, including an analysis of outcomes, returns to investment (bearing in mind that with only a few years of operation these may be thin on the ground) and an assessment of the management and governance of the funds.

• Assess the firm level impacts, including on turnover, productivity and employment. Employment growth ought to be assessed in the context of the funds enabling additional performance improvements within a business, rather than looking at the numbers of jobs created alone. There is also a need to understand the additional benefits brought by the funds so investigation and estimation of additionality/deadweight and displacement can be undertaken (using HM Treasury Green Book guidelines).

• Assess finance market outcomes, in particular the extent to which the creation of these funds has increased the supply of finance, levering in additional investment as opposed to simply acting to crowd out other finance.

• Consider local economy impacts, reflecting the regeneration emphasis of some of the funds.

1.3 In addition, given the overlapping nature of the funds, consideration needs to be given to how they act together and interrelate. For example, the comparison between the West of Scotland Co-investment Fund, and the separately VCLF-funded West of Scotland Loan Fund - do they complement each other, or is there some duplication of effort or crowding out? Where investment through either loan or equity funding is offered, do companies choose the easiest option or do they assess the long-term benefits / impacts of each course of action? Structure of the Report

1.4 This report is structured as follows:

Chapter 2 summarises the methodology and the approach to the evaluation.

Chapter 3 provides an overview of the various funds, and their objectives and coherence. Chapter 4 deals with the overall market for funds, and the evidence of market failure. Chapter 5 considers the investments of the loan funds and the respective fund performance.

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Chapter 6 considers the investments of the equity-based funds and information on performance.

Chapter 7 compares the management costs of the funds. Chapter 8 examines the economic effect of the funds. Chapter 9 estimates additionality and displacement. Chapter 10 sets out the conclusions and recommendations.

1.5 The report is supported by annexes providing a profile for each of the active funds. We also include a list of investment partners of the SCF and a list of interviews.

1.6 The study is based on surveys and interviews mainly carried out in 2006, although certain data in the main report has been updated during 2007.

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CHAPTER TWO

METHODOLOGY

Approach

2.1 Below, we summarise the overall approach that was adopted to carrying out the assignment.

Figure 2.1 - Overview of Methodological Approach/Work Plan

Phase 1 Phase 2 Phase 3

Inception phase

Inception phase Fieldwork, including Survey and Interviews

Fieldwork, including

Survey and Interviews Workshop & Final Workshop & Final ReportReport ƒ Set up meeting

ƒ Desk research ƒ Initial interviews ƒ Finalise

methodology

ƒ Analysis of fund and company data ƒ Interviews ƒ Survey of beneficiaries ƒ Survey of rejected applications ƒ Analysis of research findings

ƒ Draft final report ƒ Discussion workshop

Inception Report Interim Report Final Report

2.2 The fieldwork part of this evaluation included:

• An analysis of data on performance at the fund level

• An analysis of investments made by the various VCLFs

Surveys of companies to add to the data held by fund managers and data contained in

monitoring reports and evaluations of the various funds

Interviews with the respective fund managers, the Scottish Government and local

authorities/agencies and with other interested parties and stakeholders including those in the financial sector, and with some investee companies.

2.3 We carried out surveys at a company level for a number of the VCLFs. The table below shows the methodology applied for each survey (these differed slightly from fund to fund) and the response rate.

Table 2.1 – Survey Results

Fund Approach Companies

surveyed

Responses % response SCF Survey sent by CSES by email to all live

investees, with response to CSES by completion of on line questionnaire, or by email

86 40 46%

WSLF Survey sent by fund manager with target of 100 usable responses to be returned to him

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Fund Approach Companies surveyed

Responses % response PSYBT Survey sent by fund manager, with paper

responses to CSES

76 15 20%

Sigma Innovation

Survey sent by fund manager, with paper responses to CSES

11 5 45%

2.4 In addition, we surveyed Micro Credit East investments (there were only 2, both of which responded) and the remaining Sigma and Genomia investments (the number is small). It had been planned to carry out a survey of rejected applicants but this was only possible in respect of the Sigma funds (two responses were obtained). Other funds had recently been subject to evaluations which provided survey data. In the case of the WSLF, our survey complemented a large earlier evaluation survey which also provided additional data.

