the investor's paradigm

An entrepreneur in need for capital might be confused. In the finance industry as well as the media, two buzz words make the round: “equity gap” and “equity overhang”.

Equity gap and overhang are not two sides of a coin. In general, the term “equity overhang” refers to the gap between funds raised and funds invested and thus to a problem institutional investors are facing.  The term “equity gap” is used in reference to the gap between funds required and funds invested and thus relates to a problem entrepreneurs are facing.

Based on these definitions, a first answer to the question raised in the title of this post is: both! Depending on a company’s industry, stage within the company life cycle, and amount of capital required, today’s capital seekers find themselves in one of three clusters of the graph shown on top.

The red cluster of our “private equity cube” indicates which companies typically suffer most under the equity gap. According to the OECD, these are mostly seed and early stage innovative SMEs (“ISMEs”). While figures are difficult to obtain, in the U.S., this gap is said to be around $40 billion. Within this red cluster, first and foremost, entrepreneurs requiring between 200k € and 2 m € are affected, as these amounts are too large for informal players such as business angels but too small for VCs and private equity firms (corresponding to the medium layer of the red cluster). Currently, the only cure for these young and innovative SMEs are business angel syndicates and publicly backed funds, such as CTI Invest in Switzerland or the “Enterprise Capital Funds” in the UK. But the volumes provided by these players are still way too small.

The green cluster, on the other hand, indicates which companies in need for capital are most fought over: expanding or turnaround companies requiring >2m € capital. Only players of the formal private equity industry, such as venture capital firms (“VCs”) and private equity funds, or funds of funds respectively, play in this field. As of April 2009, current figures for the U.S. indicate an aggregated overhang of $400 billion. While the numbers differ, this situation applies globally: VCs are sitting on loads of cash but for two reasons hesitate to invest - due to the economic slowdown and due to a tendency of increasing minimum deal sizes in the formal private equity industry.

But what if an entrepreneur finds himself in the white cluster? First of all: he or she will have to rely on his own funds and capital from informal investors. And three rules of thumb apply: (a) the bigger the required capital, the more difficult it will be to find FFF or angel money; (b) the riskier the business model, the more difficult; (c) the earlier in the business lifecycle, the more difficult. Thus, even white cluster companies are confronted with an equity gap, just less severe than red cluster companies.

In wrapping up posts 1 to 4 on the investor’s paradigm, it seems that market inefficiencies are the overarching problem: from an entrepreneur’s perspective, if your business does not match the preferences of formal VCs and private equity firms, and from an investor’s perspective if you do not happen to qualify as an “accredited” or “qualified” investor. In other words: the majority on both sides relies on the quality of their personal networks.

The previous two posts on the investor’s paradigm raise an important question. If we take into consideration our findings (a) that today, only a small fraction of investors in OECD countries engage in the SME segment and (b) that in today’s private equity markets only a few offerings are available for ordinary private investors, we need to ask: why not more?

This question on demand and supply breaks down to the following aspects. Firstly, does the number of current SME investors reflect the number of people with a clear motivation to invest in SMEs? Secondly, if this should not be the case, what are the concerns on part of investors keeping them from doing so? Thirdly, is there a shortage on supply of quality investment opportunities? Lastly, if we allow for the possibility of this being an imperfect or inefficient market, what market distorting factors, regulatory and non-regulatory, can be found?

Let’s start looking at investors’ motivation. We are currently conducting a survey on investment behavior and while it is still ongoing, we already published some interesting preliminary findings. The bottom line is: approximately 40% of survey participants with money to invest would consider investing in ventures and SMEs. And more specifically: in comparison with the few investors already experienced with SME investments (approx. 3% of total investors), more than double (8.4% of investing participants) are clearly motivated to do so. These participants not only indicated an interest in SME investments but also stated that they would accept the associated risks and would be prepared to invest the time it takes to make informed decisions. On top of this, the vast majority of those also has relevant skills and significant experience with investments in other asset classes.

On average, investors participating in our survey indicated a degree of concern over all crucial aspects an SME investment involves - but no concern was seen to be irresolvable. Primary concerns mentioned were: (1.) Comprehensiveness and reliability of information provided on the investment target and (2.) Trust in the capabilities of the management. Fraud risks, concerns related to the liquidation of investments and post-investment monitoring/control were secondary. Surprisingly, the perceived general risk of such investments ranked only second last among all possible concerns. In short: investors’ concerns do play an important role and any approach aimed at promoting SME investments needs to find ways to adequately address them. Survey participants, however, believe all of those could be allayed. Watch out for our detailed survey findings on investor concerns soon to be published.

When it comes to supply, a differentiation of investment opportunities is crucial. While a small percentage of SMEs in need for capital are outnumbered by interested institutional and other accredited investors 10:1, the vast majority of startups and SMEs struggles to find capital. There is general agreement that this “equity gap”, mainly in the space of seed and early stage innovative SMEs (“ISMEs”) which are (in the words of the OECD) “economically significant” and could use this capital “productiv ely”, has largely to do with market inefficiencies in the formal capital markets. The entrepreneur’s perspective thus is important to fully understand the complications of the investor’s paradigm. For that matter, we will focus on the different types of seed, early stage and growth SMEs and discuss related market inefficiencies in part 4 on the investor’s paradigm.

