Rolet: In the last couple of decades, the UK has enjoyed strong growth and is now leading the rest of Europe, with 4.9 million of Europe’s 23 million small and medium-sized enterprises (SMEs) based in the UK. It is a great place to be an entrepreneur.
Welton: So what do you think it is that fosters this level of entrepreneurship in the UK? Why are there more entrepreneurs here than elsewhere in Europe? Is it down to fiscal, legal and regulatory systems that are more conducive to innovation? Is it cultural?
Rolet: I think the answer is that in the last few years the UK has been taking measures to broaden the funding system –and this is one of the main reasons why small and mid-sized businesses are flourishing. It is so important to recalibrate the distribution of capital so that equity investment rather than simply debt, which is technically unsuited to most growing business, is fully available and properly supported.
Debt unsuited to growing businesses
Welton: Over the last 20-30 years equity was not the most commonly used source of funding to grow businesses, be they small or large. The world got hooked on the availability of cheap debt which, as the market rose, looked fantastic. As the subsequent collapse has shown, though, the hangover is taking a long time to clear. In fact, more often than not, debt is not the best form of finance for young companies – it is too restrictive and leaves no margin for error. Entrepreneurs need to have a long-term alignment of goals with an investor rather just being focused on servicing the interest on debt. Equity investors are taking a calculated risk on the future potential of a business and they gain from shared success with management. Theirs is a vote of confidence in an entrepreneur’s ability to build a stronger, more valuable business. Key to all of this is being adequately capitalised to meet the inevitable bumps in the road along the way.
Rolet: I agree. When continental Europeans think business funding, they almost exclusively resort to bank lending. There, corporate funding is essentially fuelled by bank lending to the tune of about 75% to 80%. You see capital distribution that is in the hands of a very small number of banks who themselves refinance the deposits they collect and leverage their balance sheet from the central bank.
But not so in the US, where the opposite is true – about 18% of corporate funding in the US comes out of the banking system. I think the UK is something of a halfway house in that it has started to recalibrate its fiscal system, keeping in mind that the leverage of banks’ balance sheets is subsidised through the deductibility of interest, but risk capital still suffers from a quadruple taxation, at the corporate, dividend, capital gains and transaction level.
The measures that the UK government has taken, both fiscal and regulatory, are starting to have a positive impact, removing some of the shackles that had impeded an equity-based funding mechanism that was invented in this country. The notion of underwriting business risk through equity, which also carries the potential for reward, goes back to the17th and 18th centuries.
The UK has a real chance of breaking free from the old bank-lending, debt-fuelled culture which serves to create an unbalanced economy. After all, every economic crisis of the last 100 years has been debt related. To have a healthy banking system, debt needs to be readily available, but used in the right way.
Positive and progressive moves
Rolet: There are a number of measures being taken that are successfully serving to recalibrate the funding system, remove regulatory and fiscal shackles and make the environment more attractive for investors. These include the expansion of individual savings accounts (Isas) to include Aim stocks [traded on London’s alternative investment market], the repeal of stamp duty on trading Aim shares, making the Enterprise Investment Scheme permanent, and expanding the amount of money that Isas can invest in equities. The inclusion of Aim stocks in Isas alone has seen a 200% increase in retail investment into growth stocks since August last year.
And we could do more. We could go further to rework accounting rules and improve the general regulatory environment. Why does it take six months for an SME to get its prospectus signed off by regulators when a blue chip can get it done in six weeks? There is no evidence whatsoever that SMEs have higher incidents of fraud or corporate malfeasance compared with blue chips.
Do they represent a higher economic risk at the start-up stage? No doubt about it, but let’s separate governance, misbehaviour and fraud from pure economic risk. We need to provide an appropriately regulated environment for these businesses.
Lack of long-term certainty
Welton: The question really is whether these various measures will result in a quantum leap for equity and how it is used, or is it merely tinkering at the edges? And, what happens when sentiment changes? How do you make sure that the capital does not just run away again? For example take the EIS market, what will private investors do when interest rates go up and are at more attractive levels?
There will always be concerns about change, or at least history tells us that fiscal rules will inevitably change. This makes for a lack of long-term certainty. We need stability and patience from politicians as well as their understanding and commitment to help. The long term commitment to EIS is a really good sign, but we need to do more to promote the culture of equity.
Rolet: The UK Government has listened, perhaps some might say it is tinkering at the edges or that it is just an experiment, but they’ve started to make changes. We have to hope that all political parties whether Labour, Lib Dems or Conservatives, buy into that positive impact. Small and mid-sized businesses are after all the backbone of the economy. Political decision makers should feel encouraged by the progress, which is remarkable if we compare it to our immediate neighbours.
