Financing Scotland's recovery: analysis

Part 3: Financing Opportunity and Growth

1. Introduction

My commentary so far has focused on strengthening business resilience through effective management of debt - the first of the two criteria I identified for successful recapitalisation. In Part 3 I turn to the second: injecting new capital to drive recovery through investment in growth, sustainability and new opportunities. With access to debt finance already covered extensively, I will focus my analysis on the role of equity investment and, in particular, how we might facilitate the market conditions necessary to expand the use of equity instruments in the traditional economy and to address structural weaknesses in the equity market for high growth industries. I will close the section with a detailed treatment of the significant economic opportunities for Scotland in the emerging field of green finance.

2. Patient equity for traditional SMEs

Third party equity investment is a solution most commonly applied to large, innovative or young startup/scale-up businesses^[27] with significant growth potential. In contrast, Scotland’s economy is largely composed of more traditional SMEs with little culture or experience of sacrificing equity for capital and, in any case, where there is often limited growth potential to attract investors. The received wisdom is therefore that equity investment is only suitable for a small subset of the economy.

But, in a time of crisis, this lack of existing large scale application does not mean that equity investment is irrelevant for traditional industries; especially in circumstances where many businesses are now in no position to take on further debt and where we may well see a consolidation of SMEs through mergers and acquisitions to create larger, more investable enterprises. It is therefore worth considering whether an imaginative, targeted expansion of equity into non-traditional sectors could form part of Scotland’s recovery strategy. Equity investment is a flexible instrument and, for those businesses for whom it could be useful, it could offer at least four benefits:

• First, it removes debt burden from balance sheets, preventing companies from holding back on investment and job creation while they concentrate on reducing debt. Such a trend could accumulate to a drag on future growth and productivity – it is precisely the kind of ‘frontier’ companies best suited to equity investment that we need to lead recovery by pressing on with growth and innovation.
• Second, such deleveraging of debt allows companies the space and flexibility to access new debt finance from a position of strength and for reasons that are beneficial to the economy e.g. capital investment or expansion instead of aiding survival.
• Third, it strengthens the economy’s resilience to future economic shocks.. Heavily debt leveraged companies will find it more difficult to refinance and borrow their way out of any future crises.
• Fourth, equity investors can provide new expertise in terms of leadership, strategy and networks to reach new markets and customers.

Expanding the use of equity in more traditional sectors may require Governments to work with the market to shape instruments more appropriate to businesses whose operating models, markets and growth trajectory will be very different to their usual partners. It would also be necessary to find ways to stimulate the appetite of potential investors and investees; neither of whom has a strong culture or tradition of partnering with the other.

An important development in this discussion is the recent announcement that HM Treasury, the Bank of England and the FCA will convene an industry working group to facilitate investment in ‘productive finance’. Productive finance is defined as investment that expands productive capacity and advances sustainable growth. Examples include infrastructure, research and development, capital investment in new equipment (e.g. a manufacturer investing in a new production line) and embedding advanced technologies.

It can therefore be viewed as a new and bespoke form of equity investment that requires investors to demonstrate patience as returns can only be realised over the longer-term. This work has begun in Scotland with the development of an innovative and new financial instrument which might be applicable to traditional industries. There is a further suggestion that the group’s work will consider how such investment could be made available at tiers of the economy normally considered unsuited to equity; strongly aligning to the Scottish context that I have just described.

My advice is that this is a positive development which the Scottish Government should support: a culture of patient, long-term investment that injects capital for sustainable growth aligns closely to the needs and profile of the Scottish economy, the missions of SNIB and the Scottish Government’s wider economic ambitions.

There are also more immediate economic reasons why Scotland should support the growth of this investment model. Scotland possesses genuinely world class capability in the field of long-term asset management; often managing precisely the pools of capital that are best suited to patient investment. The Scottish industry is therefore ideally placed both to shape and benefit from such initiatives.

Recommendation 5: The Scottish Government should seek to influence the membership and work plan of the UK Productive Finance Taskforce, making clear our world-class capability in this field and ensuring that it produces solutions beneficial to the Scottish economy.

The Scottish asset management industry and the SNIB should collaborate to explore the possibility of creating Scottish patient equity instruments, tailored to the needs and profile of Scottish SMEs.

