Task Force Working Group Report

Enhancing capital market financing for Europe’s growth companies

Towards a Resilient and Sustainable Post-Pandemic Recovery

Authors: Willem Pieter de Groen

Inna Oliinyk

Centre for European Policy Studies (CEPS)

In collaboration with:

European Capital Markets Institute (ECMI)

Brussels

The Centre for European Policy Studies (CEPS) is an independent policy research institute based in Brussels. Its mission is to produce sound analytical research leading to constructive solutions to the challenges facing Europe today. The views expressed in this Report do not necessarily represent the opinions of all the Task Force members, nor were they presented by any of the participants (unless explicitly mentioned). The views expressed in the chapters of this report are those of the authors and do not necessarily reflect those of CEPS or any other institution with which the members are associated.

© Copyright 2021, CEPS Image credit: https://www.vecteezy.com/

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the Centre for European Policy Studies.

CEPS Place du Congrès 1, B-1000 Brussels

Tel: 32 (0) 2 229.39.11 e-mail: info@ceps.eu internet: www.ceps.eu

Contents

Introduction ................................................................................................................................................... 1

Enhancing capital market financing for growth companies ............................................................................. 1

Conclusions ................................................................................................................................................... 4

References ..................................................................................................................................................... 5

List of Recommendations ............................................................................................................................... 7

Authors .......................................................................................................................................................... 8

Notes ............................................................................................................................................................. 8

| 1

INTRODUCTION

If European industry is to thrive, innovative new companies with good business ideas must be able to obtain the finance they need. In the EU, small and medium-sized enterprises (SMEs) currently rely almost exclusively on banks for their external finance. But the high transaction costs, the difficulty of financing intangibles and the overall opacity of the SME finance market means that banks are often unable to provide the risk capital that small innovative companies need. Most growth companies have a short track record and their ability to provide detailed financial information is limited, and banks therefore resort to more stringent conditions (including heavy collateral requirement) and risk premiums (Berger & Udell, 2002). This creates a significant financing gap that hampers the growth of EU SMEs (TESG, 2020).

EU capital markets can serve as an alternative to bank lending, providing robust funding for innovative SMEs. In the past few years, progress has been made to enhance access to capital for these growth companies. For example, venture capital has become more available due to the EU-level harmonisation of the rules through the European venture capital funds (EuVECA) legislation. Moreover, with the introduction of the SME Growth Markets under the Markets in Financial Instruments (MiFID II/MiFIR) legislation, it has become a lot easier and cheaper for young innovative companies to get listed (Oxera, 2020). Nevertheless, there are still important challenges to realising the growth potential and empowering EU capital markets for SMEs. This policy brief aims to identify factors that impede the ability of growth companies to raise public capital and to suggest ways to overcome them.

ENHANCING CAPITAL

MARKET FINANCING FOR

GROWTH COMPANIES

In recent years, EU policies have been relatively successful in bringing small companies to the capital markets. The number of listed micro companies has consistently increased since 2000, albeit rather slowly. Micro caps (i.e. companies with up to €200 million in market capitalisation) account for more than two thirds (65%) of all companies listed in the EU.1 Most of the micro caps (60%) were listed in the past two decades (see Figure 1). The gradual increase in micro-cap listings can be partially explained by policy interventions such as the creation of SME Growth Markets under MiFID II.

Figure 1. Companies listed at EU regulated and growth markets by initial listing period and size

Note: The figure includes only individual companies listed on EU regulated markets and SME Growth Markets as of 1 January 2020 and does not take into account companies that were delisted. Source: CEPS (2021).

SME Growth Markets promote access to capital markets for micro caps and streamline the development of specialist markets that focus on SMEs and smaller large companies. Companies seeking to list on SME Growth Markets have less stringent requirements to comply with and face lower listing costs. Although SME Growth Markets are regulated and thus provide a good level of investor protection, they remain largely illiquid and

26% 7% 9% 11% 12%

43%

11% 13% 15%17%

0%

25%

50%

< 2000 2000-2004

2005-2009

2010-2014

2015-2019

Large

Medium

Small

Micro57%

2 | TOWARDS A RESILIENT AND SUSTAINABLE POST-PANDEMIC RECOVERY

unable to attract sufficient investment. More progress is needed to facilitate the functioning of the SME Growth Markets and foster investment in SMEs (ESMA, 2021).

Even after getting listed, SMEs continue to face substantial barriers to attracting financing. Only a small share of the micro caps are able to continue growing after the initial listing. The micro caps in the EU on average grew more slowly than larger caps, contradicting the economic theory that smaller companies outperform larger caps. In practice, out of all micro caps that went public over 2015-20, only approximately 5% managed to grow to a small, medium or large cap.

