Private & confidential © 2013 HM Government European Structural and Investment Funds Delivery Conference Friday 17th May 2013 Financial Engineering Instruments

Private & confidential © 2013 HM Government

European Structural and Investment Funds Delivery Conference

Friday 17th May 2013

Financial Engineering Instruments


Models for Financial Instruments:

• Access to Finance• Social Housing• Local Impact Fund• Urban Development


SME Competitiveness: Access to Finance


The unavailability of finance options appears to be particularly problematic in the UK

SME Competitiveness is one of the top 4 priorities for ERDF The Commission has recommended that the UK focus on Access to Finance

as a country specific recommendation Analysis of the UK against European comparators shows that SME

investment is relatively small in absolute terms, and also as a share of total private sector investment.


SME lending in real terms has fallen 25% since its peak in 2009 and is now almost 10% lower than in 2006

There has been a reduction in demand - confidence to borrow and invest has been held back

Impact of the Financial Crisis

There are a number of constraints on bank lending and equity finance, which are structural and long term

Demand for finance can be expected to increase as firms’ confidence in future economic performance improves

Early stage SMEs are particularly affected but can have a disproportionate impact on growth


Access to finance is identified as being amongst the biggest obstacles to business success

6Base: All SME Employers (3817/4768)

• Main obstacles include:– Economy (38%)– Taxation etc (12%)– Competition in market

(10%)– Cash flow (10%)– Regulations (8%)– Obtaining finance (7%)– Shortage of skills generally

(2%)– Recruiting staff (2%)

Source: Small Business Survey 2012


Demand side factors Only around one in ten SMEs apply for a loan or overdraft

each year

Banks report that demand for finance has declined and the use of external finance by larger SMEs (10 employees or more) has declined significantly

Around 8% of SMEs would like a loan but are dissuaded from applying

Younger firms and those with turnover of less than £10m are less able to substitute other forms of finance

Whilst demand is muted, many businesses are still seeking finance

Private & confidential © 2013 HM Government 8

Type of finance sought – by employment size

16%

4%

17%17%

44%

6%9%

14%

28%

41%

5%6%7%

37%

50%

6%7%8%

35%

48%

Asset financeGrantLeasing/HPOverdraftBank loan

Medium

Small

Micro

All that applied

Base: All SME Employers that sought finance in the last 12 months (1409). H6

Source: Small Business Survey 2012

Bank debt is the most important source of finance for UK SMEs

Loan rejection rates in the UK in 2011 were twice those in France and Germany. 24% of SMEs applying for an overdraft and 34% for a loan ended the borrowing process without a facility

Margins for facilities have also increased

Supply side issues: Debt Finance


Venture Capital and Angel investments are important for early stage high growth businesses lacking track record or collateral and seen to be higher risk

The private sector has migrated away from the smaller end of the market towards larger private equity deals

BVCA Reported equity investments

050

100150200250300350400450500

2007 2008 2009 2010 2011

£mn

LaterStageVCEarlyStage

Start-up

Seed

Supply side issues: Equity Finance


“Market Failures”

Banking concentration - In 2009, the largest five banking groups held approximately 90% of the SME banking market share

Constraints on supply of long term bank finance – The expense and capital requirements associated with longer term funding make long term finance less attractive

Lack of track record and collateral - Smaller and newer firms find it harder to raise bank finance

Regulatory changes - De-leveraging of bank balance sheets and implementing new regulatory requirements

Equity finance – There is a long recognised structural finance gap, whereby the high costs of due diligence, relative to deal size, make smaller equity investments (around £250k to £5m of investment) uneconomic


The 2014-20 Funding Period


We consider the following criteria to be essential in the delivery model for financial instruments for access to finance:

Strategic coherence with national policy A clear and influential role for LEPs Recognition of the fact that this is not a greenfield site Value for money and efficiency Scale as a key requirement Sustainability throughout successive funding rounds and development of market capacity in the long term Operationally workable Allows for re-use of legacy returns across historic regional boundaries Allows for match funding Allows for ERDF compliance


Venture Capital and Loan Funds have attracted ERDF funding in England since 1995, with a significant number of funds being established as part of the 2000-2006 ERDF programme

In the past key issues have been around: Delays in delivery Lack of strategic fit with economic strategies Fund size Cost of multiple delivery models and fund structures

A 2009 National Audit Office review established that SME schemes generally operate most effectively at sufficient scale; the experience of RDA funds, and of the Regional Venture Capital Fund programme, is that small funds, most with highly-constrained investment criteria, perform worst against their financial and economic output objectives.