3. Equity for emerging, high growth industries

The early response to the pandemic has correctly focussed on economic resilience for the protection of businesses and livelihoods. But as focus turns towards longer-term recovery, it is crucial that we maximise the potential of Scotland’s emerging economic strengths to generate growth and job creation. Promising sectors such as fintech, life sciences, space, green and digital technologies should be central to our economic future.

Since the onset of the pandemic, the Scottish Government has put in place strong new policy foundations. Mark Logan’s Scottish Technology Ecosystem Review (STER) offers a compelling blueprint to establish Scotland as a world-class tech hub. The new inward investment strategy is similarly promising and will modernise international perceptions of the Scottish economy through its prioritisation of emerging, innovative and knowledge-intensive sectors. This advice will not repeat the analysis offered in those publications. Instead, in line with my remit to focus on financing recovery, I will focus on providing Ministers with a more detailed treatment of how these policy interventions can be complemented by addressing strategic gaps in Scotland’s high growth investment market.

In this section I explain the main types of high growth equity before exploring the characteristics of the Scottish market and the impact that the pandemic may have on it. I close by echoing STER’s analysis that despite the overall strength of the Scottish investment scene, it suffers from a lack of private venture capital investment which restricts our potential as a first rate start-up nation.

High growth equity: an overview

High growth equity is a specialist form of finance designed to meet the needs of young, innovative companies which are pursuing high growth opportunities. Usually, they are pre-revenue or have minimal sales as they develop their product and achieve market traction. This lack of collateral and negative cash flow means they are unable to access traditional bank lending to finance their growth ambitions. Equity investment fills this gap by investing on a medium to long term basis in exchange for a share in the company. As STER makes clear, a healthy and diverse equity market is critical to a thriving entrepreneurial ecosystem.

Table 2: STER comparison between mature and immature investment markets

Characteristics of Mature Investment Markets	Characteristics of Immature Markets
Mostly VC capital	Mostly “angel” capital
Full range of investments from small to very large	Mostly small investments
High discoverability of prospects i.e. VCs actively scout companies the ecosystem ‘deal flow’	Poor discoverability of prospects – many companies have to go searching for VC.
Lower friction for investors	Higher friction for investors e.g. due to geographical distance and lower density of investable prospects.
Higher pitching expertise among founders	Low pitching expertise among founders
Low-level of government funding	High-level of government funding

Source: Scottish Government, August 2020, Scottish Technology Ecosystem: Review

There are two main sources of high growth equity: business angels and venture capital funds (VCs). Business angels and VCs act as parallel funding sources and, in mature ecosystems with a diverse equity market and sufficient supply of capital, provide two different financing choices for start-up/scale-up companies:

• Business angels and business angel syndicates – wealthy private individuals who invest individually or come together as a group to invest their own money. Increasingly, business angels prefer to invest as part of a syndicate, reducing individual risk and increasing the expertise the syndicate can bring to their investee companies. In combination with Scottish Enterprise, business angels and business angel syndicates dominate investment in high growth companies in Scotland. A successful exit typically takes ten to fifteen years.
• Venture capital funds - professional investors who manage money raised from Governments and financial institutions, e.g. pension funds, insurance companies, endowments and banks. VC funds typically specialise by stage of business, size of investment and sometimes sector. There are few VCs active at the earliest stages due to high levels of risk, whereas risk reduces and likelihood of success increases at the later stages of investment. A successful exit for a VC typically takes five to seven years.

A key benefit of accessing equity is that it is ‘smart money’, providing expertise as well as capital: providing advice, operational support and access to networks that will help companies access markets and customers. Well informed founders will target VCs with networks and expertise relevant to their stage and sector. It is common practice for the public sector to capitalise privately operated VC funds as a means of addressing weaknesses in high growth equity markets. For example, the European Investment Fund (owned by the EU Member States, the European Commission and the European Investment Bank) is a cornerstone investor for any VC wishing to establish a fund in Europe, often providing 30% of the capital value of new funds.

The British Business Bank has similar ambitions for UK-based VCs following Brexit, and is a key investor in the English regional funds, e.g. Northern Powerhouse Investment Fund.

Through the Scottish Growth Scheme (SGS), the Scottish Government has capitalised Techstart and Foresight, two privately managed equity funds focussed on new deals (as opposed to follow-on investment in existing investees) and, in the case of Foresight, on scale-up growth. These funds have been a popular new addition to Scotland’s small VC community.

