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CHAPTER NINE ADDITIONALITY AND DISPLACEMENT
Approach
9.1 In this chapter we consider the additionality and displacement issues as they affect both the loan funds and the Scottish Co-investment Fund. For all VCLFs, we have sought to measure additionality using two methods. Firstly, we have reviewed the documentation of the VCLFs and the procedures which are set out in the respective application forms. These procedures require the VCLFs to adopt tests to maximise additionality. We have also undertaken a survey of some of the investments of the VCLFs, where no other usable survey was available, and asked if funding could have been obtained from other sources.
9.2 For the Scottish Co-investment Fund, a further approach was adopted. In addition to surveying investee companies, we contacted a number of investment partners to ask the reasons for bringing deals to the Scottish Co-investment Fund. This has provided some information on whether the deals would have been financed had the Scottish Co-investment Fund not existed, and also on the displacement or otherwise of providers of venture capital.
Additionality - Loan Funds
9.3 All the main loan funds operate a 'lender of last resort' policy. Their documentation requires that borrowers show that they have not been able to obtain funds elsewhere. Usually a letter from a bank or some similar evidence is required to indicate that funds are not available elsewhere. It may therefore be expected that the additionality shown by loan funds will be high.
9.4 Three of the funds have previously carried out surveys of customers as part of evaluation exercises, and in the current evaluation we carried out surveys of investee companies in WSLF and PSYBT (as well as the small number of investments at Micro Credit East). The surveys gave the results shown in the following table. For WSRF, operated by DSL, most customers perceived them to be the only source of funds available.
Table 9.1 - DSL's survey of customers for additionality
Reason for seeking finance | % |
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Perceived it to be the only source of funds available to us | 69 |
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No need for security guarantees | 27 |
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Good chance of getting it | 22 |
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Good interest rate relative to commercial loan | 16 |
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Good repayment terms relative to commercial loan | 4 |
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Lack of restriction on use of loan | 2 |
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Application procedure is simple | 2 |
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Lower arrangement costs | 0 |
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Had used DSL in the past | 0 |
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Source: DSL. Multiple responses allowed
For WSLF, a relatively similar position is seen although it must be recognised that WSLF has a higher proportion of existing businesses.
Table 9.2 - WSLF's survey of customers for additionality
Barrier to obtaining further finance | Number of Responses | % |
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None | 16 | 6 |
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Company at overdraft limit | 53 | 20 |
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Lack of required security/collateral | 75 | 28 |
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Unwilling to give further personal guarantees | 65 | 25 |
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Insufficient track record | 43 | 16 |
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Other finance too expensive/risky | 13 | 5 |
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TOTAL | 265 | 100 |
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Source: WSLF. Multiple responses allowed
9.5 In both cases, there is an apparent high level of additionality shown by the funds. Further calculations in an evaluation of WSLF showed full and partial additionality at approximately 70%. The survey carried out of WSLF customers as part of this evaluation showed a relatively similar position with about 70% full or partial additionality (please note that table 9.3 is the same as table 4.4). A smaller survey which we carried out, shown below in table 9.4, had higher additionality figures.
Table 9.3 - Why did you decide to apply for funding from the WSLF?
Options | Number | % |
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No other source of funding was available | 13 | 23 |
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Other funding existed but more was needed | 28 | 48 |
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Other funding was available but on less attractive terms and conditions | 17 | 29 |
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Total | 58 | 100 |
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Source : CSES survey of WSLF companies
Table 9.4 - What would have happened if funding from this fund had not been available?
Options | Number | % |
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We would have gone ahead anyway | 2 | 3 |
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We would have been delayed or gone ahead on a different/smaller scale | 45 | 78 |
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We would not have gone ahead at all | 11 | 19 |
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Total | 58 | 100 |
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Source: CSES survey of WSLF companies
9.6 For SoSLS, evidence is based on a survey carried out as part of an evaluation of that fund. An external evaluation was carried out of SoSLS in early 2006 and a small survey of investments throws some doubt on the effectiveness of the additionality test in the application procedures. Only 2 out of 16 companies reported full additionality, and 10 out of 16 reported partial additionality.
