Risky returns
| by Peter Atrill 24 Oct 2005 Diploma in Financial Management Relevant to Paper 3 |
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Types of investment
Venture capitalists invest in small and medium-sized businesses with good growth potential. When investing in a business, the venture capitalist is looking to increase the value of a business without taking over its
day-to-day operations. Businesses that are likely to interest venture capitalists often have high levels of risk, which other providers of finance may find unacceptable. Venture capitalists, however, are often prepared to take on these higher risks if there is a prospect of higher returns. The investment made in a business may take the form of share capital and/or loan capital and will normally be for a reasonably long period (five years or more).
Venture capitalists provide finance for businesses that are at various stages of development. Businesses that attract venture capital can be classified according to their particular stage of development as follows:
- start-up finance for new business ventures
- other early-stage finance for young businesses which are ready to begin operations
- expansion-stage finance for developing businesses or for businesses that needs reviving after a period of disappointing performance
- refinancing bank debt to help a business reduce the burden of gearing
- secondary purchases to help buy out some of the owners of an established business or to buy out another venture capitalist
- buy-out finance to help managers to acquire their employer's business (management buy-out) or for the venture capitalists to buy a business and then install a management team from outside the business (institutional buy-out)
- buy-in finance to help an external management team buy an existing business.
Figure 1 shows the investments made by venture capitalists in UK businesses during 2004 according to financing stage. We can see that management buy-outs (MBOs) have proved to be, by far, the most attractive form of investment for venture capitalists, as measured by the funds invested, and that early stage finance (including start-up finance) has attracted much lower funding.
Figure 2 shows the number of UK businesses that have been backed by venture capitalists according to financing stage. The figure reveals that there is not a major difference between the number of investments made in MBOs and in start-up businesses. As the total funding provided for MBOs and for start-up businesses varies considerably (as revealed in Figure 1) it is clear that the average funding for each type of investment is very different. In fact, the average funding provided for MBOs during 2004 was £15.9m compared to £0.5m for start-up businesses.
Do venture capitalists 'cherry pick'?
In the UK, venture capitalists have been criticised for allocating relatively small amounts of their available capital to new business ventures. This type of venture is often very high risk but a continuing stream of business start-ups is regarded by many commentators as vital to ensure that the UK economy remains vibrant. UK venture capitalists, it is argued, display a preference for 'second stage' funding (after the business has started and become viable but before an initial public offering) or for providing finance for management acquisitions (buy-outs or
buy-ins). Figure 1 appears to provide some support for this criticism.
It is easy to see why venture capitalists may decide to allocate their capital in this way. Investing in established businesses can be less risky in relation to the expected returns. Moreover, the costs of investigating and monitoring start-ups can be prohibitive in relation to the financing requirement. For this latter reason, 'business angels' may provide a more suitable source of finance for start-ups than venture capitalists.
Unfavourable comparisons have been made between UK venture capitalists and those in the US concerning the level of funding devoted to start-up business ventures. It seems that US venture capitalists display a greater commitment to start-up businesses.
It is not clear why such differences exist between the UK and US although various reasons have been put forward to explain this phenomenon. The bias towards financing well-established businesses may reflect differences in underlying attitudes towards risk and investment between the UK and US. It has been suggested, for example, that UK investors tend to be more cautious than US investors. It has also been suggested that UK entrepreneurs have a shorter-term investment perspective than their US counterparts, which leads them to prefer the acquisition of existing businesses rather than helping to start up entirely new businesses. However, the differences identified may simply be due to greater competition among US venture capitalists for good investment opportunities which ultimately lead them to invest in business start-ups in order to achieve the required returns.
Lifestyle businesses
Venture capitalists recognise that the owners of many small or medium-sized businesses use their business as a vehicle for leading a particular lifestyle and have no wish to make the sacrifices required to realise its growth potential. They may enjoy the independence that owning a business provides and may well resent any form of outside interference. These 'lifestyle' businesses will be of no interest to a venture capitalist, who will be looking for owners that are ambitious and keen to increase the value of their business. The owners must also be comfortable with an outside investor having a stake in the business.
To demonstrate their commitment to value enhancement, the owners of a business will normally be required to commit a significant proportion of their personal wealth to its financing. Even though this may not represent a significant proportion of the total finance required, it should ensure that the owner maintains a close personal interest in the future success of the business. Unless the owners are prepared to make such a commitment (which may involve selling personal assets or re-mortgaging their houses) a venture capitalist is unlikely to invest.
Evaluating a potential investment
A number of factors will be considered when a venture capitalist is deciding whether or not to invest in a business. When evaluating the growth potential of a business, the following key factors will often be considered:
- The nature of the product or service offered - the particular product or service that the business offers will be examined to see whether it has an edge over its rivals or a unique selling point.
- The market for the products or services - the level of competition within the market and the existence of barriers to entry will have an important influence on future returns. The size of the market and the likely future trends within the market must also be considered. The market share of the business for the products or services of the business and the standing of the business among suppliers and customers will be also need to be examined.
