Published on

Published in: Economy & Finance, Business
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide


  1. 1. British Embassy, Vilnius, Lithuania Working Paper: Structural Funds and Risk Financing – Opportunities for Lithuania in 2007-13 January 2005 Centre for Strategy & Evaluation Services LLP Strategijos ir vertinimo paslaugų LLP centras P O Box 159 Sevenoaks Kent TN14 5WT United Kingdom www.cses.co.uk 1
  2. 2. SECTION PAGE 1. Introduction - What is Risk Financing? 1 2. Risk Financing as a Regional Policy Instrument 1 3. Support to Promote Risk Financing Through Structural Funds 2 4. Advantages & Disadvantages of Risk Financing 3 5. Risk Financing – Critical Success Factors 4 6. Challenges for the New Member States 5 7. Risk Financing in Lithuania 6 8. Recommendations 7
  3. 3. Structural Funds and Risk Financing 1. Introduction - What is Risk Financing? Risk capital financing is the term used to describe schemes that make public funds for SMEs available on a basis where they can be recycled. Examples of risk financing instruments include soft loans, venture capital and mezzanine finance, loan guarantees and other instruments such as micro credits for very small companies. Risk capital financing schemes must meet the European Commission’s requirements on state aid. Normally, the schemes will have investment criteria which require them to invest only in projects where SME beneficiaries have not been in a position to gain access to finance on a commercial basis i.e. where there is demonstrable evidence of market failure. 2. Risk Financing as a Regional Policy Instrument Risk capital financing is increasingly being seen by the European Commission and member states as an effective means of improving access to finance for SMEs and a more cost-effective policy instrument in promoting SME growth and new job creation than conventional grant aid schemes. Reasons for the increasing shift towards risk financing include the fact that, despite many years of providing grant aid from the Structural Funds on a massive scale, regional disparities have not diminished significantly. More innovative, sustainable and cost-effective means of promoting economic (and regional) development objectives therefore have to be considered. Secondly, risk capital financing is a more appropriate source of financing than conventional alternatives in the context of promoting the ‘knowledge economy’, acknowledged in the Lisbon strategy as a key driver of job and wealth creation. Thirdly, with increasing demands on resources arising from the major EU enlargement process in 2004 and planned subsequent EU enlargement (possible accession of Croatia, Bulgaria, Romania plus other potential applicant countries including Turkey, Bosnia, Ukraine etc.), there is a need to make EU funds ‘work harder’. Recycling funds on a revolving basis rather than allocating one-off grants is a sustainable means of achieving this aim. Thirdly, risk financing helps diversify the range of financial products available to meet the financing needs of SMEs and micro-firms – important in helping to address market failure. SMEs need access to finance to grow and develop. Whilst the Commission does not consider that there is a general market failure in respect of the provision of finance to SMEs, there is evidence of shortcomings in relation to some groups of SMEs which may mean they are unable to access appropriate funding (e.g. high-tech SMEs, micro-firms started by those from disadvantaged groups etc.). Reasons why a commercial bank may be unable to provide finance to a viable SME include the lack of a track record, inadequate security and a credit rating outside an acceptable range. Risk financing schemes supported through Structural Funds can help to improve access to finance for those SMEs that would otherwise have difficulties obtaining finance through conventional sources. 1
  4. 4. Below we look at an example of a scheme which seeks to combine improved access to finance for micro-firms and SMEs from specific social groups with business support and mentoring advice in order that beneficiaries improve their chances of business growth and survival. Example 1: BRUSOC (‘Bruxelles sociale’) – Brusoc administers two risk financing schemes the first providing micro credits to individuals looking to set up their own business and the second providing seed capital through both equity and loans to micro-enterprises. BRUSOC targets the financially and socially excluded - such as refugees, the long-term unemployed and those on low incomes. The objectives of the micro credits scheme are to encourage entrepreneurship amongst disadvantaged communities, to regenerate deprived urban areas and to combat social and financial exclusion. Financial support is closely tied in to the provision of business support and advisory services – which helps improve the survival prospects of SMEs assisted. The scheme provides support to both new and existing businesses situated in the Objective 2 area of Bruxelles Capitale. With regard to financing sources, both the micro credits and the seed capital schemes are eligible for ERDF funding. European funds are co-financed by the Belgian government and municipal authorities in Bruxelles Capitale. There are also disadvantages inherent in traditional grant financing to companies. Direct grants run the risk of creating market distortions and of creating a grant culture. Other problems can include insufficient levels of grant aid financing available to meet the needs of applicant businesses leading to disillusionment amongst companies with regard to EU funding programmes. This latter problem is particularly applicable in Lithuania where large numbers of applications have been received for support with only comparatively limited grant financing available compared with need. Risk financing helps leverage additional financing from the private sector which means that the needs of a greater number of businesses can be met than if only one-off grant finance is utilised. 