European Economic Studies Etudes Economiques Européennes
COLLEGE OF EUROPE - BRUGES ECONOMICS DEPARTMENT
The development of venture Capital fundraising in Europe Evidence across countries, prospects and policy issues.
Supervisor:
Thesis presented by
Pr. Christian de BOISSIEU
Aloys RIGAUT for the Degree of Master of European Economic Studies
ACADEMIC YEAR 2001-2002
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
Statutory declaration I hereby declare that the thesis has been written by myself without any external unauthorised help, that it has been neither presented to any institution for evaluation nor previously published in its entirety or in parts. Any parts, words or ideas, of the thesis, however limited, and including tables, graphs, etc. which are quoted from or based on other sources have been acknowledged as such without exception.
Acknowledgements I am grateful to Pr. Christian de BOISSIEU (University Paris 1 Panthéon-Sorbonne / College of Europe) for supervising my thesis, to Pr. Eric de SOUZA (College of Europe) for his helpful comments on my econometric model and for his advises, and to Dr. Juan Maria ARTEAGOITIA-LANDA (European Commission, DG Internal Market) for a stimulating discussion on the policy issues related to my work and for his insights into venture capital in Europe. I finally thank the Federation of European Stock Exchanges (FESE) for providing me data on IPOs in Europe. All remaining errors are of my sole responsibility.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
T he d evel op m en t of ventu re capit al f u n dr ai sin g in E ur o pe – evid en ce acr oss co untri es, pr osp ect s and po li cy i ssu es. By Aloys RIGAUT 1 (College of Europe, 2001-2002) MA Thesis - Economics Department
ABSTR AC T This study attempts to explain the dramatic development of venture capital fundraising in Europe from 1996 to 2000, and to highlight the reasons of its severe downturn in 2001. The main characteristics of the European venture capital market - compared to the US - are also documented, which leads us to some policy recommendations. There are three strands of literature that our study relates to. The first concerns the nature of the role of the venture capital industry in the economy: e.g. the comparative advantages of banks and venture capital funds with regard to the financing of innovative SMEs and the role of venture capitalists in mitigating agency conflicts between entrepreneurial firms and outside investors. The second tackles the extent of its economic impact in terms of innovation, potential economic growth and job creation: strong economic benefits have empirically been proved, from this perspective. And, finally, the third strand discusses the determinants of venture capital funding: despite contradictory findings, variables like the number of IPOs, GDP and market capitalisation growth, the level of capital gains taxation, the presence of private pension funds, the significance of government's programs have appeared as the main (environmental) determinants of venture capital fundraising. The first chapter (section 2) surveys the above literature on the economics of venture capital, presenting the main recent articles dealing with the economic role, the economic impact and finally the main determinants of venture capital fundraising. The second chapter (section 3) explains the analytic framework underlying the discussions about the European venture capital market, and notably sifts through the Risk Action Plan (RCAP) and the Financial Services Action Plan (FSAP). In the third chapter
1
Postal address: Garenmarkt, 15. Room n°331. B-8000. Bruges. Belgium. E mail:
[email protected]; Personal website: http://aloys.rigaut.online.fr
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
(section 4), the data, the regression methodology, as well as the empirical results and findings of our model are presented. Then, our last chapter (section 5) discusses the potential further developments of the European venture capital market, and puts forward some policy recommendations. Section 6 concludes. Using panel data techniques, our econometric model shows that the main empirical determinants of venture capital fundraising in Europe are ICT expenditures (relative to GDP), labour market rigidities (approximated with the general rate of unemployment), and the regulatory environment (approximated by the advancement in the implementation of the FSAP). With a strong negative coefficient, the number of IPOs surprisingly does not turn out to be significant in the expected way, which is contradictory with the stylised fact identified in the literature, while possibly being the consequence of European stock market fragmentation. As for GDP growth, it appears as strongly insignificant. Despite the current economic uncertainties, it is finally advocated that venture capital will continue to play a determinant role in the innovation, growth and job creation in Europe in coming years. Our study highlights that maintaining a robust trend of development will finally depend on the improvement of the legal and fiscal environment, on the creation of more investment opportunities (‘too much money chasing too few deals’) and on the progress with regard to the implementation of the RCAP.
Key words: venture capital, risk capital, private equity, innovation, panel data. Length: 48 pages Number of words of text: 14,989 Date of publication: May 2002
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
"The establishment of an integrated risk capital market in Europe remains a key commitment. I am confident that the European venture capital industry will emerge stronger and more competitive from the current cyclical downturn."
Frits BOLKESTEIN, European Commissioner Internal Market and Taxation and Customs Union
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
TABLE OF CONT ENTS ABSTRACT
3
TABLE OFCONTENTS
6
LIST OF TABLES
8
LIST OF GRAPHS
8
LIST OF FIGURES
8
LIST OF ABBREVIATIONS
9
1
INTRODUCTION
10
2
SURVEY OF THE LITERATURE
14
2.1
THE ECONOMIC ROLE AND CHARACTERISTICS OF THE VENTURE CAPITAL INDUSTRY
14
2.2
THE ECONOMIC IMPACT OF VENTURE CAPITAL
18
2.3
THE DETERMINANTS OF VENTURE CAPITAL FUNDRAISING
21
3 3.1
GENERAL FRAMEWORK OF ANALYSIS THE EUROPEAN V ENTURE C APITAL MARKET :
25 A BRIEF COMPARATIVE ANALYSIS WITH
THE UNITED STATES
3.2
25
THE ACTION PLANS OF THE E UROPEAN C OMMISSION: TOWARDS A SINGLE E UROPEAN 34
FINANCIAL MARKET
4
ECONOMETRIC MODEL
38
4.1
EMPIRICAL MODEL AND METHODOLOGY
38
4.2
DATA
41
4.3
RESULTS AND FINDINGS
42
5
PROSPECTS AND POLICY ISSUES
47
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Aloys RIGAUT Economics Department. MA Thesis.
5.1
College of Europe Academic year 2001-2002
THE DEVELOPMENT OF VENTURE C APITAL FUNDRAISING IN EUROPE: MAIN TRENDS
AT WORK AND POLICY CHALLENGES
47
5.2
53
6
POLICY RECOMMENDATIONS CONCLUSION
57
REFERENCES
59
INTERNET RESOURCES
69
ANNEXES
71
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
List of Tab les Table 1: Strategic Allocation to Private Equity by Pension Funds, Endowments and Foundations (% of total fund assets)........................................................................27 Table 2: Stages of investments and associated risks .....................................................29 Table 3: Target returns by investment stages.................................................................29 Table 4: The development of European New Markets (situation as at 01.01.2001) ......33 Table 5: Transposition of financial services, situation as of June 1999 .........................40 Table 6: Government policies to support the venture capital market .............................52
List of Gra ph s Graph 1: The performance of innovative SMEs ..............................................................20 Graph 2: Venture capital raised (VCR) and invested (VCI) as % of GDP: a comparison between the EU and the USA (1996-2000) .............................................................25 Graph 3: Private equity investment as a percentage of GDP in 2000: detail by European countries. ..................................................................................................................26 Graph 4: Staged distribution by percentage of amount invested in 2000.......................30 Graph 5: Expected allocation of funds raised in 2000 ....................................................31 Graph 6: Divestments by type of exits in 2000 (% amount)...........................................32 Graph 7: Market capitalisation and number of listed companies on Euro.NM (Jan. 1998 – Dec. 2000) .............................................................................................................33 Graph 8: Venture Capital Raised: a comparison between Europe and the US (19942001) .........................................................................................................................49 Graph 9: Venture Capital Invested: a comparison between Europe and the US (19942001) .........................................................................................................................49
List of Fig ure s Figure 1: The Venture Financing Chain ..........................................................................12 Figure 2: The Venture Capital Industry ...........................................................................17 Figure 3: The impact of venture capital: framework of underlying factors ......................19
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
List of abb reviati ons AIM
Alternative Investment Market (London Stock Exchange)
BEST
Business Environment Simplification Task Force
CEECs
Central and Eastern European Countries
CGT
Capital Gains Taxes
DG
Directorate-General
EASDAQ
European Association of Securities Dealers Automated Quotation
EBAN
European Business Angels Network
EC
European Commission
EIB
European Investment Bank
EIF
European Investment Fund
EITO
European Information Technology Observatory
EMU
European Economic and Monetary Union
EU
European Union
Euro.NM
European New Markets
EVCA
European Private Equity and Venture Capital Association
EVCJ
European Venture Capital Journal
FESE
Federation of European Stock Exchanges
FSAP
Financial Services Action Plan
IAS
International Accounting Standards
ICT
Information and Communication Technologies
IP
Intellectual Property
IPO(s)
Initial Public Offering(s)
IRR
Internal Rate of Return
ISD
Investment Services Directive
LBO(s)
Leveraged Buyout(s)
M&As
Mergers and Acquisitions
MBO(s)
Management Buyout(s)
NASDAQ
European Association of Securities Dealers Automated Quotation
NM
New Market
PE
Private Equity
RCAP
Risk Capital Action Plan
SME(s)
Small and Medium Enterprise(s)
UCITS
Undertakings for Collective Investment in Transferable Securities
US
United States of America
VC
Venture Capital
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
1 INT RO DU CT IO N Following the crash of the new economy speculative “bubble” in the USA and in the EU, year 2001 was characterised by a decrease of the funds invested by European private equity and venture capital firms, according to the European Private Equity and Venture Capital Association2 (EVCA): funds equalling €31.5 billion were raised 3 – a decrease of 34.4% compared to 20004. This reflects in part the economic downturn but also the relative stability of private equity as an asset class, after the dramatic development of venture capital activity in Europe from 1996: the amount of venture capital invested in 2001 (approx. €23 billion) is indeed very close to its 1999 level (€25 billion), and some signs of recovery can already be observed. Given the economic role played by venture capital, this is undoubtedly a positive evolution. Venture capital is indeed considered as one of the most relevant sources of finance for innovative and high-growth companies to fund their investments. It is thus acknowledged that “an integrated capital market, from seed funding to stock market, is the key to accelerated European innovation” 5, and - therefore - to job creation and growth. As one may indeed note: “financing is the obstacle to innovation most often quoted by firms, whatever their size, in all member states of the European Union and in virtually all sectors” (European Commission, 1995, pp.28-29). The issue at stake is therefore to look at the fundamentals that have fuelled the development of venture capital activity in Europe since 1996, and to consider if one may confirm the robustness of this trend in the long run. But before we discuss the development of venture capital in more details, we first need to clarify the use of the term. Indeed, the term venture capital does not have quite the same meaning in the EU as it does in the United States. In the US, venture capital is only one type of private equity investing and comprises three types of investments (seed, start-up and expansion), while excluding buyouts 6. On the contrary,
2
The EVCA (established in 1983) represents, promotes and facilitates the development of the European private equity and venture capital industry. 3 Preliminary activity data 2001 (based on 46% response rate). Final data will be published at the end of May 2002. 4 In 2000, funds raised were a massive € 48.0 billion. Source: (EVCA, 2001). 5 Cf. (CORDIS, 1999). 6 Buyouts include Management and Leveraged Buyouts. In a LBO, debt is used to acquire a company and reduce its equity base. MBOs are LBOs where current management takes control of its company.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
in the EU, it is referred to venture capital as a quasi synonym of private equity 7 - “a more general concept that includes any commitment to unquoted companies, at any stage, from seed investments to replacements, buyouts and turn-around operations ” (BALBOA & MARTI, 2000, p.3). While clearly distinguishing the two concepts, the EVCA uses - in practice - the second definition, thus including buyouts in its statistics (they represented 47.3% of the total amount invested in 1996-2000). Given that this paper will deal with the European venture capital market and thus mainly refer to EVCA data, we will therefore also use this definition. Nevertheless, we will exclude from our scope informal investors - also referred to as 'business angels', i.e. wealthy individuals who finance firms out of their own funds. They represent an important alternative source of financing for high-growth innovative firms, but are limited by the wealth of these very individuals 8, and can thus be distinguished from formal investors, represented by venture capital funds 9. Buying shares or convertible bonds in a company, these funds are not interested in immediate dividends, as a normal shareholder would, but in allowing the company to expand and ultimately increase the value of their investment when 'exiting' the investment. They are therefore especially interested in innovative SMEs with very high growth rates and serve as financial intermediaries in this market where it may be costly to get together lenders and borrowers. Given the very characteristics of the “new economy”10, the information asymmetries (moral hazard, adverse selection) are indeed significant in the high-tech sector11: companies are mainly based on immaterial assets; large initial investments are needed without any perspective of immediate profits; and there are high risks of failure given the ‘winner takes all’ phenomenon (networks effect). Finally, one may describe the innovation financing process as a ‘chain’, where every link must be strong: seed finance, start-up finance, expansion (or development) finance, mezzanine (or bridge) finance, management buy-out (MBO) or management buy-in (MBI) finance, and, finally, the exit (through an Initial Public Offering (IPO) on a stock market, or through an acquisition e.g.). Equity financing is indeed provided by
