2006/250/EC: Commission Decision of  3 May 2005  on the aid scheme  Enterprise Capital Funds  which the United Kingdom is planning to implement  (notified under document number C(2005) 1144)   (Text with EEA relevance)
Date: 2005-05-03
Institutions: European Commission
Subjects: State aid, United Kingdom, control of State aid, financing, investment promotion, small and medium-sized enterprises

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COMMISSION DECISION

of 3 May 2005
on the aid scheme ‘Enterprise Capital Funds’ which the United Kingdom is planning to implement

(notified under document number C(2005) 1144)

(Only the English version is authentic)

(Text with EEA relevance)

(2006/250/EC)

THE COMMISSION OF THE EUROPEAN COMMUNITIES,

7.

The Commission
interested parties:

received

observations

from 20

Having regard to the Treaty
establishing the European
Community, and in particular the first subparagraph of Article
88(2) thereof,

Having regard to the Agreement on the European Economic
Area, and in particular Article 62(1)(a) thereof,

Having called on interested parties to submit their comments
to those provisions (1) and having regard to their
pursuant
comments,

Whereas:

1.

2.

3.

4.

5.

6.

I. PROCEDURE

By letter dated 25 November 2003, registered at the
Commission on 26 November 2003, the UK authorities
notified, pursuant to Article 88(3) of the EC Treaty, the
above-mentioned measure to the Commission.

the
By letter D/58191 dated 19 December 2003,
Commission requested further information concerning
the notified measure.

the
By letter dated 30 January 2004,
Commission on 3 February 2004, and by letter dated
19 March 2004,
the Commission on
25 March 2004, the UK authorities submitted the infor-
mation requested.

registered at

registered at

By letter dated 7 May 2004, the Commission informed
the United Kingdom of
its decision to initiate the
procedure laid down in Article 88(2) of the EC Treaty
in respect of the measure.

The Commission’s decision to initiate the procedure was
published in the Official Journal of the European Union (2).
The Commission called on interested parties to submit
their comments.

registered at
the
By letter dated 11 June 2004,
the United Kingdom
Commission on 16 June 2004,
submitted a response to the Commission’s decision to
initiate the procedure.

(a) by letter dated 20 September 2004, registered at the

Commission on 23 September 2004;

(b) by letter dated 9 September 2004, registered at the

Commission on 28 September 2004;

(c) by letter dated 22 September 2004, registered at the

Commission on 29 September 2004;

(d) by letter dated 1 October 2004, registered at the

Commission on 4 October 2004;

(e) by letter dated 6 October 2004, registered at the

Commission on the same day;

(f)

by letter dated 6 October 2004, registered at the
Commission on the same day;

(g) by letter dated 7 October 2004, registered at the

Commission on the same day;

(h) by letter dated 6 October 2004, registered at the

Commission on 7 October 2004;

(i)

(j)

by letter dated 7 October 2004, registered at the
Commission on the same day;

by letter dated 8 October 2004, registered at the
Commission on the same day;

(k) by letter dated 8 October 2004, registered at the

Commission on the same day;

(l)

by letter dated 8 October 2004, registered at the
Commission on the same day;

(1) OJ C 225, 9.9.2004, p. 2.
(2) See footnote 1.

(m) by letter dated 8 October 2004, registered at the

Commission on the same day;

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(n) by letter dated 8 October 2004, registered at the

II.2. Description of the measure

Commission on the same day;

Legal basis of the measure

(o) by letter dated 8 October 2004, registered at the

Commission on 11 October 2004;

13.

The legal basis of
‘Industrial Development Assistance Act 1982’.

the scheme is Section 8 of

the

(p) by letter dated 6 October 2004, registered at the

Commission on 11 October 2004;

(q) by letter dated 8 October 2004, registered at the

Commission on 11 October 2004;

(r) by letter dated 8 October 2004, registered at the

Commission on 11 October 2004;

14.

15.

Budget of the measure

As the leverage provided to the Enterprise Capital Funds
will have to be repaid, the measure is designed to be self-
financing over the medium term.

In terms of accounting for the scheme in its pathfinder
phase, the United Kingdom has allocated GBP 44 million
(EUR 63,8 million) to cover the cash-flow cost of the
initial leverage.

Duration of the measure

(s) by letter dated 7 October 2004, registered at the

Commission on 11 October 2004;

16.

The United Kingdom seeks approval for a period of 10
years.

(t)

by letter dated 8 October 2004, registered at the
Commission on 12 October 2004.

Administration of the measure

8.

9.

letter D/57629 dated 25 October 2004,

the
By
Commission forwarded
to the
United Kingdom in order to give the United Kingdom
the opportunity to react.

these observations

The opinion from the United Kingdom in response to
the comments of
third parties was received by letter
dated 23 November 2004, registered at the Commission
on 24 November 2004.

II. DETAILED DESCRIPTION OF THE MEASURE

II.1. Objective of the measure

10.

The measure intends to increase the amount of equity
funding for small and medium-sized enterprises (SMEs)
in the United Kingdom seeking to raise equity financing
between GBP 250 000 (EUR 357 000)
and GBP
2 million (EUR 2,9 million).

11.

The measure will provide leverage for licensed Enterprise
Capital Funds
interest on the
(ECFs). The leverage,
leverage and a profit share will be repaid by each ECF.

12.

ECFs will be required to invest capital in SMEs by means
of equity or quasi-equity instruments.

17.

18.

19.

20.

21.

22.

The Department of Trade and Industry (DTI) will have
statutory responsibility through its executive agency
Small Business Service (SBS).

The Small Business Service (SBS) will supervise the appli-
cation for ECF status.

The SBS will monitor ongoing investments undertaken
by ECFs without having any direct control over ECFs’
individual investment decisions.

The SBS will also ensure that each ECF complies with its
business plan and adheres to the terms of its successful
bid.

Beneficiaries of the measure

The scheme is exclusively aimed at unquoted small and
medium-sized enterprises (3) in the United Kingdom.

in difficulty as defined by the Community
Firms
guidelines on State aid for rescuing and restructuring
firms in difficulty (4) are excluded from investment.

(3) The definition of ‘small and medium-sized enterprises’ as used by the
UK authorities for the purposes of the scheme corresponds fully to
the definition of that term given in Annex I to Commission Regu-
lation (EC) No 70/2001 of 12 January 2001 on the application of
Articles 87 and 88 of the EC Treaty to State aid to small and
medium-sized enterprises (OJ L 10, 13.1.2001, p. 33).

(4) OJ C 244, 1.10.2004, p. 2.

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23.

(‘ECFs’) will not

in
invest
Enterprise Capital Funds
sensitive sectors under State aid restrictions or
in
sectors to which the Commission Communication on
State Aid and Risk Capital (5) does not apply. Low-risk
sectors including property, land, finance and investment
companies, or finance-type leasing companies will not be
eligible for investment under the scheme.

24.

Enterprise Capital Funds will also be prevented from
investing in other ECFs

25.

26.

27.

28.

29.

30.

Size of investments

Enterprise Capital Funds will make investments in bene-
ficiary SMEs in the GBP 250 000 (EUR 357 000) to GBP
2 million (EUR 2,9 million) range per single investment
round.

investments in beneficiary SMEs beyond the
Additional
GBP 2 million (EUR 2,9 million)
limit will not be
permitted in cases where the ECF is investing on less
advantageous terms than other commercial investors.

Follow-on investments will be permitted so long as the
total equity funding raised by the beneficiary SME from
ECFs and other equity investors does not exceed the GBP
2 million (EUR 2,9 million) limit.

