The European Commission unveiled its Capital Market Union (CMU) proposal last week. While the US provides a useful model for comparison, Europe must adapt SME funding to the specificities of the domestic market, writes Simon Lewis.
Simon Lewis is CEO of the Association for Financial Markets in Europe (AFME).
Last week saw the unveiling of the European Commission’s much anticipated action plan for building a Capital Markets Union (CMU). Among the many targets of the wide-ranging initiatives are Europe’s small and medium-sized businesses (SMEs).
Certainly, providing more funding options for Europe’s small businesses has been recognised as essential for investment and business. SMEs are the backbone of the European economy, accounting for 99% of all companies in the EU and two-thirds of private sector employment. Yet they are struggling to raise capital, particularly during the all-important development phase.
The underlying challenges are threefold. The first is a general lack of awareness about the funding options available and EU small businesses still lean heavily on financing sources, such as banks. Indeed, data from AFME’s ‘Bridging the Growth Gap’ report shows that there is three times as much bank lending provided to EU SMEs as compared to their US equivalents.
The second is the underdevelopment of other sources of financing – such as venture capital and angel investing – for SMEs in the EU. Yet, for start-ups or growing companies with unpredictable cash flows, equity finance may be more suitable than loans.
Finally, a shortage of equity, particularly for the smallest and growing SMEs, is problematic. Europe’s savings market structures are less geared to equity investing and our pot of pension savings is not sufficient to provide this much-needed equity. For example, EU pension funds provide a mere €4.3 trillion in investable assets compared to €14.9 trillion in the US.
A structural challenge
With such roadblocks holding back growth, will the Commission’s CMU action plan provide sufficient support to overcome them?
While capital markets should not and will not replace bank funding for SMEs, it is clear that the EU needs a more diverse funding landscape in order to improve access to market-based funding sources at all stages of SMEs’ development.
In this respect, it can be useful to draw some comparisons with the US market, particularly given the similar €17 trillion annual GDP of the two regions. However, it is important to bear in mind that EU markets are different than the US and should be developed based on the different values and economic and political structure of Europe.
For example, the US benefits from greater diversity and flexibility of funding sources. US private pension funds play a bigger role and their risk appetite is greater than Europe. They invest more in the equity asset class than their European peers (53% vs. 37% of funds managed).
In the United States, friends, family and other private investors provide 33% of SME financing, compared with just 9% in Europe. And in 2013, business angels in the US invested €20 billion in SMEs versus only €6 billion in Europe. The private equity and venture capital (VC) sector is also less developed in Europe. For instance VCs invested €26 billion in US SMEs in 2013 versus only €5 billion in Europe.
Yet, VCs and business angels play a valuable role in the rapid evolution of the latest-generation entrepreneurial companies in America. In addition to capital, they help with strategy and business contacts. Often, their expertise is invaluable to young businesses. In this respect, properly structured and regulated crowdfunding is important too, particularly for the smallest of SMEs.
While the US provides a useful model for comparison, Europe must adapt SME funding to the specificities of the domestic market.
Finding cross-border funding opportunities
Also key to the success of the CMU will be helping SMEs identify and access cross-border funding opportunities. The multitude of financing available and the fragmented nature of pan-European support measures often make it difficult for SMEs to procure cross-border funding. This is despite the fact that many governments and pan-European institutions provide extensive loan and equity support.
For example, navigating the different funding sources offered by 28 member states and their individual treatment of tax on debt and equity can be a challenge. The Commission has therefore pledged to explore ways of building a pan-European approach to better connect SMEs with a range of funding sources. In this respect, a more comprehensive and flexible approach to SME financing in Europe could be beneficial to growth.
SMEs are watching with interest to see how the Commission’s CMU proposals will improve access to finance. Most of the action plan is still to be converted into concrete actions and legislations, however, fostering a culture of risk-taking and innovation among our SMEs and investors will be vital to this. Similarly, encouraging a culture of greater equity involvement and improving access to and information on all of the various funding options will do much to boost growth.