The latest report about equity funding in Europe puts EU’s shortcoming in the risk capital market under the spotlight.
The European Commission (EC) presented a report on equity investments in Europe drafted by an independent group of experts. The study identifies investment gaps in Europe and provides recommendations on how to address those shortcomings in equity financing.
Regarding the equity gap, the European equity market is a quarter of the size of its US counterpart, despite its ongoing growth. According to the study, Europe’s risk-capital market has the potential to increase by a third based on the correlation of the ICT and life science sector to the existing venture capital (VC) investments. ICT and life science are sectors with a large demand of high-risk capital. This gap can affect economic growth within those sectors negatively and force innovative SMEs to seek funding elsewhere for later-stage investments: e.g. the US or China. Companies may even shift their operations outside of Europe as well, which has further economic impact.
Nevertheless, the authors emphasise that the dearth of equity funding may not be the sole reason, as it goes both ways. The VC actors need innovative startups and a well-working innovation ecosystem that increases the demand for risk capital. Therefore, the objective has to be to create a flourishing ecosystem where high-potential scaleups and startups emerge in an environment with sufficient equity capital.
Promising markets like deep tech, fintech, and cybersecurity will grow in the future. Other markets that enjoy an increase in popularity are cleantech and green technologies, which are related to social and economic trends towards a sustainability agenda. Here, the study highlights the vital role of funding for green technologies that are by nature high-risk. Besides the risks associated to technology development and finding a market, clean and green tech face political risks as well, since initiatives that assign more significant costs to CO2 emissions have not been implemented so far. This is reducing market incentives to develop, adapt, and acquire cleantech. However, the potential to scale up for green technology, if appropriately incentivised, would be global in scope.
The study recommends that the EU should particularly increase its ambitions to improve framework conditions and risk capital availability in the broader context of the Capital Market Union by removing cross-border investment barriers, lowering funding costs, and supporting firms in their search of diverse sources of capital for their development and growth. Among the evaluated programmes are InnovFin Equity, COSME Equity Facility for Growth, (EFG) SME Window of the European Fund for Strategic Investments (SMEW EFSI), and VentureEU programmes.
Economically, the fundamental objective of public support is to create a thriving ecosystem that attracts private investors and then later reduce public investments gradually. Thus, public investors should not out-compete private investors but rather take up-front risks where needed and create a crowding-in effect for private entities. As the study concludes, the EU follows those principles with a “somewhat modest growth of risk capital markets in Europe,” and identified key areas with potential for improvement.
Firstly, the EU should simplify the objectives of the InvestEU programmes and create more flexibility for the participation of Implementing Partners (such as national promotional banks) in the general framework and pre-established principles. The authors acknowledge the EU efforts to consolidate its support for the equity market through one single programmes – InvestEU. However, they recommend further streamlining and simplifying the objectives and allowing the formation of a single equity product that covers InvestEU policy objectives. The experts suggest reviewing how the objectives could adhere to a more case-by-case approach.
Secondly, risk aversion limitations in EU programmes and allowing them to take higher risks should be reviewed. As mentioned, the fundamental objective of public funding for risk capital is to step in when the risk is too high for private investors. Yet, the currently implemented pari-passu principle (co-investing on terms equal to private partners) in the support programmes requires that the EU avoid these higher risks. Thus, the authors recommend adhering to a non-pari-passu risk sharing principle in specific high policy value cases. This would allow EU programmes to offer the needed support where private investors cannot.
Thirdly, the administration burden should be eased. The study discovered in a stakeholder consultation that some stakeholders have to hire a fulltime employee to deal with the workload for applying to EU funds. As it constitutes a particular burden for smaller VCs, it skews funding towards the VC funds, who have the dedicated capacity to handle application writing and administrative, and away from smaller or newer funds with the greatest need and biggest potential. The authors, therefore, recommend revisiting the administration procedure and easing its burdens.
Fourthly, later-stage Pan-Europe emerging equity funds should be supported. As outlined before, with limited access to later-stage financing, European-born companies could see themselves forced to seek equity investors in China or the US. The study assessed that new funds with a size of above €400m are needed to deliver sufficient funding for high-growth companies. The authors especially recommended that the EU should increase its support to later-stage funds and allow single contributions of €100m in order to attract private investors with larger fund sizes.
Lastly, the strong support to the European VC ecosystem should be continued. To keep increasing and strengthening the European VC ecosystem, the authors call for better support for technology transfer funds. This can lead to better transition for research into innovation and technology. Thus, there is a need to emerge dedicated technology transfer and pre-seed/seed funds led by professionals with specific expertise in tech transfer.