Open for applications
Purpose
Each ECF will be a privately managed fund, established specifically as an ECF, for the purpose of investing equity or quasi-equity (Mezzanine) capital in SMEs affected by the equity gap.
Fund Life
ECFs will be fixed-life funds, extendable only with the consent of British Business Finance Limited (‘BBFL’) and other investors; they will not be ‘evergreen’ funds that continually recycle investment returns.
Ownership
The instruments of ownership of an ECF will not be tradable on public markets.
Tax Incentives
To help ensure that ECFs attract additional capital into the equity gap, rather than merely displacing investment that would otherwise have been channelled through the Enterprise Investment Scheme or Venture Capital Trusts, the Government does not provide tax incentives to ECFs or their investors. Nor will BBFL support propositions that have already raised sufficient private capital to operate as a commercially viable fund.
Structure
The fund’s principal place of business must be in the UK. BBFL assumes that Prospective Managers will wish to structure their funds as English Limited Partnerships (“LPs”). This is a widely used structure for funds that are managed by professional fund managers on behalf of ‘passive’ third-party investors and is likely to be suitable for most prospective managers.
Waterfall
Once the ECF has met its expenses and liabilities (including fund management fees), subsequent proceeds from investments will be distributed to investors in the following priority order:
- first, repayment of capital to both the private investors and to us; and
- once all payments under (1) above have been made, as distribution of profits to private investors, BBFL and (where appropriate) as carried interest to the fund managers.
Prospective managers must specify the terms for capital repayment under (1) and the profit-sharing ratio and any carried interest arrangements under (2). Repayment of capital under (1) shall be on terms that are no less favourable to BBFL than to the private investors. Further details of the capital flows are given in Key Features. Funds will be expected to offer a fixed profit share to BBFL throughout the distribution of profits (2 above) regardless of any arrangements for profit share (carried interest) to the fund managers.
Operation of the Limited Partnership
It is expected that the standard limited partnership structure will be appropriate for ECFs. In this structure, BBFL and other investors in the fund would be limited partners, and the general partner would appoint a fund manager responsible for managing the activities of the partnership. In order to preserve their limited liability, the limited partners do not become directly involved in the management of the fund.
Structure of participation
The limited partnership must be established specifically for the sole purpose of investing as an ECF. The partnership must have a fixed lifetime, though the legal documentation may allow for extension with the consent of BBFL and other limited partners. It is envisaged that most funds will adopt a ten-year lifetime with an option to extend for up to two years, in line with common practice in the venture capital industry, but BBFL may consider alternatives where a suitable justification is provided.
BBFL, other investors and carried interest recipients will each contribute a nominal amount of capital to the partnership, in proportion to their respective shares of the profits of the fund. As in a standard venture capital limited partnership, these capital contributions will constitute a fraction of the total commitments to the fund.
The remainder of commitments will be in the form of loans, to be drawn down into the partnership as and when required by the fund manager. Loans will be non-interest- bearing
The fund manager may also wish to make commitments to the ECF on the same terms as the private sector investors, and this would be viewed as a positive signal of the manager’s commitment and belief in the likely success of the fund. Where this is the case, the legal agreements will need to contain provisions to overcome any potential conflict of interests.
Fund manager remuneration and other fees
BBFL recognises that investors typically wish to remunerate fund managers by a combination of:
- a management fee, set at a level that is just sufficient to permit the fund manager to invest and manage the fund effectively; and
- an appropriate carried interest provision. Any hurdle should be set at a level that is stretching but achievable, and the rate of the ‘carry’ should be no more than is sufficient to create a strong incentive for the fund manager to maximise the financial performance of the fund.
However, this structure may not be appropriate in all situations, and prospective managers may want to discuss alternative remuneration structures. If so, they will need to explain why the proposed structure is desirable from the perspective of BBFL and other investors in the fund, and they must demonstrate that it provides a clear link between the performance of the fund and the remuneration of the fund manager.
Prospective managers must also specify the level, structure and timing of any other fees or charges that would be applied, e.g., any application, arrangement, and monitoring fees to be charged to investee SMEs. They should also note BBFL’s very strong preference for such charges, where levied, to accrue to the fund rather than to the fund manager. Prospective managers should demonstrate that any such fees are kept to a minimum, so that as much of each investment as possible is available for the SME to use to develop its business, rather than to pay fees back to the ECF. Where fees relate to a specific investor in the ECF, e.g., in the case of commission fees paid to IFAs or intermediaries who introduce investors to the fund, BBFL would expect these to be borne by the investor or manager concerned, and not by the fund as a whole but would again expect these to be kept to a minimum.
As part of each proposal, BBFL will also wish to see projected budgets for the fund manager, to demonstrate that the level of the proposed fees will be sufficient to enable the fund to be properly managed, but not excessive.
