The SME Financing Gap (Vol. II): Proceedings of the Brasilia Conference, 27-30 March 2006

The SME Financing Gap VOLUME II PROCEEDINGS OF THE BRASILIA CONFERENCE

The SME Financing Gap

27-30 MARCH 2006

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VOLUME II – PROCEEDINGS OF THE BRASILIA CONFERENCE

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VOLUME II PROCEEDINGS OF THE BRASILIA CONFERENCE The SME Financing Gap

A significant number of entrepreneurs and small and medium-sized enterprises (SMEs) could use funds productively if they were available, but are often denied access to financing. This impedes their creation and growth. The “financing gap” was the subject of the OECD Global Conference on “Better Financing for Entrepreneurship and SME Growth”, held in Brasilia, Brazil in March 2006. This book presents a synthesis of the Conference discussions on the credit and equity financing gaps, as well as on private equity definitions and measurements. It also offers a selection of papers given by some of the key stakeholders (SMEs, government and financial institutions) confronting these important issues.

27-30 March 2006

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The SME Financing Gap Volume II

PROCEEDINGS OF THE BRASILIA CONFERENCE 27-30 March 2006

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT The OECD is a unique forum where the governments of 30 democracies work together to address the economic, social and environmental challenges of globalisation. The OECD is also at the forefront of efforts to understand and to help governments respond to new developments and concerns, such as corporate governance, the information economy and the challenges of an ageing population. The Organisation provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies. The OECD member countries are: Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Commission of the European Communities takes part in the work of the OECD. OECD Publishing disseminates widely the results of the Organisation’s statistics gathering and research on economic, social and environmental issues, as well as the conventions, guidelines and standards agreed by its members.

This work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries.

Also available in French under the title:

Le déficit de financement des PME (vol.I) PRINCIPES ET RÉALITÉS

© OECD 2007 No reproduction, copy, transmission or translation of this publication may be made without written permission. Applications should be sent to OECD Publishing: [email protected] or by fax (33-1) 45 24 99 30. Permission to photocopy a portion of this work should be addressed to the Centre français d'exploitation du droit de copie (CFC), 20, rue des Grands-Augustins, 75006 Paris, France, fax (33-1) 46 34 67 19, [email protected] or (for US only) to Copyright Clearance Center (CCC), 222 Rosewood Drive Danvers, MA 01923, USA, fax (978) 646 8600, [email protected].

FOREWORD - 3

Foreword

At the 2nd OECD Ministerial Conference on SMEs held in Istanbul, Turkey in June 2004, Ministers recognised in the Istanbul Ministerial Declaration “the need to improve access to financing for SMEs on reasonable terms [...]”. Ministers underlined the importance of this issue by encouraging the OECD to organise a thematic conference for further discussion to seek more innovative solutions and initiatives for facilitating SME access to financing, from firm creation through all stages of development. The high-level OECD Global Conference on “Financing for Entrepreneurship and SME Growth”, hosted by the Brazilian Government (Brasilia, 27-30 March 2006) in the framework of the OECD Bologna Process on SME and Entrepreneurship Policies, provided an initial occasion to achieve these objectives. The publication comprises a synthesis of the discussions held during the OECD Brasilia Conference, as well as its main result, the OECD Action Statement on SME & Entrepreneurship Financing. A number of the conference papers, selected by the OECD Steering Group in preparation for the conference, are also included The synthesis has been prepared by John Thompson, consultant to the OECD, under the supervision of Marie-Florence Estimé, Deputy Director of the Centre for Entrepreneurship, SMEs and Local Development). Significant contributions have been made by Marcos Bonturi (Secretary General’s Office), Tim Davis (Statistics Directorate), Alain Dupeyras (CFE), Stephen Lumpkin (Directorate for Financial Affairs) and Mariarosa Lunati (CFE). The valuable contributions of the Chairs of the Conference are gratefully acknowledged. The contributions of Rebecca Scheel, Damian Garnys, Brynn Deprey and Elsie Lotthé (CFE/ SME & Entrepreneurship Division) were greatly appreciated. The Conference Proceedings is issued on the responsibility of the Secretary-General of the OECD. Views expressed are those of the authors (and not necessarily their insitutions/associations) and do not necessarily reflect those of the Organisation or its member governments.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

TABLE OF CONTENTS - 5

Table of Contents Foreword .................................................................................................................................................... 3 Key Remarks: Extracts from Speeches ................................................................................................... 7 Mr. Luiz Fernando Furlan Minister of Development, Industry and Foreign Trade, Brazil............................................................. 9 Mr. Herwig Schlögl Deputy Secretary-General, OECD ...................................................................................................... 11 Mr. Ali Coskun Minister for Industry and Trade, Turkey............................................................................................. 13 Mr. Takao Suzuki Chairman, Organisation for SMEs and Regional Innovation Japan (SMRJ), Japan........................... 15 Part I: Synthesis....................................................................................................................................... 17 Plenary Keynote Session: The SME Financing Gap: Theory and Evidence ......................................... 18 Workshop A: Credit Financing for SMEs: Constraints and Innovative Solutions................................. 20 Workshop B: Equity Financing for SMEs and the Role of Government............................................... 24 Technical Workshop on Private Equity Definitions & Measurements .................................................. 29 Plenary Closing Session......................................................................................................................... 31 Part II: Selected Papers........................................................................................................................... 33 Plenary Keynote Session: “The SME Financing Gap: Theory and Evidence” .................................... 35 Access to Financial Services: A Key Element in a Comprehensive Development Agenda ................. 36 Mr. Enrique García Polish Entrepreneurs: Access to Capital [ speech excerpt ] ................................................................... 43 Mr. Andrezj Kaczmarek The Financing Gap for SMES in Brazil................................................................................................. 46 Mr. Roberto Luis Troster The SME Financing Gap: Theory and Evidence [ speech excerpt ] ...................................................... 59 Mr. Joan Trullén Thomás Get to Know Your SMEs ....................................................................................................................... 63 Mr. Stuart Wilson Workshop A: Credit Financing for SMEs: Constraints and Innovative Solutions ............................... 67 Banque de France Rating ....................................................................................................................... 68 Mr. Daniel Gabrielli Access of Micro and Small Enterprises to Credit in Brazil ................................................................... 80 Mr. José Mauro de Morais

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

6 - TABLE OF CONTENTS Credit Allocation and Efficiency: The Case of Japan ............................................................................ 92 Mr. Iichiro Uesugi The Role of State-Funded Credit Guarantee Schemes for SMEs: Italy’s Experience ......................... 106 Mr. Salvatore Zecchini Mr. Marco Ventura Workshop B: Equity Financing for SMEs and the Role of Government............................................ 125 Equity Financing for SMEs: “The Nature of the Market Failure”....................................................... 126 Mr. Jean-Noel Durvy A Review of Access to Finance Matters Related to the Development Finance Institutions of the DTI [paper excerpt]..................................................................................................................... 132 Mr. Don Mashele GBS Venture Partners, Australia – A Case Study in Government Programmes to Kick Start a Venture Capital Industry................................................................................................................... 145 Ms. Brigitte Smith Technical Workshop on Private Equity Definitions and Measurements ............................................. 151 Private Equity Definitions and Measurements: Issues Paper............................................................... 152 …Damn Lies, Statistics and Venture Capital Statistics ....................................................................... 162 Mr. Victor Bivell Standard Definitions and Valuation Methods for the Measurement of Private Equity....................... 178 Mr. Jeong Min Kim Towards Practical Valuation Approaches for Venture Capital Funds ................................................. 183 Mr. Thomas Meyer Final Plenary Session: Financial Innovations for SME Credit and Equity Financing: The Contributions of Markets and Governments ......................................................................................... 193 Building a Better Understanding of SME Financing: Lessons learnt by Canada and New Zealand on SME Finance Data Collection Initiatives....................................................................... 195 Mr. Blair Robertson Mr. Brad Belanger Financial Intermediation: The Role of Information Production in Matching the Demand and Supply of Credit ................................................................................................................................ 211 Ms. Nadine Levratto Permanent Forum of Micro-Enterprises and Small Firms: Measures to Strengthen Credit in Brazil................................................................................................................................................. 226 Ms. Cândida Maria Cervieri Annex A: Conference Programme for OECD Global Conference on Better Financing for Entrepreneurship and SME Growth ................................................................................................... 237 Annex B: The OECD Brasilia Action Statement on SME and Entrepreneurship Financing ................................................................................................................................................ 273

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

KEY REMARKS - 7

Key Remarks: Extracts from Speeches

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

KEY REMARKS - 9

Mr. Luiz Fernando Furlan, Minister of Development, Industry and Foreign Trade, Brazil

“Brazil and the world growing with SMEs” “It is a pleasure for the Brazilian Government to host, in partnership with the OECD, such an important event with the participation of more than 70 countries to discuss ‘Better Financing for Entrepreneurship and SME Growth’. The key themes of this Global Conference are the ‘SME Financing Gap’, ‘Credit Financing for SMEs: Constraints and Innovative Solutions’, ‘Equity Financing for SMEs and the Role of Government’ and ‘Private Equity Definitions and Measurements’. Moreover, it will tackle the advances and the difficulties, which must be overcome, in order to consolidate small businesses worldwide, increasing both income and occupation in developed and developing countries. In Brazil, a closer integration between small businesses and the financial system is improving SME competitiveness and facilitating their performance in productive chains. However, there must be advances in terms of making access to financial products easier and less expensive, so that SMEs can also expand significantly their share in the GDP, which currently does not exceed 20%. Brazil is the seventh country with larger percentage of entrepreneurs, who are mostly responsible for SMEs. Unfortunately, these companies present a high mortality rate. Public policies must, therefore, catalyse this entrepreneurial energy to make it an instrument of income distribution and social inclusion. In Brazil, 49% of SMEs close their doors in the first year of activity. This index rises to 56.4% and 59.9% by the end of the first three years and four years, respectively. Statistical data still shows that 60% of the entrepreneurs point to the lack of access to credit as the main cause of difficulties. This panorama has been changing as financial institutions are gradually including formal and informal SMEs, as well as lower income people, in their portfolio. They are being partially led by governmental measures to support credit cooperatives and micro credit operators. The Brazilian Government stresses its main progresses for the support and foment to SMEs as the Project of the General Law of Micro and Small Enterprises, the project of simplification for setting up and shutting down companies, the Business Information Telecentres, and the Simplified System of Taxation on the Micro and Small Enterprises. It is necessary to encourage the companies to adhere to the formal market, by means of public and private incentives that facilitate the access to trans-national credit. Brazil already counts on efficient mechanisms of sustainability and competitiveness promotion to SMEs. One of the most important governmental instruments is the Permanent Forum of Micro and Medium-Sized Enterprises, which fosters the debate and the integration

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

10 – KEY REMARKS between public agencies and the private sector in order to formulate public policies to address the needs of the Brazilian SMEs. This OECD Global Conference held in Brasilia is already a great success, due to the high level of the speakers as well as to the foreign delegations that took part of it. This event will certainly be an important landmark for the policies targeted to SMEs, significantly contributing to the objectives of all the participants.”

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

KEY REMARKS - 11

Mr. Herwig Schlögl, Deputy Secretary-General, OECD

“Small and Medium-sized Enterprises (SMEs) are essential for economic growth, job creation, innovation and social inclusion for countries at all levels of development. However, the lack of access to financing for SMEs in most countries means that a sizeable share of entrepreneurs and SMEs cannot obtain financing from banks, capital markets or other sources in order to start, innovate or grow their enterprises. In more advanced countries, the problem affects particularly innovative SMEs, found mostly in high-tech sectors, that find it difficult to access traditional forms of SME finance such as bank credits or government guarantees. In developing and emerging markets, the financing gap is more generalised, affecting all types of SMEs. This ‘SME Financing Gap’ - or the difference between the numbers of SMEs that could use funds productively if they were available, but cannot obtain finance from the formal financial system -- has been analysed in an in-depth OECD Report The SME Financing Gap: Theory and Evidence. The report found that market failures such as agency problems, asymmetric information, and adverse credit selection and monitoring problems, affect SMEs more than other firms. Moreover, barriers to international financial flows, structural rigidities and inefficient regulatory systems affect many developing countries and impact proportionally much more on SMEs than on larger firms. Heavy administration, excessive bureaucracy and reporting practices reinforce income inequalities and hamper productivity gains. A key message of the OECD Global Conference on Better Financing for Entrepreneurship and SME Growth, held in Brasilia on 27-30 March 2006, is that while this financing gap does exist, it is not insurmountable. The Conference, which for the first time brought together the major stakeholder (SMEs, financial community, and governments) for a very open and fruitful discussion, found that much can be done to resolve the ‘SME Financing Gap’. While one size does not fit all and different countries need to adapt policies to their own economic and social reality, the Conference did reach some common conclusions. Governments can play a key role by removing unduly barriers to entrepreneurship and innovation by alleviating administrative burdens, reducing transaction costs and improving contractual conditions. Public policy design and implementation needs to be conducted in consultation with SMEs from the outset to ensure that their perspectives and needs are well understood. In line with the OECD Brasilia Action Statement for SME & Entrepreneurship Financing adopted at the Brasilia Conference, the OECD will continue to work on improving knowledge of how countries can ameliorate both debt and equity financing of SMEs, and in particular innovative SMEs.”

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

KEY REMARKS - 13

Mr. Ali Coskun, Minister for Industry and Trade, Turkey

“In the last decades of 20th century, the prevalence and development of economic, political and social relations among the countries accelerated the dissolution of political polarisation of the cold war and this process resulted in the establishment of the new world order. The considerable abolishment of customs barriers paved the way for countries reaching to open economies and integration to the world markets. In the globalisation process, SMEs, which are the driving force for employment and economic development and which form more than 95% of the number of enterprises and 60-70% of employment in OECD economies, constitute a source for new job opportunities. SMEs, with their dynamic and productive characteristics, significantly contribute also to regional and local development. In addition, innovative and information based SMEs can more easily adapt to changes and development, and so stand out in competition. Thus, they play an important role in decreasing the fragility of economies. One of the most important steps aiming at increasing the competitiveness of SMEs is the OECD Bologna Process on SME & Entrepreneurship Policies (launched at the 1st OECD SME Ministerial in Bologna in 2000) and this have been continued at the 2nd OECD Ministerial Conference on ‘Promoting Entrepreneurship and Innovative SMEs in a Global Economy’ on 3-5 June 2004 in Istanbul and Brasilia conferences. The Istanbul Conference and the Brasilia Conference complement each other, because access to SME financing was accepted as one of the main issues facing SMEs in OECD Istanbul Ministerial Declaration. The main problem facing SMEs is lack of financing, mainly in the forms of inadequate working capital, insufficient equity, difficulties of credit finding, expensive credit costs, ineffective revenue collecting, not being able to utilise incentives, the impact of economic policies on firms in the countries having high inflation and interest rates and limited opportunities for benefiting from capital markets. In Turkey, SMEs constitute 98% of business enterprises, 77% of total employment, 38% of investments, 26% of value added and 10% of exports. However, they can not receive the proportional share out of the bank credits. Bank credits are either not sufficient for meeting their needs or create new problems due to high interest rates and demanded guarantees. It is vital for alleviating the SME financing problems to use so called modern financing techniques, such as financial leasing, factoring, venture capital, franchising, make them widespread and foster SME exchanges and mergers in order to strengthen their capitals. Naturally, the foremost condition for the expansion of alternative financing techniques is to abolish bureaucratic barriers. I would like to mention briefly the developments in our economy and studies carried out in the field of SME financing in our country. The Turkish economy has shown some unique developments in the last 4 years. As a result of political and economic stability,

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

14 – KEY REMARKS our economy has grown by 30% in real terms. Inflation and real interest rates have decreased to a single digit; GNP has increased to 400 billion, the foreign trade volume has been boosted to 190 billion dollars; and our economy has become one of the 20 largest economies of the world. After these accomplishments, negotiations for full membership to European Union have started. The SME sector is most affected by these developments. In our country, the most important institution supporting SMEs is the Small and Medium Industry Development Organization (KOSGEB), the affiliated organisation of our Ministry. Types of support, which used to be eight, have been increased to 38 under 22 main headings, and when submitting applications, the number of bureaucratic transactions, which used to be 45, has been reduced to five. Various types of supports have been provided for the development of priority regions by KOSGEB. In addition, the Credit Guarantee Fund (CGF), which used to give guarantee and security for the credits used by SMEs from government banks, has also begun to give guarantee and security for the credits used by SMEs from private banks since 2002. Besides, CGF was also included into the SME encouragement system implemented by the Under-secretariat of Treasury in 2002 and in this way, public sector has participated in sharing the risk of CGF. Furthermore, necessary arrangements have been made so that new credit guarantee and security firms and venture capital firms can be established. Another development is putting regulation into force on ‘SME Stock Exchange Markets (SME Exchanges)’ prepared by the Capital Markets Board of Turkey in order to enable our SMEs to benefit from modern financing techniques. By ‘Communication on Principles for Venture Capital Investment Companies’ of the Capital Markets Board, the venture capital investment company model has been updated in order to solve the financing problem of SMEs. On the other hand, for SMEs which face difficulties in finding guarantees, the ‘Law on Pledge of Commercial Enterprise’ has also been amended. Allocation of free land, income tax withholding and support of energy discount, insurance premium allowance have been provided for both the domestic and foreign investors through industrial zones and small industrial sites established by our Ministry. Moreover, 26 enterprise development centres and common laboratories of KOSGEB, and other various supports offer services ranging from informing to financing, from regional development to export promotion by means of 18 Technology Development Centres, which have been founded as incubation centres primarily for young and female entrepreneurs. Besides, 20 Technology Development Zones have been established by our Ministry within the framework of university-industry cooperation which provides various exemptions and supports for the entrepreneurs. Last but not least, terror is one of the most important factors that prevents the development of international economic relations. We, as Turkey, are against all kinds of terror, since the terror does not possess religion, geography and nationality. Therefore, international society has to co-operate on the globalised terror.”

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

KEY REMARKS - 15

Mr. Takao Suzuki, Chairman, Organisation for Small and Medium Enterprises and Regional Innovation Japan (SMRJ), Japan

“The role of SME policy and the current state of SME finance in Japan” “During Japan’s post-war recovery period, various organisations and systems were established in order to bolster SMEs, which were generally weak and lacking in resources. In 1963, these various methods of support were systematised in the form of the SME Basic Law, which viewed SMEs as a weak entity and sought to rectify the gap between large firms and SMEs in terms of productivity and management resources. The Law was revised in 1999 as SMEs were no longer seen as weak entities, but rather as creative and flexible entities acting as the driving force behind a dynamic Japanese economy. The Revised Law aims for diverse and vigorous development of a wide range of independent SMEs, with benefits including creation of new industries, employment, and regional economic vitalisation. In Japan, industrial financing has generally been developed by private financial institutions as a credit finance system. Current outstanding SME loans total about 254 trillion yen. Supplemental credit financing also comes from three governmental financial institutions (26 trillion yen), and a public credit guarantee system (30 trillion yen). The number of private venture capitals is increasing, and SMRJ is also investing in various funds with the purpose of promoting SME growth in the early stages. In the 1990s, the business exit rate was greater than the start-up rate, prompting the active support of start-ups in order to break economic stagnancy. In 2005, the Law for Facilitating New Business Activities of SMEs was enacted to strengthen financing, taxation, and management support. Depending on the circumstances, other countries may be able to use Japan’s experience as reference when formulating their own SME Policy. The theory and application of intellectual asset-based management is currently a hot topic at the OECD and in Japan. This style of management uses intellectual assets – human resources, technology, organisational capability, client networks, and intellectual property (e.g. patents and brands) – as a resource with the aim of improving stockholder’s confidence and reducing financial costs. I would like to conclude with a message from Mr. Toshihiro Nikai, Minister for Economy, Trade and Industry (METI), reasserting the importance of supplemental financing towards the development of robust SMEs.”

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

PART I: SYNTHESIS - 17

Part I: Synthesis

This synthesis comprises a summary of the discussions held during the OECD Brasilia Conference and its parallel workshops and session. For a complete Conference Programme, detailing Chairs, Speakers, Discussants and Rapporteurs, please consult Annex A.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

18 – PART I: SYNTHESIS

Plenary Keynote Session: The SME Financing Gap: Theory and Evidence

The opening session launched the debate on the very broad themes of: i) whether an SME financing gap could be identified in some countries or sectors; ii) the main explanations for any such gap; and iii) the most effective policy actions to address this gap. The meeting took place against a background of the wide recognition of the pivotal role of SMEs in job creation and technological advance, in advanced countries as well as in emerging and developing markets. Most firms in all countries are SMEs, and the majority of workers are typically employed by SMEs. At the same time SMEs were acknowledged to present particular problems for prospective lenders or investors as, in comparison to larger enterprises, SMEs have higher risk, more opacity, serious agency problems, and wider information asymmetries. Consequently, SMEs pose daunting challenges in monitoring performance and aligning interests of the enterprises and suppliers of finance. On the positive side, SMEs are more agile, with in some cases higher growth and potential for innovation. In most economies it is meaningful to speak about some form of an SME “financing gap,” but the gravity of the situation differs significantly among countries and among sub groups of SMEs. In advanced OECD economies, the situation is comparatively favourable. While there is an intuitive reluctance on the part of traditional lenders to lend to firms without collateral and track records, this disadvantage is largely offset by policies that are well targeted to the special problems of SMEs and by the efforts of private financial institutions to develop this market segment as a profitable business line. The success of government support programmes in advanced countries is not evidenced by large scale support for SMEs that uses budgetary resources or by large-scale dependence of SMEs on public support. Indeed, in OECD countries, governments typically provide only a small part of direct SME finance. By contrast, the success of policies to support SMEs may be gauged by the large amount of private financial resources they leverage. The need for policy to reflect the differences among SMEs and among countries were dominant themes throughout the discussions. On the one hand, there are some SMEs with only modest growth prospects but which can nonetheless provide a decent living to entrepreneurs and workers. These kinds of firms have their own special needs that must be met. On the other hand, high-growth SMEs exist with a potential to make extraordinary contributions to employment and technology, commonly known as “innovative SMEs” (ISMEs). There are significant differences of SME need at various stages of the high growth cycle as well. To reflect the different needs of different SMEs, it is important to develop a full range of options (sometimes called the “finance ladder”) for SMEs. The finance ladder should

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

PART I: SYNTHESIS - 19

include traditional bank funding, loan guarantee programmes and asset-based finance. Other elements of a complete financing ladder include a full menu of possibilities for equity finance ranging from “proof of concept” and “micro loan” funds through to business angel finance all the way to traditional venture capital funds and formal exit mechanisms. Some speakers argued that rather than speaking of a “financing gap” it was more useful to conceive of “information gaps” and “monitoring gaps”. Entrepreneurs perceive there to be lack of finance, while potential investors simultaneously see a lack of investment opportunities. In this case, what is needed is a catalyst to bring the two parties together by easing the flow of information between the parties. Preliminary indications suggested that, to the degree that there is an equity gap, it is found mostly in the early stages of the investment cycle. This is precisely the stage of the investment cycle where information and monitoring problems are likely to be the most acute. This is also probably the stage where governments can be the most effective in spurring development by easing access to information, supporting infrastructure (e.g. as business parks) and providing small amounts of financing, preferably in co-operation with private investors. Government support of applied research can also be a determinant of whether new technology is incorporated into the product cycle rapidly. An important consideration is that government programmes should not drive rates of return down to the point that private investors no longer find them attractive. Several speakers referred to the special problems facing SMEs in emerging and developing markets. In the first place, it is important to be cognizant of the vast differences in levels of development among non-OECD countries. Some emerging market economies, such as Brazil, India and China, have achieved rather high levels of financial sophistication. Meanwhile, many developing countries remain in much earlier stages of financial development. Although most of the population in emerging market economies and developing countries work in SMEs, these enterprises are typically characterised by low productivity, low levels of investment, obsolete technologies, low levels of labour and managerial qualification, and limited access to formal credit. These initial problems may have been aggravated by past government policies that may have favoured large enterprises. Weak institutional and legal environments, as often found in emerging markets, tend to place SMEs at a special disadvantage. As in other markets, banks in emerging markets exhibit a great reluctance to finance SMEs due in part to weak bankruptcy and recovery regimes. Many SMEs in emerging markets prefer to operate in the informal economy, partly because traditional lenders have little interest in SMEs and also to escape taxation and regulation. Several speakers from emerging markets indicated that policies pursued in earlier time periods, which tended to favour larger enterprises, have recently been re-calibrated. As a result, the prospects for access to finance have improved markedly in those cases where adequate policy readjustments have been made.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

