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Financial Instruments for SMEs -SME Revolving Flexible Fund 2014-2020

Cornwall & Isles of Scilly Local (CIoS)Enterprise Partnership (LEP)

FINAL DRAFT REPORT

January 2014

Cornwall and Isles of Scilly LEP – Financial Instruments for SMEs Final Draft Report

January 2014 1 PwC

Disclaimer 2

1. Introduction 3

PART ONE: STRATEGIC AND MARKET NEEDS 5

2. Strategic Priorities 6

3. Market Gaps and Failures 10

4. Additionality and Complementarity 19

5. Key Findings from Existing Relevant UK FinancialIntermediaries 23

PART TWO: FUND DESIGN 26

6. Fund Strategy and Design 27

7. Measures and Expected Results 38

8. Match Funding 41

9. Implementation and Management Costs and FundPerformance 43

10. Proposed Delivery Timetable 46

Appendices 47

Appendix A: Summary of People Consulted During Study47

Appendix B: Consultations Summary 48

Appendix C: EU Themes 52

Contents


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This document has been prepared only for the Cornwall & Isles of Scilly LocalEnterprise Partnership and solely for the purpose and on the terms agreed withthe Cornwall & Isles of Scilly Local Enterprise Partnership as set out in thecontract signed 26th November 2013. We accept no liability (including fornegligence) to anyone else in connection with this document and, in addition, itmay not be provided to anyone else.

This is a draft report on which you may not rely and we do not assume a duty ofcare to anyone in respect of its content. The comments in this draft report aresubject to amendment or withdrawal: our definitive findings and conclusions willbe those set out in a final report.

This report contains information obtained or derived from a variety of sources asindicated within the report. We have not sought to establish the reliability ofthose sources or verified the information so provided. Accordingly norepresentation or warranty of any kind (whether express or implied) is given by usto any person (except the Cornwall & Isles of Scilly Local Enterprise Partnershipunder the relevant terms of the Engagement) as to the accuracy or completenessof the report. Moreover the report is not intended to form the basis of anyinvestment decisions and does not absolve any third party from conducting itsown due diligence in order to verify its contents.

Disclaimer


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Our Scope of Work

PricewaterhouseCoopers LLP (“PwC”) were appointed on 26 November 2013 to review the potential approach to the use of financial instruments in the next round ofEuropean structural and investment funds. We were asked specifically to consider the issues raised in Appendix F A6.20 of the relevant Department of Communitiesand Local Government (“CLG”) guidance to Local Enterprise Partnerships (“LEP’s”) in respect of financial instruments and thus information required as part ofCornwall and Isles of Scilly (“CIoS”) LEP’s submission to CLG at the end of January 2014.

Structure of this Report

This report is structured in two parts. The first part focuses on strategic and market need and the second on subsequent fund design issues:

Part One: Strategic and Market Need

1. Strategic priorities

2. Market gaps and failures

3. Additionality and complementarity

4. Key findings from existing UK FEI’s

Part Two: Fund Design

5. Fund strategy and design

6. Key measures of a potential fund

7. Match funding

8. Funding for establishment and ongoing management costs

9. Proposed delivery timetable

As illustrated, in the figure overleaf, this report mirrors the requirements as laid out in Appendix F A6.20.

1. Introduction


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Strategic

Priorities

Market

Gaps and

Failures

Additionality and

Complementarity

Key

Findings

from

Existing

Relevant

UK FIs

Fund

Strategy

and

Design

Measures

of a

Potential

Fund

Match

Funding

Funding for

Establishment

and Ongoing

Management

Costs

Proposed

Delivery

Timetable

Analysis of local need, demand and priorities for investment.

Analysis of market failures, sub optimal investment

situations, and investment needs for the policy areas and

thematic objectives or investment priorities to be addressed.

Assessment of value added by the financial instrument and

consistency with other forms of public intervention

addressing the same market, possible state aid implications,

and the proportionality of the envisaged intervention.

An assessment of lessons learnt from similar FIs and ex-ante

assessments carried out in the area (or England) in the past

and how these lessons will be applied going forward.

An estimate of additional public and private resources to be

potentially raised by the financial instrument(s).

Overview of the proposed strategy for investment, including

an examination of options for implementing, financial

products to be offered, financial recipients targeted,

envisaged combination with grant support as appropriate.

A specification of the expected results and how the financial

instrument(s) are expected to contribute to the achievement

of the specific objectives and results of the relevant priority

or measures and indicators.

An indication of sources and size of match funding and the

stage negotiations have reached.

Identification of sources of funding for establishment costs

and ongoing management costs.

The proposed delivery timeline.

Final Draft Report

PwC

Cornwall and Isles of Scilly LEP – Financial Instruments for SMEs

January 2014 5

Financial Instruments for SMEs

Cornwall & Isles of Scilly (CIoS) – Local Enterprise Partnership (LEP)

SME Revolving Flexible Fund 2014-2020

PART ONE: STRATEGIC AND MARKET NEEDS


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Introduction

The development of FIs sits within the context of European, national and localpolicies. This section identifies the consistent themes between these policies thatare relevant to an SME revolving fund to ensure the Fund supports theseobjectives in the 2014 – 2020 funding period. Relevant policies include:

European Policies

In 2010, the European Union and its Member States launched ‘Europe 2020’ astrategy for sustainable growth for the coming decade. The strategy deals bothwith short-term challenges linked to the 07/08 financial crisis and the need forstructural reforms through growth-enhancing measures.

The five Europe 2020 targets for the EU1 are:

1. Employment: 75% of the 20-64 year-olds are to be employed.

2. R&D: 3% of the EU's GDP is to be invested in R&D.

3. Climate change and energy sustainability: greenhouse gas emissions 20%(or even 30%, if the conditions are right) are to be lower than 1990, 20% ofenergy from renewables, 20% increase in energy efficiency.

4. Education: Reducing the rates of early school leaving below 10% at least40% of 30-34–year-olds completing third level education.

5. Fighting poverty and social exclusion: at least 20 million fewer people in orat risk of poverty and social exclusion.

The 2020 targets are interrelated and mutually reinforcing. For example, moreR&D/innovation in the economy, combined with more efficient resources, willincrease competitiveness and create jobs. Similarly investing in cleanertechnologies combats climate change while creating new business/jobopportunities.

1 EUROPE 2020, a strategy for smart, sustainable and inclusive growth, 3 March 2010.

• Objectives and priorities for the 2014-2020 ERDFprogramme.

European

• Government Objectives.

National

• Cornwall and Isles of Scilly European Structuraland Investment Plan Strategy.

Local

2. Strategic Priorities


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As set out in Appendix C to maximise the impact of the European structuralfunds, the European Commission has defined a list of thematic objectives in linewith Europe 2020. The CIoS SME Revolving Fund will 6 of these (EU thematicobjectives):

TO1 - Strengthening research, technological development and innovation.

TO2 - Enhancing access to and use and quality of information andcommunication technologies.

TO3 - Enhancing the competitiveness of small and medium-sizedenterprises, the agricultural sector and fisheries and aquaculture sector.

TO4 - Supporting the shift towards a low-carbon economy in all sectors.

TO8 - Promoting employment and supporting labour mobility.

TO9 - Promoting social inclusion and combating poverty.

It is also important to note the key regulatory requirements of the EuropeanStructural Investment Funds that have a bearing on both the investment strategyand design of FIs:

A minimum of 20% of ERDF awarded must support activities that deliveragainst the EU low carbon thematic objectives.

FIs need to have an element of ‘matched’ funding with third party financialsupport at Fund of Funds or project level which will be lent or invested intoprojects.

ERDF and associated ‘match’ funding can only be spent on ‘eligibleactivities’. This definition includes land acquisition costs up to a 10% oftotal costs (excluding some environmental exceptional cases), buildingacquisitions, site investigation and preparation, building and constructioncosts and fees up to a specific percentage of total eligible costs.

Eligible projects are those that are in development (construction phase) orare considered to be material additions (refurbishment) to existinginfrastructure.

FIs can be used alongside grants, however, they cannot be used to pre-fundgrants or pay for working capital requirements of a project. It is thereforetypically necessary to have an element of third party finance within aproject that is not ‘match’ funding that can support ineligible expenditure.

FIs must be committed to projects in a state aid compliant manner.

FIs must be established in accordance with the EU regulations, which canimpact their design.

Finally all LEPs are required to develop their EU Investment Plans by 31 January2014 for approval by Government, setting out their approach to the deployment oftheir Structural Funds allocation in accordance with the EU thematic objectives.

National Policies

At the time of the 2010 General Election two priorities dominated the debate forrebalancing the economy: sectorally, from an over dependence on financialservices to other sectors; and spatially, away from London and the South East toother regions.


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In terms of spatial rebalancing, the European Institute for Urban Affairs,Liverpool John Moores University, emphasised in 2012 the need for a shifttowards ‘second tier cities’2. This is corroborated by Treasury’s report ‘Investing inBritain’s Future’ which highlights: “Despite significant investment in the regions,London, with around 13% of the population, produces around 21.5% of UK GrossValue Added (GVA), and has the highest GVA per head of all regions. Butcountries can be more successful when they are driven not just by their capitals,but by broader based growth across sectors and regions.”3

The Coalition Government has, therefore, sought to implement mechanisms tosupport greater decentralisation of decision making in support of local economicgrowth, which has included:

The establishment of 39 LEPs in England to succeed the RDAs to drivelocal economic growth and prosperity;

Acceptance of Lord Heseltine’s proposal4 to create a Single Local GrowthFund and European Commission Fund, pledging to delegate significantWhitehall budgets and EU Structural Funds to LEPs to allow decisionson spending to be more informed by the economic needs of a LEP areaand to provide LEPs with greater flexibility on how the money is used;

Competitive funds such as the:

◦ Regional Growth Fund (RGF) which provided £3.2 billion offunding across England from 2011 to 2017. Round 5 of the RGFclosed in December 2013.

◦ Growing Places Fund (GPF) of around £730 million of fundingacross England, available to invest in local infrastructure.

2 Second Tier Cities in Europe: In An Age of Austerity Why Invest Beyond the Capitals?’, European

Institute for Urban Affairs, Liverpool John Moores University; Metropolitan Research Institute,

Budapest; University of Tampere; University of Paris Est; and University College London, 2012.

3 ‘Investing in Britain’s Future’, HM Treasury, June 2013, page 57.

4 No Stone Unturned in the Pursuit of Growth’, Lord Heseltine, October 2012.

Local Policies

In November 2013 the CIoS LEP submitted its draft European and InvestmentFund Strategy to Government. This outlined a request for EU funding of £381m ofERDF and £127m of ESF with a further 20% match funding from public andprivate sector sources. In addition £9.3 million of EAFRD funding has beenallocated. This forms a part of the wider CIoS investment strategy for economicgrowth.

As this ERDF allocation is to be made on a LEP basis, rather than a regional basisas in previous periods, the CIoS strategy focuses only on the allocation to the CIoSLEP region (i.e. it does not reflect the ERDF requests for the greater South West).

The CIoS strategy highlights the rationale for seeking high levels of SME fundingsupport in terms of:

CIoS GDP levels make it a ‘Less Developed Area’ within the Europeancontext (i.e. GDP of less than 75% of the EU average);

Economic activity levels in CIoS stand at 71.6% compared to the UK averageof 76.6%;

Business closures have exceeded start-ups in each of the last 3 years;

CIoS lags behind the UK in relation to earnings;

CIoS have a lower percentage of its economically active population holdingspecific types of qualifications including NVQ4+ levels at 34.2% comparedto a UK average of 38.5% (UK);

Peripherality and physical distance from markets remains a constraint forCIoS; and,

SMEs are c98.1% of businesses in the area and are the key to achievinggrowth in the region.