Table 9.5 - SoSLS - effect of not obtaining finance
Options | Number | % |
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Project would have gone ahead anyway at the same time | 4 | 25 |
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Project would have gone ahead but at a later stage, or on a smaller scale | 10 | 63 |
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Project would not have gone ahead | 2 | 12 |
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Total | 16 | 100 |
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Source: SoSLS
9.7 In respect of PSYBT, we carried out a survey of companies in conjunction with the fund. This showed a high level of additionality, with only one out of 14 respondents saying that the project would have gone ahead anyway. In response to another question, 5 respondents said that other sources of funds were available, but on less attractive terms.
Table 9.6 - PSYBT - effect of not obtaining finance
Effect of not obtaining finance | Number | % |
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Would have gone ahead anyway | 1 | 7 |
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Would have gone ahead on a smaller scale | 9 | 64 |
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Would not have gone ahead at all | 4 | 29 |
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Total | 14 | 100 |
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Source: CSES survey of PSYBT investee companies
9.8 In respect of Micro-Credit East, where there are only 2 investments, both reported full additionality.
9.9 It is important to recognise that loan funds are in a position to influence additionality by trading off additionality against the risk of bad debts. If there is to be a high level of additionality, then there is an implication that the funds will only accept deals that the market will not accept - because of risk, or market failure. A fund can increase additionality by taking on more risky loans, but may increase bad debts.
Additionality - Scottish Co-Investment Fund
9.10 There are potential additionality effects of SCF at both the investee company level, and at the partner level. For investee companies the issue is whether their project would have gone ahead anyway without SCF finance. For partners the issue is whether they would have financed the project in full or in part without SCF input. SCF did not have any data on the additionality effect at either of these levels, so we carried out surveys. In respect of the investee company level, the results are as follows:
Table 9.7 - SCF - Why did you decide to apply for funding from this fund?
Option | Number | % |
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No other source of funding was available | 11 | 28 |
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Other funding existed but more was needed | 25 | 64 |
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Other funding sources had less attractive terms | 3 | 8 |
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Total | 39 | 100 |
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Source: CSES survey of SCF investee companies
Table 9.8 - SCF - What would have happened if funding from this fund had not been available?
Option | Number | % |
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Would have gone ahead anyway | 2 | 5 |
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Would have gone ahead on a smaller scale | 28 | 70 |
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Would not have gone ahead at all | 10 | 25 |
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Total | 40 | 100 |
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Source: CSES survey of SCF investee companies
9.11 Both questions suggest high levels of full and partial additionality at the company level. Almost all companies would not have gone ahead without the funding they received, which includes a tranche of SCF funding.
9.12 We also need to consider additionality at the level of investment partners. As noted above, we asked investment partners why they brought deals to the fund. Typically, with the Scottish Co-investment Fund the arrangement is that it participates in deals brought to it by partners. It will participate to the extent of 25% to 50% in any deal which is brought to it by one of its partners.
9.13 Our telephone discussion with partners gave 2 principal reasons for bringing the deal to SCF. One reason related to the size of deal. A second reason relates to the desire to spread risk. Details of these have been included earlier in the report. In both these cases, it is clear that the full amount of the deal would not be financed by the partner acting by themselves. The involvement of SCF is necessary for the deal to go ahead. To this extent, it may be said that most of the deals brought to SCF by investment partners are additional.
Additionality - Other Venture Capital Funds
9.14 Calculations of additionality are made less meaningful by the small number of investments by the other equity funds. The largest number of investments, 11, is made by Sigma Innovation Fund.
9.15 We surveyed all these investments and received 5 responses. One said that Sigma was the first funder they tried. The other 4 said that no other sources of funds were available, and that they would have 'not gone ahead' (2) or 'only gone ahead in part' (2), if they had not received funding from Sigma. We also received 2 responses from companies which had been turned down. Both said they had subsequently been unable to go ahead.
