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CHAPTER SEVEN OPERATIONAL COSTS

7.1 This section considers the operational costs of the funds. As far as possible we have sought to identify running costs. The change in the value of investments has been considered in a previous section. There is no consistency in the way the various VCLFs present management costs or other information in their accounts, so it has been necessary to adopt different approaches to the estimates of operational costs. We have returned to the issue of consistency in our recommendations, but we first consider the operational costs of the various loan funds, and then the costs of the venture capital funds.

Loan Funds

7.2 WSLF incurs costs both directly and indirectly through the help given by local authorities and Business Gateways. An evaluation of WSLF, carried out by Stratagem, identified those costs and also the cost of bad debts, dealt with elsewhere in this report. Stratagem identified administration and other costs as:

• "Administration costs, borne by WSLF - over a 6 year period administration costs are expected to be in the region of £200,000 per annum, i.e. a total of £1.2m.
• The hidden costs of promotion, company assessment, arrangement, monitoring, borne to differing degrees by councils and their partners in Business Gateways and Local Enterprise Companies - using a daily rate of £250 per day for 5 advisers gives a total of £1.8m."

7.3 Taking account of all of the above, a reasonable estimate for the total cost of running the fund over 6 years can be set at £3 million or £500,000 per annum. The accounts of WSLF (see above) show administrative expenditure of £242,000 for the year to December 2005 and £47,734 for the period to 31 March 2006, slightly above Stratagem's estimate of £200,000 for this area of cost. During the year to 31 December 2005, as noted above, £2.4 million of loans were issued. Accordingly, administrative expenditure is just over 20% of annual gross loans. Most of this is incurred by organisations outside WSLF. The direct costs within WSLF represent about 10% of gross loans.

7.4 WSRF - DSL take a management charge of 1% per loan (loans in 2006 amounted to £1.3 million resulting in a charge of £13,000). DSL's administrative costs are budgeted at £178,000 for 2006 and include 4 staff and consultancy costs. These costs do not include bad debts or overheads, shown in the accounts. Given annual lending of about £1.3 million, these direct costs for WSRF represent about 14% of gross loans. Such costs do not include overheads.

7.5 So SLS - The accounts for SEBSED for the year to 31 ^st March 2006 show administrative costs of £98,000, of which some £28,000 are bad debts. The remaining £70,000 represents 15.4% of gross new loans made during the year (as with other funds, there is an existing loan portfolio including legacy funds). Support in kind from Scottish Enterprise would add to this cost. The cost percentages appear higher because of the low rate of new lending by SoSLS.

Venture Capital Funds

7.6 In respect of SCF, management costs include both the costs of running the fund, and fees paid to co-investment partners.

• SCF Partners' arrangement fees - Scottish Enterprise pays their SCF Partners 2.5% of the investment every time they complete an SCF deal. If the SCF Partner completes a deal in an ERDF area, they are paid 3.5%. Partners are therefore paid between 2.5% to 3.5% of total SCF invested.
• Scottish Enterprise management costs - these are SE's costs in running the fund, e.g., staff plus legal fees, plus promotional events (for example, to stimulate the deal flow in the West of Scotland). Scottish Enterprise employs a Fund Manager, a lawyer, an administrator and a portfolio manager (their most recent appointment). It does not appear to include an apportionment of SE central costs.

A summary of the management costs shown in the accounts of SCF is as follows:

Table 7.1 - SCF Management Costs

Source - CSES analysis of SCF data

7.7 The position is different at the Sigma funds, where the manager charges an annual fee. As an annual management fee, the manager will, during the investment period, receive an annual priority share of the profits from the Fund equal to 3% of the total amount of Participations (the "General Partners Share"). Thereafter the annual management fee will be based on 3% of drawn down assets, net of written-off amounts and the cost of realised investments.

Summary:

• The operational costs of the loan schemes appear at first sight much higher than those of the venture capital schemes. The loan scheme's direct costs are in the region of 10% to 15% of gross new loans and in addition some external support is provided by local authorities and Business Gateways. The deal size of loans is, of course, much less than that of the venture capital funds and it is to be expected that administration costs will be higher where loan amounts are smaller.
• In respect of venture capital funds, there appears to be a significant cost difference between the co-investment fund and the managed fund. For SCF, the major cost is the fee to investment partners for arranging an investment. This amounts to 2.5% or 3.5%, depending on where the deal is made. In the investment stage of the fund, costs including both the arrangement fee and SE costs are running at up to 6.2%. But, once the investment stage is over and arrangement fees are not being paid, costs will drop substantially.
• For the funds managed by Sigma, the position is different. There is an annual fee of 3% (details are shown above). If investments are held (say) for six or seven years the management fee will be in the region of 20%, substantially greater than the SCF model.

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