Drawing on findings from the Wales Business Fund evaluation, Tim Fanning and Neil Evans reflect on the lessons from attempts to address the SME finance gap in Wales and other UK regions.
The SME finance gap: a key barrier to growth
Gaps in access to finance for SMEs have been recognised as a market failure since the publication of the Macmillan Committee report in 1931. The ability to access debt and equity finance is a key enabler of growth for smaller firms. However certain firms and start-ups with viable investment propositions face difficulties due to structural market failures.
Ever since that report, Governments have sought to address this gap. In the past couple of decades, the European Union’s Structural Funds have played an important role, driving the creation of regionally-based Funds offering repayable finance to SMEs where there is market failure. These emerged as early as 1995 and grew, especially in the 2014-2020 ERDF programme.
To give a sense of scale, the 2021-27 ESIF programme across the EU will see €18.5 billion invested in these financial instruments, most of it targeted at the growth and competitiveness of SMEs.
Whilst the UK obviously won’t receive any more of that EU funding, the British Business Bank – set up by the Coalition Government – provides significant funding to small businesses. The Labour Party’s report, the Commission on the UK’s Future, recently recommended renaming it the British Regional Investment Bank, with a new remit to tackle regional inequalities in access to investment capital.
Lessons from Wales and other UK regions
In Wales, the £216m Wales Business Fund (WBF) is the last in a series of EU-backed SME finance interventions. Having just evaluated the Fund, we were struck by some of the lessons we found not just there, but more generally from the experience of similar funds over the past two decades. Whilst some of these are specific to Wales, many also apply to other UK regions that have developed similar interventions (especially in the North and Midlands).
Here are eleven key observations:
1. The EU Funds facilitated the testing of approaches to repayable finance
In Wales and other UK regions, prior to the introduction of venture capital and loan Funds, the provision of economic development finance to SMEs was predominantly grant-based. Indeed, many of those who were around then have referred to a prevailing “grant culture.” Although there is still a role for grant finance for start-ups, it was recognised that grants lack the discipline that repayable finance brings, do not enable businesses to become educated in mainstream business finance, risk displacing private finance and do not generate any legacy funding that can be recycled into further investment (That is, the financial returns net of all operational costs, which, in line with EU and UK Government rules, can be reinvested in similar investment funds.)
The EU Structural Funds initially backed the creation of a small Welsh Fund to test the use of repayable finance. This then subsequently grew into the much larger Funds under the JEREMIE initiative, generating legacy funding for re-investment. This has enabled ‘learning by doing’ on addressing market failures, creating economic development benefits whilst generating reasonable financial returns, and educating new and growing businesses on the use of commercial finance. Indeed, the UK was at the forefront of Europe in the use of financial instruments to address SME finance market failure.
That said, there remain some deeply engrained and long-term attitudinal challenges. A good example is the aversion amongst some SMEs to giving up equity in their business in return for growth.
2. The Funds have helped to build wider capacity
As a consequence of the operation and growth of these Funds over a long period, significant capacity and expertise have been built in Wales and other regions. This has meant that there is a set of professionals with a long track record in the delivery of these interventions, with a niche combination of corporate finance and economic development expertise.
Whilst much of the Fund Management expertise which has been built in Wales resides in the Fund Management arm of the DBW, this will have helped to build financial services supply chains. Outside of Wales, there has been more of a focus on independent Fund Managers, which has been important in building capacity (including embedding in particular regions such as the North West) and improving standards. But this path has not always been easy and some FMs have, arguably, fallen short in terms of professional standards.
3. The Funds have served to boost the profile of the region as a place to invest
The majority of venture capital and private equity investors are located in London and its environs. The growing presence of the DBW and its predecessor, Finance Wales, and the creation of a track record and case studies of successful investments in SMEs, have helped to grow the profile of Wales as a place for investment (both from investors and companies). The Development Bank of Wales is now the fifth biggest equity investor in the whole of the UK (Source: Beauhurst). There is much, much more to be done, but there are some early signs of a virtuous circle, which makes it a little easier over time to attract a network of co-investors from these centres of finance (indeed, the early-stage equity funds run by DBW have attracted investment from Silicon Valley).
This can be particularly powerful when used alongside other public sector economic development investment targeting sector opportunities, such as life sciences in Wales. In Northern Ireland, there was some success in attracting international co-investors, including for example Angel and Tech investors from the US.
4. Pan-regional coverage has been valuable
The fact that WBF and its predecessors have both operated across Wales and had targets for investment and outputs at a sub-regional level is important. A market-led Fund may naturally gravitate towards East Wales and especially Cardiff, where there are existing concentrations of businesses and regional decision-makers. By having explicit targets for West Wales and the Valleys, the Funds have been forced to go out and source investment opportunities and develop a presence. Although this has been challenging at times, it has generated economic benefits that would not otherwise been secured.