7
Also referred to as 'risk capital ', an even more general term, notably used by the European Commission. (LESHCHINSKII, 2000) discusses this point in details. Nevertheless, "studies of the angel capital market are virtually non-existent" (PROWSE, 1998, p.786). 9 We won't deal here with Corporate Venturing Capital (defined as a larger company taking a direct minority stake in a smaller unquoted company for strategic, financial or social responsibility reasons). For a detailed study on this subject, cf. (European Commission, 2001b). 10 It is considered to have started in the US in 1992/1993, and in the EU in 1995/1996. 11 The valuation of these firms required some new methods, such as the one provided by the real options theory (DIXIT and PINDYCK, 1994, 1996). 8
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
different economic agents depending on the investment stage12: the “3 Fs” (Founders, Family and Friends) provide access to seed finance, business angels mainly to start-up finance, venture capital funds from start-up finance to IPO/acquisition (they get their profits from their investments at the exit), and banks from the expansion stage (when the company stops to make losses). From the perspective of the venture capital fund, the process is best described by a cycle, which “starts with raising a venture fund; proceeds through the investment in, monitoring of, and adding value to firms; continues as the venture capital firm exits successful deals and returns capital to its investors; and [finally] renews itself with the venture capitalist raising additional funds” (GOMPERS and LERNER, 2001, p.152). Figure 1: The Venture Financing Chain
Given this evidence, developing risk capital activities has become a policy issue in Europe. The European Commission launched in April 1998 a Risk Capital Action Plan (RCAP) defining actions to be taken at EU and national level to promote the development of the emerging European venture capital market, while a parallel Action Plan for a Single Market in Financial Services (Financial Services Action Plan, FSAP), adopted in June 1999, incorporated further measures to reduce the cost of capital. The RCAP is to be achieved by 2003, and the FSAP by 2005, according to the official deadlines. From the 1990s, some academic research was also undertaken - mainly in the USA - so as to better understand the economics of venture capital. But much remains to be done and many questions cannot yet be answered, in the own words of
12
(BERGER and UDELL, 1998) provide a comprehensive analysis of these stages of funding.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
the specialists themselves 13 - especially with regard to the internationalisation 14 of VC activities. When dealing with the determinants of venture capital funding for instance, cross-countries studies are led to very different conclusions about the significant variables that may be highlighted. In the same manner, and despite the European Commission’s initiatives (following the RCAP) and the work done by the EVCA (publication of detailed Yearbooks since 1986), only very few papers have dealt with the specific situation of the European venture capital market: is there some endogenous factors that may explain the dramatic development of venture capital in Europe since 1997, or is it a mere spill-over from the US? What are its potentialities? Is this evolution jeopardised by the recent (slow) crash of the new economy? And are the remaining obstacles to this development adequately addressed by the Action Plans drafted by the European Commission, or is there still more to be done? This paper is organised as follows: Section 2 surveys the literature on the economics of venture capital, presenting the main recent articles dealing with the economic role (2.1), the economic impact (2.2.) and - finally - the determinants (2.3.) of venture capital. Section 3 explains the analytic framework underlying the discussions about the European venture capital market, and notably sifts through the RCAP, the FSAP and the First Innovation Action Plan. Section 4 presents the data, the regression methodology and the empirical results and findings of our model. Section 5 discusses the potential further developments of the European venture capital market, and the policy issues related to these evolutions. Section 6 concludes.
13
For instance: (JENG & WELLS, 1998, p. 48): “These results point to the need for further research focusing on early stage venture capital investment”. (BALBOA & MARTI, 2000, p. 35): “More research should be conducted on this issue”. (GOMPERS and LERNER, 1998, p. 36): "There is a ripe area for further exploration". 14 This is how American economists refer to the development of VC activities outside the US.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
2 SURV EY OF THE LITERATURE There are three recent strands of literature that our study relates to. The first concerns the nature of the role of the venture capital industry in the economy (2.1.), the second tackles the extent of its economic impact in terms of innovation, potential economic growth and job creation (2.2.), and, finally, the third discusses the determinants of venture capital funding (2.3.). According to (GOMPERS and LERNER, 2001, p.166), “in some cases, the unanswered questions have been posed for years, but lack of access to data has proved to be a major barrier. (…) In other cases, new research questions have been posed by the recent rapid changes in the venture capital industry”; but “much remains to be learned”.
2.1
The ec onomic r ole a nd ch ara cte rist ics of th e ven tur e
capital ind ust ry The main discussion relates to the comparative advantages of banks and VC funds 15 when it comes to financing innovative SMEs, and to the role of venture capitalists in mitigating agency conflicts between entrepreneurial firms and outside investors. But several papers have also raised the issue of what could be described as the most efficient structure for venture partnerships. As far as the comparative advantages of venture capital firms are concerned, it is constantly argued that venture capital funds are better equipped than banks to finance high-growth start-ups, especially in the early stage of their development. Hence a significant contribution of the venture capital industry to the innovation process, given that financing is commonly acknowledged as the main obstacle to innovation. Assessing the risk of some borrowers is indeed more difficult in some cases than in than others: SMEs involved in products or markets requiring high technical expertise, with very little track record that could be used as a baseline performance, are clearly among the most costly to evaluate. As formalised by (GOMPERS, 1995), agency problems increas e when: 1) The ratio of tangible assets to total assets decreases 16. 2) R&D intensities increase. 3) Market-to-book ratios increase. Hence the deep informational asymmetries that characterises innovative SMEs: beyond the uncertainty 15
Defined as "independent, professionally managed, dedicated pools of capital that focus on equity or equitylinked investments in privately held, high-growth companies" (GOMPERS and LERNER, 2001, p. 146). 16 Increases in asset tangibility increase financing duration and reduce monitoring intensity (GOMPERS, 1995).
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
of the new markets where they operate, so much of the value of these startups indeed lies in their potential for future growth and so little in their current tangible assets. It has thus been often underlined that the solution could be the establishment of a long-run relationship between banks and SMEs. It would indeed allow the bank to build up a credit history along the SME's life cycle, and alleviate the credit-rationing problem. This would also be consistent with the results of (PETERSEN and RAJAN, 1994) that find evidence of a negative correlation between the loan rate and the length of the bank relationship in the US. But another approach would consist in asserting that bank financing may simply not be optimal for start-up ventures. In some countries - in the US e.g. 17 - banks are even prohibited from holding equity, and therefore cannot resort to equity financing. Moreover, start-ups usually require a lot of cash in the early stages of their growth, and debt-based finance is deemed to be inappropriate from a cash management perspective as it ties the cash flow of companies18. According to (BROUWER and HENDRIX, 1998, p.334), "since internal finance (cash flows) cannot meet [the firm's] capital demands and debt is hard to come by, equity [thus] figures as the prime financial resource". Equity financing will nevertheless directly reduce the entrepreneur's control of the firm: it is therefore the ‘easiest’, rather than the ‘preferred’ option (COBHAM, 1999). Entrepreneurs are indeed generally unwilling to such a dilution of control over the firm that they have created on their own, hence an ownership barrier to expansion (especially verified in Europe). From this point of view, the advantages of venture capital financing are its flexibility (financing by stages) and the additional strength that it provides to the company that is financed (more equity), but its counterpart is the unavoidable loss of control of the company by the founders as venture capitalists acquire rights (as shareholders). Financial constraints may thus often determine (the level, but also the nature of) investment decisions. (SINGH et al., 2001) nevertheless argues that “venture capital is perfectly compatible with bank based systems and, indeed, in the developing country context, the government itself may well be the best venture capitalist” (p.24). The debate that is addressed here is what kind of financial system or capital market arrangements are most conductive to fostering information technology and its use in the economy. The regression analysis carried out by the authors does not indeed suggest a robust
17
Not in Germany, however. In later stages of their expansion, bank loans may however be more appropriate. Thus, venture capital and banks can be said complementary. 18
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
relationship between stock market development and ICT usage. Contrary to the results of (BLACK and GILSON, 1998), it is therefore argued that venture capital, although normally associated with stock markets, is not peculiar to stock-market-based systems: East-Asian developmental States (e.g. South-Korea or Singapore), Israel and India 19 are cited as the most relevant examples. Anyhow, an acknowledged asset of venture capital financing is that venture capitalists understand the high-tech business better than a bank. By focusing on startups, venture capital firms indeed achieve expertise and economies of scale in locating and financing successful start-up ventures (JENG and WELLS, 2000). They intensively scrutinise firms before providing capital and monitor them afterwards, hence alleviating some of the inherent informational gaps and reducing SMEs' capital constraints (LERNER, 2000). According to (UEDA, 2000), the choice between bank and venture capital funding finally depends on two elements: how severe the problem of the asymmetry of information is, and how strongly intellectual property (IP) rights are protected20. Low collateral, high growth and high return to a project - some of the main features of innovative start-ups - all worsen the asymmetric information problem, and lead the entrepreneur to prefer resorting to VC financing. In the same manner, stronger protection of IP rights weakens the threat that venture capitalists may expropriate the entrepreneur's project, and this can account for the dramatic development of VC activities in the US. Not only venture capitalists have a better technical knowledge of small business finance, they may also be characterised as active investors (JENSEN, 1993). From a corporate governance perspective, this is highly beneficial for the start-up, as it entails an extensive diligence and close monitoring by venture capitalists: e.g. they frequently visit the company management, and often sit on the board of directors (LERNER, 1995). Sometimes venture capitalists even perform some key corporate functions for the firm: they may run e.g. the corporate finance department. But ‘staged capital infusion’ is the most powerful control mechanism a venture capitalist can employ: the owner/manager is put on a "tight leash", which may eventually reduce potential losses from bad decisions (SALHMAN, 1990). Such a staged capital infusion would result in a 19
In the Indian case e.g., the Government has helped the development of the ICT industry through multiple channels including the creation of highly trained quality manpower, the encouragement of multinational investments and exports, the setting up of software technology parks and the supplying of finance and marketing assistance to start-ups. 20 Cf. the cost of revealing the technological information and the threat of expropriation by the venture capitalist if IP rights are not well protected.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
higher financing duration and a decreasing monitoring intensity following the increase in asset tangibility of the firm. Syndicating investments may also diminish the adverse selection problem, as it allows the venture capitalist to invest in more projects and to diversify away firm-specific risks (LERNER, 1994b). Investment syndication moreover adds value to a venture through higher reputation, more contacts and intensive managerial activities (BRANDER et al., 1998). Finally, compensation schemes 21 (including stock-options) can be used so as to prevent corporate governance conflicts and to give the entrepreneur the incentive to focus on growth (SALHMAN, 1990). Figure 2: The Venture Capital Industry
The most efficient structure for venture partnership has also raised many discussions. In the US, venture capital firms are typically organised as limited partnerships with the venture capitalists serving as general partners and the investors as limited partners (JENG and WELLS, 2000): one of the advantages of such a structure is that capital gains taxes (CGT) are not paid by the limited partnership, and that the funds have a predetermined lifetime. In general, a venture capital firm will thus manage several pools of capital (also referred as funds), each of them being structured
21
Equity -based compensation (stock grants or stock options) given to the entrepreneur. Cf. (BAKER and GOMPERS, 2000).