Impact of coronavirus on the Scottish market

Data published by LINC, the trade body for business angels in Scotland, shows that angel investment activity almost doubled in value during H1 2020 compared with H1 2019^[28]. However, most of that activity was focussed on ‘follow-on’ deals to protect investment outlay on existing portfolios, with less focus on new deals, impacting the availability of capital for earlier stage start-ups looking for their first round of investment^[29]. There continues to be significant anecdotal evidence that companies looking to scale often need to access funding from outside Scotland, and so leave Scotland at the point where they are beginning to scale and create jobs.

It is expected that these trends are likely to get worse, restricting access to capital for Scotland’s best growth and scale companies, and limiting the options for new start-ups. Without broader equity capital, innovative businesses simply cannot survive or grow in Scotland. Since these companies are the employers of tomorrow, this jeopardising an important strand of recovery and growth.

Improving the Scottish equity market

Since this section is focused on financing recovery, I have chosen not to offer detailed commentary on either the UK Government’s Future Fund or the Scottish Government’s Early Stage Growth Scheme – interventions introduced to shore up investment markets in the immediate wake of the pandemic. Depending on how market trends evolve over the next 12 months, it is possible that such exercises will require to be repeated.

But in this advice I am focused on the structural issues in the Scottish equity market that pre-date COVID and that should be addressed over the longer term if we are serious about harnessing high growth emerging industries as a key route to recovery.

In my view, the key issue is that the Scottish equity investment market is too one-dimensional, relying to a very significant extent on business angels and SE co-investment.

To frame this in a different way, there is very little private VC activity in Scotland, with few major external players scouting Scottish start-ups and scalers, and with even domestic VCs focussing their activity on deals outwith Scotland. A number of important consequences flow from this lack of VC activity:

• VCs fund managers offer something different that is largely unavailable in the present Scottish market. A common misconception is that angels and VCs are part of an investment continuum or ‘ladder’, whereby angels pass the torch to VCs as the need for scale-up funding grows. The reality is that this is fairly uncommon. Indeed, a company with investment from an angel syndicate will sometimes find that disincentivises VCs who can view this ownership model as overly complex. VC funds often specialise in particular sectors or forms of technology, and will invest much larger amounts per funding round than business angel syndicates. Many have exceptional experience of advising and developing companies to scale and successful exits. For Scottish companies for whom VC funding is the correct model, the imbalance in the Scottish marketplace is a significant disadvantage.
• Informed Scottish companies more suited to VC than angel investment will therefore look beyond Scotland to find it. Scottish businesses do access VC funding but they usually have to leave Scotland to find it. Developing a relationship with e.g. a London or Paris based VC increases the risk that our best high growth and scaling start-ups will be enticed to join larger ecosystems. There is anecdotal evidence that this is already a feature of the Scottish ecosystem e.g. in preparing this advice we were informed of some life sciences businesses relocating to America in order to access informed VCs with links to an enormous market.
• Wider expertise coalesces around a varied and competitive capital environment. As STER makes clear, the best entrepreneurial ecosystems turn on the availability of talent, capital and infrastructure. Having more diverse sources of capital will attract the attention of other investors, entrepreneurs, corporates looking to acquire innovative companies and the wider community of advisors and prestigious private accelerators who can direct clients towards emerging ecosystems. A more diverse investment market, combined with the world-class support for companies proposed in STER would make Scotland an attractive hub for entrepreneurship and investment.

What we should be seeking to create in Scotland is therefore a virtuous circle in which a stronger pipeline better quality start-ups (which can be delivered through STER implementation) attracts a higher density and diversity of capital; with this vibrant capital market in turn attracting new talent and investment.

Recommendation 6: Drawing on the advice and support of industry, the Scottish Government, SE and SNIB should seek to facilitate the diversification and density of Scotland’s high growth investment market. This can be achieved pro-actively establishing relationships with key VCs, showcasing the best Scottish talent and potentially providing incentives such as capitalising privately managed VC funds with a remit to invest in Scottish companies.

4. Green Finance

From the early stages of the pandemic, Scottish Ministers have emphasised the importance of making economic recovery green. Ensuring Scottish businesses can access sufficient and appropriate finance to support them not only to recover but help them progress towards net zero will be critical if we are to end Scotland’s contribution to climate change by 2045, and to seize the wider opportunities of the low carbon economy.

2021 is an important year for the economy and the climate, with November’s COP26 in Glasgow the focal point. Green finance is a major theme of the UK Presidency, and the UK Government is planning significant interventions to establish the UK as the premier global centre for sustainable investment. Scotland’s finance and business sectors will need to be prepared for these changes, but they also represent a major opportunity for Scotland to capitalise on the spotlight COP26 will cast on our climate credentials and to attract new investment in our recovery and future economy.