Exactly the same lesson could be drawn for places in other regions which have lacked the historic infrastructure of finance providers and intermediaries (and an appetite for external growth finance amongst local businesses).
5. Scale is key to success
Funds like this need to be large enough to ensure economies of scale in operation and attraction of Fund Management talent, but also the scale of suitable investment opportunities, which in turn helps to secure the co-investment at fund and investment levels. The WBF is a good example, at £216m.
Whilst it might be tempting to establish small, niche funds that target a locally important sector or geography, these often lack the scale needed and their performance can suffer as a result.
6. Offering a mix of finance types aids flexibility
Public sector-backed funds typically need the flexibility to be able to offer a mix of finance types, address the finance gaps and meet the finance-specific needs of businesses at different stages of development. The WBF covered a spectrum of investment needs, from early-stage tech through to established SMEs seeking growth capital.
The finance offered needs to be underpinned by market evidence and a strong business case from the start. However, Funds may need to change over time in response to market conditions. The WBF had to contend with the huge economic shock of the pandemic (as well as Brexit), which saw very significant shifts in the nature of demand (from growth to working capital) as well as supply (with unprecedented Government support for SMEs). Remaining agile is an important lesson, and DBW’s close relationships with the private sector enabled real-time market intelligence to inform the decisions of DBW and the Welsh Government.
7. Patience is a virtue
Patient capital and a reasonable scope to follow your money are very important when it comes to making investments in early-stage, innovative ventures. It can take multiple rounds of investment before a business attracts large-scale private investment. The British Business Bank recognises this and emphasises the patient capital approach.
Linked to this, in planning for and managing a fund, there is a need to be aware of the economic cycle and the impact recessions and other crises can have on financial outturns. It is helpful not to be hindered by unreasonably short investment and realisation periods.
8. The creation of the Development Bank of Wales itself was underpinned by Structural Funds aligned to Welsh Government funding
The initial testing of repayable finance led to the creation of Finance Wales, which ran the WBF predecessor Funds. Finance Wales then evolved into the Development Bank of Wales (DBW) in 2017. The continuous building of financial returns has provided an important source of legacy funding – alongside ongoing contributions from ERDF and the Welsh Government – for reinvestment in SMEs and enabled the growth in the presence and reach of DBW. The expertise and track record built at Finance Wales (and its independent external review and critique) helped to drive the ambition and commercial credibility to launch the Development Bank with a wider remit. The DBW now runs many successful Funds, targeted at a wide range of market segments where there is market failure.
9. The approach of the EU Funds has enabled a head start on Environmental, Social and Governance (ESG) issues
The ESG agenda has grown significantly in recent years in the finance community, driven by legislation and the requirements of investors. Given the centrality of the “S” part of ESG to the SME finance interventions, this has meant that the strategies, systems and processes for addressing this part of the equation are already in place in EU-backed Funds. Further, the stringent EU requirements on administration, management and reporting, whilst stretching, have meant that high standards and good practices are in place on the “G” part of ESG. Similarly, the EU requirement to build in Cross-Cutting Themes has meant that DBW has had to think about the “E” part of ESG too. These good practices will help in the administration of future Funds.
10. Funds need to integrate with the wider business support offer
When done well, there can be benefits in having good links with the wider business support on offer in a region. This enables businesses to be cross-referred efficiently between different services depending on their needs. If this doesn’t happen, this risks confusion amongst SMEs, duplication of effort, and opportunities missed. Good momentum was built up here over time in Wales, with an effective relationship between DBW and Business Wales.
11. Monitoring and evaluation needs to be carefully designed
Monitoring the economic development benefits can be challenging and needs to be carefully designed and executed by professionals with appropriate expertise. Otherwise, the risk is that the data is flawed and does not provide decision-makers with the evidence they need. Likewise, independent evaluation is helpful to ensure that there is ongoing learning.
Building on what has been learned
The SME finance gap is not going to go away, especially in “the regions”. Whilst the British Business Bank offers finance at a regional level, Combined Authorities recognise that there remains a role for complementary sub-national Funds of the sort backed by the Structural Funds. These interventions should build on what has been learned, and make the most of the legacy offered by these decades of experience.
This blog was written by Tim Fanning, Director at Hatch, Urban Solutions, and Neil Evans, Independent Economic Development Consultant. For more information, contact Tim Fanning or Neil Evans, or visit their LinkedIn profiles at Tim Fanning and Neil Evans.
Disclaimer:
The views expressed in this analysis post are those of the authors and not necessarily those of City-REDI, WMREDI or the University of Birmingham.