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
as a separate limited partnership. Given the inherent restrictions on the ability of investors to intervene in the day-to-day activities of the fund, compensation and covenants, as well as the terms of the partnership agreement 22, are therefore critical for aligning the incentives of venture capitalists with those of investors (LERNER, 2000). The investors may also monitor venture capitalists through the possibility to withdraw from funding the partnership after the initial investment, but this is very rare in practice. There are some significant differences across countries, as far as the organisational form and the characteristics of VC firms are concerned (JENG and WELLS, 2000). A significant part of European VC organizations are actually subsidiaries of banks e.g., which contrasts with the relative absence of such captive funds 23 in the US. The management style of venture capitalists also differs across countries: contrary to Germany e.g., venture capitalists in the US are involved in the day-to-day management of the firm (e.g. through board representation), and they invest comparatively less but with larger equity stakes. One may also underline the significance of pension funds in the composition of VC funding in the US 24 as well as in other Anglo-Saxon countries. The emphasis on early stage is - in the same manner typical of American and Dutch venture capital firms, while German and British venture firms focus on later stages of the financing process. Finally, the high degree of geographic concentration of the US venture capital industry must be noted (GOMPERS and LERNER, 1996).
2.2
The ec onom ic impa ct of vent ure capit al
The development of VC activities may affect at least two macroeconomic variables, through the impetus given to the innovation process: more job creation, and additional GDP growth potential. Several papers thus intend to measure these expected effects, in order to evaluate their possible significance. The economic impact of the development of VC finally depends on its ability to influence significantly, and in a favourable way, the innovation process. A first cut at quantifying this impact on innovation is the study by (KORTUM and LERNER, 2000), 22
Cf. (GOMPERS and LERNER, 1999c). Funds are labelled "captive" if more than 80% of their financing derives from only one source, and "semicaptive" if when a single passive investor owns between 20 and 50% of the equity fund. If not, they are labelled as "independent" funds. Finally, a venture capital fund may be "public", when publicly owned (which entails some socio-economic objectives). 24 38% of US venture capital funds in 1995 according to (JENG & WELLS, 2000). 23
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
where the authors thoroughly examine this common rationale according to which VC spurs technological innovation. Using patent data, they find a "strong positive impact" of VC development on patenting. Moreover, the results are robust to a variety of specifications of how VC and R&D affect patenting, and to different definitions of venture capital. In more quantitative terms, and assuming that the potency of venture funding has remained constant, the results imply that, by 1998, venture funding accounted for about 14% of US innovative activity. The authors are also led to the conclusion that venture capital is about five to ten times more effective in stimulating patenting than traditional corporate R&D expenditures. Figure 3: The impact of venture capital: framework of underlying factors
Let's illustrate this stylised fact by another example. In the past few years, Germany has for instance experienced a venture capital boom: can this growth impose a wave of innovation as in the USA? (TYKOVA, 2000) addresses this question, and succeeds in proving that VC has had a significant positive influence on the number of patent applications in Germany. In quantitative terms, a doubling of the volumes of the VC investments (in real terms) causes a 12% increase in the number of patent applications, while a doubling of the number of VC-financed firms produces 21% more patent applications. At a more microeconomic level, several studies also state that, on 19
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
average, small companies proportionately achieve more innovations per amount of R&D spending than large enterprises. In the same manner, more valuable innovation is produced within independe nt research firms than when the research unit is integrated into a large company (less reward in case of success, hence less incentives). Graph 1: The performance of innovative SMEs
As far as the impact on employment figures is concerned, one may characterise venture capital market development and efficiency as a "key to job creation" (European Commission, 1999). According to several studies, fast growing SMEs are indeed one of the main engines for growth and employment. NASDAQ companies e.g. represented only 1% of US companies during the period 1990-1995, but originated 16% of the job creation (ibid.). In the same manner, the study conducted for the EVCA by (Coopers&Lybrand, 1996) highlights that staff numbers of venture-backed companies 25 increased by an average of 15% per year over the period 1990-1995, which means that their growth has been more than seven times faster than the top European companies. In addition, these companies invest heavily, develop internationally and create very high quality jobs. Firms that innovate more constantly and rapidly also employ more workers, demand higher skills, pay higher wages and offer more stable prospects for their workforce (OECD, 1996).
(GOMPERS and LERNER, 2001, p.164) have recently argued that it is a "challenging empirical problem" to demonstrate a causal relationship between the
25
80% of the companies surveyed said tha t they could not have existed or would have developed more slowly without venture capital made available to them.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
presence of venture capital investment and job creation. And, as a matter of fact, this issue has indeed been much less addressed than others. However, th is gap has recently been filled by (BELKE et al., 2001). In this paper, the authors indeed examine through a detailed panel data analysis - whether differences in VC investments (relative to GDP) have explanatory power with respect to labour market performance – across twenty OECD countries26 and over time (1987-1999). It is assumed that the rigidity of the capital market may contribute to cause structural unemployment: "the ability of a country to encourage and sustain technological innovation by entrepreneurial firms is one of the main sources of economic and employment growth. (...) Economists have [however] so far paid relatively little attention to the possibility of a virtuous circle between a dynamic venture capital industry, a well functioning stock market and entrepreneurial firms which could be of major help in improving the situation on the labour market" (p.21). Several papers 27 had addressed this issue but had never succeeded in producing any convincing empirical evidence about it. The economic intuition is nevertheless straightforward: job creation over the whole wage spectrum should not only be related to real wage costs and their flexibility in the face of shocks, but also to economic growth and, in particular, to investments (especially in risky and new ventures). From this perspective, the figures identified by the authors may be used as a rough guide: a one-unit increase in venture capital28 would reduce the change of unemployment by 46%. These results are consistent with the experience of the AngloSaxon countries, which succeeded in creating new firms in the expanding sectors of the economy (i.e. growing number of jobs), while developing adequate channels of financing through the emergence of buoyant venture capital markets.
2.3
The det erm inants of ve ntu re cap ital fundrais ing
“Little empirical research has been done on this issue [the determinants of VC funding] so far” (BALBOA & MARTI, 2000), and the papers that have dealt with it resulted in contradictory findings. Variables like the number of IPOs, GDP and market capitalisation growth, the level of capital gains taxation, the presence of private pension funds, the significance of government's programs, and the VC firm's performance have nevertheless appeared as the main determinants of VC fundraising.
26
Including 13 countries of the EU (Luxembourg & Greece excluded), as well as Switzerland & Norway. For instance, (ACEMOGLU, 2001) e.g. underlines that credit market imperfections may fuel the structural unemployment caused by rigid labour markets. Cf. also (WASMER and WEIL, 2000). 28 However, not only the total level of VC investments but also their structure (early or later stage financing, sectors of investments, etc.) appears to be conducive to job creation. 27
21
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College of Europe Academic year 2001-2002
The existence of a well-developed stock market is critical to the existence of a vibrant VC market 29, given that it allows exits from investments through IPOs. By allowing the recycling of "informed capital", stock markets encourage business creation, innovation and growth (MICHELACCI and SUAREZ, 2001). One may therefore expect a significant relationship between the number of VC-backed IPOs and new capital commitments to VC funds in the following year: this has been empirically tested by (BLACK and GILSON, 1998) for the US, with indeed positive results. While admitting that Euro.NM30 has been far from providing a pan-European stock market for innovative, high-growth companies, (BOTAZZI and DA RIN, 2000) have for example underlined its significant impact on the development of European venture capital markets. On the one hand, between April 1997 (date of its creation) and February 2000, 368 firms were introduced on Euro.NM and €14 billion raised, while a dramatic parallel increase in the amount of VC raised was taking place: e.g. €25 billion in 1999, a five-fold increase over the early 1990s. And on the other hand, venture capitalists became more often involved, with companies that are to go public, after the creation of the Euro.NM circuit. This evidence shows that Euro.NM succeeded in mobilising the VC industry: it offered to venture capitalists an outlet for the realisation of capital gains, and to entrepreneurs the incentive to take the risk of launching their start-up. In the opposite way, it has been underlined that the loss of confidence in the Dutch Parallelmarket (the 'Dutch Nasdaq'), opened in 1982 and closed in 1993 (triggered by certain high-profile underperformances), had provoked a dramatic downturn of the Dutch VC market (BOUWER and HENDRIX, 1998). In what is largely acknowledged as a pioneering 31 study, (JENG and WELLS, 2000) sift through all the different factors 32 that may influence venture capital fundraising: IPOs, labour market rigidities, financial reporting standards, private pension funds, GDP growth, market capitalisation growth, government programs. The authors use panel data techniques across 21 OECD countries and over a time period of ten
29
To some extent, it may even account for the fact that some foreign venture capital markets (e.g. in Israel) are rather well developed without the presence of a highly liquid stock market: even if quite expensive, some companies have indeed easily access to the US stock market (e.g. NASDAQ). 30 Euro.NM, created in March 1996, was the circuit of European 'New Markets'. It ceased to exist at the end 2001, as its objectives were achieved. Cf . infra. 31 Published in the Journal of Corporate Finance in 2000, the original working paper (Harvard University) was issued on May 1998. 32 Capital gains tax rates and the efficiency of bankruptcy procedures are not included, because of difficulties to find good proxies for these variables.
22
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College of Europe Academic year 2001-2002
years. The main finding is that IPOs are the strongest driver of venture capital investing33, which is consistent with (BLACK and GILSON, 1998). As noted by the authors, a viable exit mechanism is indeed extremely important to the development of a VC industry, and IPOs are said to be the best choice, given that the other alternative, trade sales34, is frequently synonymous of a loss of control. Surprisingly, GDP and market capitalisation growth 35 - as well as financial reporting standards 36 - are however not significant. As for government policies, their positive impact is very significant, especially when setting the regulatory environment and encouraging investment during downturns. (LERNER, 1999) was the first to provide evidence that government funded programs could yield favourable benefits, despite the acknowledged disadvantages of these efforts. Labour market rigidities have also a significant (negative) influence on VC fundraising, as expected 37, but only when dealing with earlier stages of financing - which is consistent with the fact that the probability of going bankrupt is higher at this stage. Finally, pension funds have a significant positive influence on VC fundraising over time, but surprisingly not across countries. A similar study was carried out by (GOMPERS and LERNER, 1998). The independent variables that the authors found to be significant were the following: capital gains tax rates, level of pension funds in the economy, GDP growth, the attractiveness of returns on the stock market, greater R&D expenditures and the company's performance and reputation (best measured by the size of the venture capital organisation). Contrary to the findings of (JENG and WELLS, 2000), GDP growth is indeed statistically significant38, while IPOs are strikingly not. Another new conclusion is that older and larger VC firms receive larger capital commitments, which is consistent with the fact that they are supposed to have more established relationships. There is also empirical evidence that the 1979 amendment to the "prudent man" rule - that governs pension fund investments - has had a decisive influence on the increase of the US venture capital industry in the 1980s. Prior to 1979, the Employment Retirement Income Security Act (ERISA) indeed prevented pension funds from investing substantial amounts of capital into ventures or other high-risk assets - a rule that was
33
Here, IPOs have however no effect on early stage financing, whereas being a significant determinant of later stage VC investing. 34 'Trade sales' is defined as sales of a start-up company to a larger company (referred to as a 'strategic buyer'). 35 Among others, (ACS and ANDRETSCH, 1994) suggest that macroeconomic fluctuations (GDP growth) influence start-up activity in general. 36 The cost of asymmetric information is reduced when there are strict accounting standards. 37 Should the individual fail in his new venture, it would be more difficult for him to find a new employment if there are labour market rigidities. 38 Increasing real GDP growth of the previous year leads to higher venture funds.
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removed after 1979. Finally, (GOMPERS and LERNER, 1998) succeed in showing an empirical negative effect of CGT on the demand of VC, which is consistent with the intuition of (POTERBA, 1989). As however pointed out by (LERNER, 2000), "much more remains to explored regarding the internationalisation of venture capital". The VC industry was indeed until recently mainly concentrated in the US, and very few papers had dealt with the factors that could lead to the development of venture capital fundraising in other parts of the world. As far as Europe is concerned, a notable exception is (BALBOA and MARTI, 2000). Their main contribution consists in explaining fundraising by means of variables directly related to the venture capital financing process rather than by variables related to the economic environment (such as IPOs, GDP growth, etc.). As in the others studies mentioned, the authors resorted to panel data techniques, across 16 European countries (EU-15 plus Norway and Switzerland, but excluding Luxembourg), and over the period 1991-1999. As noted, the focus is placed on the influence of both investments and divestments on the decision to launch a new private equity fund, and thus on the fund manager's investing capabilities. And they actually found that the amount invested as well as the amounts divested in the previous years have a statistically significant positive coefficient on the new funds raised. As the European VC industry is still under development, information on returns is indeed still scarce and past investments are therefore very important at explaining the flow of new funds raised. This is consistent with the results of (SIRRI and TUFANO, 1998), according to which the reputation of the venture capital organisation (measured by its age and the capital under its management) may influence the flow of new commitments when it raises a new fund.