20 – PART I: SYNTHESIS

Workshop A: Credit Financing for SMEs: Constraints and Innovative Solutions

This workshop examined a range of issues pertaining to SME credit financing, emphasising the regulatory and institutional framework to support the functioning of debt market for SMEs and issues related to risk evaluation, mitigation and sharing. Participants also examined international experience and best practices in order to determine the most efficient means for governments to assist in SME credit financing. SME lending is complex owing to the heterogeneity of the firms in question and the complexity of their needs. These firms require high “touch”, which means labourintensive monitoring and administrative costs, but loans to SMEs are rather small. From the view of banks, the extension and the pricing of credit often involve information asymmetry and lack of adequate collateral. The discussion in this workshop revealed that the problem is multi-faceted. In some cases, the main problems are the absence of a sound legal, institutional, or regulatory nature (e.g. lack of a good bankruptcy law, no mechanism to address firms in difficulty, weak implementation of existing laws as well as lack of collateral or security.) At the same time, firms and lenders must comply with multiple laws and cumbersome legal processes, which draw time away from the actual running of the business. For SMEs, the “bureaucratic” behaviour of banks is sometimes a big issue, with SMEs often complaining of limited access to credit and onerous terms when credit is available. Since there are many problems, multi-faceted solutions are needed. A well-functioning credit market works best inside a well-developed infrastructure, which includes a stable macroeconomic environment and a supportive legal and institutional framework. Company law, contract and property law, securities law, laws governing consumer and investor protection, and insolvency or bankruptcy laws establish together the basic framework within which financial institutions and markets operate. Good enforcement of laws is also necessary, which entails a well-functioning judicial system. Evidence suggests that when these conditions are met in a satisfactory manner, financial institutions will have the basic incentives to address the information and other problems associated with SME lending. However, even with a stable macroeconomic environment and a supportive institutional framework, some types of SMEs may still have difficulties securing financing. These include start-ups and firms lacking sufficient or appropriate collateral and those with lack of stable earnings. Debt and equity are not always substitutes, but may be complements as well. Lack of access to capital markets can aggravate the scarcity of credit. With better access to capital markets, SMEs might be able to improve their financial structures, for example through lower leverage, which in turn would make them more attractive to lenders. It also has to be recognised that, owing to higher risks, not all SMEs are bankable and may need to seek financing from other sources, notably asset-based finance or equity capital.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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For those SMEs that are bankable, banks need to evaluate each individual borrower. Thus, there is a need for credit information, credit reporting, and trade credit information. Sources for such information include court records and credit registries. Government can provide source data and an enabling environment to facilitate information flows. Some discussants noted that many banks do not serve the SME segment, partly because they do not understand lending to such entities. Since SME lending is relatively new in some banks, they often base their lending practices by drawing on experience in other activities, such as corporate banking, retail banking, or microfinance. In contrast, the “best-of-class” SME lenders draw simultaneously from all three approaches, supported by standardised risk evaluation procedures to permit operating at an efficient scale. In most OECD countries supplier credit is as important as banking credit in SME finance. It is even more important in emerging market economies and developing countries. It is very common for larger firms with access to formal credit markets to extend credit to smaller firms, especially suppliers or customers. Even though supplier credit is a very significant phenomenon, it often goes under recorded. Even when monitoring and alignment of incentives are difficult for a bank, they are sometimes relatively easy for a non-bank firm. The motivation of maintaining the trade credit and customer relationship with the company is a powerful tool to align the supplier of trade credit and the borrower. There have been some possibilities for the public sector to intervene in the trade credit sector. In Peru, COFIDE (Corporación Financiera de Desarollo) has developed a standardised product based on the production process; the repayment of loans is linked to production. If a producer does not deliver, it is replaced in the lending scheme by another producer and its assets are seized until the loan is repaid. The interest rate charged includes a multilateral guarantee fund. In recent years, the practice of trade credit extension, which has always been a key domestic underpinning of the SME sector, has become significant on an international scale. International supplier chains for discounting of receivables are emerging. The suppliers assume the risk of the buyer and make the payment. There is a growing importance of financing along the value chain, without the direct intervention of a financial intermediary. Other means of financing that seem to be working well include leasing and asset-based finance. Yet, in many countries have gaps in legislation and different fiscal treatment for leasing and loan finance that inhibit the growth of these alternative financing vehicles. The role of intellectual assets in creating value for the enterprise was stressed throughout the workshop. Business investment in knowledge in some countries is larger than investment in physical capital, and SMEs do play an important role in business R&D although the face high costs. However, many intellectual assets are intangibles that are not covered by intellectual property rights (IPRs) and might be more difficult to evaluate. As intellectual assets contribute importantly to propel growth, government can facilitate investment in intellectual assets and in transferability of value. While the meeting mostly focused on structural issues a number of speakers identified the high present level of interest rates in some emerging markets as a sizeable barrier to effective credit markets. In some emerging markets, interest rates are at such high levels that even efficient SMEs cannot afford to borrow. In that case, there is a serious risk of adverse credit selection in which only the worst borrowers will seek credit and banks will avoid lending except to very low risk borrowers, especially those with collateral.

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What role for government? The case for government intervention is strongest when the social returns to lending diverge from private returns to lenders. Most countries have government support programmes for SMEs. There are many types of programmes, including credit guarantees, subsidised fees, and factoring programmes. Some discussion took place of government programmes to guarantee loans to SMEs. It was emphasized that the absence of a guarantee is not always a problem. A guarantee reduces the price of credit but does not necessarily increase the availability. The keys for the extension of credit guarantees include reliable risk analysis, symmetry of information, different interest rates for different ratings, and adverse selection of banks (high default rate for SME loans). Where banks lack information about SMEs there are high risk premiums. Mechanisms exist to reduce the cost for bank of gathering information on SMEs, and therefore the risk premiums. In this context, the French Central Bank that has developed a database on SME credit based on voluntary participation. An innovative experience has been made in certain countries (for example, Korea and Tunisia) where banks have built up capability to evaluate projects on the basis of technical assessment of future cash flows rather than collateral. In some countries, there is a relative lack of skills for evaluating projects on the part of banks. Some participants argued that in some cases a specialised bank, with the government as a major shareholder, is an effective solution. Such a bank has better trained staff for evaluating projects. They assist SMEs with project ideas, investors in gaining knowledge and interest in financing projects; and use market-based interest rates to finance some 25-50% of projects it examines. Concessional credit lines may be granted through bilateral and multilateral support organisations. Ensuring that SMEs have adequate access to financing sometimes requires government intervention. However, such intervention needs to be carefully targeted to avoid distortions and to ensure that scarce public resources are targeted effectively. However, participants pointed out that the gaps may not be where they were initially thought to be. For instance, in some jurisdictions it was sometimes assumed that women or ethnic minorities did not have access to credit on reasonable terms, but subsequent research did not substantiate this assumption. The public sector can help to reduce the cost of financing by diminishing information asymmetries, by capacity building for SMEs and by building effective public-private partnerships. Importantly, public policy can play a role in helping to ensure that entrepreneurs have access to appropriate information on issues such as the range of financing options available, budgeting and accounting. The growth of a business depends in part on access to finance but also on training/support. Efforts need to assist SMEs in “managing” information. For example, entrepreneurs and SME staffs may benefit from technical assistance in the preparation of accounts. Government can engage in direct lending, but it is more common for public policy to intervene in the credit market through guarantee schemes. Experience suggests that these arrangements can be effective tools in helping to ensure an adequate flow of resources to disadvantaged SMEs. Guarantee schemes can encourage banks to be proactive in engaging and financing SMEs. For example, public policy can play a role in encouraging banks to build skill in lending to SMEs by placing decisions in the financial institution while observing the principle of risk sharing. Guarantee schemes must be targeted to those firms most in need of support, which otherwise lack alternative financing options; THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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and some attention must be paid to the balance between risk and reward to ensure that defaults remain in an acceptable range One frequently used method to engage in risk sharing is through participation in public private credit guarantee funds. The government often capitalises guarantee funds and manages them, but with heavy private sector involvement. Two main models are mutual guarantee schemes and guarantee funds. One innovative approach to risk sharing through guarantee programmes is found in FOGAPE in Chile. This institution guarantees private banks’ SME portfolios, charging a fee based on risk, with banks bidding for guarantees. FOGAPE started out taking 80% of each bank’s risk but that share has been brought down to 65%. Seventeen banks now bid for available resources. Participants agreed on some broad principles. In particular, governments should not distort the market mechanism. Programmes should not be targeted to all SMEs, but to subsets of this broad category, such as start-ups, very small firms, or key sectors. SMEs are complex and eccentric, and thus their financing needs are as well, and programmes must reflect this. For example, micro-credit has proven a valuable resource for developing micro-businesses in areas where start-up financing is not available from traditional banks, and business owners lack the resources to finance the start-up of a new enterprise. Finally, there is no general rule that addresses the problems of financing SMEs in all countries. The solutions depend on the nature of the market failure in each country and the purpose for which the funds are to be used.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Workshop B: Equity Financing for SMEs and the Role of Government

Is there an equity finance gap? Participants generally accepted the proposition that it was essential for SMEs to have the option of using the equity markets for financing. Even SMEs without exceptional growth prospects may raise funds by using the equity markets along with banks loans. A strong equity base makes lenders more willing to provide funds, since equity investors have placed funds at risk, thus affording greater protection to creditors. However, in many countries, there are limited prospects for SMEs to access equity capital, although the size and nature of this gap is neither stationary nor uniform. In addition to the divergences in experience among countries and regions in their ability to mobilise equity financing, sharp differences occur at various stages in the investment cycle. In a contradictory phase, there will be times when it is difficult to raise money even for good projects while during times of speculative excess it is possible to raise funds for projects that do not deserve to receive financing. Innovative SMEs (ISMEs) have a far greater need of equity capital in the appropriate form than other SMEs. In particular, ISMEs often have higher risk than is appropriate for bank finance. The high risk flows from basic characteristics of ISMEs, such as negative cash flow, paucity of collateral and untried business plans. Valuation of such firms is also much more difficult. Such firms thus require access to special kinds of equity markets suited to high risk/high return fast growing companies. Due to their pivotal role in generating well-paid employment and disseminating new technology, it is widely recognised that ISMEs are of strategic importance for economic prospects. Unfortunately, difficulties in raising equity capital for ISMEs are far more widespread that the general SME equity gap and indeed is present in nearly all countries. Thus, the task of building a framework that will enable ISMEs to access capital is challenging in virtually all countries. It was widely accepted that scarcity of investment capital can occur at any stage in the life cycle of the firm, but that problems are usually most severe in the earlier stages, such as pre-seed, seed and early stage venture capital. A lack of early stage investment was seen as especially serious because early stage investors often provide more than simply money. Investment in early stage investment was described as “intelligent capital.” Frequently, the investor (such as the business angel or venture capitalist) provides expertise and strategic guidance that assists in the development of the companies in surviving the challenges of early stage development and achieving dynamic growth. One important bottleneck in the supply of equity capital to SMEs is often a shortage of precisely such individuals with the capacity to participate in strategic decision making in an early stage company. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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The role of “co-entrepreneurs” as a possible response to the shortage of critical skills in early stage investment was discussed. Proponents of this concept argued that it is possible to identify individuals who have the skills necessary to identify promising early stage enterprises and to contribute skills in exchange for a share of the equity of the company. The industry and policy makers should consider recognising this activity as a professional specialty and develop special training and schemes and remuneration practices. Many participants observed that traditional venture capitalists are now tending to favour larger deals in later stages of the investment cycle. Thus, one of the clear priorities identified during these sessions is to identify public policies and best practices to support early stage venture capital and business angel investment. In fact, seed and other early stage investment constitute a very small share of the total of most venture capital firms, which are tending to focus on larger later stage deals. The informal equity (or business angels) sector has been critical in closing the gap. Significant differences were said to exist among various countries and regions. In general, the United States was believed to have the most vibrant equity market for ISME finance. The US market has a very deep business angel community, the largest venture capital in the world and the world’s foremost marketplace for new companies, NASDAQ. Even though the United States is often cited as an example of a vibrant venture capital industry, activity is unevenly distributed among regions. Several speakers alluded to the geographic concentration of successful ISMEs in regions of the US, such as Silicon Valley and the Boston area. In these “technology hotbeds”, key technological skills along with lawyers, accountants and consultants with relevant experience, as well as financing resources, are available in abundance. The economic and social environment is highly favourable to risk taking in high technology fields. The peculiar characteristics of Silicon Valley were explained at length. One speaker described the area as an enclave of entrepreneurship that drew talent from all over the world. Business failure is seen as a necessary part of the process of enterprise creation, experimentation and growth. Significant amounts of start-up and pre-seed capital are available. There is a cadre of experienced entrepreneurs who are willing to give their time to identify promising new companies and to engage in coaching. The practice of “bootstrapping” is common, whereby the founding team and their families and friends make the most of their personal resources. Banks and law firms will sometimes advance funds in exchange for options. Home mortgages and credit cards are used. Angel investors are growing rapidly and are increasingly specialised in certain sectors or among ethnic groups. Angel funds now receive money from pension funds. Investors enter the project with the knowledge that 2-3 rounds of capital injection will be necessary to launch the investment successfully. The ISME equity gap was seen as more acute in Europe than in the United States. However, there was some divergence of opinion as to the depth of problems in raising equity for ISMEs in Europe and of the causes of the relative backwardness of European early stage investment. Some speakers attributed the basic lack of an entrepreneurial culture in Europe and lack of incentives for business angels. Also, it was mentioned that European laws, regulations and social values have low tolerance for business failure. Some speakers argued that the only possible remedy for European backwardness is radical deregulation and tax reduction.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

26 – PART I: SYNTHESIS Two major factors underlying the gap between the United States and Europe were the low internal rates of return (IRRs) on early stage investment in Europe, which are well below those on the other side of the Atlantic, and the small size of European funds. In some European countries, very low rates of return are obtained on early stage investment, which induces investors to shun such projects. It is important to understand better why rates of return are not adequate and how this dilemma can be resolved. In fact, in the current upswing in the venture capital sectors there has been buoyant activity in European investment in later stage venture capital and in buy outs, where IRRs are high, but private equity investors still avoid early stage investment due to low returns. Moreover, many European funds do not reach critical size, and thus cannot provide finance on the scale required by fast-growing companies. At the same time, there are some positive developments in Europe. A record year occurred in 2005 in terms of funds raised and exits. Efforts to improve the legal and regulatory environment were continuing. Prospects for life sciences and alternative energy were seen as particularly good. Looking ahead, it was agreed that Europe needs a better environment for applied research with strong research-commerce links; it also needs to attract better research talent from around the world. In an Asian context, the group heard about the experience of the Republic of Korea, which has a dynamic ISME sector and has recently shifted its policy from one of direct government investment in ISMEs to one of indirect investment using a "fund of funds" structure. The equity finance gap was regarded as more significant in non-OECD countries than in OECD countries. For example, in Brazil where the venture capital industry has been functioning since the mid-1990s and where large strides have been made in the tech sector, there was a hiatus in early stage equity investment, especially in high-tech industries. Recent years have witnessed the emergence of high tech industry and venture capital in India and China. There has been some success in developing equity investment in innovative companies in China, but many of these investments are linked to large foreign direct investment projects aimed at entering the Chinese market. Additionally, many Chinese companies cannot find means to exit within China and must often exit through listings on overseas securities exchanges. In some African Countries (e.g. Congo and South Africa), the financing gap is prevalent in the entire SMEs sector, not only ISMEs. In this context, it was suggested that there was scope for the emerging markets to learn from the experience of more advanced countries. One benefit of the meeting was that participants were exposed to a diverse range of country experience. While discussion of venture capital often has taken the experience of the United States as a model, presentations showed other cases where equity finance for ISMEs had been launched successfully, such as Korea and the Nordic countries. The meeting also heard about cases of unsuccessful attempts to develop the private equity sector in advanced OECD countries. Lack of experience on the part of investors, entrepreneurs and managers, especially in the early stage, can be an obstacle inappropriate design of financing instruments. Skewed incentives and “crowding out” of private investment by an expansive public sector were also cited as examples where OECD countries are now trying to learn from their earlier mistakes.

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What role for government? There was a strong consensus that the Governments should above all make sure that the overall economic environment and a sound business climate are in place. On a basic level, society should recognise the legitimacy of entrepreneurship and profitability as useful values. In addition to according fair treatment to investors, transparency of the system in terms of accounting practices, laws and regulations as well as contract enforcement are especially important. The tax system should provide a fair incentive structure for entrepreneurs and investors. In this latter context, the delegates pointed to capital gains taxation as a particularly critical factor. A main focus of governmental action should be to improve the entrepreneurial culture and education, including the development of a culture of failure management, i.e. a sensible bankruptcy regime. Beyond the overall framework for entrepreneurship and the business environment, one crucial contribution governments can make is to help overcome market rigidities and information problems. Governments should encourage the accumulation of the necessary knowledge, information, and skills among market participants in order to enable the market for financing SMEs to function properly. Market deficiencies are often linked to lack of information and knowledge on the nature of and transactions in the market. Thus, collecting and disseminating information on the market are often a useful starting point. Support of clusters, business parks and incubators can be mentioned in this context. Likewise, governments may facilitate a thriving market by assuring the supply of education and training for entrepreneurs, managers, and investors. Conducting business with SMEs is often a networking activity. Therefore, governments may boost the industry simply by facilitating various networking activities for SMEs. In this context, award giving events may serve to signal a strong will of the governments to promote entrepreneurship. Flexibility is a key factor in designing an appropriate system of official support for SME equity finance. As the nature of the financing gap tends to change over time, the programmes/initiatives to correct it must be designed with a high degree of flexibility. The agents operating the financing vehicles must be able to redesign the instruments/products and redirect the resources on short notice. Depending upon cyclical condition, bottlenecks may arise at any point in the investment cycle. For instance, the absence of suitable exit opportunities can represent an obstacle to the development of the venture capital industry and governments should be prepared to address challenges of this kind. However, as a rule government support should be concentrated in earlier stages. Private equity and venture capital firms are usually quite adept at financing later stage venture capital and buy-outs. In this context it is especially important to support early business angels. It is especially important to be sure that financial incentives for business angels are correct. There is a role for direct government equity participation in SMEs. In the past, some government programmes were structured so as to invest directly in companies. Increasingly, however, the trend is to use the “fund of funds” structure in which governments invest indirectly though funds managed by private parties and invest only alongside private partners. The goal is to leverage public participation while leaving project selection in the hands of private investors, who are better able to assess risk/return balances. It is difficult to find the exactly correct balance of leveraging and incentives. In general, the extension of “soft money” (i.e., funds advanced without expectation of a competitive rate of return) was not recommended as it often leads to “soft” outcomes. Several speakers insisted on the importance of official programmes to provide equity THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

28 – PART I: SYNTHESIS finance that is self-sustaining in the long run. Government investments can spread risk more efficiently. The risk sharing formula in government investment programmes should aim at adequate returns that enable the official side to avoid dependence on funding from budgetary transfers, but should leave the private investors with most of the upside. International organisations can effectively contribute to the development of equity finance for SMEs. Thus, both the European Union and the Inter-American Development Bank discussed their policies of providing equity capital to SMEs. In both cases, investment is made in partnership with private funds. The public partners also aim to educate private investors as to international best practices. Institutions also see it as their role to identify the best investment managers. Despite the efforts of international organisations to broaden the horizons on investors, most public programmes have only had limited success in reaching early stage investors.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Technical Workshop on Private Equity Definitions & Measurements

Definitions of venture capital It was noted that no precise, internationally accepted definitions of venture capital or of various subcomponents of the venture capital market have been agreed. Representatives of official bodies generally argued that the development of harmonised definitions of venture capital and of various types and stages of equity capital would assist in several ways: 1. In identifying where policy interventions are required. 2. In assessing the effectiveness of policies. 3. In informing stakeholders and the general public. However, representatives of the private equity industry were more cautious, arguing that attempts to achieve harmonisation could result in a waste of resources and may create a misleading impression of precision where none exists. Moreover, it may not be possible to isolate venture capital from other forms of private equity across countries in a consistent manner.

Handbook or guidelines on venture capital valuation, disclosure and measurement Guidelines for valuation and reporting of private equity funds are critical for the development of venture capital and other private equity markets. Several industry associations, such as AFIC, BVCA, EVCA and PEIGG have put forward credible guidelines built on market “best practices” that reflect a broad consensus of private equity practitioners. Market participants are currently using these guidelines and are satisfied with these guidelines. Although no one set of guidelines is internationally accepted, participants stressed that it is important for private equity funds to adhere to one of the established sets of guidelines, and to disclose which guidelines are used. In fact, the choice of which guidelines to use is essentially determined by location. If a fund is offered by members of a particular association (e.g. BVCA – British Venture Capital Association) adherence to the association’s guidelines is often a requirement. It was suggested that the OECD can contribute to the development of this market by producing an international handbook on application of guidelines on venture capital valuation, measurement and disclosure. The handbook would be based on existing international practices. Training on application of guidelines should also be provided to facilitate knowledge transfer and ensure consistency.

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Measurement issues It was acknowledged that lack of data about critical parts of the equity market for entrepreneurship hampers understanding of the operation of the market, and thus is an obstacle to future development. Data are reasonably reliable about the relatively advanced sectors of the markets, such as private equity (including venture capital). However, measures of the less formal segments of the market, particularly the business angels segment, are very difficult to find. Data on the size of the markets are not available on a consistent basis and data on performance are even less advanced. Despite the difficulties involved, there was a consensus that efforts should be maintained to seek methods for measuring all aspects of the equity market so as to increase understanding of the market and buoy confidence of potential investors. It was not agreed which organisations should gather and process the data. It is possible that official institutions, academic bodies, private industry associations or private data vendors (or some combination of these) could undertake this task.

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Plenary Closing Session

There was a strong consensus that the meeting had offered a unique opportunity to develop understanding of the breadth of initiatives to encourage the finance of SMEs being undertaken in many countries and to benefit from the experience of other countries in identifying instruments, institutions and policies that work best. In this regard, the meeting was noteworthy because for the first time it brought together representatives of the SMEs themselves, of providers of finance to SMEs, and of governments to share experience. In summarising the overall conclusions of the meeting, the Chairman noted that there was near unanimous agreement that SMEs are essential for economic growth, job creation, innovation and social inclusion for countries at all levels of development. At the same time, lack of full access to finance from banks, capital markets or other sources represents a potential obstacle to SME development in most countries. To some degree, the lack of financing to SMEs is a reflection of the specific difficulties in financing such as asymmetric information, adverse credit selection and difficulties in monitoring. These problems affect SMEs more than other firms. The policy environment may either mitigate or aggravate the underlying challenge of SME finance. On the one hand, structural rigidities, dysfunctional financial systems, inflexible administration, excessive taxation, weak creditor protection regimes, bureaucracy and substandard reporting practices frequently worsen the incentives to finance SMEs. On the other hand, it has been proven that a sound policy framework for SME finance can significantly moderate many of the inherent problems in SME finance. Overall, it was concluded that the “financing gap” exists to some degree in most countries, but there was also a strong conviction that it is not insurmountable. Much can be done by governments, SME themselves and financial market participants. In more advanced countries, the problem tends to be localised. In particular, inability to access finance is often a serious problem for innovative SMEs (ISMEs), which are often found in high-tech sectors. OECD countries have had varying degrees of success in developing this sector and some agreement has developed about how the environment for equity finance to ISMEs can be improved. The meeting had revealed many instances in which public investment programmes had doing spurred activity in the early stages of business development. In other cases, participants learned of cases in which a framework had been established for co-operation between firms and universities, encouraged by public funding of research. Concerning equity finance, the meeting provided a platform for a lively exchange of views between government officials and the private sector representatives on the amount of SME risk that needs to be accepted by the public sector in order to “unlock” private sector financing. Although there was no agreed magic number, the discussion made clear that the public sector needs to accept some degree of risk, but that this risk must be shared with the private sector THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

32 – PART I: SYNTHESIS It was also observed that some emerging markets had made substantial strides in developing an indigenous venture capital market. Examples of business incubators and the establishment of a fund of funds have also had a significant impact in increasing SME access to finance. While the finance gap exists mainly in the equity market and for ISMEs in advanced countries, in developing and emerging markets the gap is more generalised, affecting virtually all types of SMEs. Hence, the policy response has to be more sweeping. Policy packages that that focused only on the financial system were likely to fall short of effecting systemic transformation. Reforms had to reach into the realm of financial infrastructure and to encompass reforms in accounting, the legal framework, regulatory reform and generally improved governance. First, participants concluded that governments should remove unduly barriers to entrepreneurship and innovation by cutting red tape, reducing transaction costs and improving contractual conditions. Since larger enterprises have devised ways to survive in poor institutional and regulatory settings, SMEs stand to gain the most from financial and institutional reform. Second, they agreed that government intervention is often necessary because of market failures, but that public policy design and implementation needs to be conducted in consultation with the private sector. SMEs should be engaged in the design of relevant policies from the outset to ensure that their perspectives and needs are well understood. For instance, participants were very interested to hear about the creation in Brazil of a permanent forum including government and enterprises for discussing the design and implementation of SME policies. Several types of government programmes were discussed and some very innovative solutions have been proposed to improve access to finance for SMEs. While the meeting heard of large scale success in OECD countries, many emerging markets were now enjoying the first fruits of their more recent reforms. Governments can act to alleviate information asymmetries and foster knowledge and information exchange via private sector bureaus and technology diffusion programmes. They can also improve financial education and improve knowledge of financing techniques. This will help make entrepreneurs more aware of financing options available, raise their credibility and elevate their bargaining strength vis-à-vis banks. Guarantee funds are used in many countries with success. The most successful ones leverage public funds in a market-based approach and help reduce risks associated with SME lending. In conclusion, it was said that the meeting had confirmed that the financing of SMEs, including ISMEs, should remain a high priority for officials, the SME sector, and the financial sector. The meeting had helped to establish broad outlines for future work by the OECD and other interested stakeholders. The main implications for future work are summarised in the Action Statement that was issued at the close of the meeting.