Interview Programme

2.5 The Phase 2 interview programme was carried out on a face-to-face basis supported by telephone contacts. Annex J lists the interviews which were carried out with fund managers, local authorities and agencies and officials from the Scottish Government. We also included 10 SCF investment partners in the scope of our interviews, together with 5 interviews with investee companies.

Evaluation Framework

2.6 The evaluation questions to be considered were defined using the framework outlined below. The section of the report containing the evaluation conclusions is also structured on this basis.

Figure 2.2 – Evaluation framework

Overall Framework - Evaluation of Venture Capital Funds

Relevance – the extent to which the fund objectives are relevant to economic development in Scotland given policy priorities and the key issues relating to the prevailing economic and financial environment generally.

Economy and Efficiency – the costs of managing, administering and operating the funds and whether the resources used to operate the funds could be used more efficiently to produce similar results at lower costs.

Effectiveness – the extent to which the funds are achieving their targets. There are a number of critical factors in this respect – the quality and quantity of resources, the extent to which outcomes are relevant (see above), how effectively the funds meet their objectives.

Coherence and synergies – from an internal perspective, how funds relate to other public sector and private initiatives. Externally, the question is the extent to which there is overlap between funds, or the degree to which particular markets are not met by them.

Impacts and added value – what effect the funds have overall on the Scottish economy.

Sustainability – whether the funds are likely to become self-sustaining in the longer term without the need for continuing public support, or with lower amounts of public support. Given the relatively early stage of development of some funds it may be difficult to arrive at conclusions in this area at the current stage.

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CHAPTER THREE

OVERVIEW OF FUNDS

3.1 This chapter provides an overview the policy background to the development of ERDF-supported VCLFs. The funds covered by this evaluation are then listed and information provided on fund investment policy and on financial resources. The coherence between funds and whether there are any gaps or overlaps between them is also considered. Policy Background

3.2 As SMEs start up and grow, their financing needs and sources change. A typical pattern is shown in the following table, reproduced from the ‘Guide to Risk Capital Financing in Regional Policy’ prepared for the European Commission.

Figure 3.1 – SME financing stages

Financing sources of SMEs by stage of development

Seed stage Informal equity from founder and associates. Bank loan if available and needed Start-up stage Informal equity from founder and associates and contacts including business angels.

Bank loan if available. Leasing for equipment

Expansion stage Equity from original sources, plus trade investments or venture capital. Loans from bank. Other sources of finance including leasing and factoring

Replacement Capital

Trade investment, venture capital or IPO

3.3 Early stage financing is often less attractive to commercial investors for a number of reasons. For example, a bank may be unwilling to provide finance to an SME because of a lack of a track record, inadequate security, breach of a standard threshold limit, or a credit rating outside an acceptable range. There is therefore a potential failure of the market to provide for the financing needs of SMEs at an early stage.

3.4 In addition, as the size of investments falls, so the costs of administering investments become relatively more significant. This is particularly true in the micro credit field where the relatively high administration costs make the market unattractive to commercial operators, thus compounding the risk of market failure.

EU Policy Developments

3.5 Policymakers at both an EU and national level have sought to develop cost-effective means to address this potential market failure. The development of measures such as revolving loan funds and venture capital funds has been encouraged at both a national level and by the European Commission as an alternative to grants. During the 1994-99 Structural Fund programming period, VCLF measures accounted for some €570m (2.7% of the total support to SMEs)1. In the 2000-06 period, it had increased to an estimated €1,256m2. In the UK as a whole, funding for VCLFs was €66m in the earlier period and €360m in the 2000-06 period.

