Growth capital: plugging the funding gap

With a gradual turnaround in the UK economy now underway, the new government has been keen to stress that any sustainable recovery must be led by a continuous expansion in the private sector, and in particular through growth in business investment.

The latest consultation paper acknowledges the need for the UK government to ensure businesses have access to a more diverse range of capital sources that suit their needs. The paper entitled "Financing a private sector recovery" looks at a broad range of financing options for businesses, including trade finance, corporate debt markets, securitisation and last but not least equity finance.

The origins of this lie in part in the Rowlands Growth Capital Review published in November 2009, which identified a gap in the supply of equity finance between £2m-10m for established companies looking to grow. This undersupply of finance is believed to be structural, also resulting from investors moving up-market to deals with higher risk/return profiles and greater deal size. One of the direct results of this was the creation of a Growth Capital Fund announced by the government in the June budget. The fund, with a target size of £500m, is aimed at supplying fast-growing SMEs with capital not otherwise available.

On the face of it, the creation of this fund looks even more appropriate given that the flow of bank lending to smaller businesses continues to be below par. Yesterday, UK's biggest bank HSBC reported pre-tax profits of £7bn for the first six months of 2010, but disappointingly for many SMEs the bank also reported a drop of 2% in lending to small businesses in the UK.

According to the Federation of Small Businesses, this drop was in line with a continual decline in lending from the UK's "big four" banks, with lending now at the rate of £500m a month - down from the £900m a month seen in 2008.

With SMEs relying almost entirely on banks to obtain external finance due to their higher risk profile, it is unsurprising that the Growth Capital Fund is receiving attention within the industry: it should, after all, offer a rich vein of funding opportunities for hungry growth businesses.

However, the fact remains that private equity funding is only suitable for a small amount of SMEs: not every company has the growth potential to make an equity participation attractive to private equity backers, while on the other hand, many business owners can be reluctant to accept dilution of their equity stakes.

So, can this new fund really plug a gap? Probably not - it is too little and the endemic problem is too great - but it could still be successful as long as it remains true to the principles of sound private equity investing.

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