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Part II: Selected Papers

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Plenary Keynote Session: “The SME Financing Gap: Theory and Evidence”

The first plenary keynote session focussed on better understanding the SME Finance Gap, looking at the issue from both a debt and private equity capital perspective, and providing new insights into the nature of market failure in SME finance. In so doing, it will provided the framework and broad overview for both Workshops A and B through covering both credit and equity issues. This Plenary Keynote Session considered the following issues: •

Does your country/company/institution feel that an SME financing gap exists? For which financing sources (credit and equity) does such a gap exist?

•

What are the main reasons for this gap?

•

What are the main policy actions which are (or have been) undertaken in your country to address this gap?

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Access to Financial Services: A Key Element in a Comprehensive Development Agenda

Mr. Enrique García President and CEO, Corporación Andina de Fomento (CAF) Micro, small and medium-sized enterprises (MSME) constitute one of the most dynamic and important sectors in Latin American economies. Despite their relevance, most of the MSMEs find serious obstacles in accessing credit and other financial resources, which represent a crucial element to sustain their growth, increase their competitiveness and generate more jobs. As part of its Comprehensive Development Agenda, which calls for a more equitable economic growth, CAF supports a wide range of initiatives that promote the development of sustainable businesses that generate social benefits. After a strong recovery in 2004-06, Latin America's economic performance has improved markedly. Growth rates have reached the highest levels in decades. Regional exports and capital flows to the region have increased, inflation has fallen, and fiscal and financial conditions are under control in most countries. Following a long period of stagnation and instability, there are reasons to be optimistic. Nonetheless, one should be cautious in interpreting these results. In part, they have been bolstered by favourable international conditions, including the dynamic performance of China, the sustained growth of the US economy, stronger commodity prices and ample liquidity in financial markets. In reality, the region continues to suffer from internal and external vulnerabilities that constitute formidable obstacles to the implementation of a successful development agenda. Not only does poverty remain extremely widespread and social conditions inadequate, but the region’s economic importance has diminished in global markets in the last five decades. Several reasons explain this decline, including poor competitiveness, low domestic savings, weak institutions and substantial income inequality. To reverse this situation there is an urgent need to attain high and good quality growth that is inclusive, broad-based, and respectful of both cultural diversity and the environment. These are necessary requirements to narrow economic and social gaps and fight poverty in a sustainable manner. Furthermore, the reduction of poverty and inequality should not be viewed as a spillover process or a consequence of growth, but rather as a concomitant and simultaneous phenomenon.

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High and sustained quality growth

International Insertion

Estado Sector Privado

Public and Private Sector

Environmental Sustainability

Civil Society

Efficiency

Stability Stability

Equity International Community

Democracy Governance

Investment in all forms of capital

Productivity

Productive Transformation

In order to achieve high quality growth, it is necessary to invest in the efficient accumulation of capital in all its different forms: physical, financial, natural, social, and human. At the same time, productivity should be boosted mainly through innovation and technological upgrading. In sum, maintaining macroeconomic stability, improving microeconomic efficiency and promoting social equity are the fundamental components of a comprehensive development agenda.

Better financing as a tool for development Low domestic savings and investment rates have constrained Latin America’s growth possibilities. As in the development process of other regions has shown (e.g. Asian countries), high and stable savings and investment rates are necessary conditions for a rapid and sustained economic growth. Financial sector development is key to explaining the regions low savings and investment ratios. A functioning and broad-based financial system offers households and firms the possibility of diversifying its portfolios and increases the efficiency of capital allocation. A well developed financial system has a positive effect on growth and can help to reduce income and employment volatility. Despite several decades of financial sector development and reform, Latin American countries in general exhibit shallow financial systems and ratios of credit to GDP well below those of industrial countries. Also, other indicators of financial sector strength such as stock market capitalisation and bond markets development compare unfavourably with those of OECD countries and other emerging economies.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

38 – PART II: SELECTED PAPERS Financial sector depth is not only a problem for Latin American countries. Financing is perceived as one of the main obstacles to business growth as many studies and polls report. Access to financing is perceived as the second most important obstacle to business development (after crime), with small firms experiencing more difficulties with interest rates, collateral requirements and credit procedures. Access to capital and financial services is as important as access to health, housing or education. In the region only a small minority of the population has a bank account. In addition, if one reviews other indicators such as percentage of micro enterprises with micro credit, the scores are below international averages. A broader access to financial services and credit can help countries in achieving their objective of improving income distribution while expanding productive opportunities through the enhancement of the entrepreneurship capabilities of disadvantaged sectors of the population. It can also reduce the cost of capital faced by the less favoured and helps by providing a productive alternative for productive capacities and savings.

...with low percentage of families and microenterprises using the financial system Microenterprises share with Micro Finance Credit % Bolivia

Household share with bank account

27,83

Nicaragua

20,18

El Salvador

Spain

91,6

14,06

Honduras

12,01

Chile

Brazil

42,7

Colombia

41,2

6,86

Costa Rica

4,11

Ecuador

3,88

Colombia

3,37

Mexico

Paraguay Perú

25

3,06 Guatemala

17,8

Ecuador

16,1

2,7

México

0,65

Brazil

0,33

Argentina

0,26

Venezuela

0,07

Nicaragua

2,47

The role of multilateral institutions Multilateral institutions (MIs) have a variety of possible actions to help facilitate access to capital and financial services in the region.

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To improve the chances of success in this difficult task, MIs should strive to establish partnerships between different kinds of public and private institutions such as official development banks, specialised financial institutions, universities, NGOs, and other entities interested in the development of the micro and SME sectors. Each participant would provide a different kind of input: funding, know-how, technical assistance, etc. MIs can also help disseminate the best practices in public policy in the financing of disadvantaged segments within societies. This could help each country’s authorities design legislation and regulations to foster healthy institutions able to provide financial services to those with limited access to financial services There are still some unanswered questions in public policy matters, for example; should national development banks (NDBs) operate as second tier or first tier entities? How much credit risk should NDBs take? How can NDBs operate without political pressure? Should interest rates in the banking systems be fixed or should market forces set them? Is it advisable to establish differentiated loan loss provisions to promote credit to the SMEs? How to reduce costs and increase the operational efficiency of the loan guarantee systems? MIs have played an active and important role in supporting financial systems and developing capital markets. Nevertheless, there are key challenges for MIs to continue playing an important role to broaden capital access for traditionally excluded sectors such as SMEs, micro entrepreneurs and the rural sector. Issues such as domestic currency financing, financial security networks and institutional strengthening of NDBs and emerging financial institutions should be addressed. Also multilateral financial institutions can play a central role catalyzing public and private institutional efforts to improve capital access, increase competitiveness and promote social inclusion.

CAF support to SME and microfinance Micro, small and medium-sized enterprises (MSME) constitute one of the most dynamic and important sectors in Latin American economies. Despite their relevance, most of the MSMEs find serious obstacles in accessing credit and other financial resources, which represent a crucial element to sustain their growth, increase their competitiveness and generate more jobs. As part of its Comprehensive Development Agenda, which calls for a more equitable economic growth, CAF supports a wide range of initiatives that promote the development of sustainable businesses that generate social benefits. CAF finances these initiatives by means of operations that share some characteristics: •

They are tailor-made to suit the specific needs of a segment of the economy that has limitations in the access to financial resources. • They are made in alliance with local institutions that are close to the final beneficiaries. • They combine reasonable risk/return levels with positive social impact. There are three basic lines of action followed by CAF in order to attain this goal: i) Facilitate access to financial resources; ii) encourage internationalisation, and; iii) strengthen competitiveness, diversification and entrepreneurship.

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i) Improving access to financial resources CAF is constantly establishing relationships with local and regional institutions, to develop financing mechanisms that meet the specific needs of each sector:

Supporting microfinance institutions (MIs) A sustainable way to support micro entrepreneurs from urban and rural areas is strengthening institutions specialised in providing credit to this sector. CAF provides these institutions with a wide range of financial facilities, capital and quasi-capital investments, partial guaranties to support bond issues, and technical assistance for institutional improvement. CAF has paid special attention to the development of MIs and is one of the most important supporters of this sector in the region, with 35 clients in 11 countries. CAF also sponsors and organises seminars and conferences to strengthen the diffusion of better practices, new experiences, and innovative products for the sector.

Financing small and medium sized enterprises (SME) CAF financial support for SMEs is based on creating innovative structures and alliances that meet particular needs of this sector. Experiences include a recently signed credit re-insurance agreement (2005) for up to USD 10 million with the Fondo Nacional de Garantías (FNG), in Colombia, which increased its credit re-insurance capacity for SMEs. Through this mechanism, CAF is directly helping around 6 000 Colombian SMEs obtain loans from the commercial banking system. In the same year, CAF developed another novel instrument, a co-financing agreement with a commercial Peruvian bank, which allows the CAF to act as a first-tier bank. This agreement represents an innovative change from CAF’s traditional business model by outsourcing part of the credit analysis and loan administration through a private bank. Providing venture capital to SMEs is another important instrument used by CAF to boost SME growth and competitiveness and innovation. Investments have been made through different capital strengthening mechanisms such as risk capital funds. CAF currently has capital strengthening operations in Bolivia, Colombia, Ecuador, Uruguay, Trinidad & Tobago and Venezuela. Another way to improve access to capital is to foster the inclusion of SMEs in capital markets. In Bolivia, CAF invested in a fund whose purpose is to provide guarantees that partially back promissory notes issued by SMEs in the capital market. In Costa Rica and Bolivia, CAF approved its participation in Comprehensive Support Programs for SMEs, seeking to foster growth and innovation in these countries’ technological sectors, along with local private sector institutions. The objective is to promote and create mechanisms to satisfy the financial needs of SMEs in different stages of their development. CAF is working to replicate this experience in other countries, always considering their particular needs and conditions. CAF also supports the creation and dissemination of new financial products for SMEs. In Peru, CAF participates in an investment fund that discounts the SMEs’ accounts receivable, allowing them to change their credit sales for cash. In Costa Rica, a credit line has been issued to a non-bank financial institution that specialises in factoring.

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CAF also has historically provided credit and other financial facilities to NDBs and private commercial banks that in turn provide loans to SMEs.

Supporting the rural sector Helping the rural sector to increase its access to financing is of great interest to the CAF. To achieve this CAF establish alliances with institutions that operate in rural areas. Through these alliances with industrial companies, development banks and credit cooperatives, CAF are able to provide financing to micro and small farmers in an efficient manner.

Enhancing education and healthcare access and quality Private education and healthcare are important sectors with severe limitations in accessing traditional financial systems. CAF has assigned special attention to this issue and has defined a specific line of action to back private initiatives that seek to improve access and quality of education and healthcare services through loans to organisations that provide credit for economically disadvantaged pre and postgraduate students, and the support of health insurance products and prepaid medicine for the sectors of the population traditionally unable to access these basic services.

ii) Encouraging internationalisation Sustainable and efficient access to international markets is a key factor to attain the development of the SMEs. CAF supports programmes oriented to linking private, public and academic efforts to enhance SME capacities to access international markets. An especially representative experience of this line of action is the CAF/Wharton Program, which resulted from an alliance between the Wharton’s School of Business, the Universidad del Pacífico in Peru and the Universidad de Los Andes in Colombia. Under this programme, Wharton students assist and train SMEs from these countries to place their products in the US market, thus transferring knowledge to both SMEs and local Universities. Additionally, CAF supports the Exports Development Program (PADE) in Venezuela, in alliance with the National Industrial Union, which includes the training of young consultants specialised in international trade and assisting 30 SMEs in implementing their export plans.

iii) Strengthening competitiveness, diversification and entrepreneurship The Competitiveness Support Program (PAC) is an initiative developed by CAF to strengthen five main areas throughout the region: 1. Improvement of conditions for doing business through the reduction of administrative procedures. 2. Development of clusters and building of productive and commercial capacities. 3. Enhancement of diversification and entrepreneurial capacity. 4. Institutional strengthening and regulation improvement. 5. Promotion of innovation as a means for creating added value and jobs. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

42 – PART II: SELECTED PAPERS CAF’s activities in this area include, among others, a close relationship with business incubators, universities and technological institutes, government agencies involved in the promotion of business and competitiveness, regulatory institutions, the private sector, and NGOS. The programmes and activities described above are an example of how CAF is contributing to the design and implementation of a Comprehensive Development Agenda for the region, aimed at achieving sustainable and stable growth with social equity, while taking into account not only the physical and financial capital of this region, but also, and very importantly, its natural, human and social capital. With the partnership of public and private institutions, the international community and other actors, CAF has built interesting examples of how associations, new ideas and hard work can deliver a better future for our region.

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Polish Entrepreneurs: Access to Capital [ speech excerpt ]

Mr. Andrezj Kaczmarek Under Secretary of State, Ministry of Economy, Poland This speech presents the important role that SMEs play in Poland and outlines how the Polish Government works towards overcoming the “SME financing gap”. “Over the last fifteen years, fundamental changes occurred in the Polish economy. The transformation of the system that Poland commenced in the early 1990s meant a radical political breakthrough and fundamental changes in the economic and social systems. Inclusion in Western structures and economic institutions was considered to be the most effective way to catch up with development and technological gaps; and as one of the most important factors for durable economic growth. One of the basic aspects of the transformation was changes in the current laws and their adaptation to mechanisms applied under free market economy. As a result of appropriate legal changes, the remnants of central planning were eliminated and a package of macroeconomic solutions was introduced to stabilise the economy; together with protection of private property. Conditions for internal competition were created through policies of full freedom of business activity and establishment of new enterprises. As the result of these changes, a highly dynamic development of entrepreneurship by the Poles has occurred: the number of private companies increased over six-fold, from around 572 000 in 1989 to over 3.5 million in 2004. Currently, SMEs account for 99.8% of all businesses, generate nearly a half of the GDP and play a vital role in employment and job creation: around 70% of the working population are in the SME sector. The main problem faced by entrepreneurs in transition countries is access to capital. The financial market for SMEs is the service sector, which was virtually non-existent a dozen years or so ago. Despite the registered progress in gaining access to credits, Polish entrepreneurs finance their development-related projects mainly using their own resources and still find it difficult to obtain bank credits: just around a third of the companies use this form of financing. Micro-entrepreneurs are in the most difficult position; and only about 15% of such firms use bank credits. Nearly one in four of all micro-entrepreneurs applying for a credit fail to obtain it.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

44 – PART II: SELECTED PAPERS The barriers small firms face in accessing to bank loans in Poland result chiefly from the specificity of such enterprises (they often use lump-sum taxation forms like the simplified “tax chart” and lump-sum taxation on registered revenues) and procedural requirements that small companies are unable to meet: the necessity to document the company’s credit track record and to provide high-level legal security on loans, complex procedures, no acceptance of higher risk because of the scoring. Appreciating the problems faced by companies in this area, in particular securing capital by the smallest firms, the government has undertaken a number of initiatives in recent years. It is one of the priorities of the current economic policy. Since 2002, a governmental programme to develop a system of loan and guarantee funds for SMEs, known as “Capital for the Entrepreneurial”, has been implemented. Its main goal is to establish an effective network of financial institutions consisting of robust regional funds and local funds spread evenly throughout the country. Thanks to the implementation of the programme, supported with considerable public funding, the number of financial institutions is growing systematically, as is the volume of available capital and the scope of loans and guarantees granted by the funds. There are currently 76 loan funds in Poland. Since 1992, they have granted more than 100 000 loans and have contributed to the creation of around 38 000 new jobs. Also, there are 61 loan guarantee funds operating in Poland, which have granted over 8 000 guarantees since 1994. Thanks to the support being currently given, the capital of those funds, now amounting to around 170 million euros, will increase by over 180 million euros. As prescribed in the programme, money will be transferred to the funds by the end of June 2008 at the latest. Another serious problem faced by Polish enterprises is their limited access to capital for financing innovative projects. A major market gap has been identified concerning financing high-risk innovative enterprises at the early stages of their development. This problem is present in many countries. Although the availability of venture capital funds has been growing systematically in Poland in recent years, when compared with other European countries, this sector is still poorly developed. It was thus deemed necessary to stimulate the development of capital funds. In 2005, the Act on the National Capital Fund was passed, aimed at creating an instrument to support Polish SMEs with a high development potential. The National Capital Fund was established to support financially the capital funds investing in small, innovative projects, especially at early stages of development (seed capital). Around 34 million euro of public funding has been projected to support seed capital funds. Another very important action undertaken last year was passing a new regulation concerning support for innovation. That law has created a new financial instrument for entrepreneurs – the technology credit – for investment such as purchase, implementation and start-up of new technologies, as well as implementing a company’s own new technology. The condition is that such technologies should be applied worldwide for no longer than five years. One advantage of the credit is the possibility of remission of up to 50% of its value. The instrument should encourage entrepreneurs to innovate. The stimulation of investment in innovations is also the goal of the Act on Financial Support for Investment passed in 2002. The implementation of the assistance offered under this Act has also been co-financed by EU funds, thanks to which it has been THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

PART II: SELECTED PAPERS - 45

possible to significantly increase funding for investment support. However, the interest expressed by entrepreneurs in this support instrument is still much higher than the funding available. In the nearest future, the Polish Government intends to focus mainly on supporting Polish companies in undertaking innovative projects and facilitating access to capital for innovations. Conditions favourable to the development of innovative activities will be created, the development of venture capital funds will be supported, a system enabling private savings investments in SMEs will be established and the technological credit will be available for entrepreneurs. Actions will be taken to utilise, as fully and effectively as possible, public funds and financial instruments envisaged in a new EU competitiveness and innovation programme. Without an efficiently functioning financial market fostering the development of innovative businesses, the development-related goals of the Polish economy cannot be attained. As a member of the European Union, Poland has become one of the countries implementing the goals prescribed in the Lisbon Strategy – a multi-annual agenda for reforms and structural changes aimed at turning the EU into the leading economy of the world. I am convinced that the increase of the innovation potential of Polish companies through the implemented actions will contribute to the stimulation of the economic growth of the entire European Union.”

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The Financing Gap for SMES in Brazil

Mr. Roberto Luis Troster Chief Economist, Febraban (Brazilian Federation of Banks), Brazil 1 The financing gap has been a chronic barrier for SMEs in Brazil, with adverse welfare effects. From a banking industry perspective, there are four basic causes for the gap: a) scale effect – thus calling for special treatment; b) macroeconomic inconsistency; c) an inadequate institutional environment; and d) explicit and implicit taxation – the last three raising lending costs. This paper analyses each one and makes policy recommendations.

The financing gap for SMEs in Brazil Brazil has a stable, dynamic and sophisticated banking system, but it has not managed to supply an adequate amount of credit to SMEs. It is a deep-rooted problem that must be solved fully to realise its welfare and growth implications. Shortage of credit is a chronic problem. Since the foundation of the first bank in Brazil in 1808 until the middle 1960’s, the banking system was restricted to short term commercial credit as savings were scarce and because of institutional difficulties. Investment was financed by enterprises´ internal funds. The available public funds – mainly through development banks and agencies – were channelled to infrastructure woks. In 1964, a new banking law (Lei 4595) was passed and major institutional changes took places, trying to create a segmented financial system that could meet the country’s internal financing needs. Progress was observed: an incipient capital market started; new credit instruments were created; and financing increased, although at a high cost and mostly directed to larger enterprises. Presently, Brazil shows a low credit/GDP ratio (as seen in Figure 1) and the banking is underleveraged – it has a ratio of (equity)/(weighed assets) ratio of 22.33%, almost triple the minimum of 8% recommended by the Basel Committee, thus pointing to idle capacity. There is a strong correlation between the credit/GDP ratio and GDP per capita, the richer segment of the population shows proportionally more credit. A developed credit system channels funds throughout the economic system making it easier to grow. This is a fact for countries, enterprises and people. Richer countries have succeeded in fostering SME growth through specific taxation, regulation, programmes, etc.

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Credit/GDP

Figure 1: Credit/GDP ratio 1,80 1,60 1,40 1,20 1,00 0,80 0,60 0,40 0,20 0,00

Brazil

Source: World Bank Development Indicators (2005)

Access to credit promotes economic inclusion and equality, and more inclusion supports economic growth. There is a negative correlation between the credit/GDP ration and the Gini index, an income concentration index – the higher the score, the more concentrated income (See Figure 2). Thus, promoting and efficient banking intermediation is a synonym of promoting inclusion and growth. Figure 2: Credit/GDP and Gini Index

Gini Index

0.80 0.60 0.40 0.20 0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

Credit/GDP Source: World Bank Development Indicators (2005)

In Brazil, SMEs are responsible for 56.1% of employment in the formal sector, reinforcing their welfare importance. According to IADB (2005) “Libertar o crédito”, financing is the most important barrier to SME development; it ranks first before taxation, regulation, inflation, criminality, corruption, exchange rate and infrastructure. Table 1: Employed individuals, according to the firms size and sector of activity

Industry Commerce Services Total

Micro and small 3 600 809 5 982 849 4 918 720 14 502 378

% 47.0 80.8 45.6 56.1

Medium 1 614 144 314 917 696 183 2 625 244

% 21.0 4.3 6.5 10.1

Large 2 451 844 1 104 928 5 172 913 8 729 685

% 32.0 14.9 47.9 33.8

Total

Source: Sebrae (2002). THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

7 666 797 7 402 694 10 787 816 25 857 307

% 100 100 100 100

48 – PART II: SELECTED PAPERS Brazilian banking shows an asymmetric performance. On the one hand, its numbers of branches per habitant, information technology, charges for services, financial instruments sophistication and efficiency in operations are similar to any developed country. On the other hand, its credit supply is low and concentrated on larger enterprises. Financial systems operate from top down, big clients receive financing services first and those clients on the bottom of the financial pyramid receive credit last. This is on account that fixed costs that can be better diluted with bigger client. This explains the need for specific attention to the credit needs of smaller companies, for its diseconomies of scale. A survey by Sebrae (2004) shows that credit is available, but its cost is prohibitive. From a banking industry perspective, in a competitive environment, the expansion of credit depends on a wider supply at a lower cost. Other things equal – the lower the cost, the lower will be the price charged for credit and the supply more abundant. The existence of financing at a low cost depends upon the banking system operating in more appropriate conditions. Credit charges are the result of summing all costs plus the bank’s profits. Cost includes labour, infrastructure, rents, security, technology, the compensation of risks – operational, default and market, and the cost of funds. Schematically, it can be represented in a standard supply and demand curves. In an environment with no costs, credit supply can be represented by O, with an upward inclination and a demand for loans D. In the crossing point, demand is equal to supply and the rate is i and the amount of loans is F. Figure 3: Supply and demand of funds without costs

In the next figure, supply is shifted from O to O´ due to an increase in costs, and demand will be equal to supply where O crosses D. The new equilibrium rate will be higher i, investors will receive a lower rate ia, and the new amount of loans will be F´ lower than F.

