The CMU should focus on the fast-growth and innovative firms that truly make a difference and are capital constrained
The long awaited Action Plan on Building a Capital Markets Union was published by the European commission on 30 September. Commissioner Jonathan Hill should be applauded for the scope of the plan and also the pragmatic nature of his approach. He has constantly stated that he wishes to focus on whatever is required to drive growth and jobs, taking a bottom-up approach rather than grandiose plans per se.
The plan itself is extremely comprehensive and tackles critical issues that have for too long been ignored including: the diversity of insolvency proceedings across the EU that are restricting cross-border investment; withholding tax which in certain member states is resulting in the double taxation of investments; and the fragmented securities market infrastructure which drives up the cost of cross-border investments by as much as 10 times as that in the US.
The expected revision of Solvency II capital requirements to better reflect the true risk of infrastructure is eminently sensible given the shortfall in investment, and the potential impact that infrastructure investment might have on the broader economy.
Furthermore, recommendations to improve information flows on loans rejected by banks to other providers as has been developed in France through its mediateur du credit scheme, in combination with the new securitisation proposals will also help improve the efficiency of solvent banking systems to extend credit to small- and medium-sized enterprises (SMEs). However, the proposals to improve the funding of businesses in order to drive jobs and growth need to be far more focussed if they are to solve the problem at hand.
The fact that there are so many recommendations suggests that the commission is more determined to provide as wide a choice of financial instruments as possible, rather than honing in on the critical financing gaps across the EU. Furthermore, there is not much evidence from the public or the private sector that focusing on multiple fronts is likely to be successful in realising goals. For example, some of the proposals focus on public markets where in general there are few financing issues, although without doubt rules could be improved to reduce the cost of capital.
The challenge with any policy debate about how to improve the flow of capital to SMEs is that the needs and desires of SMEs for financing are diverse and often have little in common with each other. As such the action plan could do with identifying which segments of the SME market are faced with severe funding constraints, and crucially what impact they might have on the economy in terms of growth and jobs if this financing gap were to be bridged.
Policy Network, as part of a detailed analysis of micro data from the European commission’s Survey on the Access to Finance of Enterprises, has identified the group of fast-growth and innovative businesses as having a far greater impact on the rate of growth and jobs creation than all other SME segments. Furthermore, this cohort of firms is severely capital constrained as they tend to have little collateral and have often not completed their journey to breaking even. This generally means that these firms need equity rather than debt to fund their expansion, and there is a dire shortage of equity financing across the EU.
The action plan addresses this at a very high level stating that the commission will launch a package of measures to support venture capital and equity financing. However, with so many recommendations, many of which are still extremely vague, this policy area is less likely to get the focus it needs. Crucially some of the proposed solutions suggest that underlying problems have not been appropriately diagnosed.
The plan argues that to transform equity financing in Europe, the industry needs to have greater scale. Public money already equates to nearly 40 per cent of all venture capital funds invested across Europe, hence it is not clear why just throwing more money at the issue and say bringing the total to 50 per cent will actually solve the problem and stimulate greater private sector investment.
The main reason for the fall in institutional investment is that the returns to venture capital are around zero. And while returns are close to zero, it is not clear why institutional money will increase exposure to this asset class. Institutional investors in the most advanced venture capital market in Europe, Sweden, have been shifting their asset allocation away from venture capital towards private equity because venture capital returns have been so lousy. Until the issue of low returns has been addressed this is unlikely to change.
The encouragement of retail money into this sector should also be of some concern given that average returns are zero, which means many retail investors will lose money rather than gain money. This is because fast growth and innovative firms are riskier to finance. Data collected and analysed by Policy Network shows non-performing loans to young, innovative businesses to be just under 40 per cent, with business angel losses at 44 per cent.
Given this market dynamic, which is also prevalent in the US, a better business model for many venture capital firms would be to provide both equity and debt financing for fast growth firms. The net interest margin from loans enables investors to cover their operational costs, with the equity portions in successful firms driving profitability. Financing for these loans could be provided without a cost to the taxpayer through a small business investment scheme managed by the European Investment Fund (EIF).
Finally, what often matters more for the success of these innovative and fast growing firms is not just capital, but expertise. As such the commission ought to recommend member states to prioritise tax incentives for business angels, who have the expertise, to drive up levels of local investment. The commission should also look to guarantee the financing of these tax incentives if member states are unable to afford short term deficits. Once local investment levels have reached a critical mass, developing pan-European passport products would also be beneficial.
The Capital Markets Union is a fantastic opportunity for the commission to make a difference to jobs and growth across the EU. However, for it to be successful it needs to focus on those fast-growth and innovative firms that truly make a difference and are capital constrained. The commission must prioritise an equity revolution across the EU. That means promoting best practice for tax incentives for business angels, and leveraging the capability of the EIF to provide long term loans to equity funds to help make the venture capital business model profitable.
Thomas Aubrey is senior adviser at Policy Network and founder of Credit Capital Advisory
The image is Efificio Berlaymont by Leandor Neumann Ciuffo, published under CC BY 2.0