In exceptional cases, after a period of at least 6 months
from the ECF’s initial investment in a beneficiary SME,
follow-on investments in excess of the GBP 2 million
limit will also be permitted, where
(EUR 2,9 million)
necessary, to prevent dilution. This will be subject to
an upper limit of 10 percent of each ECF’s committed
capital that may be invested in any single beneficiary
SME.

II.3. Mechanics of the measure

The role of the Enterprise Capital Funds

The Enterprise Capital Funds set up under the measure
for on-
combine private
will
investment into SMEs.

and public money

Following a licensing process conferring ECF status, ECFs
will be entitled to receive public leverage at an interest
rate at or close to the ten-year government bond rate.

31.

32.

33.

34.

35.

Restrictions on public leverage and repayment obligations

Public leverage to licensed Enterprise Capital Funds will
be limited to no more than twice the private capital
raised by the fund.

The leverage, interest on the leverage and a profit-share
the public contribution must be repaid by the
for
Enterprise Capital Funds. This will ensure that
the
programme will be self-financing over the medium term.

Minimising public intervention

The exact amounts of public leverage, profit share and
repayment priorities will be determined by a competitive
to ensure minimal public
bidding process
support.

in order

Open invitations for application through publication of
the scheme in the Official Journal of the European Union
and the relevant
trade press will ensure that public
support
the minimum necessary to achieve the
is
intended objective.

In applying for ECF status potential funds will need to
specify the required amount of public leverage (up to the
upper limit of two times private capital), the profit share
between public and private investors, as well as the prior-
itisation of repayments on:

(a)

interest on the leverage;

(b) leverage;

(c) private capital;

(d) profit distribution.

Conditions for ECF eligibility

36.

Potential ECF operators will submit a robust business
plan including:

(a)

the proposed management
relevant
experience and evidence that they possess the compe-
tencies necessary to run an ECF effectively;

team,

their

(5) OJ C 235, 21.8.2001, p. 3.

(b) the amount of private capital to be raised and the

intended sources of capital;

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(c) evidence of investor interest for the proposed ECF

III. GROUNDS FOR INITIATING THE PROCEDURE

business plan;

(d) the proposed ECF’s investment strategy, including the
the fund which is intended to be

proportion of
invested in early stage and start up companies;

(e) repayment arrangements, including the sequencing of
repayments of leverage,
interest repayments on the
leverage, profit distribution, as well as the public’s
profit share.

44.

45.

37.

ECFs will be required to abide by British Venture Capital
Association (BVCA) guidelines on accounting standards.

46.

Assuring profit-driven investment decisions

38.

Bids in which the public leverage is exposed to greater
risk than the private capital will not be accepted.

39.

40.

41.

42.

43.

Private investors in Enterprise Capital Funds may be
exposed to greater downside risk than the public,
thereby removing the
for moral hazard to
scope
influence decisions of ECF operators and ensuring
commercial best practice in the operation and decision
making of the ECFs.

Drawing down of pubic leverage by the ECFs

Once an ECF has secured commitments for the agreed
level of private capital, it will be entitled to draw down
public leverage.

Each ECF will be free to draw down as little or as much
leverage as it wishes, subject to the overall constraint
imposed by the maximum leverage ratio agreed when
ECF approval is granted.

At any point in time, the maximum leverage entitlement
will be determined by applying this ratio to the amount
of private capital already drawn down into the fund.

A maximum leverage ratio of 2:1 (public leverage will be
capped at up to two times the private capital) will be
applied for any ECF.

47.

48.

49.

50.

(hereinafter

The Commission Communication on State Aid and Risk
‘the Communi-
Capital (6)
cation’) recognises a role for public funding of risk
capital measures
identifiable
market failures.

limited to addressing

referred to as

The Communication states that specific factors adversely
affecting the access of SMEs to capital, such as imperfect
or asymmetric information or high transaction costs, can
cause a market failure that would justify state aid.

The Communication further specifies that there is no
general risk capital market failure in the Community,
but rather market gaps for some types of investments
at certain stages of enterprises’ lives as well as particular
difficulties in regions qualifying for assistance under
Articles 87(3)(a) and (c) of the EC Treaty (‘assisted areas’).

The Communication goes on to explain that in general,
the Commission will require provision of evidence of
market failure before being prepared to authorise risk
capital measures.

The Commission may however be prepared to accept the
existence of market failure without further provision of
evidence in cases where each tranche of finance for an
enterprise from risk capital measures which are wholly or
partially financed through state aid will contain a
maximum of EUR 500 000 in non-assisted areas, EUR
750 000 in Article 87(3)(c) areas, or EUR 1 million in
Article 87(3)(a) areas.

for

that

those

follows

cases where

It
the above-
mentioned tranches are exceeded, the Commission will
demand a demonstration of market failure justifying the
proposed risk capital measure before assessing the
compatibility of
the measure in accordance with the
positive and negative criteria listed under point VIII.3
of the Communication.

The Enterprise Capital Funds scheme proposed by the
United Kingdom foresees risk capital investments in the
range of GBP 250 000 (EUR 357 000) to GBP 2 million
(EUR 2,9 million) per investment tranche for SMEs in the
United Kingdom.

(6) OJ C 235, 21.08.2001, p. 3 ff.

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51.

52.

53.

54.

According to the ‘Regional Aid Map 2000 – 2006’ for
the United Kingdom, the United Kingdom consists of
regions currently classified as assisted areas pursuant to
Article 87(3)(a) of
the EC Treaty, as assisted areas
pursuant to Article 87(3)(c) thereof, as well as of non-
assisted areas (7).

the
the Communication,
In line with point VI.5 of
Commission would thus be prepared to accept
the
existence of market failure without further provision of
evidence if risk capital funding for SMEs in the United
Kingdom wholly or partially financed through state aid
would be limited to the maximum amount of EUR 1
million for assisted areas pursuant
to Article 87(3)(a)
EC, EUR 750 000 for assisted areas pursuant to Article
87(3)(c) EC, and EUR 500 000 for non-assisted areas,
respectively.

the

Communication,

capital
risk
According
to
investments proposed under
the Enterprise Capital
Funds scheme exceeding the above-mentioned thresholds
would necessitate the provision of evidence of market
failure by the United Kingdom.

Kingdom submitted

In order to demonstrate the existence of market failure,
studies (8),
the United
concluding that
there is a gap in the provision of
venture capital for SMEs in the United Kingdom in the
deal size range of GBP 250 000 (EUR 357 000) to GBP
2 million (EUR 2,9 million) for the following reasons:

two

(a) A failure in the provision of equity-type growth
finance in the United Kingdom that has persisted at
least since 1999 as evidenced from the most recent
2003 UK survey:

i. Although access

in the UK,

to finance, particularly debt
finance, has improved for the majority of busi-
small businesses with the
nesses
potential for high growth still have problems in
attracting equity capital. They can fall between the
individual business angels to provide
scope of
sufficient
financial backing and the desire of
formal venture capitalists to incur the relatively
higher costs of investing in SMEs

ii. A larger level of demand for equity type finance
than is presently being met exclusively by profes-
sional
investors. If the supply of equity finance
would be increased, particularly in the equity
gap region, awareness of equity could be raised
overall and firms would be more willing to use

55.

56.

(7) State Aid N 265/2000 – United Kingdom: ‘Regional Aid Map 2000

– 2006’. OJ C 272, 23.9.2000, at p. 43.

