Equity, not debt, will be key to pump-priming British economy and revitalising businesses. This lesson was learned by the Industrial and Commercial Finance Corporation, established after the second world war to kickstart the economy and fill the ‘Macmillan gap’ – the lack of financing options for smaller businesses.
Large businesses can issue bonds and stocks, an expensive process out of reach for small firms. Small firms also struggle to borrow from banks, which want security and reliable cash flows.
What small firms need is equity. Equity investments require a careful analysis of a firm’s prospects, its management team and technical industry knowledge, all beyond the remit of traditional lenders. Credit flows between banks and small businesses tend to be lacklustre. Tighter risk standards, introduced after the 2008 financial crisis, made lending to small businesses even harder for banks. Data from the Bank of England show that lending to SMEs was stagnant over the last decade.
This difference between what banks have to offer (debt) and what small businesses need (equity) limits the ability of banks to support the recovery. Small businesses are the backbone of the British economy. The Department for Business, Energy and Industrial Strategy estimates that small and medium entreprises employ 61% of the nation’s workers and account for 52% of its total business turnover.
What Britain needs is an ICFC to thaw frozen firms. Fortunately, the original ICFC still exists. The company evolved into 3i, a private equity firm. It is now one of many venture capital and private equity firms that use global capital to support promising businesses and management teams.
Private equity can help businesses reopen and recover. This crisis gives the sector a chance to prove its economic value. Private equity is viewed as supporting, in US parlance, Wall Street over Main Street. It needs to show that it can be a bridge between the two. Its bad reputation comes from large private equity firms aiming to create value from established businesses, which often involves restructuring and job losses.
The smaller private equity firms are focused on helping promising companies grow. The thousands of successes generated by these private equity houses are overshadowed by the headline-making failures of larger players.
Private equity houses spent £22bn acquiring stakes in UK businesses in the final quarter of 2019, according to Unquote and Aberdeen Standard. This sum is comparable to the UK’s emergency response measures. Private equity houses are sitting on a large amount of dry powder – money committed to their funds by institutional investors that has yet to be spent. A lack of transparency makes it difficult to say how much exactly, but it is likely to be of a similar order of magnitude to annual investment, around £40bn-£80bn. Many private equity houses have continued raising funds throughout the pandemic.
The post-lockdown economy will present opportunities to restructure businesses. It is in the interest of private equity managers, especially the larger ones, to show that they are as good at creating jobs as they are at destroying them. Larger managers may want to consider pooling funds into a growth equity vehicle that seeks to support smaller, growing, job creating firms. They would need permission from their institutional backers for this, and they would likely get it, given their backers’ investments in private equity are coming under greater public scrutiny. If the post-lockdown economy is greeted with a raft of private equity-backed restructurings and job losses, it will not be long before restrictions are introduced on the sector’s activities.
There is room for public policy to guide private equity investment into targeted sectors. Joshua Ryan-Collins, head of finance at University College London’s Institute for Public Policy Research, has suggested that the Bank of England use credit guidance to encourage bank lending to industry. However, the Bank of England is ill-equipped for such a policy. Over the last several decades it has transformed from a banking institution to a largely academic one and it does not have the knowhow to make decisions on the future of British industry.
The British Business Bank is better equipped to do this. What Ryan-Collins wants the Bank of England to do with debt, the BBB can do with equity. The BBB commits capital to small investment funds. Often these funds have a sector-specific remit, addressing environmental concerns or targeting new technologies. The BBB provides a vote of confidence to other investors which then complete the fundraising process. The BBB also supplies debt and equity directly to businesses. There is no reason why it cannot be expanded to better reach small businesses and local investment funds throughout the country. It is headquartered in Sheffield, which already helps to turn its focus outside of London.
Chris Papadopoullos is economist at OMFIF. He can be reached at chris.papadopoullos@omfif.org.