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Figure 4: Supply and demand of funds with costs

The point is that, in a competitive environment, higher intermediation costs mean higher rates and less loanable funds. It is crucial to diminish the causes of high costs to lower lending rates and increase the credit supply for the country as whole. Credit charges in Brazil are high and reflect a structure of high costs. The consolidated numbers of the banking system for 2003 show total income of BRL 220.382 million and expenses of BRL 203.821 million. For each BRL 100.00 of income, only BRL 7.51 are profits and the remaining BRL 92.49 are costs – interests rates, labour, taxes, etc. High credit costs for SMEs are due to four main factors: a) scale; b) macroeconomic inconsistency; c) the institutional environment; and d) explicit and implicit taxation. In the next section, each one is analysed.

Scale Size matters in banking costs and charges; they are higher for smaller firms than for the larger ones. It is a worldwide effect (see Beck, T. et al, (2002) Financial and Legal Constraints to Firm Growth – Does Size Matter?, World Bank). Credit supply is regressive. Financial systems – like other sectors – have fixed costs (e.g. contracting, monitoring, collecting, compliance etc.) which need to be diluted. Financial institutions have economies of scale when assessing and monitoring borrowers; the smaller companies have higher costs for diversifying its generation of resources, thus reducing competition in suppliers. Large companies have direct access to capital markets and international financing, besides they can diversify their banking relations, while the smaller entrepreneurs are not able to do this due to their reduced scale. It explains the regressive feature of banking financing, where smaller firms pay higher interests. In Brazil, the problem of credit for SMEs is worsened by a historical bias favouring large enterprises. Since the arrival of the first Portuguese settlers five centuries ago, economic policy has a concentration predisposition. Currently, Brazil shows one of the THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

50 – PART II: SELECTED PAPERS highest income concentrations in the world. A comparison using the Gini coefficient confirms such statement. Table 2: Income distribution – international comparison Gini’s Coefficient Brazil Latin America and the Caribbean Chile Mexico Peru Upper-middle income nations Upper income nations – OECD

60.5 49.5 56.5 50.3 44.9 42.9 31.4

Income of the poorest quintile % 2.5 3.9 3.5 3.6 4.4 6.4 7.0

Source: World Bank (2004) “Brazil Access to Financial Services”

Enterprise concentration is even larger than income concentration. While the wealthier 10% of the population own 46.4% of the income, the largest 10% companies show 59.5% of the profits and 60.8% of sales revenue. While the poorest 50% of the population have 13.2% of the income, the 50% of smaller firms record only 5.5% of sales, and do not record a profit. Table 3: Individual and corporate concentration – Brazil (%) 50% smallest 13.2 -0.3 5.5

Personal income Corporative profits Corporate sales

40% intermediary 40.4 40.8 33.7

10% largest 46.4 59.5 60.8

Source: Conjuntura Econômica July 2004 – vol. 58 N° 07

There is also an adverse selection problem for SME financing, due to the level of informality in Brazil. It is estimated that 39.8% of economic activity in Brazil is informal. High compliance costs, taxation and the bureaucracy induce part of the business community to stay to the informal sector. Table 4: Economical features Income per Capita (USD) Brazil Chile Ecuador Germany China Hong Kong Japan Mexico Peru Portugal Switzerland USA Turkey

2 850 4 260 1 450 22 670 940 24 750 33 550 5 910 2 050 10 840 37 930 35 060 2 500

Informal economy (% of income) 39.8 19.8 34.4 16.3 13.1 16.6 11.3 30.1 59.9 22.6 8.8 8.8 32.1

Number of procedures for initiating a company 15 10 14 9 12 5 11 7 9 11 6 5 13

Time for initiating (days) 152 28 90 45 46 11 31 51 100 95 20 4 38

Duration of bankruptcy (years) 10.0 5.84 3.5 1.2 2.6 1.0 0.6 2.0 2.1 2.6 4.6 3.0 1.8

Source: the World Bank (2004) “Doing business in 2004”

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As small business entrepreneurs have proportionally more difficulties and costs than the larger ones experience to start and maintain a company, this leads to a greater informality. There are too many requirements and bureaucracy on SMEs without a convincing economic justification. As a consequence of informality, the existence of extra-official accounting generates a problem of adverse selection on account of the accuracy of credit information supplied to banks. It occurs every time there is uncertainty regarding the quality of information of a borrower. As the banking sector knows the average quality and distribution of information regarding the borrowers, they tend to attribute a higher credit risk if there is not a way to assess the risks of each company in depth. BNDES (Banco Nacional de Desenvolvimento Econômico e Social), Brazil’s national development bank, is intended to correct distortions and channel public funds to disfavoured sectors. So far, its credit allocation policy is biased towards large enterprises. In 2003, 90.23% of BNDES credit grants were directed to large industries. Table 5: BNDES credit grants to the transformation industry Brazil

BRL billions (2002)

Transformation industry Small-sized industries Medium-sized industries Large-sized industries

17 428.0 600.8 708.6 16 118.6

% (2002)

BRL billions (2003)

100.00 3.45 4.07 92.49

% (2003)

16 094.7 792.3 780.8 14 521.6

100 00 4 92 4 85 90 23

Source: SPCred/FIESP

There is a call for actions correcting the concentration predisposition. Even though there are some special programmes to SMEs, a wide-ranging programme to counterweigh the scale effect is needed.

Macroeconomic inconsistency Economic volatility has been present in Brazil since its foundation. Cycles of impressive growth have been followed by deep recession and are common throughout the history of the country, even though, after the late 1970’s, the upsides of the cycles have been more limited. The main reason for the poor performance was the government's incapability of controlling expenditures, thus shortening financial horizons and pushing up basic interest rates. Table 6: Financial aggregates BRL millions Date December 1994 December 1995 December 1996 December 1997 December 1998 December 1999 December 1900 December 2001 December 2002 December 2003 December 2004 December 2005

A – Total Credit 186 003 237 495 251 095 257 914 274 730 285 775 320 022 332 383 378 307 409 876 499 604 606 874

B – Net debt 153 163 208 460 269 193 308 426 385 870 516 579 563 163 660 867 881 108 913 145 956 996 1 002 485

A/B -Credit/Debt 1.214 1.139 0.933 0.836 0.712 0.553 0.568 0.503 0.429 0.449 0.552 0.605

Source: Central Bank of Brazil THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

52 – PART II: SELECTED PAPERS A result of fiscal irresponsibility is the crowding out effect with public debt displacing banking credit. In December 1994, total credit was one fifth higher than the public debt (21.4%). Eleven years later, in December 2005, it represented half the proportion (60.5%). Therefore, public debt crowded out private credit. Macroeconomic inconsistency raises interest rates high and shortens financial horizons. With high interests and short horizons productive investment is suffocated. Considering that interest charge to SMEs is higher than of larger enterprises, the effect of higher rates is worse for them. It points to the need of consistent and lasting improvements of macroeconomic policy, demanding political determination to reduce the basic interests safely and to broaden time horizons. Table 7: Basic interest rates % per year – selected countries Country Brazil Argentina Chile Mexico

Interest rate % per year 17.95 9.38 5.16 7.89

Country United States Euro Area Canada Britain

Interest rate % per year 4.48 2.51 3.42 4.53

Source: The Economist, January 21, 2006

A perverse effect of macroeconomic inconsistency is low growth and high volatility. Not only, the growth rate is below the world average, but its volatility is superior, where booms are followed by recessions. Thus, raising the perception of credit default. Table 8: GDP growth - 1986 to 2004 GDP growth Average Standard deviation

Country 2.38 2.74

Agriculture 3.04 4.75

Industry 1.80 4.59

Services 2.52 1.85

Source: Central Bank of Brazil

A consistent macroeconomic policy is required for a more stable business environment, lower basic rates and higher growth.

Legal-institutional component: The current legal-institutional environment of the banks is a patchwork, a result of actions through time, and not the result of careful planning to promote the efficiency of banking intermediation. Regulations that give borrowers a fair treatment, protect deposits, and promote the stability of banking are needed. The lack of adequate rules generate costs, which are dispersed throughout the entire economy, while proper rules promote intermediation and must be based on the principles of stability, efficiency and justice. Most legal costs are unitary costs, that is to say, the some of the expenses of executing a debt of BRL 1 or BRL 1 million are the same. Proportionally, when estimating the recovery cost of past due loans, smaller ones cost proportionally more than larger ones. A survey by the Minister of Justice of Brazil (2006) estimates the cost of recovery past due credit operations. In an extreme, in BRL 500 (approximately EUR 200) the cost THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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is equal to the total amount of the operation, whilst in operations with a higher ticket the cost is lower. Table 9: Recovery cost % – selected operations Process Out of court In court – up to 3 years In court – up to 5 years

BRL 500 43.2% 97.2% 100.0%

BRL 5 000 19.9% 60.4% 79.8%

BRL 50 000 17.0% 56.2% 75.9%

Source: Ministério da Justiça, 2006

SMEs are therefore more affected by legal cost. Improving the efficiency of the judicial system is a synonym for lowering the cost of credit to SMEs. In this sense, some distortions are highlighted: i) inefficiency of the justice enforcement; ii) lenience with informality; iii) undefined competitor competence of sub-national institutions; and iv) jurisprudence tendency of altering clauses of loans.

Inefficiency of the justice enforcement The judicial process in Brazil is expensive and slow. There are some distortions that make the justice enforcement unnecessarily costly and inefficient. Among them, it should be emphasised that the following are important: an obsolete administrative structure of courts; a lack of human and technical resources; the politicisation of court decisions; the existence of too many postponing alternatives; and the unnecessary complexity of the judicial code. In order to change that it would be necessary: to modernise the administrative management of courts; to allocate more human and technical resources; to link sentences (same case, same sentence); to restrict politicised decisions; to limit postponing resources and to simplify the judicial code (see Armando Castelar Pinheiro e Célia Cabral (1998) “O mercado de crédito no Brasil: o papel do judiciário e outras instituições” Rio de Janeiro: Estudos BNDES No 9). The inefficiency pushes banks’ legal costs upwards.

Lenience with informality Part of the business sector operates at semi-informality, distorting its economic data at banks inducing over borrowing. The legal consequences for false information are trivial, thus inducing to a loss of credibility. It is a fact that affects specially SMEs, increasing banking costs of collecting and verifying information.

Undefined competence of sub-national institutions. Sub-national institutions (state and municipal governments) impose operating restrictions (operating hours, branches layout, etc.) on banks, even though the Constitution states that the power of regulating the banking system belongs to the “Conselho Monetário Nacional” (National Monetary Council). Those regulations create special treatment for each municipality (over 5 000) in Brazil, instead of homogeneous behaviour for the whole country.

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Jurisprudence tendency of altering clauses of loans Some loans have its clauses altered by judicial decisions, generating a systemic risk. An example is the treatment given to leasing loans. Some loans and deposits are indexed (foreign rates, inflation etc.) and, there are cases, where courts obligated banks to alter loans in an arbitrary way, giving asymmetric treatment to assets and liabilities, mismatching them, imposing loses, and increasing market risk. The financial cost of legal-institutional framework may be visualised by analysing the structure of spreads. The better the contract, the lower the spread. Table 10: Average spread rate of selected operations – December 2005 Credit line Equipment financing Hot money

% per year 11.7 30.8

Individual entity Personal credit unsecured Payroll personal credit

% per year 64.2 19.8

Source: Central Bank of Brazil

The average spread (11.7) for equipment financing – where the equipment is collateral – is roughly a third of the cost (30.8) of an unsecured loan of hot money. A similar relation exists between the spread of personal credit clean (64.2) and the cost of a loan on the very same conditions, with the only difference that the payment of the operation is discounted at the payroll of the borrowers (19.8). The numbers are very conclusive pointing to the need of improvements in the legal institutional framework.

Explicit and implicit taxation Banking is taxed explicitly by taxes and contributions, and implicitly by imposing cross subsidies like high reserve requirements and obligatory loans below market rates. Explicit taxing of financial intermediation is high and distorting. To illustrate this, an hypothetical banking case is used with the following ideal conditions: a) one month long; b) the investor deposits BRL 100 000 and the bank will pay interest to cover taxes only (CPMF and IRF), so that the net return is null; c) assume that the bank has no costs; d) there are no profits; e) there is no default; and f) the basic rate of the economy is zero. The hypothesis of the loan are ideal, but, on account of FGC, reserve requirements, CPMF, income tax, PIS, Cofins and IOF, the cost for the borrower is an annual rate of 29.40%. It is an operation that does not create value, does not generate profits for the bank and nor returns for the investor. And the bank, on account of the reserve requirements is not allowed to borrow the totality of resources. The result demonstrates the fiscal cost in banking intermediation. Another example to illustrate fiscal costs in Brazil is a banking operation closer to reality: a) a one month operation; b) an investor deposits BRL 100 000 at the annual rate of 17.25% per year – Brazil’s basic rate in February 2006; c) the bank lends at a rate of 35.00% per year – exactly the double; and d) the bank has no operating costs and the default rate is zero.

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Table 11: Hypothetical banking operation I – net depositors rate = 0% Time deposit G - CPMF depositing CDB (time deposit) Net value of CDB

100 000.00 378.56 99 621.44

Gross interests of the investor (V)

950.02

G – Income Tax

190.00

Redemption value of CDB G - CPMF when withdrawing resources Investor redemption I – Net profit for the investor

100 381.45 381.45 100 000.00 0.00

Compulsory requirement (23% flat rate)

22 912.93

Balance for borrowing – Loan

76 708.51

G – IOF (0.0041% per day) Resources deposited at the borrower account G – CPMF Amount available to the borrower T – interests of loan (I) Payment of loan (+ CPMF of BRL 295.20) Fixed costs and default (VI) G/B – interests of compulsory (II) FGC – Deposit insurance (III) G – PIS Cofins (IV)

94.35 76 614.16 291.13 76 323.02 976.33 77 684.84 25.10 1.22

Bank Gross profit (I)+(II)-(III)-(IV)-(V)-(VI)

(0.00)

G - IR + Social Contribution 34%

(0.00)

Net Profit

(0.00)

In this case, the bank can only lend BRL 76 614.16 due to the reserve compulsories and taxation. The investor, after paying CPMF and Income Tax, will earn only BRL 302.78 as net profit. The bank, with no cost and no default, will have a return of BRL 544.64. The FGC keeps BRL 25.17. The government, besides the available resources which were compulsory borrowed, keeps BRL 1 727.57 due to the IOF, Income Tax, CPMF, PIS, Cofins and Social Contribution, deducting the reserve requirement payment. The borrower will pay the bill disbursing BRL 2 600 at an effective rate of 49.48% - apart from the tax charged by the bank which will also be an extra charge. This is a simulation where there are no operating cost and no risks (credit, market, liquidity, etc.) The bank charges double of what it pays and of each BRL the borrower pays 66.44 cents go to the government, 11.64 cents to the investor, 20.95 cents the bank and 0.97 cents to the FGC. The bank can only borrow part of its resources and still it has to pay its costs and risks. The numbers are impressive.

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56 – PART II: SELECTED PAPERS Table 12: Hypothetical banking operation II – return to investor = 17.25% Time deposit

100 000.00

G - CPMF when purchasing CDB

378.56

Investing value of CDB

99 621.44

Gross interests of the investor 17.25% a year (V)

1 329.93

G – Income Tax

265.99

Redemption value of CDB

100 685.38

G - CPMF when withdrawing resources

382.60

Investor redemption

100 302.78

I – net profit of the investor

302.78

Compulsory deposit of 23%

22 912.93

Balance for borrowing – Loan

76 708.51

G – IOF 0.0041% a day

94.35

Resources deposited at the borrower account

76 614.16

G – CPMF

291.13

Amount available to the borrower

76 323.02

T – annual interests of loan 35.50% per year. (I)

1 915.89

Payment of loan (+ CPMF of BRL 295.20)

78 624.40

Fixed costs and default (VI)

-

G/B – interests of reserve requirement (II)

305.88

FGC – Deposit insurance (III)

25.17

G – PIS Cofins (IV)

41.47

Bank gross profit (I)+(II)-(III)-(IV)-(V)-(VI)

825.21

G - IR + Social Contribution 34%

280.57

Net Profit

544.64

Figure 5: Interest rate distribution Investor 11,6%

Bank 21,0% FGC 1,0%

Government 66,4%

Besides the explicit taxation, banks are subject to implicit taxation like high reserve requirements, limits to legitimate tax deductions and obligatory loans at below market rate. Reserve requirements illustrate the role of implicit taxation.

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The use of reserve requirements as taxing is well described in economic literature. As the cost of reserve requirements is lower than the market rate, there is the difference seized by the Central Bank. It works as a camouflaged tax. Thus, increasing banking costs and diminishing the amount of funds supplied. Besides the cost effect, there is also a liquidity effect worsening the effect. The need to compensate the loss with the reserve requirements of the Central Bank and the reduction of the available resources raises the price of credit costs and represses its supply. International experience points to an elimination of reserve requirements as an instrument of monetary policy due to its harmful effects. The European Union has an effective rate lower than 2% and some countries like Switzerland, Australia and Canada have already abolished them. In an opposite direction, Brazil has the highest reserve requirements in the world. Currently, the rate for demand deposits is 80% - 45% in cash at the Central Bank of Brazil, 2% in investment in the micro-credit, 8% in bonds and 25% in rural credit. There are also the reserve requirements on time deposits, saving accounts, collections, payment operations and other. Presently, reserve requirements represent 174.78% of demand deposits (see Table 12). Besides, directed credit (lending for specific purposes at controlled rates) represent roughly one third of total credit. Table 13. Financial aggregates selected in December 2005

Public cash holdings Demand deposits Reserve requirements Free credit Directed credit Total credit

BRL million 57 046 85 396 149 263 404 775 202 099 606 874

Source: Central Bank of Brazil

Conclusive comments and recommendations Brazil presents inadequate numbers as to income distribution and growth, which can and should be improved. Easing access to credit to SMEs facilitates economic insertion, promotes the formality and growth of these enterprises. Public policies for SMEs financing in Brazil are ambivalent. There are some subsidised operations, but most SMEs credit is expensive due to a high basic rate, taxation, crossed subsidies and the institutional setting. The current policy shows advances and set backs. On one hand, it increased taxation (PIS-Cofins), it raised reserve requirements and directed credits. On the other hand, it improved macroeconomic indicators and some advances in the institutional setup were made. To overcome the SME financing gap, it is necessary to focus policies, improve in macroeconomic dynamics, rationalise taxation, reduce cross subsidies and improve the institutional settings. Solid and lasting improvements should be made to the macroeconomic indicators; an solid and dynamic economic policy requires political persistence. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

58 – PART II: SELECTED PAPERS Taxation should be rationalised. There a series of distortions in banking operations due to taxation. The corrections should follow the principles of taxation – equity, symmetry (losses and gains must be treated the same way), neutrality (not distorting the resources distribution), simplicity, stability of regulation, certainty, convenience of payments, elimination of cascade taxes, and the ending of implicit taxes. Taxation on financial intermediation operations to SMEs should be exempted to compensate the scale effect. There is a need to improve the efficiency of law enforcement. To do so it is necessary to invest resources in technology, hire personnel, modernise the administration of courts, allocate more matter resources, link sentences, control the politicisation of decisions, limit postponing resources, reduce the complaisance with false information, and define the regulatory competence of the sub-national institutions. Banking is an intermediary sector and not a final one. Banks take deposits and lend, the more efficient they are (similarly to any other intermediary sector) the more resources will be intermediated at a lower interest rate. International statistics are conclusive: nations with higher income per capita have a higher credit/GDP relation and the causality relation goes from the credit to the GDP. There is a need to improve the efficiency of financial intermediation in order to increase the credit/GDP relation. The issue of the financing gap for SMEs from a banking perspective is clear: to overcome the scale effect, a special treatment of SMEs is needed as well as having a consistent macroeconomic policy, an efficient taxation and a legal-institutional framework that foster banking efficiency, and finally, stability to protect borrowers’ rights. These are necessary conditions for a better Brazil.

Notes 1 The views expressed here are the sole responsibility of Roberto Luis Troster, and do not necessarily represent those of Febraban.

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The SME Financing Gap: Theory and Evidence [ speech excerpt ]

Mr. Joan Trullén Thomás Secretary-General for Industry. Ministry of Industry, Tourism and Trade (MITYC), Spain This speech presents the Spanish Government’s view on the “SME financing gap” and how it addresses the obstacles faced by Spanish SMEs when trying to obtain funding. “As a government representative at this gathering, I want to immediately address the two issues under debate in this plenary session.

The theory The magnificent document prepared by the OECD Secretariat provides us with a succinct, ordered relation of the theoretical elements which are generally taken to characterise the existence of a financing gap affecting small and medium-sized enterprises or SMEs. On the question of whether this financing gap exists in fact, I have two answers to give. The first is that, yes, it is real, and the second, that it will always be with us, though under different guises depending on the economic reality of the day. In cases where the gap owes to a shortage of liquidity in the financial system, it is evident that the correspondingly high interest rates will exceed the expected rates of return on equity investments resulting in a financing deficit. Likewise, under certain circumstances, the risk premium embedded in commercial lending rates and expected returns on capital transactions will provoke financing gaps in companies that are unable to negotiate with or inspire the trust of their lenders or financing partners. But it is also true that, even in cases where an economy finds itself in a liquidity trap, there will always be business projects with such low returns that they can find no backers at market rates or through capital contributions. It is accordingly received wisdom in exchange economies that artificial liquidity increased by national monetary authorities has no sustained effect, unless directed at highly concrete and localised objectives, and preceded by an impact evaluation and the taking of precautionary measures to limit their

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60 – PART II: SELECTED PAPERS adverse effects, whether in the form of macroeconomic imbalances or crises of confidence in the credit system. As I see it, then, the first reaction to the SME financing gap should be to see how the damage can be limited, so it exacts the lowest possible cost in terms of growth and employment.