3. Support to Promote Risk Financing Through Structural Funds A key question is what sort of support is available to promote risk financing through the Structural Funds (SFs)?. Within the framework of the SFs, there is considerable scope for the use of risk capital financing. In regions eligible for SFs support, risk capital financing backed by the SFs may be provided through risk capital funds and other non-grant forms of financing for SMEs, subject to finding the necessary co- financing and meeting state aid rules. To encourage the greater use of risk financing instruments in regional policy, the 2000-06 Structural Fund Regulations allow Member States the option of providing an additional 10% of assistance to SMEs for those parts of an investment project funded in other ways than through direct grant aid. The development of risk capital financing instruments supported through the SFs can also be supported through the provision of Technical Assistance, the exchange of experiences and through the strengthening of administrative capacities (the latter only eligible from 2013). As familiarity has grown with regard to the use of risk financing instruments amongst national and regional authorities, so SF expenditure on risk capital financing has increased, with a marked rise between the 1994-99 and 2000-06 programming periods. Notwithstanding, the proportion of expenditure being devoted to risk financing measures as a proportion of total SFs expenditure remains low. Moreover, 2
  5. 5. there remain considerable variations with regard to the level of expenditure being devoted to risk financing measures between member states. Below we briefly review the relative advantages and disadvantages of risk financing instruments. We consider critical success factors and good practices in the utilisation of risk capital financing. Recent examples of risk financing measures being supported through the SFs are then highlighted. 4. Advantages & Disadvantages of Risk Financing Research suggests that risk financing:  Is better suited to the needs of the ‘knowledge economy’ than traditional grant aid. The availability of risk and innovation financing are important competitiveness drivers  Public funds can be recycled improving the sustainability and cost- effectiveness of SFs expenditure compared with more traditional interventions  Enables the Structural Funds to leverage additional private financing so increasing the total resources available to pursue regional policy objectives  Helps improve access to finance for SMEs particularly in [perceived] high risk sectors and / or where there is evidence of market failure (e.g. provision of seed capital).  In the case of seed/ VC funds, SMEs not only receive a capital injection but often also receive ongoing mentoring support and business advice from experienced business professionals  Helps to diversify the range of publicly funded financial support measures for SMEs/ micro-firms  Enables the financial expertise and knowledge of the private sector to be tapped into particularly where the private sector is involved in helping to manage risk capital financing schemes. With regard to disadvantages, there can be considerable complexities in setting up risk capital financing schemes, particularly in demonstrating that state aid rules have been correctly adhered to. Where a scheme may constitute a state aid, there is a statutory requirement to notify the proposed scheme to the European Commission’s Competition Directorate which then determines whether or not the scheme constitutes a state aid. If the scheme is subsequently classified as a state aid, the Commission then assesses whether the scheme complies with the exemptions in Article 87(3) of the EC Treaty. Adhering to the state aid rules can absorb significant management time and requires professional advice from financial and legal advisers1. A second potential drawback is that SMEs and micro-firms in some member states have not been as enthusiastic with regard to risk financing instruments compared with more conventional funding schemes. For example, in Italy, a number of SFs-financed 1 For more detailed guidance on the application of the state aid rules in respect of risk financing instruments, please consult CSES’ Guide to Risk Capital Financing for DG REGIO, available in multiple Community languages 3
  6. 6. venture capital schemes were set up in the 1994-99 period but were unsuccessful due to low take-up rates. This reflected a lack of familiarity amongst SMEs with innovative financial instruments, adverse attitudes to risk and an unwillingness to finance growth through equity financing since this meant partially relinquishing ownership and control. Clearly, if potential beneficiaries demonstrate little interest in risk capital financing measures, there are risks with regard to low absorption rates and consequent N+2 problems etc. 5. Risk Financing – Critical Success Factors We now consider critical success factors in setting up and operating risk capital financing schemes drawing on good practice experience. Previous experience suggests that there are a number of critical success factors in the use of risk capital financing financed through Structural Funds. These include:  The need for a good understanding amongst those involved in implementing Structural Funds (managing authority, implementing agencies etc.) with regard to the benefits of risk financing instruments  The extent to which the private sector is willing to provide co-financing support as well as fund management / risk management expertise.  