Lending to Lemons or Investing in Peaches?

Yes, it could well be the case that in the short term (5-7 years) some of the government's preferred stock may yet be sold on for a profit to the taxpayers. The problem in the short term is relying on the bailout and the recapitalisation of the British Banking system as the way to bring bank liquidity into the system and, in particular, to supply liquidity to small and medium sized enterprises (SMEs). Is this simply trying to renew trust in the system that got us into this mess in the first place? Or put another way, where's "the pro for the quid"?

The real problem is the short-termism endemic within the UK banking and business investment systems. If that goes unreformed, even in the short-term, some of the capitalisation moneys supplied by the issue of gilts and handed over to the banks could simply end up throwing good money after bad.

The government made it clear that the amount now available to the banks (the gilts were issued on 22nd October) would be well in excess of that actually needed to adequately recapitalise under the Internationally agreed banking treaties and agreements. The government may have over-egged the pudding deliberately to over-reassure. The banks were certainly well re-assured, though (child-like) complaining about dividend restrictions (but they would say that anyway).

The 'capitalisation surplus' could have been held back pending clear agreement as to the expected (contractually enforceable) future behaviour of the banks with regard to business and private lending.

Or rather, let's think more radically. Why couldn't the surplus over adequate recapitalisation be held back entirely and remain in the hands of the state banks specifically to micro-invest long-term in SMEs in a way that the unreformed banks show little sign of embarking upon.

The government could then direct investment and liquidity into the SME and other business sectors immediately. Why wait for the shell-shocked re-capitalised new bank executives to go through their internal procedures and processes eventually to emerge with a probably half-hearted plan to provide liquidity to business generally and SMEs in particular?

What is required is not a renewal of 'lending' to business and SMEs, but 'investment' in business and SMEs, and for the very long term. And the model that is required is, indeed, the Paulson model: the owning of a stake by government not just in Banks, but in ordinary, everyday businesses. If it's good enough for the banks, why not for SMEs?

Taking equity, preferred stock, A ordinary shares, small business mortgages, debentures: whatever form it takes is not some new model of socialist iniquity or 'crypto-communism', it's the way non-banking investment businesses have actually been doing it for decades.

It's called long-term venture capitalism. A venture capital company (e.g. 3i Group plc) invests often for 15 years or over in another business (usually an SME) in return for (the now ubiquitous) preferred shares. The aim is for higher returns over the long-term.

The long term partnership between bank and investee sees the investment through shorter business and economic cycles and may not provide immediate short-term return; but long-term, the nature of the investment can become extremely profitable for the Venture Capital company and the investee business as well. It's not able to be called in at a moment's notice like a business overdraft.

A long-term, maturing business investment makes the holding of and eventual disposal/redemption of the shares extremely valuable, outperforming short term investments on both sides.

The preferred shares structure (as with the re-capitalisation model with squealing banks) restricts the pure freedom of the directors and ordinary shareholders in the short-term but for a disciplined reason: to protect the risk of the investment and to ensure that it is a partnership of sorts in which everyone is pulling together. A restriction of 'pure' capitalism, certainly. But a system designed to strengthen it. Note the end of capitalism but rather a different form perhaps, building on some of its best features.

We will get nowhere on either side of the Atlantic if we simply leave the future of business to the short-termism which has characterised the economy over the last 30 years. We need to re-write the rules and start again with regard to the way business works to protect business from itself.

The squealing of the banks over dividend restrictions is an indicator of how much they do not 'get' the new environment springing up around them. The same will apply in business generally. Business may not like the idea of giving away control, indeed giving away shares, in return for solid, long-term investment which will massively benefit the business and the economy for the long term.

The problem is that business generally and sometimes SMEs too often rather like the financing of their businesses by large overdrafts form their bank and short-expensive business loans - it's what they're used to. But as Public Sector reform mantra of the last 15 years has it: if you always do what you've always done, you'll always get what you always got.

There's a common phrase amongst venture capitalists which rings true: Lemons ripen before peaches. Short-term, apparent success can often accompany an absolute Lemon in terms of long-term success. Long-term patient finance can often grow steady, successful mature businesses in a wider economy that is similarly steady, successful and mature as a result. Venture capitalists also identify the 'Dead Cat Bounce': even a dead cat will bounce when dropped from a height, looking like it still has life in it when it's as dead as a doornail. Short-term views can be deceptive.

Recapitalisation must not be part of a dead cat bounce. We should aim for peaches. And that will mean that the government must not rely on the old structures in which we have little confidence. The major banks simply do not have a clue how to go about long term, investing in business for the benefit of all of us. They will simply want to lend. Why would they know anything about it? They haven't been doing it for the last 60 years.

Consequently, the government in the UK and in the US should retain part of the recapitalisation moneys or issue new gilts directly to invest in the market place now in return for equity and/or secured assets for 15 year investments.

These should be directed at the regional and even local government level in state-owned regional investment / development banks. The banks might be even based (even owned) at city or city-region level with re-investment of the profits in that area. These investments are just as, if not more likely, to mature with significant long-term profits for the tax payer. Bonds could be re-issued on the strength of the maturing investment.

Over ten years ago we wrote a piece for the journal Renewal which proposed this model. We called it Venture Socialism. It proposed the setting up of regional development banks to invest long-term for equity stakes in SMEs. Along with the investment we suggested would come obligations by the company in respect of transparency, ethical business practices, environmental protection, community position, employment rights, trades union recognition etc.

Many of the businesses which may go to the wall over the next few years without having had the confidence of long-term investment might have been better able to weather the coming storm if they had received this long-term equity investment.

Standard traditional approaches to the new order will mean that the US or UK government will have decided that they wish to Lend to Lemons rather than Invest in Peaches. Those readers who think this is pie-in-the-sky might like to note that there was substantial government support for venture capital over decades in the US. Maybe we could do something similar here to plug the finance gap.

David Bailey and Alex de Ruyter both work at the Birmingham Business School and John Clancy is a former Birmingham City Councilllor, venture capital solicitor and runs two SMEs including MediaFuturesAlert.com