ECONOMIC GROWTH PLAN
By Barry Edwards
All the commentators and advisors writing about the banking and government debt crisis make reference to the vital part of the solution to the problem being a suitable economic growth plan to stimulate business activity.
Although the solution is agreed unanimously, there is no proposal presented by anyone explaining how this can be done.
The discussion is currently dominated by the Euro zone survival, banking solvency and budget deficit problems mainly in Europe and the USA. The politicians are beginning to work through a plan that may finally resolve these crises.
Whatever is decided to solve the problems described above, there will have to be a convincing plan to stimulate growth in conjunction with the overall plan if the solution is going to have any chance of success, especially in the European Union.
The governments, the commentators and advisors all agree that there is precious little funding available from national budgets, consequently there has to be another method of implementing an economic growth plan without direct finance from the national treasuries.
Large companies automatically generate sufficient cash flow to provide the capital to invest in plant, equipment and new projects if they are comfortable with the economic environment that they can see ahead of them.
That is not the situation currently and therefore they are not investing. Vast sums of cash are being accumulated by the largest businesses waiting for the right climate to encourage that investment.
The other main point about the biggest companies quoted in the UK is that the bulk of their earnings are generated overseas and any capital expenditure investment is almost certainly going to be in other countries, which clearly has no impact on the UK economy at all.
The smaller medium sized companies that have traditionally found it difficult to attract the funding to invest in capital expenditure to develop their businesses are the ones that would like to make the investment if they had the access to funding that has consistently been unavailable to them without some form of guarantee. These are the enterprises together with smaller businesses that need the support to invest which will make the difference to any country trying to grow their way back into a healthy economic climate.
Although it is not always stated directly, this is what most commentators are referring to when they ask for stimulation to the economy.
These businesses are the ones that will generate the employment opportunities for people, which is ultimately where the expansion of the economy will come from. All the countries that have this support in place clearly demonstrate that this policy of a balanced economy, properly stimulated in these sectors by government, will reduce the effects of recession substantially. Statistics show that it also helps them to come out of recession much more quickly.
The main point here is that if you wish to stimulate economic growth you have to assist those companies that want to grow and want to invest. They usually have a very good idea how to grow their businesses because they are fully aware of the opportunities open to them.
The trouble is that in many cases they do not have a good detailed plan to show how they are going to take things forward, often because they do not have the time to develop their plans because they are too busy running their businesses, fire fighting and dealing with red tape. This means that if the funding is available, the plans will need to be prepared with professional support and acted upon quickly helping to stimulate activity in a reasonably short time frame, which is exactly what is needed.
This will have the effect of changing the employment environment starting to get people, many of whom are highly skilled, back into work making the confidence of people change dramatically. This in itself changes attitudes, stimulating further investment that has been held in abeyance. The cycle begins to change and the incentive is back in the economy giving that vital stimulus that can only be achieved by people feeling inspired again.
Providing other EU countries follow a similar path this would have a big impact very quickly.
There is nothing like the security of full time employment with a good future to really encourage people to feel confident about their opportunities and start spending the income they are earning.
The Current Situation
The large banks and investment banks are geared to support quoted companies and they are mainly interested in the biggest since they require the services they offer which have been devised specially for them.
Financial institutions handling the savings of most people are only interested in investing in the biggest companies mainly for the security and risk free investments they provide to protect the ordinary saver.
Some banks operating in the High Street are still keen to lend to the right businesses, however they are few and far between. In addition to that they have restrictions placed on them by a) a lack of capital either because of BASEL III regulations or because of the fact that the Investment arm of their organisations are using and losing too much and b) the fact that Risk still holds sway due to the problems of the last 10 years.
POOR BANK MANAGEMENT STRUCTURE
That means that the borrowers need to have a strong advocate in their Bank Manager to stand any chance of getting anywhere. For the majority who are dealt with by a “Small Business Manager” they are reliant on being able to answer the right questions for the computer system. Usually, their bank contact is neither a manager nor does he/she have any in depth experience of understanding business. Only those, and they remain the minority in number, who are able to move up to a Corporate Manager stand any real chance of getting over this hurdle and assess a business directly.
FUNDING SME’s NEGLECTED
That means the financial system is not really structured to handle smaller, medium sized enterprises (SME’s) and larger medium sized companies which is why they tend to get left behind by all those involved servicing the biggest companies and fund managers handling our savings.
