CandidCapital

UK venture capital investment activity - investment in early-stage companies - fell in 2008 to its lowest level for three years. Despite the Government's announcement of the £150M UK Innovation Fund in June this year, it is the culmination of a process in which investors have become increasingly disillusioned with UK venture investment. This three part post seeks to expose the factors that have led to this disillusionment and to ask whether there is a credible future for commercial, early-stage venture investment or is it destined to remain a public sector activity. Part 1 looks at the role and legacy of 3i in UK venture capital.

From the Foundation of ICFC to Present Day 3i

In the last great depression - which ran from 1929 until well into the 1930s - the government of the day (the short lived second Labour administration of Ramsey MacDonald) commissioned an enquiry into "the depressed state of British Industry". The Macmillan Committee, which included such established political and economic figures as Reginald McKenna and Ernest Bevin, issued its report in 1931 - most of which was authored by John Maynard Keynes. Keynes saw the financial, especially monetary, system as the root of much that had contributed to the sharpness of the depression.

Among the recommendations that the committee made was the creation of financial institutions that could "advise on ... and arrange.. the provision of long-dated credit" to British industry - but the committee made clear that this institution would primarily be concerned with larger businesses. It went on to recommend that "it may be desirable to form yet another type of finance institution which would confine itself to smaller industrial and commercial issues." The Industrial & Commercial Finance Corporation was announced in February 1945 as an initiative of the then private Bank of England and the principal commercial clearing banks (see Origins of UK Venture Capital Industry) as a direct, if delayed, response to the Macmillan Committee recommendations.

By the mid 1980s, 3i (ICFC had re-branded itself on the advice of Wolff Olins in 1983) had a portfolio of nearly 5,000 investments and accounted for nearly 40% of the investment activity by members of the of the BVCA (1988 data). It had a network of 23 regional offices and nearly 800 staff and had investments in every kind of business in every corner of Britain. It was the very embodiment of the institution, aimed at the "small and medium sized concern", envisaged in the Macmillan Committee report.

Today in 2009, however, 3i is an entirely different institution. It's a mid-sized, mid-market private equity house operating in the UK, mainland Europe, north America and Asia. It has 4 remaining offices in the UK, including its London HQ, and invested £316M in the UK in 2008 - out of £8,556M invested in the UK by BVCA members as a whole (3.7%). It no longer touches the vast majority of UK Small and Medium-sized Enterprises, has become a major player in the financing of Indian infrastructure projects and has abandoned venture capital (early-stage, innovation-based investment). Why is this?

The reasons lie in the success of 3i's, or ICFC's, investment activity, which had given it real value by the mid '80s. Some of its shareholders (not least Midland, Reginald McKenna's old bank, strapped for cash after the near failure of Crocker, the Californian bank it bought in 1981) were eager to turn that value into cash. Moreover, 3i's senior and middle management had started to eye the performance related bonuses of executives at other private equity and venture capital firms with envy. 3i's competitors, usually structured as fund management businesses managing separate funds on an arms-length basis, were incentivised by a share in the capital growth of the funds they managed (a structure known as 'carried interest'). In the boom of the 1980s, the decade in which management buy-outs really took off, carried interest had made several venture executives seriously wealthy.

This combination of pressures created an impetus for flotation in order to provide liquidity for shareholders and create real value for the internal share option scheme - which was the only way that 3i could realistically offer capital gains to its staff, since the bulk of its invested funds were on its own balance sheet rather than in arms-length funds. It seems to me, and I was an investment executive (albeit very lowly) in 3i at the time, that the senior management also sought to change the culture of the organisation. As ICFC, it had previously pulled off the trick of being very focused on financial return while believing in the purpose of 'the Corporation' as a entity created to do good - i.e. address market failure in the financing of SMEs. From the 1983 re-branding onwards, 3i's senior management were resolute in erasing the remaining vestiges of a wider public service ethos and focusing only on financial return. In the light of the privatisation ethos of the Thatcher administration and pressure from most of the other shareholders there was little that the Bank of England could do to halt this process, even if it had wanted to do so.

Inevitably, the changed focus of 3i's owners and managers led to a 'flight to quality' or, more relevantly, a 'fight to scale'. There's an old venture capital adage that it takes as much time, effort and due diligence to do a £1M deal as its does to do a £50M one. This fuelled a rapid increase in the average size of investment made - from c £350,000 in 1987-88 to £1.5M in 1997-98 and £51M in 2008-09. This went hand in hand with a steady, and then rapid, decline in the number of UK investments in the portfolio, from nearly 5,000 in March 1988 to under 3,000 in March 1998 and just 319 in March 2009 (of which only 10 were new investments).