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To address these issues the strategy identifies 7 areas of potential opportunities,namely:

Capitalising upon FE and HE infrastructure to increase R&D andinnovation;

Making use of emerging markets and sectors (e.g. e-health / renewables /agri-tech) to increase productivity and drive long term growth;

Exploiting existing competitive advantages including superfast broadbandto improve content and access to markets;

Making use of environmental assets to increase productivity and growth inkey low carbon sectors;

Leveraging the large number of SMEs to create growth;

Utilising the existing physical assets and social capital which have thepotential to grow further (e.g. Innovation Centres, Newquay Aerohub andEnterprise Zone and Wavehub); and,

Developing replicable pilot and research projects to lead future growth(including smart energy infrastructure and e-health).

In the context of these opportunities the CIoS Strategy outlines three investmentthemes or criteria for ERDF, European Social Funding as well as public andprivate match funding, namely:

1. Growth for Business – investments that accelerate productivity andcompetitiveness of business including intensive support for businesseswith high growth potential;

2. Future Economy – research and innovation where there are recognisedglobal opportunities. This includes sectors such as marine technology,renewables, R&D based, digital, creative, and e-health; and,

3. Conditions for Business – investments that address continuing blocks togrowth and support the wider social and low carbon outcomes.

As importantly - recognising both the economic and commercial benefits thatmight be delivered from focusing on opportunities that meet one or more of thesecriteria - the CIoS strategy also proposes the use of a revolving fund approach toensure commercially successful investments provide a source for further roundsof funding.


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IntroductionThis section considers the range of market failures that are likely to be addressedby the proposed Fund. In drawing conclusions as to the nature and extent of suchfailures we have drawn upon several evidence bases. These include nationalreports and data in relation to UK SME funding which highlight the continuedand systemic constraints that SMEs face in securing funds from market sources.We also consider regional and local data sources which, in turn, mirror nationalevidence.

While at both levels there is broad evidence of market failure, we also conducted adetailed consultation programme with a range of stakeholders in the region whohave experience of the SME sector in general and the specific sectors identified inthe CIoS proposals.

Examination with these representatives focused upon the nature of marketfailures faced, on a specific sector by sector basis, and the consequent type andsize of funding (as well as funding structures and mechanisms) that might addressthese current (and future) failures.

We have, on the basis of all the above, indicated – in broad terms – the potentialvolumes of funding that might be required through the revolving fund over thenext seven to nine years.

It is important to recognise that while these stakeholders were particularly clearon the nature of the failures and how these might be addressed the volume of anyfuture investments will in turn be driven by agreed investment criteria and theconsequent potential of any given SME to meet these criteria.

Setting a range of investment support for any given sector according to likelyneeds (e.g. micro businesses may need on average £7,000 loans while in contrast

high growth organisations might require up to £250,000) needs to be balancedagainst how many organisations in such sector are likely to deliver the outcomesenvisaged under the fund.

Consequently the focus of our work has been upon assessing both the “type ofinvestment need” and, given the size of particular sectors in terms oforganisations that might seek support through the Fund, the potential take up andimplied “volume of need”. The potential of any particular project proposal to meetthe investment criteria proposed will by definition require some further marketsoundings and related due diligence.

The Context for SME Finance in the UKThe substantial reduction in the availability of commercial funding and increasesin the costs of funding, as a result of the Global Financial Crisis, has been one ofthe key constraints to SMEs accessing funding.

The decline in lending and the quantum of future funding requirements wasobserved in Tim Breedon’s report: “Boosting Finance Options for Business” inMarch 20125: This outlines how lending from banks has fallen sharply since thefinancial crisis. Although some of this is attributed to falling demand, supply offinance is still a critical issue:

“There is a consensus that credit availability needs to increase as the economyrecovers, but analysis suggests that bank credit may not grow to the extent

5 Boosting Finance Options for Business, Report of industry-led working group on alternative debt

markets, March 2012. Department for Business, Innovation & Skills.

3. Market Gaps and Failures


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required to support sustainable economic recovery. The modelled estimatessuggest a potential credit funding requirement over the next five years ofbetween £84bn and £191bn for the business sector as a whole.”

Despite the passage of time, since the Breedon report, there appears to be littleimprovement. Bank lending to SMEs has been declining continuously from 2010to present at a rate of approximately 4% per annum6. For example, as part of theBritish Chamber of Commerce 2013 Q2 results, its Chief Economist, David Kern,stated:

“the economy’s performance is still inadequate and the recovery faces majorrisks….. In these difficult circumstances, it is vital that the government takes thenecessary steps to switch policy priorities towards growth enhancing policies,by supporting infrastructure investment and by boosting the flow of lending togrowing businesses, while continuing to cut current spending in real terms.”

Similarly the “SME Access to Finance: An information paper for LEPs” releasedin August 2013, stated that there is currently market failure because bank’sdecisions to lend are focused on collateral and track record rather than focusingconsideration on the economic viability of a given business.

According to the SME Finance Monitor (which is commissioned by the UKBusiness Finance taskforce and assesses SMEs across the UK) for Quarter 3 2013:

41% of SMEs use external finance. This is stable in context of the previousyear’s figure of 40% (although still lower than 2010 figures of 51%).

70% of SMEs are ‘future happy non seekers’ of additional external finance.

15% of SMEs reported some kind of borrowing ‘event ’ with applications fornew or renewed facilities at their lowest level to date (7%) .

6 Alternative Finance for SMES and Mid-Market companies, October 2013.

7% did not apply but are still seeking finance. These have either beendiscouraged by the general environment or they think the process ofapplying is too difficult.

Of the SMEs which applied for external finance:

70% of all loan and overdraft applications have resulted in a facility, 5% insome other form of funding and 25% in no facility. Of those who obtainedfunding not all received the level they had sought or under the conditionsfirst proposed.

7% of SMEs in Q3 2013 met the definition of a ‘would-be seeker’ of externalfinance, who had wanted to apply for a loan or overdraft but felt thatsomething had stopped them.

New or early stage businesses were less successful in obtaining finance.

Consequently significant proportions of SMEs were unable to receive thefinancing they sought (e.g. 25% of overdraft applications and 7% who weredeterred from applying for funding).

Furthermore some 34% applying for a loan ended the borrowing process withouta facility according to the “Strategy Update for Building The Business Bank” (HMGovernment). This report also highlights that:

Although demand has reduced nationally, many firms are seeking financefor fixed asset investment, firm expansion and development of newproducts. Ensuring these firms are able to get the finance they need is“vital” to the UK’s future investment prospects.

SME investment is relatively small in absolute terms, and also as a share oftotal private sector investment, when compared with other Europeancontemporaries. According to 2011 data, UK Loan rejection rates weretwice those in France and Germany.

Many of the constraints to bank finance are structural and long term, butthese have been heightened by recent economic events.


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Bank funding is too concentrated to a small number of lenders. In 2009,the largest five banking groups held approximately 90% of the SME and75% of the personal loan market share. When these five banking groupsreduce activity in the market, or become more risk averse, this directlyimpacts funding availability for SMEs.

Smaller and newer firms, as well as existing firms seeking investment fornew products, are finding it harder to source financing in recent times.This is often due to a lack of collateral or difficulty in valuing intangibleassets (e.g. intellectual property).

Bank demand’s for information on company performance and futureprospects is difficult and costly for many SMEs to obtain. This leads to adisproportionate reliance on track record and security.

In light of the recent economic climate, regulators and banks are resettinglevels of lending and risk-taking in the process of de-leveraging balancesheets and meeting new regulatory requirements. Whilst the rationale forthis has its merits, the transition is seen to be directly encumbering theSME finance market.

Longer term financing needs, including for new products, are also not beingmet by banks. This is often due to the higher risk and uncertain nature oflonger timeframes. Much of this need may be met through short term andlong term equity but availability of debt is still important.

There is also an investment gap relating to equity. The high costs of duediligence relative to deal size mean that smaller equity investments (around£250k to £5m of investment) are often uneconomic for investors.

Finally – in regard to national evidence of market failure - BIS concluded in theconsultation on the Business Bank:

“Our analysis suggests the following types of firms are particularlyunderserved for finance:

“SMEs of all sizes that seek finance to expand their business or to developnew products and services;

“SMEs that lack the collateral to take out a secured loan;

“SMEs at the smaller end of the SME scale;

“Young SMEs which have existed for less than five years.”

National Context Key Findings

Consequently in a national context there is significant evidence that the supply offinance from commercial (i.e. “market”) institutions has fallen since the financialcrisis without yet reverting to the previous level. This in turn - given current andfuture demand opportunities - both constrains the potential for future SMEgrowth and justifies public sector intervention, via tools such as structural funds,to support such growth (that would otherwise remain unrealised).

CIoS SME ContextOn the basis of Official Labour Market Statistics (2011 data) and CIoS Economicinformation, there are 20,895 VAT registered SMEs in the region andapproximately further 20,000 unregistered. The biggest sectors by SME numbersare farming (c19%), construction (c14%), retail (c11%), and accommodation andfood (c10%). In addition around 89% of these are micro enterprises (0-9employees) with c9.5% small (9-49 employees) sized and the remainder aremedium sized (50-250 employees) businesses.


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CIoS has a similar level of SMEs as the regional average, however, there are asmaller number of larger businesses (and employees in larger businesses) thanthe UK average.

The main sectors contributing to CIoS GVA in 2010 were wholesale and retail(14.4%), real estate (10.4%), manufacturing (10%), health (9.9%), andconstruction (8.4%).

CIoS has a high percentage of its workforce as self-employed: 20.7% of 16-64 yearolds compared with the UK average of 13.5%.

Market Failures in CIoSSimilar to the rest of the UK, significant market failures persist for certainsegments of the SME market. Our consultations with local key stakeholderssuggest for example that:

A number of growth businesses (between 200-600) are unable to obtainfinance from traditional sources and wish to do so. For example currentSouth West Investment Group (SWIG) uptake of loans – from those growthfirms that have been “turned down by banks” -demonstrates such demand.

The majority of businesses in the region comprise of micro-enterprises;many of these are unable to gain funding at a micro level due to a lack ofappetite from banks, high transaction costs and limited business readiness.

Social enterprises have also encountered similar issues (in part due tolonger payback periods and perceived lower returns profiles and lack ofinvestment readiness).

Emerging and innovative sectors lack initial development capital and earlystage support through bank aversion to the higher risk profiles, longerreturn timetables, and lack of security, compounded by limited equityfunding available to meet such gaps in finance.

Reduced supply of finance has also meant a reduction in available workingcapital funding for growth and expansion.

Investor readiness was also cited by all our consultees as a common issue acrossmost types of SMEs in the region – their ability to generate growth may be inplace but the means and personnel to deliver such potential may not. Whilst thereare business support services available in the region their coordination, throughthe Fund, may provide a focal point to ensuring businesses applying for funds cansecure those support services most appropriate for their needs.

Regional DemandDespite the constraints to accessing funding there are, however, signs of recentgrowth in the South West as a whole. The Lloyds Bank Commercial BankingRegional Purchasing Managers’ Index® survey for November 2013, indicatedpositive growth in the South West of England, stating:

There is seen to be consistent improvement in SME performance in theSouth West over the last 12 months.

Metrics for firms in the South West showed the: “sharpest expansion ofoutput in the series history” in November of 2013. This is at a faster ratethan the UK economy.

Proportion of SMEs in Cornwall bySize

Micro

Small

Medium


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There was strengthened client demand leading to increased orders andincreases in workforce numbers.