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3 GENERAL FRAM EWO RK OF AN ALYSIS Comprehensive and thorough quantitative descriptions of the European venture capital market have already recently been conducted 39. The present study thus does not aim at achieving such a work. The dramatic increase of the European VC market since the mid-1990s nevertheless raises the question of whether it has followed the same path as the development of the American VC market, or if its characteristics substantially differ from it. Our econometric model (cf. infra) will directly address this issue, trying to explain this dramatic increase of European VC fundraising by specific European factors, instead of interpreting it as a mere spillover from the US. This section therefore proposes a general framework for the subsequent analysis of the specificities of the European VC market.
3.1
The Eu ro pea n Ven tur e C api tal
Market: a brie f
comparati ve ana lys is with th e U nit ed Stat es Europe is often considered as a polar case to that of the US because of its underdeveloped venture capital industry and stock exchanges for high-growth companies. Only the Netherlands had experienced an early boom of its VC industry, from the mid-1980s, thanks to the incentives set up by the Government 40. The UK has also managed to foster a well-developed VC industry (37% of the total of raised funds in Europe in 2000, followed by France with 16% total), but with very different features to the US (focus on later financing stages e.g.). Graph 2: Venture capital raised (VCR) and invested (VCI) as % of GDP: a comparison between the EU and the USA (1996 -2000)
39 40
Cf. e.g. (SCHERTLER, 2001) or (CHRISTOFIDIS and DEBANDE, 2001). Cf. e.g. (BOUWER and HENDRIX, 1998).
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Finally, when we look at private equity investments as a percentage of GDP in 2000, only the UK (0.86%) and Sweden (0.92%) had a level close to that of the US (1.01%), while Europe as a whole 41 was lagging behind (0.35%). Graph 3: Private equity investment as a percentage of GDP in 2000: detail by European countries.
Thanks to a dramatic increase of the European VC market, 2000 was nevertheless the record year for funds raised in Europe (€48 billion, almost double the previous record set in 1999: €25.4 billion), as well as for funds invested (€35 billion). As for year 2001, it was characterised by a decrease of funds raised and invested both in the US and in the EU, leading to a diminution of the discrepancy between the two continents: $40.6 billion were raised and $37.7 billion invested in the US, to compare with €31.5 billion raised and €23 billion invested in Europe 42. Despite parallel dramatic increase in amounts raised and invested, European markets for private equity still differ considerably with respect to the amounts of money invested in enterprises' early and
41
In this paper, we include in the European venture capital market the EU- 15 countries plus Norway, Switzerland and Iceland, but excluding Luxembourg. We also do not include Central European countries, contrary to (EVCA, 2001). 42 Sources: NVCA and EVCA websites.
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College of Europe Academic year 2001-2002
expansion stages as a share of GDP, to their sources of funds 43, and to governments' role (SCHERTLER, 2001). It is nevertheless interesting to try to characterise the similarities between European national markets, and to underline the emerging features of the European VC market compared to that of the US, from the perspective of the most recent data (EVCA, 2001): §
A market dominated by banks? Banks used to dominate the European venture capital market, but, in 2000, pension funds overtook them as the largest contributor to funds raised. €10.7 billion were indeed raised by pension funds (24% of the total amount), i.e. more than the double of 1999, to compare with €9.6 billion by banks (22% total). This is the result of a long-run trend characterised by a decreasing significance of banks and an increasing significance of pension funds (SCHERTLER, 2001), and is consistent with the expansion of British pension funds (where US pension funds are increasingly investing). Pension funds have also strongly developed in Germany and Finland.
Table 1: Strategic Allocation to Private Equity by Pension Funds, Endowments and Foundations (% of total fund assets)
§
A majority of captive funds? Captive funds accounted for 22% of new funds raised (more than the double of 1999) and 15% of funds invested in 2000, which is very high compared to the US. But independent funds are however still largely dominating the market with 69% of new funds raised (+82% compared to 1999) and 64% of total invested funds. Once again, this has been the result of a long run trend, as captive funds used to be even more present in Europe at the beginning of the 1990s: e.g. 36.1% of funds raised and 41% of invested funds in
43
For instance, realised capital gains are a significant source of funding in France, Belgium and the Netherlands, but not in other countries. In the same manner, corporate investors play a much more significant role in Sweden and Austria (1/5 of new funds in 1999) than elsewhere (SCHERTLER, 2001).
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
1992 (EVCA, 1993). On the one hand, in the UK and the Netherlands, known for being mature venture capital markets, the share of independent equity investors is comparatively high. But, on the other hand, in France, captive and semicaptive funds are still dominating the domestic VC market and are often subsidiaries of banks (SCHERTLER, 2001). §
A more important role devoted to Government? Public funds have accounted for only 4% of venture investments (€1.4 billion) in 2000, but 49% in Belgium 44, 21% in Portugal, 13% in Germany and 8% in Finland. The degree of State involvement in the provision of VC thus distinguishes some European VC indus tries from their counterparts in the US. Almost all European governments utilise public policies to improve the capital supply for young, high technology enterprises (OECD, 1997)45: legal environment (the Netherlands), tax incentives (UK), state-owned funds (Belgium and Portugal), capital provision at favourable conditions, loans at favourable interest rates, etc.
§
A fragmented market? The European venture VC market is characterised by very little cross-border activity: 50% funds raised are from domestic sources. One may however note an increasing contribution from the US, with 20% funds raised (+16% compared to 1999). Most investments are made domestically too: 83% of the total number and 73% of the total amount of venture investments. Overall, 93% of the total amount of venture capital invested went into investments located in Europe, and only 5% to the US. According to (BAYGAN and FREUDENBERG, 2000) 46, Belgium was the biggest exporter of private equity in 1999, followed by Sweden, the Netherlands and the UK (highest negative net flows). The highest net inflows were realised by Ireland, Denmark, Finland, Portugal and Spain 47.
§
Less syndication of investments? Syndication of venture investments is much
less developed in Europe than in the US, as noted by several authors (e.g. TYKOVA, 2000). And indeed, over 70% of the investments made in 2000 (€25.3 billion) did not involve any syndication, to compare with only 10% in the US
44
For a detailed study of the Belgian venture capital market, see (VAN SEBROECK, 2000). Also described in (JENG and WELLS, 2000, pp. 34-39). 46 Cf. annex 3. 47 One may note the presence of four out of the five 'cohesion countries'. Cf. section 5. 45
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College of Europe Academic year 2001-2002
(OECD, 1996). Investments involving a national syndication represent a decreasing share, while trans-national syndication has increased to 9% by number. §
Less specialisation in early-stage financing? The worldwide trend goes to
desegregation, fragmentation, and stage-financing of the innovation process into smaller units (OECD, 1996a). Venture capital funds should thus in theory specialise in earlier financing stages (especially the start-up phase), where they have an acknowledged comparative advantage (cf. supra), and where the IRR is a priori much higher (cf. table infra), but this is rarely the case in practice. Table 2: Stages of investments and associated risks
Source: (CHRISTOFIDIS and DEBANDE, 2001, p. 8)
Table 3: Target returns by investment stages
Source: (BYGRAVE, HAY and PEETERS, 1999)
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
The European early-stage venture capital market remains small, and the bulk of European VC companies' activity has been devoted to buyouts and other later stage investments. While funds earmarked for high-tech early stage and expansion investments increased by 81% to €15.2 billion, funds raised for buyouts increased by 106% to € 24.3 billion. Notwithstanding, if MBOs still lead the amount of investments, their share is substantially reduced compared to 1999 (from 53% to 41% of the total amount invested). In the meanwhile, start-up investments more than doubled to €5.8 billion (29% total invested) and funds raised for investment in high-tech companies at the early/expansion stages increased by 81%. However, the largest category (by number) remains the expansion stage: 42% of the number and 37% of the total amount of investments. Relative to GDP, in 1999, early investments were the highest in Sweden, the Netherlands and Belgium. As for MBOs, they have traditionally played a significant role on the British private equity market, the biggest market in Europe, all along the 1990s. Graph 4: Staged distribution by percentage of amount invested in 2000
Seed 2%
Start-up 17%
Buyout 41%
Expansion 37%
Replacement capital 3%
Source: (EVCA, 2001)
§
Deals of inferior average size? The average size of deals is increasing but is still
inferior to US levels - where the large size of the deals has sometimes been interpreted as an evidence of a speculative 'bubble'. There are actually less deals made in the US but their size is indeed much larger, which may account 30
Aloys RIGAUT Economics Department. MA Thesis.
for
the
interest
College of Europe Academic year 2001-2002
of
American
venture
capitalists
in
being
'active'
investors/shareholders. §
Less investment opportunities? The increase of new funds raised in 2000 (+89%) was larger than the increase of funds invested (+39%). High-tech48, that is supposed to be the sector with the highest opportunities, was nevertheless the largest industry category (31% total amount, 42% total number), especially in Ireland, Belgium, Denmark and Finland. Graph 5: Expected allocation of funds raised in 2000
Not Available 3%
High-Tech Early-Stage 18% Non High-Tech Early-Stage 3%
Buyout 50%
Non High-Tech Expansion/Dev elopment 12%
High-Tech Expansion/Dev elopment 14%
Source: (EVCA, 2001)
§
More divestments by trade sales? Divestments by trade sales remains the main
exit route for VC investments in Europe in 2000: 33% of the total amount divested, to compare with 19.6% by re payment of preference shares/loans and 14% by IPOs. There are however some exceptions: repayment of preference shares/loans is prevalent in Austria and the UK, while IPOs are prevalent in Portugal (46% total amount divested) and Switzerland (67%). One may also note that both trade sales and IPOs divestment amounts (and shares) fall compared to 1999. This is consistent with the difficulties that fund managers
48
Include telecommunications hardware, Internet technology, computer hardware, software and computer services, electronics, semiconductors, biotechnology, medical instruments and devices (EVCA, 2001).
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face when exiting their investments (MARTI, 1999). There is indeed a lack of developed stock markets for high growth companies in Europe, hence less divestments by IPOs than in the US. The only encouraging sign is that the increase in the number of venture-backed IPOs (+67%) has superseded, in 2000, the increase in the number of companies divested by trade sales (+5%).
Graph 6: Divestments by type of exits in 2000 (% amount) Sale to financial institution 4%
Other means 10% Trade sale 32%
Sale to another venture capitalist 12%
Repayment of preference shares/loans 20%
Write-off 8%
Public offering (incl. IPOs) 14%
Source: (EVCA, 2001)
§
Less efficient stock markets? Europe's under-specialisation in high-tech industries has often been related to European stock markets' lack of efficiency: the lack of liquidity makes indeed individual flotation particularly costly. If there is no recycling of informed capital, the economy cannot take-off: the informed capital gets "stuck" in some "bottlenecks" (MICHELACCI and SUAREZ, 2001). But this situation may have started to change with the introduction of "new markets" in the main European stock exchanges 49 since the mid-1990s: AIM in 1995, EASDAQ (now Nasdaq-Europe) and Euro.NM50 in 1996, etc.
49
Cf. annex 2 for a comprehensive list of European New Markets. It comprised the French 'Nouveau Marché' (Feb. 1996), the Dutch NMAX (Feb. 1997), the German 'Neuer Markt' (March 1997), Euro. NM Belgium (April 1997), and the Italian 'Nuovo Mercato' (June 1999). Euro.NM Belgium ceased to exist after the creation of Euronext. 50
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Graph 7: Market capitalisation and number of listed companies on Euro.NM (Jan. 1998 – Dec. 2000)
Table 4: The development of European New Markets (situation as at 1 January 2001)
Source: (GIUDICI and PALEARI, 2001, p. 16)
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
While still lagging behind the US market, the emerging European venture/risk capital market is thus characterised by encouraging features. There are nevertheless still many more policy challenges to face. Our model (section 4) will shed light on certain of these issues.
