The term “credit crunch” was first uttered by some of my contacts all the way back in the summer of 2007 as a means of explaining Ford’s difficulty – at least initially – in finding a buyer for Jaguar Land Rover. That deal did not go through until early 2008, when the full scale of the global economy’s problems was beginning to be revealed. That drying-up of credit was blamed throughout the recession for the failure of many otherwise sound businesses and, as we reach the end of an economically catatonic 2011, it is by no means clear that the situation has improved.
For example, the Office for National Statistics has found that in 2007 90% of approaches to banks for loans were successful – this fell to 65% last year, when engineering firms were enjoying a strong exit from the recession. The ONS data also found that the number of small and medium-sized businesses seeking finance rose sharply during the recession and that five out of six businesses surveyed were dependent on finance from banks. The taxpayer-owned Royal Bank of Scotland has recently admitted that it must increase lending to small businesses, by around 15%. The bank has been criticised for not doing enough to support the economy.
Manufacturers’ organisation the EEF monitors bank lending to engineering businesses and its chief economist Andrew Johnson says there are some grounds for optimism. There has been some improvement in the availability of credit, he says. “For the last couple of quarters the number of companies saying availability of credit has improved has outweighed the number saying it has got worse. During the financial crisis that balance had been consistently negative. What’s particularly encouraging is that small firms, who tend to have the worst access, have also come into positive territory.”
But the cost of credit is not improving, Johnson says. This may not be so much in terms of the rates at which loans are being offered – although these are none too generous – but in terms of extra fees and charges applied by the banks. Such charges, says Johnson, are more in the control of the banks as they are unrelated to the volatility of the wholesale funding markets.
Perhaps what is needed most of all is more competition among banks on the British high street. “If you look at the competitive landscape of UK banking – or rather the non-competitive landscape of UK banking – the cost of lending is the kind of thing that would be amenable to competitive pressure.”
There could also be improvements in the relationships that manufacturers have with their banks. While banks are arguably not lending as they could, customers are also discouraged from even applying for finance. This concept of “discouraged demand” reveals what Johnson calls “a broken relationship” between banks and their customers.
He says: “The banks keep telling us that they are open to lend and they want to lend but businesses are saying they don’t want to go and see the bank for fear of being rejected or worse, such as a change in relationship or withdrawing of facilities.”
Banks sometimes cite a dearth of demand as part of the reason why lending is down, with companies also perhaps cautious about taking on debt in choppy economic waters.
Big bucks
Money is available for large investments in engineering companies, says Lloyds Development Capital (LDC), the private-equity arm of Lloyds Banking Group. The company announced
£200 million of new investment funding for specialised engineering and manufacturing businesses recently. LDC typically makes investments of £10 million to £100 million.
Rob Schofield, a Birmingham-based LDC investment director, says engineering companies are part of the firm’s heritage since it has a strong presence in the Midlands and the North. Schofield believes debt finance has become a problem again in recent times. “I think that’s probably something that’s happened in the last few months. The world has started to change and credit has started to tighten,” he says.
“The banks have started to look more closely at who they’ll lend to, what they will lend, and the cost. Your ability to fund growth through debt finance runs out. A way of bridging that is to find another form of finance, and private equity is an obvious solution.”The desire to invest in engineering firms with the £200 million fund is based on strong fundamentals, Schofield points out. “We’ve seen an increase in orders and activity over a two-year period. In certain sectors, such as aerospace, you can see a point where companies are running out of available forms of finance to fund their growth if aircraft deliveries increase at the rate anticipated over the next three or four years.”
So what does Lloyds Development Capital look for in an engineering business in which it considers investing? A strong management team is a prerequisite as well as a business plan that targets growth or value creation in other ways, such as operational improvements.
Some of the companies LDC targets have very high-end design or engineering capability but others make simple things that have a strong proposition in terms of service or aftermarket support. Others make simple things in innovative ways where the processes themselves are hard to replicate.