According to Eurostat, Statistics in Focus, September 2011, Cornwall is the onlyarea in the UK where GDP growth has been consistently greater than 3% between2004 and 2008. This growth was however from a lower base level than otherareas in absolute terms and GDP per capita is lagging behind the UK average:£13,848 compared to £20,873 (2011 CIoS data).

Whilst there is recovery nationally and regionally in the SME sector - in additionto CIoS specific growth –unless matched by increased access to various fundingsources growth in the SME sector in CIoS may be constrained from realising itsfull potential.

Local Need: Specific CIoS Demand and GapsAs indicated in the introduction to this section the main focus of our consultationswas upon particular sectors and types of organisations to understand their(varying) funding needs and consequently what might be implied in terms of theinstruments and size of future fund required relative to the types of prevailingmarket failures in the region.

In the rest of this section we summarise our findings across various sectors andrelated needs.

Micro Enterprise

The evidence for tightening of bank lending and a general lower appetite for smallscale lending leads us to the view that there is a gap (or failure) in the market forlending to established enterprises at a micro level.

From our consultations and SWIG experience in the CIoS area (of £1.5m of loansunder £50k provided to such enterprises between July 09 and Jun 13) takingforward such an approach at the same level suggests around £2m-3m of fundingdemand (2014-2020) which given consultees expectations equates to 40-48investments per year at average loan size of £7k over the seven year period.

In addition while there has not been a small loans scheme in CIoS targeted forearly stage and start-up businesses in the recent past -and there is a gap inthis area (both in terms of national study evidence and as identified throughconsultations) - it is likely that the government Start up Loan scheme, incombination with the above microcredit scheme, should sufficiently cover thismarket gap.

High Growth Business

Our consultations have (consistently) suggested that there is a pool of 200 to 600high growth businesses (i.e. with performance of 20%+annual growth over 3years) that could potentially be supported by the Fund.

Evidence from our analysis (including SWIG data) suggests that demand fromsuch sources for appropriate types of funding could be in the region of between£15-£30m based on:

SWIG precedent - between July 2009 and June 2013 SWIG invested £5.4mof loans (up to £250k) into 83 Cornish businesses at an average of £65k.Comparable demand over a 7 year period implies funding of c£9.5m.

Given the potential pipeline of 600 firms a further 11-17 investments overthe same seven year period (1-3 investments a year at an average size of£500k) would suggest a total of £15m-18m potential size.

Moreover even at 300 investments (42 per year) - with an averageinvestment size of £100k - the maximum size of the funding required wouldbe £30m.

Business Competitiveness

There is further scope for investment into growth businesses (but not necessarilyhigh growth) to boost competiveness.

Financial support to enhance competitiveness of business is a priority for the LEPin addition to bringing businesses to new markets and improving their financialplanning. Developing investor readiness of businesses, and business support


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activities that improve business networks, is integral to improving SMEcompetitiveness.

Technical Support

Our consultations identified the need for a technical support fund which wouldboost the competitiveness of business through, for example, buying groups, lettersof credit and foreign exchange facilities which serve to improve business efficiencyand enhance revenue generation. Consultations and SWIG data suggest that thesize of demand for such a fund to be around £2m.

Equity and Mezzanine

There is a mezzanine and equity funding gap in the market. Within CIoS there isa need for various products that is not matched currently by investor sources,implying the potential benefit to a direct Equity and Mezzanine fund for certainearly stage businesses, in higher risk or emerging sectors and to businesses withless security.

SWIG estimates that up to around £16m could be utilised to meet such needs withmatch funding of a further £7m using Investment Angel networks. Much of thiswill be used to fund firms in the future economy where an equity and mezzaninefacility will be important. We therefore estimate, based on previous experience,that a fund of between £8m-£13m would be suitable (implying 40-65 investmentsat an average size of £200k) within a Growth For Business stream.

Restructure fund

There is also potentially a market gap in supplying finance to businesses thatwould benefit from restructure. In 2011 in the CIoS area there were 1,715 startups and 1,835 closures resulting in a decline in the number of enterprises (ONS,UK Business Demography).

Banks are reluctant to support certain businesses that fall into this category(especially given the financial climate) and there is room for interventionproviding it complies with State Aid rules. Demand for this fund could be up to£7m based on the premise of investment in 10 businesses an annum (70 over a 7year period) at an average size of £100k.

State Aid issues will need to be fully considered, however, before committing to aRestructure Fund. For example State Aid stipulates that Rescue/Recoveryfunding must meet various conditions7:

Restricted to the amount needed to keep the firm in business.

Only for the time needed (max. 6 months) to devise the recovery plan.

Be warranted on the grounds of social difficulties and have no adverseeffects on the industrial situation in other Member States.

Should be a one-off operation – one time last time principle.

Rescue aid can be given before notification but notification must be madeimmediately afterwards.

A firm is not eligible for rescue or restructuring aid for the first three yearsfollowing the start of operations in the relevant field of activity.

Future Economy

The LEP strategy prioritises investment into new and emerging sectors. This isbased on various competitive advantages and opportunities in the region such asthe Wave Hub and The Enterprise Zone. Specifically the target emerging areashighlighted by the LEP are in:

Marine technology – for example, the “Wave Hub” is perceived aspotentially a world class technology.

E-health – the demographics in CIoS of an elderly population regionallydispersed, provides the potential for pilot testing (remote) e-healthinitiatives.

7 ‘The state aid guide: guidance for state aid practitioners’, Department for Business Innovation and

Skills, June 2011, page 45.


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Digital - CIoS is one the best digitally connected rural areas (82%superfast broadband rates, CIoS, 2013 figures).

R&D based - In 2009 R&D spend in CIoS was 0.19% of GDP (UK averagewas 1.85%); CIoS spends the lowest percentage of its GDP on R&D whencompared to all other regions (EuroStat 2012) reinforcing the need forinvestment support. The Universities of Exeter, Plymouth, and Falmouthdo, however, have a strong innovation base.

Aerospace – CIoS is home to Newquay airport which is the onlycommercial airport in the UK with an Enterprise zone.

Creative - the second fastest growing sector since 1999 has been arts,entertainment and recreation at 8.2% (ONS, 2011).

Renewables – the CIoS region has a unique natural resource profile.

Based on ONS data (opposite) the total number of SMEs falling into theseemerging sectors is likely to be low and mostly on a micro enterprise scale(especially after discounting healthcare SME most of which are unlikely to providee-health services). Many of the firms that will produce growth in these sectorsare, therefore, likely to be early stage or start-ups.

Micro

(0-9 employees)

Estimate

Small/Medium

(10-250

employees)

Estimate

TOTAL

Digital 60 0 60

Renewables 5 0 5

Creative 255 5 260

Healthcare* (includes low value

healthcare)100 80 180

R&D based** 220 0 220

Marine (includes maritime

sectors but not food)50 0 50

690 85 775

Source: 2011 ONS Labour Market Statistics (registered Businesses only).

*includes hospital, residential care, and nursing home activities many of which are low value.

** includes “Other professional, scientific and technical activities” a proportion of which will not fall

within R&D.

There is a low appetite from commercial lenders to invest in SMEs operating inthese (and other) emerging sectors due to the higher risk nature and relative lackof track record – characteristics of many start-up businesses. Mezzanine andequity financing may be more appropriate in building these sectors but theinsufficient availability of these funding types intensifies the financing issue.

There is therefore room for intervention in financing enterprises in these sectors.This funding may primarily need to be on a grants and equity basis given the earlystage nature of many of these businesses.

Given the small number of established businesses and lack of track record it isdifficult to estimate the actual levels of demand for a fund. Moreover suchdemand might significantly rise, for example, with a large infrastructure


January 2014 17 PwC

investment or investment from a large business into the region could stimulatethe SME sector (and supply chains).

Given the total “market of around 650” organisations we suggest the potential fora £20m (excluding proof of concept) fund to invest on a commercial basis withscope for further investment depending on the risk appetite of the LEP.

This equates to 20-40 businesses over a 5 year period or less than 6% of the likelytarget population and in turn mirrors the types of average “rejection rates”experienced nationally by all SMEs. We have assumed based on our consultationsaround 4 to8 investments per year at an average investment size of £500k. Thisexcludes business support work.

Proof of Concept

There has been a consistent message with regard to developing a proof of conceptfund which would work closely with innovation centres (but not only withbusinesses aligned to innovation centres) to provide early stage support, proof ofconcept, proof of market, and initial development investment. This approachwould de-risk many investments and filter viable investments toward funding.After the proof of concept phase many businesses may also be able to meet theirfinance needs through banks.

We suggest based on our consultations that demand for such support could be upto £5m on an equity or quasi equity nature:

Equating to 3 investments per year (21 over a 7 year period) at £200kaverage size and a further 2-3 investments per year (16 over 7 years) at anaverage investment size of £50k.

This funding would include business readiness support as well projectdevelopment costs.

Social and Environmental Outcome SMEs

We have also noted a significant (although hard to quantify) need to meet thefinancing demands of SMEs that act in the social enterprise domain.

We would include community initiatives and small scale low carbon ventures (asrevenue and profit generation are not the primary motivations of theseenterprises).

A desire to invest in these sectors is a priority within the CIoS strategy where 5%of a potential fund has been earmarked for investment into the social enterprisesector.

This implies around c£0.7-£1.4m funding in low carbon and social enterprisebusinesses a year using an estimate of 50 investments at an average of £100k or67 investments at an average of £150k at the higher end.

Summary: Priorities for InvestmentOn a national level there is a recognised shortfall in financing to SMEs. This is anexperience that has been mirrored in the CIoS region, in addition to furthermarket specific failures including at the micro level and in equity financing. Thereis opportunity to service many of these key failures and to capitalise on some ofthe regions key competitive advantages in the “Future Economy”.

Consequently, as detailed in the table overleaf we suggest that there is arequirement for between £61m to £96m funding support to address the marketfailures and the demand issues identified for the CIoS area across 6 key roles:

1. Supporting high growth businesses.

2. Enhancing Business Competitiveness including through businessrestructure and technical support.

3. Supporting the funding gap for enterprises at the micro level.

4. Investing in the future economy and providing a proof of concept tohelp early stage business.

5. Providing finance and support to social and low carbon enterprises.


January 2014 18 PwC

6. Supporting investments with a thorough investor readiness packagethat underpins investments in each of the above areas.

Area of funding Key pointsPotentialDemand

Growth/ High GrowthSupport to businesses that have high growthpotential

£15m-£30m

Micro LevelAddressing the finance gap for non start-up smallgrant/ loans below £50k (average £7k)

£2m -£3m

Technical SupportSupporting competitiveness of business throughspecific technical interventions

£2m

Equity and MezzanineProviding equity and mezzanine finance includingleveraging business angel networks

£8m -£13m

Business RestructureHelping address failures in business failure throughtechnical support and financing to select businesses

£6m -£7m

Future EconomyDeveloping key emerging sectors and supportinginnovation

£18m -£25m

Proof of conceptProviding intensive support to early stage futureeconomy SMEs

£5m -£6m

Social Enterprise and LowCarbon

Improving the conditions of growth throughsupport to social impact and low carbon enterprise

£5m -£10m

TOTAL£61 m -£96 m


January 2014 19 PwC

Introduction

This section outlines the national, regional, and European funding sources thatcurrently operate in the SME finance market. By understanding the currentsources of funding (both public, private, and third sector) that is available it willbe possible to assess the:

Degree of overlap or complementarity with existing sources of funding toa new fund; and,

Potential gaps in financial products offered by these funds.

