Government interventions in venture capital have been coming thick and fast since 2000, climaxing with the announcement of not one but two mega-funds last year expected to raise well over £1 billion between them. So the publication of a report slamming the performance of existing public-private funds was, from the government’s point of view, diabolically timed.
The National Audit Office (NAO) found that £338 million had been invested by the government in specially designed VC funds since 2000, along with £438 million of private sector money. Returns for the Treasury were as low as minus 15.7 per cent a year for the regional venture capital funds (RVCFs), and minus 9.7 per cent for the UK High Technology Fund – comparing poorly even with the dismal returns achieved by purely private VCs. The government did not set clear objectives for its forays into venture capital, the report concluded, and with large chunks of cash eaten up in fees, it could not be demonstrated that the funds offered the taxpayer value for money.
It wasn’t long before a backlash began from the venture industry, especially those parts of it that had participated in managing the funds. The NAO report, they insisted, didn’t give the full picture: it was virtually meaningless to try and measure the performance of funds halfway through their expected ten-year life, and there was no assessment of wider economic benefits.
David McMeekin, former chairman of The Capital Fund, the largest of the RVCFs, and now head of the EU-backed London Technology Fund, says, ‘Criticising the performance of the funds at this stage is like saying that a perfectly good bridge is not fit for purpose when it’s only half-built.
‘I would hope that this exercise will be repeated in years nine and ten of the funds, when it is possible to make meaningful judgements.’
Lemons and cherries
To its credit, the NAO report does point out that, in a favourite VC axiom, ‘lemons ripen before cherries’ – in other words, losses from failed businesses will crystallise before successful investments bear fruit (see diagram, right). Another problem in assessing the funds’ overall performance is that earlier efforts, such as the RVCFs, were structured so that the government bore the ‘first loss’, with private investors protected to a large degree. The NAO figures refer purely to the Treasury’s return on investment.
While recognising that it is hard to assess the performance of a fund in mid-cycle, NAO director Peter Gray rejects the claim that the exercise was pointless. Even an incomplete assessment provokes discussion and draws out data that can inform future state interventions. ‘We’ve had to try and provide a snapshot of progress,’ says Gray. ‘If we’d waited for ten to 15 years before doing that, no-one would have learned anything at all.’
There is one thing that everyone seems to agree on – the structure of the earlier funds, in particular the RVCFs, set them up for failure. The investment limit for an initial round of funding was fixed at £250,000, and applied to all institutional investment, not just the RVCF’s contribution. Another £250,000 could be invested after six months, but any further investment was permitted only to prevent dilution, and even then only up to certain limits.
David Hall, managing director of YFM, which manages three of the nine RVCFs, says, ‘These constraints, which were rigidly enforced, were extremely unhelpful. It skewed the sort of business you could invest in. You had to find businesses deploying much less capital, which generally meant service-based businesses rather than manufacturers.’
Hall adds that the restrictions will, in the end, depress overall returns. ‘It was a massive design flaw and [the government] has learnt from that.’
Another fund manager, who prefers to remain anonymous, echoes this point in a striking metaphor: ‘If you are a high jumper and someone takes an axe to your knees, you are not going to be best in class.’
cvvMark Boggett is managing director of Seraphim Capital, the first of the enterprise capital funds (ECFs) to launch in 2006. He agrees with Hall that lessons have been learned. ‘[The RVCFs] are an experiment that didn’t really work,’ he says. ‘They’ve evolved into the next model, and that was the right thing to do.’
ECFs have no specific regional or sectoral targets and can invest up to £2 million in companies, which according to YFM’s Hall is enough for a business to ‘employ a decent number of high-quality people, a few scientists and a sales team, and run it for a good two years’. According to Boggett, ECFs are better able to follow their investments to avoid dilution.
Another innovation of the past few years has been the establishment of Capital for Enterprise (CfE), an organisation set up by the government to deliver and monitor its programmes of support to growing businesses. Richard Hepper, its deputy chief executive, says, ‘Developing these funds is an iterative process with the Department for Business, Innovation and Skills (DBIS). We are always feeding back information about what works and what doesn’t.’ The NAO identifies the creation of CfE as a positive step with ‘the potential to strengthen oversight of the funds’.