Taxation
Limited partnerships should be treated as transparent vehicles for UK tax purposes; the tax treatment of the general partner will depend upon its legal structure
The rights of BBFL as a Limited Partner
BBFL requires a right to participate in decisions that normally require the consent of the majority of limited partners, such as extending the lifetime of the partnership, replacing the general partner, changing the terms of the partnership agreement or resuming drawdowns and investments following a suspension.
Although BBFL will often be investing the majority of the funds into an ECF, it recognises that private investors may be reluctant to invest if BBFL were able to liquidate an ECF or take other major decisions without consulting the other limited partners. For such decisions, the consent of BBFL and a majority of the other limited partners would normally be needed. This should provide reassurance for private investors that, although BBFL is the majority investor in an ECF, it cannot unilaterally act to their disadvantage.
The only exceptions would be in cases where the fund manager has materially breached the terms of the partnership agreement (including the agreed investment strategy) or is otherwise fraudulent or negligent. In such cases, BBFL will require an option to remove the general partner, with or without the consent of the other limited partners (please see the ECF draft Limited Partnership Agreement). The choice of replacement general partner would need to be agreed between BBFL and the private investors.
Investor Committee
It is envisaged that each ECF would have an Investor Committee, which meets at least twice annually, comprising representatives of BBFL and some or all of the limited partners. This would provide an opportunity for the investors to meet to discuss the performance of the fund with the fund manager. The fund manager could also consult the Investor Committee on specific issues, for example if it were unclear whether a proposed investment fell within the agreed investment policy.
The role of the Investor Committee would be purely advisory. To protect their limited liability, the investors should not participate in the day-to-day management of the partnership’s business.
BBFL expects that each representative on the Investor Committee would be remunerated by the investor(s) whom they represent, although prospective managers may specify that reasonable travel costs incurred by representatives attending Investor Committee meetings will be charged to the fund.
Interaction with the regulatory system
Although ECF’s themselves are unregulated the General Partner will be required to appoint a fund manager to establish, operate and in due course wind up the partnership. If the fund manager manages the ECF from the UK, the fund manager will need to be authorised by the Financial Conduct Authority (FCA) to carry on regulated activities, in accordance with FSMA.
No implied warranty
Any specific reference to the Government, the British Business Bank or BBFL in publicity materials relating to an ECF must be approved in advance by BBFL, except where providing only basic factual information that is already in the public domain,
e.g., the amount or terms of proposed BBFL participation in the fund. Under no circumstances should our agreement to participate be described or interpreted as implying any kind of endorsement, warranty or guarantee of performance by the fund, and any promotional materials issued in relation to the ECF must include a warning to that effect.
Drawdowns
Loan commitments will be drawn down into an ECF on a ‘side by side’ basis from BBFL and the private investors, pro rata to their total loan commitments. It is anticipated that loan commitments from BBFL will be drawn down on an ‘as required’ basis. BBFL will require at least 10 business days’ advance notice of any drawdowns and will expect ECFs to provide monthly indicative forecasts of likely drawdown requirements.
Prospective Managers wishing to raise private capital from individual investors will need to propose arrangements to satisfy BBFL that the private capital will be available for drawdown when needed. For example, it may be appropriate for some or all of any commitments arising from individual investors to be placed in an escrow account or drawn down into the ECF at the start of the fund’s lifetime.
In the event that a limited partner fails to meet a drawdown notice, it will be liable to pay interest and, unless the default is rectified, the defaulting partner will lose their entitlement to distributions during the lifetime of the fund. Any distributions to that investor at the end of the lifetime of the fund would be limited. However, BBFL does not believe that such punitive provisions should be applied following the death of a limited partner.
Capital that is drawn down into the fund but not yet invested or otherwise expended (e.g., on management fees) must be held on deposit with a major UK clearing bank, except where BBFL approval has been sought and obtained.
Fund managers may wish to cancel outstanding loan commitments if it becomes clear that they will never be drawn down. In such cases, loans will be treated as having been drawn down and repaid immediately.
Distribution of returns
When an ECF earns a return from an investment, either from interest or dividend payments from an investee SME or from a realisation, it will not be permitted to recycle those funds for further investment (except under the specific circumstances described in ECF draft Limited Partnership). An ECF will be expected to make distributions once it has the necessary income or capital gains from realisation of its investments and has met its expenses and liabilities (including fund management fees). The two ‘tiers’ of the distribution are summarised in Waterfall above and are discussed in more detail now.
Repayment of capital
Once BBFL has received its prioritised return, outstanding loans may then be repaid to BBFL and the private investors under the terms specified in the proposal, which will be written into the legal agreements. Loan repayments may be made to the various parties on a pro rata basis, or Prospective Managers may specify an alternative arrangement that repays BBFL more quickly.