In this climate of crisis, even the larger medium sized companies are finding it difficult to attract funding, causing plans for capital expenditure to be postponed, seriously affecting the potential of these businesses to compete in the global market in the years to come.
The efforts to change the support for SME’s over the years have created an environment of sporadic help at times but mainly an income and capital gains tax-free process of investing for better-off individuals. There has never been a properly coordinated policy to set up the system to manage equity investment and lending to SME’s that allows intervention by government to participate in supporting this sector in times of crisis.
The only organisation that is quoted and invested in SME’s is 3i. Unfortunately, they have withdrawn from this market and become a private equity house dealing mostly with larger businesses.
Those professional investors that can invest do not have a proper mechanism by which they can get involved unless they employ the right people to analyse many small businesses which makes it very expensive for them. Some institutions have tried to participate in the past but the funds made available were so small and their term so short that they had no chance of making any impact. Those with experience of professional investment will understand the difficulty of trying to allocate funds to unquoted companies and the advisors to those businesses are fully aware of the unavailability of funding from financial institutions. Even medium sized quoted companies are finding it difficult to attract interest from fund managers.
Clearly a new approach has to be considered to make it possible to direct funding to these companies in a format that is acceptable to the institutional market and the businesses that are looking for their support.
The Economic Growth Plan
This plan is described around the financial environment in the UK but it could be adopted anywhere with the right financial infrastructure in place.
The City of London has widespread sophisticated experienced professionals in most areas of finance equal to any other country in the world. Therefore, it would not be difficult to get the right people involved to manage and fund a new approach to supporting unquoted companies. Some fund managers especially would like to see a way to participate in funding SME’s if there was a proper investment strategy in place to give them the assurances they require. This can only happen if government sets out the strategy for this to be done since there will be a need to change a few investment regulations which can be done in a budget.
The plan involves setting up two organisations described below, which will provide support for SME’s and sizable capital expenditure investment by larger companies and/or new project enterprises specifically created for the construction of new plant. The purpose of this is to have the ability to provide financial support and advice to companies from the early years to enabling large capital-intensive projects to be established in the UK creating many new jobs and helping to rebalance the economy encouraging more high tech manufacturing.
It is expected that many medium sized companies, some of whom may be quoted, will request support to help them expand in the UK and abroad where there is a requirement for capital expenditure investment that would be unavailable from normal funding sources especially in these difficult times.
The organisation proposed to assist SME’s is called an Enterprise Manager, the following is a description of how it would work:-
- It is proposed that Enterprise Managers (EM’s) are authorised by Government to invest equity capital into early stage companies and any viable SME with the potential to grow. In addition, they would offer an advisory service to all SME’s preparing and presenting proposals for lending to banks and other lenders with the option to guarantee all or part of that funding. The rules establishing the EM’s need to be carefully discussed to ensure protection for all parties.
- The companies that approach the EM’s for the advisory service would be asked to sign a simple agreement to state that if they take up the offer made to them by the EM there would be no cost since this would be allowed for in the funding arrangement. If they can find a better offer elsewhere then they would be charged for the work done.
- It is suggested that the Government allows the EM’s to participate in the current Enterprise Finance Guarantee (EFG) and the EU Guarantee Scheme (EUGS) to give them the necessary influence in dealing with investors and lenders. These two schemes are currently managed by the banks and other asset finance lenders. The EM’s would also be authorised to issue guarantees for a fee to lenders to SME’s when all other avenues of financial support have been explored and failed to provide a solution. These loans are currently 75% guaranteed by Government, the directors of the SME’s and the lenders providing the balance of 25%. It is proposed that the EM’s could guarantee 100% of a loan in exchange for a small equity stake for the balance of 25% not guaranteed by Government.
- These EM’s would be authorised to issue 5 year zero coupon bonds on a rolling basis as demand dictates which would provide the equity investment funding. It is proposed these bonds are quoted on the stock market to attract fund managers who would be encouraged to invest on a tax-free basis. It is proposed these bonds would be priced to give a redemption yield of 7% compound. At this yield, each bond would raise £70 on issuance after 2% costs and be redeemed at £100 in 5 years’ time.
- The cash raised from the sale of the bonds would be used for equity investment or profit participating loan instruments (such as convertible loan stock). The cash investment and guarantees would be limited to the full redemption value of the bonds (£100). This would allow the difference of £30 per bond to be used for guarantees for lending at a fee of 3% per annum. The purpose of this is to impose a limit on the issuance of guarantees by each EM, this amount could be increased if it was decided it is too low.
