Last week HM Treasury closed its consultation into the supply of "patient capital" in the UK and will soon be publishing its formal recommendations after analysing the varied responses it received from stakeholders around the country.
Patient capital supports small firms to grow into large, world-leading businesses. These firms increase productivity by introducing new ideas into markets. The UK provides a fertile ground for world-leading innovation, but a lack of effective supply of patient capital continues to hold some UK firms back from commercialising this innovation successfully.
HMT's consultation sought to set out the evidence around a gap in the supply of patient capital in the UK, considering potential policy options that might help to address any gap. Responses were welcomed from all stakeholders with an interest in how the government supports growing innovative firms.
As a forward-thinking law firm that regularly advises both innovative UK companies and ambitious entrepreneurs looking to build large scale businesses, and investors in those businesses, Fieldfisher submitted its response to the consultation. Our response largely addressed the 2 areas in which we regularly deal with innovative businesses, from venture capital and private equity (including early stage tax incentive schemes) to equity public markets and growth companies seeking investment on London's Alternative Investment Market (AIM).
Venture Capital & Private Equity
Much has been done to address private investment into early-stage companies and to stimulate innovation and accelerate growth in the UK technology and life sciences sectors. Since their respective launches in 1994/95 and 2012, the Enterprise Investment Scheme (EIS), the Venture Capital Trust (VCT) scheme and the Seed Enterprise Investment Scheme (SEIS) tax reliefs have done much to encourage investment by private individuals into high risk early stage companies who are willing to tie-up their investment for at least 3 to 5 years in order to qualify for those reliefs. More recently, relaxations in the regulations around crowd-funding have given a further boost to the financing of these early stage business. In our view, the current lack of long term finance available to UK growth businesses is not felt as much at this early stage of the market – the gap is felt most acutely we think at the later development capital stages as revenue generating companies begin to scale and require expansion capital of £20m or more (i.e. Series B funding rounds and beyond). Indeed, latest figures from Beauhurst suggest that whilst the total amount invested in UK high growth businesses in H1 2017 increased by 74.7% from H2 2016, later-stage companies saw a decline in deal numbers of 7.6%. Over the same period seed stage deals accounted for 46% of the total deal volume as opposed to 17% for growth/development capital. Our experience and that of some of our clients is that early stage companies still do suffer from a lack of patient capital notwithstanding the availability of capital at the early stage end of the market: this may be more to do with problems around connectivity as opposed structural inefficiencies. There are several new platforms in the market seeking to connect companies to investors, both retail investors and professional firms, and to enable deal syndication and execution online. These are operating at the edges of existing regulatory frameworks which should be relaxed to enable these online networks and secondary liquidity exchanges to flourish.
It is important therefore that the SEIS, EIS and VCT schemes are retained – they are working well and it would be foolish to revise the terms of these schemes to either repeal them, reduce the scope of their existing benefits or make qualifying criteria more difficult to achieve. The surge in seed stage financings over the last few years will hopefully give a systemic rise to a greater pipeline of promising companies seeking later stage development capital over the next 5 years. Indeed some of the recent improvements to the schemes under the Finance (no 2) Act 2015 are welcome, and could be further extended to assist companies to scale-up, for example:
- increasing the maximum threshold which companies can raise SEIS from £150,000 to £500,000. This would reduce the deal costs of raising seed funding rounds by enabling the company to raise significantly more without having to do a split SEIS/EIS round, giving companies additional runway to enable entrepreneurs to focus on building the business rather than being distracted by multiple funding rounds;
- removing some of the existing conditions which can be notoriously capricious, deterring taxpayer from using them or requiring expensive legal advice to avoid bear traps: see for example the Flix Innovation case, where the presence of £150 of deferred shares gave HMRC a technical reason to deny the tax relief. The complexity of some SEIS/EIS structuring can lead to disproportionate deal costs given the amount of capital being raised at early stage companies;
- increasing the maximum aggregate threshold a company can raise in its lifetime across all state-aid schemes from £12,000,000 to £20,000,000 for all companies, and for Knowledge Intensive Companies the limit should be increased to £30,000,000. This will help more promising UK growth companies scale-up by continuing to attract tax incentivised investors in addition to professional VCs during later stage rounds.
It is perhaps unhelpful that EIS/VCT funds may no longer be used to fund the acquisition of an existing company or trade. Whilst the organic growth and development of a business is to be encouraged, strategic bolt-on acquisitions are a key way in which UK growth companies can achieve scale quickly, and help give liquidity to an illiquid asset class. A suitable amendment could be made to this to enable share acquisitions below a certain consideration threshold and a certain structure to be carved out, for example, all share consideration and reverse acquisitions, or "acqui-hires" where the staff of the target company are retained and incentivised for a certain minimum period post-closing. This would potentially allow UK growth companies to combine and scale more quickly.
An additional tax incentive scheme (a Patient Capital Scheme (PCT)) could be considered which encourages a longer hold period for individual investors as currently required under EIS and VCT). Suitable incentives could also be explored which give limited partners in investment funds and institutional investors additional incentive to hold investments for longer. An investment horizon of 3 years does not particularly give entrepreneurs sufficient time to build companies of great scale. 5 years should be seen as a minimum opportunity to build a company of significant scale, even upwards to 10 years. The Business Growth Fund's approach to investment horizons of 10 years is refreshing and that should be encouraged across the industry. Where an investment involves the use of venture debt facilities, structures which enable cash to be retained in the business (such as roll-up of interest and bullet repayment on maturity rather than quarterly or other periodic interest repayments) could be encouraged by giving certain tax breaks to the lenders for having provided loans on such terms.