Where there are amounts of loan commitment still to be drawn down, repayments will continue in this tier until BBFL has been repaid an amount equal to 85 per cent of its total loan commitments (regardless of whether those loan commitments have yet been drawn down). This is necessary to protect BBFL from a position in which early profits are distributed to private investors, and the fund subsequently fails to generate sufficient returns to repay future drawdowns.
Distribution of profits
Assuming obligations under tier (1) above have been met, all further distributions to investors will be divided between BBFL and all other parties in a fixed profit-sharing ratio. Prospective Managers must specify BBFL’s profit share in their proposals, expressed as a percentage that will apply to all distributions of profit; the remainder will be allocated between the private investors and, where there are carried interest provisions, the fund manager. BBFL’s profit share should be a fixed percentage of profit that remains constant throughout all profit distributions.
In cases where standard carried interest provisions are to be included, profits will be distributed:
(i) first, to BBFL and private investors, in line with the profit-sharing ratio, until a certain ‘hurdle rate’ has been achieved and distributed. The hurdle rate is to be specified EITHER:
- as an amount equal to interest calculated on the daily balances of loans outstanding to BBFL and private investors; OR
- as being just sufficient to ensure that the private investors have received a certain annualised IRR.
In either case, the level of the hurdle and the basis for calculation should be clearly specified. Prospective Managers may choose to provide for a gradual ‘catch-up’ for the carried interest recipient from the private investors’ share; and
(ii) second, any further profits are divided between BBFL (in line with its fixed profit share), the fund manager (in line with the carried interest share), and the other investors (pro rata to their investments in the fund).19
Prospective Managers may specify alternative incentive structures to the standard carried interest provisions if this is more appropriate for their proposals, so long as they can still demonstrate a clear link between fund performance and fund manager remuneration.
Co-investment agreements
ECFs wishing to enter into co-investment agreements with other parties should provide details of the proposed terms of such agreements as part of their initial proposal, including the reasons why the proposed arrangements would be in the interests of the ECF’s investors. This might, for example, be appropriate for an ECF wishing to raise and leverage funds from institutional investors, to be co-invested alongside a group of experienced business angel investors.
Co-investment agreements may also be appropriate where an ECF fund manager is associated with another venture fund and where the investment mandates of the two funds overlap. In these circumstances, it would be appropriate to agree in advance how deals will be allocated and shared.
Management of EIS / SEIS Funds
BBFL has seen many proposals that include provision for an ECF to be managed alongside current or future EIS funds. Whilst this is not precluded under the rules of the programme, prospective managers should note that, other things being equal the management of an ECF alongside the management of an EIS fund by the same manager is a less attractive option than one where all funds are invested through the fund. This structure will only be allowed where BBFL can be satisfied that the manager will put in place satisfactory mechanisms to deal with the commercial and governance issues that arise from such an arrangement. In cases where this can be achieved it is still likely to add significant time to the selection process.
Conflicts of interest
There is scope for various conflicts of interest to arise during the lifetime of an ECF. Potential managers will be required to highlight any potential areas where this may be the case and should propose mechanisms to resolve or manage these conflicts. This will not be regarded as a negative feature of an application, so long as BBFL is satisfied that any conflicts would be handled in a manner consistent with the interests of BBFL and other investors in the ECF. Wherever possible, prospective managers should follow commercial best practice in managing potential conflicts. prospective managers should note that failure to disclose any material conflict of interest that is subsequently identified in the assessment process will be regarded as a significant negative feature.
Involvement with investee companies
An ECF may wish to designate one or more individuals to serve as an officer, director, or other participant in the management of a portfolio company. Such person, if they are not employed as part of the ECF management team, may receive commercially appropriate director’s fees and properly reimbursable expenses incurred by that person in their capacity as a director, and distributions based on the person’s ownership interest (if any) in the company. The level or basis of calculation of any such fees and expenses should be specified in the application. Any income received by a member of the ECF management team in connection with their involvement with an investee company, or anything else of value received from the portfolio company must accrue for the benefit of the ECF and not the appointed director.
Key personnel
‘Key personnel’ includes any individual whose experience and expertise a prospective manager wishes BBFL to take into account when assessing their application. For these individuals, the ECF partnership agreement will include provisions to ensure that the key personnel named in the application actually dedicate the specified amount of time and effort to the ECF.
The partnership agreement will specify the circumstances under which key personnel may be replaced. Such changes will require the consent of the limited partners, including BBFL. Before giving such consent, BBFL will wish to be satisfied that the replacement is at least as well qualified and experienced as the individual being replaced and will integrate successfully with the rest of the management team.
