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Economic Observer.
KfW-Research.
No. 7, February 2005.
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In March 2000 the Lisbon European Council set the goal to transform
Europe into the world's most competitive and dynamic knowledge-based
economy. However, the recently published mid term evaluation by the
former Prime Minister of the Netherlands, Wim Kok, states a disappointing
delivery so far. To reach the target of spending 3 % of GDP for R&D it is
essential to increase the level of R&D expenditure by private companies. In
the past years, promotional banks in Europe have set up specific financing
schemes to support R&D investments of SMEs, which contribute around a
quarter to business R&D in the EU. KfW together with nine other promo-
tional institutions (Network of European Financial Institutions -NEFI1) has
recently published a survey which shows that, depending on the stage of
the life cycle and the innovation intensity of the investment, four main
clusters of promotional financing programs can be observed, which each
share similarities in their characteristics 2):
Category I Programs support founders of high-tech companies in their
pre-seed and seed stage carrying out top of the art research. Category II
Programs target enterprises which realise R&D projects but are situated in
the later stage of their life-cycle. Category III Programs target at SMEs in
the early/seed stage of their life cycle trying to realise an innovative busin-
ess idea, which does not necessarily involve high-tech research, and Cate-
gory IV Programs target the vast majority of innovative projects initiated
by companies in their later stage with relatively low innovation intensity.
BETEILIGUNGSKAPITAL IN DEUTSCHLAND.
2
FINANCING INNOVATION AND RESEARCH INVESTMENTSFOR SMES: CHALLENGES, PROMOTIONAL APPROACHES
AND RECOMMENDATIONS FOR EU SUPPORT.
1)ALMI (Sweden), BDPME (France), Finnvera (Finland), Hipoteku Banka (Latvia), ICO (Spain),KfW Bankengruppe (Germany), MCC (Italy), MFB (Hungary), SNCI (Luxembourg) and SZRB (Slovakia)
2)The survey was conducted in April 2004. Some of the mentioned programmes have in themeantime been redesigned, and some additional promotional programmes have been launchedthat are not yet described in the survey.
DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 2
The survey of NEFI identifies a clear financing gap in Europe for high-
potential pre-seed, seed and start-up companies with a strong R&D focus
(Category I). These newly founded companies can be spin-offs from
existing companies and scientific institutions or private individuals be-
coming entrepreneurs. Their R&D projects are complex and costly, poten-
tial for success is high, but difficult to assess and track record or collateral
is not available - these elements result in market failure as no funds are
available for this target group. Therefore, these companies need public
3
P
R
O
G
R
A
M
F
O
C
U
S
INNOVATION
RESEARCH
ICO Innovation Loan
KfW ERP Innovation Loan
KfW ERP Innovation Equity
BDPME Equity GuaranteeCapital SME
BDPME Equity GuaranteeTechno. Development
KfW BTU Early Stage
ALMI Innovation Loan
BDPME InnovationDevelopment Contract
MCC National ResearchFacility Fund
MCC law 598 researchprogram
BDPME Biotech Guarantee
KfW FUTOUR
III IV
I II
S e e d S t a r t - u p G r o w t h E x p a n s i o n
E A R LY S TA G E I N V E S T M E N T S TA G E
Innovation Intensity
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support at the beginning of their life cycle. The objective of a financing
scheme for this target group is to support R&D which clearly exceeds the
state of the art and has the potential for commercial success, and to make
the new companies ready for private investors. For an efficient use of
public funds, a strict selection of companies must be made to clearly iden-
tify high-potential projects.
NEFI proposes a European financing scheme jointly implemented by EU
financing institutions and national promotional banks. Through a strict and
lean selection process at national level carried out by independent institu-
tions, only very promising projects would be accepted for subsequent
financial support. National promotional institutions and the EC would then
jointly provide financing to these new companies through a financing mix
of grants and quasi-equity (silent participations). The latter allowing the
public investor to participate in the success of the company (up side sha-
ring).
Innovative seed and early stage companies (Category III) need primarily
equity or mezzanine capital with equity character to pursue their innovative
business ideas. To enhance existing national promotional schemes for these
companies, the EU should broaden the scope of existing EU guarantee sup-
port schemes (e.g. open the equity guarantee scheme under successor of the
Multiannual Programme to equity or mezzanine schemes of banks).
