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The regional venture capital funds

Considerable opportunities still exist to invest in the smaller end of the venture capital market with an integrated and specialised approach dedicated to smaller companies. Regional venture capital funds aim to prove that good commercial returns are available in an area of the venture capital market that has been neglected in recent years. Geoffrey Doyle from WM Enterprise explains.

Over the past decade there has been a general trend among private equity providers in the UK to increase the absolute size of deals that are completed. For instance, according to BVCA statistics, during 1993 the average amount of equity invested in each transaction by its member firms was £1.15 m; by 1999 this average had increased to £5.56 m. Higher returns have attracted more capital for investment and larger funds have, of necessity, been obliged to focus on larger deals in order to invest and develop their portfolios within stipulated time frames.

The general trend highlighted has not eliminated the demand for private equity at the small and medium-sized company end of the market. Small companies, which require smaller amounts of capital face a very limited range of potential funding sources - the so-called ‘equity gap'. Private individuals (‘business angels') have had some impact in this smaller investment range, however support is fragmented and figures suggest that this informal network operates at the bottom end of the equity gap.

Historically, funds investing at the lower end of the size range have yielded returns that have been less attractive than the average for all venture capital funds. For example, mature early-stage funds achieved an average return of 8.7 per cent over ten years compared to an industry average of 20 per cent for all funds in 1999. This is not surprising; most early-stage funds are small and therefore suffer from higher proportionate operating costs, and an insufficiently diversified investment portfolio that results in higher risk. More recently, there has been an improvement in returns for the early-stage funds compared to the industry average (mature early stage funds achieved an average return of 24.5 per cent over ten years compared to an industry average of 20.4 per cent for all funds in 2000), most likely due to some exceptional returns achieved in a few specific technology funds and a well ridden dotcom boom.
 
In order to address this equity gap, as well as encourage a more favourable entrepreneurial environment and thus drive general economic prosperity, the government has been working with a group of specialist smaller company fund managers and the English Regional Development Agencies towards creating regional venture capital funds. These funds are expected to launch over the coming 12 months and will support SMEs with equity investments of up to £500,000. Although there is an element of public finance support, the funds will be commercially focused in order to attract the private investors that will contribute up to 75 per cent of the funds' capital. The Government money will take a subordinated position to that of private investors in terms of returns and therefore will take on a higher proportion of the risk.

The key drivers in terms of returns and managing the risk in these funds include the management teams' expertise within the small and medium-sized company domain, diversification of the portfolios and leveraging the local business support infrastructures. The management teams specific expertise and portfolio diversification across industry sectors and stages of development could be perceived as contradictory, however it is believed that risks can be dramatically reduced by including the third element of local support infrastructure. The number of investments necessary to develop the required levels of diversification dictates high volumes. To tackle these high volumes, we use intermediaries who act as a filter and who ‘rebound' opportunities. These have existing and substantial roots within the local business network. At the one extreme, the filter and rebound intermediary sends ready investments forward for further consideration and due diligence by the fund manager. At the other end, prospects that are not ready for investment but are considered to be potentially viable propositions are redirected to the local  business support infrastructure for further development to nurture them to the investment-ready state.

The nature of small and medium sized companies can often dictate the need for close support to provide development across many business functions after the investment. Continued support is crucial to further reduce the risks of investing, however this can be time consuming and impractical with the volumes of deals predicted by the regional venture capital funds. A key element in providing the support necessary is again through the substantial existing local business support infrastructure. With the use of grass-root and experienced local business practitioners and advisors, it is reasonable to expect a higher investment success rate, particularly if they are proactive and take a long-term interest in an investee company.

Geoffrey Doyle, a trainee investment executive with venture capital firm WM Enterprise writes about the regional venture capital funds.