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The Credit Crunch - One VC’s Perspective on how equity investment is replacing debt
John White, Founder and Director
East Midlands Early Growth Fund
E-Synergy Ltd
Introduction:
The “Credit Crunch” has seen at least £40k wiped off every British adults wealth on average. Since July 2007 the value of their property and equities has slumped by 28%. For high net worth individuals and those lucky to have £500k of free assets at their disposal to invest in speculative start ups - the effect of the credit crunch would be expected to be much worse with a consequent reduction of start up capital being available in the market place. The recession is only in the first stages and it is likely to be the world’s first global depression.
This article will look at the initial effects of the credit crunch and where companies can still obtain early stage start up cash; firstly though some further information on how the crunch has effected overall wealth in the UK.
The affect on Average Wealth:
PWC estimate that the £1.9 trillion fall in UK wealth could reduce annual spending by around £45 billion, or around 3 per cent of GDP. The world now has 30% less billionaires than 18 months ago and countries, such as Iceland & the Ukraine, that have encouraged heavy borrowing have effectively gone or are on the brink of becoming bankrupt. Closer to home and of more immediate interest, interest rates have been cut to a record low of 0.5 per cent in this economic cycle and the Bank of England is now embarking on a process known as ‘quantitative easing’, whereby it buys up gilts from institutions such as banks in the hope that the extra cash will get the economy moving again. Yet if you are small company wanting an overdraft or a loan to support your business you can’t get it from a bank!
The world financial system effectively froze up for at least a year as every financial institution tried to improve it’s capital adequacy i.e. the amount of “real” money and solid assets it possessed as opposed to borrowed. Although interest rates have now been reduced dramatically the Banks remain loath to lend as they slowly build back their “real capital” base.
Ironically through all this maelstrom, and value destruction, it is the likes of Sir Fred Goodwin ex RBS who has certainly benefited, although in many ways overseeing if not responsible for the excessive lending spree. And on the other side those who took out excessive loans or who spent excessively now have the luxury of some of the lowest mortgage rates in history. Whilst the government has previously encouraged saving; it is those pensioners and cautious savers who now suffer with asset value destroyed and low interest on those monies the banks haven’t lost for them.
But this is probably getting too serious and instead for a fuller picture and further biased explanations I would direct you to the following :
http://www.youtube.com/watch?v=wGxmgwUWNr0
http://www.youtube.com/watch?v=s_iMS31mqmU
http://www.youtube.com/watch?v=kQdNLFVdwfQ
How we got there
Years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property. And of course this seemed a good idea when Central Bank interest rates were low; the trouble was it just couldn’t last. Interest rates hit rock bottom in America in the early part of 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments but unfortunately for us in the UK the US banking sector had packaged sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations) and sold on as obscure debt packages to hedge funds and investment banks who generated high returns without understanding the risk. (Jon Moulton, a shareholder of E-Synergy is quoted as having said on television before the crunch started that a large number of the heads of major banks in the UK did not understand a CDO! )
When borrowers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally. But no one really knew where the losses were because they had been packaged up!
But the CDO debacle shouldn’t have come as a surprise – those who remember the 1987 Wall Street crash – made famous by the Oliver Stone film with Charlie Sheen – will be aware that a similar obscrurification had been employed then by striping off the dividend from a quoted share and then subsequent packaging up with others to produce a “pure” dividend product sold on to others. Again the risk element was not understood correctly.
The affect for small businesses: Finance Availability
To get back to the main point of small company investment finance, irrespective of how we all got here the current situation for small companies is very difficult. Even small companies with good turnover and strong orders are not easily able to get bank overdrafts renewed. One small company in the North East successfully running for 19 years , with £1m turnover, had both its bank overdraft of £50k and its mortgage of £750k refused, even though it had been trading successfully. This inability to obtain a bank loan is becoming fairly common now and those of us who interface directly with businesses in the East Midlands can tell of many similar stories.
The recently announced Enterprise Finance Guarantee scheme, a successor to the Small Firms Loan Guarantee (SFLG) scheme just hasn’t worked. This £1.3 billion scheme is designed to support bank lending, of three months to ten year maturity, to UK businesses with a turnover of up to £25m who are currently not easily able to access the finance they need. It should enable them to secure loans of between £1k and £1m through a Government guarantee and is available up to 31 March 2010. The problem highlighted by recent publicity in the papers and media is that the banks are still demanding guarantees from the Directors. Consequently as with the previous SFLG scheme very few applications are proving successful. I’m afraid there are a lot of arguments for banks to return to simple old fashion lending where the banks did proper due diligence on individuals and companies and understood what and who they were lending to!