- The sale of the equity investments would be used to repay the bonds and any excess would be divided equally between the bondholders and the EM’s. In the event of any shortfall, the bondholders would receive less than the full amount of the redemption price at the end of the 5 years if the reserves of the EM’s are not sufficient to make up the difference. An alternative could be that the Government could consider guaranteeing these bonds, similar to the KfW organisation in Germany and removing the tax-free status.
- The EM’s would be encouraged to use all the equity and loan structures available including convertible loans and profit participating instruments, where a share of the annual profit is paid over and above the rate of interest fixed when the loan is made.
- The Government would be asked to pass legislation to extend tax free status to the capital gains generated from investment in the zero coupon bonds and any equity investment by the EM’s to individuals for the risk of investing in the bonds.
- Once the EM’s have been established for a while, the guarantee issuing function of the EM’s for loans could be extended to include a securitisation programme for the loans by issuing bonds similar to some other European countries and in the USA. The banks and other lenders would lend initially and then have the option to submit loans that meet the EM’s criteria for inclusion in the programme. Those loans would determine the amount of bonds to be issued. This would provide access to this sector by institutions and smaller banks that do not have the staff and the monitoring capability in place. This would be important to extend the exposure to the SME sector to those that have not been involved in the past.
- Accounts; every company assisted by the EM’s would be required to make their accounts accessible by the EM’s on line on a regular basis (at least once a week) allowing constant monitoring. It would be a requirement that the accounts are prepared in the format set out by the EM system to enable immediate assistance to be given if the analysis shows that the company is not performing in accordance with the business plan. In some cases this would mean the EM’s appoint financial controllers that provide this service for the companies they support where there is no proper financial management.
- Net Asset Value; on day one a formal asset valuation would be carried out and then the on line accounting format would make it possible to calculate the net asset value giving a true value to the zero coupon bonds issued throughout the year. The EM’s would have the option to purchase them if they are quoted below net asset value (not expected to happen unless a large discount occurs). It is proposed that the bonds would be marketable without restriction and capital gains tax free to encourage trading activity.
- Coordinators; every company that is supported by the EM’s would have a Coordinator appointed to visit the company at least once a month to establish everything is conforming to the business plan and discuss with the executive directors the strategy and development of the business. These Coordinators would also be non-executive directors paid for by the company and be the main connection between the EM’s and the company in conjunction with the on line accounting and monitoring process. All these positions will be reviewed annually to confirm compatibility.
- Specialist Professional Advisors; the EM’s would retain a group of specialist professional advisors to provide their expertise when required for the use by companies that they support. Initial consultation would be free to the SME and only work to be carried out would be charged at an agreed rate. It is anticipated that these advisors would be used constantly and permanently engaged for most of their time although they would be self-employed.
- The structure of the EM’s is proposed to be limited liability companies with a small equity base provided by private sources and initial Government guarantees to ensure an administration can be properly created to manage the processing of applicants for funding. It is expected that most of the licensed EM’s would already be active in the SME market with experienced people familiar with funding and advising these businesses. For most it would not take much time to gear up to cope with demand.
- The income generated from the accounting, monitoring, consultancy, interest and guarantee fees would be the revenue to cover the costs of the EM’s. These are costs all companies would normally be paying and are not likely to be that different apart from the all-important expert advice which would be allowed for in the funding package.
- The equity investment made by the EM’s is intended to be for early stage and all SME’s below an agreed turnover level to fill the current gap in the market that has proved difficult to satisfy. The companies supported would have to show that they have the potential to grow to above £500K turnover within 3 years and employ additional people on a long-term basis to be eligible for funding.
- There will need to be new and larger venture capital funds (VCF) with a longer time frame created to take these companies on to the next stage when they have had the opportunity to prove their growth potential and allow the EM’s to re-invest the proceeds into other early stage and growing businesses. The EM’s may also be involved in these VCF’s but independently from their main purpose. They could still provide the monitoring and financial control service for a fee for extra income.
- The EM’s would provide Government with the mechanism to encourage certain sectors of business if they believe special incentives are required to stimulate activity in a specific industry. Another real advantage for Government would be the accurate up to date information available for the SME sector and through the EM’s, enable them to assist and support the whole sector in times such as now.