(8) ‘Assessing the Scale of the “Equity Gap” in the UK Economy’, 2003;

‘Assessing the Finance Gap’, 2003.

external sources as a mechanism for financing
growth

(b) Qualitative evidence that there are shortfalls in the
funding for small entrepreneurial and high growth
businesses. This equity gap has the greatest impact
for
investments
between approximately GBP 250 000 and GBP 2
million (EUR 357 000 and EUR 2.9 million):

firms wishing to attract

initial

(i) Capital

rationing does exist within the UK
economy and particularly affects SMEs seeking
small amounts of external
finance for early
stage, firm growth and development. The avail-
and particularly
ability of
sources of equity from professional investors, is
particularly problematic below an investment
size in the region of GBP 1,5 to GBP 2 million
(EUR 2,17 million to EUR 2,9 million)

external

finance,

(ii) A majority of UK professional equity providers
interested in investments which are
are not
smaller than GBP 3 million (EUR 4,35 million).
While smaller tranches of money from informal
investors/business angels and government/private
schemes such as the regional venture capital
funds are helping to address funding sources
below GBP 500 000 (EUR 725 000),
the UK
does not yet have a system in operation that
‘tiered’ or
would
‘escalator’
capital
constrained businesses

funding to attractive but

allow the provision of

(iii) The evidence also points to a gap that has been
growing over time, driven in part by the success
of the private equity industry moving to larger
size investments. The prognosis is that this gap is
likely to grow in scale as fixed cost issues will
encourage professional venture capital firms to
increase the size of both their funds and their
minimum acceptable deal sizes.

By letter dated 7 May 2004, the Commission informed
the United Kingdom of
its decision to initiate the
procedure laid down in Article 88(2) of the EC Treaty
in respect of the Enterprise Capital Funds scheme.

In its letter, the Commission stated that it had doubts
whether the arguments presented by the United Kingdom
in order to justify the existence of market failure could
sufficiently justify the granting of risk capital investment
tranches considerably exceeding the maximum amounts
anticipated by the Communication.

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57.

The Commission went on to explain that it considered a
more thorough analysis of the issue to be necessary. Such
an analysis would need to include any observations made
by interested parties. Only after consideration of third
party comments could the Commission decide whether
the measure proposed by the United Kingdom affects
trading
to the
to an extent
common interest.

conditions

contrary

IV. COMMENTS FROM INTERESTED PARTIES

58.

In response to the publication in the Official Journal of the
its decision to open the formal
European Union of
the Commission received observations by
procedure,
the following interested parties:

59.

60.

— Northwest Development Agency

— One NorthEast

— Lietuvos Respublikos Ukio Ministerija

All comments received were positive and underlined the
importance of the measure as well as the appropriateness
of the proposed maximum investment amounts.

The arguments put
forward by the above-mentioned
interested parties can be classified and summarised as
follows.

— Nelfunding

— England’s Regional Development Agencies

— Confederation of British Industry

Vereniging

van

Participatiemaat-

— Nederlandse
schappijen

— VNO-NCW

— Cavendish Asset Management

— The University of Warwick

— Stonesfield Capital Ltd.

— YFM Group

— Close Venture Management Ltd.

— Bundesministerium der Finanzen Deutschland

— Enterprise Corporate Finance Ltd.

— The Institute of Chartered Accountants in England &

Wales

— Pénzügyminisztérium

— Interregnum

— Permanente Vertegenwoordiging van het Koninkrijk

der Nederlanden

— 3i Group plc

Comments from Member States

61.

In its comments on the opening of the formal investi-
gation procedure, Germany highlighted the following
facts:

a. According to expert surveys conducted in Germany,
there is a gap for the provision of venture capital and
private equity financing for small and medium-sized
enterprises in the range of up to EUR 5 million.

b. It is generally difficult to demonstrate market failure
as stipulated by the Communication and there is a
need for the Commission to elaborate clear criteria
in order to support Member States in appraising
market gaps in specific domains.

62.

The Netherlands emphasised the following evidence in
their comments on the opening of the formal
investi-
gation procedure:

a. The problem in the venture capital market occurs
particularly at the bottom end of the capital market.
For high tech start-ups, a gap between supply and
demand in the range of EUR 100 000 to EUR 2,5
million per financing round has been noted for the
Netherlands.

b. The thresholds set out in the Communication were
based on market knowledge before 2001, when in
the midst of the ICT boom private equity seemed
abundant even for seed and early stage investments.
The venture capital market has evolved rapidly since
and the equity gap extends significantly beyond the
thresholds laid down in the Communication. Venture
capital
larger deals and
towards ever
towards well established businesses.

funds drift

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63.

In its comments on the opening of the formal investi-
gation procedure, Hungary highlighted the following
facts:

357 000)
therefore believes
market gap in the funding of growth companies.

to GBP 3 million (EUR 4,3 million) and
that ECFs meet a clearly defined

a. The ECF model proposed by the United Kingdom is a
model deserving consideration for application in
Hungary as well.

66.

b. In 2003, a marked switch towards larger deal sizes
could be observed in Hungary. Whereas deals below
EUR 2,5 million accounted for 14% of total private
investment in Hungary, deals above EUR 5 million
made up for the remaining 86% of private investment.
There were virtually no deals in the deal size range
between EUR 2,5 and EUR 5 million.

c. An unduly strict interpretation of the already tight
thresholds contained in the Communication could
prevent public action in support of
filling the
above-mentioned important equity gap and could
thereby block the growth potential of SMEs.

67.

68.

d. Instead

of

fixing maximum thresholds,

the
Commission should develop a control system that
the
would enable it
markets depending upon the relative level of devel-
opment of
the Member States and their capital
markets.

to survey the evolution of

64.

Lithuania accentuated the following experiences in its
comments on the opening of the formal
investigation
procedure:

a. Private equity investment

is more concentrated on
large funds and investment into relatively established
larger businesses, while
in
smaller, young businesses are proportionally lower.

investment

levels of

van

Nederlandse

Participatie-
The
Vereniging
maatschappijen (NVP) states that
there is an evident
equity gap at the bottom end of the market up to EUR
2,5 million. Whereas this gap may vary from Member
State to Member State,
the difference will not be
significant.

of Netherlands

The Confederation
and
Employers VNO-NCW supports the observations made
by the CBI and the NVP, particularly with regard to the
size of the equity gap.

Industry

The Institute of Chartered Accountants in England and
Wales believes that there is an equity gap that could be
as high as GBP 5 million (EUR 7 million)
for the
following reasons:

(a) The majority of professional private equity providers
are not interested in pursuing deals which are smaller
than GBP 3 million (EUR 4,3 million).

small companies

(b) Experience tends to suggest that few venture capital
houses in the UK are actively investing in businesses
at or below GBP 2 million (EUR 2,9 million).
Therefore the volume of
that
receive investment at or near GBP 2 million (EUR
2,9 million) from these sources is very limited in
any twelve month period. Others may be interested
in this size range, but either as part of a much larger
round above GBP 2 million (EUR 2,9 million), or
where they are participating in the financing of a
management buy out
the change of
ownership of a company, rather than its organic
development.

(MBO) or

b. The ECF scheme might be an important part of the
strategy to tackle barriers
to successful entrepre-
neurship and therefore are in keeping with the
Community objectives for entrepreneurship and inno-
vation.

Comments from Associations and Academics

65.