Co-investment funding : Public and Angel investment
That really only leaves VCs or Angels to step into the funding breech.
At E-Synergy we initially thought that everyone would put on hold investing in new start-ups and if they did invest would only invest in the equity gap, higher up the food chain, in established companies with reasonable turnover and approaching breakeven.
Between the summer and Christmas we did indeed notice a hold in investments but others have not seen this, which is initially surprising: In 2008 Ascendant (http://www.ascendant.co.uk/) reported the highest level of investment (2008: £1,001m, 2007: £872m) since the technology bubble of 2001, with 253 deals done ( 242: 2007) of over £0.5m. In particular in the last quarter of 2008 (when the crunch was hitting hard) £229m of funds was invested in 55 companies - an indicator that the crunch was neither putting off institutional investors nor private/angel investors who represented 19% (last year 13%) of the total funds committed. These figures represent UK/Irish tech companies only and some of the biggest investors were Scottish Enterprise, Enterprise Ireland, NorthStar Equity and others with a considerable proportion of their funds derived from the Public Sector.
Of note also is the report from Nesta with information supplied by Library House titled Shifting Sands (September 2008) unfortunately written before the main crunch impacted but nevertheless with useful pointers. Of key importance is that between 2000 and 2008 the public sector has become considerably more important as an investor in both absolute and relative terms rising from 18% of all VC deals at the beginning of this period to 43% in 2007. Together with a notable increase in business angel funding doubling from 15% to 30 % , this has resulted in co investment deals being the dominant form of funding (62%) in early stage company finance.
On the face of it this information is all consistent and in a downturn one might expect, given both the public sector leverage and past history of Business Angel cyclical investment (low sensitivity) should hold up well in a downturn.
Further on hindsight perhaps this is not as surprising as one might initially think. As a high net worth individual in an environment with “safe” banks crashing all about you one’s perception of risk changes: a risky seed start-up becomes relatively less risky compared with a bank or building society particularly as the hi net worth individual can do his own due diligence and “get his head around” the investment; better than a CDO!
So to date the VC investment area has held up reasonable well, Business Angel and Co investment funding, such as the East Midlands Early Growth Fund (EMEGF), is critical to this early stage financing and co investment funding appears to be the best source of funding new company start ups. And in turn one of the better ways of “recycling” jobs and employment into dynamic new growth companies required by the region.
The Future
Well I wouldn’t like to openly predict the future for investment in this sector: but a few things can be said together with the fact that there is starting to be some overall consensus emerging;
Firstly: Inflation is currently zero or negative and the Government is doing everything it can to get people to spend; to encourage the same people who borrowed too much before to do the same again. Quantitative easing is another way for saying the government is printing money – yet they argue it is not printing money for the likes of me and you but for institutions and therefore won’t produce inflation.
Secondly: In all previous histories of recessions and large debts being incurred, the Government has always inflated its way out of debt. Which would you prefer as a Government – any government? A debt approaching £30k on every man women or child in the country to be paid off over the next generation or a quick dose of inflation to reduce the debt to low values over the course of a few years? So my guess would be that the government fails to react quickly enough to all the spending measures it has introduced and we move rapidly from zero to high inflation in a couple of year thus solving the debt problem in one go!
Thirdly: If you are a VC, on this scenario– it is a buyers market! Lots of new company start-ups from newly unemployed people. Lots of previously well run companies looking for cash to replace bank loans. Which means in turn companies must lower their valuations to attract any chance of investment funding.
Lastly: As a company seeking finance, get as much money as you possible can now – it’s going to get harder first before it gets better or inflation starts to kick in and the economy rebounds. Do not worry about giving away too much equity – if you are confident in your company negotiate performance related options. No VC worth his salt will mind giving away a proportion of equity as a strong incentive if the company does well. Remember also, that if you are lucky enough to get funding from a public/private co investment fund such as the EMEGF you also will be able to tap into a databank of expertise that can facilitate your company to grow and successfully exit.
copyright© john White 2009
Disclaimer : This article does not nor is intended to constitute investment advice and represents personal views of the author who accepts no responsibility for any loss or otherwise of any actions taken as a consequence of reading the article etc.