3.2
The A ctio n Pl ans o f the European Comm iss ion :
toward s a sin gle Eu rop ean fi nan cia l m ark et In the horizon of making a single European financial market emerge, several waves of European directives were adopted from the mid-1980s for each branch of the financial sector: banking, insurance and financial services 51. But from the point of view of European financial integration, this was not sufficient to address all the needs in terms of structural reforms - especially in the field of risk capital 52. At the end November 1997, the European Council on Employment thus acknowledged "the importance of the role that large pan-European risk-capital markets 53 can play in job creation" and asked the Commission to report on the barriers to the development of such markets in the EU. This led to the adoption in June 1998 of the Risk Action Plan54 (RCAP, 1998-2003) by the Cardiff European Council. In parallel, a Communication by the European Commission outlined a series of measures to ensure the EU's financial services sector realises its full potential and to reap the full benefits of the introduction of the euro ("Financial Services: Building a Framework for Action", October 1998), which prepared to the adoption of the Financial Services Action Plan 55 (FSAP, 2000-2005). The objective of the RCAP is the creation of a large transparent and liquid European capital market able to provide financing to (in particular high-growth) SMEs. This requires some reforms both at European and at Member States level, and the RCAP thus aims at identifying the priorities for action in this field. Now, according to the European Commission, one may distinguish six types of barriers holding back European risk capital markets:
51
The most significant directive, in this field, was the Investment Services Directive (ISD), which started to be implemented in 1996, making e.g. the creation of EASDAQ possible. 52 Each link of the financing chain shall be addressed to ensure a smooth functioning of the European financial markets. 53 In the European Commission's words, "risk capital markets" include all segme nts of private equity investing activities (investment by business angels and venture capital funds, notably), as well as the high -growth equity markets 54 Cf. annex 4. 55 Cf. http://europa.eu.int/comm/internal_market/en/finances/actionplan
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§
Market fragmentation: cf. supra.
§
Institutional and regulatory barriers: e.g. need to harmonise accounting, taxation and market platform rules, and to improve bankruptcy rules
§
Taxation: e.g. lack of fiscal transparency for venture capital funds and of fiscal incentives to investments in equities
§
Paucity of high-tech SMEs in the EU: This has led to the drafting of the first Innovation Action Plan (1998) 56. The Gate2Growth Initiative e.g. aims at supporting innovative entrepreneurs in Europe, notably by helping service providers to improve their capacity to assist entrepreneurs by fostering networking and the exchange of experience and good practice at European level.
§
Lack of human resources: e.g. lack of expertise and experience in SME financing. In the framework of the 'Action Plan to promote Entrepreneurship and Competitiveness' (BEST project), several initiatives were launched to exchange experience and good practice between venture capital operators, technology incubators, and industrial liaison offices linked to research institutes and universities across Europe.
§
Cultural barriers: Assertions such as "Europe still lacks entrepreneurial, risk taking culture" (European Commission, 1999, p.9) may be questioned. Beyond the disadvantages of such a static perspective, the assessment of risk may indeed depend much more on the (legal, etc.) environment than on "cultural" aspects. However, promoting a "culture of entrepreneurship" by adapting the regulatory environment - e.g. bankruptcy rules - may be indeed a relevant policy issue. "Timely implementation of the Financial Services Action Plan (FSAP) will do
much to foster a more integrated EU risk capital market" (European Commission, 2000). Of particular importance for the European VC capital market development are indeed the timely adoption of the directive on the prudential supervision of supplementary pension funds, the two directives on UCITS, the amendments of the prospectuses directives, the renovation of the ISD and the legislative follow -up to the EU accounting strategy Communication (Oct. 2000). One may also recall the correlation 56
Adopted by the European Commission on 11 May 1999. This Action Plan is managed by the Innovation Directorate of DG Enterprise and has a legal mandate to promote the emergence of a favourab le environment for financing the exploitation, adaptation and dissemination of technology. This includes the interlinking of financiers, investors and technology sources as well as initiatives to mobilise private capital for the financing of innovation. Source: http://www.cordis.lu/innovation .
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College of Europe Academic year 2001-2002
between the growth of the VC market and the development of the market for IPOs: from this perspective, the creation of small cap markets like the AIM, Easdaq and Euro.NM are said to be encouraging signs (European Commission, 1999). Anyhow, at the Lisbon summit (March 2000), the European Commission identified - in the framework of the FSAP - 43 key-measures to dismantle the barriers to achieving a true single market for financial services in the EU and to ensure the stability and competitiveness of the European financial markets. The aim is to achieve this action plan by 2005.
Finally, what has been the main relevant actions undertaken at European level so far? Including both the FSAP and the RCAP, one may emphasise the following priorities: §
Upgrading
existing
financial
services
directives :
especially those e.g. on
prospectuses to facilitate companies raising cross-border capital (e.g. IPOs), and the renovation of the ISD to promote stock market integration. §
Dissemination of best practices in corporate governance: An initiative was recently
launched by the European Commission on this matter, and the final report of the study that was asked has just been published on January 2002: "Comparative study of corporate governance codes relevant to the EU and its Member States". Notwithstanding legal differences, the trend is clearly towards convergence, while most differences regard company law and securities regulation rather than differences in codes' recommendations. Shareholders participation rights and disclosure requirements still vary significantly across European countries, which poses some impediments to a Single European equity market. It is therefore concluded that the European Commission need not "expend energy on the development of a [Community] Code" (p.6): the reduction of legal and regulatory barriers to shareholder cross-border involvement (participation and information barriers) shall be the priority. §
Assessment of existing accounting and auditing requirements. According to the new
policy, all EU-listed companies shall now prepare their consolidated financial settlements in accordance with International Accounting Standards (IAS)57.
57
By a recent vote, on 12 March 2002, the European Parliament endorsed the Commission's proposal that all EU listed companies must follow standards issued by the IAS in their consolidated financial statements starting no later than 2005. Member States are allowed to decide whether non-listed companies must also follow IAS.
36
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§
College of Europe Academic year 2001-2002
Adoption of more ade quate prudential rules: The aim shall be to allow institutional
investors to invest in venture capital. From this perspective, one must note the improvement stemming from the adoption by the Council of Finance Ministers on 4 December 2001 of the two Directives on harmonised investment funds (UCITS) - one of the top priority actions of the FSAP. The first directive ("Product") indeed widens the scope of assets in which investment funds can invest, while the second directive ("Management") gives management companies a "European passport" to operate throughout the whole Union. §
Reform of the European patent system . A proposal of regulation for a Community th
patent has been put forward by the Commission on July 5 2000. Such a 'Community patent' would give inventors the option of obtaining a single patent legally valid throughout the EU. This proposal is however still under discussion. But the essential part of the structural reforms actually remains to be done at the Member States' level. In a communication by the European Commission (18.10.2000), Member States are thus asked to act in three priority areas: §
The easing of quantitative constraints on institutional investment in equity capital. Only
four member states had no legal restrictions / regulatory constraints in 2000: Finland, Ireland, the Netherlands and the UK. §
The softening of bankruptcy laws to allow failed entrepreneurs a "second chance"
(while affording adequate protection of creditors' rights). §
The development of a fiscal framework more conducive to investment and
entrepreneurship. With the exceptions of Finland and Italy, all the Member States indeed favour the use of debt over equity financing in their tax structures. The issue of capital gains taxation exemption is also very relevant, but not yet fully addressed because of its political sensitiveness.
The EU has thus been active in trying to develop the European VC market through adequate structural reforms. But the question remains: were all these measures effective in fostering VC activities? Will the RCAP be sufficient or is it only a first step?
37
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4 ECO NOM ET RIC MO DEL As acknowledged in many papers: "given the general benefits to the economy of venture capital activity, or more specifically its impact on innovation, it is recommended to conduct further research on the key aspects that affect venture capital fundraising" (BALBOA and MARTI, 2000, p.10). And this statement is especially relevant for venture capital markets outside the US, i.e. what is called by American economists "the internationalisation of venture capital" (LERNER, 2000). As a contribution to this challenge, we thus present here a model that aim at explaining the development of VC fundraising in Europe, using the most recent data (EVCA, 2001) as well as the most standard58 methodology (panel data techniques).
4.1
Empiri cal m odel an d m eth od ology
We believe that some key factors specific to the European environment (in addition to return percentage) have determined the growth of VC fundraising in Europe since the mid-1990s, and that the recent surge in VC fundraising is not a mere spillover from the US. Our econometric model will therefore aim at testing this hypothesis: we will be using only domestic factors (external/environmental variables), and test if they have/had a significant influence on the VC fundraising in Europe. These factors are: the number of IPOs on European exchanges, the annual GDP growth of European countries, the existence (or not) of a domestic “new market”, the penetration of ICT in Europe, the rigidities of the domestic labour market, and the advancement with regard to the implementation of financial services directives. We use pooled regressions (OLS) and (static and dynamic) panel data techniques on data from the European countries studied in the EVCA Yearbooks (1998-2001). The model is estimated on a sample of 17 European countries over the period 1996-2000 (5 years), namely: Austria (1), Belgium (2), Denmark (3), Finland (4), France (5), Germany (6), Greece (7), Ireland (8), Italy (9), the Netherlands (10), Portugal (11), Spain (12), Sweden (13), UK (14), Norway (15), Switzerland (16) and Iceland (17) 59.
58
Cf. e.g. (BELKE et al., 2001), (JENG and WELLS, 2000), (BALBOA and MARTI, 2000) for an application of panel data techniques on venture capital data. 59 The numbers attributed to each country correspond to the numeration of the individual effects in the LSDV modelling (cf. infra, the
Ii
dummy variables).
38
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
Central and Eastern European Countries (Poland, Hungary, Czech Republic & Slovakia) are not included, as relevant data is only available from 1998. The panel data methodology offers several advantages 60: it controls for individual heterogeneity, it provides a great amount of data (increasing the degrees of freedom) and it allows us to analyse a number of important economic questions that cannot be addressed by using cross-sectional or time-series data sets. The basic model (equation 1) we wish to estimate is the following, using a fixed effects transformation61:
VCR
i, t
= const . + α . IPO
i ,t
+ β .GPDG
i ,t
+ χ . ICT i , t + δ . LAB
i ,t
+ ε . NM
i ,t
+ φ . FSAP i + I i + u i , t
Where t stands for the period (t = [1996, 2000]), i for the country (i = [1, 17]), and
Ii
for the individual/country effects: we thus have, in total, 85 observations (17*5). And
where:
§
VCR: the amount of venture capital raised (in billion €) normalised by GDP (also expressed in billion €).
§
IPO: the number of IPOs on domestic equity markets normalised by GDP
§
GDPG: the annual GDP growth rate.
§
LAB: the general unemployment rate (% labour force) as a proxy for labour market rigidities. Labour market rigidities is indeed often cited as one important reason why venture capital market is not prevalent in Europe. Thus, as underlined in (BALBOA and MARTI, 2000, p.27), unemployment rates should be considered as a macroeconomic/environmental variable when estimating VC raised.
§
ICT: Expenditure on Information and Communication Technologies62 (ICT) as a percentage of GDP. As indeed highlighted in (BALBOA and MARTI, 2000), "the
60 61
See (HSIAO, 1986) and (ARELLANO and BOVER, 1990). We indeed assume that the unobserved component is correlated with the explanatory variables. In such a
I
model, the individual effects - i - may be interpreted as dummy variables 62 Includes hardware, software and other services.
39
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
surge of investments in ICT since 1998 [may be] the main reason for the immense amounts raised by fund managers in 1999 and 2000" (p.34), because of the increase in technological opportunities that it provides.
§
NM: a dummy variable indicating the presence (or not) of a domestic ‘New Market’ 63. Several variables have been tested, some with a weighting function representing agents' learning (NM3). "The opening in Europe of new stock exchanges targeted at firms with high-growth potential in high-tech, innovative sectors [indeed] creates a new and unexplored topic to study" (BOTTAZZI and DA RIN, 2000, p.5).