The evidence I am sure we will hear different opinions voiced in this Conference about how each of our economies is addressing the core topic. In this respect, it may be worth stressing that the OECD has reiterated its call to governments to concentrate their policy efforts on risk capital provision, the combating of market failures for small-scale investments, better management by financial intermediaries and regulations favouring the mobility of capital. At the same time, the European Commission – in the frame of the Lisbon Process – has put the emphasis on better functioning risk capital markets, the concentration of funding at the early stages of business development, the priority financing of more technology-intensive business ventures and, in general, measures to stimulate higher investment. To this end, the future ‘Framework Programme (2007-2013) for Competitiveness and Innovation’ will give budgetary priority to securing greater financial support for the seed and start-up phases of business development, and preventing the loss of the national entrepreneurial fabric due to intergenerational transfer. Public aids will also prize more technology-intensive business ventures or those with a marked innovation profile. I started my speech with a reference to differing economic realities, which is what ultimately underpins the entrepreneurial heterogeneity we see today, even in such integrated spaces as the European Monetary Union. This diversity means the public authorities must develop concrete solutions for concrete ends, acknowledging the limited efficacy of general policy guidelines. This reason alone justifies the new action vehicles designed for the incoming ‘Competitiveness and Innovation Programme (2007-2013)’, including the Mechanism for Innovative, Fast-Growth SMEs of the European Investment Fund (EIF), the Guarantee Mechanism and the Skills Development System. Turning to the Spanish experience, the ‘Enterprise Promotion Plan’ approved by the government last January addresses our economy’s endemic entrepreneurship deficit, as evidenced by the bare 3% of the corporate sector engaging in export business or the fact that the technological intensity of our companies is roughly half that of the European Union’s average. By these means, we hope to prolong the excellent performance that has recently characterised the Spanish economy well into the medium-term future. In order to favour the structural transition from an economy organised around traditional sectors to a more competitive one participating fully in the information and knowledge society, each of the five strategic axes making up the ‘Enterprise Promotion Plan’ is accompanied by specific financial instruments. These instruments can then be adapted by central or regional government agencies to the particularities of each local enterprise fabric. The promotion of an entrepreneurial culture is accompanied by micro loan schemes run by the Official Credit Institute, in partnership with banks, savings banks and credit cooperatives, acting as financial intermediaries. A similar initiative is the Entrepreneur THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Financing Facility to help fund the incorporation and start-up expenses of new SMEs, especially those created by women and young people. The second axis corresponds to the promotion of new enterprise creation and growth. The accompanying financial vehicle is the ICO-PYME credit line of the Official Credit Institute, providing finance for SME investment in productive assets and their modernisation through the purchase of high-technology capital goods. Meantime, small businesses in need of higher-risk loans than those qualifying for this ICO line will be helped by the greater counter-guarantee resources available to Mutual Guarantee Societies, thanks to an increase in the funds of the state-owned Spain’s counter-guarantee society (CERSA). The enhancement of innovation and knowledge transfer capacity that is the third plank of the ‘Enterprise Promotion Plan’ is being made operational through support schemes for research centre spin-offs, organisational and quality innovation, ICT incorporation, research clusters, and SME research agreements with technology and innovation centres and technology transfer offices. The result will be to enlarge the range of advanced services available to small businesses. Activities under this third axis draw financial support from the subsidies granted to intermediary bodies, subject to EU state aid legislation, as well as soft loan schemes, mezzanine financing from the state-owned Society for Innovation (ENISA) and, above all, the equity provided by business angels networks or risk capital funds operating in business segments selected for the technology intensity of their projects. Of particular relevance here is the NEOTEC Programme, sponsored by the Centre for Industrial Technology Development, whose purpose is to provide support for the creation and early development stages of technology-based enterprises, while funding risk capital lines to consolidate business projects in industrial restructuring areas. The fourth axis of the ‘Enterprise Promotion Plan’ is business internationalisation. This basically means encouraging Spanish SMEs to move into foreign markets through a mix of financial instruments and incentives comprised of: capital transactions with local partners, organised through development financing company COFIDES, soft loans from the Official Credit Institute and export insurance from the Spain’s export credit insurance company (CESCE). Spain’s Development Financing Company (COFIDES) administers the risk capital funds FIEX and FONPYME to channel equity funding to Spanish companies mounting joint ventures abroad with local partners. The second of these funds, FONPYME, was especially designed with the needs of smaller businesses in mind. It bears mention, I think, that between 1990 and 2005, COFIDES promoted a total of 35 new companies in Brazil, accounting for 16.9% of the company’s South American investment. Along these same lines, the ‘Enterprise Promotion Plan’ seeks to get more Spanish companies involved in international tender processes and to promote human resource training for exporting SMEs. This labour falls to the PIPE Programme, which provides expert consultancy services to steer firms through their first international experiences. Finally, the fifth axis of the ‘Enterprise Promotion Plan’ sets out to ensure that measures reach their target audience, by means of an ambitious administrative simplification plan to facilitate companies’ dealings with the public authorities. Streamlining and simplification measures extend to aid applications, their electronic

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62 – PART II: SELECTED PAPERS processing, and the delivery of timely, up-to-date information to the enterprise constituency.

Messages In exchange economies, the main challenge for SME financial structures is to bridge the financing gap that opens up when the demand for capital outstrips the supply. This, in appearance, would warrant subsidiary action by the government authorities to attenuate the negative impact on growth and employment of a supply side which is either underfinanced or unable to raise finance at a competitive cost. One clear course for policy makers from this perspective is to create regulatory frameworks that serve to strengthen their countries’ financial systems and the efficiency of their resource allocation. SME financing difficulties, at a global level, can respond to a shortage of financing resources in the system, however only temporarily, or to obstacles in the way of tapping such resources, even at times of plentiful liquidity. But these two difficulties will never arise in the same form or in the same proportion. What we must do then is develop dynamic financial instruments that can be stylised to the requirements of the local business fabric at any given moment in time. In closing, I would like to reiterate, on behalf of the Spanish government, our allegiance to risk capital formulas as a means to finance projects that can raise the technological and innovation profile of the Spanish business sector and build its international reach and competitiveness.”

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Get to Know Your SMEs

Mr. Stuart Wilson1 Executive Director, Breathe Group, New Zealand. This paper conveys the point of view of a successful SME when it looks at how its government treats SMEs and how unwilling government officials are to change. There are three things policymakers could start doing tomorrow that would ensure they create the right environment for SMEs to grow.

SMEs are not big businesses waiting to grow up Firstly, policymakers should stop thinking about, and treating, SMEs like adolescent children. From an SMEs’ perspective, policymakers (and financiers): •

Usually welcome SMEs’ enthusiasm for their business idea but do not wholeheartedly endorse it (because they assume it will just be a passing infatuation).

•

Make a virtue out of not understanding SMEs business ideas (so they can disclaim any responsibility for future failure or misdemeanour).

•

Might give SMEs some of the money they ask for (but assume that, as they are unlikely to stick to their task, it would be spoiling them to give them all the funds they need).

•

If they agree to help SMEs, they impose on SMEs the same risk management and reporting regimes that they would use for the management of huge investments in more mature firms ( because they want to avoid criticism if the SME fails).

SMEs are telling you that it is high time you changed your approach. SMEs are not big business waiting to grow up! They are fully-functioning enterprises in their own right. They are committed financially and personally to making a success of their businesses. They ask that your response to their requests for assistance demonstrate that you really believe that SMEs are major contributors to job creation and innovation within economies and that they deliver a sizable and growing portion of GDP and export income.

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Walk in the shoes of an SME Secondly, policymakers should walk more often in the shoes of SMEs – to see the world as they see it. To take a few examples: An average SME looking out on a conference such as the OECD Brasilia Conference and would calculate that the majority of attendees have spent as much on attending this conference as an SME might have available each year for marketing their goods and services. Their marketing funds are, more often than not, only available because they have borrowed the money, and used their personal assets as collateral. So, who amongst the attendees at this conference has had to mortgage their house to get the funds to be here? Imagine that you had done so, and so had to demonstrate to business partners that you had achieved at least a 100% return on the investment you made to be here. How would that alter your attitude to the content of the Action Statement that will emerge from this event or to the need for immediate and practical action on the issues of finance for SMEs? If you thought like an SME and shared their sense of urgency, then the outcomes of these two days may be remarkably different. To take a second example, an average SME looks at the assistance its government offers to help firms grow and observes that the schemes (and their associated rules) have too often been designed for government agents’ convenience and to shelter them from later criticism. Therefore: •

They offer to pay for consultants to give SMEs textbook-based marketing advice when SMEs want operating funds to set up distribution channels in new markets.

•

They demand information in application forms that they do not ultimately use in deciding whether to assist SMEs, without regard to the costs to the SMEs of gathering the data.

•

They take months, rather than hours or days to make decisions on firms’ requests for assistance (are they secretly hoping SMEs will give up and go away?).

•

They assume that, like government agencies, SMEs have uninhibited access to support and equipment, like computer technologies and photocopiers, when they insist firms submit applications online or request 20 copies of proposals.

In short, the perspectives of policymakers and SMEs are often worlds, if not light years, apart. The entrepreneur may have staked everything he or she has to help his or her business succeed. This includes his or her good name, his or her friendships (as friends and family are the major source of funds for new firms) and the home he or she shares with partners and children. Entrepreneurs are not going to take unnecessary risks – they have too much to lose. And compared to the risks they are taking, government’s level of risk is minuscule.

Quality of regulations Thirdly, you must consider what other things governments might do (apart from improving access to finance) to alleviate, what feels to SMEs to be, a constant outflow of funds from their firms to meet government-controlled business costs. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Are you brave enough to ask the following questions? •

Do you need to impose such complex requirements on SMEs that they must pay professional advisors to assist them to comply?

•

Do SMEs have to pay more than is necessary to protect their intellectual property because officials are too lax in administering laws or because disputes procedures are too expensive?

•

Do your labour laws and other social legislation stifle the growth of SMEs?

•

Why should not preference be given to domestic SMEs, over multinationals, for lucrative IT contracts?

•

Why do you prefer to give little bits of assistance to many firms rather than giving a lot of money to a few firms who you know will be winners?

•

Why, in too many economies, are SMEs required to pay bribes to get the government services they require?

Your SMEs believe governments are too often afraid to address those critical issues. And for as long as that continues SMEs will have to keep diverting their scarce financial resources into complying with government regulations and away from the activities they know will grow their firms faster.

Conclusions This paper has attempted to convey some of the frustration and bewilderment successful SMEs feel when they look at how their government treats them and how unwilling government officials are to change. You have to “get real” – to truly understand the world in which SMEs operate, and to tailor government support to their realities. If you truly want to help to grow new and innovative firms then you have to accept (like they do) that there will be failures. For nothing new, nothing innovative has even happened by holding fast to the status quo.

Notes 1 Stuart Wilson is a member of the New Zealand government’s Small Business Advisory Group. The Breathe Group is a private company consisting of three specialist firms.

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Workshop A: Credit Financing for SMEs: Constraints and Innovative Solutions

There were two sessions for Workshop A which reviewed the following themes: First Session: The Nature of the Market Failure in Relation to Debt Financing Regulatory and Institutional Framework •

Do the accounting framework and other mechanisms satisfy information needs?

•

Does law or jurisprudence ensure appropriate conditions for creditor income?

•

How do financial institutions ensure secure contractual arrangements between creditors and borrowers?

Risk Evaluation, Mitigation and Sharing •

What is the perceived impact of international banking regulations (Basel II) on the assessment of risk represented by SMEs?

•

How can risk be managed when debt cannot be securitised through the financial market?

•

What practices have financial institutions developed to fund: Creation? Exports? High-growth SMEs?

•

What are some alternative means in which borrowers can manage their relationship with financial institutions?

•

What is the role of government and rating agencies in the management and sharing of information between partners?

Innovation?

Second Session: What Role for Government? •

What are the most effective and efficient SME financing schemes and incentives, taking into account policy targets/priorities, the various types of SMEs they serve and the overall budget constraints and financial markets?

•

What are the best ways to encourage the active involvement of informed intermediaries, without which investors perceive high risks and low returns from investment and entrepreneurs find themselves unable to raise capital?

•

Session speakers were invited to share good and bad practices based on their country/institutional experiences.

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1

Banque de France Rating

Mr. Daniel Gabrielli Deputy Head of Monetary Research and Statistics, Banque de France, France The Banque de France assigns a full-scale rating to about 220 000 non-financial companies on a yearly basis, among which SMEs constitute the largest group. The Banque de France rating reflects the Banque de France’s overall assessment of companies’ ability to meet their financial commitments on a three-year horizon. Since 1982, the Banque de France has undertaken to award ratings to companies in order to ensure smooth implementation of monetary policy and effective banking supervision. Today, the Banque de France rating constitutes a unique combination of data, experience and methodological skills. Given that the rating process is based on a co-operative approach with companies, the Banque de France also aims to provide companies with a highly accessible and transparent means of assessing their own credit risk profile, and thus, build a sound relationship with their creditors.

Objectives Monetary policy Within the monetary policy framework of the Eurosystem,2 operations between credit institutions and the national central banks of the Eurosystem have to be guaranteed with assets that meet various technical and minimum risk requirements in order to ensure smooth implementation of central bank operations. These assets (also known as “collateral”) are included in a list that is drawn up and published on the basis of the decisions of the Governing Council of the European Central Bank (ECB). Bank loans are included in the list of eligible assets, provided that they are granted to companies that are financially sound. The ECB’s Governing Council confirmed at a meeting on 3 February 2005 that the eligibility of bank loans could be assessed on the basis of ratings delivered by central banks’ “in-house” credit assessment systems, provided that these meet high standards of performance criteria. The Banque de France’s in-house credit assessment system complies with the requirements laid down by the Eurosystem.

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Banking supervision and financial stability The Banque de France rating is used to assess on an ongoing basis the overall quality of credit extended to enterprises. The Commission bancaire (France’s banking supervision authority) is allowed under banking secrecy rules to use this information to monitor the quality of banks’ portfolios. Furthermore, Banque de France ratings may be used by credit institutions to assess the creditworthiness of companies to which they offer (or are likely to offer) credit. The Banque de France also uses this data for analysis and research on financial stability issues.

Risk management of credit institutions Ratings are covered by professional secrecy rules. They are used by credit institutions governed by the French Banking Act: in the normal course of their business. These institutions may neither publish them nor pass them on to ratings agencies. FIBEN database is used by: •

650 clients, i.e. the totality of main banks, and nearly all the credit institutions located in France;

•

50 000 daily bank requests, >50% for ratings.

The credit risk information market is quite developed in France. But although there are no statistics on the particular segment of banking information, the market share of the Banque de France on this particular segment is significant.

Understanding of credit risk and financial constraint issues by companies During the updating process, company managers collaborate with the Banque de France analysts. The rating helps managers to improve their awareness and understanding of credit risk and financial constraint issues. Managers may take advantage of the Banque de France rating process to anticipate financial risks and monitor more closely their relationship with investors and credit institutions. Ratings are communicated individually and confidentially to the legal representatives of the companies concerned, by mail on a systematic basis. This is usually combined with an interview which constitutes a special opportunity for dialogue between companies and the Banque de France. The Banque de France conducts about 40 000 interviews a year, which also make it possible to gather qualitative information about sectorial and local economic developments, changes in financing behaviour or in the relationship with the financial partners, providing the Governing Council of the European Central Bank with real-time data on the real economy.

Field covered and data used Banque de France rates resident companies of all sectors except financial sectors (banking, insurance).

Companies rated Companies are awarded a full-scale rating if they are deemed to be economically significant – i.e. those with a turnover exceeding EUR 0.75 million, and equity capital of THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

70 – PART II: SELECTED PAPERS over EUR 30 000 for an SARL (private limited company) or over EUR 74 000 for an SA (public limited company), as well as those with bank loans reported to the Banque de France’s Central Credit Register amounting to EUR 0.38 million or over. About 220 000 companies receive a full-scale rating. Small companies are rated using a simplified rating scale when the Bank possesses relevant non-balance sheet information concerning them (bank loans, known partners or directors, legal and payment incidents, etc.). Both scales are consistent with one another, the notches of the full-scale rating being subdivisions of the notches of the simplified rating scale (see section 5). In total, about 3 million entities are registered in the database, including about 2.6 millions companies and about 0.4 million associations or other legal forms.

Coverage Data collected in the database covers different categories of firms: •

The first category is made up of 3 million economic entities, small firms for which a wide range of financial and qualitative information is available, except for legal financial accounts. The allocated rating is neutral (which means that there is no negative information) or expresses reserves about the company (meaning at least one information item is negative: e.g. unpaid commercial bills of exchange, judicial information, etc.). Any negative information is analysed before setting the rating: the banker is called on the phone and even the firm when the payment capacity is considered questionable. Eventually, personalized written communication may also be transmitted to the manager.

•

The second category consists of 210 000 companies and holdings (turnover >EUR 0.75 m, credits >EUR 0.38m), submitted to a comprehensive financial analysis. A specific rating process is followed. A personalized relationship is built with the company: phone calls with the financial department or the management, and, if needed, financial meetings. Each year, around 40 000 formal meetings of this kind are organised. At the end of the process, personalised written information is sent to the manager.

This means a high rate of coverage: •

80% companies of 20 to 500 employees

•

98% companies > 500 employees

Further explanations will treat only these 210 000 firms rated on the basis of financial accounts.

Range of data collected and analysed The range of data collected and analysed by the Banque de France’ analysts has been specified so as to cover the key aspects of credit risk analysis: •

Descriptive data: company name, address of registered office, legal form, etc.

•

Accounting and financial data from the company’s accounting records.

•

Data relating to trade bill payment incidents and bank liabilities reported by credit institutions.3 THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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•

Legal information: judgements handed down by commercial or civil courts ruling on commercial cases.

•

Information relating to companies’ micro-environment (managers, partners and affiliated companies) and their macro-environment (sectorial performance, etc.).

•

Data on the environment of players or activities with which the company maintains close economic ties (associated activities) or close commercial relations (clients, suppliers, etc.). This data is updated on a continuous basis, within the extensive FIBEN information system.4

When an update raises a concern from a credit risk point of view, the pool of analysts in charge conducts a review of the rating. In any case the review of ratings is made at least on an annual basis. In total, about 18 000 updates of ratings or closely related data are entered every day, which can be accessed in real time via the FIBEN online banking services.

Criteria for gathering accounting records Accounting records are gathered by the Banque de France if a company has: •

Its registered office in France

•

A turnover of at least EUR 0.75 million,

•

Bank loans of at least EUR 0.38 million.

About 200 000 companies are registered on the basis of these criteria.

Method Making use of the data Ratings are not awarded using an automated process. They are assigned by analysts in the Companies Divisions of the Banque de France branches. Data needed for their assessment is gathered, processed and analysed according to guidelines and procedures that are defined and monitored by the Companies Directorate at the Bank’s headquarters. Analysts update ratings whenever relevant new information is reported to the Banque de France. As a rule, the Banque de France collects and analyses the data on a co-operative basis with companies and banks. Companies are not legally bound to provide data to Banque de France. However, the Bank has been able to build a relationship with companies and credit institutions based on confidence and transparency, enabling the sharing information related to credit risk and increasing the awareness of company managers of the risks associated with financial imbalances.

Means of registering, periodicity All registered data has a date of entry, and each rating has a date of last review. The most vital data has a period of validity: that is the case for example for capital links and balance sheets. After that period, data is declassified if it has not been refreshed before, THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

72 – PART II: SELECTED PAPERS and the credit rating is reviewed. A great part of data is now automatically refreshed. All the ratings are re-estimated at least once a year.

Components and scale of the rating The “Banque de France Rating” has two components: 1. A turnover rating. 2. A credit rating, reflecting the Bank’s assessment of the company’s ability to meet its financial commitments: 3++: Excellent 3+:

Very good

3:

Good

4+:

Quite good

4:

Acceptable

5+:

Fairly poor

5:

Poor

6:

Very poor

7:

Requires particular vigilance, in view of at least one reported payment incident

8:

In difficulty, in view of rather frequent reported payment incidents

9:

Compromised, when reported payment incidents indicate severe cash flow difficulties

P:

Initiation of legal proceedings (turnaround procedure or judicial liquidation)

0:

No unfavourable information or accounting records

The turnover rating This rating indicates the level of turnover: Turnover Rating Euro A turnover equal to or exceeding 750 millions B turnover between 150 and 750 millions C turnover between 50 and 150 millions D turnover between 30 and 50 millions E turnover between 15 and 30 millions F turnover between 7.5 and 15 millions G turnover between 1.5 and 7.5 millions H turnover between 0.75 et 1.5 million J turnover between 0.75 million N companies whose turnover does not constitute a measure of their business or those whose activity is not directly industrial or commercial, in particular holding companies that do not publish consolidated accounts X level of turnover that is unknown or not sufficiently up-to-date (year-end more than 21 months ago)

The credit rating The Banque de France’s rating system was overhauled in 2004 in reference to the requirements laid down in the Basel II Accord. Henceforth, it boasts 13 credit ratings that give a snapshot of a company’s health. Each notch of the rating scale is associated with a default rate over a one year and over a 3 year horizon. These figures are published on Banque de France website (www.banque-france.fr/instit/services/page3.htm). A company’s ability to meet its financial commitments can be expressed as: 3++: excellent: THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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The company’s financial position, assessed in particular with regard to its earning power and its solvency, is highly satisfactory. In addition, the company is highly resistant to adverse developments in its environment and to specific events. 3+: very good: The company’s financial position is very satisfactory, but slightly less favourable than that required for a 3++ rating. The company’s financial position is very satisfactory but its resistance to adverse developments in its environment and to specific events, while being substantial, is not as high as that required for the 3++ rating. 3: good, for example: The company’s financial position is satisfactory but less favourable than that required for a 3++ or 3+ rating. The company’s financial position is extremely or very satisfactory but its resistance to adverse developments in its environment and to specific events, while being great, is not as great as that required for a 3++ or 3+ rating. 4+: fairly good, despite some factors of uncertainty or weakness, such as: Its financial position does not warrant a higher rating. The business is just starting up. A business recovery plan is in progress as part of a turnaround procedure, whereas if the rating were based on an assessment of accounting records it would be higher. 4: acceptable, given the existence of certain factors of uncertainty or weakness, such as: The financial position displays weaknesses with regard to earning power, financial autonomy or solvency. •

Factors other than analysis of accounting records may also warrant the awarding of a 4 rating, for example the following circumstance: − One firm held by the company has been served with a ruling of judicial liquidation within the three last years ;

5+: fairly poor, due to one or more of the following reasons: Following the analysis of accounting records, a rating of 5+ may be attributed if the company is in one of the following situations: •

The financial position displays certain imbalances, for example with regard to earning power or the balance and structure of the balance sheet. These imbalances must however be moderate.

•

Economically significant firms held by the company are poorly rated. Factors other than analysis of accounting records may also warrant the awarding of a 5+ rating, for example one or more of the following circumstances: − A legal representative (natural person) is a cause for concern (in relation to a judicial decision, see section 7).

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74 – PART II: SELECTED PAPERS − Affiliates with combined holdings of over 50% of shares or equity are poorly rated. 5: poor, this rating is usually awarded to companies displaying at least one of the following difficulties: Following the analysis of accounting records, a rating of 5 may be attributed if the company is in one of the following situations: •

A company’s financial position displays marked imbalances, for example with regard to earning power or balance sheet structure.

•

Economically significant firms held by the company are subject to a turnaround procedure.

Factors other than analysis of accounting records may also warrant the awarding of a 5 rating, for example one or more of the following circumstances: − The company is initiating a recovery plan as part of a turnaround procedure. − A legal representative (natural person) prompts serious reservations related to a judicial decision (see section 7). − Affiliates with combined holdings of over 50% of shares or equity are very poorly rated. − The company (joint-stock company) has lost half of its equity capital over the past 36 months, and no attempt by the company to rebuild this capital has been reported to the Banque de France. 6: very weak, this rating is usually awarded to companies displaying at least one of the following difficulties: Following the analysis of accounting records, a rating of 6 may be attributed if the company is in one of the following situations: •

Its financial position displays major imbalances that could jeopardise the company's continued existence (“growing concern”).

•

Economically significant firms held by the company have been served with a ruling of judicial liquidation or liquidation of assets.

Factors other than analysis of accounting records may also warrant the awarding of a 6 rating, for example one or more of the following circumstances: •

The company is deemed to be in a position of suspension of payment.

•

The company (joint-stock company) has lost half of its equity capital over the past 36 months, and no attempt by the company to rebuild this capital has been reported to the Banque de France.

•

Very serious concerns (e.g. a personal bankruptcy ruling) about a legal representative (natural person – see section 7).

•

Affiliates with combined holdings of over 50% of shares or equity have been served with a ruling of judicial liquidation or liquidation of assets.

7: requires particular vigilance due to the reporting of a significant payment incident.

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A credit rating of 7 is only awarded to companies for which the Banque de France does not possess any recent accounting records and for which the reported payment incident do not require an 8 or a 9 rating. 8: in difficulty, reported payment incidents reflect cash flow difficulties. 9: compromised, reported payment incidents indicate severe cash flow difficulties. P: initiation of legal proceedings (turnaround procedure or judicial liquidation). In principle, the rating P is replaced by a rating of 5 as soon as approval of a recovery plan or a certificate of bankruptcy is obtained. Lastly, a credit rating of 0 is given to companies for which the Banque de France has not gathered any unfavourable information: Companies that, while being entered in the FIBEN database for the purposes of recording managerial positions, financial links and reports to the central credit register, are not of sufficient economic importance to warrant the gathering of accounting records. Companies for which the Banque de France either does not possess any recent accounting records – in this case the credit rating 0 may be accompanied by information on the failure to file or late filing of accounts – or possesses documentation that cannot be used as a result, for example, of the specific nature of the company’s activity. This is the case for certain holding companies, companies set up as the legal vehicle for property development programmes, etc. It should be noted that a rating: 1. Between 3+ and 6 may also be based on the existence of close economic ties (associated activities) with one or more lower-rated companies. 2. Between 3 and 6 may also be based on the existence of close commercial relations (customers or suppliers) with one or more lower-rated companies. 3. Between 4+ and 5 may also be awarded on the basis of how favourable the economic environment is. Furthermore, the awarding of a rating of 3++, 3 +, 3 or 4+ always requires that the accounting records be analysed by the Banque de France. For certain entities, ratings are applied in a specific manner: Non-resident entities (excluding French overseas territories and Monaco)5 have a turnover rating of 0 and a credit rating of 0, 5, 6, 7, 8, 9 or P. Public authorities, the State and credit institutions are assigned a turnover rating of 0 and a credit rating of 0. State-owned industrial and commercial companies (Établissements Publics Industriels ou Commerciaux – EPIC) identified as such are given a credit rating of 0, 3++, 3+ or 3, provided their payments are regular.