1 Ernst & Young (1999), Impact of the Structural Funds on SMEs 2 Based on returns to DG Regio by Member States, as analysed by CSES

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3.6 According to DG REGIO, there are a number of key reasons why VCLF instruments are a useful alternative or adjunct to grant aid. More specifically, they:

• Target commercially viable investments providing long-term sustainable financing to meet SMEs’ needs

• Contribute to developing a new culture amongst entrepreneurs with less of a grant dependency

• Optimise the use of scarce funding resources for sustainable SME development

• In addition, VCLF instruments are well adapted to the requirements of the Lisbon/Growth and Jobs Agenda as they can be specifically focused on the creation of business and employment in high added value activities and sectors.

3.7 The 2000-06 Structural Fund Regulations placed increased emphasis on the use of VCLF instruments as a more cost-effective and sustainable public policy instrument than traditional grant-based aid. The Regulations gave Member States the option of providing an additional 10% of assistance to SMEs for those parts of an investment project funded in other ways than by grant aid. The Regulations for the current (2007-13) Structural Fund programming period continue this emphasis. In addition, there are specific arrangements for VCLFs to be managed by the European Investment Fund (EIF) in the current programming period if Managing Authorities so request. VCLF instruments must also meet criteria established by the Commission to ensure that any state aid element is compatible with the Common Market.3

Developments in Scotland

3.8 ERDF supported VCLF instruments have been made available in Scotland during both earlier Structural Fund programming periods and continue into the 2007-13 period. Based on an assessment in 1995/96 that there was a continuing market failure in the supply of debt funding up to a level of £250,000, 3 funds were established. The Strathclyde Investment Fund was established in the West of Scotland and two funds, Eastern Scotland Investments (ESI) and Edinburgh Technology Fund (ETF), were established in the East of Scotland. ESI and ETF made their initial investments in 1999 and an evaluation published in July 2001 found that they “had facilitated better business propositions and ensured larger turnovers than would otherwise have been achieved”.4

3.9 During the 2000-06 programming period, a number of new funds were established and it is mainly these funds that are the subject of this evaluation (although some funds, like WSLF and DSL were established earlier). The funds include both loan and equity funds. Equity funds, in turn, include both directly managed funds, where the fund is under the control of a professional investment manager, and a co-investment fund, where the fund appoints private sector partners who introduce deals.

3 The current regulations are contained in Commission Regulation (EC) No 1628/2006 of 24 October 2006 4 Firn Crighton Roberts (2001), Evaluation of Effectiveness of ESEP Risk Capital funds

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Fund Covered by this Evaluation

3.10 The table below shows the VCLFs that were included in the scope of the current evaluation:

Figure 3.2 – VCLFs included in this Evaluation Funds included in this evaluation Equity funds – Co-investment

• Scottish Co-Investment Fund

Loan funds

• West of Scotland Loan Fund

• West of Scotland Regeneration Fund

• South of Scotland Loan Scheme

• PSYBT Growth Fund

• Micro Credit East (substantially closed) Equity funds – Managed

• Sigma Sustainable Energies Fund

• Sigma Innovation Fund

• The Genomia Fund

Superseded funds

• Dumfries & Galloway Business Loan Scheme

• Finance for Business (Scottish Borders)

3.11 Of the above funds, the Dumfries & Galloway Business Loan Scheme and Finance for Business (Scottish Borders) (the “New Ways” fund) have now ceased to take new business and have been incorporated into the South of Scotland Loan Scheme (SoSLS). Both PSYBT and Micro Credit East had small financial resources. Micro Credit East is now administered in conjunction with ESF funding. Accordingly, much of our evaluation work has concentrated on the other VCLFs listed above. However, to the extent that the smaller funds meet the demands of a niche sector not elsewhere covered, they were considered as part of the overall evaluation.

Geographical Coverage and Objectives of currently operating VCLFs

3.12 The table below summarises the objectives, type of investment (equity or loan), the maximum fund investment level, and the geographical coverage (highlighted) of each of the VCLFs covered by the evaluation. Following the table, we also described briefly the nature of each VCLF and in particular its investment policy. More detail on these issues is included in appendices.