§
FSAP : a dummy variable indicating the advancement of the country in the transposition of financial directives (situation as of June 1999). FSAP takes the value 1 if the country is among the most advanced (i.e. ranked first ex aequo by the European Commission), 0 if not (cf. infra).
Table 5: Transposition of financial services, situation as of June 1999
Source: (European Commission, 1999)
Fixed effects regressions, as in (GOMPERS and LERNER, 1998), also include dummy variables that are intended to pick up unmeasured country-specific factors.
63
Cf. annex 2.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
The above model is static in nature, but there are reasons to believe that such a model may be dynamically mis-specified. We therefore specify a second estimating equation:
VCR i , t = const . + λ .VCR i , t − 1 + α .IPO i , t + β .GPDG i , t + χ .ICT i , t + δ .LAB i , t + ε .NM i , t + φ .FSAP i + I i + ui , t
Dynamic panel models are characterised by the presence of a lagged dependent variable, and highlight both short-run and long run impacts of independent variables.
4.2
Data
This study empirically examines 17 countries, selected on the basis of availability of information, and using panel data covering the years 1996-2000 (cf. supra). Our data sources are the following: ð Data on the amount of VC raised per year and per country are obtained from
the EVCA Yearbooks (1998-2001). ð The Federation of European Stock Exchanges' (FESE, www.fese.be) Annual
reports 1996-2000 provides data on the number of IPOs per year and per country. ð Data on GDP levels, GDP growth rates and exchange rates (from domestic
currencies to Euro) are obtained from OECD Sources (background economic indicators) and the IMF. Conversion in Euro has been operated with IMF data on exchange rates USD/ECU and USD/EUR. ð EUROSTAT 64 and EITO (cf. Internet resources) provide data on ICT
expenditure per country and per year. ð Data
on
general
unemployment
rates
are
also
obtained
from
EUROSTAT/European Commission. ð The websites of European New Markets (cf. annex 2) provide information
about their history and date of creation. Some more information has also
64
Collection: key indicators. Theme: General statistics.
41
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
been found in (FULGHIERI and TURNER, 2001) and (GIUDICI and PALEARI, 2001). ð Data on the FSAP variable is obtained from (European Commission, 1999):
cf. table supra.
4.3
Res ults an d fi ndi ng s
Modelling VCR by Ordinary Least Squares (OLS), through a pooled regression and using robust standard errors, gives the following final results 65 as a first approximation (after reducing the model as far as possible): Coefficient
t-prob
LAB
-0.000140107
0.007
ICT
0.000824727
0.027
FSAP
0.00152453
0.014
NM3
0.00284496
0.009
IPOs
9.34150e-006
0.035
Constant
-0.00258846
0.220
66
Wald (joint):
Chi^2(5) =
58.05 [0.000] **
Wald (dummy):
Chi^2(1) =
1.530 [0.216]
AR(1) test:
N(0,1) =
2.653 [0.008] **
AR(2) test:
N(0,1) =
1.647 [0.099]
The R² is equal to 47.1%, which is quite significant but shows that the model is not complete and totally satisfactory so far. According to the Wald test, the hypothesis that the coefficients on the regressors are jointly zero is strongly rejected, while the hypothesis that the coefficients on the dummy variables (and the constant) are jointly zero is not rejected. As far as serial correlation is concerned, the AR(1) test fails at rejecting the null hypothesis, even at a 99% level of confidence, which may be a sign of a dynamically mis-specified model. As for the significant variables that come out from this basic pooled regression, one may note that, as would have been expected, labour rigidities (LAB) impact negatively the amount of venture capital raised (VCR), while ICT expenditures (ICT) 65 66
The econometrics software used is GiveWin 2.0. © J.A. Doornik, 1994-2001. Cf. annex 1 (complete results). IPOs: number of IPOs on domestic stock exchanges (not normalised by GDP)
42
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
has a positive impact on it. The dummy variable that aim at catching the influence of the creation of a 'new market' on the amount of VC raised (NM3) also comes out as significant - whether expressed as a learning function (NM3) or not (NM) -, as well as the dummy variable representing the advancement in the implementation process of the financial services directives (FSAP), both with strong positive effects. As for the impact of the number of IPOs on VCR, it is only significant when non normalised by GDP, but even then, the coefficient - despite positive as one would have expected - is so small that we can exclude it. The coefficients of the other variables are at first sight very small, but one must bear in mind that VCR has been normalised by GDP and is expressed in billion €, which means that even a coefficient of +0.0001 may be very significant in absolute terms.
If we now resort to a static panel data modelling, using Least Squares Dummy Variable (LSDV) estimators (fixed effects model / within regression), we are led, after reducing the model as far as possible67, to the following results: Coefficient
t-prob
IPO
-0.00215285
0.000
LAB
-0.000422272
0.006
ICT
0.00121659
0.005
FSAP
0.00209758
0.000
-0.00347081
0.107
Constant
R² = 0.6966307 Wald (joint):
Chi^2(4) =
133.4 [0.000] **
Wald (dummy):
Chi^2(17) =
396.3 [0.000] **
AR(1) test:
N(0,1) =
-1.960 [0.050]
AR(2) test:
N(0,1) =
-2.537 [0.011] *
In this model, the R² is much higher (69.6%) than in the previous model (47.1%), which is a positive sign. ICT expenditures (ICT), labour market rigidities (LAB) and our FSAP dummy variable are once again strongly significant (even at the 99% level of confidence), with the expected signs on the coefficients (positive for FSAP and ICT, and negative for LAB). But what is surprising is that the coefficient on our IPO variable 67
For the initial model, cf. supra equation (1). The details of the results of the individual effects are not produced here (cf. annex 1).
43
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
comes out as significantly negative, which is contrary both to the intuition and to the results of (BLACK and GILSON, 1998) and (JENG and WELLS, 1998). This would tend to show that, relative to the GDP, domestic IPOs played a minor role on the development of venture capital fundraising in Europe, and that other variables better explain this development. On the contrary, the other variables - the dummy variable NM and the GDP growth rate (GDPG) - are not significant. This non-significance of our NM variable may not be surprising, given the deep fragmentation of European stock markets (especially with regard to European New Markets) and its small size compared to that of the US. As moreover pointed out in (SCHERTLER, 2001, p.40), the increase in the share of enterprises divested via an IPO in the second half of the 1990s does not seem to be correlated with the establishment of the national stock market segment for fast-growing firms: "obviously, [the influence of] the creation of a liquid secondary stock market on divestment channels chosen by private equity investors is only observable after some time lag". Some further studies should thus be conducted on this subject in coming years, when European stock exchanges will be more integrated. Finally, the Wald tests conclude to the strong rejection of the hypothesis that the coefficients on the independent variables are jointly zero. As for the AR tests, only the test of order 2 strongly fails in this model, while the AR(2) test is close to satisfactory (at a 95% level of confidence). It may however be cautious to run a dynamic model A dynamic panel data model is thus estimated, and we are led, after reducing the model as far as possible68, to the following results: ----
1-step estimation
Coefficient DVCR(-1)
----
t-prob
-0.0564746
0.922
DLAB
-0.000385065
0.250
DIPO
-0.00311267
0.000
Constant
0.000577907
0.037
Wald (joint):
Chi^2(3) =
451.0 [0.000] **
Wald (dummy):
Chi^2(1) =
4.588 [0.032] *
Chi^2(21) =
34.89 [0.029] *
Sargan test: AR(1) test:
68
N(0,1) =
-1.167 [0.243]
For the initial model, cf. supra equation (2).
44
Aloys RIGAUT Economics Department. MA Thesis.
AR(2) test:
College of Europe Academic year 2001-2002
N(0,1) =
----
-1.682 [0.092]
2-step estimation ----
Coefficient DVCR(-1)
t-prob
-0.298767
0.539
DLAB
-0.000583926
0.057
DIPO
-0.00350085
0.000
Constant
0.000489336
0.038
Wald (joint):
Chi^2(3) =
183.5 [0.000] **
Wald (dummy):
Chi^2(1) =
4.565 [0.033] *
Sargan test:
Chi^2(21) =
10.22 [0.976]
AR(1) test:
N(0,1) =
-1.328 [0.184]
AR(2) test:
N(0,1) =
-1.530 [0.126]
With a different method of reduction of our model (dropping LAB instead of ICT in the first steps69), we are led to different results: ----
1-step estimation ----
Coefficient DVCR(-1)
t-prob
0.0133256
0.976
DIPO
-0.00275020
0.000
DICT
0.00103870
0.064
0.000498228
0.165
Constant Wald (joint):
Chi^2(3) =
243.4 [0.000] **
Wald (dummy):
Chi^2(1) =
1.986 [0.159]
Sargan test:
Chi^2(21) =
38.56 [0.011] *
AR(1) test:
N(0,1) =
-1.285 [0.199]
AR(2) test:
N(0,1) =
-1.587 [0.113]
----
2-step estimation ----
Coefficient DVCR(-1)
t-prob
-0.133736
0.693
DIPO
-0.00291146
0.000
DICT
0.00108968
0.013
69
Cf. annex 1.
45
Aloys RIGAUT Economics Department. MA Thesis.
Constant
College of Europe Academic year 2001-2002
0.000501356
0.056
Wald (joint):
Chi^2(3) =
259.3 [0.000] **
Wald (dummy):
Chi^2(1) =
3.855 [0.050] *
Sargan test:
Chi^2(21) =
12.69 [0.919]
AR(1) test:
N(0,1) =
-1.441 [0.150]
AR(2) test:
N(0,1) =
-1.708 [0.088]
While all the tests (Wald and AR tests) are now satisfactory, three regressors (when taking into account both methods of reduction) come out as significant in this dynamic modelling of VCR: labour rigidities (LAB), ICT expenditures (ICT) and the number of IPOs (normalised by GDP). We must however remain extremely cautious: it is indeed impossible to interpret these results satisfactorily, given that our lagged DVCR variable (DVCR(-1)) does not come out as significantly different from 0 (t-probability equal to 54% in the first case, and to 69% in the second case). Notwithstanding the weaknesses of our dynamic modelling, the general finding of this econometric model is therefore that the decrease in labour market rigidities (measured by the general rate of unemployment) and the increase in ICT expenditures (relative to GDP) are the main significant variables to explain the development of the European venture capital market since 1996. In a dynamic perspective, labour market performances may also be a significant variable, which would be consistent with (BELKE et alii, 2001) 70. Very interestingly, the advancement of the Member States in the implementation/transposition process of the financial services directives (FSAP) is also very significant in accounting for this rising amount of funds raised, while the presence of a New Market hardly plays a role at this point, given perhaps the persisting fragmentation of European stock markets. As for the number of IPOs (relative to GDP), it is also strongly significant, but unfortunately not in the way expected (negative coefficient) - without a priori any rationale for that. Finally, the only variable included in this model that did not turn out as significant at any step of the modelling process is the GDP growth rate (GDPG), which is consistent with the stylised facts identified in the literature.
70
"The positive effect of venture capital investment on labour market performance is more dynamic than static in nature, possibly due to a time-build period " (p.19).
46
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
5 PRO SPECTS AN D PO LICY ISSUES "Only very recently have researchers begun to examine the ways in which policy makers can catalyse the growth of venture capital and the companies in which they invest" (LERNER, 2000). This is however critical to the further internationalisation of venture capital activities, especially in Europe, given the fragmentation of its financial market and the numerous remaining barriers to the development of VC fundraising. This section thus aims at identifying the main trends at work as well as the main challenges that one may expect in coming years (5.1), and at defining what should be the main European policy priorities with regard to these evolutions (5.2.).