Schofield says: “We like companies with those assets. There are plenty of businesses that just get given a print from their customer to build something, but actually making it involves a huge amount of know-how or art in the process to do it cost-effectively, and those companies are interesting too.”
LDC is also keen on companies that are either already operating overseas or have ambitions to do so. “We’ve been good at operating in China and have an office there. And we can assist companies that need to buy businesses in Asia to get into those markets,” he says.
“Obviously everything is subject to the macroeconomic environment, and there’s more uncertainty there now than there has been for some time. But British engineering and manufacturing still has a strong base and many firms have the opportunity to export thanks to the strong dollar. While headwinds could rise, the underlying engineering and manufacturing sector is in good shape.”
Prize fight
Another financial avenue that could prove particularly useful to companies that are at very early stages of development – such as university spin-outs – is prize competitions. Cella Energy, a spin-out from the Rutherford Appleton Laboratory at Harwell, Oxford, won a £156,000 prize fund in October when it took first place in a global energy storage challenge sponsored by the US Office of Naval Research.
Cella focuses on developing low-cost hydrogen storage materials. The result is a fuel with more energy than gasoline or lithium-ion batteries that could be handled safely in the open air and pumped like a fluid, Cella says. The company’s chief scientific officer, Professor Stephen Bennington, has overseen two rounds of investment in Cella Energy over the past year which he admits is “quite astonishing” in the current climate.
“To have two rounds within a few months is very pleasing,” he says. “We are already thinking about the next stage, which we hope will raise in the order of £10 million to £20 million.”
Winning the £156,000 prize fund in the energy storage competition is not enough to, for example, enable the company to change direction, but it does raise Cella’s profile as it looks for strategic partners in the automotive industry. Bennington says: “Winning the award gives us a lot more freedom than we would have otherwise. It gives you a level of exposure and investors a level of confidence, in that you’ve been judged by a panel of experts and that panel thinks that what you are doing is real.”
The contest that Cella won was organised by OmniCompete, which runs prize competitions in security and healthcare as well as energy. The model – in which large organisations sponsor prizes to solve problems – was developed by chief executive officer Simon Schneider while he was on an MBA programme at the London Business School.
Schneider identifies a £2 billion shortfall in funding in the UK alone for small firms. For early-stage funding, venture capital tends to favour projects with low start-up costs such as social networking or other websites at the expense of capital-intensive programmes in engineering, he says.
“In Europe there is a gap. There might be initial university funding but the only venture-capital firms who play in high-tech or heavy engineering come in at a later stage. Those are the people we can reach because we can give them the first £100,000 that brings them to the next level where they can go to, say, private equity,” says Schneider.
“Banks are even further along the entrepreneurial lifecycle. If you’re at the beginning, and you don’t have any assets, no bank in the world will lend you any money.”
Schneider worked for a large US technology corporation in New York in the wake of 9/11 when he first began to develop his ideas. Interest in security products was strong and he was charged with hunting for new ventures with groundbreaking ideas in areas such as biometric scanning and fingerprinting. The problem was, he says, that it wasn’t always the provider with the best idea that would be selected.
“The process wasn’t transparent,” he recalls. “There was a big middleman in the way. I wanted a change. We needed to change the way we connect with people, to bring the people who have the ideas to the people who need the ideas.”
OmniCompete points to the level of subsequent investment – $117 million – in companies that have won its prizes or reached competition finals as evidence of the success of its early-stage approach. “It’s the only number that counts, the number by which I measure my own success,” says Schneider.
The model might well change in the future, with companies and organisations doing more than sponsoring competitions – they could take stakes in the firms that win. “Who says you have to give away a prize for free? It could get to the stage where organisations don’t just donate the prize fund but make an investment in the winner, or the best entrants, whose ideas can solve previously unsolvable problems.
“Prize competitions can be used for a wide range of purposes. This is a remarkable tool that can produce incredible results for many countries and companies around the world,” he says.