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CHAPTER THREE OVERVIEW OF FUNDS

3.1 This chapter provides an overview the policy background to the development of ERDF-supported VCLFs. The funds covered by this evaluation are then listed and information provided on fund investment policy and on financial resources. The coherence between funds and whether there are any gaps or overlaps between them is also considered.

Policy Background

3.2 As SMEs start up and grow, their financing needs and sources change. A typical pattern is shown in the following table, reproduced from the 'Guide to Risk Capital Financing in Regional Policy' prepared for the European Commission.

Figure 3.1 - SME financing stages

3.3 Early stage financing is often less attractive to commercial investors for a number of reasons. For example, a bank may be unwilling to provide finance to an SME because of a lack of a track record, inadequate security, breach of a standard threshold limit, or a credit rating outside an acceptable range. There is therefore a potential failure of the market to provide for the financing needs of SMEs at an early stage.

3.4 In addition, as the size of investments falls, so the costs of administering investments become relatively more significant. This is particularly true in the micro credit field where the relatively high administration costs make the market unattractive to commercial operators, thus compounding the risk of market failure.

EU Policy Developments

3.5 Policymakers at both an EU and national level have sought to develop cost-effective means to address this potential market failure. The development of measures such as revolving loan funds and venture capital funds has been encouraged at both a national level and by the European Commission as an alternative to grants. During the 1994-99 Structural Fund programming period, VCLF measures accounted for some €570m (2.7% of the total support to SMEs) ¹. In the 2000-06 period, it had increased to an estimated €1,256m ². In the UK as a whole, funding for VCLFs was €66m in the earlier period and €360m in the 2000-06 period.

3.6 According to DGREGIO, there are a number of key reasons why VCLF instruments are a useful alternative or adjunct to grant aid. More specifically, they:

• Target commercially viable investments providing long-term sustainable financing to meet SMEs' needs
• Contribute to developing a new culture amongst entrepreneurs with less of a grant dependency
• Optimise the use of scarce funding resources for sustainable SME development
• In addition, VCLF instruments are well adapted to the requirements of the Lisbon/Growth and Jobs Agenda as they can be specifically focused on the creation of business and employment in high added value activities and sectors.

3.7 The 2000-06 Structural Fund Regulations placed increased emphasis on the use of VCLF instruments as a more cost-effective and sustainable public policy instrument than traditional grant-based aid. The Regulations gave Member States the option of providing an additional 10% of assistance to SMEs for those parts of an investment project funded in other ways than by grant aid. The Regulations for the current (2007-13) Structural Fund programming period continue this emphasis. In addition, there are specific arrangements for VCLFs to be managed by the European Investment Fund ( EIF) in the current programming period if Managing Authorities so request. VCLF instruments must also meet criteria established by the Commission to ensure that any state aid element is compatible with the Common Market. ³

Developments in Scotland

3.8 ERDF supported VCLF instruments have been made available in Scotland during both earlier Structural Fund programming periods and continue into the 2007-13 period. Based on an assessment in 1995/96 that there was a continuing market failure in the supply of debt funding up to a level of £250,000, 3 funds were established. The Strathclyde Investment Fund was established in the West of Scotland and two funds, Eastern Scotland Investments ( ESI) and Edinburgh Technology Fund ( ETF), were established in the East of Scotland. ESI and ETF made their initial investments in 1999 and an evaluation published in July 2001 found that they "had facilitated better business propositions and ensured larger turnovers than would otherwise have been achieved".⁴

3.9 During the 2000-06 programming period, a number of new funds were established and it is mainly these funds that are the subject of this evaluation (although some funds, like WSLF and DSL were established earlier). The funds include both loan and equity funds. Equity funds, in turn, include both directly managed funds, where the fund is under the control of a professional investment manager, and a co-investment fund, where the fund appoints private sector partners who introduce deals.

Fund Covered by this Evaluation

3.10 The table below shows the VCLFs that were included in the scope of the current evaluation:

Figure 3.2 - VCLFs included in this Evaluation

3.11 Of the above funds, the Dumfries & Galloway Business Loan Scheme and Finance for Business (Scottish Borders) (the "New Ways" fund) have now ceased to take new business and have been incorporated into the South of Scotland Loan Scheme ( SoSLS). Both PSYBT and Micro Credit East had small financial resources. Micro Credit East is now administered in conjunction with ESF funding. Accordingly, much of our evaluation work has concentrated on the other VCLFs listed above. However, to the extent that the smaller funds meet the demands of a niche sector not elsewhere covered, they were considered as part of the overall evaluation.