5.1
The de vel opm e nt of Ve ntur e Capital f und rai sin g i n
Eur ope: m ain tre nds at w ork an d p olic y c hall enges As underlined before, the VC fundraising trend as been explosive in Europe since 1995/1996, and some reasons for this surge in venture capital activities have been put forward (cf. econometric findings): increasing ICT expenditures, more flexible labour markets, less regulatory barriers, apparition of 'New Markets' for high-growth companies, etc. But the 'slow crash' of the sector of the new economy since the beginning of 2000 has led to a significant downturn of the US and European VC industry in 2001 71. "The year 2001 was a very difficult one for the venture capital community. The combination of significant market volatility, declining valuations and much uncertainty forced venture capitalists to rethink investment strategies and return to investing fundamentals" recently commented Mark HEESEN, president of the NVCA72. One may thus be worried about the robustness of the previous fast development of venture capital fundraising in Europe: was it part of the underlying speculative process or was it founded on a more solid basis? Euphoria for the ‘new economy’ stocks and the arrival of Euro boosted European stock markets (especially European ‘New Markets’), so that more companies were listed on European exchanges than in the US in 2000, despite an abnormally high
71
This is consistent with the cyclical nature of VC activity detected by (BAYGAN and FREUDENBERG, 2000, p. 33). The only exception to this general downturn is the healthcare/biopharmaceuticals sector, with a 13% increase in funds raised in 2001 compared to 2000 (source: VentureOne, 10.04.2002). 72 Source: NVCA, Press release, 19.02.2002.
47
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
volatility (GIUDICI and PALEARI, 2001). The propagation of the so-called ‘Internet bubble’ from the US 73 to Europe has been well documented so far and illustrated by the severe correction of stock indices in late 2000/beginning of 2001. But one may emphasise that this speculation may be have been encouraged by the surge of money that entered the European VC industry during the years 1998-2000. Indeed, if there are too few worthy projects to finance, the result can be a substantial decrease in the returns on investment (according to the principle “too much money chasing too few deals”). Now, as has been shown by (GOMPERS and LERNER, 2000), inflows of venture capital tend to raise valuations74 (IPO being the preferred exit for venture capitalists), while over-investment leads to too many projects at too high valuations (with regard to their low returns). Paul GOMPERS and Josh LERNER (2001) thus comment: “the next few years will show whether information technology companies can absorb very large increases in venture capital from 1998 to 2000, or whether the inflow of venture funds has overwhelmed the number of profitable opportunities”. The decline of VC fundraising in Europe and in the US in 2001 largely confirms these fears. However, as noted by Tracy LEFTEROFF, global managing partner of the venture capital practice at PriceWaterhouseCoopers (quoted by NVCA 75): "the free-fall is over and we've landed safely on higher ground". And indeed, US venture capital investment started to re-increase in Q4 for the first time since mid-2000 and, despite the strong downturn, 2001 actually finishes as the third highest year in terms of the amount of venture capital invested. The same is true for Europe, where long term overall returns remain robust in 2001 at 14.2% annualised IRR for total private equity with 31.7% for top quarter funds 76. "No doubt this difficult year has supplied many valuable lessons to private equity practitioners, which can be applied in coaching tomorrow’s promising growth companies. Nevertheless, the results published today also confirm the long-term robustness of the European private equity asset class to weather storms and to produce sustained returns throughout economic cycles ” comments Max BURGER-CALDERON, Chairman of the EVCA Investor Relations Committee.
73
Cf. (COOPER et al., 2000). The NASDAQ began to crash on March 2000, later followed by other equity markets (NYSE e.g.). 74 A doubling of inflows into venture funds leads to between 7% and 21% increase in valuation levels. 75 Source: NVCA, Press release, 04.02.2002. 76 Source: EVCA, Press release, 13.03.2002.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
Graph 8: Venture Capital Raised: a comparison between Europe and the US (1994-2001)
Graph 9: Venture Capital Invested: a comparison between Europe and the US (1994-2001)
This optimism may be also based on the evolution of the economic environment. Indeed, the main significant determinants of the development of the European venture capital market have been previously underlined (cf. supra): ICT expenditures, labour 49
Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
market performances, and the implementation of the FSAP. Now, the European ICT market continues to grow above the international average, according to the latest EITO figures: "while the global economic downturn is having the greatest effect on IT investment in the USA, Europe is so far doing rather better" 77. It is indeed expected that the west-European ICT market (hardware, software and services) will grow by 6.8% to €575 billion in 2001. And even for the year 2002, EITO anticipates market growth around 7% in Europe. As far as the labour market performances are concerned, unemployment should have continued to fall in 2001 in the EU, according to the spring 2001 forecasts of the European Commission, but the unemployment rate stood at 7.8% in December 2001 (compared to December 2000) 78. Nevertheless, structural reforms are under development and job creation should be significant in coming years, with a reduction of unemployment as a consequence. As for the implementation of the RCAP and the FSAP, they are also to be achieved respectively by 2003 and 2005, which is obviously positive from the perspective of the development of the European VC industry. Finally, the other factors are also encouraging: e.g. the macroeconomic environment is said relatively satisfactory and the GDP growth should re-increase after the recent downturn 79, and the European stock market integration/consolidation is going on at a rapid path since 2000 (creation of Euronext 80, launch of Nasdaq-Europe, etc.). The fundamental factors are thus leading to think that the growth of VC fundraising was/is indeed robust, despite the speculative excesses of 1999-2000. One of the policy challenges related to this expected development of venture capital fundraising is the enlargement of the EU to Central and Eastern European Countries (CEECs). On the one hand, access to finance is indeed a paramount determinant of growth, and these countries not only have a high density of SMEs but also are fast-growing because of the catch-up/convergence process. The higher GDP growth of CEECs and the accession to the EU horizon should therefore make CEECs attractive to venture capital 81. But on the other hand, ICT expenditures are still much lower than in Western Europe, the fiscal and regulatory barriers are significant and the lack of VC specialists is moreover critical. When one looks the situation of CEECs in 77
Source: EITO, Press release, 22 October 2001. Source: EUROSTAT. 79 The autumn 2001 forecast of the European Commission (DG ECFIN) was the following: +1.6% in 2001, +1.3% in 2002 and +2.9% in 2003. 80 Euronext has recently launched a specific pan- European segment for ‘new economy‘ firms: “NextEconomy”. Source: Euronext, Press release, 18.12.2001. 81 This remark could also be applied to cohesion countries. Cf. annex 3: Ireland, Portugal and Spain are among the five European countries with the highest net flows of private equity investments in 1999... 78
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
terms of private equity as percentage of GDP in 2000 (cf. supra graph 3), they are thus among the least developed - with the notable exception of the Czech Republic 82. The increase in VC activities has nevertheless been very significant since 199883: e.g. €376 billion and €333 billion were raised respectively in the Czech Republic and in Poland in 2000, which is higher than in Greece, Austria, Ireland and Portugal (EVCA, 2001). While private equity fundraising could be a precious contribution to the convergence process undertaken by CEECs, these countries will need some time before catching up Western European Countries in this domain. And the factors determining VC fundraising highlighted in this study may provide a guideline to further develop VC markets in accession countries. The role of Government with regard to the development of venture capital fundraising is also at stake. This role has traditionally been justified by the presence of market failures: "there is a role for public funding limited to addressing identifiable market failures. However (...) the advantages need to be weighted against risks of market distortion, and, particularly in the risk capital market, of displacing or crowding out private sector activity" (European Commission, 2000). But what are the main market failures characterising the venture capital market? The main reason for public intervention is obviously the presence of asymmetries of information, a critical feature of high-growth SMEs' financing: because of this lack of transparency, some good project may thus not find any financing. But there are two approaches to this issue: whether Government substitutes itself to the market and finances these projects, whether it provides the regulatory environment conducive to an efficient financing of the economy. At this point, one must indeed differentiate between the government programs that aim at getting the basic legal and tax structures into place, and those that provide direct government funding (public venture capital funds) - the risk of crowding out private sector activity being crucial in the second case. At EU level, for instance, the European Commission has recently been given a mandate to review the coherence of the European Investment Fund 84 financing (cf. Lisbon conclusions).
82
0.265% for the Czech Republic, to compare with 0.133% GDP for Poland and 0.121% for Hungary (EVCA, 2001). 83 The surge in capital committed to VC funds in CEECs actually started during 1994 and 1995 when the prospects for economic stability in the region improved and when stock markets greatly developed (AYLWARD, 1998). 84 One may however note that, as a “fund of funds”, the EIF does not invest directly in firms but through the intermediary of other funds. The EIB holds 60.75% of the shares of the EIF.
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
Table 6: Government policies to support the venture capital market
Source: (CHRISTOFIDIS and DEBANDE, 2001, p. 49)
However, while the relevance of the financing of projects in countries where private venture capital funds are prevalent may indeed be questioned, one may also underline the advantages of a public (co-)financing of certain projects in countries where the fiscal and regulatory environment is not yet satisfactory, as a way to counterbalance the noted information asymmetries. For example, the total I-TEC85 contribution per venture capital fund must not exceed 5% of the investments effectively made (with a maximum of 500,000 €): it is therefore just a complement. In other words, a public co-financing of certain projects provides a 'signal' to private VC funds of the interest of the project, hence the significance of its role. The role of government policies is therefore also crucial in helping the early development of a VC industry, i.e. when information asymmetries are the highest. Portugal - analysed in (JENG and WELLS, 2000, pp.3436) - is a telling case, from this perspective. The creation of a new type of corporate structure in 1986 (the 'venture capital corporation'86), and the large increase in government financing87 in the early 1990s (up to 57% of the total VC funds raised in 1994), are indeed considered to have considerably helped private funds to develop in Portugal from this period. But, now that the Portuguese VC market is well developed, (ANDREZ, 2000) e.g. argues that public intervention (direct public financing still accounts for 24.7% of total private equity raised in 2000 88) should be reduced to facilitating the linking between venture funds and innovative SMEs, and to creating an 85
The -I TEC pilot project (launched in July 1997) is an initiative to encourage early stage investments in technologically innovative SMEs. It is supported by the European Commission under its INNOVATION/SMEs Programme, and implemented in collaboration with the EIF. Source: http://www.cordis.lu/finance/src/i-tec.htm 86 These corporations were granted a number of significant tax benefits, which indeed led to a dramatic increase of private equity investments in Portugal. 87 Cf. e.g. the two EC supported regional development agencies, NORDEPIP and SULDEPIP. 88 Source: (EVCA, 2001).
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
environment (i.e. developing market mechanisms) conducive to more innovative businesses and venture capital activity. This role of Government in encouraging the development VC activities - that is also very significant in the case of a today mature market such as the Dutch VC market - could apply to the CEECs too, where so many structural reforms are needed from this point of view. With regard to the role of the EU (in the framework of the EIF), such an approach could also be a way to address the risk of an increasing concentration of venture capital activities in the economic core of the EU89 (UK, Benelux, France and Germany) that may jeopardise cohesion policy objectives.
5.2
Poli cy r ecomm endatio ns
The development of venture capital market has attracted much attention from policy makers - including the European Commission. Following the previous discussion about the role of Government in promoting such a development, one may therefore wonder what policy recommendations and priorities could be put forward - beyond the necessity of the timely implementation of the RCAP (by 2003). This paper does not aim at being an exhaustive study of the subject. Notwithstanding, the following brief policy recommendations may be made, taking into consideration some of our results: q
The priority should go to improving the legal and fiscal environment o
Capital gains taxation (CGT) should be softened, when dealing with venture capital, so as to give a tax incentive to equity investors (and to innovative SMEs). Some capital gains tax exemptions e.g. already exist in Austria, Belgium, Denmark, France, Germany, Netherlands, Spain, Switzerland, and a similar measure has been recently proposed in Sweden 90. An alternative solution is to give a lump-sum subsidy to those firms that make use of equity finance (equity-market-contingent grants).
o
Pension funds should be allowed to invest part of their assets in VC funds according to the well-known "prudent man" principle (qualitative
89
Where the main stock markets are situated, which is the result of the ‘networks effects’ that characterise financial activities. Cf. also the emergence of technology clusters in Europe (Cambridge region, Munich, Sophia Antipolis…). 90 On February 2001, a tax propos al for major changes in Swedish corporate taxation was proposed, implying the abolition of capital gains taxation on shares held for business purposes.