Displacement
9.16 Displacement effects can occur at both the fund level and at the company level. We need to consider if there is any evidence that the existence of ERDF supported funds might displace other fund providers. A particular case of displacement might be where one ERFD supported fund displaces another and where companies receiving loans or investments might displace other companies.
9.17 At the company level there is no evidence to indicate the extent of actual displacement, if any, either from the funds or the various evaluations which have been carried out. It has been outside the scope of work of this study to investigate the effect at local level of an investment on the competitors of the company receiving the investment. We have, however, discussed this issue with some fund managers. State Aid issues are fully considered when setting up and managing ERDF supported funds. But at the level of individual small investments (which fall under the de minimis rules) there does not appear to be general consideration of the effect on competitors as part of the loan evaluation procedure. So it is not possible to say to what extent, if any, displacement actually takes place.
9.18 We can, however, compare the potential for displacement to occur at the company level in equity and loan funds. Most of the equity funds invest in early stage businesses, generally in new markets. In such circumstances there is less likelihood of displacement at the company level, because markets are growing. On the other hand, the loan funds often lend to established businesses, later in their life cycle. For these investments, the likelihood of displacement of a competitor is higher. A previous evaluation of WSLF by Stratgem, referred to earlier, showed that 84% of WSLF investee companies had many or some competitors at the UK level, and 64% had many or some competitors in the West of Scotland. Whilst this information does not tell us the actual level of displacement (to do so it would be necessary to survey competitors), it does emphasise the potential that competitors might be displaced.
9.19 At the fund level, the issue of displacement is linked to that of market failure, considered elsewhere in this report. If funds operate only where there is market failure, then displacement effects are likely to be less significant. This leaves two further questions to be considered - the special position of SCF investment partners, and displacement effects between ERDF supported funds.
SCF Investment Partners
9.20 The involvement of investment partners bringing deals to SCF ensures that there is no displacement of private sector finance providers - at least of those elements of the private sector who are SCF investment partners. This is an innovative aspect of the design of SCF. SCF advertises openly for investment partners and continues to attract new partners. A list of current partners is shown in annex K and consists of a wide range of institutions, both from Scotland, elsewhere in the UK and other EU Member States.
9.21 The target rate of return of SCF shown in its business plan is well in excess of the actual rate of return of most early stage funds - the business plan states " an average annual return of 20% is expected". If these rates - or anything close to them - are achieved, one result could be a demonstration effect of SCF in attracting VC funding to Scotland. One of the objectives of SCF was to help improve the market in venture capital and discussions in particular with business angel groups suggest that the fund has had a positive effect.
Displacement between Funds
9.22 Displacement between funds can take place both where funds operate in a similar area, or provide alternative sorts of funding to the same company.
9.23 In respect of the funds in the West of Scotland, there is a degree of overlap between WSRF, WSLF and PSYBT. However, these funds now apparently exchange information on applications to minimise the extent of displacement.
9.24 It has been suggested that there is a potential displacement effect between SCF and the loan funds in the West of Scotland, in particular WSLF. We looked at the details of the investments and sectors in which those funds were invested. The analysis of investments is shown elsewhere in this report. There is no material evidence that there is any overlap in sectors between SCF and WSLF. WSLF only invest in a few high tech companies and the level of investment is low.
Summary:
- Additionality is high - for the major loan fund, WSLF, it appears to be in excess of 70% and it is higher for SCF at the company level. All funds have formal additionality tests in place.
- For co-investment funds, additionality may be measured both at the company level, and at the level of co-investment partners. To the extent that it is optional for co-investment partners to bring deals to SCF, additionality may be said to be high.
- There is a demonstration effect on the venture capital market in Scotland and, for example, the strength of the major business angel syndicates is helped by the use of SCF.
- There is no major evidence of overlap between the venture capital funds and the loan funds. There is some overlap between WSLF and DSL, but this is managed by the two funds.
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