Later stage companies involved in research(Category II) or in an inno-
vative business field (Category IV) are often not suited for pure equity inve-
stors. The character of their investment however makes it difficult for them
to offer collateral to banks and subsequently to access bank loans. NEFI
experience shows that mezzanine capital (with loan characteristics) can be
4
DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 4
5
the financing solution for these companies. The advantage of mezzanine
capital is that it does not require collateral, it is subordinated to senior
loans in case of default, and it strengthens the equity base of the SME
allowing access to additional loans for investments.
NEFI therefore recommends to design a EU support scheme to
enhance and trigger promotional mezzanine financing instruments offe-
red by national promotional institutions to innovative and research inten-
sive SMEs. The support could take the form of a counter guarantee to pro-
motional banks to cover their so-called unexpected losses. For those risks,
banks normally have to set aside equity capital, which can be substituted
by such a guarantee. By covering unexpected losses through budget
resources / a guarantee, the EU would highly leverage the introduction of
mezzanine capital for innovation investments of small companies into the
market.
NEFI experience shows that research intensive companies need net-
works in order to fully exploit their innovative potential. The 6th Frame-
work Program for Research and Technological Development (FWP) has the
objective to support the establishment of European networks between
companies and research institutions. However, the support mechanisms of
the program do not take account of the specific situation of small compa-
nies. The result is that SMEs so far only benefit to a very small extent from
the 6th FWP.
NEFI therefore proposes to design new and more effective support
mechanisms for research intensive and innovative SMEs for the 7th Fra-
mework Program, based on the experience with promoting this target
group.
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6
Experience in financing R&D and innovation shows that it is difficult
to assess the viability and the potential success of R&D projects. This
assessment is however an important factor for the financing decision of
equity investors and banks. Though all partner banks possess of individual
tools and processes to ensure that projects are carefully selected, a com-
parison on a European level can not be made. NEFI therefore proposes to
elaborate a technological rating as an evaluation tool which could be
sponsored by the European Commission. Such an evaluation tool should
provide an integrated analysis of the level of innovation taking into
account the technical feasibility of a project, the company's managerial
and organisational skills as well as the market opportunities of the innova-
tion. The benefit of such a technological rating would be that promising
projects could easier be identified, easier be compared and thus more
carefully be selected by those who engage in providing equity and loans
especially to Early Stage companies.
The NEFI survey with more details on the specific financing challenges
encountered by SMEs investing in innovations, as well as on different exi-
sting promotional approaches and NEFI recommendations can be downlo-
aded at www.nefi.be.
Authors: Claudia Mori, Tatjana Bruns
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7
Based on an extensive survey of private equity companies in Germany and
Great Britain, conducted in close cooperation with a German-British group
of researchers, KfW Bankengruppe (KfW banking group) has recently
published new insights on market structures and behaviour patterns in the
German Private Equity Markets1). This survey was addressed to all mem-
bers of the German Venture Capital and Private Equity Association (BVK)
and the British Venture Capital Association (BVCA). Now a comparison of
the German and British private equity markets has been presented, which
provides a number of new and additional information2). Selected results of
the study are summarized here.
STRUCTURES AND BEHAVIOUR OF EQUITY PROVIDERS.
Why comparing the German and British private equity markets? There are
several reasons for choosing these countries for comparison. Among these
reasons we find a differing financial, institutional and regulatory framework
impinging upon the private equity industry and different development paths
in the evolution of the industries of both countries.
Against this background, the study reveals remarkable differences of the
two markets: Firstly, there is a differing concentration of market actors with
respect to specific stages of financing. German private equity companies spe-
cialize more frequently on early-stage investments than their British counter-
parts, who on average concentrate rather on the later-stage segment.
PRIVATE EQUITY IN GERMANY AND GREAT BRITAIN –A COMPARISON OF MARKET STRUCTURES.
1)Cf. Economic Observer No. 4 2003 and the full study to be downloaded atwww.kfw.de/DE/Research/Sonderthem68/Beteiligun15/Inhalt.jsp.