The Confederation of British Industry (CBI) fully supports
the UK proposal for establishing ECFs. CBI identified the
stretching from GBP 250 000 (EUR
market gap as

(c) The professional venture capital community in the
UK has established an active medium and large
scale private equity industry, whose main focus is
to acquire either large stakes in, or the control of,
significantly profitable and large scale businesses.
During the last 5 to 6 years,
the number of
venture capital houses with committed funds to
invest in a reasonable volume of smaller companies
with a specific range of up to GBP 2 million (EUR
2,9 million) appears to have diminished.

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The Institute believes that the proposed ECF scheme will
provide a valuable source of
finance for businesses
seeking a relatively modest amount of equity capital
and will
to participate in
investors
investment amounts where they can follow a
small
fund that
is dedicated to this sector, as opposed to
investing opportunistically from time to time.

stimulate other

71.

The University of Warwick, after having conducted face-
to-face discussions with technology transfer professionals
from over 50 UK universities, comments on the early
stage venture capital market and particularly on the
issues facing university sector spin-off companies by
highlighting the following aspects:

69.

England’s Regional Development Agencies state that a
recent study by the Advantage West Midlands RDA
shows that the barriers to accessing growth finance are
most acute
seeking between GBP
firms
250 000 (EUR 357 000) to GBP 2 million (EUR 2,9
million) as demonstrated by the following facts:

those

for

(a) The study shows that the equity gap has grown since
1999/2000 as formal venture capital has migrated
towards larger deal sizes of GBP 2-3 million (EUR
2,9-4,2 million).

(b) At the lower end of the risk capital market, the UK
has a number of existing interventions that have
successfully provided small
amounts of growth
capital
to SMEs. However, recent reports indicate
that there are significant numbers of businesses that
require amounts well in excess of the GBP 250 000
(EUR 357 000) limit.

70.

The Northwest Regional Development Agency makes the
following observations:

(a) The funding needs of investee companies trying to
raise follow-on funding between EUR 750 000 and
EUR 2,9 million have been below the interest level of
mainstream venture capital.

(b) The UK venture capital

industry is moving its
minimum thresholds per investment nearer to GBP
5 million (EUR 7 million).

(c) The real equity gap in the UK is probably at GBP
3 million (EUR 5,2 million) to GBP 5 million (EUR
7 million).

(d) The

recognition of market

failure below GBP
2 million (EUR 2,9 million) by the Commission
will make a significant and crucial difference to the
stimulation of high growth potential businesses in
the UK.

72.

(a) Whereas

it

seems

relatively straightforward for
university spin-offs to raise small amounts of grant
and equity funding up to GBP 500 000 (EUR
700 000), there is a thinning of sources of capital
above GBP 500 000 (EUR 700 000). The main, and
often only, source of risk equity at this stage is tech-
nology specialist venture capital.

(b) There are relatively few venture capital companies
specialising in this
them resource
area,
constrained. The shortage of equity at this level has
both constrained and delayed the growth of
indi-
vidual spin-off companies.

all of

(c) From the reference group,
company in 15 has
500 000 (EUR 700 000)
1,4 million) range.

less

than 1 spin-off
raised equity in the GBP
to GBP 1 million (EUR

(d) The problems faced by university spin-off companies
seeking to raise equity in the range GBP 1 million
(EUR 1,4 million) to GBP 2 million (EUR 2,9 million)
are overwhelmingly similar. Because they are at the
same stage of development, companies looking for
less than GBP 2 million (EUR 2,9 million) will face
the same challenges due to the shortage of sources.

(e) Of the universities referenced, none had investment
capital for spin-off companies in the GBP 1 million
(EUR 1,4 million) to GBP 2 million (EUR 2,9 million)
range. For university spin-off companies, there are
more sources of equity available if more than GBP
2 million (EUR 2,9 million) is required.

Comments from Private Venture Capital Companies

Northern Enterprise Limited (Nelfunding) believes that
there is market
investments
below GBP 2 million (EUR 2,9 million) in the UK, and
that this is adversely affecting SME development as a
consequence.

risk capital

failure for

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EN

Official Journal of the European Union

29.3.2006

73.

Stonesfield Capital Limited is actively investing in the
equity gap between GBP 500 000 (EUR 700 000) and
GBP 2 million (EUR 2,9 million)
targeted by the
Enterprise Capital Funds and submitted the following
comments:

2003. In 2001, GBP 1,4 billion (EUR 2 billion) was
raised to invest in early stage venture capital oppor-
tunities, compared to GBP 369 million (EUR 517
million) in 2003. Only 1% of the GBP 369 million
(EUR 517 million) raised in 2003 was targeted at
deals less than GBP 10 million (EUR 14 million).

(a) The supply of capital available throughout the UK for
investments in the size range between GBP 500 000
(EUR 700 000) and GBP 2 million (EUR 2,9 million)
is extremely limited. There is a severe equity gap for
small businesses looking to raise these sums of
money and the gap is widening rather than closing.

(b) According to the most recent ‘Report on Investment
Activity 2003’ published by the British Venture
Capital Association, there has been a 32% fall
in
the
companies
between 2001 and 2003.

invested in early stage

amount

(i) SMEs

in

justify

cannot

increase

capital
an
requirements in excess of GBP 2 million (EUR 2,9
million) because their size and stage of development
mean that
they are not mature enough and the
dilution to the entrepreneur would be too great.
This leaves a significant funding hole that needs to
be filled if these SMEs are to grow into successful
larger businesses. The provision of funding between
GBP 500 000 (EUR 700 000) and GBP 2 million
(EUR 2,9 million) is essential for many small busi-
nesses to survive and prosper.

(c) The performance of early stage funds has also
declined markedly over
same period. The
overall long term return to investors per annum for
early stage funds was 14,1% in 2001 and fell to 4,7%
in 2003.

the

(d) Both the decline in investment and performance over
this period has led to a number of early stage venture
investors pulling out of the market.

(e) These market dynamics have also been reflected in
the average size of investment in early stage oppor-
tunities. In 2001 the average deal size was approxi-
mately GBP 1 million (EUR 1,4 million). This has
increased to GBP 1,6 million (EUR 2,3 million) by
2003.

74.

The YFM Group submitted the following observations:

(a) The latest British Venture Capital Association (BVCA)
statistics show that in 2003 BVCA members invested
GBP 724 million (EUR 1 billion) in sums of less than
GBP 2 million (EUR 2,9 million) in 1 015 UK based
companies.

(b) If one strips out sub GBP 500 000 (EUR 700 000)
deals the picture changes dramatically. In 2000, GBP
482 million (EUR 675 million) was invested in sums
of between GBP 500 000 (EUR 700 000) and GBP 2
million (EUR 2,9 million) with 348 companies bene-
fiting. By 2003 the amount invested had fallen to
GBP 286 million (EUR 400 million), a 41% drop
on the 2000 figure, with 277 companies benefiting.

(f) This demonstrates

that

investors

in the venture
market are investing larger sums of money typically
in an attempt to reduce risk, thereby contributing to
a widening of the equity gap up to GBP 2 million
(EUR 2,9 million).

(g) Companies requiring between GBP 1 million (EUR
1,4 million)
to GBP 2 million (EUR 2,9 million)
struggle the most to raise the required funds. This
is because GBP 2 million (EUR 2,9 million)
falls
below the radar screen for most venture capitalists.

(h) The amount of funds raised to invest in early stage
venture opportunities has fallen 73% from 2001 to

(c) These figures include management buy outs (MBOs),
management buy-ins (MBIs),
later stage expansions,
secondary purchases and deals where bank debt has
been refinanced.
these transactions were to be
stripped out to focus on start up and early stage
deals,
and
companies benefiting would be discounted yet
further.

for monies

invested

figures

the

If

(d) Funding for start up and early stage propositions,
regardless of the size of the deals completed,
fell
from a grand total of GBP 703 million (EUR 984
million)
in 2000 to GBP 263 million (EUR 368
million) in 2003, a fall of 63%.