Geographical Coverage and Objectives of currently operating VCLFs

3.12 The table below summarises the objectives, type of investment (equity or loan), the maximum fund investment level, and the geographical coverage (highlighted) of each of the VCLFs covered by the evaluation. Following the table, we also described briefly the nature of each VCLF and in particular its investment policy. More detail on these issues is included in appendices.

Table 3.1 - Overview of VCLFs

Fund Investment Policy

3.13 The investment policies and other relevant information on the various VCLFs is summarised below:

• SCF - the Scottish Co-investment Fund is a fund providing equity capital to companies with high growth potential and which often use proprietary technology. SCF is a commercial investment vehicle and as such it is expected to make financial returns (dividends, early realisations, disposals and loan repayments). SCF is a coinvestment fund. As such, the fund invests pari passu with private sector investors. SCF has appointed (after a tendering process) approximately 24 investment partners who bring deals to SCF. These partners can be institutional investors, professional fund managers, smaller regulated and unregulated fund managers and investors, business angel syndicates and private individual investors. Partners were appointed after an advertisement to meet public procurement rules, and include both Scottish partners and others from the rest of the UK and abroad. SCF enters into deals on a pari passu basis with its partners. SCF is a passive investor in the deals, although it is highly likely that Scottish Enterprise will keep in close touch with such companies for other reasons. Due diligence and the decision to invest is made by the partners. SCF co-invests with these partners after carrying out some basic company and deal eligibility checks. There is therefore a light touch by SCF. The Fund has no particular sectoral bias, although some of the partners have a geographic ( WL Ventures and UK Steel Ventures) or sectoral (Sigma Technology Group, Pentech, BioCatalyst Scotland) focus. The maximum deal size is £2 million, with a maximum commitment by SCF of £500,000. Most investments by SCF are in the range of £3,000-500,000.. An investee company will receive private sector investment from an SCF partner in addition.
• Sigma Innovation Fund - invests in Scottish companies from funds provided by Bank of Scotland, the European Regional Development Fund, Scottish Enterprise Fife and Sigma. The fund was established November 2003. It invests between £20,000 and £300,000 per investment, in high growth, innovative SMEs with their principal place of business in the East of Scotland. The fund can provide a mixture of debt and equity packages. The fund is managed by a professional fund management company, Sigma. Founded in 1996, Sigma is a private equity and advisory group specialising in venture capital in the technology sector. Sigma is listed on AIM and currently has 3 funds under management: the Sigma Technology Venture Fund, the Sigma Innovation Fund (East of Scotland) and Sigma Sustainable Energies Fund. Sigma is in the process of establishing a dedicated fund, for investment in Robert Gordon University spin out companies.
• Sigma Sustainable Energies Fund - invests in Scottish companies from funds provided by Scottish & Southern plc (now the UK's largest renewable generator), the European Regional Development Fund, Scottish Enterprise Fife and Sigma. It invests between £50,000 and £500,000 per investment and is able to provide a mixture of debt and equity packages. The fund invests in companies based in the East of Scotland involved in novel renewable and sustainable technologies. It is also a managed fund, like the Sigma Innovation Fund, and has the same management company.
• Genomia - was established with funding of £764,000 from the Office of Science and Technology, Public Sector Research Exploitation Fund and is dedicated to supporting the early stage commercial development of life science research from institutes such as the Institute for Animal Health, Moredun Research Institute, Roslin Institute, Rowett Research Institute, and the Scottish Agriculture College. Genomia provides a programme of investment options aimed at technology and business development and is tailored to address the different stages along the research to commercial realisation continuum. The Genomia Fund is a seed and pre-seed fund which seeks to provide modest amounts of pump-priming funds to support emerging technologies and to help bring them to market.
• WSLF - the West of Scotland Loan Fund was set up in 1996 to provide gap funding for new and existing SMEs where the companies had good commercial proposals but were unable to find the level of finance which was necessary to support their proposals - it is a loan fund operating in the West of Scotland as a lender of last resort. WSLF is administered by the West of Scotland Loan Fund Ltd., which was set up by the 12 unitary authorities that succeeded Strathclyde Regional Council. The fund addresses 2 different segments. It provides loans up to £30,000 for start up companies up to 2 years old; and from £30,000-£50,000 for existing businesses over 2 years old. Asset finance for property purchase up to £50,000 is now also eligible. The scheme can fund up to 50% of total project costs but will normally provide no more than 25%. The fund has invested in over 1,000 businesses to date.
