The Macmillan Gap (Part 1 of m)

The Macmillan Gap (c.1931) vs the SME funding gap (c.2012).

As discussed in my first post most problems have been thought of and solved somewhere, in someway before. In this post I explore the Macmillan Gap, a fascinating problem to which a solution was first created in 1945 which holds important lessons for today. I believe it is an essential consideration in modern innovation and entrepreneurship policy in the UK. This will be the first post of many (a currently unknown number, m) on this subject.

Three questions are immediately apparent when looking at how an old problem might inform policy today: What is the nature of the problem it addressed? what was the solution? and why did it fail?

Keynes and Bevin, amongst others, submitted to the Macmillan Committee (1931) that there was a gap in SME funding in the UK. Macmillan’s 1931 report states (Numbers adjusted to 2010 prices):

“It has been represented to us that great difficulty is experienced by the smaller and medium sized businesses in raising the capital which they may from time to time require even when the security offered is perfectly sound. To provide adequate machinery for raising long dated capital in amounts not sufficiently large for a public issue i.e. amounts ranging from £150k, say, £8m or more, always presents difficulties. .”– The report of the committee on Finance and Industry, June 1931. Numbers adjusted to 2010 prices.

This is the same problem that exists in the UK today – frequently referred to as a gap in the funding escalator, or just the funding gap – that is varyingly stated at between £200k-£8m (usually toward the lower end).

So what was the solution, and how did it work? In 1945 the government created what we would now call a small business bank, the ICFC (Industrial and Commercial Finance Corporation for Industry).

~~Deep breath, and rose tinted specks firmly attached~~

The ICFC was set up to self-fund by specifically lending in to the Macmillan gap. It could lend in flexible ways (it was backed by govt. & big bank investment + borrowing), provided expertise locally (including changing loan terms in tough times), and had no requirements for post-investment liquidity (it was not shareholder owned so no need for a quick payoff). Loss making loans at the smaller end of the gap were subsidised by the more profitable loans with larger scales.

It had the flexibility to choose the appropriate investment tool for each investment; in 1953 the ICFC had leant most of its available capital with 37% of investments in preference and ordinary shares (4:1 ratio between the two), and 63% in secured and unsecured loans (2:1 ratio between the two). And in 1953, only 10% of investments were in liquid (quoted) assets.

Its services were in demand and it addressed the Macmillan Gap. So why did it fail?  It failed because the ICFC was allowed to turn into a commercial success; it succumbed to the pressures that first created the Macmillan gap. Those pesky loss making small-scale deals weren’t nearly as exciting or money making as larger scale venture finance:

By the 80’s the ICFC hand changed. In 1967 the ICFC started to do M&A work, expanding its reach into larger deals. Multiple recessions (’74 and ’81) eroded the banks financial balance sheet, which put policy makers in a tough position; either they could prop up the ICFC (now the FFI), which would require more investment (a cost!), or they could allow it to stop its less profitable activities. The ICFC itself wanted to be able to behave like its market based peers.

These pressures led to a complete loosening of its original obligations in 1981, and through the 1980s it funded large numbers of management buy-outs and ceased the boring banking function at the smaller end of the scale. It was renamed 3i before its flotation in 1987.

In becoming a commercial success, 3i had re-opened the Macmillan gap.

The forces that created the Macmillan gap eroded, over time, the institution created to bridge it.

Three final thoughts:

To have an equivalent impact today a new bank would need to match the expansion in the UKs economic activity. Adjusting for GDP growth and prices, the ICFC today would require £2.5bn of upfront investment with the capability to borrow a further £4.5bn. £7bn in total, quite a sum.

The current credit squeeze hitting lending to SMEs is not the Macmillan Gap – it is exacerbated by it. But wouldn’t it have been nice to have an institution ready to go that operated right in that gap? One of the issues facing the government is that it seems to lack the institutional levers that would allow it to tackle the issue head on. It now should be thinking seriously about changing the tools it has available.

The Macmillan Gap is just one way of looking at the phenomena of small businesses. There have been great advances in theories of SMEs, gazelles, innovation etc. that mean there are even more potential ways of tackling this issue… I’ll save that thought for my next post.