Investor Profile: Rory Earley, CEO and CIO, Capital for Enterprise Limited

Asset manager Capital for Enterprise Limited (CfEL) designs, implements and manages finance measures to support small and medium size enterprises (SMEs) across the UK.

CfEL brings together knowledge of and experience in investment management alongside an understanding of SME finance markets, public policy objectives and the interaction between the two.

CfEL has a detailed overview of the UK venture market. Taken together, the debt and equity programmes mean that CfEL has over £1.1bn of assets and liabilities under its direct management. When all of the private sector money is taken into account, these schemes have created SME financing schemes totalling some £2.9bn.

Rory Earley was appointed CEO and CIO in April 2008 following four years of advising the UK government on the development and implementation of its venture capital programmes. Prior to that, he was senior investment manager at Westport Private Equity, designing and investing in venture capital funds around the world. Rory was previously responsible for developing and implementing the UK government’s first interventions in venture capital funds in the 1990s. He has been chair of, and investor in, a successful university spin-out company, chair of an EU expert group on risk capital, member of the Investment TaskForce advising UK government and was also a director of Greece's first venture capital investment company, TANEO.

Could you explain what Capital for Enterprise is and what it does?

“We describe ourselves as an asset management company which is independently managed – we have an independent board of directors which is made up of people with deep experience in the business space we operate in.

We have a great board that is independent of the shareholder, the UK government’s Department for Business, Innovation and Skills. We were established to professionalise and commercialise the management of the government’s interventions in SME finance, predominantly made up of venture capital fund investments, some co-investment programmes and loan guarantee programmes. That’s the history. CforE was formally incorporated in April 2008 but existed in shadow form in the Department for three years before that.  

It was recognised that it wasn’t possible to manage what is a very complex venture capital programme from within the civil service; it just doesn’t work. I was brought in to create an entity that was then spun out. It’s still owned by government but operates at arm’s length and has the ability to recruit the best people within the industry to manage the programmes the government wants managed in the best way possible. We are the commercial interface between the government’s policy and the venture capital and debt markets.”

Why do you think that commercial interface has been put in place at this point? Does the government see this as a critical time for UK businesses to end up with backing?

“The intent was announced back in 2003 when there was an extensive consultation called ‘Bridging the Finance Gap’. There was a recognition at that point that something new had to be done to address the equity gap. This has to be done independently and at arm’s length so we can attract the best fund managers and the best investment opportunities. The government has been involved in direct venture fund investments since 2000; fund of funds activity, attracting institutional investors to early stage technology investment came first; and then government-backed regional venture capital funds were set up, unfortunately under some serious constraints that were imposed largely by the European Commission.

A lot was learnt from those developments and the government realised that if this is going to be done properly it needs to be done at arm’s length by a dedicated management team. And we’re very proud of the team we’ve put together to do that. It’s made up of people from investment banks, fund of funds managers, fund managers and retail banks.”

Are you continuing to build on that team and grow CfEL’s operations?

“We have reached a level of resource that is appropriate for what we are doing. We get peaks and troughs – we were asked by Lord Drayson to find fund of funds managers to run the UK Innovation Investment Fund (UKIIF) and were given a very tight deadline. That used a lot of core investment team resource because it was obviously a big due diligence exercise.”

What is CfEL’s relation to the UKIIF?

“A key part of our role has been sourcing the fund of funds managers who will invest that money. Going forward we will act as the limited partner, representing government’s interest as an investor in those funds. And we have a history of being an active investor, we have a very close interest in the investment programmes and what is happening within the portfolios.

We can be very helpful to fund managers, too. Because we have interests in 40 UK funds now, we see a lot of things going on in the venture space that fund managers who are busy focusing on their own portfolios don’t necessarily see. We bring value to them.”

The UKIIF will invest in pan-European and transatlantic venture capital funds. So far there is no stipulation as to how much of the UKIIF’s capital will end up with UK businesses. How can there be any guarantee that a significant portion will back UK innovation?

“A key part of the negotiations with all of the fund of funds managers that bid for the UKIIF was how they could satisfy our customer’s, that is the government, and Lord Drayson’s expectations that a significant proportion would be used for the benefit of the UK. It’s very difficult for him to be seen to be using UK taxpayers’ money for the benefit of European venture funds. It’s been a key part of our discussions with the fund of funds managers and looking at how best they can offer reassurance that UK taxpayers’ money, as well as the private money, will be used predominantly for the benefit of the UK.