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evaluation) – and not be restricted by too constraining quantitative rules 91. o
The adoption of the new directive on Prospectuses, included in the RCAP, is of course a necessity, so as to facilitate companies raising cross-border capital.
o
The legal and regulatory barriers to the cross-border participation and information of shareholders should be reduced (cf. the results of the comparative review of existing codes of corporate governance).
q
A more differentiated approach to private equity financing is needed o
There may be a need for a more differentiated approach to venture capital: "risk capital" is indeed a too vague and general notion, while the different stages of private equity financing should be considered as specific. Early-stage financing by private venture capital funds, in particular, should be encouraged as such – given its high benefits for the economy. The different sources of private equity (venture capital, business angels, banks) are however complementary, and the European Commission has adopted the adequate approach when taking into account - as a first step - all stages of private equity activities.
o
'Successful' and for 'unsuccessful' SMEs should not be subject to the same policy92, even if some common concerns exist (e.g. the encouragement of some rigorous auditing standards for non-listed SMEs). This is of critical significance with regard to the control of state aids by the European Commission93: the motives and effects (in terms of market distortion) of a public investment in an innovative high-growth SME have indeed not much to do with those of a public aid to an enterprise close to bankruptcy. This concern is also very relevant with regard to countries with a high density of SMEs94 that by definition are not all high-growth ‘innovative’ SMEs.
91
This has led the EVCA, in a recent position paper (10.04.2002), to take position against the so-called “prudent person rule plus”. According to the EVCA, it would indeed lead to “severe disturbances” in countries having adopted a qualitative prudent person rule, and would constitute a threat to the European PE market. 92 Venture capital is indeed a realistic possibility only for a small minority of SMEs (e.g. in the high-tech sector). Cf. (COBHAM, 1999a and 1999b). 93 Cf. Communication on “ State aids and risk capital ” (European Commission, DG competition, 23.05.2001). 94 Mainly Southern European countries: cf. (SANCHEZ, 2001). On the contrary, large enterprises are mainly located in the central regions of Europe, and regions with the highest R&D business expenditures show a high concentration of large units.
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o
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European governments and institutions (cf. the EIF) appear willing to finance early stage projects that would not be funded privately (cf. e.g. the development of regional incubators), but an evaluation of the usefulness of such a role appear as necessary, so as to avoid a crowding-out effect on private investments. The priority of public venturing should go to firms located in countries with less efficient risk capital markets (often cohesion/peripheral countries).
q
Stock market integration should be further encouraged o
The timely implementation of the FSAP - from which the RCAP cannot be separated - is of course absolutely necessary. Some of the measures included in the FSAP are indeed of particular significance for the European VC industry: e.g. the pension fund proposals, and the modernisation of the ISD.
o
The emergence of one large and liquid pan-European stock market for technology-based high-growth companies (on the model of NASDAQ in the US) should be one of the priorities. The fragmentation of European stock exchanges is indeed clearly weakening the European VC industry, making equity markets less efficient and thus flotation more costly 95. A large efficient pan-European equity market, easily accessible from all countries, would moreover help cohesion policy objectives.
q
Fostering entrepreneurship and ICT development remains an absolute priority o
Higher ICT expenditures (relative to GDP) should be encouraged. And, in this endeavour, the Innovation Action Plans of the European Commission and the Innovation 2000 Initiative96 (“i2i”, launched by the EIB in 2000) should be further developed.
o
It is not only the supply of VC that might restrict the total volume of investments, but possibly also the lack of suitable entrepreneurs with innovative ideas. The education system should thus address such a
95
Stock market fragmentation leads to poorer average liquidity of European New Markets, while higher volatility is the natural consequence of a lack of liquidity. 96 It provides finance for education/e-learning, ICT, R&D and diffusion of innovation (including the audio-visual sector).
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scarcity of able human resources, focusing on the effectiveness of ‘national innovation systems’ – as outlined in the RCAP. o
At the national level, policies have to address the remaining disincentive effects of bankruptcy and insolvency procedures.
o
The adoption of a European Patent System, still under discussion, could also be a significant step forward in fostering entrepreneurship in Europe and in helping cross-border VC investments.
o
Beyond a good economic climate, structural reforms in the labour market are also needed so as to make it more dynamic and further decrease unemployment.
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6 CO NCLU SIO N As has been underlined, the development of venture capital fundraising in Europe has been dramatic for the last five years (1996-2000), and has moreover been characterised by a rather robust trend. Despite the current economic uncertainties, the optimism has therefore remained strong about venture capital activity - considered as a long-term business. "As we look forward to the next thirty years, we expect venture capital to play a critical role in nourishing entrepreneurial companies and sparking innovation" e.g. recently commented Mark HEESEN, President of NVCA 97. Our literature survey has underlined two major issues with regard to venture capital: its impact on the economy and the determinants of its development. Our study documents these two aspects, while highlighting the specificities of the booming European venture capital market. Despite a dramatic increase since 1996, European VC still largely lags behind the US, in terms of funds raised and invested (as a percentage of GDP). This discrepancy fell in 2001, with the crash of the new economy 'bubble', but somehow remained. Among the encouraging signs is the fact that captive funds do not dominate the market anymore: this is consistent with the parallel declining role of banks compared to pension funds with regard to the sources of VC funding. But some critical characteristics of the European VC market - compared to the US - may still be pointed out: e.g. less specialisation in early-stage financing, a still relatively fragmented market, a more significant role devoted to Government, globally less investment opportunities, less efficient stock markets and more divestments by trade sales. These 'weaknesses' have been addressed at European level by the RCAP and the FSAP (that cannot be dissociated from each other), but, as has been underlined in a Communication from the European Commission (2000): "much remain to be done is the EU risk capital market is to be brought onto par with that of the United States".
In this general framework of analysis, our econometric model investigates the determinants of VC fundraising in Europe since 1996, and produces empirical evidence of the significance of labour market rigidities and ICT expenditures from this perspective. Interestingly, the advancement in the implementation of the FSAP also
97
Source: NVCA, Press release, 22.10.2001.
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turns out to be significant, while the number of IPOs is strongly significant but not in the expected way (a negative coefficient) - which can be put down to the fragmentation of European stock exchanges. This led us, in our policy recommendations, to underline the primary importance of the legal and fiscal environment, that must be favourable to creating and sustaining a new innovative business (i.e. in creating new investment opportunities 98), but we also note that further stock market integration and ICT development should be encouraged.
A wide range of actions thus still need to be undertaken in order to take full advantage of the positive economic and social potential of a mature private equity and venture capital industry: as a benchmark, the US VC industry has created over the past three decades 7.6 million jobs and $1.3 trillion in revenue, according to the NVCA. In this endeavour, the awareness of the Member States should be developed, since many critical measures actually depend on them. This will require some more studies to be conducted, so as to estimate the impact and foster the growth of VC activities in Europe. "VC is a national phenomenon that helps the US economy apart from others in the world" said Thomas McConnell, Chairman of NVCA, in October 2001: this should illustrate the strategic dimension of such a goal for Europe.
98
Cf. principle supra: ‘too much money chasing too few deals’.
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http://www.nsf.gov/sbe/srs/issuebrf/ib99303.htm
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ROBBIE, Ken and WRIGHT, Mike (1997): Venture Capital. Dartmouth Publishing Company Limited.
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SAHLMAN, W. A. (1988): Aspects of financial contracting in venture capital. Journal of Applied Corporate Finance 1:2, pp. 23 -36.
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SAHLMAN,
W.
A.
(1990):
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governance
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§
SANCHEZ, Aurora O. (2001): High density of SMEs in southern Europe. EUROSTAT / SME Regio, Statistics in focus, Sectorial profiles (Industry, Trade and Services), Theme 4, n°17.
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YLI-RENKO, H. and HAY, M. (1999b): The major European venture capital markets. In: BYGRAVE W., HAY M. and PEETERS J. (eds.): The Venture Capital Handbook. London, Financial Times-Prentice Hall, pp. 23-77.
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INT ER NET RESO URCES http://www.business-angels.com
Business-angels.com (France)
http://www.buyoutsnewsletter.com
Buyout Newsletter (US data)
http://www.cordis.lu/finance
CORDIS
http://www.eban.org
European Business Angel Network (EBAN)
http://www.eib.org
European Investment Bank (EIB)
http://www.eif.org
European Investment Fund (EIF)
http://www.eito.com
European Information Technology Observatory (EITO)
http://www.euronext.com
Euronext NV
http://www.europa.eu.int/economy_finance
DG ECFIN (European Commission)
http://www.europa.eu.int/eurostat
EUROSTAT
http://www.europa.eu.int/internal_market
DG MARKT (European Commission)
http://www.europeanvc.com
Venture Capital in Europe
http://www.evca.com
The European Private Equity and Venture Capital Association (EVCA)
http://www.evcj.com
European Venture Capital Journal
http://www.fese.be
Federation of European Stock Exchanges
http://www.fibv.org
Fédération Internationale des Bourses de Valeurs . 99
http://www.gate2growth.com
The European portal for growth businesses
http://www.gopublic-it.com
The Pre-IPO Technology Market Place (3-4 December 2001).
http://www.hvca.hu
Hungarian Venture Capital and Private Equity Association
http://www.nasdaq-europe.com
Nasdaq-Europe (previously EASDAQ)
http://www.nvca.org
The
American
'National
Venture
Association' (NVCA) http://www.oecd.org
OECD
http://privatequity.cpr.fr
CPR Private Equity
http://www.privateequityweek.com
A publication of Venture Economics
http://www.sourceoecd.org
Source OECD
99
The Gate2Growth initiative is supported by the European Commission.
69
Capital
Aloys RIGAUT Economics Department. MA Thesis.
http://specials.ft.com/ln/specials/sp9ba6.htm
College of Europe Academic year 2001-2002
European
Venture
Capital
Report
by
the
Financial Times (8 June 2000). http://www.unibg.it/sige/iposineurope
Resources on IPOs in Europe
http://www.unicer.asso.fr
Regional Risk Capital in France
http://www.vcr1978.com
100
Venture Capital Report
http://www.venturecapitaljournal.net
Venture Capital Journal (US data)
http://www.ventureeconomics.com
Daily news and statistics about the US, European and Asian private equity markets
http://www.ventureone.com
VentureOne, the leader in venture capital research
http://www.webcapitalriesgo.com
100
Private Equity in Spain
Cf. in particular: http://www.vcr1978.com/resourcecentre/main.htm
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Aloys RIGAUT Economics Department. MA Thesis.
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ANNEXES
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Aloys RIGAUT Economics Department. MA Thesis.
College of Europe Academic year 2001-2002
ANNEX 2: EU ROPEAN NEW MA RK ETS Name
Country
Date of
More information
creation AIM
UK
June 1995
http://www.londonstockexchange.com/a im
Nouveau Marché
France
February 1996
http://www.nouveau-marche.fr
EASDAQ /
Pan-European
October 1996
http://www.nasdaq-europe.com
NMAX
Netherlands
February 1997
http://www.aex.nl
Neuer Markt
Germany
March 1997
http://www.neuer-markt.de
Euro.NM
Belgium
April 1997
http://www.stockexchange.be/pg/pgc/en
Nasdaq-E urope
Belgium
gc00.htm
Nya Marknaden
Sweden
January 1998
http://www.stockholmsborsen.se
Nuovo Mercato
Italy
June 1999
http://www.borsaitalia.it/ita/infomercati/n uovomercato
TechMARK
UK
November 1999
http://www.londonstockexchange.com/t echmark
SWX New
Switzerland
July 1999
http://www.swx.com/products/swxnm_in
Market NEXA
tro_en.html Greece
July 1999
http://www.ase.gr/content/en/markets/N EXA
NM List
Finland
1999
http://www.hex.fi
Nuevo Mercado
Spain
April 2000
http://www.bolsamadrid.es
ITEQ
Ireland
September 2000
http://www.ise.ie/iteq/iteq_contents.htm
KVX
Denmark
September 2000
http://www.xcse.dk
Novo Mercado
Portug al
December 2000
http://www.bvl.pt
Virt-X
Pan-European
June 2001
http://www.virt-x.com
NextEconomy
Pan-European
December 2001
http://www.euronext.com
Sources: Various Internet websites.
“The future of the ‘new markets’ in Europe is fluid: a debate is still going on about what kind of model should be privileged, i.e. a pan-European exchange versus single national markets” (GIUDICI and PALEARI, 2001, p. 13).
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Aloys RIGAUT Economics Department. MA Thesis.
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ANNEX 3: CROSS-BORD ER VE NT URE CA PIT AL INV ES TMENT FLOWS A S A PE RCENTA GE OF DO ME STIC I NVES TM EN TS
Source: (BAYGAN and FREUDENBERG, 2000, p. 23)
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