Table 3.1 – Overview of VCLFs

Geographical coverage

Fund Objective Max fund

investment East West South

Equity funds (co-investment)

SCF Growth companies £500,000

Equity funds (managed) Sigma

Innovation

Innovation and early stage (not seed or pre-seed) companies with high growth potential and capacity for job creation

£300,000

Sigma Sustainable Energy

Early and development stage in sustainable or renewable energy technologies in East of Scotland

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Geographical coverage

Fund Objective Max fund

investment East West South

Early stage risk capital (managed) Genomia To commercialise university research, support

spin-outs and creation of IP at Public Sector Research Establishments (PSREs) in animal health and the life sciences.

£250,000

General loan funds

WSLF All qualifying sectors £50,000

WSRF All qualifying sectors, with a concentration on start up companies

£1,000 to £30,000 (first loan)

SoSLS Growth companies £50,000

Loans - Micro credit Micro

Credit East

All qualifying sectors (now through ESF) £5,000

Loans - Younger applicants

PSYBT All qualifying sectors, applicant under 31 £25,000 Fund Investment Policy

3.13 The investment policies and other relevant information on the various VCLFs is summarised below:

SCF – the Scottish Co-investment Fund is a fund providing equity capital to companies with high growth potential and which often use proprietary technology. SCF is a commercial investment vehicle and as such it is expected to make financial returns (dividends, early realisations, disposals and loan repayments).SCF is a coinvestment fund. As such, the fund invests pari passu with private sector investors. SCF has appointed (after a tendering process) approximately 24 investment partners who bring deals to SCF. These partners can be institutional investors, professional fund managers, smaller regulated and unregulated fund managers and investors, business angel syndicates and private individual investors. Partners were appointed after an advertisement to meet public procurement rules, and include both Scottish partners and others from the rest of the UK and abroad. SCF enters into deals on a pari passu basis with its partners. SCF is a passive investor in the deals, although it is highly likely that Scottish Enterprise will keep in close touch with such companies for other reasons. Due diligence and the decision to invest is made by the partners. SCF co-invests with these partners after carrying out some basic company and deal eligibility checks. There is therefore a light touch by SCF. The Fund has no particular sectoral bias, although some of the partners have a geographic (WL Ventures and UK Steel Ventures) or sectoral (Sigma Technology Group, Pentech, BioCatalyst Scotland) focus. The maximum deal size is £2 million, with a maximum commitment by SCF of £500,000. Most investments by SCF are in the range of £3,000-500,000.. An investee company will receive private sector investment from an SCF partner in addition.

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Sigma Innovation Fund – invests in Scottish companies from funds provided by Bank of Scotland, the European Regional Development Fund, Scottish Enterprise Fife and Sigma. The fund was established November 2003. It invests between £20,000 and £300,000 per investment, in high growth, innovative SMEs with their principal place of business in the East of Scotland. The fund can provide a mixture of debt and equity packages. The fund is managed by a professional fund management company, Sigma. Founded in 1996, Sigma is a private equity and advisory group specialising in venture capital in the technology sector. Sigma is listed on AIM and currently has 3 funds under management: the Sigma Technology Venture Fund, the Sigma Innovation Fund (East of Scotland) and Sigma Sustainable Energies Fund. Sigma is in the process of establishing a dedicated fund, for investment in Robert Gordon University spin out companies.

Sigma Sustainable Energies Fund – invests in Scottish companies from funds provided

by Scottish & Southern plc (now the UK’s largest renewable generator), the European Regional Development Fund, Scottish Enterprise Fife and Sigma. It invests between £50,000 and £500,000 per investment and is able to provide a mixture of debt and equity packages. The fund invests in companies based in the East of Scotland involved in novel renewable and sustainable technologies. It is also a managed fund, like the Sigma Innovation Fund, and has the same management company.