2)See the full study which can be downloaded atwww.kfw.de/DE/Research/Sonderthem68/Beteiligun15/Inhalt.jsp.
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8
A differing focus with respect to investment stages corresponds with diffe-
ring investment sizes realized. On average commitments in Great Britain
have higher volumes than those in Germany, though in the area of early-
stage financings British private equity companies are also willing to accept
smaller commitments than their German counterparts.
Major differences also exist in the handling of financing requests: The
share of financing requests which is accepted (5 %) is roughly equal in
both countries. But in Germany private equity companies spend much more
time and effort on the appraisal of individual investments than their British
counterparts do. Nevertheless, the German companies relatively more
often use standardized rating procedures to appraise investments.
This difference is even more pronounced when we look at the intensity
put into handling a deal after contract conclusion: In Great Britain almost
all deals are handled hands-on, whereas this applies to only half of the
deals in Germany. This also corresponds with the different importance of
Illustration 1: Specialisation on financing phase
0 20 40 60 80
Early Stage(n = 35/13) 21,7
32,7
No Specialisation(n = 31/19) 31,7
29,0
Later Stage(n = 41/28) 46,7
38,3
GermanyGreat Britain
in % of all enterprises surveyed
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9
mezzanine financing forms in the two countries, which are represented
much more strongly in Germany than in Great Britain.
As for funding sources, the funding structure of private equity compa-
nies mainly reflects the obvious differences in the economic and financial
structures of the two countries. The private equity segment in Germany is
dominated by group-internal financing and borrowing from banks while in
Great Britain private equity is provided on a large scale by private individuals
and institutional investors. The investments themselves are also orientated
towards the general structure of the respective industry and go primarily to
those industries, which are the focus of the respective national economy.
MARKET GAPS AND PROMOTION.
The survey also looked at the question as to what extent both markets
ensure that the demand for private equity is actually covered and in which
areas additional promotion is required. The share of private equity compa-
nies that make out a permanent lack of private equity is roughly equal in
both countries (just under 70 %). In Germany gaps in the supply of private
equity are primarily made out in the service sector and the low-tech sector
of the producing industry and in Great Britain this concerns rather the
sectors of IT, telecommunications, media and life sciences.
Additional important insights were gained with regard to gaps in the
range of products offered for specific financing stages: In particular in the
field of early-phase financing demand often exceeds the supply of private
equity companies in both countries; this is especially so in the British
market. This might at least partly be due to the fact that promotion in
Germany strongly focuses on early-stage financing.
DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 9
10
Illustration 2: long-term private equity supply gaps
0 20 40 60 80
71,475,0
52,977,5
20,010,0
5,72,5
4,35,0
4,37,5
40,015,0
Seed
Start-up
Expansion
MBO / MBI
Replacement
Bridge
Turnaround
IT, Telecom.,Media
22,930,0
Other Services28,6
10,0
Manufacturing,high tech
21,415,0
Manufacturing,low tech
48,612,5
Life Science15,7
25,0
Other Industries15,7
7,5
Branches
Specialisation on the financing phasen
GermanyGreat Britain
percentage of firms that identified market gap
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11
CONCLUSION.
It is obvious that the private equity markets in Germany and Great Britain
took off from different starting points and, under unequal conditions,
experienced different developments. Differences in how the markets func-
tion are partly due to the differing structures of the market participants
and their portfolios.
Though one cannot say that the German private-equity market, which
is primarily dominated by financing through commercial banks and by
group-internal financing, is stuck in the infant stage, it might probably be
fair to say that it still has clear development potentials, especially when
compared with the UK market.
Author: Dr. Jörg Fischer
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KfW Bankengruppe
Economic Department
Palmengartenstrasse 5–9, 60325 Frankfurt am Main
Phone +49 69 7431-0, Fax +49 69 7431-2944
www.kfw.de
Infocenter KfW Förderbank
Phone +49 180 1 335577, Fax +49 69 7431-9500
www.kfw-foerderbank.de
Infocenter KfW Mittelstandsbank
Phone +49 180 1 241124, Fax +49 69 7431-9500
www.kfw-mittelstandsbank.de
1873
22
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