While government-backed VC funds have so far failed to present a compelling investment case, they have been more successful in providing support to growing businesses. Nine-tenths of businesses backed by the funds report that they were able to start or grow more quickly thanks to the finance, while a similar proportion would recommend the funds to others, according to a survey commissioned by the NAO.
Will Walsh, chief executive of mobile specialist Sharpcards, received £1.5 million from one of the ECFs in 2007 with a further funding round last year. He says the cash has enabled Sharpcards to move on from the ‘small beer’ business model of providing themed wallpapers for mobiles into the more lucrative market for mobile greetings cards, as well as bring in heavy-hitting board members such as Miles Flint, ex-president of Sony Ericsson. ‘You’re always looking for a bit more than just the cash, and [our investor] has been excellent in that respect,’ says Walsh.
But Walsh concedes that at the time the ECF invested, other purely private VCs were courting the company. Indeed, in the NAO survey, only a third of entrepreneurs who received investment from government funds said they would not have been able to obtain money from elsewhere. While this is not a worry for Walsh, it does cast doubt on how far the government is filling an equity gap, as opposed to displacing private sector activity.
Bruce Savage, a serial entrepreneur who has raised more than £12 million for five start-ups in his career, including biotech research business BioAnaLab, agrees that public and private funds are often interested in the same companies, but argues that multiple funding sources are often necessary to raise sufficient capital. An investment round for BioAnaLab in 2003 was only completed successfully after one of the RVCFs entered the syndicate, he reveals. The company was recently sold with positive returns for investors.
Spreading it wider
The additional support provided by funds like the RVCFs has particular impact outside London and the South East, where more than half of all VC deals completed between 2001 and 2009 involved public sector money, according to research from NESTA. In 2008 that figure swelled to more than 80 per cent, suggesting that government support proved a lifeline for regional ventures during the credit crunch.
Boggett of Seraphim says that one of the unsung achievements of the RVCFs has been to create an ‘entrepreneurial economy’ across the country whereby ambitious businesses can access funding.
‘You might not succeed with your first vehicle, but if you look at research from the US, most entrepreneurs don’t – they succeed in a big way with their second or third company. By seeding money throughout the UK, [the RVCFs] have created an entrepreneurial environment that will help the economy going forward.’
Hall of YFM echoes this argument, pointing out that government funds have backed success stories such as Avanti Communications and Pressure Technologies, companies that have created generous returns for investors and enriched the UK’s economy through employment and exports. In the US, says Boggett, Small Business Investment Companies, a form of government intervention in venture capital launched in 1958, have contributed to the growth of companies such as AOL, FedEx, Intel and Apple.
In the light of this, Boggett is convinced that the introduction of two more funds, each expected to be larger than any previous intervention, can only be a good thing. ‘This is absolutely the right thing to do at this stage of the economic cycle because you should be investing at relatively low valuations. If the government can prove you can really make money [in venture capital], that will encourage the participation of banks and, more importantly, pension funds, which don’t invest in venture in the UK.’
Winds of change
There is the small matter of a general election this year. CfE’s Hepper believes that there is little difference between the two main parties when it comes to their approach to supporting growing businesses through venture capital.
However, the reaction of some politicians to the NAO report will be worrying to those who believe the funds are vital to support growth. In mid-January, DBIS and CfE faced aggressive questioning from the Public Accounts Committee, chaired by Conservative MP Edward Leigh, about the funds’ performance, effectiveness in supporting business and fee structure. In response, Simon Fraser, permanent secretary to DBIS, has undertaken to present a ‘better picture’ of how the funds are performing in two years – by which time a new government will be sitting in Westminster to decide on their future.
Whatever the political climate, the UK’s entrepreneurs will be hoping that any shortcomings of individual schemes do not discredit the entire concept of government-supported venture capital. It’s still early days for what everyone accepts is an ambitious and innovative programme of intervention, and after all, lemons ripen before cherries.