The legal agreements will include a right for the investors (including BBFL) to agree to remove the general partner or suspend new investments by the partnership in the event that satisfactory replacements are not put in place within a reasonable time period.
Transfer or sale of instruments of ownership in an ECF
It is intended that investors should be committed to retaining their interest in an ECF for the lifetime of the fund, but BBFL recognises that changing circumstances may mean that a private investor wishes to sell or transfer their interest in a fund. On transfer, the recipient will take over the obligation to meet any loan commitments not already drawn down from the vendor (as well as the right to receive repayments of capital and profit share).
BBFL approval will not be required for transfers of ownership where the ECF is operated by an FCA-authorised fund manager who has undertaken an appropriate level of due diligence in relation to the new investor. However, consultation with the investor committee will be required.
BBFL will also wish to retain the right to transfer its interests in an ECF.
Reporting requirements
Meetings
An ECF must have a Limited Partner Advisory Committee comprising of at least two members, one of these being a representative from BBFL. The Advisory Committee will meet at least twice a year with the fund manager providing commentary on deal flow, marketing activity, investment and disposal activity, progress of portfolio companies and fund administration.
Quarterly Reporting
ECF managers will be expected to produce quarterly reports in the form of BBFL’s reporting templates which as a minimum contain:
- the length of time since the acquisition of each investment within the portfolio;
- details of the investments purchased and sold within the period;
- a statement of the investments and assets of the partnership with commentary on the progress of investments and any significant developments or events affecting the portfolio;
- the fund managers unaudited valuation of each investment; and,
- all prospective investment opportunities considered by the fund manager in the period.
Valuations
Fund managers will be expected to follow the International Private Equity and Venture Capital Valuation Guidelines produced by the International Private Equity and Venture Capital Valuation (IPEV) Board when valuing investments, and will be required to produce quarterly reporting following the BVCA reporting template (a copy of which will be provided by BBFL). This will cover summary fund data and more detailed portfolio reporting for all investments, including details of investments bought and sold in the period, brief updates of the progress of each portfolio company, valuations of each investment and BBFL’s interest in the ECF, and brief details of investment opportunities considered (but rejected) during the period.
In addition to the BVCA best practice BBFL considers that two additional measures should be added to the monitoring data requirement:
- a measure of the investee’s performance against the fund manager’s forecast; and
- the holding period of the investment
Fund managers should be prudent and consistent in their valuations and will do this by valuing investments in line with current IPEV guidelines. BBFL may also require additional reporting data (for example in relation to the employment and turnover of investee companies) to enable it to further evaluate the impact of the ECF programme on equity gap SMEs. Consequently, the ECF should make it a condition of funding that the SME provide such data if and when required.
The quarterly reporting produced by fund managers will provide the template and the data required for the ECF’s annual report. The annual report, consistent with the BVCA’s reporting guidelines, will include an audited profit and loss account and balance sheet.
Annual Reporting
Fund managers will be expected to prepare annual accounts for ECFs, in accordance with IFRS accounting standards.
ESG
Relevant ESG reporting, determined by BBFL’s requirements, will be requested from the fund manager on a quarterly basis. We intend to work with fund managers who can demonstrate they have credible plans, to report on their own portfolio emissions and to enable portfolio companies to transition towards net zero. Regulation around emissions reporting is fast changing, and the Bank will work with fund managers throughout this journey.
All such information received by BBFL will be treated as confidential, although BBFL may wish to release aggregated data on the performance of the ECF programme as a whole. Information relating to specific funds or businesses will be passed to external parties only where required by law or where necessary to support independent evaluation of the ECF programme, and any external researchers would be bound by appropriate confidentiality provisions.
National Audit Office Requests
The role of the National Audit Office (NAO) is to report to Parliament on the spending of central Government money. It conducts financial audits of all Government departments and agencies and many other public bodies, and reports to Parliament on the value for money with which public bodies have spent public money.
ECFs will be required to cooperate fully with any requests for information from the NAO
Where an enterprise is not autonomous, the employment, turnover and balance sheet of ‘partner’ and ‘linked’ enterprises must also be taken into account when ascertaining whether or not the enterprise is a SME. An enterprise is autonomous if:
- it does not have a holding of 25 per cent (in terms of capital or voting rights) or more in another enterprise;
- it is not 25 per cent or more (in terms of capital or voting rights) owned by any enterprise or public body or jointly by several linked enterprises or public bodies, with a few exceptions; and
- does not draw up consolidated accounts and is not included in the accounts of an enterprise which draws up consolidated accounts and is thus not a linked enterprise.
However, generally, venture capital companies may own up to 50 per cent of an enterprise’s capital or voting rights without affecting its autonomous status.
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