It’s a returns-driven programme, so the fund of funds managers will want exposure by investing capital in various funds, some of which will have pan-European exposure. The fund of funds managers are, therefore, having talks with the managers they want to put money with to see what their expectations are for allocation to the UK.

It’s a tight-rope we find ourselves walking down a lot – the more restrictions you place on a fund, the more difficult it is to attract commercial money. The more it’s limited by region, institution or sector, the more difficult it is to invest successfully. The temptation for government  is to always do that because they have a policy in mind. Our role, therefore, is to work out how to fulfil the policy objective on the most commercial terms possible.”

Does that potentially mean that, in a bid to maximise returns, only a minority of the UKIIF’s capital will end up with UK businesses? 

“As an LP you enter into a limited partnership agreement with a fund manager and you don’t know what’s going to happen in the future. An investment strategy is written up at the outset and there is a clear expectation that the general partners will abide by it, but you have to be flexible because you have to react to what’s happening in the economy. That’s no different for the UKIIF. We have our customer, the government, who provides the capital and has a very clear objective and we have to show that we can implement that on their behalf in the best way possible. We have very close discussions with the fund of funds managers and expect them to have those same discussions with the underlying managers on how to achieve those objectives. At the same time, it is a return-driven programme, so we have to recognise that balance whilst also making sure our customer gets what it needs. Otherwise it becomes very difficult to deploy and generate value from taxpayers’ money.”

A recent report conducted by the National Audit Office said that the failure rate for government-backed venture investments was around 80 per cent?  What are your thoughts on that finding?

“We are very familiar with that report as the data the NAO has used is the data we hold on behalf of the Department for Business. If you read the report in detail, the conclusion is that the failure rate in even the earliest, most constrained programmes is actually not out of line with what you’d expect in the venture industry. In fact, the report says it’s rather less because two thirds of start-ups fail and we haven’t seen a failure rate of anything like that from the Regional Venture Capital Funds.

The NAO does say that the returns generated by the Regional Venture Capital Funds, the funds that had to invest by region and were the most constrained, are below the European average: a -15 per cent internal rate of return average versus -0.4 per cent. But that’s not a like-for-like comparison. The funds they are comparing to are not constrained in the way the Regional Funds were; they could only invest up to £500,000. That’s a serious constraint. In hindsight, people recognise now that two tranches of £250,000 will often only take you through to the next financing. It’s very difficult to create value investing with those sized tranches. We know that now. The government consulted widely with the industry at the time and that’s what people were saying should happen, so that’s what the government enabled to happen. It’s very easy to look back and say ‘We should have done it differently’. At the time nobody knew differently.   

There is no doubt that the Regional Venture Capital Funds have underperformed against the wider venture market. Because of the way they are structured, however, government is in the first loss position, so it will lose its money first and private investors will come out pretty clean on most of the funds as they currently stand. On around half of those funds, private investors are still looking to make a ten per cent IRR. So, for them, it’s no worse, and sometimes better than investing in European venture funds that weren’t constrained, which is good because it means the government didn’t create a moral hazard for the private investors.

Also, the government doesn’t just invest for financial returns. It’s important to realise that the government invests for greater economic benefit. The funds have invested in companies, which have created jobs, which have created more export opportunities, which have created more turnover, which have paid more taxes. Even if the government loses money on the fund investment, if you calculate the total gross value added from the activity stimulated by bringing all of this private sector money into this space, that is going to be very positive.

A great example of the wider benefits is ScriptSwitch, which was invested in by one of the Regional Venture Capital Funds. ScriptSwitch is a great investment and has made a significant return for that fund. The company produces software to improve the efficiency of doctors’ drug prescriptions. It has been adopted by 60 per cent of the National Health Service’s primary care trusts and has conservatively been estimated to be saving the NHS £20m each year. Of the £74m invested in the government-backed regional funds, that one investment, in broad terms, has repaid massively through savings to public expenditure, whilst ensuring that private investors have not lost out on their original investment in the fund. If you look at it in that context, you could say the Regional Venture Capital Funds are very successful.