- The management - the quality of the management is a key issue for venture capitalists. The management team must include suitably-qualified and experienced individuals with a proven track record. The team should be well-balanced in terms of expertise and experience and must be capable of working together effectively. A high level of commitment from key managers to the venture will be expected.
- Financial performance - the performance of the business to date will be examined as well as the projected returns. The key assumptions and estimates employed in deriving the projected returns will be subject to close scrutiny. The expected future cash flows and the need for finance in the future is usually of particular concern.
- Internal business operations - the venture capitalist will want to establish whether the internal business operations are efficient. It may also be important to determine whether the products or services offered involve complex processes or whether the processes are dependent on key individuals who possess high levels of skill.
- Risk factors - the main areas of risk and the ways in which these risks will be managed by the business will be taken into account.
Opportunities for change - the venture capitalist will be interested to see whether there are opportunities to cut costs or to sell under-utilised assets. The possibility of acquiring other businesses to increase market strength may also be considered.
Exit route
A major part of the total returns from the investment is usually achieved through the final sale of the investment. The particular method by which the realisation of the investment is to be made is, therefore, of acute concern to the venture capitalist. In practice, realisation may be achieved through various means including:
- a 'trade sale' to another business
- flotation of the company on a recognised stock exchange
- selling the investment to the management team
- selling the investment to another venture capitalist
- other shareholders buying out the venture capitalist.
A number of European stock markets specialising in small company shares have recently been established. These markets are important to the venture capitalist as a possible means of exiting from an investment through flotation. The Alternative Investment Market (AIM) in the UK is the largest and most successful market for small businesses in Europe. AIM, which is a second-tier market of the London Stock Exchange, was established in 1995 and offers smaller businesses many of the advantages of listing without the cost and bureaucracy that accompanies a listing on the main market.
However, the importance of stock markets as an exit route should not be overstated. During 2004, for example, flotations accounted for only 10 per cent of the total amount realised by venture capitalists from their investments. The most important form of realisation was through trade sales, which accounted for 28% of the amount realised, followed by sales to another venture capitalist, which accounted for 20% of the amount realised1.
The investment process
Making an investment is time consuming: it usually takes between three to six months after receipt of the initial investment proposal from the owners or managers before funds are committed by the venture capitalist. This delay occurs because the proposed business plan must be reviewed and, following this, enquiries must be made to gain a more complete picture of the proposal. Due diligence must also be carried out to ensure that the risks associated with the investment are properly identified and considered, which may involve the use of external accountants and consultants.
Negotiations with the owners or managers must take place in order to reach an agreement concerning key issues such as voting rights, composition of the board of directors, warranties and indemnities to be provided by the directors, the right of the venture capitalist to have a say in key decisions, and to have access to the management accounts and so on. Finally, the venture capitalist must value the business and decide a suitable financing package. In order to reduce the level of investment by the venture capitalist, a business may be required to borrow part of the financing requirement from a bank or similar institution. The use of borrowing can also help the venture capitalist to increase expected returns from a gearing effect.
Undertaking a finanical evaluation
A proposed investment is usually evaluated using the internal rate of return (IRR) method of investment appraisal. The 'hurdle rate' chosen will reflect the perceived level of risk, which will vary according to circumstances. However, hurdle rates in excess of 20% are common. To understand how a possible investment is appraised, let us consider the following example, which involves a management buyout where part of the finance required must be raised from bank borrowing. This example is adapted from an examination question from a past exam paper.
Example
Ceres plc is a large conglomerate which, following a recent strategic review, has decided to sell its agricultural foodstuffs division. The managers of this operating division believe that it could be run as a separate business and are considering a management buy-out. The division has made an operating profit of £10m for the year to 30 September 2005 and the board of Ceres plc has indicated that it would be prepared to sell the division to the managers for a price based on a multiple of 12 times the operating profit for the most recent year.
The managers of the operating division have £5m of the finance necessary to acquire the division and have approached Vesta Ltd, a venture capital business, to see whether it would be prepared to assist in financing the proposed management buyout. The divisional managers have produced the following operating profits forecasts for the next four years:
| Year to 30 Sept | 2006 | 2007 | 2008 | 2009 |
| £m | £m | £m | £m | |
| Operating profit | 10.0 | 11.0 | 10.5 | 13.5 |
To achieve the profit forecasts shown above, the division will have to invest a further £1m in working capital during the year to 31 May 2007. The division has freehold premises costing £40m and plant and machinery costing £20m. In calculating net operating profit for the division, these assets are depreciated, using the straight line method, at the rate of 2.5% and 15% on cost respectively.
Vesta Ltd has been asked to invest £45m in return for 90% of the ordinary shares in a new company specifically created to run the operating division. The divisional managers would receive the remaining 10% of the ordinary shares in return for their £5m investment. The managers believe that a bank would be prepared to provide a 10% loan for any additional finance necessary to acquire the division. The freehold premises of the division are currently valued at £80m and so there would be adequate security for a loan up to this amount. All net cash flows generated by the new company during each financial year will be applied to reducing the balance of the loan and no dividends will be paid to shareholders until the loan is repaid. There are no other cash flows apart from those mentioned above. The loan agreement will be for a period of eight years. However, if the company is sold during this period, the loan must be repaid in full by the shareholders.