29.3.2006

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Official Journal of the European Union

L 91/25

(e) Stimulated by the European Commission and UK
government efforts, the number and value of trans-
actions in the sub GBP 500 000 (EUR 700 000)
marketplace is expanding.

increasing reluctance of venture funding to make
small investments in such ventures.

(f) However, at the next level up, the migration of UK
financial houses to larger and larger transactions is
leaving a funding gap. Supply side constraints are
becoming a major
that have
received investments in the sub GBP 500 000 (EUR
700 000) range and that are likely to need significant
amounts of follow-on finance are unable to raise the
monies they need because of a funding gap in the
GBP 500 000 (EUR 700 000) to GBP 2 million (EUR
2,9 million) range.

issue. Companies

75.

Close Venture Management Limited highlighted the
following facts:

(a) There is strong evidence that the equity gap, which
has evolved over time, now covers the GBP 500 000
(EUR 700 000) to GBP 2 million (EUR 2,9 million)
range. With time and increasing amounts of funds
under management, venture capital investors left the
sub GBP 2 million (EUR 2,9 million) segment behind.

(b) This is symptomatic of a common and inevitable
trend. As investment managers establish a successful
track record they raise more funds which in turn
allows
there are
economies
inherent
in the venture/private
scale
equity industry,
investment managers will typically
leave the smaller deals behind as soon as they are
able to do so.

them to do bigger deals. As

(c) This means that there are extremely few professional
investors in the sub GBP 2 million
or institutional
(EUR 2,9 million) segment
in the UK. Currently,
about 60% of all the deals between GBP 500 000
(EUR 700 000)
and GBP 2 million (EUR 2,9
frustrated demand with no readily
million)
available suppliers of risk capital to go to.

is

76.

Limited has become
Finance
Enterprise Corporate
increasingly frustrated in its endeavours to raise capital
in the range between GBP 500 000 (EUR 700 000) and
GBP 2 million (EUR 2,9 million)
their client
companies:

for

78.

(a) The main reason is not a lack of quality in the
the

opportunities

investment

themselves

but

few years to the extent

(b) The marketplace has become significantly worse over
the last
transactions
requiring less than GBP 5 million (EUR 7 million)
have a very slight probability of receiving funding,
notwithstanding the merits of the investee company.

that

(c) The problem is

for

significantly worse

those
companies seeking funds in the GBP 250 000 (EUR
357 000) to GBP 2 million (EUR 2,9 million) bracket
due mainly to prohibitively high costs and a lack of
appropriate commercial skill. The lion’s share of
venture funding is targeted towards more substantial
and mature businesses with assets and a track record
of producing profits.

77.

In its comment, 3i emphasises the following:

(a)

In the past two to three years the venture capital
market has gone through a significant transformation
as investment returns from early stage and smaller
growth companies have declined.

larger

(b) This, combined with an industry-wide trend of
and more prudent
making
investments
investment strategies, has resulted in a decline in
the supply of investment flowing into the smaller
end of the market.

3i currently estimates that the equity gap has increased
from GBP 500 000 (EUR 700 000) to GBP 1 million
(EUR 1,4 million) to as much as GBP 2 million (EUR
2,9 million).

the market. Whereas it

3i has significantly reduced its own investment in this
segment of
invested approxi-
mately EUR 1,1 billion in early-stage venture capital
investments across Europe in 2001,
in
similar companies has declined significantly with 3i
investing approximately EUR 150 million in this
segment of the market in 2004.

investment

Cavendish Asset Management Limited supports
observations made by
Accountants
point 68 above.

the
Institute of Chartered
in England and Wales described under

the

L 91/26

EN

Official Journal of the European Union

29.3.2006

V. COMMENTS FROM THE UNITED KINGDOM

86.

79.

The comments from the United Kingdom on the decision
of
the Commission to open the formal procedure
pursuant to Article 88(2) of the EC Treaty as well as
on the observations
from third parties will be
summarised in points (80) to (96).

The expected use of newly-raised venture capital funds is
becoming increasingly focused on larger deals in well-
established companies. The most recent data from the
BVCA indicate
raised are
that only 4% of
expected to be allocated to early-stage investment, 3%
to expansion deals, and 1% to MBOs of less than GBP
10 million. It was expected that only 3% of funds raised
would be allocated to early stage and expansion tech-
nology investments, compared to 5% in 2002.

funds

80. While access to debt

finance has improved for

the
majority of businesses in the UK since the mid 1990s,
an important minority of SMEs with high growth
potential still have problems in attracting equity finance.

81.

82.

83.

84.

85.

Equity finance is suitable for businesses at an early stage
of development that are not yet generating a sufficient
stream of revenue to service debt interest repayments. It
is also suitable for businesses developing new tech-
nologies, products or markets that offer the potential
to achieve substantial rates of growth, but also hold a
significant risk of failure.

The public consultation on access to growth capital for
small businesses, aggregated BVCA data and academic
research all point
to an equity gap in the United
Kingdom affecting businesses seeking to raise between
GBP 250 000 (EUR 357 000) and GBP 2 million (EUR
2,9 million) of equity finance.

The equity gap has extended upwards in recent years,
particularly since 1999, driven in part by the success
the private equity industry moving to larger size
of
investments. Average deal sizes have risen substantially,
as venture capital firms seek to benefit from increased
economies of scale.

The equity gap has been accentuated for early stage SMEs
in recent years due to a marked shift in the types of
capitalists. Evidence
investments made by
shows venture capital investments have drifted towards
later-stage, management
and
out
management buy in (MBI) investments.

venture

(MBO)

buy

The most recent BVCA data available for 2003 demon-
strate that there is a continued emphasis on later-stage
deals, and particularly on large buy-outs. Early stage
just 6,5% of UK venture
investment accounted for
capital
less than 0,02% of
in 2003, or
investment
GDP. This contrasts with an average of 0,05% of GDP
invested in early stage in the years 1998-2001.

87.

88.

89.

90.

Furthermore, data suggest that of those investments that
take place within the equity gap of GBP 250 000 (EUR
357 000) and GBP 2 million (EUR 2,9 million), only 1 in
4 are initial, un-syndicated investments. Of approxi-
mately 1 000 investments in the sub GBP 2 million
(EUR 2,9 million) range in 2000-2002, more than 70%
were follow-on investments.

investment

teams into the lower end of

As venture capitalists are migrating towards larger fund
sizes, there is little evidence of a flow of new venture
the
capital
market. The importance of reputation in the venture
sector creates a significant entry hurdle for
capital
prospective new fund management
teams seeking to
compete in the venture market. This trend will result
in a worsening shortage of talent and experience in the
equity gap segment of
that will become
increasingly hard to replace as time progresses, with
quality fund managers raising larger funds, and hence
making larger deals. Given the skills needed for successful
smaller-scale and early-stage investing, ensuring a good
flow of quality new entrants is a precondition for a
dynamic early stage market.

the market

The UK concludes that there appears to be full agreement
among all respondents that there is a risk capital market
failure that makes it difficult for SMEs with high growth
potential to get funding. All third party comments have
supported the UK’s view that the market has changed
and that an equity gap now exists beyond the level set
in the Communication.

