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Will the capital markets union boost SMEs investment financing and funding? 1. Will the EU Capital Markets Union ease SMEs access to capital? The European Commission launched in September 2015 an action plan in order to create a Capital Markets Union (“CMU”). The CMU aims to build a uniformed market for capital across the 28 EU member states and make it easier for small and medium-sized enterprises (“SMEs”) to access finance. The initiative comes in the wake of the financial crisis that has caused structural changes in especially SMEs access to banking credit. The banks’ lending has declined precipitously after the financial crisis - only just beginning to slowly recover. Bank loans are, however, still the main source of finance for European SMEs, but according to Eurostat, the proportion of unsuccessful loan applications has risen since 2007. Thus, SMEs find themselves in a dangerous funding gap, forcing them to search for new financing methods. In the below paragraphs, I will look at how SMEs can access capital in the current European equity and debt markets and introduce some of the new initiatives from the EU in this respect. Please be informed that the below matters are solely my own illustrations and personal opinions. 2. Limited options to raise capital in equity and debt markets European companies have a limited role in the equity and debt markets compared to US companies. Loan liabilities in the EU account for 212% of EU’s Gross Domestic Product (GDP), assets of debt securities are worth 171% of GDP, and public listed shares issued in the EU represent 60% of GDP. The European debt market is mainly dominated by government issuance (45% of total debt securities) while non-financial institutions’ issuance of debt only represents 7.6% of total debt securities. By contrast, in the US, loans represent 147% of GDP, debt securities 220%, and listed shares 115%. The below demonstrates the ratio between resepctively the GDP of EU and USA and the size of the different financing markets as of 2014. Besides the obvious problem that banks’ lending to SMEs are decreasing, the current European capital markets are also mainly suitable to large companies or medium/large sized SMEs, leaving small SMEs and startups with limited financing opportunities. SMEs can access equity and debt markets either through regulated public exchanges for listed securities (LSE, Euronext etc.) or through new platforms dedicated to SMEs. In many European countries, the stock exchanges have a second listing market that acts like an alternative to the main market. E.g. First North that is administered under NAQDAQ OMX Nordic. Such alternative markets have lower listing costs and legal requirements which make them more appropriate for SMEs

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The economic crisis has made it more difficult for especially SMEs to access banking credit, and these companies find themselves in a dangerous funding gap, forcing them to search for new financing methods. Thus, the European Commission launched in September 2015 an action plan in order to create a Capital Markets Union, aiming to build a uniformed market for capital across the 28 EU Member States and make it easier for SME’ s to access the capital markets. In the this paper, I look at how SMEs can access capital in the current European equity and debt markets and introduce some of the new initiatives from the EU in this respect.

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Page 1: EU Capital Markets Union

Will the capital markets union boost SMEs

investment financing and funding?

1. Will the EU Capital Markets Union ease SMEs access to capital?

The European Commission launched in September 2015 an action plan in order to create a Capital Markets

Union (“CMU”). The CMU aims to build a uniformed market for capital across the 28 EU member states and

make it easier for small and medium-sized enterprises (“SMEs”) to access finance.

The initiative comes in the wake of the financial crisis that has caused structural changes in especially SMEs

access to banking credit. The banks’ lending has declined precipitously after the financial crisis - only just

beginning to slowly recover. Bank loans are, however, still the main source of finance for European SMEs,

but according to Eurostat, the proportion of unsuccessful loan applications has risen since 2007. Thus, SMEs

find themselves in a dangerous funding gap, forcing them to search for new financing methods.

In the below paragraphs, I will look at how SMEs can access capital in the current European equity and debt

markets and introduce some of the new initiatives from the EU in this respect. Please be informed that the

below matters are solely my own illustrations and personal opinions.

2. Limited options to raise capital in equity and debt markets

European companies have a limited role in the equity and debt markets compared to US companies. Loan

liabilities in the EU account for 212% of EU’s Gross Domestic Product (GDP), assets of debt securities are

worth 171% of GDP, and public listed shares issued in the EU represent 60% of GDP. The European debt

market is mainly dominated by government issuance (45% of total debt securities) while non-financial

institutions’ issuance of debt only represents 7.6% of total debt securities. By contrast, in the US, loans

represent 147% of GDP, debt securities 220%, and listed shares 115%. The below demonstrates the ratio

between resepctively the GDP of EU and USA and the size of the different financing markets as of 2014.

Besides the obvious problem that banks’ lending to SMEs are decreasing, the current European capital

markets are also mainly suitable to large companies or medium/large sized SMEs, leaving small SMEs and

startups with limited financing opportunities.

SMEs can access equity and debt markets either through regulated public exchanges for listed securities

(LSE, Euronext etc.) or through new platforms dedicated to SMEs.

In many European countries, the stock exchanges have a second listing market that acts like an alternative to

the main market. E.g. First North that is administered under NAQDAQ OMX Nordic. Such alternative

markets have lower listing costs and legal requirements which make them more appropriate for SMEs

Page 2: EU Capital Markets Union

seeking finance through the capital markets. However, these platforms have minimum size requirements

because issues of debt or shares involve high transaction costs and a relatively complex legal framework.