Vesta Ltd intends to realise its investment after four years when the fixed assets and working capital (excluding the bank loan) of the company are expected to be sold to a rival business at a price based on a multiple of 12 times the most recent annual operating profit. Out of these proceeds, the bank loan will have to be repaid by existing shareholders before they receive their returns. Vesta Ltd employs the internal rate of return (IRR) method to evaluate investment proposals and wishes to use a hurdle rate of 25% for this investment. Ignore taxation.
Required
Evaluate the proposal from the perspective of Vesta Ltd.
To evaluate the proposal, we must identify the purchase price, which is £120m (ie 12 x £10m). The loan element required to finance the purchase is £70m (ie £120m - (£45m + £5m)).
The IRR method uses cash flow rather than profit flow in the calculations. Thus, to derive the annual cash flows from the investment, we must add back any depreciation that is included in the calculation of annual net profit. The total annual depreciation charge is £4m. This comprises £1m for freehold land (ie £40m x 2.5%) and £3m for plant and machinery (ie £20m x 15%).
Once these initial calculations have been carried out, the amount of the loan that will be outstanding at 30 September 2009 can be calculated as follows:
| Year to 30 Sept | 2006 |
2007 |
2008 |
2009 |
£m |
£m |
£m |
£m |
|
| Operating profit | 10.0 |
11.0 |
10.5 |
13.5 |
| Add Depreciation | 4.0 |
4.0 |
4.0 |
4.0 |
| 14.0 |
15.0 |
14.5 |
17.5 |
|
| Less Additional working capital | - |
(1.0) |
- |
- |
| Interest on loan (10%) | (7.0) |
(6.3) |
(5.5) |
(4.6) |
| Cash available to repay loan | 7.0 |
7.7 |
9.0 |
12.9 |
| Loan outstanding at beginning of year | 70.0 |
63.0 |
55.3 |
46.3 |
| Cash available to repay loan | 7.0 |
7.7 |
9.0 |
12.9 |
| Loan outstanding at end of year | 63.0 |
55.3 |
46.3 |
33.4 |
Having calculated the loan that must be paid off in four years' time, we can calculate the IRR as follows:
| £m | |
| Proceeds on sale of business (12 x £13.5m) | 162.0 |
| Less Loan to be repaid | 33.4 |
| Proceeds available to ordinary shareholders | 128.6 |
| Less | |
| Amount due to managers (10% x £128.6m) | 12.9 |
| Amount from realisation of investment by Vesta Ltd | 115.7 |
The IRR of the investment is the discount rate which, when applied to the future cash flows, will produce a net present value (NPV) of £0. This rate can be derived by a process of trial and error as follows.
Trial 1
NPV of the realised investment using a discount rate of, say, 28% is as follows:
(£115.7m x 0.37) - £45m = (£2.2m).
The NPV is negative and so the IRR must be lower than 28%.
Trial 2
NPV of the realised investment using a discount rate of, say, 24% is as follows:
(£115.7m x 0.42) - £45m = £3.6m
The NPV is positive and so the IRR must be higher than 24%. The IRR falls between the two discount rates chosen. Using linear interpolation, we derive the approximate IRR as follows:
= 24% + 4%[3.6/(3.6 + 2.2)]
= 26.5%
We can see that the IRR exceeds the chosen hurdle rate and so acceptance of the project would increase the wealth of the shareholders of Vesta Ltd. However, the IRR is not significantly above the cost of capital and so it would be useful for Vesta Ltd to check carefully the key assumptions and estimates employed. In particular, the exit price of the investment is heavily dependent on the operating profit figure for the year to 30 September 2009. It is interesting to note that this operating profit is significantly higher than in previous years.
Summary
Venture capital provides an important source of long-term finance for small and medium-sized businesses. It is seen by many as an important means of ensuring a vibrant economy and the creation of jobs. In the UK, the venture capital industry is well-established and dwarfs the venture capital industries in other European countries. However, there is some criticism that the investment portfolios of UK venture capitalists show a bias towards later-stage investments. Venture capitalists will only invest in businesses with good growth potential and will expect the owners and managers to have the drive and ambition to achieve this growth. An important consideration when a venture capitalist is investing is the likely exit route. In recent years a number of stock markets have been created which can provide an exit route for venture capitalists, including the Alternative Investment Market (AIM) in the UK. However, trade sales appear to be the most important form of exit route.
Figure 1: Amount invested by financing stage 2004
Source: Compiled from information in BVCA Report on Investment Activity 2004, British Venture Capital Association, www.bvca.co.uk
Figure 2: Number of businesses backed by financing stage 2004
Reference
- BVCA Report on Investment Activity 2004, British Venture Capital Association, www.bvca.co.uk
Peter Atrill is examiner for Module B