The United Kingdom has sought to demonstrate that a
funding gap exists in investment sizes up to GBP 2
million (EUR 2,9 million). A number of respondents
suggest this is a modest estimate and that the gap may
now reach as high as GBP 5 million (EUR 7 million). The
United Kingdom believes however that the evidence is
strongest
in support of GBP 2 million (EUR 2,9
million) as the appropriate figure.

29.3.2006

EN

Official Journal of the European Union

L 91/27

91.

92.

93.

level or

responses from
The United Kingdom highlights that
those businesses operating within the UK venture
capital sector are in line with those of its own detailed
consultation. Respondents universally acknowledged the
existence of a risk capital funding gap at the GBP 2
above. These
million (EUR 2,9 million)
respondents have practical experience of
this market
and have researched it
from a commercial point of
view. Their experience supports the United Kingdom’s
own research, which says that funds operating in this
area are not able to attract private investors because of
perceptions of risk and the economics of making smaller
investments. The United Kingdom is therefore satisfied
that
scheme will not
displace existing private provision in this market.

the Enterprise Capital Funds

the

The United Kingdom also welcomes the level of support
for the practical design of the ECF model. The United
Kingdom welcomes
amongst
understanding
the proposed fund structure means
respondents that
that a distortion of competition will not occur and that
the incentive will be for sound commercial
investment
decisions. The key driver for this is that the proposed
ECFs give no down-side protection to the private
investors. This sharpens their incentive to select good
fund managers who will
funds to best
effect. If an ECF does not make a positive return the
private investor will lose his or her money. The United
a more powerful
this
Kingdom believes
is
commercial
incentive than an alternative model where
there is a lower proportion of public investment but
where public funds are at
risk before the private
investment and private investors can get their money
back from loss making funds.

invest

their

that

such as

By including key aspects of each fund’s structure within
the competitive bidding process the United Kingdom will
pay the minimum necessary in fund management charges
and subordination. The bidding process will set out some
minimum requirements,
the pari passu loss
position and a prioritised return to the public but it
includes the flexibility for applicants to specify alternative
terms where these are more generous to the public. This
opens up the possibility that private investors may be
exposed to greater downside risk than the public or
that less than the anticipated leverage is required where
a bidder could show that this would prove attractive to
investors in its fund.

of this the United Kingdom agrees that there will need to
be some fundamental revisions in the Communication
when it is revised in 2006. This will almost certainly
need to go beyond looking at tranche sizes to look at
other issues such as the balance of private sector risk as
compensation for greater public funding and greater use
of instruments such as block exemptions.

95.

96.

97.

an important

The United Kingdom considers that the ECF scheme will
make
contribution to tackling what
remains an important barrier to innovation and entrepre-
neurship and to meeting the goals set out at Lisbon and
in the Entrepreneurship Action Plan. The ECF scheme
will also help meet the recommendations of the Kok
report which noted that finance for SMEs in Europe is
currently too lending based and called for more use of
risk capital.

The United Kingdom concludes that the support shown
both by the public and private sectors and by other
those operating in the
Member States as well as
venture capital market positively reflects the need for
an investment vehicle of the ECF type.

VI. ASSESSMENT OF THE MEASURE

The Commission has examined the scheme in light of
Article 87 of the EC Treaty and in particular on the basis
of the Commission Communication on State Aid and
Risk Capital (9). The results of
this assessment are
summarised below.

VI.1. Legality

98.

By notifying the scheme,
the UK authorities have
complied with their obligations under Article 88(3) EC.

VI.2. Existence of State aid

99.

According to the provisions of the Communication, the
assessment of the presence of State aid must consider the
possibility that a measure may confer aid on at least
three different levels:

(a) aid to investors;

(b) aid to any fund or other vehicle through which the

measure operates;

94.

The United Kingdom further notes that the responses
from other Member States highlight a desire to update
the current Communication. The risk capital market
across the European Union has changed markedly since
the publication of the Communication in 2001. In view

(c) aid to the companies invested in.

(9) See footnote 6.

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Official Journal of the European Union

29.3.2006

100. At the level of investors, the Commission considers that
there is State aid within the meaning of Article 87(1) of
the EC Treaty. The involvement of state resources is
demonstrated by the fact that the UK authorities will
provide public leverage to the Enterprise Capital Funds.
Private investors in Enterprise Capital Funds, who may be
undertakings within the meaning of the EC Treaty may
be entitled to higher returns than the public and may
thus receive an advantage. Even though no person or
organisation is debarred from investing in the funds,
the limited size of the funds will not guarantee that all
potential
the
Commission therefore considers that there is selectivity.
Finally, the scheme affects trade between Member States,
as investment in capital is an activity that is the subject
of considerable trade between Member States.

investment will

accepted

and

be

101. At the level of the funds, the Commission in general
tends to the view that a fund is a vehicle for the
transfer of aid to investors and/or enterprises invested
in, rather than being an aid beneficiary itself. However,
in certain cases, notably measures involving transfers in
favour of existing funds with numerous and diverse
investors, the fund may have the character of an inde-
pendent enterprise. Under
the
Enterprise Capital Funds will be newly created and will
be prevented from diversifying into other activities than
those intended by the scheme. The Commission therefore
does not consider the Enterprise Capital Funds to be
separate aid beneficiaries. This principle is in line with
the Commission decisions on the ‘Viridian Growth
the ‘Coalfields Enterprise Fund’ (11) and the
Fund’ (10),
‘Community Development Venture Fund’ (12).

the present

scheme,

102. At

the

the

level of

companies

invested in,

the
Commission considers that there is State aid within the
meaning of Article 87(1) of
the EC Treaty. State
resources are involved because the investments of the
fund in beneficiary SMEs will contain public funding.
The measure distorts competition by conferring an
advantage on the beneficiary SMEs as
they would
otherwise not be able to obtain risk capital funding at
the same conditions and/or volume. The measure is
selective as it is targeted at specific SMEs in the United
Kingdom. The measure has the potential to affect trade
between Member States, as there is the possibility that
the target SMEs are engaged or will be engaged in
activities involving intra-Community trade.

(10) Commission Decision 2001/406/EC of 13 February 2001 on the
aid scheme ‘Viridian Growth Fund’ notified by the United Kingdom
(State Aid C 46/2000): OJ L 144, 30.5.2001, p. 23.
(11) State Aid N 722/2000: OJ C 133, 5.6.2002, p. 11.
(12) State Aid N 606/2001: OJ C 133, 5.6.2002, p. 10.

103. The Commission therefore concludes

that State aid
within the meaning of Article 87(1) EC is present at
the level of the investors and at the level of the bene-
ficiary SMEs.

VI.3. Evidence of market failure

104.

In line with the provisions of the Communication, the
Commission may be prepared to accept the existence of
market failure without further provision of evidence in
cases where each tranche of finance for an enterprise
from risk capital measures which are wholly or
partially financed through state aid will contain a
maximum of EUR 500 000 in non-assisted areas, EUR
750 000 in Article 87(3)(c) areas, or EUR 1 million in
Article 87(3)(a) areas.

105. The measure proposed by the United Kingdom foresees
risk capital
investments in the range of GBP 250 000
(EUR 357 000) to GBP 2 million (EUR 2,9 million) per
investment tranche for SMEs in the United Kingdom.

106. According to the ‘Regional Aid Map 2000 – 2006’ for
the United Kingdom, the United Kingdom consists of
regions currently classified as assisted areas pursuant to
the EC Treaty, as assisted areas
Article 87(3)(a) of
pursuant
to Article 87(3)(c) EC, as well as of non-
assisted areas (13).