Companies belonging to a group The credit rating awarded to companies belonging to a group takes into account the financial position of the economic group to which they belong provided that the Banque de France can obtain consolidated accounting records or can establish a reliable financial picture of the group:

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76 – PART II: SELECTED PAPERS •

Holding companies are therefore awarded a “group rating”, after the Banque de France has analysed the financial position of the group as a whole and any other available information on the holding company.

•

Subsidiaries are given one of the following three credit ratings depending on their position within the group and possibly their legal status: − Group rating, based on the analysis of the group’s consolidated accounts: the subsidiary’s rating is aligned with that of its parent company, in relation to its status, for example when this status renders its affiliates jointly and severally liable (e.g. Sociétés en nom collectif, sociétés en commandite par actions, sociétés en commandite simple and groupements d’intérêt économique). − Influenced rating, awarded on the basis of a combined analysis of corporate financial and consolidated statements when the subsidiary has close relations with its group, justifying an appraisal of the health of the parent company in order to assess the subsidiary’s rating. The influence of the parent company’s rating on the subsidiary can be: − Favourable: the subsidiary’s rating, which intrinsically is lower that that of its parent company, may then be upgraded by a maximum of two notches. − Unfavourable: the subsidiary’s rating, which intrinsically is higher than that of its parent company, is then aligned with that of the latter. − Autonomous rating, based solely on an analysis of the subsidiary’s financial statements, when it is seen to be independent of its parent company. The rating awarded to the subsidiary results solely from the assessment of its own. In most cases, the subsidiary in France of a non-resident group will be awarded an autonomous rating, taking into account the differences in bankruptcy law and, for the time being, the restrictions regarding the enforcement of a commercial court decision on a cross-border basis.

Nevertheless, the occurrence of certain events, not relating to accounting data per se, may lead to the intrinsic rating being maintained, and therefore, the group rating or influenced rating is not awarded. Such events include: •

Legal proceedings.

•

Notification of payment incidents resulting in the awarding of a rating of 8 or 9.

•

The loss of more than half of the company’s equity capital.

•

Concerns about its legal representatives.

Information on managers and sole traders The Banque de France assigns an indicator to natural persons who are in managerial positions in joint-stock companies or who are sole proprietors. This indicator is expressed by one of the following groups of figures: 000, 040, 050 or 060. The management indicator sums up objective information gathered on a given manager and the companies he runs. Only information that the Banque de France is authorised to record is used to determine ratings. This notably excludes legal decisions of a commercial nature that are covered by amnesty laws, as well as convictions, factual evidence or rulings relating to criminal procedure.

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Devoid of any value judgement of the managerial skills of the manager in question, it gives an incentive to the banking profession to carry out a more or less in-depth analysis. It may be used solely with regard to lending for professional purposes. In the case of individuals, the Banque de France awards a legal entity-type rating to sole proprietorships and a natural person-type indicator to sole traders, but as there is no legal distinction between personal and professional assets in this case, the two ratings generally impact on one another and are mutually transparent. For example, a 040 indicator for a sole proprietor will imply a 4+ rating value for the company if its accounting records meet the 3++, 3+ or 3 rating criteria, but will become 4 if they meet the 4+ or 4 rating criteria. Indicators with a value other than 000 are communicated systematically and individually to the persons concerned. Under the terms of the Act of 6 January 1978 on data processing, computer records and freedom (“Loi Informatique et Libertés”), all natural persons have the right to examine and correct any information concerning them. The 000 indicator: the information collected by the Banque de France on the manager gives no cause for concern. The 040 indicator: the information collected by the Banque de France on the manager gives some cause for concern. This rating is usually awarded to: •

A manager who holds office as a legal representative in a company that has been put into judicial liquidation within the last three years or in at least two companies which have credit ratings of 9.

•

A sole trader whose company has been awarded a credit rating of 4+, 4 or 8.

The 050 indicator: the information collected by the Banque de France gives serious cause for concern. This rating is usually awarded to: •

A manager who holds office as a legal representative in two companies that have been put into judicial liquidation within the last five years (unless the two companies have close ties), or to a manager required to pay the debts of the legal entity, irrespective of the amount of the pecuniary liability.

•

A sole trader whose company has been awarded a credit rating of 5+, 5 or 9.

The 060 indicator: the information collected by the Banque de France gives serious cause for concern. This indicator is usually awarded to: A manager who holds office as a legal representative in three companies that have been put into judicial liquidation within the last five years, or who has personally been issued with a court ruling. A sole trader whose company has been given a credit rating of 6 or p.

Additional information In addition to the ratings and indicators, Banque de France assigns additional indicators aimed at broadening the view of FIBEN users on the credit risk profile of companies and their commitment to transparency. This information is separate from the company rating and is not taken into account when the rating is attributed. Where relevant, it is given with the rating when it is conveyed to the banking industry through the FIBEN online services.

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78 – PART II: SELECTED PAPERS Transparency: Information on transparency indicates that the company has met with its financial partners (banks and other credit institutions) within the last year, in the presence of a Banque de France representative, to review its financial position and future prospects. Late Filing or Non-Filing of Accounts: Information on late filing or non-filing of accounts relates to a company which, although subject to a legal obligation to file its accounts with the register of commerce and companies, has failed to comply with this obligation within the deadline set by law and to transmit recent accounting records to the Banque de France.

Aggregated data: Results Aggregating the data allows to draw the distribution of the rated companies according to the rating scale. Chart 1. Company distribution

Chart 2. Default and failure rates - 1 year horizon

October 2004 (in %)

(Arithmetic means/accounts closing between 1999-2002)

25,00% 5.50% 5.21%

20,3%

20,00%

15,00%

15,8% 14,8% 13,3%

13,0% 11,1%

4.48%

4.50%

% failure rate 1 year

3.50%

% defaut rate 1 year

3.39% 2.72%

2.50% 2.21%

10,00% 4,6%

5,00%

0,5% 0,3% 0,5

0,00% 3++

1.57%

1.50%

5,9%

3+

3

4+

4

5+

5

6

8

9

P

0.62% 1.04% 0.83% 0.09%0.14% 0.50% 0.47% 0.03% 0.12% 0.02% 0.07% -0.50% 3++

3+

3

4+

4

5+

5

6

The distribution (Chart 1) appears meaningful and does not contain excessive concentration in specific grades. Population is lower at both ends of the curve. Concerning defaults (Chart 2) the statistics disseminated by the BDF now distinguish: • •

The “business failure rate”, that refers to the legal proceedings during the period under review. The “default rate” that refers to the legal proceedings or the assignment of the 9 rating during the same period.

This chart is an example of the way the predictive power of the rating scale is able to be checked. The new rating scale has been implemented since April 2004. For the time being, no sufficient track record is available to permit publishing statistics derived from ratings awarded by the analysts. But preliminary results are available. They come from mechanical simulations: the data was used to simulate the impact that the new assessment rules would have. This gives a rather realistic picture of future performance of the new rating scale. Several simulations were run on the whole rated population over different periods. This chart shows the arithmetic means of simulations based on data covering the years 1999 to 20028. These simulations cover the years 1997 to 2002.

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Notes 1 This paper is strongly based on documents prepared by the Companies Department of the Banque de France and benefits from their staff advice. Additional information on Banque de France ratings and on FIBEN online services to the banking community is available on Banque de France website, including downloadable documentation on FIBEN, the central credit register, the central balance sheet data office and credit default statistics www.banque-france.fr/gb/instit/services.page2.htm - Email : [email protected]. 2 The Eurosystem comprises the national central banks of the 12 countries that make up the euro area and the European Central Bank. 3 This date is reported to Banque de France on a compulsory basis by resident credit institutions in accordance to the French Banking Regulations 86-08 and 86-09. 4 More information on the FIBEN information system can be downloaded from the Banque de France’s website: www.banque-france.fr/gb/instit/services/page2.htm. 5 Given that banks in the French overseas territories and Monaco are not obliged to report payment incidents they may have recorded to the Banque de France, these entities have: - A turnover rating of 0. - A credit rating of 0, 5, 6 or P. - Companies in the French overseas departments are rated in the same way as companies in mainland France. 8 This period is characterised by increasing general failures in the economy.

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80 – PART II: SELECTED PAPERS

Access of Micro and Small Enterprises to Credit in Brazil

Mr. José Mauro de Morais Expert, Applied Economic Research Institute, IPEA/Diset/, Ministry of Planning, Budget and Management, Brazil This study aims at evaluating the main restrictions faced by micro and small enterprises (MSEs) in the bank credit market in Brazil. The text discusses barriers restricting MSE access to credit associated with flaws in the judicial framework, legal impediments for the supply of positive information on credit applicants, crowding out of private resources by the financing of the public debt as well as firm management and accounting shortcomings increasing information asymmetry. Current interpretations for high spreads charged by banks on small loans are also presented. Research results are synthesized in a table showing the main factors restricting credit and their effects on small enterprises, the banking system and the overall economy. The paper presents the main measures that have been implemented in the last years to alleviate the credit shortage faced by small firms.

Introduction This study evaluates the main difficulties faced by micro enterprises and small enterprises (MSEs) in the banking credit market in Brazil.1 It is well known that a great number of firms have their loan requests refused due to problems meeting banking bureaucracy requirements and risk classification rules, lack of collateral and informational asymmetries. Other firms do not apply for credit due to the high interest rates banks charge on loans. While a significant part of small firms do not succeed in obtaining the amount of credit they need or do not have access to credit at all, banks have large amounts of resources available to lend. The total value of spare banking resources invested in public titles represents some 60% of the credit they grant for all sectors in Brazil. This factor constrains credit supply for small firms. To evaluate the above questions, analyses in this work discuss the legal, informational and macroeconomic causes behind the Brazilian credit market failures. Analyses focus on the MSE segment rather than medium-sized enterprises, given the specific characteristics of services offered by banks to small firms. These firms are catered for by the banks’ retail market sector, differing substantially from services offered for medium-sized firms. The concept of small firms used by the banks varies considerably but the more common annual revenue limits are small and BRL 5 million or BRL 10 million (Brazilian reals) (USD 2.1 millions or USD 4.2 millions). Some banks set a specific limit of BRL 500 thousand (USD 210 thousand) for micro firms. Definition criteria vary more widely in the

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case of medium-sized enterprises, ranging form BRL 40 million (USD 16.9 million) to BRL 80 million (USD 33.7 million), and BRL 180 million (USD 75.8 million).

Small firms in the Brazilian economy In 2003, MSEs accounted for 54.6% of overall employment in industry, commerce and services, and for 23.9% of total earnings paid to firms in these sectors (Table 1). The importance of MSE in the Brazilian economy has grown significantly in recent years. The number of enterprises rose from 3.1 million in 1996 to 5.09 million in 2003, employees increased from 10.3 million to 15.5 million, and total earnings paid grew from BRL 38.1 billion to BRL 58.3 billion in real terms (USD 13.2 billion to USD 20.2 billion), in the same period. As for large firms (250 employees and over), the number of units in operation rose from 8.3 thousand, in 1996, to 9.3 thousand, in 2003, and employment increased by 1.03 million; although, in 2003 total earnings were practically the same as in the base year. Table 1. Indicators of industrial, commercial and services firms in Brazil - 2003 Firm sizes by number of people employed

Indicators

Total

Micro (1 – 9)

Small (10 – 49)

Medium (50 – 249)

Large (250 +)

Firms

4 757 909

325 889

41 842

9 294

5 134 934

Employment

9 625 748

5 905 691

4 075 998

8 847 567

28 455 004

People per firm

2

18

97

951

-

Earnings (BRL billion)

22.1

36.2

41.4

144.5

244.3

Source: IBGE – CEMPRE, 2005; prepared by the author.

The bank credit market in Brazil: Evolution of loans, interest rates and spreads Brazil’s degree of credit deepening, measured by total loans as a proportion of GDP is very low compared to other countries. After reaching 34.8% in 1995, the ratio remained below 30.0% from 1996 on, attaining a low proportion of 23.9% in 2002. However, the recovery in the general supply of credit from 2003 onwards has reversed this downward trend, and total loans as a percentage of GDP attained 31.7% in 2006 (March).2 Credit to firms of all sizes increased 20% in nominal terms between July 2003 and July 2004, and 27% between July 2004 and July 2005, increasing the GDP rate of credit using nonearmarked funds from 5.0%, in December 2002 to 6.5% in July 2005. The expansion of loans was aimed especially at segments that present strong growth potential and high rates of return to the banks, such as the financing of consumer goods, credit for individuals, and loans to MSEs and medium-sized firms. Banks interviewed by the Economic Commission for Latin America and the Caribbean (ECLAC) survey gave the following reasons for increasing the amount of credit to MSEs: low bankarisation of MSEs, constituting a significant potential market for loans, bank products and services; higher interest rates on loans to this segment; bank desire to increase the scale of loan operations to reduce their average operational costs; encourage the employees to become bank customers; and greater fidelity of small enterprises compared to bigger ones.

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82 – PART II: SELECTED PAPERS To attract small firms, private and public banks interviewed have adopted specific policies and strategies, such as setting up platforms or areas designed to cater to these enterprises, training managers and credit operators in these firms’ legal and economic particularities, launching specific credit lines for MSEs, increasing the number of preapproved lines of credit, offering services previously available only for large firms, and implementing automated credit analysis methods to speed up decisions on loan applications.3 Banks have substantially increased credit to MSEs from the second half of 2003, but interest rates remain high as will be seen in the next section.

Interest rates and banking spreads According to the figures from the Central Bank of Brazil, the average annual interest rates in all modalities of credit for enterprises using non-earmarked funds reached 42.3% in 2003, 40.7% in 2004, and 39.5% in 2005, as of December of each year (Table 2), falling very little on average. The average terms of the credit lines most used by MSEs are also shorter: 13 days for hot money, 22 days for guaranteed accounts and 33 days for trade bills. The annual interest rate average spreads were 26.4%, 23.2% and 22.5% (Table 3). Spreads for some credit lines were considerably higher than the average, as in the case of guaranteed accounts in which spreads surpassed 50% during the period.4 The main aspect to be observed is that the figures do not reflect the effective cost of credit for MSEs since they represent average values of credit granted to firms of different sizes in each credit line type. Thus, they reflect the weight of credits granted to big borrowers with their larger volumes and lower interest rates. A better idea of the interest rates and spreads paid by small firms will only be possible when the Central Bank makes information on interest rates according to corporate loan size and types of credit lines available. Table 2. Brazil - Interest rates and average term on loans to firms (2003–05) Types of credit line

Average term (Dec 2005)

Annual average interest rates(%) 2003/Dec

2004/Dec

2005/Dec

In days

Working capital

35.8

36.7

34.7

334

Guaranteed account

69.7

66.5

70.3

22

Purchase of goods

29.3

29.0

28.2

282

Vendor

22.4

22.8

22.5

88

Hot money

53.6

51.1

47.4

13

Trade note discount

44.2

40.5

39.5

33

Promissory note disc.

55.5

49.6

49.0

35

Average rate (Pre-fixed interest rates)

42.3

40.7

41.5

-

Source: Central Bank of Brazil – Economic Indicators.

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Table 3. Brazil - Bank spreads on loans to firms (2003–05)

Types of credit line

Annual average interest rates(%) 2003/Dec

2004/Dec

2005/Dec

Working capital

20.1

18.7

17.7

Guaranteed account

54.0

50.3

53.7

Purchase of goods

13.6

11.2

11.7

6.4

4.9

4.9

Hot money

37.9

34.9

30.8

Trade note discount

27.9

22.8

21.7

Promissory note disc.

39.2

31.9

31.2

Average spread

26.4

23.2

22.5*

Vendor

Note: * Estimated. Source: Central Bank of Brazil – Economic Indicators.

Conditions of access and MSE share of credit ECLAC research results are reported in this and the next Section. After a brief evaluation of the procedures adopted by banks in credit approvals, the point of view of banks will follow on the factors which prevent greater access to credit and data obtained on the share of MSEs in total credit grant from a sample of the eight biggest banks.

Credit risk analyses, MSE accounting records and creditor rights Besides their own procedures and criteria used in credit analyses, banks have to observe the Central Bank’s risk classification rules, according to the Basel Agreement on banking supervision.5 The need for better quality information about the credit applicant has been growing in importance in recent years. More demanding banking supervision rules and capital reserve requirements tailored to the specific risk of each credit operation should become even more stringent with the new Basel II Agreement rules6. Major banks have been making increasing use of credit scoring, a risk analysis tool that automatically provides the customer’s rating (the probability that the credit taker may default on commitments within a set time frame of around six months). The tool also establishes the amount of credit to be granted, which facilitates the definition of the operation interest rate and meets the need for speed and impersonality in retail market loan decisions. Given the importance of gathering information to support credit approval decision, interviews with banks and other institutions sought to focus on the reasons for the difficulties and other barriers hindering credit access, which is due mainly to information asymmetry and low fulfilment of creditor rights. According to the opinions expressed by the banks, credit analysis of MSEs is hampered mainly by the low transparency of accounting track records, under-invoicing firm turnover, and flaws in information on indebtedness with banks and suppliers of THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

84 – PART II: SELECTED PAPERS goods and services. Accounting records are often kept merely for tax payment purposes and are seldom used to support management and financial control of small businesses. Even legally constituted firms have problems providing such documents necessary for loan applications such as up-to-date documents relating to the firm’s legal status (company charter), accounting and financial statements, proof of ownership of real estate or capital goods used in the productive process and partners’ declarations of income and assets. As firms will be increasingly assessed through credit scoring, one of the actions helping to increase the transparency of firms in the market and diminish informational asymmetry is to perfect consumer protection legislation to allow private credit information bureaus to supply so-called positive information - records of debt and punctuality in repayment of financial and mercantile debt - overcoming current legal restrictions which allege invasion of privacy to forbid or hamper the furnishing of data on credit applicants. Some banks stated that judicial morosity and high costs of judicial collection actions are - after the low transparency of accounting and financial information - the second most important factor responsible for the cautious attitude of banks on loans to small firms. They emphasised the need for clearer rules and speedier legal process procedures for collecting loans in arrears. In the words of the person responsible for a private bank’s risk analysis department, “all information flaws and judicial delays end up increasing loan interest”.

MSE share of credit Three public banks and five of the seven private banks consulted in the ECLAC research provided data on their loans to MSEs.7 Data include both non-earmarked and earmarked credit since it was impossible to separate loans from government sources. Table 4 presents the value of the eight banks’ total loans and those granted to MSEs. Table 4. Brazil - MSE share of bank credit - industry, commerce and services – 2003 Balances – BRL millions (current prices) Banks

Total Loans (A)

Banco do Brasil – BB

Loans to MSEs (B)

B/A (%)

29 900

9 800

32.8

Caixa Econômica Federal – CEF

3 439

3 301

95.6

Nossa Caixa

1 088

782

71.8

34 427

13 883

40.3

Private banks

108 243

14 775

13.6

Public and Private Banks

142 670

28 658

20.1

Public banks (above)

Source: Interviewed banks.

Public and private bank figures are shown separately, the latter shown in aggregate form. The information gathered indicates that public banks, on average, allocated 40.3% and private banks 13.6% of their total loans to MSEs. An average of 20.1% of overall public and private bank loans went to MSEs. MSE share of the total amount lent by each THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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private bank was 7.0%, 9.0%, 13.0%, 16.6% and 18.9%. In the case of the two federal public banks (BB and CEF), the higher share of MSEs in their total loan distribution is partially explained by the resources received from development credit programmes and institutional funds.

Assessing high interest rates on loans to small firms Analyses and interpretations of causes for the high cost of credit in Brazil point to a broad set of factors associated with flaws in the judicial framework, macroeconomic instability, high risks of loan default, high rates of compulsory deposits at the Central Bank, high basic interest rates to rollover the public debt and various taxes paid on financial intermediation. Another approach relates high spreads to the low level of competition of the Brazilian banking system and the considerable market power of banks in setting interest rates (Belaisch, 2003). Another factor influencing spreads is the difficulty firms encounter in changing banks, subjecting the small borrower to the conditions established by the financial intermediary. As for the commented high risks of loan default, observations in Section III regarding procedures used to select customers strongly suggest that improved credit management has led to a more efficient monitoring of default rates reported by bank risk analysts and managers in interviews to the author: “risk analysis and credit scoring have greatly reduced the probability of error regarding customer repayment capacity” and “credit scoring allows for a better control over loan default”. Moreover, the selection of safer borrowers has contributed to the improvement in banking performance aided by more solid economic conditions prevailing since 2003, with banks showing record profits in the 2004-06 period.

Large public debt as a factor of imbalance in the credit market The federal government’s total net debt accounted for 51.6% of GDP in 2004 and 2005, after having reached a maximum of 57.2% in 2003. The debt has been financed by government bonds with less than two years of maturities on average. The high basic interest rate (Selic) used to rollover government securities, which oscillated in this decade between a minimum of 15.2% in February 2001 and a maximum of 26.3% in April 2003, increased the overall interest rates and crowded out credit to the private sector. The crowding out effect can be roughly measured by the value and proportion of the banks’ investments in federal bonds, compared with total credit to the private sector. In June 2005, these investments amounted to BRL 307 billion (USD 129 billion), equivalent to 59.0% of total credit, which attained BRL 522 billion (USD 219 billion). Besides crowding out of the private sector, the strong presence of the government raising funds in the financial market imparts an element of downward rigidity to interest rates on bank loans because it establishes a minimum level used by the financial market to set all other interest rates. Public debt rollover allows banks to optimise their profitability by enabling them to adopt a mix of investments in securities and credit supply. This combination varies over time according to the level of the basic interest rate, demand for credit, macroeconomic conditions and prospects for economic growth.

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Overall assessment of the causes of the credit shortage and high interest rates Information gathered by the ECLAC research in interviews with banks, specialists in management and accounting assistance for small firms, government officials and credit studies are summarised in Table 5. The first column highlights the main flaws that hamper MSE access to credit and raises interest rates. Table 5. Brazil – Determinants of credit restrictions and high interest rates for MSEs Effects Determinants On the banking system

On the enterprises

On the Economy

1. LEGAL RESTRICTIONS ON POSITIVE INFORMATION REGISTERS

Information asymmetry

Low transparency of the firm in the market

Reductions of the potential supply of credit

2. MOROSITY OF DEBT COLLECTION PROCESSUAL LEGISLATION

More rigid customer selection

Credit restrictions

Constraints on the production of firms

Higher interest rates

Higher financial expenditures

3. HIGH BANKING SPREAD Components: taxes on loans, high compulsory deposits, default rate, high administrative and profit margin

Higher interest rates

Higher financial expenditures

Constraints on the production of firms

4. PUBLIC DEBT FINANCING

Reduction in credit supply

Closure of firms

High basic interest rate

Crowding out of resources to private sector Higher interest rates

5. MSE FLAWS

Information asymmetry

Insufficient accounting track records and documentation; lack of balance sheets and financial statement Low management skills Sketchy knowledge of the market Shortage of collateral/assets

Low confidence in the viability of the firm

Higher financial expenditures Low transparency of the firm in the market Weak bargaining position to negotiate credit conditions

Lower job generation

They represent institutional, macroeconomic, informational and demand-side factors restricting access to credit: 1. Legal restrictions on the disclosure to banks by private credit information bureaus, of clients’ positive information regarding past repayments of debts and other commitments, thus hampering creditors’ proper assessment of the punctuality of loan candidates in repayment of financial and mercantile debts. 2. Flaws in Brazil’s judicial system causing morosity and high cost of judicial recovery of loans, increasing interest rate spread. 3. Financing of the public debt, which keeps interest rates high and crowds out credit to the private sector. 4. Cost components of financial intermediation (spread) due to default rate, taxation on loans, high intermediation bank costs, large profit margins and compulsory deposits with the Central Bank. 5. As important factors also hampering access to credit, Table 5 lists MSE errors when requesting loans: a) insufficient track records and lack of documentation and

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financial statements, which increase informational asymmetry between suppliers and demanders of credit, and b) low financial management skill, sketchy knowledge of the market itself, and lack of collateral and assets, which reduce bank confidence in the viability of small enterprises. The three other columns synthesise the consequences of each of the flaws for the banking system, small enterprises and for economic activity with credit restrictions and high interest rates constraining output and job growth.