Commercial Banks

Commercial banks are typically one of the first sources of funding for SMEprojects. As indicated by national and regional evidence, however, the availabilityof funding for these projects has declined substantially as a result of the GlobalFinancial Crisis. This has led to banks not being prepared to back SMEs or fundgrowth opportunities to the same level as in the past.

Banks will continue to be an important source of funding for projects, however,within the SME sector it is considered unlikely that commercial banks will stillprovide the entire funding need. This has been reinforced through ourconsultations and review of previous fund uptake. There remains an unsatisfiedneed for capital.

Public Intervention through Banks

There are a number of national government interventions that leverage banks toboost the supply of finance to SMEs and improve the bank acceptance rates onapplications. The three main schemes are:

The Regional Growth Fund and Assisted Asset Purchase Schemeproviding grants to support SMEs considering investing in new capitalassets and creating new employment.

The Enterprise Finance Guarantee which can be used in instanceswhere banks do not initially lend due to a lack of security or proven trackrecord.

The Funding for Lending Scheme providing funding to banks andbuilding societies for an extended period, with both the price and quantityof funding provided linked to their lending performance.

These schemes are run leveraging (mostly high street) bank skills and funding.While this helps improve the supply of financing, bank risk adversity is still afactor and many businesses without full security, track record, or with poor initialinvestor readiness are still – as evidenced by national and regional data - turneddown. A market failure, therefore, still exists for businesses that are viable but aretoo high risk for banks.

Funds operating in SME Access to Finance

There are funds that operate within SME finance gaps where banks have turneddown applications. There is potential to complement these funds but someoverlap may also occur.

4. Additionality and Complementarity

http://www.gaininbusiness.com/article/22091/Regional-Growth-Fund-and-Assisted-Asset-Purchase-Scheme


January 2014 20 PwC

Start-up loans and New Enterprise Allowance

Government’s Start Up Loans and New Enterprise Allowance suppliessmall scale funding for early stage business. The potential SME Revolving Funddesign has considered the operation of this government intervention and has notcreated a separate stream to address the same area (and create overlap).

Regional Growth Fund

The RGF was launched by Government to support projects and programmes withsignificant potential for economic growth and the creation of additional,sustainable private sector employment. The key investment criteria include:

Number of jobs created/ safeguarded (typically with a value of £15,000 perjob or less).

Applications for grants considered for particularly transformative projectsor significant projects such as those creating 200 jobs or greater, and onlywhen no other sources of funding are available.

The initial total national allocation was £2.4 billion spread across 4 rounds anda further £600 million was made available (for ‘rounds’ 5 and 6) – round 5 isnow closed and round 6 is set to be launched in the summer of 2014. Theremay be (albeit limited) opportunities for Fund ‘matches’ subject to whetherregional projects for these latter rounds are approved and are seeking futureinvestment. As LEP approval will be sought by applicants such opportunitiescan be identified (and qualified) over the next few months.

Business Growth Fund

BGF was established in 2011 to help Britain’s growing SMEs primarily throughequity. The BGF is backed by five of the UK’s main banking groups: HSBC,Barclays, Lloyds, RBS and Standard Chartered. BGF is an independent companywith up to £2.5 billion available to make long term equity investments of up to 10years. BGF’s investment criteria include:

Investment size of £2m – £10m of growth capital for a minority equitystake and a Board seat.

Supporting privately owned profitable companies with a turnover of £5m -£10m.

BGF does not, however, service equity investments below £2m and this is asignificant area of “opportunity” for a new fund.

Small Scale Regional Funds

Start Up Growth Support in the Greater Dartmoor Area providesbusiness support for start-up and pre-start-up businesses. This scheme couldcomplement the investor readiness work of a potential fund.

Torbay Business Growth Fund is a £1m Growth Fund (loans/grants up to£150k) seeking to create jobs and boost business growth launched in April 2013with £158k already committed. This is a relatively small fund and overlap will beminimal. There is potential to leverage local knowledge and experience of thisfund in Torbay and supplement funding through a new revolving SME fund.

Business Boost in CIoS

Business Boost is the suite of investment funds totalling £17 m that is designed toenhance business growth in Cornwall and the Isles of Scilly. This includes:

Business Investment for Growth (BIG - ERDF).

Business Innovation Fund (BIF - ERDF).

Business Catalyst fund (Regional Growth Fund).

Superfast Cornwall fund (Regional Growth Fund).

Growing Places fund.

http://www.gaininbusiness.com/article/22088/Start-Up-Growth-Support-in-the-Greater-Dartmoor-area

http://www.gaininbusiness.com/article/22269/Torbay-Business-Growth-Fund


January 2014 21 PwC

Rural Business Investment Scheme (RDPE).

Business Investment for Growth Programme (BIG) is a £3.6m funddesigned to improve the competitive advantage of high growth SMEs in CIoSmanaged by the Cornwall Development Company. Grants are between £1k-50k.This uses current ERDF funds and is set to expire in March 2015.

Business Innovation Fund provides grant funding to Cornish SMEs forprojects seeking £1,000-£50,000 for up to 50% of total project cost. Applicationsfor this fund will close on 31 December 2014.

Business Catalyst Fund is a £5 million fund aimed at businesses in Cornwalland the Isles of Scilly that want to improve business productivity throughinvestment in capital or revenue projects. The fund has experienced strongdemand and is currently closed for new applications. As of December 2013 thefund had:

£3,946,438 applications approved.

£906,147 pipeline expressions of interest.

£147,415 funding remaining.

The Business Boost sub-funds are either complementary to the fund (RDPE andSuperfast Cornwall) or are close to completion and are unlikely to providesignificant overlap with a new funding instrument over the 2014-2020 period.

Complementary Funding Sources

There are a number of complementary sources of funding that could beconsidered within a portfolio of funding streams to achieve the strategicobjectives. This is particularly with regard to sectors that are not permitted withinAccess to Finance instrument ERDF regulations (e.g. direct agriculture) and todevelop the “Conditions for Growth” objective including superfast broadband,housing, and workspace needs.

Superfast Cornwall Fund is a £1 million fund to accelerate business growthin Cornwall and the Isles of Scilly though the use of superfast broadband. Asof December 2013 the fund had:

£378,901 applications approved.

£403,959 pipeline expressions of interest.

£217,140 funding remaining.

The Growing Places Fund has £6 million of investment funding availableaimed at housing and commercial development to create jobs in Cornwall andthe Isles of Scilly. This fits within the remit of improving the conditions forgrowth in the region. As of December 2013 the fund had:

£4,000,000 committed.

£1,600,000 approved subject to due diligence.

£200k - £300k funding remaining.

Agricultural DEFRA and EU funding – economies of scale could beexperienced by linking this support under the same fund management(particularly given that businesses cannot receive this funding alongside ERDFfunding). Agriculture funding in the region includes:

Rural Business Investment Scheme of which £500k grants have beencommitted (between £10k to £40k) to 20 businesses creating 32 jobs and£1.2 million GVA.

The Farming and Forestry Improvement Scheme (FFIS).

Rural Enterprise Grant Programme.

In parallel the LEP and Cornwall Council are developing proposals for aHousing Investment Vehicle to boost investment in and development of arange of housing products across the area. It is proposed that finances from the

http://www.gaininbusiness.com/BIG

http://www.gaininbusiness.com/article/4268/Business-Catalyst-Fund

http://www.gaininbusiness.com/FFIS

http://www.gaininbusiness.com/article/22183/Rural-Enterprise-Grant-Programme


January 2014 22 PwC

local Growth Deal - potentially in the order of £20m - £30m may be availableto seed such a 'fund'. There will clearly be synergies, given the housing supplychain issues, and links to wider health, sustainable construction and lowcarbon issues, with this potential FI.

There are also 3 schemes available in the region looking at low carbon. Twoschemes are part of the national governments £200m commitment between 2011and 2015 to spend on energy issues:

The Energy Entrepreneurs Fund Scheme - a competitive fundingscheme to support the development and demonstration of innovative,new technologies, products and processes.

Investment in renewable energy generation –a scheme to developrenewable technologies and skills.

In addition there is the Energy Efficiency Financing Scheme. This is aCarbon Trust Implementation Services and Siemens Financial Services schemesaid to be worth £550m financing projects in organisations seeking to reduceenergy use.

Proportionality of a Potential Fund

As indicated in the previous section the size of fund proposed has been predicatedon matching the needs of various sectors for different forms of commercial typesof finance that are unlikely to be provided by the current market.

The total uptake likely is also predicated on the assumption that this needrepresents a small but important proportion of the total firms and other types ofenterprises within the CIoS area and that neither the funding available will inanyway distort existing market activities nor compete with the other types ofinterventions available to the public sector.

Summary: Value Added by a New FinancialInstrument

There is a strong evidence base demonstrating the market failures within CIoSwith regard to SME finance. Bank lending has fallen and there is a lack ofavailable equity financing.

On the whole there is a demand for alternative financing to SMEs (which has beenevidenced by the high take-up rates of regional funds) that is beyond the scope ofexisting interventions. This is due to term expiry for regional funds, the smallscale of specific area funds and the lack of suitability and penetration of nationalschemes to many SMEs in the region.

A new revolving SME fund will therefore add value by replacing, andsupplementing schemes set to be completed over the next 12-18 months, whilstcomplementing related interventions in areas outside the remit of ERDF funding.

http://www.gaininbusiness.com/article/22068/The-Energy-Entrepreneurs-Fund-Scheme

http://www.gaininbusiness.com/article/22083/Investment-in-renewable-energy-generation

http://www.gaininbusiness.com/article/22081/Energy-Efficiency-Financing-Scheme


January 2014 23 PwC

Introduction

In order to inform fund development -based on local interviews and fundperformance to date, our national knowledge, and wider published reviews - weconsider below the lessons learnt and issues addressed by other UK SME FinanceFunds.

SME focused FIs in the UK

As section 4 outlines there is a national reduction in the supply of SME financingwith demand (though reduced) still present. Both the current and previousGovernment have attempted to address the market failures through a variety ofschemes. Since 1999 more than 150 ‘publically’ backed venture capital and loanfunds have been established in the UK.

This has comprised £1.1bn of investment by the HM Government, £1.1bn ofprivate investment and £0.5bn of European Regional Development Fund (ERDF)monies. The nature of the funds deployed has varied considerably – ranging fromsmall microloan facilities (£1m to £2m) to larger ‘fund of funds’ of up to £200mincluding JEREMIE type interventions (such as £90m Fund managed by FinanceYorkshire Limited).

Currently almost 70 funds are operating comprising a commitment of over £1.6bn- 60% of which have a regionally focussed investment policy. From examining thecommitment by country and region in the UK it is clear from the research that theSouth West is the most “poorly represented” in volume terms. Investments in

Scotland, Wales, North West and the North East range, for example, from £125-£240m whereas the South West “0nly” has a commitment of c£20m.In general recent large scale FIs in SME financing are seen to be meeting theirobjectives in terms of:

Addressing the finance needs of SMEs that had initially been unable to gainprivate sector funding (particularly in higher risk businesses) on acceptableterms.

Achieving a high proportion of assisted SMEs that would not haveproceeded with their proposed investment without the finance provided bythe funds.

Key Lessons Learnt from Experience of FIs in theUKFund Structure and Scale

A recent move toward using a large scale fund of funds approach (includingJEREMIE interventions) have notable advantages including:

The ability to meet substantial access to finance gaps. Research pointstoward fund minimum size of £100m being ideal - furthermore the EIB wassaid to have indicated a desire to set the £100m as a minimal threshold forfunds it invests in.

5. Key Findings from Existing Relevant UKFinancial Intermediaries


January 2014 24 PwC

The opportunity to adopt a more integrated and coherent approach to theprovision of public sector backed SME finance across each region (avoidingthe fragmentation of past interventions).