107.

the

In line with the provisions of the Communication, the
Commission has informed the United Kingdom that in
the proposed risk capital
that
view of
fact
investments under
exceed the
the present
above-mentioned thresholds anticipated by the Commu-
nication, the United Kingdom would have to provide
evidence of market failure.

scheme

108. The arguments put forward by the United Kingdom as
well as the observations made by third parties demon-
strating the existence of a market gap in the investment
range of GBP 250 000 (EUR 357 000) and GBP 2
million (EUR 2,9 million) will be summarised in the
following.

(13) State Aid N 265/2000 – United Kingdom: ‘Regional Aid Map 2000

– 2006’: see footnote 8.

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L 91/29

Economic rationale for equity gaps in the risk capital market
for SMEs

109. The most important single source of external finance for
SMEs is bank debt, principally in the form of overdrafts
and fixed-term loans, which together account for around
half of all external finance. (14) Bank debt is most suitable
where businesses are generating sufficient cash flow to
service interest payments. The availability of debt finance
has improved significantly over the past decade. There is
no real evidence of
firms having difficulties assessing
bank finance. Nevertheless, lenders can still face consid-
erable uncertainty when assessing the prospects of indi-
vidual businesses. They often rely on collateral to support
SME lending, especially where the borrower lacks an
established track record in business. Not all business
owners are able to offer suitable security.

110. Market imperfections in the debt market arise from infor-
mation asymmetries, whereby the lender is only partially
informed about the prospects of a business. Information
asymmetries mean that lenders are unable to quantify the
level of risk involved in a particular SME. It is therefore
difficult to assess the quality of investment propositions,
and even harder to charge an interest rate that accurately
reflects the level of risk involved. Banks typically make
lending decisions on the basis of criteria such as credit
history, past bank account management, the applicant’s
track record in business and willingness to invest their
own money in the business, and evidence of repayment
capability based on a business plan. However, an indi-
vidual may not have a previous track record and may
have no personal capital to invest in the business. As a
lenders also place significant emphasis on the
result,
entrepreneur’s willingness
to
underwrite the loan. While lenders’ reliance on collateral
enables many businesses to secure debt
this
approach to SME lending can create difficulties for entre-
preneurs who lack suitable assets to offer as security.

to provide

collateral

finance,

111. While debt and asset-based finance are sufficient to meet
the needs of most firms, an important minority require
equity finance. Equity investors inject capital in exchange
for shares in the business, enabling them to receive a
proportion of its future profits. This form of financing
is most appropriate when the business is at an early stage
of development, and is not yet generating a sufficient
stream of revenue to service debt interest repayments
the business is developing new technologies,
and/or
products or markets with the potential
to achieve
substantial rates of growth, but also with significant
risk of failure.

112.

Equity finance accounts for only 8 per cent of all external
its
this
finance for SMEs, but

statistic understates

(14) Bank of England: ‘Finance for Small Firms – A Tenth Report’, 2003.

importance in a modern, enterprising economy. Busi-
nesses that are most likely to need equity finance are
often highly innovative, and have the potential to make
In
an important contribution to productivity growth.
is
the finance provided by venture capital
addition,
sometimes
support,
accompanied
advice and other expertise.

by management

and more widely across

113. While equity finance is an important driver of growth of
the
individual businesses,
there is a strong body of evidence that
economy,
structural features of the private equity market give rise
to a significant and growing ‘equity gap’ facing businesses
seeking modest
amounts of growth capital. These
structural causes relate to both the supply and demand
sides of the market.

114. The information problems highlighted for

the debt
market are also applicable to the equity market. On the
supply side, there are commonly three issues involved,
namely information asymmetries, transaction costs, and
the perception of risk and reward.

115.

of

the

size

investment.

the flow of

‘Information asymmetries’ mean that equity investors can
face significant costs in identifying suitable investment
opportunities. These information problems are typically
greatest for smaller, younger firms and especially inno-
vative businesses seeking to develop unproven tech-
nologies, products and markets. Information difficulties
present a significant impediment to smaller-scale equity
investments, because the costs of investment do not vary
proportionally with
In
comparison with large companies that are quoted on
public stock markets,
information about
small, unquoted companies seeking investment is much
Investors can therefore incur significant
more limited.
search costs when seeking out suitable opportunities.
Furthermore, it is often difficult to assess the prospects
of a business, especially where the management team,
product or
equity
investors can make informed investment choices, they
must
therefore undertake a process of due diligence.
These information gathering costs do not vary propor-
tionally with the size of the investment and, for smaller
investments, can be prohibitively large relative to the
potential financial rewards from making the investment.
Finally, having invested in a business, equity investors
need to monitor
their
investment. They will often do this by taking a seat on
the board, and may contribute significant time and effort
to providing management support, especially where a
business’ management team is relatively inexperienced.
This
contribution to the
performance of the investee business but, again, these
costs do not vary proportionally with investment size.

technology is unproven. Before

the ongoing performance of

an important

can make

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Official Journal of the European Union

29.3.2006

116. There are significant

fixed costs involved in making
equity investments,
for example in negotiating the
terms of investment and putting in place the necessary
legal agreements (‘transaction costs’). As with other fixed
these transaction costs tend to militate against
costs,
investing in smaller sums.

122. As to the overall performance by investment stage, funds
focusing on early stage investments made an average
return of - 18,1% in 2003 compared to an average 3-
years return of - 25,1% and an average 5-years return of
- 12,5%.

117.

Investment decisions will be driven by perceptions of risk
and likely financial returns.
If investors have incorrect
expectations, this will result in a sub-optimal allocation
of capital.

123.

specialising in development
return of

stage investments
Funds
recorded
- 3,4% in 2003
compared to an average 3-years return of - 8,2% and
an average 5-years return of 2,7%.

an average

118. Demand-side

equally

significant

constraints

in
are
limiting the flow of equity finance from investors to
SMEs. Research has highlighted a number of issues that
deter small businesses from seeking equity capital. Loss
of control and restricted management freedom are the
concerns most commonly cited by SMEs, but the costs of
securing equity finance and a lack of knowledge of
external sources of finance are also common obstacles.
that actively seek equity
Many of
investment are also constrained by a lack of ‘investment
readiness’. SMEs may be hampered by a
limited
awareness and understanding of the various forms of
risk finance available and how to access it, and by insuf-
ficiently developed or poorly presented business plans.
Inadequate business preparation and planning will deter
potential
least by increasing the infor-
mation and due diligence costs involved.

those businesses

investors, not

Informal

119. An equity gap arises where viable businesses are unable
to attract investment from either informal
investors or
venture capitalists, which are the principal sources of
equity finance for SMEs.
investors (business
angels and other
investors) have access to
limited financial resources and therefore generally invest
relatively small amounts of equity. By contrast, formal
venture capital investors typically incur far greater costs
in evaluating potential
investments. For the structural
reasons mentioned above, these costs are often prohi-
bitive where a business
seeking only a modest
is
amount of equity finance.

informal

120. An equity gap therefore affects businesses

that are
seeking a sum of money that is beyond the financial
means of most informal
investors, but below the level
at which it is viable for venture capitalists to invest.

124. At

the

time,

same

funds

concentrating on MBOs
(management buy outs) performed significantly better.
For mid-sized MBOs, the average return in 2003 was
12,2%, compared to an average 3-years return of 2,9%
and an average 5-years return of 6,7%. The difference
becomes even more evident when looking at
large
MBOs, with an average return of 15,3% in 2003, an
average 3-years return of 9,1%, and a corresponding
return figure of 13,6% for a 5-years period.