What has been done to reduce bank credit restrictions for small enterprises? In the last three years, a strong development in credit markets has been taking place in Brazil. The value of total bank credit from private sources rose: 27% in 2004, 23% in 2005 and 21% in 2006, on an annual basis in March. Most of this credit has been directed to high potential demand segments, such as MSEs and medium-sized firms. Despite the credit supply increase, interest rates have remained high especially for the credit lines most frequently used by small firms. Given rigid market interest rates, a series of public actions have been developed since the end of the last decade in two broad areas: i) microeconomic reforms to diminish informational asymmetries and correct the inadequacies of the legal structure which have a negative impact on the financial intermediation market; and ii) measures to increase the supply of public credit from institutional sources for investment and working capital.8 The measures encompass actions to strengthen creditor rights and speeding up guarantee foreclosure and settlement, aiming to lower spreads and increase competition in the banking sector. Regarding vulnerabilities of small firms, the measures are designed to reduce tax burden and informality and improve the management and accounting assistance to SMEs.

Disclosure of positive information on bank customers There are two basic government initiatives to improve the diffusion of positive information on loan candidates in the Brazilian financial system: a) The Brazilian Central Bank’s new credit risk centre, “Central Bank of Brazil Credit Information System” (SCR); b) The sending of a draft law to Congress which regulates credit protection databanks, allowing private credit information bureaus to reveal positive information on loan candidates. The SCR furnishes information on loans granted to individuals and firms, guarantees provided and credit limits approved by financial institutions. The information is up-dated on a monthly basis allowing interested parties to ascertain customers’ punctuality regarding payments. Customers’ volumes of credit are furnished in a consolidated form, without details of the operation, the creditor’s identity, and the risk classification level. Draft Law nº 5.870, of 2005, which has been submitted to Congress, will regulate the functioning of data banks administered by private credit information bureaus in order to permit the furnishing of information on individuals and firms on commercial transactions.

Measures to increase creditor rights In order to reduce legal problems relating to credit, the Central Bank of Brazil has been adopting different measures. This study has selected two because of their direct THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

88 – PART II: SELECTED PAPERS relevance on improving creditor rights: the institution of the bank credit bond (CCB), and the application of statutory lien to guarantee fungible assets and credit rights and securities (Law nº. 10.931/04). The bank credit bond was instituted in order to lower creditor loan risk, allowing a speedier debt foreclosure as the judicial procedural phase of the recognition of loan legitimacy is not required. In June 2001, statutory lien to guarantee rights, which had been previously applied especially in the case of financed sales of vehicles, began also to be applied to guarantee fungible assets, credit rights and other financial securities, thus increasing creditor loan guarantees. This instrument should reduce the number of judicial actions and allow an increase in the supply of credit, given that the creditor now has a more secure and speedier way of recovering rights in the event of default. According to the analyses in Section III, judicial morosity increases the cost of credit by increasing banking spread for borrowers. The following measures were implemented in the last two years to improve procedural performance, avoid appeals which merely involve delaying tactics and speed up the execution of sentences: 1) Law nº 11.232/05 Speeds up civil debt foreclosure; 2) Draft Law 4.497/04 – Simplifies and speeds up extrajudicial foreclosure; 3) Draft Law 4.728/04 - Avoids repetitive matters; 4) Draft Law 136/04 - Inhibits mere delaying appeals by terminating the suspending effect of an appeal, favouring lower court decisions and guaranteeing the provisional execution of the sentence in favour of the creditor, except in those cases where the decision may cause irreparable damage to the losing party; and 4) Complementary Draft Law 90/05 - Aims at reducing the number of judicial actions in tribunals.

Reform of the Bankruptcy Law The new Bankruptcy Law (Law nº 11.101/2005) instituted judicial and extrajudicial recovery. This opens up new possibilities for the restructuring and rescue of firms with financial difficulties. Firms able to recover from an economic and financial crisis can present a recovery plan to be assessed by creditors and decided upon within 150 days after the judicial decision has been taken. In the case of bankruptcy, a joint sale of the assets of the bankrupt firm is permitted, providing an opportunity to restart under new ownership. To strengthen creditor rights, the law reduces risks by granting priority over tax credits to loans provided by banks guaranteed by collateral in the event of insolvency.

Reduction of tax burden and informality In Brazil, MSEs account for 70% of the total income tax-paying firms but collect only around 2% of the union’s tax revenues,9 and therefore should not be seen as an important source of tax revenues. The principal measures aimed at lightening the tax burden on firms and providing incentives to their formalisation are to be found in a draft law currently in the final stages of voting by the National Congress, the National Micro and Small Enterprise Statute (Complementary Draft Law nº. 123-B/2004). It consists of a consolidated body of proposals, which aim at supporting MSEs in several different areas, such as the reduction and simplification of taxation, de-bureaucratisation of registers, stimulating the formation of associations and technological innovation, and providing greater access to the market, credit and government procurement. The law creates an integrated taxation system, the “Simples National” (replacing the current “Simples” system) which will encompass federal, state and local government taxes and contributions. Firms will be subject to 22 different tax rates, ranging from 4.0% to

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11.61% of annual gross revenues between BRL 60 thousand (USD 25.2 thousand) and BRL 2.4 million (USD 1 million).

Management and accounting assistance A structured action, which involves accounting methods improvement and management support for small firms, is to be found in the “Contabilizando o Sucesso” (“Accounting for Success”) Programme, whose objective is to prepare accountants all over the country for the task of supporting the management of firms. The programme was launched in October 2002 and is a result of the joint efforts of the Brazilian Micro and Small Firms Support Service (SEBRAE) and the Federal Accounting Council, which furnished the financial, logistical and technical resources necessary to implement the project. 10 From December 2002 to 2005, 93 groups completed the course and 1 472 accountants were trained in 23 states.

Supply of credit from public sources There are currently three major government mechanisms in operation to supply financing for medium and long-term fixed capital investments and working capital for industrial, commercial and service firms: the financing of the National Economic and Social Development Bank (BNDES), the Constitutional Financing Funds of the Northern, North Eastern and Centre West Regions (FNO, FNE and FCO) and the Employment and Income Generation Programme (PROGER). They constitute the principal sources of funds available for investments to increase productive capacity, set up new undertakings and modernise equipment. PROGER grants credit exclusively to micro and small firms and informal business segments, while the other programmes finance firms of all sizes. Table 6 presents the financing granted in 2004 by the three programmes, total of USD 16 783 million (2.3% of GDP) with micro, small and medium firms accounting for 27.5% or USD 4 613 million. Most of them consisted of financing for investment in machinery and equipment, the execution of civil works and installations, real estate and transportation and cargo vehicles, besides working capital associated with investments and pure working capital in specific credit lines. Using funds from fiscal sources and the Worker’s Assistance Fund – FAT, the credit programmes offer maturities of up to twelve years for investments (twenty years in some sectors), loans for working capital with maturities of up to three years at fixed interest rates, besides offering public guarantee funds to cover part of the collateral required.11 Table 6. Brazil – Share of micro, small and medium-sized firms in special credit support programmes: Industry, commerce and services (2004) Values in USD million Size of Firm

BNDES Value

CONSTITUTIONAL FUNDS %

Micro

514

3.8

Small

690

5.0

1 218

Large Total

Medium

Value

%

PROGER Value

TOTAL %

118

10.1

1 913

8.9

159

13.7

11 279

82.3

890

13 702

100.0

1 168

Value

%

100.0

3 235

19.3

-

-

1 378

8.2

76.2

-

-

12 170

72.5

100.0

1 913

100.0

16 783

100.0

Source: “Credit Support Programmes for Micro, Small and Medium Enterprises in Brazil”, OECD Global Conference on Better Financing for Entrepreneurship and SME Growth - 2006. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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References Aernoudt, Rudy, Red. (2001), Financer les PME, L’Approche Européenne (Actes du Colloque Européen Louvain-la-Neuve, organisé par Serge Kubla), Roularta Books. Belaisch, Agnès (2003), Do Brazilian Banks Compete?, IMF Working Paper WP/03/113. Central Bank of Brasil (1999, Oct), Juros e Spread Bancário no Brasil, Departamento de Estudos e Pesquisas - DEPEP. Central Bank of Brazil, Press Notes. Confederação Nacional da Indústria (2003), Revista Indústria Brasileira, nº 25. European Commission (2005), How to deal with the new rating culture, http:/europa.eu.int/comm/enterprise/entrepreneurship/financing/basel_2.htm European Commission (2003), SMEs and access to finance, Observatory of European SMEs, http:/europa.eu.int/comm/enterprise. Hochschule für Bankwirtschaft (2003), The New Framework for Capital Adequacy (Basel II): Consequences for Small and Medium Sized Enterprises (SME) and Presentation of Political Options for Implementation, Frankfurt am Main, July 2003, www.europarl-eu/workshop/basel_ii. IBGE (Instituto Brasileiro de Geografia E Estatística), www.ibge.gov.br. Inter-American Development Bank (2005), Libertando o crédito, Relatório 2005. Morais, Jose Mauro de (2005a), “Crédito Bancário no Brasil – Participação das pequenas empresas e condições de acesso”, Economic Commission for Latin America and the Caribbean – ECLAC/UN, Santiago, Chile, www.eclac.org. Morais, Jose Mauro de (2005b), O Crédito Bancário e as Pequenas Empresas no Brasil, Economic Commission for Latin America and the Caribbean – ECLAC, unpublished. OECD (Organisation for Economic Co-Operation and Development) (2004), Financing Innovative SMEs in a Global Economy, OECD, Paris. Pinheiro, Armando Castelar (2003), O Componente Judicial nos Spreads Bancários, in: Economia Bancária e Crédito (Evaluation of 4 years of the Interest rate and spreads Project), Central Bank of Brazil. SEBRAE and Conselho Federal de Contabilidade (2003), Contabilizando o Sucesso. SEBRAE/São Paulo (2004), O Financiamento das MPEs no Estado de São Paulo – Sondagem de Opinião.

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Notes 1 This work is based on a research drawn up for the Economic Commission for Latin America and the Caribbean – ECLAC/UN, which analysed the bank policies and strategies for small enterprises and interviewed bank representatives, government officials and specialists in management and accounting assistance for small firms during the second half of 2003 and the first half of 2004 (Morais, 2005a). 2 Central Bank of Brazil, Press Note, www.bcb.gov.br. 3 Description of bank strategies can be found in Morais (2005a). 4 Spread is the bank’s intermediation cost in credit transactions, the difference between the interest rate charged by the bank on loans and the interest rate paid on funds raised in the market. 5 The credit risk classification rules were established by National Monetary Council Resolution nº 2.682, dated 21.12.99. All credit operations involving individuals and firms must be classified by financial institutions in 9 levels, from AA to H, according to credit takers’ risk and payments in arrears. 6 At the end of 2006 the Central Bank of Brazil will assess the new rules related to bank capital requirements, following the recommendations of the Basel Banking Supervision Committee (Basel II). Proceedings and schedules for the implementation of Basel II were established by Communiqué 12.746/2004 of the Central Bank of Brazil. 7 Three public banks were surveyed: Banco do Brasil, Caixa Econômica Federal and Nossa Caixa (São Paulo State bank) - and seven private banks - Bradesco, Itaú, Unibanco, HSBC Bank Brasil, Real ABN Amro, Santander Banespa and BankBoston. These banks account for almost 80% of the total loan volume of the Brazilian banking system. 8 An assessment of the main government credit programmes can be found in “Credit Support Programmes for Micro, Small and Medium Enterprises in Brazil”, written for the OECD Global Conference on Better Financing for Entrepreneurship and SME Growth – Brazil, 2006. 9 In 1999 the firms which contributed under the “Simples”, a simplified tax collecting regime paid BRL 3.9 billion in taxes, with the union raising a total of BRL216 billion; see the site of Receita Federal (Internal Revenue Service), Estudos Tributários (Tax Studies), www.receita.fazenda.gov.br. 10 Sebrae and Conselho Federal de Contabilidade, Programa “Contabilizando o Sucesso”, Brasília, 2003. The programme is in a pilot phase and its effective results have not yet been wholly ascertained by the two institutions. 11 See note 8.

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Credit Allocation and Efficiency: The Case of Japan

Mr. Iichiro Uesugi1 Fellow, Research Institute of Economy, Trade and Industry, Japan This paper empirically examines the development of credit allocation among Japanese SMEs, and its relationship with economic efficiency. In the late 1990s, public scrutiny of Japanese credit markets was intense as it was strongly believed that the massive amount of non-performing loans in the financial sector distorted the market for credit leading to the inefficient allocation of funds. Moreover, it was generally believed that the government rather than containing these distortions, in fact, exacerbated these problems. The paper first investigates whether the credit market is inefficient, in that the survival of underperforming firms prevents innovative newcomers from entering the market. Secondly, the paper tests whether government interventions can improve the efficiency of credit markets. Using two different but unique firm-level datasets, the paper come to the following conclusions: (1) the selection mechanism in the credit market is efficiencyimproving such that lower quality firms with higher borrowing costs exit, and (2) the massive credit guarantee programme implemented by the Japanese government in the late 1990s did more to improve credit availability and profitability than to worsen adverse selection. Implications of these results to other countries are briefly discussed.

Introduction This paper empirically examines the development of credit allocation among Japanese SMEs, and the relationship between credit allocation and economic efficiency. How to improve the efficiency of credit markets, either by facilitating the flow of funds or by reducing interest payments, has been of major interest, not only to borrowers and lenders, but also to policy makers and academics. In Japan, during the late 1990s and early 2000s, public scrutiny fell heavily on credit markets and the possible “inefficient” allocation of funds. The belief was that these markets were distorted by the increase in non-performing loans. Banks continued to lend to “doomed-to-fail” firms in an effort to postpone the realisation of losses incurred by the mounting non-performing loans. The government tried to facilitate the flow of funds to SMEs, but was criticised for adding another source of inefficiency to the market. The fact was that the federal credit programmes were so lenient that they attracted low quality firms and/or discouraged firms' managerial efforts. The focus of this paper is twofold. First, it investigates if the credit market for SMEs is inefficient in that the survival of underperforming firms prevent innovative newcomers from entering into the market. A number of economists claim that this inefficient selection, most frequently observed among large-sized firms, contributed significantly to

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Japan's stagnant decade (1990s). Furthermore, many researchers believe that this inefficiency was much more severe among small businesses. The paper looks into these claims, and investigates whether a rational selection mechanism for SMEs exists. Secondly, it examines whether government interventions in the credit market can be efficiency-improving. Many fear that these interventions worsen the information problems between lenders and borrowers and exacerbate moral hazard and adverse selection problems. These predictions are then tested by focusing on a massive credit guarantee programme, with exceptionally lenient lending conditions, that was temporarily implemented by the Japanese government. It should be noted that empirical studies of this type have only recently become possible as a variety of new firm-level data sets of SMEs have increasingly become available in Japan. Establishment of the Credit Risk Database (CRD) with more than 5 million SMEs' balance sheets and annual surveys by the Small and Medium Enterprise Agency of Japan (SMEA) since 2001 are the two notable examples. The remainder of the paper proceeds as follows. Section 2 examines if the credit market for SMEs has an appropriate selection mechanism. Effectiveness of government interventions is discussed in section 3. Section 4 concludes with some possible implications for other countries.

Examining the selection mechanism of the credit market2 Natural versus unnatural selection3 To test for market efficiency, this paper specifically focuses on the process of “selection,” in which surviving firms and defaulting firms are separated from one another. Natural selection is defined as lower quality firms being separated out from good performers, charged higher interest rates, and eventually being forced out of the market. If selection is natural, overall efficiency improves since low-quality inefficient firms are expunged from the market. In addition, the pricing of loans by financial institutions improves the efficiency of the market since high quality firms benefit from the lower borrowing costs, and thus, have greater chances of survival. The nature of the selection process in the late 1990s has been one of the most important empirical issues to Japanese economists. Sekine et al (2003) and Peek and Rosengren (2005) use firm-level data to investigate whether the selection process worked properly for large, publicly traded firms. Using various performance indicators, including productivity, profitability, and debt ratios, to distinguish bad from good firms, they find that troubled banks tend to increase (rather than decrease) loans to bad firms in order to avoid the realisation of losses on their own balance sheets. They interpret this as evidence against natural selection. Peek and Rosengren (2005) dub this “unnatural selection.”4 Also, Nishimura et al (2003) finds that some Japanese industries were characterised by the survival of low productivity firms and with the exit of high productivity firms in the latter half of the 1990s. Furthermore, Caballero et al (2004) argue that Japanese banks have kept unprofitable (“zombie”) firms alive by extending loans at extremely low interest rates, and that these zombies crowded out firms with profitable projects, thereby distorting resource allocations. One common feature of this line of research is the focus on large firms.5 This is partly because the misallocation of bank loans is believed to occur only for large firms. There is no a priori reason, however, to believe that small firms are free from unnatural selection. In fact, a number of practitioners and researchers argue that the misallocation and the THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

94 – PART II: SELECTED PAPERS “mispricing” of bank loans to small firms is a much more serious issue. Also, given that large parent firms and their subsidiaries are closely related in terms of their activities, it would be possible that unnatural selection of large firms would have some adverse impact on small firms. Based on this understanding, the paper examines whether SMEs have also been vulnerable to unnatural selection.

Data The data in this study are obtained from the Credit Risk Database (CRD),6 which covers about 60% of all small corporations in Japan.7 One of the advantages of the CRD is that it contains detailed information on firm defaults. In fact, defaults are characterised in four ways: (1) delinquent payment for three months or more, (2) de facto failure, (3) failure, and (4) repayment of debts by a loan guarantee corporation. This information allows us to identify defaulters and non-defaulters in each year of our sample. Using more than 5 million firm-years contained in the CRD, a panel data set is constructed. To be sure that there are enough observations in each year, the period is set at 1997-2002 as the sample period. Second, the sample is limited to those firms satisfying either of the following two conditions: (1) surviving firms from 1997 to 2002 that reported information to the CRD in each year, or (2) defaulting firms during this period that reported information to the CRD until the year of default. Put differently, a firm is not included in the sample if it does not report to the CRD in 1997, or if it disappears without a record of default. Thus, firms born in and after 1998 are not included in the data set. Third, outliers are removed for each variable based on the following rules. For interest rates, first outliers removed in the lower tail by omitting observations with exactly zero interest rates (0.91% of the total observations), and then removing the same percentage of observations in the upper tail. For the other variables (operating profits and net worth), the top and bottom 1% of all the observations are removed. After making the above adjustments, we finally obtain a panel data set whose structure is described in Table 1. The sample starts with about 240 000 firms in 1997, a number which declines by about 8 000 firms per year,8 finally numbering about 200 000 in 2002. Below the major variables employed in the analyses are explained. •

Borrowing Cost The CRD does not provide borrowing cost information for each individual loan contract. To calculate the borrowing cost, we divide interest payments for a year by the average of total borrowing outstanding (including discounted notes receivable) at the end of the current and previous years.

•

Birth Year and Firm Age The year when a firm is registered at the Legal Affairs Bureau is defined as its birth (cohort) year. The difference between the current year and the cohort year is the age of the firm. The number of firms that are very old or very young is quite limited, and thus, we mainly focus on the samples with cohort years between 1950 and 1995.

•

Operating Profit These performance variables are proxies for the quality of a firm. Operating profit are defined as business profits divided by the value of total assets outstanding.

•

Table 2 shows summary statistics for these variables. The mean borrowing cost for all firms is 2.83%, and there is a substantial difference in performance between the surviving and defaulting firms. The performance of defaulting firms,

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in terms of default probability and operating profit, is markedly worse than that of surviving firms.

Hypothesis tests Natural selection implies that lower quality firms are required to pay higher borrowing costs, and eventually forced to exit the market. Therefore, whether selection is natural or unnatural depends on how different surviving firms are from defaulters in terms of firms’ borrowing costs and performance. Specifically, one can say that selection is unnatural if:

Ei∈S ( t ,τ ) Ri (t ,τ ) − Ei∈D (t ,τ ) Ri (t ,τ ) > 0,

(2-1)

and natural otherwise. The first term is the expected value of the borrowing cost (R) paid in year t by the firms born in year τ that survive into year t+1. The second term represents the expected value of R for the firms born in year τ that default in year t+1. In terms of performance, selection is unnatural if:

Ei∈S ( t ,τ )Qi (t ,τ ) − Ei∈D ( t ,τ )Qi (t ,τ ) < 0,

(2-2)

where Q is a variable representing the firm's performance (higher Q means better performance), such as operating profit. Table 3 presents the results of a one-tailed t-test against the null hypothesis that equation (2-1) holds. Similarly, Table 4 presents the results against the null hypothesis that equation (2-2) holds. In both cases we can reject the null hypotheses, not only for the entire sample, but also for almost all sub-samples divided by cohort years and industries. For the entire sample, defaulters pay higher borrowing costs than survivors by 0.6%, while they have lower operating profit by 2.3%. One of the few exceptions is the real estate industry, where one cannot reject the null hypothesis for borrowing costs, although one can safely reject it for operating profit. Hence, with a few minor exceptions, one observes that low quality SMEs are separated and pay higher borrowing costs, and are eventually forced out of the market, which improves the overall efficiency of the credit market. Interest payments charged by financial institutions distinguish between good and bad firms, and facilitates the proper selection of SMEs. These findings are strong evidence for natural selection is occurring in the SME credit market.

Effectiveness of government interventions9 In this section, the paper examines the role played by the government in the credit market. Government interventions often aim to facilitate the flow of funds to SMEs, which is expected to stimulate profitable investments and to increase economic efficiency. In spite of abundant theoretical literature on how interventions affect economic efficiency,10 empirical evidence on the effectiveness of federal credit programmes has been rather hard to come by.11 The Japanese government, in an effort to stimulate the flow of funds to the small business sector, temporarily implemented a massive credit guarantee programme that was unprecedented in both scale and scope. Because the programme was accessible by nearly every small firm, it was possible to clearly identify the policy effect. Utilising a new panel data set of Japanese firms, which

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96 – PART II: SELECTED PAPERS covers the implementation period of the programme, the effectiveness of the programme is empirically tested.

The Special Credit Guarantee Programme In the 1990s, as the Japanese economy entered a period of prolonged stagnation, public guarantees were frequently included in government economic stimulus packages. This culminated with the introduction of the Special Credit Guarantee Programme for Financial Stability (SCG programme), which ran from October 1998 to March 2001. The purpose of the measure was to alleviate the severe credit crunch faced by the small business sector. Beneficiaries of the programme were subject to little in the way of collateral or third-party guarantor requirements. The scale of the SCG programme, in terms of funding, was unprecedented. It is presumably the largest single credit guarantee programme ever implemented in any country. Funding was initially capped at 20 trillion yen, but, in 1999, the cap was increased to 30 trillion yen. Another unique feature of the SCG programme was its loose examination policy. An applicant could be rejected for a guaranteed loan only under certain conditions: significantly negative net worth, tax delinquency, default, or window dressing of balance sheets.12 Needless to say, it was very difficult to be rejected. In most cases, the credit risk of an applicant was no longer a concern for approval, which meant that there was virtually no incentive for a risky firm to masquerade as an eligible firm to obtain funding. Hence, an astonishing number of small businesses (1.7 million approvals totalling about 28.9 trillion yen in guaranteed loans) benefited from the SCG programme. It is clear that the introduction of the SCG programme led to a significant increase in the amount of guaranteed loans.

Investment versus adverse selection effect Based on the above characteristics of the SCG programme, this paper compares the positive and the negative impact of government intervention. The positive effect of the programme was that the 100% repayment ratio to the default amount reduced the borrowing cost to the risk-free rate. As the market interest rate falls, loans are more available and more investment projects are undertaken. However, profitability of each undertaken project depends on the creditworthiness of the firm. Low creditworthy firms are less likely to repay the debt as they are more likely to default. Since their expected cost of repayment is low, they are allowed to undertake less profitable projects. In contrast, high creditworthy firms are more likely to repay the debt and need to implement only profitable projects to break even. In sum, loans and projects are uniformly more available among programme users, and efficiency improvement is expected only among high creditworthy firms. This is referred to as the “investment effect”. On the other hand, a series of media reports have exposed the blatant misuse of funds by some borrowers, suggesting the negative aspect of the programme. Some borrowers made stock investments with loans guaranteed for daily company operations (Nikkei Financial Newspaper, February 16, 2000), others filed for bankruptcy less than one month after receiving loans (Nikkei Newspaper, January 11, 1999), and finally some, who were in no need of financing, simply obtained the loans because they could (Nikkei Newspaper, January 11, 1999). Most of these abuses can be attributed to information problems, which were worsened by the SCG programme. Inherently, informational asymmetries exist between lenders and SMEs. Two features of the programme magnified THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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these effects. First, due to the complete coverage of default costs by the credit guarantee corporation, private financial institutions had no incentive to properly screen or monitor their borrowers. Secondly, since the number of SCG applications was enormous due to the generous guarantee conditions, it was impossible for the credit guarantee corporations to adequately examine the credit risk of each applicant. One of the typical realisations of worsening information asymmetries is adverse selection, where creditworthy firms are excessively discouraged from undertaking profitable projects and less creditworthy ones are excessively encouraged to undertake unprofitable projects. The changes wrought upon the market by the adverse selection effect are unequivocally efficiency-reducing. In sum, more loans and projects are undertaken by high risk firms, while a smaller number of them are undertaken by low risk firms, all of which reduce economic efficiency. This is referred to as the “adverse selection effect.” Table 5 summarises the “investment effect” and “adverse selection effect.” Hereafter, the paper examines which of these effects is stronger.