If we wrap up the following interim results: (a) almost double of today’s non-sophisticated investors are qualified and motivated to invest in SMEs, (b) these investors articulate a number of concerns over SME investments, but none of them is seen to be insurmountable, (c) there is no shortage on quality SME investment opportunities, then we are mainly dealing with a problem of market inefficiencies.

Let’s start our analysis on market inefficiencies with a look at potentially distorting regulatory interventions. First and foremost, regulators intend to protect “non-qualified investors” based on the assumption that those are not able to understand and manage risks associated with certain investments. Point taken. A closer look at existing regulations, however, reveals that policy makers settle for damage containment rather than problem-solving. As discussed in the previous post, regulators define a “qualified investor” mainly depending on a person’s salary and wealth. Their logic goes “if rich investors fail, at least they survive”.

The real problem, however, is not one of definition. Instead, the trade-off between investor protection and promotion of SME financing seems out of balance. Many Swiss business angel networks, for instance, grant membership only to “qualified investors” - voluntarily. In other countries, e.g. the UK, business angels are requested by law to sign an official document certifying their capacity as “qualified investors”. For better or worse, our preliminary survey findings underline that many people are qualified and keen to invest long before they make their first million: see our post “A different take on small investor interests”.

Last but not least on non-regulatory market distortions. As mentioned before, the supply side is clearly characterized by market inefficiencies. Formal players (VCs, private equity firms and banks) are not willing to invest in high-cost, high-risk ventures requiring less than €2 million in equity. The OECD therefore acknowledges the need for informal venture capital, especially for innovative companies in their seed and early stages.

In summing up, it’s high noon for governments to not only acknowledge the general importance of informal venture capital, but also the specific importance of private investors not qualifying as business angels, often referred to as friends, family and fools (“FFFs”). Our market study indicates that the last “F” comprises not only fools, but many individuals that are by all means capable to invest. According to our calculations, Swiss business angels made up for only 7-10% of venture capital provided by private individuals in 2008. So with 90-93%, other private individuals (incl. founders) already provided the lions share – despite limited investment possibilities. Let’s make sure they provide even more.

Read part 4 on the investor’s paradigm.

Today, the situation private individuals in search for direct SME investments are facing, reminds me a lot of my visit to Havana in the early Nineties. Grocery store shelves were mostly empty, and Cubans needed to show a special permit in order to gain entrance to exclusive stores that used to cater for the needs of the Cuban elite, diplomats and foreigners.

Even in the world of Private Equity, it takes a special permit to enter its exclusive stores. If you happen to be a wealthy individual, someone private bankers consider to be a “high or ultra high net worth individual”, you can declare yourself as a "qualified"or "accredited investor". Among other requirements, a high net worth and salary are the paramount preconditions for any membership in business angel networks or exchanges. In Switzerland, in order to qualify as angel, individuals need to declare an individual net worth of >$1m (can be joint with spouse) and an annual income of >$200k (or >$300k if joint with spouse). In addition, the invested sum per individual investment has to be $100k at the minimum. Once accepted as a member, you can directly tap into a flow of investment opportunities: many angel networks and exchanges have excellent connections with local university incubators and maintain close ties with its international sister organisations. 2006 figures indicate 290 individuals organized in Swiss business angel networks.

Qualified business angel or not, the majority of direct investments on the part of private individuals originates from family, friends or personal business contacts. This is what Cubans call the "economía sumergida" - it works, but not very efficiently. Far from being a reliable source of deal flow, this situation clearly indicates a lack of liquidity and transparency in this market. Consider yourself lucky, if you’re among those who were personally approached with a high-quality SME investment opportunity that meets your needs.

Elite aside, like most Cubans, ordinary investors like myself can’t help the feeling that what’s on offer for ordinary people is not only limited but also just not exactly what we are looking for. Let’s look at the few SME products that made it onto the shelves.

If you don’t care whether to lend debt or invest equity, you could use an existing online lending service (aka social funding or crowdfunding). The first generation of lending services however was mostly focusing on people-to-people lending (aka peer-to-peer lending) - among those are Prosper, Zopa, and Lending Club. In addition, services tailored to the funding of charitable and development projects were launched - among those are Kiva, Fundable and MicroPlace. There are, however, some new kids on the block, dedicated to facilitating lending to businesses, such as 40billion. So far however, only a few people have gained experience with online lending, given the limited number of providers and a restricted regional and product scope.

Which leaves us with indirect options of investing equity. Private individuals can buy shares of (globally around 250) listed private equity firms (LPEs), such as 3i Group, Blackstone or KKR. They can invest in private equity funds, offered by companies such as the Carlyle Group or Partners Group. And last but not least, they can invest in funds of funds, managed by players such as Pantheon or Conversus. The portfolio of SMEs they invest in, however, is entirely in the hands of the respective asset manager.

Read part 3 on the investor’s paradigm, addressing common arguments on why direct SME investment possibilities are limited.