Cultural issue
Welton: So do you think there is a cultural issue at play – an equity aversion, an over reliance on debt, a default that means we look toward the banks? Is this ingrained in our culture? Do not we need to build a familiarity and understanding of what equity is and how it works?
Rolet: I think investors have been affected by a historically hostile regulatory approach to equities, taxation and an imbalanced fiscal treatment. But there are things that we can do – are doing – to mitigate this sentiment.
For example, two years ago we launched Elite. It is been a huge success in Italy, a country that is very anti-equity and where the fiscal and regulatory environment is hostile. But close to 200 Italian companies have now joined the programme. This has in turn created a new wave of optimism that has been noticed by a new generation of Italian politicians.
We have also launched Elite here in the UK, and intend to expand it across Europe. The first cohort of companies that have joined – including, of course, two companies the Business Growth Fund has invested in – are seeing exciting results. We think there is potential for tens of thousands of companies in the UK and Europe to benefit from these sorts of initiative, which introduce them to private and public investors at an early stage.
And it is not just about giving access to investors, but also helping these companies to refine their business plan, look at governance and prepare themselves for the business of raising capital. We provide access to legal advisers, broker-dealers and financial intermediaries.
Welton: The Business Growth Fund is a strong supporter of the Elite programme. Taking a business to the next stage can be daunting for any company and it can be a lonely place at the head of smaller or mid-sized private business. As many successful and established enterprises have proved, there is often real benefit to be gained from looking outside an organisation for support. The Elite programme, like the Business Growth Fund, is a much-needed source of education, support and contacts for businesses with ambitions to grow. Growth is, of course, highly dependent on ambition, on innovation and on entrepreneurism – all qualities that should quite rightly be supported.
We would also like to see big businesses getting behind equity funding of SMEs.
Rolet: There is close to a trillion pounds of cash sitting on the balance sheets of large UK corporations, which is not generating much growth. There is a real opportunity for them to make equity investments in younger, growing businesses that operate in sectors that they know, while enjoying tax relief that they would not achieve for investment in their own business. This sort of corporate venturing would make a huge difference.
Welton: Do you think large corporates would be willing to do that?
Rolet: I think some would. The amounts of money needed are minimal – you are talking about a few millions, maybe a few tens of millions. When you think about it, innovation is not coming out of the well-established companies that have been around for decades – it is coming out of SMEs and universities. This could make enormous sense for the large engineering, drugs or software companies that may have failed to convincingly innovate in the last few years, and may now be under pressure from its shareholders: “You are big, you spend billions on research and development but we are not really seeing too much coming out.”
European corporates need to do this too – otherwise they will miss out on so much innovation.
What we are ultimately hoping will happen is that our European neighbours will ask why they are still in recession, or why growth is low, and why conversely the UK is growing at a 4% annual rate? We are talking about an identically-sized country to, say, France or Italy with relatively equal economies and generally stable access to commodities and cheap raw material.
So why is the UK economy out performing so massively versus its European neighbours? It is because of job and wealth creation, which has been driven by the smaller, and mid-size enterprise segment over the last two and half years.
Welton: What about insurance companies investing in private companies as well as public companies? There is certainly more that could be done here – encouraging, rather than actively discouraging, pension funds and insurance companies to invest.
Rolet: Absolutely. I remember when I joined the London Stock Exchange in 2009, National Association of Pension Funds statistics showed that UK pension funds were invested in equities to the tune of about 70%. Last year it was down to 30%, mainly owing to regulatory and fiscal decisions. Pension funds have been forced to invest in government bonds. European governments have been piling on debt for several decades – the headline numbers do not account for a lot of the pensions infrastructure and social security debt, which is a clear legal liability of the government. So the fully-adjusted debt situation of many of these governments is far worse than the 100% to 150% of GDP as currently stated.
We need to create wealth to finance that and help governments effectively balance the accounts. I think the UK has an opportunity to lead the way here.
Welton: We must hope that the Treasury and the wider government will start to build on the success achieved to date. In the UK, encouraging action has been taken and it is about building on these positive steps. We need to build confidence that equity can be the fuel to power growth – wealth, value creation and ultimately jobs.
Rolet: And it is not just about creating new wealth, which is important on its own, but it is about reducing the reliance on a high concentration of leverage among the very small banks, which is detrimental to the economy.
I would also very much like to see European countries take similar steps to creating new wealth. It would be enormously helpful to the UK because we export to these countries. It would make Europe less bureaucratically motivated and more SME oriented. It would make for more compatibility and a better deal-making environment. I strongly believe that there is huge potential to stimulate the UK and international small and mid-size enterprise environment.
This is an edited version of an article that appeared in the Business Growth Fund Review