A flexibility of a fund of funds approach and ability to reallocate resourcesbetween funds.

Consideration of sectoral requirements and the potential for a thematic fund isalso important. Thematic based funds have been evidenced to perform well inmany contexts though they are not applicable to all strategies. Considering thistype of fund and picking what suits the specific regional need is important. ForCIoS this includes analysis of sectoral fund needs and potential adoption of athematic fund. Developing a sub-fund structure that suits the needs of the localarea whilst staying aligned to strategic objectives is therefore integral to funddesign.

Funds should also consider the differing forms of investment products available tomeet its strategies (equity, quasi-equity, mezzanine, debt et al). Allowing fundingstreams to be flexible and utilise the funding instrument most appropriate to therecipient is vital. A CIoS fund needs to also recognise that SME’s will be atdifferent stages of their development lifecycle (pre-seed, seed, start-up, emerginggrowth, high growth et al.).

In addition the LEP and the Fund manager needs to be willing and proactive inchanging the fund strategy in line with changing market needs over the 7 yearfund lifespan. This monitoring of the market and adaptation to its needs helpsovercome two key long term risks to a fund:

Vulnerability to external risk factors including economic performance andchanges in national and European policy; and,

Vulnerability to internal risk factors including underperforming fundmanagement and changes to regional LEP priorities.

Investment Strategies

In general investing in fewer larger projects (over many smaller investments) isseen to be more effective in achieving financial returns relative to fund costs andbad debt levels.

By definition this has led to some of the current gaps and the LEP recognises thatthat, while on the one hand the proportion of recycled funds may not necessarilybe as high as investing in larger projects, this needs to be balanced against theeconomic benefits that would otherwise not have been generated without theFund.

Funds need to be aligned to the local and national business support networks andto wider instruments. In CIoS this means that funds should add additionalelements to the business support market (such as providing a central hub) andwork alongside existing providers of which there are many. The LEP also needs toensure that funding available from other sources are complimentary and thatneighbouring regions support the strategic aims.

Planning and Early Stage Issues

There is a recognised potential for optimism bias in assumptions of investmentand financial performance for an FI. For instance recent delivery issues withinthe North West and the Yorkshire JEREMIE funds led to a revision of fundallocation and fund size respectively. Understanding demand and designing FIsthat align to this are therefore important to CIoS.

Many funds nationally and in the South West region have experienced slow initialuptake of the funds with back ended pressure on utilising all funds available. Toovercome this the LEP should consider marketing and targeting strategies earlyand ensure that funds are established as soon as possible.

In particular a lack of availability of match funding has caused delays to deliveryof some ERDF based funds. It is therefore important that the LEP plans early inconsidering potential sources of match funding and that negotiations progress assoon as possible. In this respect CIoS has already started discussions and


January 2014 25 PwC

identified match funding volumes – as long as negotiations advance rapidly overthe coming months the CIoS LEP should overcome these issues.

Fund Implementation

Securing fund managers who have the appropriate expertise and will deliver highquality fund management services is integral to fund success. In this respectCIoS needs to secure fund managers with:

Strong knowledge of the CIoS region, with ability/resource to actively targetbusinesses.

Fund managers with adequate track record and preferably managingsimilar funds (to achieve economies of scale).

CCA compliance will be needed and ideally fund managers should be FCAapproved to ensure adequate training.

Appetite to interact regularly with investees and build relationships toshare skills and knowledge.

However given ERDF constraints on management costs the LEP needs tomanage these requirements within cost limits which typically benchmarkedat 2% for a holding and between 2% to 4% for fund management dependingon the nature of the fund8.

Encouraging businesses to take equity and mezzanine structures has been difficultacross many FIs leading to lower performance with these instruments. There wasa perception from businesses that mezzanine finance was complex and there werechallenges selling the benefits of equity finance.

8 Consequently subject to the fund structure used the range of such costs – as a proportion of funds

allocated over a given period – might range from 2% (vanilla fund’) to 6% (for a ‘fund of funds’).

These instruments need to be targeted (and appropriate levels set) to the relevantmarkets. For instance new business in emerging sectors could be aligned toequity finance. Ensuring SMEs understand the options with regard to equity andmezzanine finance is also a key role for business support and fund managers.

Final Draft Report

PwC

Cornwall and Isles of Scilly LEP – Financial Instruments for SMEs

January 2014 26

Financial Instruments for SMEs

Cornwall & Isles of Scilly (CIoS) – Local Enterprise Partnership (LEP)

SME Revolving Flexible Fund 2014-2020

PART TWO: FUND DESIGN


January 2014 27 PwC

IntroductionThe aim of this section is to provide an initial recommendation of the possiblestructure of an SME revolving fund, based on:

The proposed investment strategy for the FI as outlined;

The range of options available and the preferences expressed of the LEP;and,

Permissible structural options in respect of the set-up and operation of afund.

This recommendation is subject to possible changes resulting from:

Any legal advice taken to test regulatory and State Aid compliance;and/or,

Testing the proposal with the Department of Communities and LocalGovernment (CLG) for acceptability; and/or

The ongoing development of the project pipeline for both FIs, theirfunding needs and the implications this may have on the possiblestructure and/or alignment of the FIs going forward.

Strategic alignment

The fund should align with – as detailed in the table overleaf – national andregional strategic priorities. For example, investments should be consistent withthe:

The themes of the CIoS European Structural and Investment FundStrategy - enterprise and innovation (future economy, growth forbusiness, conditions for growth), infrastructure, social inclusion andskills; and,

CIoS Strategy Priorities.

6. Fund Strategy and Design


January 2014 28 PwC

Alignment with Key Strategic Priorities

Priorities Future Economy Growth for Business Conditions for Growth

Strategic priorities 1. Priorities investment in research and

innovation especially within:

o E-health and wellbeing

o Offshore renewables

o Agri-tech

o Creative industries

o Marine technology

o Aerospace/space

2. Investment in activities that help grow a

“green and marine” region

1. Building Business Capacity and helping

businesses achieve growth potential

2. Provide intensive support to businesses

with best growth potential

3. Growth through innovation

4. Increase access to local, national, and

international markets

5. Progression through the labour market

1. Digital investment and digital skills growth

2. Optimise carbon management and improve energy

efficiency

3. Infrastructure investments to aid business growth

4. Develop socially resilient, sustainable, and inclusive

communities

5. Progression in the labour market

How the Fund will be able

contribute to the strategy

The Fund will need to specifically target these

emerging sectors and offer early stage support

in addition to equity, grant, and debt funding.

A separate fund or group of funds will need to

be setup to absorb the higher risk profiles of

these businesses and utilise specialist skills to

help growth.

This will therefore increase the total number of

businesses operating in these sectors

(including through supply chains) and add

additional technology.

The fund will need to support growth and high

growth businesses. This will follow the success

of current SWIG fund. Specific fund needs will

be in areas of high growth and growth, supply

of equity, and micro level loans.

There is also a need to provide support for

investor readiness and business support

activities to help develop skills and link

businesses to additional markets.

Through a potential future economy element of the fund,

or sector specific funds, businesses in the digital economy

will need to be supported.

The SME fund will also need to include a stream

prioritising social impact and low carbon/environmental

outcomes.

Infrastructure and progression in the labour market will

not directly be supported, however through business

support activities certain skills can be developed, and

enhancing business networks can help overcome

infrastructure barriers.

Alignment with ERDF

Thematic Objectives

TO1, TO2, TO4, TO6, and TO8

ERDF Priority 1 Research and Innovation

TO1, TO3, TO8, and TO10

ERDF Priority 3 – Business Competitiveness

TO2, TO4, TO5, TO7, TO9, and TO10

ERDF Priority 9 – Social Inclusion and Poverty

ERDF Priority 4 – Low Carbon Economy


January 2014 29 PwC

Fund ParametersPermitted investments

Based on the work undertaken in this assessment, this may include:

Sector focus: Current growth sectors and emerging sectors such asmarine, aerospace and digital.

Investment recipients: predominantly private sector organisations.

Investment Products: senior and mezzanine debt with a tenor of up to5 years, equity and quasi equity structures and matched grants whereapplicable.

Geography

Whilst discussions may have taken place over alignment with regional LEPs forthe purposes of this assessment it is assumed that the geographic focus will beCornwall and the Isles of Scilly only and not any joint regional LEP intervention.

Investment returnsIt is intended that the majority of funding will be provided at commercial terms asa function of:

The credit strength of the borrower.

The risks associated with the repayment (e.g. the certainty of futurerevenues).

The debt tenor.

The overall funding package proposed by the borrower.

Equity investments will also consider risk and returns profiles and socialenterprise investments may involve consideration of wider social impactmeasures.

Non-financial returns

Each investment will be expected to contribute to some or all of the non-financialoutcome measures included in the final version of the CIoS EU Investmentstrategy. This will include a contribution to the employment numbers andleveraging of private sector funding.

Regulatory compliance

Investment of FIs into projects will be required to be undertaken in a State Aidcompliant manner. Structural Funds regulations require that investment adhereto EU Rules, which includes, for example, ensuring each project has ‘eligibleexpenditure’ that is greater than, or equal to, the FI project commitment plusassociated ‘match’ funding.

Overall responsibility for meeting these requirements will reside with the Fund(rather than any appointed fund managers) and will form part of the conditions ofsupport from the Commission and DCLG. The exposure to any risk of ‘non-compliance’ will also fall upon the Fund so it is particularly important tin duediligence procedures to ensure, for example, that any recipient of grant fundinghas not received any state aid support in the previous three years (or at least theseamounts fall with de minimis limits). Similarly it will be important to establishthe relevant reference rates for any loans to ensure the principles of the ‘marketinvestor’ rulings are met (i.e. that if rates are below those in commercial marketsthe benefit obtained does not exceed de minis levels).

Finally it is our understanding that State Aid legislation is currently under reviewby the Commission and, as a consequence the de minis levels may increase. Suchchanges are, however, unlikely until 2015.


January 2014 30 PwC

Investment exclusionsBased on experience from other UK FIs exclusions that the LEP may wish to adoptwithin the investment strategy, this could include:

Activities which are wholly a statutory duty on public bodies are notpermissible;

Specific technologies and/or counterparties that are not permitted by‘match’ and/or complementary funding providers;

Projects where the site is not within the permitted area covered by theInvestment Plan, i.e. all activity has to be within Convergence area;

Funding of the design and development of financial instruments such asventure capital, loan and guarantee funds; and,

Concentration limits in respect of individual investment scale and/orinvestment into the same counterparty. For instance single project loansup to a max of 20% of the FI commitments.

Interface with other funding products

It is important to ensure ongoing complementarity with other investmentproducts or programmes that have overlapping or complementary targets (asconsidered in section 5). This could be achieved by aligning the fund withinitiatives being undertaken by other the South West LEPs.

Fund Design Options

It is important that the main design options for the fund have been properlyassessed before outlining a suggested design. There are many differentapproaches (within the ERDF limits) that could achieve the required objectives ofthe fund, these have different advantages and disadvantages in the context of theneeds of the CIoS region. These are considered below:

Single structure fund or fund of funds approach

Key Advantages of Single Structure Fund

Lower transaction and marginal costs of investments.

Economies of scale and potentially lower overall management costs.

Less bureaucracy and complexity.

Larger size makes it more attractive to a greater number of fundmanagers.

Key Disadvantages of Single Structure Fund

Tendency toward single strategy - less focus on specific priority objectivesectors and areas.

Harder to make specialist measures and outcomes for niche andalternative sectors.

