Creating Risk Capital. Ian Whalley
area of finance.
Yet all too often, sadly, the lack of risk capital on suitable terms frustrates the ambitions of such people. Much worse, it can lead them into unsuitable arrangements, often followed by debt and distress for themselves and for others involved in their enterprises. So while there is no single or simple solution to the difficulties associated with the provision of risk capital, if this book can lead to one complementary route, suited to finance providers and users alike, it will achieve its purpose.
A current perspective
It is hard to exaggerate the vital importance of private enterprises. They provide all manner of goods and services for citizens and consumers. They generate employment and public revenues through the taxes they pay. They create the wealth which allows for education, health, provision for old age, defence, entertainment, leisure and much more besides. In short, they play a critical role in society and the economy, and in the prosperity and well-being of citizens. Whether they are business firms, major companies, or diverse enterprises such as mutual, co-operative or non-profit organisations, they affect the quality of life every day, everywhere.
These enterprises owe their existence to the rich infrastructure of industrial, commercial, financial and legal systems, which has been developed and honed over centuries to meet the ever-changing needs and problems of society, business and government. Rarely are the needs and problems of today entirely new: the merchants and bankers of Augsburg, Lombardy, Florence and Venice, like the Fuggers and the Medicis, will have met many of them in their day. Nor are most of the innovations entirely new, however much trumpeted as such: present and future generations will surely build on existing systems for solutions to the challenges and problems that emerge.
And problems do emerge. Constantly. For example, raising capital for small and medium-size enterprises seems to present chronic problems in terms of both supply and demand. At the other end of the scale, widespread dissatisfaction with standards of behaviour and competence in some major companies, where managers have exploited their position for their personal gain and prestige, has led to disenchantment with the dominant public company model.
Moreover, this model seems ill-suited to many enterprises, like banks and utilities, which provide what are traditionally regarded as public services: here there is a question of legitimacy, when the need to make profit as a major quoted company may be perceived as taking precedence over the public interest. Nor does the model work for the very large number of enterprises which want or need to retain their independence, such as private firms, non-profit and employee-owned enterprise. We will be looking at how these sorts of enterprises can raise risk capital without losing their distinctive character.
The financial crisis of 2007-2009
Endemic problems like the ones cited above came into sharp relief in the financial crisis of 2007-2009, when extremely serious banking failures threatened whole national economies and the international financial system. Among the very damaging consequences of this crisis, capital and credit became unobtainable for many small and medium-size firms and the diverse independent enterprises which complement them; the inadequacy of regulation and corporate governance norms with regard to abuses and failures at major companies and core financial institutions was starkly revealed; and the provision of public services, including those delivered through private enterprise, came under acute pressure amid severe austerity measures.
The steps taken to resolve the crisis, frantic as they often were, involved large-scale state intervention to restore confidence and stability in financial institutions, even bringing some of them into public ownership. The outcome remains uncertain, as unsettled financial and economic conditions continue to cause much hardship in 2011. Meanwhile, the crisis provides a salutary reminder that whatever systems, models and regulations are adopted, and however rigorously they are applied, none of them are foolproof or perfect, and they will all ultimately depend on the integrity and trust which sustain all social and business dealings.
Some basic facts
A number of principles apply to enterprises of all kinds. When new, they require capital, because they have to spend money before they can earn any; they tend to need more capital as they grow, a constant amount when they are running evenly, and less as they decline. This capital is at risk of loss, because once spent or invested, it may not be easily recovered. Where it comes in different forms or from different sources, some parts of the capital rank behind others and are therefore more at risk when it comes to repayment; and finally the providers of the capital which is most at risk usually take ownership and control of the enterprise.
It is the last of these facts which can cause a major problem if good investors make poor owners or vice versa. Thus, if those who are best equipped to own and control the enterprise cannot provide, borrow or generate the risk capital which is needed, they may have to cede ownership and control in whole or in part to those who can, but who may not necessarily be such good owners.
Philosophy and ideology
Much of what is written about capital and the ownership of enterprise, as well as related subjects like governance and control, or risk and reward, covers issues like public versus private ownership, mutual versus investor ownership, and profit-driven versus non-profit enterprise. In addressing such issues, it may reflect a particular philosophy or even ideology.
This book is not driven by any such philosophy or ideology. It takes a pluralist view and recognises, pragmatically, that different ownership structures might suit particular enterprises better than others, and that there is much virtue in diversity of ownership form as well as of enterprise itself. A sound, well-managed enterprise should, regardless of its ownership, be able to raise and reward capital.
Risk
This book is about risk capital but it is not about seeking risk for its own sake, nor is it about speculation and gambling; on the contrary, it assumes that the risks of an enterprise are carefully weighed and minimised. Yet it recognises that the world is an uncertain place, and that without some risk, whether high, low or somewhere in between, no projects can be undertaken and no progress will be made. It also provides an enticing prospect that the corollary may hold: that if more risk capital were available, and properly applied, more enterprises could prosper and grow to the benefit of us all.
PART I. A RICH INHERITANCE
It should not be forgotten that England is enjoying a higher standard of living to-day because of the efforts of the nineteenth-century industrialists to open up vast tracts for settlement… and create risk capital. All of us… are living upon the riches that they made possible.
Bryher, The Heart to Artemis: A Writer’s Memoirs (Paris Press, 2006), p. 312.
The novelist and poet Bryher was the daughter of an outstanding industrialist, Sir John Ellerman, and was herself a pioneer in publishing, literature and film, and a brave benefactor of refugees escaping Nazi persecution in the 1930s. Ellerman, whose father came to England from an emerging Germany in the mid-nineteenth century, built a shipping and property empire which helped to make him the richest man in Britain. His merchant fleet played a key role in the Boer War and then in World War I, when Britain faced a deadly submarine threat from an Imperial Germany.
It is the builders of enterprises, like Sir John Ellerman, who create risk capital in its classic form: the ownership capital, or equity, which serves as the core financing of private enterprise and represents much of our wealth. Equity, in this specific sense, is pure risk capital, but in a wider sense it conveys fairness and moral justice: key elements of the bedrock which all societies need in order to flourish.
Due in no small measure to the efforts of these enterprise builders and their supporters, an immense number and variety of enterprises enrich our civilisation. A broad view of the historical origins of enterprise, and of some entrepreneurs, founders and builders, provides useful background to the ideas which follow in this book. Further background comes from the different ways in which enterprises are organised, the diverse forms of ownership adopted,