This scheme offers a number of advantages:-
- The banks are regularly castigated for failing to lend to SME’s. At the same time they are under pressure to improve their capital bases, further reducing the liquid funds that they have available, this scheme would bring an entirely new stream of funding for SME’s to the market.
- It will enable institutional investors to take part in a market segment which has always proved impossible for them to penetrate. It will make it easier for private investors to fund and support SME’s but by investing in a spread of investments their risk will be significantly reduced and it will become much easier to choose where they invest.
- Constant monitoring of financial performance and regular support from Co-ordinators will greatly enhance the performance of the SME’s supported under this scheme and reduce the risk of failure.
- While the tax-free provision of the bonds will be a cost on Government, the actual cost will be dependent on the success of the scheme. The more successful the EM’s become, the businesses supported by the scheme will increase the cost in tax advantages; however this will be more than offset by the tax produced by these companies and the employment they create. Additionally the constant monitoring and support will reduce the failure rate. Failing businesses are an expense to the public purse since they cease to generate tax revenue.
The organisation for capital expenditure has been named The Collateral Guarantee System; this is purely a working title and will probably change. The following is a short description of how this would work: –
THE COLLATERAL GUARANTEE SYSTEM
The Collateral Guarantee System (CGS) is an interest enhancement and project finance mechanism that simplifies the involvement of financial institutions, asset and resource rich enterprises in this area of finance without requiring capital investment.
The purpose of the CGS is to fund projects that do not have substantial equity or guarantees available to help secure the finance required. Many first class projects are not funded because the financiers cannot use the viability of the project as collateral, however good it maybe. Only development banks can actually consider financing projects on this basis.
The following is a description of how the CGS works to help solve this problem.
- Project finance is specialised and demands preparation and analysis to the highest standards. Most projects these days are delivered on time and on or below budget forecasts. Computer software programmes have allowed much of the laborious work to be organised by systems capable of handling and processing every aspect of the construction process to give the professional specialist engineers and technicians the time to correct any problems that do occur long before they become a serious complication. It is a secure and safe risk for lenders with all the checks and confirmations built into the process of disbursing the funds as the construction progresses.
- Stock lending and the use of suitable assets as collateral have been around for a long time. In the case of stock lending, many fund managers use this practice as a means of earning extra income for their pensioners and investors. The fees earned from this activity are usually quite small (about 0.025% per transaction) and only available when a particular fund wishes to sell stock they don’t have, referred to as going ‘short’. All financial institutions that manage investors’ savings are familiar with lending stock.
- The CGS proposes to develop this technique by borrowing securities and assets of all kinds form financial institutions, asset rich large companies and other private asset owners, referred to here as the collateral providers, to be used as the collateral to issue five-year guarantees to lenders to finance projects of all kinds. The CGS takes a charge over this collateral; it is not sold into the market. The securities are held in special accounts and can be traded as normal providing they are replaced with similarly rated securities or cash. All other assets are pledged as per usual lending procedures. Guarantees from the largest companies would be perfectly acceptable instead of a charge over assets.
- In exchange for this commitment, the CGS pays to the collateral providers an annual fee of 3%. This means that if the guarantee is in force for the full five years, the cost of the guarantee is 15%, which is paid out of the funding raised and the profits earned by the project company. In addition, the CGS requires an equity allocation of 15% per annum while the guarantee is in force. It is up to the project controllers to decide when they wish to refinance to remove the guarantee commitment and minimise the equity apportionment, although, the CGS will work closely with the project company to assist with this activity. It would be expected that most projects would be refinanced during the 2nd and 3rd year.
- The CGS would become a shareholder in many project companies that have received guarantees and consequently it would have a significant influence in the development of those businesses. The eventual sale of these shareholdings would provide a substantial extra income for the collateral providers on top of the 3% per annum they would automatically receive. This would most likely be paid during the 4th and 5th year of the original commitment. The CGS would earn a percentage of this extra income.
- All projects must show that they can achieve an internal rate of return (IRR) of 10% and demonstrate that they can generate sufficient cash over the five-year period to enable a refinancing to take place.
- Engineering and specialist consultants, bankers, accountants and lawyers control the projects themselves with the CGS co-ordinating the whole process which is standard practice for most projects where lending is involved. Project managers will monitor the projects while the guarantees are in issue and the CGS will create a specialist-troubleshooting department to handle any major problems.
- It is proposed in the beginning that The Government guarantees that all assets used as collateral will be returned at the end of the 5-year period. A premium would be charged for all those providers wishing to use this insurance. It is expected that commercial insurers and re-insurers will offer this insurance beyond the first 5 years.