Less specialised targeting and fund management.

Less overall flexibility.

Given the distinct thematic objectives within the CIoS strategy (Competitiveness,Future Economy, Conditions for Growth) a Fund of Funds approach appearsmore suitable. This allows for easier implementation of different targets andstrategies between distinct thematic areas.

Sector specific fund structure or non-sector specificapproach

Key Advantages of Sector Focused Approach Specialist sectoral fund management expertise which could produce

better results within each sector.


January 2014 31 PwC

Fund autonomy - specific targets and measures can be set for eachparticular sector.

Directly aligns with strategy - CIoS strategy has specific sectors in the“Future Economy” which are a priority to support and will needindividual attention.

Creates greater competition between fund managers.

Key Disadvantages of Sector Focused Approach

Smaller sized funds with higher transaction and overhead costs

Smaller fund sizes less attractive for fund managers

Insufficient data to determine demand and set fund size for majority ofsectors in CIoS.

Less flexibility (i.e. more bureaucracy) in reassigning funds betweensectors.

Given the lack of sector specific demand data it is difficult to adopt asector approach and the higher ongoing costs of this approach may beprohibitive.

Investment instruments

The market gap analysis has identified a need for the use of debt, mezzanine,equity and grant mechanisms within a potential fund. It is, therefore, consideredoptimal to include all of these elements.

Funding areas

Given the analysis of market failures, gaps, opportunities, and demand there is acase for:

1. Supporting High Growth businesses.

2. Enhancing Business Competitiveness including through businessrestructure and technical support.

3. Supporting the funding gap for enterprises at the micro level.

4. Investing in the future economy and providing a proof of concept tohelp early stage business.

5. Providing finance and support to social and low carbon enterprises

6. Supporting investments with an investor readiness package thatunderpins investments in each of the above areas.

Level of Recyclable Funding

While it is desirable to have a fund where the majority of funds are recycled, theobjectives and market needs in CIoS provide reasons to include grants and investin areas with higher default rates suggesting lower rates of refunding availablegiven:

High risk “Future Economy” investment activities will have a higherdefault rate. Furthermore a proof of concept may require a grantselement.

Funding through equity and mezzanine are higher risk and couldpotentially have higher default rates.

At the micro level given the high transaction costs of overseeing loansover a period, grants maybe more appropriate in some instances(though not without significant transaction costs).

There is a need for significant investor readiness activity which doesnot generate a direct return.


January 2014 32 PwC

Based on Community Development Finance Association (CDFA) benchmarks fora similar fund a default rate of around 30% could be applicable. This level couldbe set as a target across all three funding themes. Where individual fundsbreached this level future funding could be reallocated to other elements of thefund. Based on our experience of other funds (also of a similar nature) defaultrates, however, can be as high as 60%-70%.

Other Considerations in Fund Design andManagement

During our consultations it was suggested that some SMEs might benefit from a‘repayable grants’ offering. Given the appetite for a revolving fund, grant useshould be minimised with the majority of investment on a debt or equity basis – agrant reluctant approach.

Where grants are used the majority should ideally take the form of matchedgrants with the level of matching can be tailored to the specific situation.Repayable grants (dependant on performance), and sliding scales of repaymentcan also be considered as options.

The fund should be set up as an investment fund tracking revenue growth, grossmargin, net margin and balance sheet investment. IRR performance should alsobe monitored and needs to take into account the incidence of grants (where noIRR will be achieved).

Monthly management reports should be tracked for performance.

Running business metrics such as productivity, ROC, interest cover ratiocan then be calculated for better monitoring.

Monthly management report supervision will help fill the bank/businessrelationship gap and ensure better financial planning and supervisoryrigour.

Specific and unique KPIs should be set (in conjunction with the business) for eachinvestment to improve individual SME performance and participation.

Similarly, within the competitiveness stream of a fund, there is scope to workalongside banks and leverage their skills and financing.

It is important to ensure flexibility between the funding instruments whereverpossible. This is in terms of allowing the redirect of money from lower take-up tohigher take-up areas, flexibility between shorter term and longer term lending,and switching between funding instrument (debt/equity/mezzanine/grant)depending on need.

Targeting of businesses is key – managers need to be proactive and have resourcesto identify and approach businesses directly. Previous funds in the region havenot had extensive marketing – there is now an opportunity to use online sources,proactive targeting, general marketing and existing professional services to buildawareness.

Recommended FI structure option

As outlined in the Section 2 and illustrated again in the table below a 3 tierflexible revolving fund of between £61m to £96 million is proposed whichseparates the 3 CIoS strategic priorities whilst minimising the total number offunds namely:

Growth for Business Fund;

Future Economy Fund; and,

Social Enterprise and Low Carbon Fund.


January 2014 33 PwC

Area of funding Key pointsPotentialDemand

Growth/ High GrowthSupport to businesses that have high growthpotential

£15m-£30m

Micro LevelAddressing the finance gap for non start-upsmall loans below £50k (average £7k)

£2m -£3m

Technical SupportSupporting competitiveness of businessthrough specific technical interventions

£2m

Equity and MezzanineProviding equity and mezzanine financeincluding leveraging business angel networks

£8m -£13m

Business RestructureHelping address failures in business failurethrough technical support and financing toselect businesses

£6m -£7m

Future EconomyDeveloping key emerging sectors andsupporting innovation

£18m -£25m

Proof of conceptProviding intensive support to early stagefuture economy SMEs

£5m -£6m

Social Enterprise and LowCarbon

Improving the conditions of growth throughsupport to social impact and low carbonenterprise

£5m -£10m

TOTAL£61 m -£96 m

The elements within these funds follow a theme and have different expectations ofperformance against targets.

The priority for a Growth for Business fund should be supporting high growth aswell as and existing businesses in their growth, competitiveness and restructureneeds. The output focus here will be to achieve growth and revenue increases, anincrease in employment, safeguarding of jobs and SMEs and providing support toa wide number of organisations. This would primarily be in the form of debt andmezzanine finance at between £15-30m.

Meeting the needs of businesses that require micro-level loans is also a priority.This could be achieved through small debt and grant schemes (to reduceoverheads of administering a large number of relatively small loans) at a level of£2-3m of funding.

Business restructure – safeguarding jobs and supporting commercially viablebusinesses in short term distress. This would be in the form of debt or equityfinance. Demand for this fund could be around £7m.

Technical Fund – in terms of improving the competitiveness of the regionincluding access to tools such as Letter of Credit facilities at a potential fund size£2m size over the 7 year period.

Equity – there is an identified gap in equity finance availability in the region. Anequity funding stream would allow the fund to invest in businesses of a higher risknature that lack the profile for debt funding at a range of between £8m-£13m.

The priority for a Future Economy fund should be to help businesses enter newmarkets, support innovation and the development of new products, and provideinvestment in potentially viable but high risk emerging sector businessesincluding:

Future Fund – This would be a fund investing primarily in (but notlimited to) identified sectors of high potential and new products. Thismeets the need for funding of these higher risk longer return investmentsthat are not serviced by the market. Equity (both short and long term),debt, mezzanine could all be applicable depending on the specificbusiness needs with the potential for a £20m (excluding proof ofconcept) fund to invest on a commercial basis with scope for furtherinvestment depending on the risk appetite of the LEP. There is also thepotential to use this fund to co-invest with traditional funding sources(with the Fund “de-risking” other partner investments).

Proof of Concept – There is also a need to help emerging ideas and earlystage business through intensive support within a proof of concept fund.


January 2014 34 PwC

Equity and mezzanine finance should be the primary tools of this fund.Demand could potentially be as high as £5m.

The priority for a Social Enterprise and Low Carbon fund should be to supportbusinesses in the social enterprise sector and small scale low carbon to achievejobs and growth whilst improving social inclusion and environmental outcomes.

The Social Enterprise and Low Carbon Fund could invest in projects that producewider social outcomes. Debt finance is likely to be the primarily tool here withpotential demand of between £5m-10m.

Outlined overleaf are the proposed structure and funding streams for the Fund.


January 2014 35 PwC


January 2014

Growth for Business Fund

Growth and High Growth Fund

£15-£30m: Debt

Micro Fund (£1k-50k)

£2m-£3m: Debt / Grants

Competitiveness Fund£8m-£9m: Debt

£6m-7m - Business RestructureFund £2m - Technical Fund

Equity and Mezzanine Facility£8m -£13m: Equity and Mezzanine

£3m-6m Business Growth Equity £5m-7m Co-investment Equity

Fu

36 PwC

ture Economy Fund

Future Fund£18m-£25m: Debt, Mezzanine,

Equity

Proof of Concept Fund£5m-£6m: Equity, Mezz

Social Enterprise &Low Carbon Fund

Social Impact Fund & LowCarbon Fund£5m-£10m: Debt

Holding Fund


January 2014 37 PwC

1. Growth for Business Fund

High growth and growth business finance c£38 - £54m size of fund.

a. £15-£30m: General growth and high growth business investment(core stream) primarily debt funding.

b. £2m-£3m: Micro level (£1k-50k), primarily debt and grant.

c. £8m-£9m: Competitiveness stream, primarily debt funding.

i. £6m-£7m - Business Restructure Fund

ii. £2m - Technical Fund

d. £8m -£13m: Equity and mezzanine facility.

i. £3m-6m Business Growth Equity

ii. £5m-7m - Business Angel co-investment

programme

2. Future Economy Fund

High risk but high potential emerging market finance.

a. £18m-£25m: Future fund, primarily Debt/Mezzanine/Equity.

b. £5m-£6m: Proof of concept fund, primarily Equity/Mezz.

3. Social Enterprise and Low Carbon Fund

Funding for enterprises and community initiatives that produce social outcomesincluding small scale low carbon initiatives.

£5m-£10m: Social Impact Fund, primarily Debt

Investor Readiness

To achieve success across the funds an investment readiness programme needs tobe implemented with the priorities of:

Providing a central hub to link all available support and link “likeminded” businesses and to develop competition between providers.

General business planning.

Specialist support for certain sectors e.g. marine in order to becomeinvestment ready.

It is envisaged that by utilising existing services through the Fund the set up costsof such signposting will be relatively marginal.

From our experience the costs of supporting SMEs through investor readiness canvary widely depending on various design and market contexts. We wouldenvisage in CIoS that the levels of investor readiness support needed will be at thehigher end given the SME demographics of mostly smaller and micro businessesand the focus on emerging sectors. Investment per unit be higher than in otherfunds but will require full ex ante assessment and further demand data to fullyquantify (as an initial approximation, however, we have assumed that 2% of fundcost may be devoted to this activity).


January 2014 38 PwC

Overall Draft Programme TargetsThe table below presents the outputs identified in the European Structural and Investment Fund Strategy (CIoS LEP) of October 2013.

Measure Early Draft Output Targets (ERDF)

GVA / Growth A blanket Value for Money assessment applying national average delivery costs is not appropriate in Cornwall and the Isles of Scilly. A Less

Developed region is recognised as starting from a lower base line and cannot therefore achieve similar targets as more developed areas.