The mediocre performance of micro caps on the European stock market can be explained by limited investor interest. Micro caps have a relatively low market value compared to larger caps, expressed in lower price-earnings ratios. For example, on average, the value of micro caps was just over half of small caps between 2015 and 2020 (see Figure 2). These results are generally consistent across most countries, exchanges and sectors.

Figure 2. Aggregate price-earnings ratio of listed companies by size

Note: The data presents aggregate price-earnings ratios between 2015 and 2020. The figure includes individual companies listed on EU regulated markets and SME Growth Markets and does not take into account companies that were delisted. Source: CEPS (2021).

The limited investor interest in micro caps stems from, among other things, limited liquidity. More specifically, the stocks of micro caps are relatively less traded than those of larger caps. For instance, total trading value of the micro companies over the second half of 2019 made about one third (29%) of their total float-adjusted market capitalisation (see Figure 3). In turn, for small, mid and large caps, trading value was 35% or more of their total float-adjusted market capitalisation.

Figure 3. Aggregate trading value-market capitalisation ratio of listed companies by size

Note: The data presents aggregate trading value to free-float-adjusted market capitalisation ratios over the last six months of 2019. The figure includes individual companies listed on EU regulated markets and SME Growth Markets and does not take into account companies that were delisted. Source: CEPS (2021).

The most pronounced factors that impede the liquidity and ability to raise public capital of micro caps are research deficit, lack of investors’ trust, and alternative forms of risk financing. This is reflected in the policy recommendations for developing market financing for growth companies.

R1. Improve the dissemination of corporate information (financial, environmental, social, governance, etc.) either through a central EU database or one set up by the exchanges and made freely accessible to investors.

Micro caps are substantially less covered by equity research than larger caps. Between 2013 and 2019 analysts issued, on average, about three recommendations per month on small caps in the EU,2 or five times less than the equivalent number for recommendations on large caps (Oxera, 2020).

Availability of research is one of the main factors informing the investment decisions of investors in micro caps (CFA, 2013). Complete and accurate information on micro caps is necessary for pricing the stocks accurately and gaining trust in the company. Some micro caps go as far as paying analysts for research or corporate access to be visible to investors who would not otherwise have the stock on their radar. Besides this, it is costly and can also potentially create conflicts of interest (FESE, 2020).

Free equity research on smaller companies is less and less available to investors. The reduction in investment research could to some extent be due to the

13

22 17 19

-

5

10

15

20

25

Micro (2916) Small (760) Medium (490) Large (326)

29%38%

42%35%

0%

10%

20%

30%

40%

50%

Micro (2916) Small (760) Medium (490) Large (326)

ENHANCING CAPITAL MARKET FINANCING FOR EUROPE’S GROWTH COMPANIES | 3

regulatory provisions introduced under the MiFID II in 2018. The rules unbundled research costs from order execution costs, which prohibited fund managers from accepting free research provided by brokers. The aim of the unbundling was to prevent unfair competition between brokers offering research free of charge. Although views diverge as to whether unbundling provisions under the MiFID II have led to a reduction in research on micro caps, experts tend to agree that micro caps remain largely under-researched, have a higher probability of losing coverage, and that the research is of lower quality (ESMA, 2021).

To facilitate the assessment of listed companies by both analysists and investors, it is recommended that the dissemination of the corporate information (financial, governance, etc.) is improved. This can be done through a central EU database, for example, or a database set up by the exchanges and freely accessible to investors.

R2. Promote the involvement of anchor investors to enhance the trust among retail investors and reduce the under-pricing.

Active participation of the retail investors in capital markets is crucial for liquidity. However, cultural perceptions of risk-taking mean that retail investors in the EU are generally risk-averse (ECB, 2020). Micro caps are considered to be more risky because of their relatively short track record and less granular information.

Additionally, the free float of many micro companies is rather limited, which is also an important factor for investors’ trust (OECD, 2017). Most micro caps have a high concentration in the ownership due to more block holdings by management, founders, and strategic non-tradable holdings (Oxera, 2020). In particular, small family-owned companies are often not willing to give up a significant ownership stake. A limited free float reduces liquidity but also poses questions about the company governance, further fuelling a decline in the demand for SME stocks.

While imposing minimum requirements on the free float is likely to enhance the liquidity, it might also prevent small companies from getting listed (European Commission, 2018). In turn, the qualified

institutional investors from the initial investors can contribute to enhancing trust among retail investors. There is already broad support for the establishment of an EU fund to promote investment in SMEs on capital markets at different stages of the IPO process (pre-IPO, IPO, and post-IPO) with a focus on growth firms (CESS, 2020).

R3. Develop alternatives to public markets, including business angels, venture capital and other forms of private equity, to serve as a stepping-stone to public listing.

To build a track record and strengthen the governance, young and innovative companies require growth financing before listing. The most suitable vehicle for such financing is private equity (business angels, venture capital, private equity funds, etc.). Private equity investors can provide the capital and governance oversight at early stages, preparing the company for a potential listing later on.

