Bridging the gap

Since 2002, the nine Regional Venture Capital Funds (RVCF) set up by the UK Government have raised a total of £250.5m, and invested in almost 200 companies. Established to support growing companies languishing in the equity gap, they were set up by the Department of Trade & Industry (DTI) in order meet the need for capital at the smaller end of the market in England. Tom Allchorne looks at the progress being made by Regional Venture Capital Funds, and the future of public-private funding.

RVCFs work like any other early stage venture investor. Despite being set up and backed by the UK Government, they still aim to make a profit on their investments. The largest is the Capital Fund, which targets businesses operating in the London region. It is managed by YFM Finance, which also runs two other regional funds, the Yorkshire & Humber Equity Fund and South West Ventures Fund. Their London-based fund has to date made 36 investments, with two exits. The first came in July 2004 when Avanti Screenmedia, a provider of retail television services, floated on the London Stock Exchange’s Alternative Investment Market raising £3m and achieving a market cap on launch of £12.9m, less than seven months after the Capital Fund made its investment. The second exit came in February last year when UK Explorer, a provider of wired and wireless Internet access solutions for hotels and airports, was bought by Spectrum Interactive, earning a 30% IRR for the Capital Fund less than a year after investing £250,000.

Like all RVCFs, it takes minority equity stakes in the businesses it invests in, ranging from a 10% to 40%, frequently co-investing with a private sector venture capital firm. One of the Capital Fund’s most recent deals saw it take part in a £675,000 round for Delphic Europe, a provider of specialist diagnostics products and services for HIV clinics, with MMC Ventures.

Quester has invested alongside RVCFs on three occasions, the most recent being a £3.1m round for Leicester University spin-out Haemostatix. Quester led the round, committing £2.4m, alongside the East Midlands Regional Venture Capital Fund, managed by Catapult Venture Managers. Dr Jonathan Gee, investment director at Quester, says of working with regional funds: “We are looking at RVCFs to help bridge the gap between early stage investment and mainstream venture capital. The East Midlands fund needed specialists in this particular sector, which we have.”

There are some differences between how the two work: Gee says RVCFs come at deals from a more LBO-type approach, which isn’t always appropriate, whereas the regional fund may be uncomfortable putting in purely equity. “Sometimes we have to move to each others’ positions,” says Gee.

The idea of the funds acting as a bridge is one of the cornerstones of their existence. The DTI names this as one of the RVCFs long-term objectives, providing funding to companies operating in the

equity gap in order to encourage private sector VCs to get involved. In order to assist in this, the DTI’s stake, through its Small Business Service (SBS) division, is subordinated by capping any return on investment, thereby increasing the VC return.

RVCFs are allowed to invest up to £250,000 in the initial tranche. If another VC has already invested, then the cost of that investment is deducted from the £250,000 ceiling to arrive at the amount the fund can invest. Similarly, if an RVCF co-invests with a venture capitalist, the combined amount invested must not surpass £250,000. The reason for such a cap, says SBS, is to ensure the funds remain committed to the lower end of the market. After six months from the original investment RVCFs are allowed to make follow-on investments of up to £250,000, and even more in exceptional circumstances.

The relationship between the funds and their relevant Regional Development Agency (RDA) is particularly important to the success of the RVCF. RDAs are public bodies charged with overseeing the economic prosperity of a particular region, be this with regard to business development and regeneration, promoting efficient and competitiveness, promoting employment or improving skills in the area. In relation to RVCFs, the job of the RDA is to use its contacts within the region to alert and encourage private sector investors operating in the area, and provide links to organisations that could support businesses once they have received investment.

RVCFs remit isn’t limited to early stage companies; they can invest in start-ups and early stage, provide development capital, and back management buyouts and management buy-ins. But it hasn’t quite panned out this way: most of the investments being made in the early part of a company’s life.


Capital Funds

The next step in the funding of smaller companies is the Enterprise Capital Funds (ECFs). One of the complaints by made the managers of RVCFs is that the restrictions on investment are too severe: £250,000 simply isn’t enough, particularly in an MBO deal. ECFs, modelled on the American Small Business Investment Companies (SBIC), were first unveiled in the 2003 Pre-Budget Report as another way of bridging the equity gap, this time between £250,000 and £2m (the upper limit an ECF may make in one investment). They will be privately owned and managed; Catapult Ventures is one of the firms that has reportedly been short-listed to manage one, and will use both private and public money, borrowed at a low interest rate from the UK Government (at or close to gilt) to invest in British businesses. There are no specific tax reliefs attached to ECFs, but it is hoped that the underwriting of them with public funds will create a sufficient reduction in risk to make them attractive to investors. See Legal & Regulatory this issue.

There are a number of state-aided schemes in existence in the UK and as a consequence some are asking if there is really a need for another one. Some in the industry argue that rather than introduce something new, it would be wiser to relax the investment rules of the RVCFs.

But it’s too early to assess the overall success of RVCFs, especially with regard to exits given typical investment time horizons. But on the investment side, it is possible to be more critical. While some have invested in over 30 companies, others, like South West Ventures Fund, has backed just nine companies, and even the Advantage Growth Fund, which has backed 30 companies, has only managed to invest £6.5m, even though it’s been going for over three years now (RVCFs have a life-span of 10 years). This isn’t necessarily the fault of the fund managers; it’s more of an indication that there aren’t enough companies out there worthy of investment, and if this is the case, then perhaps an equity gap doesn’t really exist at all, at least not at that level. It could be argued that the very idea of ECFs is recognition of this fact, and most VCs will admit that if a funding gap does exist, it’s for companies seeking £1m or more. VCs generally don’t like investing at that level, so it’s up to public sector funds or public-private funds (and business angels), to address the problem and demonstrate to the private sector guys that deals at this level can reap rewards.