WEEKLY COMMENT 5-03-2015
By Barry Edwards
European Investment Bank Report
The European Investment Bank (EIB) has published a report on investment and investment finance in Europe 2015. The description of the report is taken direct from the executive summary;
‘Europe faces a twofold economic challenge. Post crisis, Europe still suffers from weak confidence, with would-be investors across Europe sitting on ample liquidity but afraid to invest, while deleveraging goes on in both the public and private sector. From a structural point of view Europe faces the long lasting challenge of declining productivity and competitiveness, which has made it more vulnerable to economic turmoil, is undermining the recovery and threatens its economic well-being over the longer term. Getting the conditions right for investment to take place and to accelerate the competitiveness-enhancing reallocation of resources is crucial for the future of Europe.
The EIB’s annual economic publication focuses on investment and investment finance in Europe, discussing both cyclical and structural factors. This year’s special topic is investing in competitiveness.’ If you click on the link below you can read the full report which is long (234 pages) but the executive summary and introduction are 10 pages;
Since the report is lengthy and there is a section on SME Finance in Europe, I thought I would concentrate this weekly comment on that; it is 23 pages from page 99-122. The summary states; ‘Given the importance of small and medium-sized enterprises (SMEs) as the backbone of the EU economy, the financing of their activities and their access to finance is of particular relevance. In this paper, we analyse the current state of SME finance in Europe.’
If you read the first couple of pages, it gives a good overview of the work being done which we have discussed in previous comments regularly. I wanted to devote this week’s comment to explaining why all the procedures and regulations the EU is activating are still not addressing the fundamental problems that rapidly growing SME’s encounter. For that reason, this weekly comment will be slightly longer than usual.
The first point to make is that the EU is doing everything that government can do with legislation to improve the environment for SME’s. In my view, it is the relationship with each company that has the potential to grow that will make all the difference to the determination being made by the EU. Before we start, here are the relevant statistics for the EU; In the EU’s non-financial sector, more than 21.6m of SME’s accounted for 99.8% of all non-financial enterprises, employed 88.8m people (66.9% of total employment) and generated EUR 3.666tn in value added (58.1% of total value added) (European Commission, 2014a).
For most businesses that seek loan funding, the lender has to do the due diligence which is expensive and time consuming compared to the amount of finance required. As the report points out; ‘Information asymmetries can be reduced in three ways: through a firm’s ability to signal its creditworthiness (by, for instance, an institutional assessment or rating by an independent agency and the provision of collateral), through a strong relationship between lender and borrower, and through due diligence/lender scrutiny (screening). However, this means that new or young firms, with a lack of collateral and by definition without a track record, are those that encounter the greatest difficulty in securing access to debt capital (Kraemer-Eis, 2014).’ The EU has plans to create the independent rating agency but we are not there yet. At the moment all lenders have to make the judgement whether to invest in the people to assess potential customers or rely on adequate collateral to determine the commitment to lend.
Currently, relying on the right kind of collateral is favoured and that often excludes unpaid invoices unless they are to the largest companies. For most SME’s that is their main asset and consequently they fail to get funding from banks unless they are willing to use their homes as collateral which some countries forbid. There are many small lenders specialising in this market referred to as ‘invoice discounters’ or ‘asset based lenders’ who have and are providing funding against this collateral. It is still a small percentage of lending compared to the banks. We discussed ‘alternative finance’ last week as another option which is currently only a tiny portion of the market but growing fast.
Many SME’s are one or two person enterprises often referred to as ‘lifestyle’ businesses which will probably not grow much bigger for all kinds of different reasons. These are not the SME’s that we are concerned with here because the potential to grow rapidly is the area where most attention is concentrated by all serious funders and government. What that means is that out of the 21.6 million SME’s mentioned in the figures above, only about 500,000 of those actually meet the growth criteria I have described. It is these businesses that will transform the economy and employ many people as they grow; this is where the fundamental problems are focused and need a different approach.
For those of us who work with SME’s, it is noticeable that the lack of coordination of advice and support with finance has always been the main reason for many of the failures that occur in this market. It is also surprising how many of these failures could have been prevented if the advice and support had been available in the right format for these businesses to access. It is this core area where the proposals by government need redefining to change how these businesses evolve and develop.
When you analyse what happens as companies grow; for example the phases they go through such as borrowing from banks or other lenders, coping with rapid expansion which involves employing more people and improving the financial control among many other important facets, it requires a lot of experience which most of these businesses do not have. The business plans submitted for fundraising discuss these matters but there is usually no monitoring facility or structured advice and support to make sure the plan is adhered to or if opportunities present themselves a proper strategic plan prepared for the change in circumstances.
Lenders normally only become aware of these rapid changes long after they have been acted upon which can often be quite different from the plan originally proposed. If the plan does not go well, they are presented with a fait accompli which is not a situation they can do much about quickly and they usually react adversely causing the business to suffer the consequences. All businesses that grow rapidly need permanent advice and support because it is natural that the path that the business plan forecasts is often quite different from the reality for these young growing companies. Handling that unpredictability is the key to the survival of these enterprises and why constant back up is the only way to support the management team.
It is not possible for government to enshrine rules and regulations to manage these changing circumstances and it requires new organisations to evolve in conjunction with government to handle the growth potential of this select group of companies. Since there isn’t the space here, how these organisations would operate and their structure is explained in ‘Venture Beyond’ and the ‘Economic Growth Plan’ in the right hand column of this page under categories. There is very little government funding required and they could be established quickly.
Where I have experienced this kind of support being practised, the results are impressive and the companies find the involvement extremely beneficial. The EIB report and the two mentioned last week show that government is doing a lot to help SME’s; taking this extra step would complete the practical support for this important sector.
That’s all for this week, more observations next week.