Enterprise Capital Funds (ECFs) are part of the UK Governments continued efforts in its crusade to address the “Equity Gap” for growth companies seeking up to £2m in equity capital.

The “Equity Gap” is a market failure based on entirely rational economics – the monetary returns that professionals have made from early stage investments have not been sufficient to offset the levels of risk that result from a large proportion of early stage investments failing.

In addition, there are certain levels of transaction costs (legal, accounting, due diligence etc.) that are incurred regardless of the size of transaction. Clearly, the lower the level of the funding round, the greater the percentage of the round that is consumed by such costs, further weakening the attraction of making such investments.

The Enterprise Capital Fund programme is a Government initiative aimed at addressing this market failure. The initiative is a variation of the US Small Business Investment Company (SBIC) model, which has been running since 1950’s and has backed the growth of successful companies such as Apple, Intel, FedEx and AOL.

One year after the launch of the first vehicle funded through the ECF “Pathfinder” initiative – the £30m Seraphim Capital Fund, the Government has announced a further three groups that will each receive £20m public funding.

ECFs are privately managed funds that leverage private investment with public funds. The Government invests up to £2 for every £1 of private investment. Government money is provided at rates of interest similar to those applicable to other government bonds and attracts a profit share.

Following a period of fund raising from private investors, MMC Ventures, Dawn Capital and Oxford Technology will launch their respective £30m funds some time early next year. This increases the ECF funding pool to a total of £225m.

ECFs offer a potential mechanism for groups of high net worth and sophisticated private investors to take the first steps towards formalising existing loose networks. Seraphim is unique amongst its peer group as the only unregulated fund. It has adopted an “angel-led” model carved out by the Government to encourage angel investors into an area of the market vacated by traditional VC’s who have moved up the value chain.

Government have clearly acknowledged the vital role that experienced Business Angels play in the funding of early stage fast growth companies. Through its consortium of angel networks, including the pre-eminent Pi Capital, Seraphim has direct access to over 1,000 business angels.

Drawing on this pool the Fund invests alongside successful entrepreneurs who are re-cycling returns from their own enterprises whilst adding a degree of experience, expertise and business contacts to aid the growth of the investee company. Boggett says:

Smart money attracts the better opportunities – we’re already building a strong reputation as providers of ‘Mentor Capital’. Given that it is commonly understood that market access and introductions are one of the greatest challenges for an early stage company Seraphim enables entrepreneurs to gain access to one of the largest international business angel investor networks in the world.

At the risk of using evidence in the US as a proxy for the UK market, the Government could see a healthy return from this initiative or at least achieve its “cost neutral” objective. The largest study on the financial returns of angel investors in North America, published in November 2007 by the Kauffman Foundation, shows investors participating in organised groups achieved an average 27% internal rate of return on their investments. Overall, angel investors experienced exits that generated 2.6 times their invested capital in 3.5 years from investment to exit. This return compares favorably to that of other private equity investments, including those of early-stage venture capital. Seven percent of exits generated returns above 10 times their initial investment.

According to Library House, the level of investment falling within the £0.5m – £2m equity gap has been flat for the past three years. In 2004 some 168 deals were undertaken, with 176 in 2005 and 165 in 2006. To date a total of 18 investments have been reported by the 5 existing pathfinder ECF’s. On the basis that the new funds invest at a similar run rate of 4 deals per annum the ECF initiative could account for over 20% of transactions in the equity gap in coming years.

My thanks to Mark Boggett, an investment director at Seraphim Capital for his help with this post.

Free updates:
If you enjoyed this post and would like to be kept updated on future posts, then please click here to get updates by Email. Alternately you can follow the updates the Business Opportunities And Ideas Facebook page or follow me on Twitter.