Business Growth Fund: Myth versus reality

Not many people like the Business Growth Fund (BGF). Spawned by the Rowlands Report and a key recommendation of the British Bankers' Association's Business Finance Taskforce, BGF is a £2.5bn equity investment fund backed by five of the UK's largest banks. Business folk are quick to denounce the vehicle, which makes for enticing journalist fodder, and so there is no shortage of negative publicity for it.

On the face of it, it is easy to see why. Most deal-doers - be they GPs or advisers - feel BGF has taken the banks' money and run to a safer haven than was spelled out in the Rowlands Report, its raison d'être. One of the banks even ditched the idea: unquote" initially reported that Santander was a backer (alongside Barclays, HSBC, Lloyds, RBS and Standard Chartered), but the institution mysteriously disappeared off the list at BGF's launch last May. A bit of investigating revealed the bank was among the skeptics, and instead used its money to set up a £200m mezzanine fund (Breakthrough) to plug its own definition of an equity gap (much lower than Rowland's area, incidentally).

BGF's haven is precariously close to private equity GPs' turf - and the humongous balance sheet it can invest from is generating fears of upward pressure on pricing. Thus, much of the ill will is sour grapes, but others with less of a vested interest share the sentiment. Says one industry body head: "BGF used very selective reading of the Rowlands Report, which indicated the equity gap needed mezzanine. BGF is not doing what it was meant to and I am very sad about that. But, to be fair, I would have moved the goal posts, too."

Nearly every interviewee indicated the BGF had strayed from the Report's target business size, but the fund's chief executive Stephen Welton (pictured) was shocked when asked about this. In fact, reviewing the Rowlands Report reveals that BGF is investing precisely in the space prescribed: £2-10m in businesses with revenues of £10-100m per annum. The major deviation is that it is equity provision rather than mezzanine. "The report suggested mezzanine to address a demand-side aversion to pure equity. But in fact we've found businesses find equity attractive; there is not an unworkable aversion to equity," Welton explains, adding a statistic from the Breedon Report, which reveals that just 1% of firms took on mezzanine last year.

Plugging the gap
If anything, BGF has actually expanded its remit to include businesses with revenues as low as £5m - and one deal even fell short of this. This puts it more firmly in the venture capital trust (VCT) hunting ground, though Welton is adamant that it will, for the most part, look at different businesses. "VCTs are sold to retail investors with low risk appetites. The VCTs are therefore naturally not taking excessive risk. They play a very important role, but it is not enough. The time frame and sums they put to work are insufficient to plug the gap. The market can work better and we are trying to help it do so."

But in fact BGF did compete with at least one VCT in its first deal, Benefex. Peter Hodson is a director at NVM Private Equity, which operates VCTs, and was among the losing bidders. He says: "They were competitive in that process and we didn't win it. But if we look across a year, I'd say BGF is a subset of our market where we are less active. We rarely come up against them and so we're glad they have started to do deals. There really is a market for them."

VCTs are not the only group to come round. The angel community, initially disenchanted with BGF's remit, is now working with it. "There was a very large gap between where we angels invest and where the BGF will go," explains Jenny Tooth, a director at Angel Capital Group (ACG).
To help bridge this divide, the BGF has supported the British Business Angels Association (BBAA), of which ACG is a member, to the tune of £30,000. BGF can refer businesses too small for its own criteria to the angels and then monitor the businesses' progress for a few years; these collectively form part of BGF's "shadow portfolio".

"The idea is BGF can then take those companies on to the next stage of their development," says Tooth. "BGF can, in theory, even back businesses with less than £5m revenues since they will have been monitoring them under our stewardship. We are effectively helping to ‘de-risk' these firms for BGF. So it is a two-way street." Welton agrees: "BBAA takes the start-up risk; we take the growth risk."

Time is money
Six months in, BGF got stick for taking six months to do its Benefex deal. The market was basking in schadenfreude about the fund's apparent failure to launch, citing a need to do hundreds of deals a year to get through the behemoth £2.5bn war chest. Even Labour MP Toby Perkins, shadow minister for small business, berated Welton in a panel your editor hosted, suggesting such a delay was unacceptable.

But in fact, despite widespread belief to the contrary, BGF does not have to spend all its money. And there is no clock ticking, unlike in limited partnership funds or VCTs.

"Our business started from a piece of paper. It was a genuine start-up. I was the first employee. We inherited no office or infrastructure. The first 10 months saw us grow from zero to 55 members of staff across six UK offices," Welton says.

When put like that, it is clear the team were not sitting on their hands. And it is also clear the team, now functional and fighting fit, is upping its pace: It completed two deals the week Welton spoke with unquote". "We are currently finding that it takes around three months to go from an initial conversation to a completed deal. This is why it is so important to build a firm that reflects this. And the national infrastructure, scale and quality of the investment team we are building will enable BGF to be conducting dozens of these conversations and negotiations at any one time."

Due diligence is a time-consuming process, and one BGF is aiming to streamline for SMEs. For example, its £4.8m investment in Wow! Stuff in March saw a three months lapse between the time legal adviser Pinsent Masons was brought on board and the deal completing. "BGF is probably at the teething stage as regards the legal process. I can see it developing its approach to its investment documents and its legal due diligence to be more in line with its positioning as a long-term growth capital investor," says Paul Harkin, partner at Pinsent Masons. He indicates the knowledge is there, with a handful of BGF's senior professionals coming from a growth capital background, including head of investments Richard Bishop. "I would not be surprised to find they come up with more streamlined processes to reduce the time required to do a deal."

"Because of the size of BGF's investments and the speed it is aiming for, it is crucial to focus just on key areas," Harkin explains, adding that for Wow! this meant IP as well as arrangements with manufacturers and distributors.