The need for clear investment criteria to be set and for the target market for the risk financing scheme to be clearly defined  The need for appropriate risk assessment procedures to be put in place to ensure that funds are managed professionally [and on a sustainable basis]  The importance of positive attitudes to risk amongst potential beneficiaries Research by CSES suggests that there is considerable variation with regard to the usage of risk capital financing between member states. More needs to be done to raise awareness about the potential benefits of risk financing to public authorities as well as to spread good practices with regard to setting up and operating risk capital schemes. Experience suggests that private sector expertise is often important in the setting up and operation of risk capital financing schemes both in relation to securing adequate co-financing support and in the application of a rigorous, commercial-oriented approach in screening applications for funding, applying investment criteria and in devising and implementing risk management criteria and procedures. It is therefore important that public authorities communicate the potential benefits of involvement in publicly funded risk capital financing schemes to the private sector to secure their participation and active involvement. This is particularly important in respect of seed and / or venture capital schemes where the nature of investment and the level of screening, monitoring and risk management needed is much more complex than for other types of risk capital instruments such as soft loans. Appropriate investment criteria need to be drawn up to provide a framework through which funding applications can be assessed. Linked to this is the need to define how funds will be targeted and how criteria might be drawn up to enable fund managers to prioritise funding applications in line with the overall targeting strategy. Thought needs to be given as to whether a given risk capital scheme will be sectorally focused 4
  7. 7. or should be targeted at a much broader group of potential beneficiaries e.g. high-tech SMEs. In defining target groups, the overall SFs programming strategy (i.e. SPD) should be taken into close account. A sound approach to risk management based on commercial principles is essential in ensuring that risk capital schemes financed through SFs prove sustainable and cost- effective. While SMEs receiving seed-financing are likely to carry a higher element of risk than that would normally be acceptable to a bank/ other commercial providers there is a need for risk to be managed professionally to maximise the fund’s effectiveness and to reduce the level of business failures. Below is a good example of a highly professional approach to managing a SFs-backed risk capital fund: Example 2: Merseyside Investment Fund (MIF), UK, Objective 1 programme – MSIF provides seed and venture capital to several dozen companies and has instituted an ‘early warning system’ whereby businesses identified as being at high risk of failing are provided with regular mentoring advice and support from experienced business practitioners. This proactive approach has reduced the incidence of business failures. Lastly, an important pre-requisite is that market demand amongst the target group should be tested prior to developing risk financing measures to ascertain that there is genuine latent demand amongst businesses for such instruments. Evaluation work by CSES on risk financing in the Structural Funds in the 1994-99 period suggested that there remain significant cultural and attitudinal obstacles to participation in risk financing schemes amongst SMEs/ micro-firms in some member states. 6. Challenges for the New Member States There are a number of challenges in implementing risk financing instruments through Structural Funds in the new member states. These include:  Lack of awareness amongst national and regional authorities with regard to the potential benefits of risk financing schemes as opposed to conventional financing means in regions eligible for Structural Funds  Lack of experience and knowledge with regard to how to go about setting up and operating risk financing schemes  The complexity of Structural Funds and the challenge of implementing the programmes for the first time (leaving little time to experiment with more innovative ways of utilising the funds)  The need for closer partnership working between public authorities responsible for managing Structural Funds and private sector financial providers  Lack of familiarity with state aid rules With regard to challenges faced by the new member states, these mainly stem from the lack of previous experience of implementing risk capital financing schemes which are publicly financed. This in itself should not prove an insurmountable obstacle although clearly a steep learning curve will be required. 5
  8. 8. In light of the current low level of capacity in this area, there is a need for good practice exemplars to be diffused more widely. Case studies undertaken by CSES on the study ‘Guide to Risk Financing in Regional Policy’ illustrating risk financing schemes currently in operation should help in this respect. 7. Risk Financing in Lithuania – Tentative Beginnings, Significant Opportunities There is no explicit provision in the Lithuanian Objective 1 2004-06 Single Programming Document for the usage of risk financing instruments. There were difficulties in including risk financing measures in the current programming period because of the complexities involved - state aid issues, lack of previous experience in implementing risk financing schemes etc. and the brevity of the current programming period (3 years). The Ministry of Economy therefore chose to delay the introduction of risk financing schemes until 2007-13. However, there is a growing recognition at a policy level with regard to the potential positive role of risk capital financing through Structural Funds in Lithuania for a number of reasons including:  Likelihood that SF resources will be reduced in the next programming period due to economic growth, increased pressure on EU resources from continuing process of EU enlargement  There is therefore a need to consider more sustainable sources of financing such as revolving public funds  Huge demand amongst small and medium businesses for grants. Insufficient resources to meet the capital requirements of Lithuanian businesses  The need to promote