Chances and Risks for Venture Capital and Private Equity in Europe

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Table of  Content  

1.  Risk Capital and R D - 5 -  

2.  Financing SMEs and Entrepreneurs - 6 -  

3.  Challenges facing the European Risk Capital Industry - 9 -  

4.  Conclusion - 13 -  

5.  References - 14 -  

Appendix: Recent  Development of the Venture Capital and Private Equity Industry in Europe - 15 -  

  September  2003

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Abstract

The specific aim of this paper is to offer suggestions and guidance on improving the effectiveness between the private and public sector to boost risk capital investment in R&D activities, presenting a series of recommendations in the chapter “Challenges facing the European Risk Capital Industry”, based on the latest report of policy makers in the EU (report of the European Commission) in 2003.

The immediate background of the report was the dramatic change in the economic environment for private providers of risk capital, combined with rising concern for insufficient public risk capital measures in the European Union.

This paper starts with the description of the important link between Risk Capital and R&D, followed by the analysis how private and public risk capital investments affect the business activity of SMEs and Entrepreneurs in Europe.

After reviewing the important use of private risk capital instruments, the author summarizes major findings and explains which lessons have been learnt from the past to tackle the current risk capital funding gaps.

September 2003

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1. Risk Capital and R&D

Risk Capital is an indispensable “public” and “private” financing instrument in order to support activities and investments for innovation and value creation in an economy. Although R&D spending accounts in most European countries for less than 3% of total economic activity 1 , it is an elementary driver of new processes, jobs and products. Innovations from R&D research do improve the economic welfare of a country many times greater than their initial investment. Risk Capital provided to entrepreneurs in the first phase of their business life cycle is associated with “pre-seed” or “early seed” activities, generally supported by incubators. Incubators (“Impulse Zentren”) help improving the management knowledge, techniques and skills of entrepreneurs and SMEs via Competence Centers and represent the first channel of micro-finance initiative for start-ups and growth. Still, the conditions facing potential entrepreneurs in Austria and the European Union are continually being debated, as is the question of whether politicians could and should do more to stimulate firm creation. 2

Looking at the current figures presented by the European Commission, the EU is lagging behind both the USA and Japan in terms of expenditure on R&D as a proportion of GDP, primarily due to slow relative growth in business R&D expenditure.

In 2002 the European Council in Barcelona set an overall EU R&D investment target of 3% of GDP by the year 2010, with about two thirds of this figure expected to be contributed by the private sector. 3 To approach this level, however, dramatic improvements between the public and private sector are needed to stimulate R&D, innovation and further economic value creation.

One way to progress towards this goal is by tackling directly the legal framework in which Incubator, Venture Capital and Private Equity Industry operate, lowering entry and exit barriers, for instance. Secondly, fiscal measures can have, with some time lag, positive effects on the short- and mid term avaibility of risk capital for Seed and Start-up Capital Finance. Thirdly, mechanisms could be found to facilitate loan and equity guarantee instruments from the public sector for Entrepreneurs to stimulate private sector R&D. But hasn’t this been already discussed for quite some time? The simple answer to this question is: yes. But actually the contrary is happening. 4

1 The Barcelona European Council in March 2002 set a target for R&D spending in the European Union of 3% of GDP by 2010, two third of this to come from the private sector.

2 Keuschnigg, Ch.; Nielsen, S.B. (2003): “Taxation and Venture Capital Backed Entrepreneurship", Keynote Lecture at the 59th IIPF Conference in Prague, August 25-28, 2003, p.1 (available online: www.cepr.org/pubs/dps/DP4097.asp) 3 European Commission (2003): “Raising EU R&D Intensity - Improving the Effectiveness of Public Support Mechanisms for Private Sector Research and Development”, Report to the European Commission by an Independent Expert Group, European Commission Directorate-General for Research Information and Communication Unit, Brussels, page X.

4 i.e. The new Basel Capital Accord, currently being negotiated, proposes risk weightings for banks allocating capital for these investments of 150%, or even 200% for start-up investments, against the current requirement of 100%. Such a change is likely to dramatically reduce the allocations that banks can make to risk capital investment, exacerbating the current problems faced by the industry and endangering its future development. September 2003

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The amount of additional R&D investments that should be stimulated in the European Union by beginning of 2003 was guessed at around €2-5 billion, deriving from a total of new investment of €6-15bn. The contribution to closing the R&D gap of approximately €100 billion per year might therefore take more than a decade. 5

2. Financing SMEs and Entrepreneurs

Private Risk Capital is generally given to research intensive SMEs or to Entrepreneurs, both looking to develop their innovation with solid R&D investment levels over a 2-7 years period of time.

Table 1: The classical ways to finance Entrepreneurs by Incubators

SMEs as a group contribute a relatively small proportion of business R&D spending in the EU as whole, and in the USA (under 20 percent). Overall R&D intensities can be substantially higher among technology based SMEs than among technology-driven large firms. More important, though not well understood, are the leverage and perhaps catalytic effects of SME innovation activity within the whole innovation process. A key function of risk capital, besides relieving specific innovation bottlenecks, may be to enable the establishment of new SMEs that are permanently more R&D intensive in their business culture than the bulk of SMEs, even than the class of leading technology users. Some of these SMEs will grow to be large enterprises while maintaining high R&D intensity. Small technology-based firms are also important in the competitiveness of large firms that adopt a “buy” rather than a build “strategy”.

5 European Commission (2003): page xi.

September 2003