• WSRF - the West of Scotland Regeneration Fund is a loan fund operating in the West of Scotland as a lender of last resort. Developing Strathclyde Limited ( DSL) manages the fund. Its objective is to provide funding to companies which have not been able to obtain funds from other sources. The loan fund includes contributions from local partners, the Department of Trade and Industry's Phoenix Fund, the ERDF and the Unity Trust Bank. In addition, DSL has an ERDF grant from Strathclyde European Partnership to develop the fund. DSL is a Community Development Finance Initiative ( CDFI) that operates in Ayrshire, Dunbartonshire, Glasgow, Lanarkshire and Renfrewshire. DSL currently manages 2 loan funds, the Western Scotland Regeneration Fund ( WSRF) and the Social Enterprise Fund ( SEF). DSL has also managed the National Micro-credit Fund, on behalf of Scottish Enterprise National. WSRF has now moved to a more commercial basis. The respective funds in the West of Scotland are beginning to cooperate but the level of cooperation is dependent upon personal relationships and informal networking.
• South of Scotland Business Loans Scheme - a loan fund operating in the South of Scotland. The scheme is open to small to medium enterprises ( SMEs) located in or looking to locate in the Scottish Borders or Dumfries and Galloway. Eligible companies can apply for loans between £5,000 and £50,000, to be repaid within 60 months. The scheme is designed to provide gap funding for business growth projects, and applicants must demonstrate that they have exhausted conventional funding sources. For loans of less than £20,000 security will not normally be required (although it may be taken). For loans in excess of £20,000, security will normally be required. The South of Scotland Loan Scheme is vested in SEBSED Ltd, a company limited by guarantee, of which Scottish Enterprise Borders and Scottish Enterprise Dumfries and Galloway are the members. We refer to either SoSLS or SEBSED as appropriate in this report. Most companies are reached through Scottish Enterprise's advisers. The management of the scheme is outsourced to WRDF, a development company in Newton Stewart. The fund is partly financed using the repayments from earlier South of Scotland loan schemes, including the Dumfries & Galloway Business Loan Scheme, the equivalent scheme in the Borders "New Ways", and predecessor schemes in each region to make non farm loans at the time of the foot and mouth crisis.
• Micro Credit East - a small fund providing micro credit, particularly to women entrepreneurs in the East of Scotland. It now uses ESF funds.
• PSYBT - the Prince's Scottish Youth Business Trust was set up in 1988 as an independent Scottish organisation with the aim of providing seedcorn finance and professional support to young people generally aged between 18-25 (older in some cases). It is a company limited by guarantee and operates as a partnership between the public and private sector. PSYBT operates across the whole of Scotland through a network of regional offices where they are generally supported by the Business Gateway or other local enterprise networks. In 2002, PSYBT established a Growth Fund with pilot funding to provide access to loan funds in the £5,000-£25,000 range to businesses in all qualifying sectors that have previously received PSYBT support. A Development Loan Fund for expanding businesses up to £10,000 is available up to 3 years after start-up (applicants aged 18-29) and an Accelerator Loan of £10,000-£25,000 for businesses seeking to expand significantly up to 5 years from start-up (applicants aged up to 31).

Financial Resources

3.14 We now summarise the financial resources available to the VCLFs, including the amounts made available from ERDF funding, and from other sources including public sector and private sector funds. The following table shows the gross resources available to the VCLFs, rather than the amounts invested in the Funds (this is considered in subsequent sections of this report). Because funding from the Dumfries and Galloway Business Loan Scheme and from the "New Ways" loans scheme is being transferred into the South of Scotland Business Loan Scheme, these 2 schemes are not included in the table.

Table 3.4 - Fund Resources during life of ERDF Programming Period, £'000

Source: Fund profiles contained in appendices to this report

3.15 Because of the different nature of the funds, figures may not be wholly comparable. An analysis of the ERDF funding applications showing the amount of ERDF grant aid applied for in each of the VCLFs is contained in Appendix M. The funding is broken down between the different European partnerships in Scotland, in the East, South and West and is based on ERDF application forms.

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