Well-developed private equity markets can bring substantial economic benefits. For instance, more private equity investment is associated with an increase in patented innovation, new business creation and new industrial leaders (ECB, 2020). Additionally, company-level evidence suggests that private equity investments, combined with the development and execution of value creation plans,3 are associated with stronger economic growth, higher operating revenues and increased operational efficiency even after the exit of the private investors (EBRD, 2020).

The alternative forms of risk financing for SMEs remain underdeveloped in the EU. They are characterised by a persistent fragmentation as well as a strong home bias (Raposo and Lehmann, 2019). However, little is done to promote the development of alternative forms of risk financing. The European Commission proposal for broad-based EU support for private equity has been rejected by the Council, the grant-based solvency instrument has been defunded, and the funding for InvestEU (network of EU private equity funds) has been cut significantly. These actions are projected to have a disproportionate impact on EU companies, and micro caps in particular (Lehmann, 2020).

4 | TOWARDS A RESILIENT AND SUSTAINABLE POST-PANDEMIC RECOVERY

CONCLUSIONS

SMEs are the backbone of the European economy. However, many of them, particularly young and innovative companies, struggle to access risk capital to finance growth. EU SMEs are largely illiquid and undervalued. More needs to be done to foster investment in SMEs.

To this end the EU industrial policy should focus on empowering capital markets for innovative new companies, and contribute to the development of a capital markets eco-system that would support growth companies through both public and private equity channels.

ENHANCING CAPITAL MARKET FINANCING FOR EUROPE’S GROWTH COMPANIES | 5

REFERENCES

Amzallag, A., C. Guagliano and V. Lo Passo (2021), “MiFID II research unbundling: assessing the impact on SMEs”, Working Paper 3, European Securities and Markets Authority, Paris (https://www.esma.europa .eu/sites/default/files/library/esma_50-165-1269_ research_unbundling.pdf).

Anselmi, G. and G. Petrella (2021), “Regulation and stock market quality: The impact of MiFID II provision on research unbundling”, International Review of Financial Analysis, Volume 76, July (www.sciencedirect.com/science/article/abs/pii/S1057521921001265).

Berger, A.N. and G.F. Udell (2002), “Small business credit availability and relationship lending: the importance of bank organizational structure”, The Economic Journal, Volume 112, Issue 477, February (https://onlinelibrary.wiley.com/doi/full/10.1111/1468-0297.00682).

Biesinger, M., C. Bircan and A. Ljungqvist (2020), “Value Creation in Private Equity”, Working Paper 242, European Bank for Reconstruction and Development, London (https://www.ebrd.com/ publications/working-papers/value-creation-in-private-equity).

Centre for Strategy & Evaluation Services (2020), “A Public-Private Fund to Support the EU IPO Market for SMEs”, Final Report, European Commission, Brussels (https://ec.europa.eu/info/sites/default/files/economy-finance/a_public-private_fund_to_support_the_ eu_ipo_market_for_smes_final_report_updated.pdf).

CFA Institute (2013), “Helping SME’s access funding”, Survey Report, CFA (https://www.cfainstitute.org/-/media/5690E2E9C1 8047C1A5979D49252EDDC2.ashx).

De Guindos, L. (2020), “Capital markets union: the role of equity markets and sustainable finance”, Contribution on the occasion of the publication of the ECB report on “Financial integration and structure in the euro area”, European Central Bank, Frankfurt (https://www.ecb.europa.eu/press/inter/date/2020/html/ecb.in200303~8296db2801.en.html).

European Commission (2018), “Impact Assessment Accompanying the document Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Regulations (EU) No 596/2014 and (EU) 2017/1129 as regards the promotion of the use of SME growth markets”, Staff Working Document, European Commission, Brussels (https://eur-lex.europa.eu/ legal-content/EN/TXT/PDF/?uri=CELEX:52018SC 0243&rid=4).

European Securities and Markets Authority (2021), “MiFID II review report on the functioning of the regime for SME Growth Markets”, MiFID II Review Report, European Securities and Markets Authority, Paris (https://www.esma.europa.eu/sites/default/files /library/final_report_on_sme_gms_-_mifid_ii.pdf).

European Investment Bank (2020), “Building a smart and green Europe in the COVID-19 era”, Investment Report 2020/2021, European Investment Bank, Luxembourg (https://www.eib.org/en/publications /investment-report-2020).

Federation of European Stock Exchanges (2020), “European IPO Report 2020”, Report, Federation of European Stock Exchanges, Brussels (www.fese.eu/app /uploads/2020/03/European-IPO-Report-2020.pdf).

