Speakers' Corner
Is there a gap?

Posted: Tuesday, 12th September 2006

I was a little surprised to see an article in the Telegraph the other week quoting research that apparently concluded there is no equity gap (Don't mind the gap, 'it's a perception', 1 August 2006).

The conclusion is apparently based on Library House records. These show a 'significant gap' between the amount of money companies wish to raise and the amount they actually raise. However, the argument put forward is that this is less to do with the amount of available funding and more to do with the fact that 'the majority of companies seeking funding simply do not have the potential required to warrant investment by an investor motivated by financial gain.'

I think most practitioners would agree that the pool of companies failing to raise the funds they seek is mixed in terms of quality, but we need to be careful of the inferences we draw. It does not mean that there is no equity gap and it does not mean that government schemes are unnecessary.

First, many of the early stage companies that have raised finance were only successful in their search for funding because of government schemes aimed at bridging the equity gap. Research published in 2005 (A Mapping Study of Venture Capital Provision to SMEs in , Small Business Service, October 2005; see www.sbs.gov.uk/analytical) illustrates this point. This research was based on an analysis of venture capital (defined as any private equity to SMEs, excluding buy-outs); an analysis of active investors (defined as those who had made such an investment in 2003 or 2004 or who still had capital available for that purpose); and an analysis of investments made in England (defined as both new and follow-on investments i.e., not equating to the number of companies). The research divided the providers into five main categories: publicly-backed funds, venture capital firms, venture capital trusts, angel networks and other funds (such as investment trusts and corporates, and including 3i). This research showed the following:

• Importance of publicly-backed funds:
• • The study identified 191 active funds, managed by 131 investment firms: 26% of the funds were publicly-backed, 24% were VCTs, and 12% were angel networks. This means that 62% of the active funds were either directly benefiting from some form of government support or they were benefiting indirectly via tax incentives to their investors.
  • Publicly-backed funds had made up more than half of all new active funds in the previous three years.
  • 'The publicly-backed funds accounted for nearly a third of all investments during 2003 and 2004, making them an extremely important source of capital to the SME sector. The figure also understates the relatively large number of individual companies they have backed than other fund types because of differences in the way they co-invest.'
  • The figure of 1,714 total investments in the period was analysed as follows: publicly-backed funds (33%), VCTs (21%) and angel networks (16%).
• Regional analysis:
• • Whilst 51% of the 191 active funds were based in London, most of these invest across the (almost 80% made investments outside London in 2003-04). Just 5% of active funds had a regional focus on London , compared with 9% which had a regional focus on the South East.
  • Despite the fact that London has a larger economy than any other region (the National Statistics estimate of 2004 GVA is £165bn on a residence basis), by number of investments at the seed and start-up stage it was ranked fourth amongst the English regions. The figures are as follows: South East (268), Eastern (181), North West and Merseyside (152), London (124).

Second, there are likely to be some companies within the pool that fail to raise funds that could grow to become viable businesses with the help of an existing or planned government scheme. Why? Because an investor 'motivated by financial gain' weighs the risk:reward profile of an investment. In doing so the investor is likely to conclude that the potential gain in absolute terms from a successful small investment, requiring the same amount of assessment and due diligence as a larger investment, is unattractive. Additional barriers apply for early stage companies seeking funding, particularly in the technology sector.

Major government schemes in the and, for that matter, in the , are designed to address the risk:reward balance of early stage and small-scale investing. Thus a business that doesn't warrant investment with an unadjusted risk:reward balance may do so with an adjusted risk:reward balance. An adjustment may be made, for example, by incentivising the private sector to put money at risk - for example, tax breaks for individual VCT and EIS investors or subordination of returns to the public sector investor in some venture capital funds. This is not an argument to support investment in all companies that currently fail to raise funds - it is an argument to support funding for companies which are judged to be attractive by experienced investors and lenders but which would fail to raise funds in competition with larger, later-stage investments in a market dominated by the economies of scale. By increasing the potential returns, government is able to compensate for the disproportionate costs of making small scale investments.

Government has made an important contribution to understanding and bridging the equity gap. Without these government schemes the equity gap would be an even more severe problem and the would be greatly disadvantaged in its efforts to promote an entrepreneurial economy and exploit the technology it develops.

My own experience, gained through over 25 years in SME finance and most recently as chairman of two venture capital funds operating in the 'equity gap', is closer to that of David Quysner (Chairman of venture capital firm Abingworth Management and of the Small Business Service's Capital for Enterprise Board), who is quoted as saying: 'I would be delighted if there was no equity gap, but I have spent most of my working life aware of its existence.'

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