Green finance in Scotland

Scotland has committed to reaching net zero carbon emissions by 2045, five years earlier than the UK as a whole. The economic and social transformation required to achieve it will be enormous, but Scotland’s strengths – including in access to renewable energy and natural carbon sinks such as peatland and woodland – mean there are also significant opportunities.

Securing the requisite finance for green projects has historically been challenging, and the public sector has often had to provide incentives through subsidies, price guarantees or regulation to provide certainty of returns. Given the scale of the investment required to reach net zero, this cannot be sustained in the long run.

Technological improvements, combined with a global movement to significantly reduce emissions, is beginning to change this – for example, the decline in the costs of funding offshore wind projects in the UK has contributed to new contracts likely becoming subsidy free by 2023. The growing momentum behind reducing emissions has made investing in combatting climate change more attractive, particularly through Environment, Social and Governance (ESG) investment vehicles^[30].

This year, ESG-focused funds broke through $1 trillion in assets under management. Despite still being a relatively small segment of the market the direction of travel is clear, and has even seen acceleration during the pandemic. In the UK as a whole, more new money was invested in ESG funds in the second quarter of this year than in the previous five years combined, and global estimates show flows into ESG funds comprising between a third and half of all global fund sales over the past year.

As technologies and markets mature, green investments will become increasingly mainstream, bringing even more capital into scope.

To ensure Scotland is taking advantage of the finance that is available, we will need to better understand the market conditions and barriers to investment that Scottish businesses and projects face. Learning from initiatives like the Green Investment Portfolio – which launched in September, and identifies low carbon propositions and markets them to international investors – and the newly established Scottish National Investment Bank, will be important for identifying ways to get as much of this capital flowing into Scotland, and supporting a green recovery, as possible.

Scotland is not alone in looking to expand access to green finance. In November 2020, the UK Government made several significant announcements designed to demonstrate regulatory and policy leadership, as well as solidify London’s position as the leading global centre for green finance. Though light on details, the policies – announced as part of a “Future of Financial Services” statement – are wide-ranging and have potentially significant impacts for Scottish businesses and financial companies.

The Treasury and major regulators released a roadmap for making climate-related financial disclosures (referred to as ‘the TCFD^[31] recommendations’ for shorthand) which sets out mandatory requirements to be applied across the UK economy by 2025 at the latest, with many large firms required to comply from 2021. Requiring more comprehensive climate-related disclosures will allow investors to better price these risks, which in turn should drive investment towards more sustainable projects. This provides opportunities for Scottish firms, but may also impact existing businesses’ access to capital if they are less net zero aligned.

This is likely to be complemented by a new UK ‘green taxonomy’ which will classify investments according to their compliance with the net zero objective.

The taxonomy will be largely based on the version agreed by the EU in 2019, though there may be divergence in some areas. The objective again is to tilt the investment landscape away from ‘brown’ to ‘green’ investments by increasing transparency.

The UK Government also announced that it would issue its first green sovereign bond in 2021, with the intention of building a ‘green yield curve’ over the coming years. While corporate green bonds have existed for some time, the development of a sterling-denominated ‘green safe asset’ could act as a significant boost to market liquidity and create opportunities for Scottish firms that are able to issue green bonds.

The Opportunity

The momentum that is building behind green finance is a very significant economic opportunity for the future of Scottish financial services. We are already a global centre for active fund management and, with the correct positioning, this shift to green has the potential to significantly grow our domestic capability and attract new inward investment.

Together with our natural assets; political commitment to green recovery; world-class research capabilities and an emerging green technology sector, Scotland has all of the necessary ingredients to reap the economic benefits of the shift to green. It is essential that these opportunities are realised.

Hosting COP26 in Glasgow next year will be an important opportunity to showcase Scotland’s credentials as a green finance hub, as well as an attractive destination for green investment.

Major public spending announcements – such as the £1.6bn invested into decarbonising heat and buildings, the creation of SNIB and the implementation of STER to transform the environment for early stage businesses – can all be leveraged to this end.

Recommendation 7: The Scottish Government, Scottish Financial Enterprise and SNIB should work together much more closely to develop a plan to use COP26 to showcase Scotland as a hub for green finance, technologies and investment.