a knowledge economy in Lithuania As a result of the increased interest in risk financing, the Ministry of Economy recently set up a working group to identify the sorts of financial instruments that might be piloted, to assess current provision (public and private) and to consider what sorts of schemes might be set up in the next programming period. In common with other new member states, Lithuania already has some limited experience with regard to managing risk capital financing schemes involving public funds and private management expertise. For example, approximately 8 million euros of PHARE funding was used to finance two SME credit lines. These were implemented through local commercial banks and provided businesses with start-up capital in the form of ‘soft’ loans at favourable interest rates. The credit lines recently expired after 10 years of operation and the Ministry of Finance wrote to the Commission to determine how these funds might be recycled in future (probably though INVEGA, although initial research suggests that some businesses would prefer the previous approach working through commercial banks). Secondly, INVEGA, the guarantees agency, provides state-backed guarantees to Lithuanian SMEs which are counter-guaranteed by the European Investment Fund. In recognition of the growing capital requirements of small and medium sized businesses in Lithuania, the maximum guarantee size has recently been increased from 1m to 2m litas. If the loan is co-financed through SFs, loans of up to 3m litas can be granted. For new investment, up to 80% of total loan value can be guaranteed and in the case of loans used to finance working capital, up to 50% can be guaranteed. 6
  9. 9. Loans are exempt from state aids under the de minimis rules and are counter- indemnified by the European Investment Fund (EIF). Moreover, whereas previously INVEGA only dealt with small businesses, it can now issue guarantees to medium sized companies with up to 100 employees. Banks are the main mechanism through which INVEGA guarantees are promoted. However, INVEGA also promotes its activities through SMEDA’s nationwide network of business information centres. In theory, guarantees of up to 25,000 euros can also be issued in respect of micro credits – although in practice the micro credit scheme has yet to get underway since the European Commission is currently reviewing the proposed scheme and has yet to make a decision with regard to whether it can go ahead. As well as the expertise of public agencies such as INVEGA, Lithuania also has private sector expertise in the venture capital field. A number of key players such as Hermis Capital and Bridge Capital are active in the field. This expertise could be drawn on in helping to set up and operate risk financing funds supported through Structural Funds. In summary, the use of risk financing instruments in the 2007-13 programming period is a significant opportunity for Lithuania to improve the sustainability and cost- effectiveness of interventions. As well as helping to improve access to finance for SMEs, it has the potential to increase the supply of risk financing, particularly important given the objective of transforming Lithuania into a knowledge-driven economy. 8. Recommendations Our assessment suggests that action at both a policy and a practical level is needed in a number of areas in relation to risk financing and future Structural Funds in Lithuania. Below we provide a number of recommendations: Risk Capital Financing and Structural Funds in Lithuania: Recommendations  Risk capital financing instruments should be widely used in the 2007-13 programming period in Lithuania to increase the sustainability of SF interventions and to encourage the growth and development of knowledge-intensive businesses  A feasibility study should be undertaken of risk capital schemes drawing on lessons from existing schemes in other EU Member States to share and diffuse good practices. As a minimum, an assessment of lessons from previous experience in implementing such schemes in Lithuania should be carried out 2  Risk financing schemes should be piloted using national funds in the current period to gain experience and understanding of how to implement ‘financial engineering’ schemes in the next period.  The Ministry of Economy should further develop its capacity to implement risk capital financing measures in 2007-13. It should then make its expertise available to intermediaries likely to be involved in the future implementation of risk financing schemes (INVEGA, banks, VC funds etc.). An effort should be made in improving understanding of state aids issues and risk financing  Close partnership-working should be encouraged between the public and private sectors in developing/ implementing risk financing schemes. The public sector needs the private sector’s 2 According to research by CSES/ PPMI, a number of years ago an attempt was made to introduce SME credit lines financed through the Phare programme but these suffered from significant shortcomings such as a lack of stability in the banking sector, poor design and inefficient management 7
  10. 10. financial, legal and management expertise to devise, operate and oversee successful schemes  Positive messages should be disseminated to small firms with regard to how risk financing measures might benefit their businesses (e.g. equity financing, access to mentoring support etc.). Key stakeholders such as the Ministry of Economy, LVPA and other business support agencies e.g. the Chambers of Commerce, SMEDA and Business and Information Centres clearly have a role here Mark Whittle, CSES January 2005 For a more comprehensive guide to risk capital financing, please consult the Centre for Strategy & Evaluation Service’s 2002 publication for DG REGIO ‘Guide to Risk Financing in Regional Policy’, available in Lithuanian from http://europa.eu.int/comm/regional_policy/sources/docgener/guides/risk/risk_lt.pdf The English version is available from www.cses.co.uk/publications 8