125. The data presented above underlines the current pattern
in the UK venture capital market. Venture capital
providers migrate towards larger deal sizes as the asso-
ciated returns are higher, thereby widening the equity gap
expansion
early
between
investments and larger-scale investments in well-estab-
lished companies.

smaller-scale

stage

and

126. This trend towards ever larger investment sizes is further
underlined by recent figures on investment activity in the
United Kingdom (16). The average financing across all
stages of investment increased to GBP 4,3 million (EUR
in 2003 from GBP 3,8 million (EUR 5,3
6 million)
million)
that
smaller-scale expansion stage investments fell by 57%
to GBP 477 million (EUR 670 million) in 2003 from
GBP 1,2 billion (EUR 1,7 billion) in 2002. The average
amount received by an expanding company fell from
GBP 2 million (EUR 2,9 million)
in 2002 to GBP
800 000 (EUR 1,1 million) in 2003.

in 2002. This is explained by the fact

Evidence for an upward-moving equity gap in the UK venture
capital market

121. According to recent BVCA data (15),

large MBO funds
showed good returns in 2003 and over
the longer
term, whereas average returns from early stage and tech-
nology funds continued to be depressed in 2003.

127. Of the total funds raised in 2003, the vast majority of
92% (GBP 8,2 billion or EUR 11,5 billion) has been
invested into MBOs and MBIs, up from an 87% allo-
cation in 2002. The report anticipates that only 3%
(GBP 290 million or EUR 406 million) will be invested
into expansion stage companies, compared to 6% in
2002. For early stage investments 4% of
funds
raised in 2003 (GBP 368 million or EUR 515 million)
compare to 3% in 2002.

total

(15) BVCA: ‘Performance Measurement Survey 2003’, 2004.

(16) BVCA: ‘Report on Investment Activity 2003’, 2004.

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Official Journal of the European Union

L 91/31

128. Within the MBO/MBI category, 58% is expected to be
allocated to the largest MBOs/MBIs
(over GBP 100
million or EUR 140 million total deal value), compared
to 45% in 2002. 20% will be allocated to MBOs/MBIs
between GBP 50 million (EUR 70 million) and GBP 100
million (EUR 140 million), up from 17% in 2002, and
13% will be allocated to MBOs/MBIs of between GBP 10
million (EUR 14 million) and GBP 50 million (EUR 70
million), compared to 24% in 2002. Like in 2002, a
mere 1% will be allocated to MBOs/MBIs of up to GBP
10 million (EUR 14 million).

129. Both the decline

and performance
in investment
presented above has led to early stage venture investors
pulling out of the market. This is further highlighted by
the fact that the average financing (across all stages of
investment) is steadily moving upwards and has reached
GBP 4.3 million (EUR 6 million) in 2003. Investors in
the UK venture market are investing larger sums of
money typically in an attempt to reduce risk, thereby
contributing to a widening of the equity gap.

that

the EC Treaty,

Commission’s decision to open the procedure pursuant
to Article 88(2) of
the Commission
concludes
the United Kingdom has provided
sufficient evidence for the existence of an equity gap in
range between GBP 250 000 (EUR
the deal
357 000) and GBP 2 million (EUR 2,9 million) in the
venture capital market of the United Kingdom.

size

the measure – Conformity
VI.4. Compatibility of
with the positive elements of the Communication

Restriction of investments

134.

ECFs will be restricted to investments in small and
medium-sized enterprises within the Commission defi-
nition. This is to be considered positively.

130. The amount of

in early stage
funds raised to invest
venture opportunities has fallen 73% from 2001 to
2003.
In 2001, GBP 1,4 billion (EUR 2 billion) was
raised to invest in early stage venture capital opportu-
nities, compared to GBP 369 million (EUR 517 million)
in 2003. Only 1 % of these GBP 369 million (EUR 517
million) raised in 2003 was targeted at deals less than
GBP 10 million (EUR 14 million).

Focus on risk capital market failure

135.

ECFs will be required to invest capital in SMEs by means
of equity or quasi-equity instruments. Investments that
instruments with no
are composed wholly of debt
equity features will not be permitted. The Commission
considers this as a positive element.

131.

the EC Treaty in respect of

In its decision to initiate the procedure laid down in
Article 88(2) of
the
proposed aid measure, the Commission stated that in
view of
the proposed maximum investment amounts
proposed under the scheme, which considerably exceed
the maximum investment amounts anticipated by the
by
potential
Communication,
interested parties were necessary in order
to decide
whether the measure affects trading conditions to an
extent contrary to the common interest.

observations made

132. All comments received from interested third parties were
positive and underlined the importance of the measure in
general as well as the appropriateness of the proposed
maximum investment amounts.

133. Taking into account the information presented in the
initial notification, the comments submitted by interested
information
third parties as well as
the
by
delivered

the United Kingdom following

the additional

Decisions to invest should be profit-driven

136. A link between investment performance and the remu-
neration of
the commercial managers responsible for
investment decisions is established. The public authorities
will not be involved in the investment choices and
decision making of ECFs apart from setting restrictions
are
to ensure
limited to SMEs.
investments
that
Investment decisions will be
taken by commercial
managers of the ECFs with an interest in ensuring a
maximum return for the fund. The administrative body
SBS will only approve ECFs where operators have a clear
incentive to maximise returns. The terms on which the
invest in ECFs will give private
public authorities will
investors very strong incentives to ensure that
their
funds are profit-driven and perform successfully. These
incentives arise because private investors will have to pay
interest on the public capital, and fully repay capital to
both the public and private investors, before any profits
can be distributed. As a result, private investors will bear
at least a proportionate share of any losses made by
ECFs. ECFs or their operators will be required to act in
line with industry standards (British Venture Capital
Association BVCA guidelines). All these elements have
to be assessed positively.

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Official Journal of the European Union

29.3.2006

Level of distortion of competition should be minimised

VII. CONCLUSION

137. The UK authorities will ensure that the ECF scheme is
publicised and that applications are invited from across
the EEA with notices in the Official Journal of the European
Union and the relevant trade press. There will be no
restriction on location for any investor or operator.
This is again considered as a positive element.

141. The Commission therefore concludes that the aid granted
under the Enterprise Capital Funds scheme fulfils the
conditions of the Commission Communication on State
Aid and Risk Capital. It has therefore found the measure
to be compatible with the common market pursuant to
Article 87(3)(c) of the EC Treaty.

Sectoral focus

138.

invest

Enterprise Capital Funds will not
in sensitive
in sectors to
sectors under State aid restrictions or
which the Communication does not apply. Low-risk
sectors including property, land, finance and investment
companies, or finance-type leasing companies will not be
eligible for investment under the scheme. This has to be
regarded positively.

Investment on the basis of business plans

139. All investments undertaken by ECFs will be made on the
basis of robust business plans. This is a further positive
element.

Avoidance of cumulation

140. The UK authorities have committed themselves that the
beneficiary SMEs’ eligibility for other publicly funded
grants,
loans or other forms of investment aid outside
of this notification will be reduced by 30% of the aid
intensity that would otherwise be permissible. The
Commission considers this to be a positive element.

HAS ADOPTED THIS DECISION:

Article 1

The State aid which the United Kingdom is planning to
implement is compatible with the common market pursuant
to Article 87(3)(c) of the EC Treaty.

Implementation of the aid is accordingly authorised.

Article 2

The United Kingdom shall submit an annual report on the
implementation of the aid.

Article 3

This Decision is addressed to the United Kingdom.

Done at Brussels, 3 May 2005.

For the Commission

Neelie KROES
Member of the Commission