Hands-on or Hands-off? The Role of the Venture Investor

There is also a more pervasive and insidious aspect to 3i’s legacy, which derives from its role as the training ground for so many of the executives who ran the UK venture industry in the ‘80s, ‘90s and into this decade. 3i was always a financially centred institution – in some ways more like a bank than a venture capital firm. Its assessment of the attractiveness of a potential investment principally revolved around financial measures: cash generation, dividend cover, gearing, margins and the extrapolation of future growth from historic growth.

The average 3i investment executive in the ‘80s was likely to be an accountant recruited after qualification or a direct graduate entrant. Few in the finance stream (i.e. those actually doing the deals) had had direct management experience in industry – this was the preserve of the sector experts in Industry Department (an in-house consultancy service housed in the leafy suburbs of Birmingham) who were tasked, on an ad hoc basis, by the investment executives to review a potential investee’s products, marketing and operations. With personal portfolios that could have 20, 30 or even 40 businesses in them, the average executive simply didn’t have the time or opportunity to take any significant interest in the business strategy, marketing or product development of a single investee.

Although a board seat was a usual condition of a 3i equity investment, this was invariably taken by a third-party nominee with hazy accountability to 3i and almost never a clear mandate on how the business was to be developed using 3i’s influence or voting power to enforce adherence to the agreed strategy. Conscious that the world was changing, especially in high-technology businesses, 3i experimented in the 1980s and again in the early 2000s with specialist venture capital teams, which would be closely involved in the management and direction of investees, following the US model pioneered by west coast funds such as Kleiner Perkins, Sequoia or Mayfield.

The original 3i Ventures of the 1980s attracted much internal hostility, akin to that shown towards highly-paid corporate finance executives or traders in a large integrated bank, and was closed following the 1989 recession. The 3i Venture Capital business (formed as a distinct business in 2001-02) was effectively closed in 2007-08 - signalled with the laconic statement in the 2008 Annual Report “The transition from early to late-stage investing, which was driven by the objective to maximize shareholder returns and reduce the volatility inherent with an early-stage investment activity, has now been substantially completed” and was accompanied by a £17M asset write-off.

The lessons of the 3i Ventures experiment were not lost on the UK venture industry – that 3i’s original financially driven business model was the one that worked (and the same conclusion can be seen reinforced in the statement in the 2007-08 3i Annual Report). 3i knew that it had been successful in using investment structure to extract value, through both running yield and return of capital, before the other owners of businesses in which it invested as well as using wide-ranging control rights to ensure that the opportunity of a realization was taken when it arose. This approach simply had no room for the business building role of US venture investors.

Venture investment takes real industry knowledge and experience, not expertise in financial engineering, and the decimation of British industry in the recessions of the 70s and 80s had left a shortage of the kind of UK management talent that would be needed to emulate the example of the US west coast funds, especially in investment in technology-based businesses.

The fruits of this process can be seen in the modern day UK private equity industry. For that’s what it is - even the full name of the British Private Equity & Venture Capital Association gives it away. In the introduction to the 2008 BVCA Report on Investment Activity, Simon Walker BVCA CEO writes “The stark decline in early-stage investments is particularly worrying” – sentiment born out by the statistics: £343M invested in early-stage businesses in 2008 compared with over £600M in 2006 and dropping as a share of overall private equity and venture investment from 9% to 4% in the same period.

I’ll return to the role of the venture investor in the development of investee companies in Part 3 of this post.

The Legacy of 3i

This erosion of the role and function of 3i, to the point where it's an also-ran mid-market MBO house, has left many smaller British businesses, especially those with ambitions for growth, with few attractive options for raising the necessary capital. The government has been well aware of this for some time: Lord Mandelson, Secretary of State for Business, Innovation & Skills, said in a speech in March to the annual dinner of the BVCA "New start-ups and SMEs with quality products or ideas are struggling to get the business finance they need. Banks are regrouping and business angels and investors are looking first to protect the success of their existing deals, rather than take a risk on new ventures." He went on to add "[we need]...something like the original ICFC – a means of using public seed money to leverage private long term capital for existing small firms that want to get a lot bigger." In the speech he referred to his having made many of the same points when he spoke to the BVCA annual dinner in 1998 as Secretary of State for Trade & Industry.

Yet for over 20 years, governments, both Labour and Conservative, have placed their confidence in the market, and particularly the increasing role of business angels, as the solution to the problem of making capital available for smaller growth businesses. In the next part of this post, I look at why the business angel phenomenon has not delivered the SME financing miracle so long hoped for.

29 August 2009