Genomia – was established with funding of £764,000 from the Office of Science and

Technology, Public Sector Research Exploitation Fund and is dedicated to supporting the early stage commercial development of life science research from institutes such as the Institute for Animal Health, Moredun Research Institute, Roslin Institute, Rowett Research Institute, and the Scottish Agriculture College. Genomia provides a programme of investment options aimed at technology and business development and is tailored to address the different stages along the research to commercial realisation continuum. The Genomia Fund is a seed and pre-seed fund which seeks to provide modest amounts of pump-priming funds to support emerging technologies and to help bring them to market.

WSLF – the West of Scotland Loan Fund was set up in 1996 to provide gap funding for

new and existing SMEs where the companies had good commercial proposals but were unable to find the level of finance which was necessary to support their proposals – it is a loan fund operating in the West of Scotland as a lender of last resort. WSLF is administered by the West of Scotland Loan Fund Ltd., which was set up by the 12 unitary authorities that succeeded Strathclyde Regional Council. The fund addresses 2 different segments. It provides loans up to £30,000 for start up companies up to 2 years old; and from £30,000-£50,000 for existing businesses over 2 years old. Asset finance for property purchase up to £50,000 is now also eligible. The scheme can fund up to 50% of total project costs but will normally provide no more than 25%. The fund has invested in over 1,000 businesses to date.

WSRF – the West of Scotland Regeneration Fund is a loan fund operating in the West of

Scotland as a lender of last resort. Developing Strathclyde Limited (DSL) manages the fund. Its objective is to provide funding to companies which have not been able to obtain funds from other sources. The loan fund includes contributions from local partners, the Department of Trade and Industry’s Phoenix Fund, the ERDF and the Unity Trust Bank. In addition, DSL has an ERDF grant from Strathclyde European Partnership to develop the fund. DSL is a Community Development Finance Initiative (CDFI) that operates in Ayrshire, Dunbartonshire, Glasgow, Lanarkshire and Renfrewshire. DSL currently

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manages 2 loan funds, the Western Scotland Regeneration Fund (WSRF) and the Social Enterprise Fund (SEF). DSL has also managed the National Micro-credit Fund, on behalf of Scottish Enterprise National. WSRF has now moved to a more commercial basis. The respective funds in the West of Scotland are beginning to cooperate but the level of cooperation is dependent upon personal relationships and informal networking.

South of Scotland Business Loans Scheme – a loan fund operating in the South of

Scotland. The scheme is open to small to medium enterprises (SMEs) located in or looking to locate in the Scottish Borders or Dumfries and Galloway. Eligible companies can apply for loans between £5,000 and £50,000, to be repaid within 60 months. The scheme is designed to provide gap funding for business growth projects, and applicants must demonstrate that they have exhausted conventional funding sources. For loans of less than £20,000 security will not normally be required (although it may be taken). For loans in excess of £20,000, security will normally be required. The South of Scotland Loan Scheme is vested in SEBSED Ltd, a company limited by guarantee, of which Scottish Enterprise Borders and Scottish Enterprise Dumfries and Galloway are the members. We refer to either SoSLS or SEBSED as appropriate in this report. Most companies are reached through Scottish Enterprise’s advisers. The management of the scheme is outsourced to WRDF, a development company in Newton Stewart. The fund is partly financed using the repayments from earlier South of Scotland loan schemes, including the Dumfries & Galloway Business Loan Scheme, the equivalent scheme in the Borders “New Ways”, and predecessor schemes in each region to make non farm loans at the time of the foot and mouth crisis.

Micro Credit East – a small fund providing micro credit, particularly to women

entrepreneurs in the East of Scotland. It now uses ESF funds.

