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CHAPTER SIX INVESTMENT PERFORMANCE - EQUITY FUNDS

6.1 This chapter considers the performance and management of equity-based funds including the Scottish Co-Investment Fund. It covers the rates of investment and cash resources, the types of investment, fund financial performance and demand issues.

Rates of Investment

6.2 The tables below show the rates of commitment of equity or early stage funds to date.

Table 6.1 - Equity fund investments (£'000)

Source : Managing authorities

6.3 There is still much to be done to achieve the full investment of these funds. For SCF, the issues arise in the West of Scotland. An analysis of SCF commitments of ERDF funding by programme is shown below. The relatively recent Sigma Innovation Fund is likely to reach close to full investment on current trends. It is too early to say if the new Sustainable Energies Fund will be fully invested but current media and other equity fund activity would suggest strong potential interest. By February 2007, the fund was 18% invested, In respect of Genomia, as at July 2007, the managers point to a continuing high level of potential deals

Table 6.2 - Analysis of SCF investments (£'000)

Source: SCF and managing authority

6.4 When our fieldwork was carried out, the rate of investment of SCF was lower in the West of Scotland and the South of Scotland than in the East. Because ERDF funding has been provided to SCF for venture capital purposes, it cannot be decommitted. If the investment allocated to SCF is not utilised by the end of 2008, then there is a danger that some ERDF funding may be lost. In the South of Scotland, the planned funding to be allocated to SCF was reduced from £2 million to £1.5 million, but in the West of Scotland this is no longer possible. In late 2006, there have been two major investments in the South of Scotland which have increased the ERDF commitment to 59% of the allocation of £750,000, so the major issue on undercommitment remains in the West of Scotland..

6.5 SCF point out that there is a likelihood that second stage funding requests will be received from many of the companies in which investments have already been made. These requests, if met, may have the effect of increasing the rate of investment. Clearly, it will be necessary for SCF to consider whether in these cases they are acting as a gap funder, or whether the market can meet the requests without public intervention. We understand that SCF may also invest in some circumstances where other ERDF supported funds invest as well. Clearly, in such cases ERDF funds are being matched against other resources within each fund - as it would not be possible to match two sources of ERDF funding against each other.

6.6 SCF recognises the need to increase the deal flow in the West of Scotland and commissioned a study to consider the reasons for the relatively low deal flow and the action to be taken ¹⁸. An important recommendation was that investment readiness of companies should be improved, and that in particular links between advisers and SCF should be improved so that there is a better deal flow. Grants averaging £5,000 (a maximum of £10,000) are given to companies to improve investment readiness. There is no doubt that it is necessary to develop the demand side for funds as well as ensuring an adequate supply of funds. Further details are shown in Annex L.

Cash Resources

6.7 None of the VCLFs have reached a stage where investments are being realised. Accordingly, the remaining resources of the funds are best indicated by the rates of commitments and investment shown above.

6.8 SCF has sufficient cash in the West and South of Scotland to maintain commitments until the end of the programming period. The issue is of course whether commitments will be made. It seems likely to be fully committed in the East of Scotland before that date. During the period 31 March 2006 until 31 December 2006, additional commitments of £5.62 million were made in total. Available cash at 31 March 2006 amounted to £29.4 million, so if the rate of investment seen in the last three quarters of 2006 is maintained, the fund will not be fully committed by 31 December 2008. However, the Sigma funds are likely to be committed by the end of the programming period.

6.9 At this stage there will be no substantial cash flow from disinvestment, although some investments could be realised at any time. It is more likely that it will take 6 years before major realisations take place and possibly longer. Consequently, even if the investment performance of the funds is good, substantial funds will be needed from the next programming period before the funds can become self-sustaining.

Sectoral Analysis of Investments

6.10 We now carry out a sectoral analysis of the investments made by the equity funds. The one investment by Sigma Sustainable Energies Fund took place in the sector for which the fund is assigned, as did the biotechnology investment by Genomia. The 2 remaining funds have a broader spread of investments.

6.11 For SCF, the main sectors of investment are Biotechnology, Electronics and IT. The sectors invested in by the SCF are very different from the more general range of sectors covered by the loan funds in the West of Scotland.

Table 6.3 - Sectoral analysis of SCF investments

Source: SCF

6.12 In respect of the Sigma Innovation Fund, an analysis of investments to date is shown in the following sectoral breakdown.