High Level Forum on Capital Markets Union (2020), “A new vision for Europe’s capital markets”, Final Report, High Level Forum on Capital Markets Union (https://ec.europa.eu/info/sites/default/files/business_economy_euro/growth_and_investment/documents/200610-cmu-high-level-forum-final-report_en.pdf).

Lehmann, A. (2020), “Private equity and Europe’s re-capitalisation challenge”, Blog post, Bruegel, Brussels (www.bruegel.org/2020/09/private-equity-and-europes-re-capitalisation-challenge/).

Organisation for Economic Co-operation and Development (2017), “Financing SMEs and Entrepreneurs 2017”, OECD Scoreboard, Organisation for Economic Co-operation and Development, Paris (https://read.oecd-ilibrary.org/ industry-and-services/financing-smes-and-entrepreneurs-2017_fin_sme_ent-2017-en#page1).

Organisation for Economic Co-operation and Development (2018), “Enhancing SME access to diversified financing instruments”, Discussion Paper,

6 | TOWARDS A RESILIENT AND SUSTAINABLE POST-PANDEMIC RECOVERY

Organisation for Economic Co-operation and Development, Paris (www.oecd.org/cfe/smes/ ministerial/documents/2018-SME-Ministerial-Conference-Plenary-Session-2.pdf).

Oxera (2020), “Primary and secondary equity markets in the EU”, Final Report, European Commission, Brussels (www.oxera.com/wp-content/uploads/2020/ 11/Oxera-study-Primary-and-Secondary-Markets-in-the-EU-Final-Report-EN-1.pdf).

Rahman, A., J. Belas, T. Kliestik and L. Tyll (2017), “Collateral requirements for SME loans: Empirical evidence from the VISEGRAD countries”, Journal of Business Economics and Management, Volume 18(4) (https://core.ac.uk/download/pdf/97495189.pdf).

Raposo, I. and A. Lehmann (2019), “Equity finance and capital market integration in Europe”, Policy Contribution, Bruegel, Brussels (http://aei.pitt.edu/ 95641/1/PC-2019-03.pdf).

Ständer, P. (2017), “Public policies to promote venture capital: how to get national and EU measures in sync”, Policy Paper, Jacques Delors Institut, Berlin (https://institutdelors.eu/wp-content/uploads/ 2018/01/publicpoliciestopromoteventurecapital-stnder-august17.pdf).

Technical Expert Stakeholder Group (TESG) on SMEs (2020), “Empowering EU capital markets for SMEs”, Final Report, Technical Expert Stakeholder Group (TESG) on SMEs (https://ec.europa.eu/info/ sites/default/files/business_economy_euro/growth_and_investment/documents/210525-report-tesg-cmu-smes_en.pdf).

World Bank (2019), “Capital markets development, Causes, effects, and sequencing”, Literature Review, World Bank, Washington (https://documents1. worldbank.org/curated/en/701021588343376548/pdf/Capital-Markets-Development-Causes-Effects-and-Sequencing.pdf).

ENHANCING CAPITAL MARKET FINANCING FOR EUROPE’S GROWTH COMPANIES | 7

LIST OF RECOMMENDATIONS

R1. Improve the dissemination of corporate information (financial, environmental, social, governance, etc.)

either through a central EU database or one set up by the exchanges and made freely accessible to investors. .....2

R2. Promote the involvement of anchor investors to enhance the trust among retail investors and reduce the under-pricing. .......................................................................................................................................................3

R3. Develop alternatives to public markets, including business angels, venture capital and other forms of private equity, to serve as a stepping-stone to public listing. ..................................................................................3

8 | TOWARDS A RESILIENT AND SUSTAINABLE POST-PANDEMIC RECOVERY

AUTHORS

Willem Pieter DE GROEN is a Senior Research Fellow & Heading the Financial Markets and Institutions Unit at the Centre for European Policy Studies (CEPS) in Brussels. He has since joining CEPS in 2009 (co)-authored studies and coordinated projects on finance policies in the EU and beyond. He is a visiting professor at the College of Europe and member of the expert panel of the European Parliament in the field of banking resolution.

Inna OLIINYK works as a Researcher in the Financial Markets & Institutions Unit. Her research interests lie in the field of banking and international finance with a particular focus on development of capital markets. Prior to joining CEPS, she interned for HSBC in Paris. Major in international economics, she has studied in Ukraine, China and France and undertook courses on financial market analysis and macroeconometric forecasting from the IMF.

NOTES

1 Small caps are companies with market capitalisation between €200 million and €1 billion, which represent about 17% of all companies listed in the EU. Mid caps are companies with market capitalisation between €1 billion and €5 billion, which account for 11%. Large caps are companies with market capitalisation over €5 billion, which account for the remaining 7% of all companies listed in the EU. 2 The study identified small companies as those with market valuation of less than €500 million. 3 Detailed action plans related to operations, cash management, governance, financial engineering and cash management.