No. Ents. supported 4,000 light touch interactions leading to 2,500 substantial assists

No. New Ents. Supp. 700

No. jobs created 4,000

No. Ents Co-operating with research Institutions 1,000 light touch interactions leading to 400 substantial interactions

No. Ents with new to market products Require further information regarding the England wide target for this output

No. Ents with new to firm products. 400 minimum

No. Ents. using ICT 4,000 new enterprises connected

4,000 new enterprises using ICT

Enterprises providing Private Match Further local assessment required

Established GHG reduction Further local assessment required

No. Enterprises with Resource Efficiency 2,000

Site Development (Ha) 15

7. Measures and Expected Results


January 2014 39 PwC

Potential Output

Our estimation of the potential outputs of the Fund are:

Measures OutputsGross Jobs created 2346 - 3692Businesses Assisted;of which start ups

686 - 1080(up to) 180 - 283

Gross Increase in GVA £70.4 - £110.8 m / paPrivate sector investment £83.0 - £130.6m

These calculations are based upon the following assumptions:

Gross jobs created. We have assumed, based on local and national

benchmarks, that 1 gross job is either created or maintained for every

£26,000 invested

Business Assisted. Based on the breakdowns of organisations likely to be

assisted through local discussions on potential scale of individual investments

across the Funds

Start-ups. Based on our estimates the number of assists by type of fund we

have assumed all organisations securing proof of concept funding are likely to

be start-ups and, up to 50% of recipients of micro funding will also be start-

ups.

GVA. Our consultations with existing, locally based fund managers,

suggested a target rate of £30,000 gva for employee per annum.

Private sector investment. Based on evidence from JEREMIE funds and

elsewhere we have assured a likely (‘average’) leverage ratio of 1: 1.36

Potential Additional Measures

In general we recommend that targets are set at different levels between subfunds. We do not expect uniform performance against measures between aGrowth and Competitiveness fund, a Future Economy and a Social Enterprise and

Low Carbon Fund and adapting the measures to each fund type will be importantto assess wider performance and economic and social impacts.

While it is favourable to have as few measures as possible to reduce the adminburden on SMEs, there are certain additional metrics the LEP may wish toconsider utilising. For example using financial statements of SMEs and simplefund financial information various areas could be tracked:

No. of businesses achieving revenue growth of 20% or moreafter intervention – this would allow tracking of high growthperformance.

Average salary levels – salary levels are below UK averages in CIoS,keeping track of salary levels in SMEs intervened may be a useful metricin considering the LEPs priorities as well as the quality of jobs generatedor secured.

Internal Rate of Return (IRR) of fund - this would provide anindication of fund performance on a commercial basis

Economic and demographic data must also be collected. Forinstance the number of women who lead businesses supported ispotentially an important metric for social inclusion (and relatively easy tomeasure).

It may also be useful to track certain measures with relation to SME networks.The number of businesses with access to new markets could be tracked byfund managers on an ongoing basis to achieve this.

Innovation sectors and managers of future economy could also track the numberof new patents directly related to investments of the fund. This would providean indication of Future Economy performance and would offset the potentialhigher failure rates of these emerging businesses. The number of organisations“co-operating with research institutions” may not provide a full picture of theoutput of Future Economy investment.


January 2014 40 PwC

Whilst “number of enterprises with new to firm products” is being measured,given the EU and LEP priority for environmental targets it may also be worthmeasuring the number of additional environmental goods and services.

Lifecycle and Realisation Period

Our understanding is that a potential FI would be part of a 7 year programmerunning from 2014 to 2020.

There is allowance under the regulations for the money to be spent in thesubsequent 2 years after 2020 on the basis that the money is committed. Thisadditional 2 years is included in planning investment timelines.

Recycled “clean” funds will continue to be invested post 2020 with the fundoperating in perpetuity.

The actual levels of recycled funding that may be available will be subject to awider range of parameters including the:

Size of the fund and the timescales over which they are released;

Loan periods and timescales over which equity might be realised;

Bad debt/default levels;

Terms of any loans (and equity performance); and,

Management costs of the Fund.

For purposes of providing an indication of possible legacy funding we have

assumed that the cost of administering the fund would equate to the return

received. We have made no assumptions at this stage regarding pay back periods

or performance of the fund or re-investment of early returns. Therefore assuming

all monies are spent once during the N+2 period and a default rate of 30% the

legacy fund would be in the order of £42.7m to £67.2m, and gross jobs created by

this would equate to something in the order of 1642 - 2585 using the £26,000/job

benchmark.


January 2014 41 PwC

Introduction

This section provides an indication of sources and size of match funding and thestage negotiations have reached. By understanding other sources of funding thatare available it will be possible to assess the:

Potential sources of ‘match’ funding; and,

Potential sources of project level co-finance.

Match Funding OptionsThere are a range of options from our review for matching the fund. These insummary are:

EIB – prefer larger investments, but in discussions with HMG have madethe potential for match funding clear. The EIB have a strong track recordin the UK in respect of investing in JEREMIE and JESSICA Funds inrecent years. The match would be in the form of debt finance.

Local Authority Pension Funds – these have been used elsewhere toinvest in fund structures. Such funds will have to appraise the investmentpotential and the benefits to its members – and, from our experienceelsewhere, while “patient” in regard to returns tend to prefer low risksecured investments - these are significant and arguably relatively newentrants into this market.

Private Sector Banks – banks have shown interest in investing in arange of ERDF backed revolving funds. Clearly this is more attractive tothe private sector once the money is ‘clean’ – namely invested once andthe regulatory restrictions are less onerous – but nonetheless others haveshown interest in the SME market (including, for example, the

Cooperative and Unity Trust banks who have co-funded a £60 UK millionSME fund with RGF administered by CDFA).

Business Bank – the Government’s proposed Business Bank – whilststill in development – provides a further matching source.

Local Authorities – Local Authorities have invested in other fundsacross the UK and local Authority financial contributions may be availableshould the fund meet the strategic objectives of the Council.

Crowd funding – there is potential to use crowd funding as a source offunding.

There are also a number of regional funds and new initiatives that couldpotentially be leveraged. These include:

Legacy programmes of SWIG – from discussions and informationsupplied it appears the SWIG legacy programme could have over £6m of“clean money” available to invest in a SME focussed revolving facility.

Big Issue Invest are looking to setup a Social Enterprise fund in theregion. While size and scope of fund are not decided there is a potentialopportunity.

An estimate provided by SWIG put forward legacy monies of £6m “clean”funding that can potentially be used over the next two to three years. This ismoney from funds that are currently running and have been sourced from variouschannels.

A Business Angel co-investment programme in the region is seen as havingpotential to leverage/match a further £2m-£6.75m. This will need further market

8. Match Funding


January 2014 42 PwC

testing to verify the appetite of investors but there is definitely an opportunity toleverage existing Angel networks in the South West.

Big Issue Invest is considering setting up a social impact fund in the region.While this is still in its formative stages discussions have opened up the possibilityof exploring match funding.

Once the scale of the Fund is agreed a definitive model of match funding will bedetermined from the sources identified. At this stage progress is being madeacross all sources noted above.


January 2014 43 PwC

Introduction

In this section we consider the potential costs associated with the Fund in terms ofinitial implementation and subsequent operation of the Fund over a seven to nineyear period.

Consideration of these costs is also set in the context of potential performance –the net costs of running the fund will depend on the nature of the fundingprovided, payment periods, returns generated, the potential to secure matchfunding and the consequent legacy funding available to reinvest (and support on-going management fees).

Implementation Costs

Subject to approval to take forward the Fund from DCLG - and the value andnature of the funding that might be considered - significant work will be requiredto develop and implement the current proposals.

In our view more detailed market soundings will be required with individual firmsand organisations to establish the extent and timing of future demand as well asthe nature of support that they may require in terms of amounts of individualfunding required and terms on which this may be provided. Inter alia suchsoundings provide a basis to undertake an initial level of due diligence andexamination of the appetite from other sources to match fund (and under whatterms).

Our consultations with funders suggest that there is both this appetite to providesuch funding and consider management of the overall fund or component parts.Again in the context of implementation it will be important to establish what rolessuch funders could play – to avoid conflicts of interest – and the type ofprocurement mechanisms and rewards to management that will need to beconsidered in ensuring the efficient and effective management of the fund.It is our understanding post DCLG review and (assumed) approval that the stagesand related costs of implementation and set up are likely to involve:

An ex ante analysis to assess the detailed demand and supply issues(through market soundings and detailed financial modelling) that willdetermine the structure, size and funding mechanisms to be adopted;

Setting up an operational framework for the fund that will set out the legalstructure, compliance requirements for this structure, Board andmanagement responsibilities, overarching objectives, investment policiesand criteria to ensure State Aid compliance;

A parallel exercise to assess the appropriate procurement routes forappointing a Fund Manager (and the terms and potential performanceincentives that might be offered); and,

Identifying the marketing mechanisms and investment readiness supportservices and potentially grant regime that might be necessary to maximisethe potential to realising the volumes of projects and overall “pipeline”anticipated to release investment at the levels and timescale currentlyanticipated.

9. Implementation and Management Costsand Fund Performance


January 2014 44 PwC

Management and Operating Costs

Given the preliminary nature of the Fund proposals and in the absence of detailedmarket soundings we have estimated the management costs associated with thecurrent proposals based on industry benchmarks of other similar funds (includingthe CDFA BIS SME Fund, Big Society Capital, Social Investment Business andvarious JESSICA and other European funds).

As illustrated in the table below this suggests as a proportion of funds that up to10.5% of total funding would require to be allocated to management andoperation over the life of the fund comprising up to:

2% for management fees for the holding fund with a further 2%-4% for subfunds;

2% for overheads and advisory fees;

0.5% for transaction fees; and,

2.0% for investment readiness support.

Starting

fund size

Management

costs

Other overheads (inc.

marketing, audit fees etc.)

Transact

ion costs

Investor

readiness

Estimated

% cost5.0%* 2.0% 0.5% 2.0%

61 3.1 1.2 0.3 1.2

96 4.8 1.9 0.5 1.9

*5% taken as median of 4%-6% range of sub fund and holding fund management fee

Fund Performance

The actual performance of the Fund will depend on whether loans or equity areprovided and the relevant terms and timescales over which such investment may

be realised together with the bad debt “ratio” or proportion of investments that donot realise any return.

For example a 3 year term loan at 10% is obviously different to a 10 year term loanat 4%. Similarly a bad debt ratio of 6% is again significantly different from that of60%. Funding types (i.e. equity v loans) also will impact on return levels and theamount of funds that might be recycled.

In our view – given the nature of the funds proposed – we suggest that further tomore future detailed financial modelling initial assumptions should be that the:

Majority of the funding provided will be in the form of loans over aminimum of 5 years as evidenced by similar SME loan funding provided bysuch bodies as CDFIs

Likely default rate of such funding should be in the region of 30% asevidenced by the Co-op and other funders in the small SME market(although we wish to note that we have observed bad debt levels in thissector of over 60%); and,

In the case of loans the return rates should be set at single digit levels (theprecise amounts per project being subject to the balance between risk andreward) with due regard to any reference rates agreed with the DCLG or theCommission.

Adopting these assumptions suggests that over time there will be the potentialto reallocate returns in the form of a “rolling fund” which, over a 5 to 10 yearcycle, suggests that around 30% to 60% of initial funding (net of operating andfund management costs) may be available for an initial future refundinground.

In addition the relative costs associated with the fund might be reduced if, forexample:

Management fees were incentivised (in relation to default rates wheremanagement fees might be reduced if a particular fund performance


January 2014 45 PwC

experienced bad debts above a certain percentage or such fees wereincreased if returns exceeded projections);

There was future flexibility in funding in order to maximise returns andreduce bad debts and/ or take up;

Performance related grants were also incentivised so that uplifts in revenueattributed to the grant could also lead to partial repayment by the (of theoriginal grant) by the recipient organisation9;

Investment readiness grants were incentivised so that if future investmentwas secured (outwith the Fund) a proportion of such investment was“repayed” back to the Fund (in a similar manner to the Cabinet OfficesInvestment Contract Readiness Fund for social enterprises); and,

Management of the Fund was absorbed into an existing fund or othermatch funds to secure economies of scale.