- The CGS is an attractive solution for those seeking to expand risk exposure to project finance and a new source of income for institutions, asset and resource rich enterprises. It is also a very good method of helping to reduce the deficits of many pension funds since the extra income will increase their yield as soon as they commit to the CGS.
There are available more detailed descriptions of Enterprise Managers and for The Collateral Guarantee System on request.
If it was decided that the proposals outlined here are suitable as the method of stimulating the economy, there are options available to implement the organisations quickly. Although government will not be providing the funding, it will be underwriting the guarantees issued by the Enterprise Managers and ensuring the collateral is returned for the CGS at the end of the 5-year period. The government is already providing guarantees for SME’s through various schemes so this would not be a major change from the current arrangements. Insuring the collateral for the CGS would work like a re-insurance arrangement (similar to Pool Re, this was the reinsurance company set up by government to cover the IRA bomb threats) and is unlikely to be claimed against since the CGS would build up reserves which should cover any calls against the guarantees, which are not likely to happen until the end of the 5 year period.
To establish the organisations quickly, it would be possible to involve the Bank of England with their quantitative easing programme, an opportunity to get some money to where it is needed directly. The Enterprise Managers will be issuing bonds into the market; these could be bought initially by the bank and resold as demand developed allowing the EM’s to start straight away. The Government would have to guarantee the first tranches to satisfy Bank of England procedures.
A similar approach could work for the CGS; certain projects will be ready to go immediately and bonds could be issued and bought by the bank with a Government guarantee while the collateral pledging was being established and the commercial banks were preparing to make loans against it. The bonds could be placed in the market when everything was setup and working smoothly. Where government guarantees these bonds it would receive the annual 3% fee.
There is a range of other possibilities to get the plan moving quickly which can be considered if the decision is to go forward. However, the structure and implementation described above would be the basis for the economic plan.
THE EXTRA ADVANTAGES OF THE CGS
Although the basic principle of the CGS is very straightforward, it does help solve various major problems that have a serious impact on Government thinking and decision-making. The list below gives a brief description of some of those:-
1) Government starts to receive tax revenue from the moment the CGS is created.
2) Government can establish an increase in the state pension for those that have savings or equity value in their homes creating a real advantage for those people who have made provision for their retirement. This would allow government to increase the pension tax allowance for those pensioners with a lower income.
3) Pension fund managers can make plans to restore the private pension entitlements that have recently been cut back for pensioners both current and for the future with the annual extra income of 3% from the CGS.
4) Commercial activity will start to be rebalanced increasing industrial investment immediately.
5) Exports will begin to increase as the industrial investment begins to work through the system.
6) The CGS is very flexible and will allow involvement in many business activities creating many new businesses.
7) The film industry in the UK would be particularly suited to the CGS removing the need for government support. This would really allow the recognised talents which are well respected worldwide to flourish without restriction that have been held back because of the lack of funding available in the UK and Europe.
8) The CGS will involve itself in funding investment worldwide helping to provide the professional consultants with a substantial increase in fees allowing them to expand internationally.
9) Provides a return for marketable assets that do not pay out a regular income such as forests, farmland, zero coupon bonds, vacant property, works of art, jewellery and corporate tangible assets.
10) Introduces new techniques for investment such as new derivatives based around the CGS structure enhancing the market acceptability.
11) Reduces unemployment and increases industrial activity in areas that need regeneration.
12) Provides an alternative to the private finance initiative (PFI). This would be a special division for infrastructure investment. It would allow government to undertake a much bigger infrastructure plan that is under consideration at the moment utilising the CGS mechanism.
13) Allows government to encourage specific industries without providing grants. This would be another special division where the guarantee commitment would be taken over by government completely or in part. There would be no equity involvement for the CGS where there is no risk. These projects would utilise the experience, facilities and reporting process provided by the CGS.
14) Simplifies the process of financing commercial and industrial investment. This would allow companies to be certain they could raise the funding for a capital investment plan providing they met the criteria set out on the website. This would be an enormous incentive for companies of all sizes to explore expansion and growth plans.
The concept of the CGS especially has been devised over many years and has embedded within it many advantages that are not immediately obvious to someone reading through this paper. It is also very adaptable to utilising new ideas and innovations since every aspect of the process described is currently being used by the financial community in the daily course of business activity within the system currently practiced.