Being a public listed SME is also a considerable cost in respect of on-going compliance and securities law

matters, and since the investor appetite and liquidity on most of these alternative markets are rather low,

there are limited reasons for the small SMEs to admit there shares or debt to trading on such markets in

Europe. With regard to debt securitisation, the legal issues on true sales, set-off and assignment of rights are

also still challenged in some jurisdictions in Europe, especially making it difficult for banks to pool loans

across national borders.

The second types of platforms are the new direct lending and crowdfunding platforms, such as FundingCircle

in the UK and KreditMatch in Denmark that allows investors to lend money directly to small businesses

without a bank or intermediary interfering. In the UK, alternative finance to businesses is projected to hit

£12.3bn in 2020, up 10-times from the £1.2bn loaned out in 2014. Although the rate of growth sounds

extraordinarily fast, the market has already grown from just £90m in 20111. Costs and market requirements

are lower compared to being a public listed company. The problem is, however, the lack of a transparent legal

framework throughout the EU. Some European countries require banking license in order to store monetary

value, some countries require license as a securities trading platform and some countries, notably UK and

Italy, have actually passed tailor-made legislation on direct lending and crowdfunding. These lending

platforms seem to be the obvious financing solution to many SMEs. However, inconsistency in legal

frameworks could be an obstacle for cross-border lending and expansion of lending platforms throughout

Europe.

3. New initiatives from the EU Commission

The EU Commission are certainly aware of the structural changes in the financial markets across the EU.

That is also the reason why the Commission wants to build this Capital Markets Union, mainly by adopting

new regulation. Insofar, the EU Commission have introduced an action plan and some proposals. More

initiatives are expected in 2016 and 2017.

3.1 Shares trading on regulated markets

In terms of access to the public stock markets, the Commission aims to tackle the legal issues that deter funds

from investing across borders and cutting the number of documents a company must produce when issuing

shares or debt instruments.

The European Commission published on 30 November 2015 its proposal for a new prospectus regulation to

reform the European prospectus regime. This new prospectus regulation requires consent of the European

Council and the European Parliament. It is, however, expected that the legislation will come into force in

early 2017 and will be directly applicable in each member state.

The new Prospectus Regulation implies that no EU-prospectus would be required for offers of securities with

a total value below EUR 500,000. Also, SMEs will be able to benefit from new minimum disclosure regimes

for their prospectuses. A new optional Q&A prospectus format is also introduced which will helps SMEs and

small caps draw up their own prospectus for shares and bonds, sparing them some costs.

In addition, issuers that do not offer securities to the public will have the ability to issue up to 20% (today the

threshold is 10%) of existing capital in a 12-month period without triggering the obligation to publish a

prospectus.

1 Study from the Centre for Economics and Business Research and payments firm Fiserv.

Page 3: EU Capital Markets Union

3.2 Securitisation

In terms of securitisation, the new prospectus regulation also creates higher thresholds to determine when

debt issuers must issue a prospectus. The Commission will double the existing threshold for SMEs who can

take advantage of it – from €100m market capitalisation to €200m.

In addition, the European Commission published on 30 September 2015 a proposal for a securitisation

regulation aiming to harmonise the existing rules on due diligence, risk retention and disclosure, and to

create a new framework for simple, transparent and standardised long-term securitisations and asset-

backed-securities. By way of example, the proposal includes that securitising parties will have a direct

obligation to retain risk – even though the investors are located outside EU. Also, certain special purpose

vehicles will not qualify as originators for risk retention purposes.

4. Need more than a uniformed legal framework

Simplified access to the capital markets is a great step along the way and it will not only benefit the SMEs.

Venture capital and private equity funds will also benefit since this might increase their exit possibilities. The

introduction of the CMU might also be a great opportunity for some countries or platforms who want to

positions themselves as specialist platforms. Instead of competing internally within the EU, the CMU could

be based on a series of specialist markets. Rather than having one dominant financial centre, the CMU could

become a collection of financial hubs specialising in different products or industries.

However, it seems like the EU Commission aims to build the CMU mainly by harmonising the European

securities laws. In order to create more opportunities for investors and connect finance to the wider

economy, the markets truly need a uniformed legal framework - but this is not enough. Market prices of

equivalent shares should be equal irrespective of their country of domicile, and also the cost of bonds and the

interest rate applied to loans should be uniformed from one country to another for same types of debt etc.

Investors currently argue that they are challenged by scarce liquidity and incomplete credit rating coverage of

SMEs. These imperfections are inherent to SMEs that do not have a long credit history. Thus, transparency

in respect of collection of information and data on the creditworthiness of the SMEs is a key matter.

European startups and small SMEs will still need to get funded through bank loans, direct lending platforms,

business angels or venture capitalist. The listing costs, prospectus requirements and on-going compliance

being a public listed company will remain to be a too huge burden for such companies. In this regard, I

believe that crowdfunding and direct lending will continue its growth within the EU, and please note that the

EU Commission will release a report on crowdfunding in Q1 2016.

The EU commission will instead have to focus on removing barriers for entering the European capital

markets for large SMEs and foster a more resilient financial system with deeper integration. I am looking

forward to seeing the outcome.

Author: Andreas Vallentin-Hansen

Profession: Lawyer – M&A and Capital Markets

Company: Gorrissen Federspiel