DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 1 - KfW...DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 2...

Economic Observer.

KfW-Research.

No. 7, February 2005.

DV-Observer-07-e.qxd 03.02.2005 08:22 Seite 1

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.


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


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


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.


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


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.


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


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.


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


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


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

[email protected]

www.kfw-foerderbank.de

Infocenter KfW Mittelstandsbank

Phone +49 180 1 241124, Fax +49 69 7431-9500

[email protected]

www.kfw-mittelstandsbank.de

1873

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