9 This form of incentive, however, would need to be carefully considered in relation to the on-going

profitability of any recipient and, in our view, would need to be compared to equity support (as

well as pure grant funding).


January 2014 46 PwC

An indicative delivery timetable is outlined below. This is dependent on approvalfor the fund being given by the end of February.

23rd January 2014: EU SIF Strategy signed-off by the LEP Board.

31st January 2014: LEP submits final European Structural andInvestment Funds Strategies for agreement with the National GrowthBoard.

28th February 2014: The England National Growth Board agrees LocalEnterprise Partnership Strategies.

01 March – 30th July 2014: Procurement of fund management. CentralInvestor Readiness hub designed and made market ready.

30th August 2014: Setup of fund(s) structure and governance put inplace.

October 2014: Fund operational, marketing/targeting starts, initialapplications for funding are received and evaluated.

Autumn 2014: Spending of Funds for 2014-2020 begins (subject toapproval of the UK’s Partnership Agreement and European RegionalDevelopment Fund and European Social Fund Operational Programmes).

10. Proposed Delivery Timetable


January 2014 47 PwC

AppendicesAppendix A: Summary of People Consulted During Study

Name Title Organisation

Sarah Forster Deputy CEO and Development Director Big Issue Invest

Steven Ford Programme Manager, Green Cornwall Cornwall Council

Nick Blandford Interim Head of Business and Skills, Cornwall Development Company

Nicky Pooley Head of Corporate Services (Finance Team) Cornwall Development Company

David Rodda Rural Development Manager, Cornwall Development Company

Brent Treloar Business Investment for Growth, Project Manager Cornwall Development Company

Badder Alferesi and Richard HoskinsHoskins - Grants for Business Investment Scheme Department of Communities and Local(Badder - maternity cover for Josie Gough) Government (local team)

Jason Granite Owner FC Fund Managers

Ms Denise Major Branch Manager Handelsbanken

Mr David Beaumont Area Director Commercial Banking Lloyds TSB

Andrew Finley Commercial Director Oxford Innovation

Julian Alexander Regional Director Santander

Jean Taylor and Robert Misselbrook Head of Strategic Economic Development in Cornwall University of Exeter

Anne Carlisle Vice-Chancellor and CEO University of Falmouth

Julian Beer Pro Vice Chancellor University of Plymouth

Peter Casey Director Southwest Investment Group

John Peters Managing Director Southwest Investment Group


January 2014 48 PwC

Area of

discussionGrowth business Future economy

Social Enterprise and Low

CarbonGeneral/Other

Regional context Only 80-100 businesses that employ

more than 200 people.

Macro economy in Cornwall is

different – generation of grant based

entrepreneurs with aversion to risk.

“Grant culture” within CIoS –

businesses seen to rely on grant

funding and tailor there needs to grant

terms.

Region has done well in food sectors

and encouraged IT sector.

Region has skills shortages.

Plenty of supply of funding for

agricultural sector – loss rate close

almost zero because land prices

continue to increase. Average size of

farms has increased.

Lots of good manufacturing business

which also need to be promoted.

“World class” facilities at universities;

leverage this expertise.

May require upfront large investment

(i.e. infrastructure) to fund

start/invigorate certain sectors e.g. help

initial step for Wave Hub (mooring is

key constraint) and geothermal

investment.

Many SMEs in the emerging sectors will

be parts of supply chains – supporting

the development of supply chains

therefore important.

Majority of Social Enterprise is at

micro level.

Majority of business in Cornwall is

less than £100m.

Appetite to develop social sector in

the region - social enterprise is part

of LEP strategy.

Strong social enterprise culture in

region, Cornwall declared a “social

enterprise centre”.

What banks are perceived to require

of SMEs:

Monitoring their own finances

well and with their have own

management accounts.

Producing retained profits

and/or with debt levels aren’t

too high.

Clear about what they want and

the rationale behind this.

Willingness to build

relationship with the bank;

businesses that are not only

about the rate

Ideally growing businesses

(even if slow growth).

Appendix B: Consultations Summary


January 2014 49 PwC

Area of



CarbonGeneral/Other

Market

condition,

failures and gaps

Gap in equity funding

Hospitality and Leisure – capital

intensive, needs funding. Travel costs

from increased fuel costs could impact

region.

Has been appetite and demand for

investment to SMEs that cannot raise

finance from banks

Micro level investment is lacking.

Gap in seed capital for new businesses

General absence of quality workspace

(office/industrial) in CIoS. Also need

places of incubation and environment;

property developers are “blind” to the

market needs especially in

creative/digital sectors.

Funding for investments up to £250k

currently a challenge.

High risk areas need more funding.

Need for intensive early stage support –

use proof of concept fund?

Not much development capital in

Cornwall for social enterprise and

low carbon small scale projects.

50% of SE are early stage – early

stage funding issue.

Many social enterprises and

community initiatives run on

different business model with fewer

assets for security and longer term

payback profiles.

General gap in efficiency and

profitability scheme e.g. biomass

boilers, micro-level green initiative

Low failure rate in investment into

farming because land value

increases. However this is not the

case with tenant farmers. Perception

that funding is available for this

sector.

Established businesses are seen to

be able to source finance through

traditional channels.

Sectors and

growth potential

Many SMEs seen to have potential to

grow and become large businesses.

Supply chains for sectors need to be

developed especially in new sectors.

Aerospace – Newquay Airport enterprise

zone (largest planning free enterprise

zone in UK but greenfield zone), runway

in Newquay is longest in UK. Not heavily

utilised but an important asset.

Marine/Renewables - Wave device

prototype testing going on (only place in

world that can do this). High risk, long

term, difficult to align this to output

impacts over short term.

Super-fast broadband – 85% of premises

have access to superfast broadband (2-3

years ahead of most parts of UK)

Perception of no real SMART tech.

Potential in Geo thermal.

Strong R&D sector.

Social finance is specialist market –

hard to get traditional finance,

particularly at early stage.

Emergence of clusters could be

important in many sectors.

Invigorate equity investor

community (investing angel

networks).

Focus on business with export

potential – these tend to be more

high growth.


January 2014 50 PwC

rea of discussion Growth business Future economySocial Enterprise and Low

CarbonGeneral/Other

Demand

feedback

200-600 high growth businesses at

any one time have the right profile and

appetite for support.

£30m achievable by some estimates,

as low as £15m from others.

High perceived demand for Micro level

funds.

Sector specific demand levels hard to

gage. Pipeline in marine, renewables,

digital, creative. Limited activity in

aerospace and e-health at the moment

but there is potential.

Contradicting perceptions on demand;

could be demand for up to £60m

according to some, only £10m from

other sources. c£20-25m most frequent

number.

Potentially include grant element.

Smaller grant stream alongside

investment to help with capacity

gaps, organisational strengthening,

Demand for community level low

carbon initiatives

Purportedly 2-3 £500k Cornwall

Social Enterprise deals annually,

more in £25-100k bracket.

Low appetite for debt reported - less

than 50% said would take debt in

post investment survey. Educational

side to address this important -

change grant expectations amongst

business.

Future funding

instruments

CIoS has lots of family owned

businesses - these are reluctant to give

up equity.

Start-up funding scheme available

from government – overlap?

Use longer term equity instrument and

some grant.

Risk + reward and option to take equity

model also possible

Matched grants for proof of concept

fund. Repayable grants dependant on

performance possible

Innovation funding - 80% grant (upto

£50k)

Equity fund + proof of concept grant

fund key

Generic non sector fund preferable

Mezzanine type funding preferable to

debt from some.

Equity not appropriate as many

social enterprises are not

shareholdings.

Unsecured loans required in many

social enterprises.

Longer term repayment profile

because of early stage.

Social enterprise requires different

set of management/advisory skills to

rest of SME market - probably

requires separate funding stream.

Cash flow challenges to SMEs:

Guarantee for LC facilities

(need clearing bank, banks

make credit assessment)

Factoring dependency (short

term financing)

Business r for short term

funding issues.

Opportunity to use alternative

measures:

Grant + Loan together (50%

50%, then 60% 40% second

time etc.) for growth/high

growth business.


January 2014 51 PwC

Area of



CarbonGeneral/Other

Investment

readiness

Business planning, cash flow and financial

planning are weak among many businesses.

No focal point for Business Support -

struggle to let businesses know what services

are available. Business Link closure has left

gap. “Business Pulse” (LEP online help) to

try and fill gap but perceived to be not very

well used – Communication issues.

Micro-businesses often have poor business

plans. Potential to supply grants for

professional support (then debt for actual

project).

Take-up significantly improved if business

support provided alongside access to finance

Use of back ended success fee (bank

covenant friendly) a possibility.

Post investment support and

support during investment key to

de-risking investment

Potential to tie business support

activity to debt for win win

situation.

Success has been noted when

innovation centre takes a non-exec

type role in the investment

business

High demand for investment

readiness among SE. Significant

shortfall in financial management

reported.

Feeling that there is lots of business

support available but lack of

connectivity/central information

point i.e. support available but there

is an information gap.

Business support services not

incentivised to promote good

businesses – simply to provide

support and receive their payment.

Facilitation of networking amongst

like-minded businesses.

Digital

marketing/information/online sales

need expansion as there is currently

low capacity

Turnaround advisory funding

needed for some SME e.g. on doing

HMRC deals, cash flow forecasting

etc.

Potential KPIs

and

measurement

Agree KPIs with each applicant e.g. increase

export by x%, i.e. specific to business and

relevant and measurable.

Conflicting messages on appropriateness of

GVA as a measure; some feel it is integral,

other that it is not applicable (and hard for

businesses to understand).

Possible KPIs:

# Female lead businesses

# of businesses assisted to improve

performance

# of new business supported

# Environment goods and services

There have been overambitious

targets on previous projects.

Need to take some risks with

money but overall outlay needs to

be significant.

Possible KPIs:

Net # of businesses operating

in sector (especially new

sector)

Patent numbers

Meeting social needs is a priority of

social business, therefore separate

approach needed on outcomes.

Possible KPIs:

Greenhouse gas emission

Other project specific related to

social inclusion and the

environment

Generally it is hard to get reporting

data from business

Success down to fund managers

(through business contacts)

Use monthly management

information on

Other measurement considerations:

Greenhouse gas emission

Company profitability

IRR

Salary levels


January 2014 52 PwC

EU Themes

TO1: Strengthening research, technological development and innovation

TO2: Enhancing access to and use and quality of information and communication technologies

TO3: Enhancing the competitiveness of small and medium-sized enterprises, the agricultural sector

and fisheries and aquaculture sector

TO4: Supporting the shift towards a low-carbon economy in all sectors:

TO5: Promoting climate change adaptation, risk prevention and management

TO6: Protecting the environment and promoting resource efficiency

TO7: Promoting sustainable transport and removing bottlenecks in key network infrastructures

TO8: Promoting employment and supporting labour mobility:

TO9: Promoting social inclusion and combating poverty

TO10: Investing in education, skills and lifelong learning

TO11: Enhancing institutional capacity and an efficient public administration

Appendix C: EU Themes

This document has been prepared only for the Cornwall and Isles of Scilly Local Enterprise Partnership and solely for the purpose and on the terms agreed with the Cornwall and Isles ofScilly Local Enterprise Partnership. We accept no liability (including for negligence) to anyone else in connection with this document, and it may not be provided to anyone else.

© 2014 PricewaterhouseCoopers. All rights reserved. In this document, “PwC” refers to PwC PricewaterhouseCoopers which is a member firm of PricewaterhouseCoopers InternationalLimited, each member firm of which is a separate legal entity.

END

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