Equity Gap: the new 3i ?

The UK government is very, very concerned about the impending death of innovation.  So much so that it appears willing to earmark a cool £1bn to early financing through Nesta, according to the Guardian.  It all sounds quite grandiose: "The fund has won the backing of the new science and innovation minister Lord Drayson. It will form the centrepiece of a dramatic shift in industrial policy which will see more intervention from government."

I understand that the government wants to be seen to be doing something in these testing times.  It is clearly more headline grabbing to say "£1bn to go into startups to save jobs and future of Britain" than "£1bn to go into various and obscure research labs featuring lots of foreign students", or to talk about core science and education, which yield no immediate results.  Yet this is normally where the government should be focused.

It's really back to the future; remember 3i ?   It was a post-war national initiative focused on fostering very early stage investing in the regions.  Many in the UK lament the gradual drift towards private equity and the loss of this powerful and sustainable force for local innovation.  Revive the Cambridge, Bradford, Manchester teams of old !  Now NESTA is proposing to fight the recession through innovation, in a challenging report co-authored by the noted Charlie Leadbetter.  All well and good.  But hold on a minute...

I thought about giving this post the title of "Equity Gap syndrome is back".  A number of years ago I chuckled (too loudly, would you believe) at some British Private Equity event when John Moulton from Alchemy derided regional government-sponsored funds as "a great initiative to keep mediocre investors employed and with a company car" (I paraphrase).  I cannot really comment on whether all the vitriol that was unleashed by the ever-entertaining Mr Moulton was justifiably poured, but behind the gratuitous insult he did have some kind of point.

The job of the government is to foster innovation at the source, i.e. to fund great reasearch and science education.  As far as I am aware there seems to be little correlation between government funding for startups and an economy's potential to deliver great business successes.  One only needs to look at France and its much lauded OSEO (formerly ANVAR) initiative.  I was at the 40th anniversary of the OSEO/ANVAR a few years back, and one fellow asked the question of how many companies employing more than 100 people had ever come out of the programs.  The answer, it seems, is three.  Humbling.  A poor case study that has led to some fierce pushback and still creates frustration.

Some of you may point to the US and the fact that military funding is one of the core reasons for the success of Silicon Valley.  Ah yes, but let's not confuse the absolutely epic scale of defense funding in the US during the cold war, which creates an entire industry, with government sponsored funds.

In normal times the government should focus on:

• research / core science
• great education
• tax breaks to investors

Investing money is just not part of the job description here.   But let's acknowledge that much research efforts may well be wasted if funding is not provided through this period of drought.  Maybe.  In that case let's think about how government could act.  Here are three I put together on the fly as possibiities:

• A/ New 3i: set up a big and ambitious long-term venture funding initiative that will structurally help the segment, the new 3i
• B/ Rescue Fund: set up an emergency 2-year fund, whose mandate is to be renewed, to bridge promising companies through these tough times.  Set up a number of different investment committees to look at companies in life sciences, medical, clean-tech, internet and media and so on drawing on independent industry practioners to determine access to this "rescue fund".
• C/ Co-Invest Fund: invest alongside incoming investors to make up the funding shortfalls

A/ poses the problem of building teams to do this right.  It comes down to some basic facts: it's tough enough to invest well when you are putting your own money alongside your fund (which we all do) and spend our days in relentless pursuit of returns.  It's going to be tough to get this done well and there is little to suggest this would lead to good returns for the money invested.  I am impressed by the strong investment committee (including noted angel and exec Sherry Coutu and Adrian Beecroft)

B/ is harsh and unjust (a bit like us VC's), but it can probably be made to work and has the benefit of clearly stating its goals.  A time limited bridging fund focused on fixing the liquidity dislocation in the early stage market.  I could be made to believe in this.

C/ strikes me to be  a bad idea.  There is such an obvious adverse selection phenomenon here (I would not want you as a co-investor) that I can see collusion between regional funds and this new fund to protect a bunch of deals that should not get funded in the first place.  Yes, have been called a cynic before.

It's tough because these are abnormal times and the government is probably facing an unprecedented death rate on its carefully nurtured projects.  But it should resist the temptation of getting back into venture for anything other than a very temporary basis.  We do not need another 3i (and check out the profiles of the team BTW).  Certainly not a 3i redux that is relying on regulation to give it market power. 

It is natural in times of crisis that we oscillate back from market rule to benign state rule.  It is also clear that we do need much stronger consumer protection (and frankly against their own judgement, it seems) as people will believe in the mirage of easy wealth creation if allowed to do so.  However this does not mean it is necessary to be creating new state sponsored venture investment vehicles.  I agree with most of the diagnosis of the undoubtedly smart NESTA think tanks, I just think the conclusion is self serving and not focused on the right outcome.

Comments

[Chris Padfield]

Paul,

Seedcamp is exactly the sort of thing I am talking about - education is clearly important (we do a lot of that where we work) but there also needs to be people to fund these early stage companies at the end of the process. Angels do most of this now; but having early stage co-investment VCs helps.

The returns from early stage investment have been very bad over the last few years. I think this is actually far more todo with bad investors (and investment decisions) than any lack of quality seed companies.

[Paul Fisher]

@chris padfield
"It is not really contentious to say there is a sub £2 million equity gap in the UK"
You are incorrect.

Do you think there would be a larger number of VCs doing sub £2mn investments in Uk / Europe if there were tens of companies in each European Geography each year making these series A investors 10x their money? The answer is yes.

There is insufficient quality. The Nesta fund is tackling the sympton. As Mr Destin points out, investing in education (and even things like Seedcamp) are tackling the cause.

@Fred Destin. Good Post. Nice one my son.

[Chris Padfield]

I disagree on c). Co-investment funds are generally limited to co-investment with private money. Setup correctly, they can help mobilise significant private investment (e.g. from angel investors) which otherwise would not happen. This is not because the deals are bad, but because having a small co-invesment VC can help professionalise the process (doing the DD, term sheets, legals etc).

It is not really contentious to say there is a sub £2 million equity gap in the UK; the level of investment at this stage is significantly less than in the US. There are very few private VCs operating in this space (and most VCs that do are really an angel investor with a professional investment manager). There are a few public VCs but less (particularly in London) than there used to be.

So a few private matching co-investment funds combined with increasing the EIS tax relief (40% income tax relief instead of 20% would be good - still not as generous as France where there is 75% tax relief on wealth tax) would make a huge difference to early stage VC.