PSYBT – the Prince’s Scottish Youth Business Trust was set up in 1988 as an

independent Scottish organisation with the aim of providing seedcorn finance and professional support to young people generally aged between 18-25 (older in some cases). It is a company limited by guarantee and operates as a partnership between the public and private sector. PSYBT operates across the whole of Scotland through a network of regional offices where they are generally supported by the Business Gateway or other local enterprise networks. In 2002, PSYBT established a Growth Fund with pilot funding to provide access to loan funds in the £5,000-£25,000 range to businesses in all qualifying sectors that have previously received PSYBT support. A Development Loan Fund for expanding businesses up to £10,000 is available up to 3 years after start-up (applicants aged 18-29) and an Accelerator Loan of £10,000-£25,000 for businesses seeking to expand significantly up to 5 years from start-up (applicants aged up to 31). Financial Resources

3.14 We now summarise the financial resources available to the VCLFs, including the amounts made available from ERDF funding, and from other sources including public sector and private sector funds. The following table shows the gross resources available to the VCLFs, rather than the amounts invested in the Funds (this is considered in subsequent sections of this report). Because funding from the Dumfries and Galloway Business Loan Scheme and from the “New Ways” loans scheme is being transferred into the South of Scotland Business Loan Scheme, these 2 schemes are not included in the table.

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Table 3.4 - Fund Resources during life of ERDF Programming Period, £’000 ERDF funding Other public sector Total public sector Private sector or other Total resources SCF5 23,526 20,000 43,526 40,697 84,223 Sigma Innovation 2,225 125 2,350 3,650 6,000 Sigma Sustainable Energy 2,400 500 2,900 3,100 6,000 Genomia 327 765 1,092 0 1,092 WSLF6 8,500 4,942 13,442 4,222 17,664

WSRF7 1000 n/a n/a 1,400 approx 1,800

per annum SoSLS8 796 796 1,592 1,358 2,950 Micro Credit East9 15 26 40 n/a 40 PSYBT 191 201 392 429 821

Source: Fund profiles contained in appendices to this report

3.15 Because of the different nature of the funds, figures may not be wholly comparable. An analysis of the ERDF funding applications showing the amount of ERDF grant aid applied for in each of the VCLFs is contained in Appendix M. The funding is broken down between the different European partnerships in Scotland, in the East, South and West and is based on ERDF application forms.

5 To 31st March 2006. Public sector funding is for the whole programming period and £17.32m of this is

committed. Based on monitoring report to SEP

6 Based on analysis of balance sheet at 31st March 2006

7 Because the fund substantially uses repayments to finance new lending figures are not comparable. A detailed

balance sheet is shown the in the fund profile in the appendix.

8 Private sector or other represents mainly funds transferred from previous loan schemes 9 One area only

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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)

Stage 2004 2003 2002 2001 Early stage 14 7 12 45 Expansion stage 69 59 101 235 MBO/MBI 93 43 158 160 Total 176 109 271 440 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 deals10 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 billion11, 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

10 Gavin Don (Equitas) and Professor Richard T Harrison (Queen’s University Belfast) (2006), The Equity Risk Capital Market for Young Companies in Scotland 2000-2004.

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2% per annum of the loan. Across the UK as a whole, the loan guarantee scheme provides support for about £250 million12 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)

Sources of funding used – SCF respondents Number %

Personal resources 27 67.5

Friends and relatives 5 12.5

Bank loans 19 47.5

Other 26 65.0

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)

Sources of funding used – WSLF respondents Number %

Personal resources 48 81.4

Friends and relatives 10 16.9

Bank loans 43 72.9

Other 18 30.5

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 200113 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).

12 Based on Bank of England small business statistics, 2003

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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?

WSLF PSYBT

Options Number % Number %

No other source of funding was available 13 23 4 28 Other funding existed but more was needed 28 48. 4 28 Other funding sources had less attractive terms 17 29 5 36

Other 1 8

Total 58 100 14 100

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?

Option Number %

No other source of funding was available 11 28 Other funding existed but more was needed 25 64 Other funding sources had less attractive terms 3 8

Total 39 100

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

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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.

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• 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.

Figure

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References

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