Table 6.4 - Sectoral analysis of Sigma Innovation investments

Source: CSES analysis of Sigma Innovation fund investments

Fund Financial Performance

6.13 All the equity funds are at a relatively early stage of their life cycle, and therefore returns are uncertain. Typically, investments may be held for 6 to 10 years and go through a number of funding rounds. If the fund is successful, a few substantial winners will emerge, but it must be expected that many companies will not meet their objectives. The few winners will provide the fund return.

6.14 Valuation of companies at an early stage is rather uncertain, particularly before trading has commenced. The BVCA publish guidelines (these are referred to below) which are relatively conservative. It is also worth noting that Scottish Enterprise's High Growth Start-up Unit has commissioned work about the valuation of their early stage portfolio, but the indications are that there is much uncertainty about early stage valuation.

6.15 SCF has a target rate of return of 20%, as shown in its business plan. The last accounts we have seen show a diminution in the value of investments of about £1.45 million, or 8% of the value of investments. Such a diminution of investment value is not unexpected at this early stage but will need to be further monitored. As shown later in this report ( Chapter 7), our survey of a number of other SCF investee companies reports strong growth.

6.16 In respect of Sigma Innovation Fund value, their investment is in accordance with BVCA guidelines which take into account future cash flow, amongst other factors. According to these guidelines, companies who have no sales and are still investing will be very conservatively valued. The Fund therefore shows a diminution in value, but at this stage the calculations have little real meaning.

6.17 Because of the early stage of investment of Sigma Sustainable Energies Fund and Genomia, it is not yet possible to comment on fund performance.

Benchmarking Fund Returns

6.18 A report by DGECFIN at the European Commission ¹⁹ based on an analysis of European venture capital and private equity funds demonstrated the 'J effect' which is to be expected as funds mature. The analysis showed the increasing IRR as funds matured and realised investments. For the first few years, IRRs are negative. The equity funds dealt with in this evaluation are all still at this negative stage.

Table 6.5 - Pooled IRRs of European Venture Capital and Private Equity Funds (%)

Source: DGECFIN report

6.19 The value of SCF's investments shows a diminution of value of about 8%, after about one year's average investment. Using the data available from DGECFIN's study above, it is possible to show a 'J curve' of internal rates of return over time, and to compare this J curve with the data available from SCF. This is shown in the table below, which plots the cumulative % IRR against the number of years of investment.

Table 6.6 - J curve effect showing relationship of IRR to period of investment

Source: CSES analysis of DGECFIN report

6.20 It will be seen that the investment returns of SCF are in line with the investment returns seen in other early stage EU-supported funds. But after a short period of investment, it is really too early to predict the final outcome, or even the outcome in the short term. Sigma's investment decline is somewhat greater than comparable benchmarks, but as indicated previously, early stage valuations of investments are likely to be conservative if based on future funds flow. It is therefore too early to draw conclusions.

6.21 Turning to SCF's business plan, as indicated above, a target IRR of 20% was assumed. This is not out of line with comparable funds. For example the target IRR of the North West Business Investment Scheme in England (another co-investment fund) is 18%. But whilst returns of 20% have been achieved over 20 years by US early stage and seed funds, the targets set by SCF would seem to be ambitious is comparison with other EU-supported funds. What is clear is that early stage funds are often only marginally profitable in Europe, and that it is the later stage funds (such as those that concentrate on buyouts) which are the most profitable.

Summary:

The principal findings of this section are that:

• SCF's current rate of investment is insufficient for the fund to be fully invested by 31 December 2008 in the West of Scotland. The overall rate of investment for the period from 31 March 2006 to 31 December 2006 confirms this trend. In the South of Scotland recent investments have helped the rate of commitment. It is important to increase the rate of investment if funds are not to be lost.
• SCF consider that second stage funding requests will increase the rate of investment. It will be necessary for SCF to ensure that they continue to act as a gap funder in such circumstances, or to see if funding can be met by the market.
• The other managed equity funds are at an earlier stage of investment but appear more likely to be fully invested.
• There is a concentration on high growth sectors, in line with the investment policies of the various funds.
• The financial performance of the funds depends on the realisation of investments when the funds are mature. Normally, there is an expectation of a 'J curve' showing an initial decline in investment value (because some companies fail and others are valued on a conservative basis), followed by an increase as some fast growing successful investments emerge. Initial evidence suggests that the funds are still on the down slope of the J, and that SCF is in line with comparators, but that Sigma may be below. It is, however, too early to make firm estimates.
• The internal rate of return aimed at by SCF (20%) is in line with the aim of some other comparable funds, but appears high in relation to EU funds overall.

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