Whilst it is not yet clear to what extent EU legislation will continue to apply in the UK after Brexit, it seems likely that UK companies funds will be excluded from accessing capital from the European Investment Fund (EIF), which is understood to have injected approximately £800, in equity and £400m in other forms of support such as loan guarantees in 2016. The introduction of a private sector fund of funds, or an incubated fund like the National Investment Fund alongside the British Business Bank will be welcomed, to enable venture capital and private equity funds to close new funds where the EIF would have otherwise participated, and be seen as an "anchor investor". Such a fund, which invests only as an LP into the venture capital and private equity funds themselves, could be done as single fund of significant scale. However we would be cautious about a single fund which also invests directly in companies as a direct investor, which risks monopolising and cannibalising the deal flow that professional VCs and PE funds would have any way.
In order for companies to scale significantly, it is also important that their investors are willing to follow-on in significant later rounds. We have had experience of client businesses which albeit started in the UK, have had to look to new investors in the US for further funding rounds, who require a new US holding company to be put in place. How can UK venture capital funds be encouraged to keep following on in subsequent rounds, thus helping to keep UK companies in the UK and preventing them from establishing themselves abroad?
The SEIS/EIS and VCT tax schemes have most effectively supported the investment of patient capital to date, but as indicated this has been targeted at the very early stage of the market. We believe there is stronger need for more patient capital in the UK lower mid-market (enterprise values of between £10m - £100m). Whilst some recent statistics on deal volumes for H1 2017 reflect a resilient UK lower mid-market, many fewer deals are done in this segment and where we lag behind other jurisdictions. As a matter for policy, it seems perverse to have an environment where individual retail investors are encouraged, on the one hand, to invest in and have exposure to very early stage high risk companies through direct investments or via EIS/VCT funds, whilst on the other hand, retail investors are not able to access latter stage private equity and private debt markets. Whilst venture debt is high risk - middle market lending is far lower risk. In the last 5 years there have been no defaults in any European senior secured private middle market funds with an average yield per annum north of 7% net. We have spoken to a number of our clients in this space who believe more could be done to:
- relax regulation to enable retail investors to access middle market asset classes; and
- create tax incentives to enable HNWs to invest into well managed companies that require relatively large sums of debt.
Tom Ward, a Director in Fieldfisher's Private Equity and Venture Capital team said: "We think more could be done to replicate the success of the SEIS/EIS and VCT schemes for the latter stage, lower middle market, providing tax incentives and a more relaxed regulatory environment to allow retail investors to access more established businesses as opposed to 'start-ups'. This acts as a barrier to investment in patient capital for individual investors that the government could look to remove – enabling sophisticated and self-certified investors to invest in structures that give them access to leading private equity and private debt funds. This could enable the government to unlock billions from individual investors with long term capital incentives to invest some of their ISA and SIPP allocations into these funds, helping to prevent funding drying up following Brexit. This in tandem with the setup of a series of private sector fund of funds to invest in patient capital will be welcomed".
Growth company public markets
From the perspective of AIM companies and unlisted companies seeking to make public offers, the changes proposed by Prospectus Regulation (EU) 2017/1129 (PR) are welcome, in particular:
- From July 21, 2019 a potentially less onerous ‘EU Growth’ prospectus may be available for eligible issues up to €20 million (if AIM became a SME Growth Market);
- From July 21, 2018 no prospectus will be required for issues below €1 million; and
- From July 21, 2018 the threshold beyond which a prospectus is mandatory is increasing from €5 million to €8 million.
It is not yet clear to what extent EU legislation will continue to apply in the UK after Brexit. It seems likely that EU regulations and legislation will effectively be frozen into UK law by the Great Repeal Bill, continuing to apply until such time that the UK decides to amend, repeal or retain them. An ongoing regime mirroring or perhaps expanding on the above proposals and increasing such thresholds would be welcome, particularly given a perceived lack of patient capital at this latter stage / development capital of £20m or more.
As a related observation, on one hand we are seeing smaller AIM companies regularly seeking to raise amounts of less than the current €5 million prospectus limit but struggling to do so from institutional investors who are unwilling to invest small sums, or invest larger sums which would give them a disproportionately large stake in a company with a small market capitalisation. We therefore see AIM companies struggling to raise money from institutional investors.
At the same time we are seeing significant pent up demand from retail investors to invest in listed securities. In many cases, this demand is going in to crowdfunded equities, which are almost certainly higher risk than AIM companies. We are beginning to see more open offers made by AIM companies, and we would hope to see their frequency increase if the prospectus threshold is raised. However, we would like to see more being done to encourage AIM companies to make exempt offers to the public.
George Cotter, a Partner in Fieldfisher's Equity Capital Markets group, said "We have spoken to a number of crowdfunding platforms about the possibility of using their infrastructure to offer retail investors participation in AIM IPOs and secondary offers, from which they are usually excluded. We think this is an area which should be explored and encouraged. Making AIM shares available to crowdfunding investors would likely raise the quality of investment opportunities available to those investors, who would benefit from investing in companies subject to the regulation and reporting requirements of AIM companies (as opposed to most private crowdfunded companies which are subject to very limited regulation). At the same time AIM companies would benefit from increased availability of investment at the smaller sub-€5 million fundraising level, and potential increased liquidity levels thereafter".
Fieldfisher is a European law firm headquartered in the City of London, with market leading practices in many of the world's most dynamic sectors. We are an exciting, forward-thinking organisation with a particular focus on technology, finance & financial services, energy & natural resources, life sciences and media. Our growing European network of offices supports an international client base alongside our Silicon Valley and China colleagues. In addition to working with large global firms, financial institutions and governments, we regularly work with innovative UK firms led by ambitious entrepreneurs who want to build large scale businesses. We assist them through early stage venture capital and development capital (including venture debt) through to late stage private equity, as well as flotations and secondary fundraisings on the public markets, primarily via the UK's growth company Alternative Investment Market.