A lot of learning points have been taken from these past government-backed funds and how they were constrained, and we will make sure that areas that need improving for future funds will be improved. And that’s what the NAO report says.”

Does any of the government’s money end up with first time fund managers?

“One of the investment objectives is to put money with ‘new teams’. However, new teams don’t necessarily mean first-time teams. It’s incredibly difficult to back a first-time team: you’ve got people with little experience coming together, people who’ve never worked together before, and you’re expecting them to manage your money over a ten to 12-year relationship. There are huge organisational risks associated with doing that. We have only backed one team of that nature and they were exceptional. They all had very strong backgrounds and showed significant commitment to working together and building something meaningful. The other teams we backed with CfEL money were teams we knew before, who have been doing smaller deals and proven their ability to invest well together. We’ve also backed spin-out teams. Panoramic is one of the most recent ones and is the ex-Uberior Investments team from the Bank of Scotland. They wanted to become independent and came to us looking for investment in their first fund.

If you’re putting taxpayers’ money into a long-term contract, you have to believe that the team can deliver through the period of the contract. The team dynamic and whether that team will stay together is paramount. We look for stable, competent, well-motivated teams whose interests are aligned with ours. That’s what we are open to. We talk to everybody, because it’s in our interests to know everybody out there, then we invest in the best.”

Aside from potentially making returns on public money, what are some of the individual benefits that government-backed investments can offer the UK?

“The first one is simple and that is addressing the equity gap. There is a huge reluctance on the part of private investors to invest in smaller investments – currently sub-£2m investments. That gap’s been with us in various manifestations since the 1930s, when it was first identified in the MacMillan Report. Putting money to work in that space, to help small businesses get the finance they need to innovate and grow, is the first benefit.

It also provides a seeded deal flow for later stage venture funds. They help with the heavy lifting and there’s no doubt that the mainstream venture industry has moved to  later stage, because it needs to demonstrate and generate the returns required by its institutional investors.

Beyond that, there are all sorts of external benefits: stimulating innovation, commercialising industry spin-outs, commercialising research from the universities’ and government’s own research base, sustaining jobs, creating intellectual property. There are many benefits.”

What’s the biggest challenge facing the UK’s venture capital industry in today’s market?

“Fundraising. That’s why Lord Drayson is launching the UKIIF, to kick start the mainstream venture industry, to kick start the syndication market. The industry is sitting on its cash to support its existing portfolio companies and that’s not the way to maximise returns. CSR (a venture funded company that makes single chip radio devices) reportedly took £50m in syndicated venture investment to reach an IPO. Nobody’s raising that kind of money for a single investment at the moment.  

With our Enterprise Capital Fund programme we aim to create new funds. Even when we’re two thirds of the size of the fund with a £25m investment, we’ve noticed an increasing difficulty amongst managers to close those funds. Investors who were interested before are finding their appetite and enthusiasm has declined. The funds are still set to close, but it is taking longer and this demonstrates how difficult it is for funds to raise money at the moment.”

As well as venture and growth capital funding, CfEL is also involved in debt investment. Can you explain how that works?

“We run a loan guarantee programme called Enterprise Finance Guarantee, which has enabled close to £1bn of bank lending to SMEs in the last year. It is for small businesses that wouldn’t normally meet banking criteria and usually don’t have access to sufficient collateral.

It was previously called the Small Firms Loan Guarantee and has been around since the early 1980s. That scheme had become out of line with modern banking, so we were given the opportunity at the end of 2008 to help redesign the programme. We relaunched in January last year. Because of our closeness to the market, we helped it become better aligned with how the banks operate today, a real boost given the issues that they’ve been facing.

Banks will lend you money if you have the cash flow to support the service payments and the security for them to fall back on if you don’t meet those service payments. That’s not to be criticised, that’s mainstream, core banking. If a rapidly growing business doesn’t have the asset base to justify traditional lending, it will struggle. Our loan guarantee programme substitutes for that lack of collateral and puts a guarantee behind the company to be used responsibly by the lenders. This has generated significant additional lending. An awful lot of venture-backed companies who are continuing to fund their additional growth do call on that guarantee programme.  It helps them with their short-term financing needs without having to give up any additional equity in their business.”

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