Lessons learned from previous funding rounds


A fund-of-funds approach could build on the existing JEREMIE model

Technology

Mezzanine Loans Plus

Digital & Creative

Energy & Environment

al

Biomedical

£155 million for investment across 6

funds

For the current 2007-13 programme period 3 regions in England established a fund-of-funds structure known as a JEREMIE*. Wales also established a JEREMIE

The three England JEREMIEs combined ERDF funds, EIB match funding and RDA Single Programme Funds

£90 million for investment across

3 main funds

Seedcorn (convertibl

e loans and/or equity)

Business Loans

Equity linked investments

(and mezzanine

loans)

£125 million for investment across

7 funds

Venture Capital

Accelerator (high

growth early

stage)

Growth

Growth Plus

Proof of

Concept

Angel Microloan

* Joint European Resources for Micro to Medium Enterprises


We believe there are benefits to employing a fund-of-funds structure

Secures match funding at a holding fund level and at sufficient scale to attract EIB funding

Businesses looking for finance will continue to access fund managers in their own areas; local fund delivery is considered to be a key factor

Enables a sufficient scale of fund size to be achieved

Portfolio approach offers a mix of finance

Fund managers can be appointed and monitored rigorously

The fund-of-funds structure is designed to be revolving and recycle legacy returns back

Auditing, reporting and other administration costs are pooled at the holding fund level


This could look like….

2014-20 Proposed Delivery Models

Holding Fund

Holding Fund

Holding Fund

E.g. Venture Capital

E.g. Mezzanine

E.g. Loan fund

E.g. Sector Specific fund

LEP area LEP area LEP area LEP area

• Local deal origination and delivery

• LEPs determine investment priorities

• Funds invest across LEP group geographies with indicative area targets

LEP area

Holding Fund

National Holding Fund

• Funds can be pre-matched at national or sub-national level

• Operational costs are pooled at holding fund level

• ERDF reporting / auditing requirements are managed by holding fund

1


Or this could look like…..

E.g. Venture Capital

E.g. Mezzanine

E.g. Loan fund

E.g. Sector Specific fund

Funds invest across England with some form of geographical targeting

• Local deal origination and delivery

• Investment priorities determined by LEP strategies & consultation

National Holding Fund

• Operational costs are pooled at holding fund level

• ERDF reporting / auditing requirements are managed by holding fund

• Funds can be pre-matched at national or sub-national level

2

3

LEPs collaborate to deliver a fund or series of funds covering their combined geographic area

LEPs deliver individual funds to cover their own LEP geography

OR


Why have we proposed a ringfence? There is a recognised need for scale to deliver value for money and attract match funding

– Small venture capital and loan funds can be very inefficient. Management costs can become disproportionate

– Particularly important for Venture Capital where diversification is essential– Small funds may lack capacity to make further investments in successful companies

ERDF Restrictions– Need for match funding, sustainable management of legacy returns and compliance with

regulations Consistency of approach and provision for businesses

– Avoid a perception that there are different levels of delivery in different parts of the country– We would like to provide a mix of finance across broad areas so that businesses around the

country can access the type of finance that they need. – We want to avoid frustration for businesses linked to boundary issues

Operationally workable for Fund Managers– Restrictive geographical coverage would lead to significant issues appointing fund managers– Attracting fund managers with strong track record is critical to success. – This is about attracting credible fund managers to the area for the long term and proving that

returns can be made Best use of resources

– For LEPs– Ability of HMG to support LEPs


Financial Instruments:

Social Housing Model Local Impact Fund (Social Sector) Urban Infrastructure Funds


Social Housing Model

Buy-in from LEP ERDF and ESF allocations

EIB/Other investment

National Financial Intermediary

Retrofit/new build projects in LEP areas





Local Impact Fund

Local Impact Fund

LEP ERDF and ESF allocatio

ns

Social sector

organisations

Other national

social investors

Investment

readiness support

Local social

investors

Grant

GrantEquity/debt

Big Society Capital


Urban Infrastructure Funds

LEP

ERDFOther sources of match funding

Urban Infrastructure Fund * (Private Sector Fund Manager)

Projects Projects Projects Project level investment* In large LEPs, there maybe sufficient scale to create

discrete low carbon and urban development funds with different fund managers

Investment returns


We are keen to hear your views

Q&A

Documents

Private & confidential © 2013 HM Government European Structural and Investment Funds Delivery Conference Friday 17th May 2013 Financial Engineering Instruments