Questions remain over regional VC funds

Yorkshire Business Insider, July/August 2003

The government-backed regional venture capital funds have been given a cautious thumbs up by the VC community, even though they are not yet producing the deal flow they were intended to. Leading investors have however questioned the government's plans for developing the programme.

Launched last year with much fanfare from central government and the regional development agencies, the RVCFs are a DTI-backed programme to close the "equity gap" – the lack of available risk finance in amounts greater than those offered by business angels but below those provided by commercial VCs. Separately managed funds in each English region can invest up to 250,000 in promising SMEs, in funding rounds of up to 500,000. The DTI provides around a quarter of each fund, on less favourable terms than other investors. Another quarter comes from the European Investment Fund.

A confidential report on the funds' early performance, presented at an RVCF conference in London in June*, found that the DTI investment was critical to attracting other investors. There is plenty of evidence to support the idea that RVCFs are helping to fill the particular equity gap they were set up to address, and are definitely stimulating interest in SME market, according to the report produced by Iain Hasdell of KPMG in Leeds.

As of June, the funds have together received over 2,600 applications, and made 48 investments of a total 9.2 million in 40 SMEs. "Lots and lots of applications are coming in. They're not of the quality which some expected, but the quantity is very good," noted Hasdell. The average investment was 191,000, with over half at the maximum 250,000.

The next 12-18 months will be critical to the success of the funds, Hasdell emphasised. "There's plenty of flaws being ironed out of these initiatives which should help future initiatives," he said. "There's still a massive amount to do in terms of raising the game with the general entrepreneurial culture and general business attitudes to venture capital."

The Yorkshire and Humber RVCF is managed by Yorkshire Fund Managers, and closed its fundraising in July 2002 with 25 million in the pot. It made its first investment in June, backing York-based H&A Marketing, an established supplier of gifts and toiletries to major retailers. According to YFM managing director Phil Cammerman, the fund has another ten serious potential investments in progress out of "many hundreds" of inquiries.

It is still too early to draw any real conclusions about the success of the RVCF programme, says Cammerman – the real question is whether investors are satisfied with progress.

"One of the problems with these kinds of funds in years gone by is managers have rushed out and invested the money – they haven't been as careful as they might have so that's caused problems," he notes. "We want to make sure that the investments we make are in line with the objectives of the fund. We do take risks, but hopefully they're reasonably calculated risks based on good management teams or teams that we can supplement, in businesses that can show some growth either because of something special they're doing in the marketplace, or because they have some innovative part of their business that can take a big share of their market."

The current funds are however intended to prove to investors that they can win commercial returns by backing SMEs, but fund managers are worried that they will not prove their case in time to raise the next round. "We're still working towards finding a solution for SMEs that can generate returns that can in the long term win the support of institutional investors," John McCrory of Westport Private Equity, who manages the DTI-backed UK High Technology Fund, told the London conference. "[The RVCFs] are going to be successful, but they're not going to be successful quickly enough to provide evidence for raising the next round of finance."

What happens in the general economy and with government policy will be more important factors for any next round, Cammerman argues. Although the life cycle of the RVCFs is ten years – six years to invest and four for realisation – investors should be able to judge their success by the mid-point. "Investors may want to take a look at what happened in the meantime, but actual cash-on-cash returns won't be known for a very long period of time," he says.

A more pressing problem is the widening of the equity gap. "When the government conceived these funds, it was seen as up to 500,000, but now we believe it's up to 2 million," Cammerman notes. "There's a whole lot of VC companies that have moved up market – that's all to do with the economic cycle, the economies of running a VC company, and what the investors are looking for. If there is another gap between 500,000 and 2 million, there are things like VCTs that have been designed some time ago to address that gap. We believe there's a lot of room within that legislation to improve that without necessarily going to SBICs."

SBICs, or Small Business Investment Companies, are at the heart of the government's proposals for further addressing the equity gap, but drew a frosty response from the VCs in the audience at the conference. Based on a US model, the highly leveraged funds will give preferential rights to the government if the funds make a loss, rather than the subordinated rights that were critical in attracting investors to the RVCFs. Critics says that private investors will be very reluctant to back this model because of this increased downside.

"We need to listen to what investors are saying," says Cammerman. "If they don't invest, we cannot proceed with it." Investors who are traditionally risk-averse such as pension funds will probably avoid the new model, he suggests, although others such as overseas investors may find it more attractive. At any rate, the SBIC model with do little to meet the recommendations of the Myners Report to attract more investment in venture capital from pension funds.

* - 'Addressing the Equity Gap: The English Experience', SBS/DTI, 9 June 2003.