Reviving a forgotten asset class

The following article appeared in Investment Week Magazine.

Introduced in 2006 by the UK Government, following the extensive Bridging the Finance Gap consultation paper, ECFs are designed to tackle the equity gap by improving access to development capital.

The equity gap exists for many reasons: the maturity of private equity as an asset class, the focus on large transactions and the retrenchment of the banks, or, more simply put, the inability for small businesses to find money to grow.

Over the last decade there has been a continual upscaling in the global private equity market as larger houses abandon traditional venture capital territory to claim more lucrative slices of the cake. 3i’s evolution is prime example of how this gaping divide has left little in the way of growth finance provision.

In 1998 3i invested an average of £1.5m in over 600 companies (including names such as FirstGroup, Grampian Country Foods and Research Machines). Nine years later, its average investment had risen to £26m but in only 62 companies worldwide. The upshot of all of this is that early stage businesses don’t have a lot of options out there to raise growth capital. Welcome to the ‘forgotten asset class’.

When did it begin?

It would not be hard to guess the cracks started to appear when the dotcom bubble spectacularly burst in the early 2000s. With the large crevasses that have since ravaged the financial and economic landscape in the UK due to the longest and deepest recession ever experienced, investors are still licking their wounds and tying their harnesses tighter.Banks do not want to look over the precipice, leaving many small businesses out there trying to negotiate this hazardous terrain with few places to turn to for development capital.

So in come Enterprise Capital Funds (ECF). Introduced in 2006 by the UK Government, following the extensive Bridging the Finance Gap consultation paper, ECFs are designed to tackle the equity gap by improving access to development capital. ECFs are not the panacea for small and medium enterprises (SMEs) in this country but they do restore the oxygen supply to growth businesses that had been cut off because of the financial services crisis.

Using a similar model to the US Small Business Investment Company (SBIC) scheme, through which many global brands have prospered – Apple, Costco and Fedex to name a few – ECFs crucially feature Government funds working alongside private sector finance. There is no maximum fund size, however the UK Government will commit no more than £25m to a single fund or no more than twice the private sector capital, whichever is lowest. To-date Panoramic Growth Equity has received the largest public sector injection, with the Government committing £21.7m to the Panoramic ECF 1 fund.


Despite being a majority stakeholder, the Government places few restrictions on fund managers vis a vis investment criteria and sector eligibility. Plus its upside is capped: a welcome incentive for the investors from the private sector.

The core aim of the ECF scheme is to address this market weakness in equity finance for a wide range of SMEs in the UK. Sums of up to £2m are invested exclusively in established British businesses, with funds following a standard private equity structure, in that they are closed-end funds run on a fully commercial basis by qualified and experienced fund managers. Fund term is typically 10 years with a five-year investment period and the option to extend for up to a further two years.

ECF applications are invited each year and historically, three ECF mandates have been awarded on an annual basis. Bidding can be a highly competitive process with each recipient going through rigorous due diligence from the scheme’s administrators Capital for Enterprise Limited (CfEL). Currently, there are a total of nine ECF’s operating in the market and all vary in approach and investment strategy. Some support early stage technology development, whereas others, such as Panoramic, look to support established later-stage mainstream companies with a plan to grow.

Panoramic will back British businesses that show real growth potential across a range of sectors. The team has supported three of the top ten fastest growing UK companies in the past through similar schemes (UBS 2007). Beyond a capital requirement of between £0.5m and £2m, companies must exhibit a scalable business model, an entrepreneurial management team, low operating leverage and strong financial discipline. Essentially, businesses must be well run, nimble and have an insatiable desire to grow.

A valuable growth route

For the right entrepreneur, ECFs present a valuable growth route when traditional debt financing opportunities either do not exist or have become prohibitively expensive. An investment from an ECF brings cash, and also the added benefits of a having a genuine partner with the same interests as management together with the flexibility of not having such a great strain on monthly cashflows.

For ECF investors, advantages are multifold: enhanced returns, capital efficiency and equal ranking making these funds an increasingly appealing prospect to both institutional investors and the retail market.

The Government takes only a small priority return in exchange for a reduced profit share. Put another way, a fund that generates a 15% return can equate to a 22% per annum return for private investors. In pound terms, a £1m investment that becomes a £2m return in a traditionally structured fund could be enhanced to £3m through the ECF framework.

Capital drawdown

Capital is drawn down over time on an ‘as needs basis’, meaning investors do not need to invest all their capital straight away, enabling them to manage their positions more effectively. But the most overwhelming evidence to support the ECF is demand. Since Panoramic closed its fund earlier this year, there have been applications from well over 100 companies looking for growth capital.

In contrast the European private equity market is dominated by larger leveraged buyouts, while the venture capital industry supporting developing technology companies attracts much lower levels of capital. These funds are most often structured as closed-end limited partnerships (although more quoted vehicles are now appearing as well) and performance tracked, like the wine business, by vintage. Venture capital trusts operate tax incentivised quoted investment vehicles that invest in a variety of businesses, both unquoted and listed on AIM. Other tax breaks are available through the Enterprise Investment Scheme, targeted at business angels and individual investors who are generally looking to take an active role in helping early stage businesses become established. Unlike VCTs, tax breaks are not the major driver for investing in ECFs, it is the potential of enhanced returns through the innovative fund structuring. Not only do investors benefit from an increased profit share but also have a capital position that ranks equally to the Government.

In the period since the general election and emergency Budget there has been limited discussion on the future of the ECFs. Given their proven ability to bring new equity capital into the market from the private sector and to increase enterprise growth in the UK, it is clear this is an area of government investment that remains crucial to SMEs and the wider recovery of the UK. The ECF concept also chimes with the outlined objectives of the coalition government. A further ECF was announced within the last Budget and, together with extensions to other schemes such as the Enterprise Finance Guarantee, these interventions must be seen as positive steps to help resolve the market failures of the past.

So will growth equity continue to be the ‘forgotten asset class’ or not? The public profile has begun to see a re-emergence and, indeed, 3i has recently closed a €1.2bn growth equity fund, focused on larger transactions. It can be argued the traditional strengths of growth equity – that is working in partnership with the businesses invested in to create value – are enhanced in a recessionary environment as the focus is on building companies rather than achieving opportunistic exits that may not necessarily be in the best interests of all stakeholders.

Growth equity remains key in bridging the gap between business angels and larger buyout houses and, if the UK is to start building a successful enterprise culture, growth equity cannot continue to remain the ‘forgotten asset class’.