Crunching numbers
The team at BGF is expected to grow to 100 by year end, and the fund aims to do 20-25 deals this year and around 30-40 per annum thereafter. Ambitious. But is there sufficient demand from SMEs? The Rowlands Report estimated some 25,000-32,000 growing or restructuring UK businesses might need an injection of growth capital. Of these, 5,000 firms a year were likely to experience significant problems in accessing capital as the economy emerged from recession.

"In the first eight months since launch, we have worked hard to build up a strong pipeline of potential investment opportunities, holding detailed discussions with approximately 300 companies across the UK. We are talking with 5-10 new companies every week. These are relationships we are cultivating for the long term."

Additionally, research suggests that there are more than 7,000 businesses in the UK with a turnover of between £2.5-100m - and growing at more than 10% per annum - and yet fewer than 40 first-round growth capital investments of £2-10m were made in this sized company last year.
"Every entrepreneur I have met feels banks are their first source of capital; it is cheap. But businesses have been more geared than they should have been and we are seeing the consequences of that now," Welton says.

A matter of taste
Indeed, BGF has won deals that other private equity firms have looked at. NVM was one such firm to lose out on Benefex, and BGF's co-investment in Unruly Media beat competition from Advent Venture Partners. But sources close to the deal indicate price was not the determining factor - putting a spanner in cynics' argument of cheap money.

BGF's first deal, the £4.2m injection into Benefex, was not about the money. "It was a very close race," says Benefex chief executive Matt Waller. "The offers were similar in terms of equity stakes and money, with just one seeking a majority stake and offering cash out. By the time we short-listed it to the final three, the offers were literally carbon copies from a money point of view. It came down to people. BGF took the time and energy upfront to get to know our business, more so than the others. The runner-up in the deal hadn't quite grasped our strategy and had their own ideas for how to grow the business."

That BGF's first deal saw it beat five other traditional private equity firms punctures the theory that it doesn't compete with private equity. When asked what the business would have done had the BGF not existed, Waller replied: "We would have gone with another private equity firm."

Frustrating if you were number two in that auction. But the flip side of the coin is the Benefex deal highlights that BGF is no Daddy Warbucks, splashing cash to win deals. In fact, chats with other investee companies paint BGF as Mary Poppins - doing the job with altruism and care.

"Learning about what BGF did brought the barriers down," explains Wayne Martin, chief executive of Lincoln-based telecoms and data service provider GCI Telecom. Recorded in February, BGF's first deal in the Midlands saw £10m pumped into GCI. The business turned over around £45m last year and employs 220 staff in nine locations. Not exactly a high-risk start-up: the revenues, and the size of BGF's cheque, point to a business that could have attracted a traditional private equity house. But it was within Rowland's parameters. The issue was a matter of control.

"I have had a phone call nearly every week in the last year from a private equity firm interested in my business, but I'd heard too many scary stories of them taking control of businesses. I knew I didn't want to partner with vulture capitalists," quips Martin. "BGF's values and objectives fitted with mine."

The GCI deal - the largest cheque BGF has written to date - was proprietary. "An old connection of mine from BDO moved to the BGF and he and Richard Bishop took me to lunch to explain what it was up to. It sounded very different to the private equity I knew of."

With 35 of BGF's 55 staff on the deal frontline and 25 private equity houses represented between them, there could be a lot of deals sourced from personal networks. This can only be a good thing, since the industry's reputation among business owners has been deteriorating as broadsheets report countless tales of private equity taking control and over-leveraging.

The owner of V.Ships, a tertiary buyout recorded last year, was said to be relieved to be partnered with OMERS Private Equity following 18 years with various traditional private equity funds. The $520m deal saw the Canadian pension fund beat Permira and Charterhouse to win the business. The time horizon is what lured V.Ships to OMERS (www.unquote.com/2119554) - just as it did Benefex's Waller to BGF. The fund says it is "comfortable investing (and re-investing) for seven to 10 years".

"We were drawn to the longer time horizon that the BGF seemed to indicate," Waller explains. And so far, so good: "Six months since the investment, they have truly delivered on every promise they had made."

Here to stay
Perhaps the realisation that BGF won't go away has generated a more sanguine attitude. The apprehensive brouhaha that surrounded BGF's launch 10 months ago seems to be giving way to quiet acquiescence.
"If they do their job right, the mid-market should benefit from BGF. Good executives are supporting it and therefore the businesses they back should benefit. At some juncture they are likely to evolve as businesses and require further funding via a buyout process, and that is where institutional firms can step in," says LDC's Rob Pendleton.

When asked what BGF's biggest competitor was, private equity was not Welton's answer. "The option to do nothing, or to ‘wait until it is a better time to invest'. Our goal is to still be around in 10 years' time."

The most obvious comparison, with 3i, Britain's largest backer of SMEs, is one Welton agrees with. "We do have much in common with ICFC," he says, but with caveats: namely BGF's better relationship with banks. But the 3i comparison begets worries: cynics point out 3i's move towards buyouts in the upper mid-market and, more recently, its increasing focus outside the UK. True, it opened in Brazil last year (and has outposts in Europe, the US and India). But it was roughly 40 years before 3i turned its sights to buyouts and began to look beyond Britain's shores. In those decades (and since), it helped countless businesses realise their potential, and boost Britain's economy in the meantime. It is thus worth giving BGF a chance to do some good before writing it off as an ill-fated initiative.

"If we look across a year, I’d say BGF is a subset of our (VCT) market where we are less active. We rarely come up against them and so we’re glad they have started to do deals. There really is a market for them.” - Peter Hodson, NVM Private Equity

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