Data A firm-level, balanced panel data set is constructed based on the Survey of Financial Environments. In conducting this survey, the SMEA sends questionnaires to 15 000 corporations annually and typically receives 7 000 to 8 000 replies. The 2001 survey includes a question on whether the firm made use of the SCG programme between October 1998 and March 2001. Based on the answer to this question, the entire sample of SMEs is divided into two groups: (1) SCG users and (2) Non SCG users. The sample is made up of 1 344 SCG user firms and 2 144 non-SCG user firms. For each responding firm in the 2001 survey, annual balance sheet data is added, provided by the Tokyo Shoko Research Incorporated, from 1997 to 2003. Summary statistics for users and non-users are shown in Table 6. Then, the sample is further divided into three periods: (t-1) the precrisis period (January 1997 and December 1998), (t) the crisis period (January 1999 and December 2001), and (t+1) the post-crisis period (January 2002 and December 2003). The crisis period roughly coincides with the period of the SCG programme.

Hypothesis tests To test the effect of the SCG programme on both the allocation of credit and efficiency, the paper considers the following variables: •

Leverage (Total liabilities/ Total assets;%).

•

Long-term borrowing ratio (Long-term loans / Total assets;%).

•

Fixed tangible asset ratio (Fixed tangible assets / Total assets;%).

•

ROA (Business profit / Total assets;%).

The first two of these variables are measures of credit allocation. Firm investment is measured with the fixed tangible asset ratio. We use the rate of return to measure economic efficiency. The idea is that if the SCG users efficiently allocate guaranteed loans, they will be more profitable. To test the theoretical predictions of the model, the time series development of each variable is first calculated by comparing their pre-crisis values to their post-crisis values. Then the differences across users and non-users are calculated.

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98 – PART II: SELECTED PAPERS In Table 7, the paper summarises the development of these variables over the sample period after controlling for industry, region and year. Looking at the credit allocation variables, one can see that users of the programme, relative to non-users, became increasingly more dependent on loans. Users increased their leverage by 2.71%, while non-users decreased their leverage by 1.35%. SCG users, therefore, increased their holdings of debt by 4.06% more than non-users. Furthermore, users increased their dependence on long-term loans by more than non-users, as shown by the 2.49% increase in the long-term borrowing ratio for users, and the 1.31% decrease for non-users. These findings are consistent with the set-up of the programme. The SCG programme allowed financial institutions to extend five- to seven-year guaranteed loans. Note that the differences in leverage and long-term loans between users and non-users are significant at the 1% level. One can also find that SCG users increase their fixed tangible asset ratio by 0.70% more than non-users. Notably, the numbers also reveal that ROA increases by 0.69% for users, while it decreases by 0.33% for non-users, or a difference of almost 1%. The developments in ROA significantly differ between users and non-users at the 1% level. Since the theoretical predictions of the model depend on the repayment probability of the firm, to more clearly determine the effectiveness of the programme one must further divide the sample according to the riskiness of the firm. The capital ratio is used as a proxy for creditworthiness, with high capital ratios corresponding to low-risk firms and low capital ratios corresponding to high-risk firms. The model predicts that under the investment effect, high capital ratio firms possibly become more efficient, while low capital ratio firms become less efficient. In addition, the capital ratio is crucial for controlling selection bias. The difference-in-means estimator, presented in Table 6, is only consistent when the SCG user samples are chosen randomly. In most cases, however, randomisation of the policy treatment is not feasible even when a policy programme is accessible by every firm. A firm’s decision on whether or not to apply for a programme is based on the expected benefit to the firm of that programme, and the expected benefit depends on each firm’s characteristics. In this case, the benefit of the SCG programme is dependent upon the creditworthiness of a firm, which is relevant for loan availability. Less creditworthy firms are often credit rationed by private financial institutions, and, thus, greatly benefit from the programme. Hence, by sub-dividing the sample by the capital ratio, it is possible to control for a significant portion of the selfselection bias.13 In Table 8, the paper presents summary statistics for loan allocation, investment, and profitability for each quartile of net worth. One can still find that, regardless of the precrisis capital ratio, SCG users are more likely to increase their leverage and their use of long-term loans. For all levels of the capital ratio, these variables significantly differ across users and non-users at the 1% level. One can also still find that, except for the highest capital levels, investment, as measured by the change in the fixed tangible asset ratio, increases more among users than non-users. Finally, one finds that profitability depends crucially on the ex-ante capital ratio. SCG users are more likely to improve their ROA when their net worth is high, while the ROA for users is more likely to fall when net worth is low. Overall, these findings are more consistent with the investment effect rather than the adverse selection effect. When the availability of loans is considered, there is, uniformly, a more sizable dependence on loans, particularly long-term loans, among the programme users. In addition, the results provide evidence that lower risk firms become more THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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efficient, while higher risk firms become less efficient following the introduction of the programme. This contrasts strongly with the publicly held view that the programme worsened informational asymmetries in Japanese credit markets and led to a misallocation of funds in the economy. It should be noted that the period of analysis was characterised by a large amount of non-performing loans in the financial sector. In this environment, financial institutions may have been perversely motivated to keep lending to the riskiest (doomed-to-fail) programme participants in an effort to avoid having to increase their loan loss reserves. This bank policy of “evergreening” loans results in the riskiest firms making heavy use of the programme, which possibly reduces the overall efficiency of SCG users. In spite of this possible bias, however, one still finds that the positive effects of the programme dominate the negative ones.

Conclusions It is clear that SMEs in Japan remain heavily dependent on the funding from financial institutions. The findings of this paper is that the debt market functions in an efficient manner may be good news for borrowers and lenders. Why? This is so is much more difficult to answer. There are possibly a few things worth mentioning. First, most of individual SME loans are too small to be renegotiated in times of distress, which limits the extent of forbearance lending. Loans extended to large-sized firms are often repeatedly renegotiated because their loss realization significantly impairs banks’ balance sheets. In contrast, SME loans are not so problematic for banks. This could explain why we observe natural selection among SMEs, and unnatural selection among large-sized firms. Other countries may benefit from this information when assessing their own credit markets. It is possible to infer from our evidence that the relative size of lenders to borrowers matters. Secondly, for credit guarantee programmes to be efficiencyimproving, reputations must play an important role. Bank reputations are crucial because banks and guarantee corporations play repeated games. If a bank constantly brings applications by doomed-to-fail firms to a guarantee corporation, which incurs heavy losses on the corporation, the bank’s future applications are more likely to be rejected. This implies that there exists non-pecuniary default cost shared by financial institutions, even with the current 100% guarantee coverage. This reputation story is actually consistent with the fact that credit guarantee users are more frequently monitored by banks than non-users. Though this paper finds strong evidence of the efficiency of the SME credit market, we do acknowledge that further improvements are needed, especially in the pricing of loans. The paper has found that government interventions significantly alleviate the credit crunch by increasing the availability of long-term financing. In contrast, no evidence can be found that the credit guarantee programme reduced interest rates.14 One possible explanation is that banks who usually act on behalf of small businesses in the filing of guarantee applications gain bargaining power and, as a result, are able to demand payments above the risk free rate. If this is the case, excessively high interest payments may discourage Japanese SMEs from undertaking more profitable projects, and thus, increasing economic efficiency. This is more of a serious concern among lenders and borrowers in Japan, where the economy is overcoming deflation, and where it is expected that interest rates will increase significantly after many years of the zero-interest rate policy set by the Bank of Japan.

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Tables Table 1: Number of observations

Year

All Firms 1997 1998 1999 2000 2001 2002

240,384 232,811 224,005 215,404 208,644 203,337

Total

1,324,585

Surviving Firms Defaulting Firms Default Ratio (%) 232,811 7,573 3.150 224,005 8,806 3.782 215,404 8,601 3.840 208,644 6,760 3.138 203,337 5,307 2.544 203,337 1,287,538

37,047

2.797

Table 2: Summary statistics

All Firms Mean Std. Dev.

Variables: Borrowing Cost (%) Default Probability (%) Prime Rate (%) Age Assets (1,000 Yen) Number of Employees Operating Profit (%) Net Worth (%)

2.83 (1.22) 1.94 (3.23) 2.38 (0.59) 23.16 (13.44) 594550.30 (1113733.00) 23.87 (35.27) 0.40 (7.72) 8.95 (30.17)

Surviving Firms Mean Std. Dev. 2.82 (1.21) 1.84 (3.02) 2.38 (0.59) 23.27 (13.44) 600352.50 (1119771.00) 24.18 (35.54) 0.46 (7.65) 9.51 (29.71)

Defaulting Firms Mean Std. Dev. 3.45 (1.63) 5.40 (6.68) 2.42 (0.54) 19.75 (12.92) 389908.00 (849531.90) 12.94 (21.40) -1.56 (9.81) -11.49 (38.56)

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1) Standard errors are in parentheses 2) a: Significant at the 1 percent level. b: Significant at the 5 percent level. c: Significant at the 10 percent level.

Service

Real Estate

Retail

Wholesale

Manufacturing

Construction

All

Table 4: One-tailed t-Test for Operating Profit Cohort 1950－1955 1956－1960 1961－1965 1966－1970 1971－1975 1976－1980 1981－1985 1986－1990 1991－1995 2.113 a 1.897 a 1.973 a 1.264 a 1.596 a 1.879 a 2.170 a 1.993 a 2.291 a (0.219) (0.257) (0.222) (0.190) (0.169) (0.175) (0.182) (0.162) (0.202) 0.952 c 0.942 c 1.911 a 0.195 1.249 a 1.193 a 1.457 a 0.927 a 1.322 a (0.590) (0.656) (0.473) (0.377) (0.316) (0.308) (0.332) (0.295) (0.353) 2.951 a 3.060 a 2.524 a 1.519 a 1.782 a 1.981 a 3.069 a 2.336 a 2.892 a (0.408) (0.451) (0.407) (0.378) (0.347) (0.386) (0.410) (0.373) (0.527) 2.084 a 1.144 a 2.068 a 2.132 a 1.413 a 2.637 a 2.267 a 1.831 a 2.089 a (0.339) (0.442) (0.439) (0.381) (0.386) (0.392) (0.415) (0.394) (0.515) 1.132 b 1.127 c 1.889 a 0.595 2.454 a 1.908 a 1.811 a 3.131 a 3.172 a (0.579) (0.749) (0.672) (0.580) (0.525) (0.522) (0.527) (0.461) (0.546) 5.301 a 2.168 b 0.944 3.998 a 2.491 a 2.150 a 1.240 b 0.850 c 4.317 a (1.378) (1.023) (0.855) (0.642) (0.577) (0.652) (0.635) (0.585) (0.889) 2.645 a 1.793 c 1.715 b 2.021 a 1.351 b 3.447 a 2.338 a 2.976 a 2.974 a (1.072) (1.208) (0.963) (0.744) (0.671) (0.657) (0.596) (0.495) (0.595)

1) Standard errors are in parentheses 2) a: Significant at the 1 percent level. b: Significant at the 5 percent level. c: Significant at the 10 percent level.

Service

Real Estate

Retail

Wholesale

Manufacturing

Construction

All

1950－1955 1956－1960 -0.410 a -0.529 a (0.032) (0.038) -0.348 a -0.674 a (0.097) (0.104) -0.529 a -0.521 a (0.054) (0.058) -0.401 a -0.598 a (0.058) (0.076) -0.386 a -0.594 a (0.082) (0.112) 0.404 0.185 (0.247) (0.201) 0.222 -0.318 b (0.151) (0.167)

Table 3: One-tailed t-Test for Borrowing Costs Cohort 1961－1965 1966－1970 1971－1975 1976－1980 1981－1985 1986－1990 1991－1995 -0.521 a -0.614 a -0.562 a -0.600 a -0.614 a -0.689 a -0.729 a (0.032) (0.029) (0.027) (0.027) (0.027) (0.023) (0.027) -0.510 a -0.646 a -0.626 a -0.802 a -0.770 a -0.879 a -0.847 a (0.071) (0.059) (0.050) (0.048) (0.050) (0.041) (0.048) -0.568 a -0.748 a -0.618 a -0.614 a -0.531 a -0.649 a -0.706 a (0.052) (0.052) (0.050) (0.055) (0.058) (0.051) (0.069) -0.418 a -0.587 a -0.616 a -0.535 a -0.689 a -0.559 a -0.623 a (0.071) (0.065) (0.067) (0.066) (0.068) (0.064) (0.076) -0.598 a -0.574 a -0.488 a -0.549 a -0.477 a -0.651 a -0.578 a (0.097) (0.084) (0.079) (0.077) (0.072) (0.063) (0.068) 0.607 -0.009 0.179 0.279 0.033 -0.511 a -0.865 a (0.178) (0.126) (0.119) (0.126) (0.124) (0.106) (0.175) -0.227 b -0.464 a -0.406 a -0.278 a -0.516 a -0.437 a -0.521 a (0.134) (0.113) (0.098) (0.092) (0.080) (0.064) (0.072)

All 2.320 (0.057) 1.448 (0.116) 2.934 (0.112) 2.171 (0.121) 2.388 (0.170) 2.464 (0.226) 2.797 (0.215)

All -0.613 (0.008) -0.726 (0.017) -0.612 (0.015) -0.570 (0.020) -0.523 (0.024) -0.050 (0.044) -0.405 (0.029)

a

a

a

a

a

a

a

a

a

a

a

a

a

PART II: SELECTED PAPERS - 101

102 – PART II: SELECTED PAPERS Table 5: Predicted effects of a Credit Guarantee Programme

Firm Type

Investment Effect +

Adverse Selection -

+

+

H

+ (possibly)

-

L

-

-

Loan Allocation & Newly H Undertaken Projects L Efficiency

Note: H firms are high credit-worthy firms and L firms are low credit-worthy firms.

Table 6: Summary statistics

User Non-user All Mean Mean Mean Std. Dev. Std. Dev. Std. Dev. 1,951,822 4,092,362 3,266,990 Asset (1 Thousand Yen) (3,175,077) (6,959,977) (5,893,597) 2,226,895 4,131,651 3,397,094 Sales (1 Thousand Yen) (3,033,945) (5,822,400) (5,023,496) 51.85 86.24 72.97 Number of Employees (55.88) (104.75) (90.68) 34.50 37.19 36.15 Age (years) (14.04) (14.58) (14.43) 1.86 2.61 2.32 ROA (business profit / total asset; %) (4.91) (5.63) (5.38) 82.96 65.94 72.50 Leverage (liabilities / total asset; %) (18.01) (24.23) (23.54) 17.05 20.60 Short-term borrowing to total asset ratio (%) 26.26 (19.75) (17.83) (19.13) 17.14 22.23 Long-term borrowing to total asset ratio (%) 30.36 (19.77) (18.56) (20.09) 2.83 2.58 2.69 Interest payment rate (interest payment / total borrowings; %) (2.30) (3.58) (3.12) 30.30 30.57 30.47 Fixed tangible asset to total asset ratio (%) (19.64) (21.08) (20.54) Number of Observations

9,408

15,008

24,416

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Table 7: Development of variables between pre and post crisis periods

Pre-crisis

Post-crisis

Difference (Post-Pre)

Leverage (%)

User Non-user

Long-term borrowing ratio

User Non-user

Fixed tangible asset ratio (%)

User Non-user

ROA (%)

User Non-user

Notes: 1. 2. 3. 4.

8.93 (15.81) -5.07 (21.75) 6.82 (18.20) -4.08 (17.58) -0.10 (17.84) -0.10 (18.10) -0.75 (4.30) 0.42 (4.95)

11.64 (19.70) -6.42 (25.12) 9.31 (19.05) -5.39 (17.88) 0.29 (18.78) -0.41 (18.90) -0.06 (4.42) 0.08 (5.04)

2.71 (11.76) -1.35 (14.05) 2.49 (13.67) -1.31 (12.70) 0.39 (9.76) -0.31 (9.22) 0.69 (5.25) -0.33 (5.47)

t-test (User vs. NonUser) 4.06a (0.45)

3.79a (0.47)

0.70b (0.34)

1.02a (0.19)

We display the mean values for each variable. Standard errors are in parentheses. Each variable is a residual from a regression on year, industry and region dummies. a, b, and c represent significance at the 1% level, 5% level, and 10% level, respectively.

Table 8: Development of variables between pre and post crisis periods, by capital ratio

Leverage (%) Long-term borrowing ratio Fixed tangible asset ratio (%) ROA (%) 1. 2. 3.

All +4.06 a

Lowest +3.50 a

2nd quartile +2.84 a

3rd quartile +4.74 a

Highest +3.42 a

+3.79 a

+3.61 a

+2.64 a

+3.98 a

+4.03 a

+0.70 b

+0.65

+0.93

-0.53

+1.14

+1.02 a

-0.11

-0.28

+0.94 b

+0.49

The mean values are displayed for each variable. Standard errors are in parentheses. Each variable is a residual from a regression on year, industry and region dummies. a, b, and c represent significance at the 1% level, 5% level, and 10% level, respectively.

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104 – PART II: SELECTED PAPERS

References Caballero, R., Hoshi, T., and Kashyap, A., (2004), “Zombie Lending and Depressed Restructuring in Japan,” Working Paper. Cowling, M. and Mitchell, P., (2003), “Is the Small Firms Loan Guarantee Scheme Hazardous for Banks or Helpful to Small Business?” Small Business Economics, Vol. 21, 63-71. Craig, B. R., Jackson, W. E., and Thomson, J. B., (2005), “SBA-Loan Guarantees and Local Economic Growth,” Federal Reserve Bank of Cleveland Working Paper 05-03. Gale, W. G., (1991), “Economic Effects of Federal Credit Programmes,” American Economic Review, Vol. 81, No. 1, 133-152. Innes, R., (1991), “Investment and Government Intervention in Credit Markets When There is Asymmetric Information,” Journal of Public Economics, Vol. 46, 347-381. Mankiw, G. N., (1986), “The Allocation of Credit and Financial Collapse,” Quarterly Journal of Economics, Vol. 101, No. 3, 455-470. Matsuura, K. and Hori, M., (2003), “Tokubetsu Shinyo Hosho to Chusho Kigyo Keiei no Sai Kochiku,” (Special Credit Guarantee and Restructuring of Small Firms), ESRI Discussion Paper Series No.50, (in Japanese). Nishimura, K., Nakajima T., and Kiyota, K., (2003), “Ushinawareta 1990-nen dai, Nihon Sangyo ni Nani ga Okottanoka?” (What Happened to the Japanese Industry in the Lost 1990s?), RIETI Discussion Paper Series, 03-J-002, (in Japanese). Ono, A. and Uesugi, I., (2005), “The Role of Collateral and Personal Guarantees in Relationship Lending: Evidence from Japan’s Small Business Loan Market,” RIETI Discussion Paper Series 05-E-027. Peek, J. and Rosengren, E. R., (2004), “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan,” American Economic Review, Vol. 95, No. 4, 11441166. Riding, A. L. and Haines, G. Jr., (2001), “Loan Guarantees: Costs of Default and Benefits to Small Firms,” Journal of Business Venturing, Vol. 16, 595-612. Sakai, K., Uesugi, I., and Watanabe, T., (2005), “Firm Age and the Evolution of Borrowing Costs: Evidence from Japanese Small Firms,” RIETI Discussion Paper Series 05-E-026. Sekine, T., Kobayashi, K., and Saita, Y., (2003), “Forbearance Lending: The Case of Japanese Firms,” Monetary and Economic Studies, 21(2), 69-91. Smith, B. D. and Stutzer, M. J., (1989), “Credit Rationing and Government Loan Programmes: A Welfare Analysis,” AREUEA Journal, Vol. 17, No. 2, 177-193. Uesugi, I., Sakai, K., and Yamashiro, G. M., (2006), “Effectiveness of Credit Guarantees in the Japanese Loan Market,” RIETI Discussion Paper Series 06-E-004. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Notes: 1 Valuable comments by Koji Sakai and Guy M. Yamashiro are gratefully acknowledged. 2 This section is based on Sakai, Uesugi, and Watanabe (2005). 3 Needless to say, the term “natural selection” is borrowed from evolutionary biology. Even with non-trivial differences between industrial and biological evolution, the authors think this analogy is useful for readers to clearly understand their exercises. 4 Note that, in Peek and Rosengren (2005), selection, whether it is natural or unnatural, does not imply exit from markets: unnaturally selected firms (with poor performance) increase debts but continue in the market. This is presumably because their sample is limited to publicly traded firms which seldom default. 5 An exception is Nishimura et al (2003) who uses a data set containing small firms. The “Basic Survey of Firm Activities,” from which they take data, does not include, however, information on default events. Thus, it is not possible to identify defaulters and non-defaulters in a reliable way. 6 The CRD was established in 2001 at the initiative of the Small and Medium Enterprises Agency of Japan (SMEA) in order to provide financial institutions with detailed and reliable P/L and B/S information about small businesses, thereby enabling financial institutions to accurately estimate default probabilities. 7 There were about 1.6 million small- and medium-sized corporations in Japan as of 2001, of which the CRD covers 0.9 million. 8 The default rates are two to four percent per year. 9 This section is based on Uesugi, Sakai, and Yamashiro (2006). 10 For example, see Mankiw (1986), Gale (1991), Smith and Stutzer (1989), and Innes (1991). 11 Among the many possible instruments used in credit market interventions, credit guarantee programmes are the most frequently investigated. For example, Craig et al (2005) examine the effectiveness of these programmes in the U.S., Cowling and Mitchell (2003) do so for the U.K., Riding and Haines (2001) for Canada, and Matsuura and Hori (2003) for Japan. Most of these studies, however, do not have control samples even when they have access to firm-level data. 12 This list of “negative” conditions was also unprecedented. 13 In Uesugi, Sakai, and Yamashiro (2006) the authors carefully treat the non-random sample selection by using a two-step estimation procedure, which yields similar results as those in Table 3-4. 14 This is not limited to the provision of public credit guarantees. Provision of collateral and personal guarantees does not significantly reduce the interest payments either. For details, see Ono and Uesugi (2005).

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106 – PART II: SELECTED PAPERS

The Role of State-Funded Credit Guarantee Schemes for SMEs: Italy’s Experience

Mr. Salvatore Zecchini Professor of International Economic Politics, University of Rome Tor Vergata, Rome, Italy Mr. Marco Ventura Researcher, ISAE [Istituto di Studi e Analisi Economica (The Institute for Studies and Economic Analyses)], Rome, Italy This essay provides an in-depth evaluation of the impact of public credit guarantees to SMEs in increasing credit availability, reducing borrowing costs and attaining financial sustainability. Extensive econometric tests have been carried out by comparing the performance of the SMEs that benefited from this guarantee in Italy with a sample of comparable firms. The findings confirm the presence of a causal relationship between the public guarantee and the higher debt leverage of guaranteed firms, as well as their lower debt cost. Italy’s guarantee instrument has proved to be an effective instrument, although it has had a limited economic impact.

Introduction Is state intervention or a state-funded guarantee scheme a necessary and effective instrument to promote lending to small firms? In the economic literature, there is no consensus on the answers to these questions. Theoretical and empirical studies lead to different views. On the one side, it is argued that credit guarantee schemes (CGSs) are costly instruments that pose problems of financial sustainability. At the same time, benefits have yet to be proven, as there is no conclusive evidence about the contention that they allow additional lending to financially constrained SMEs (Vogel-Adams,1997 and Llisterri, 1997). In any case, they should not be viewed as a substitute for correcting financial market or legal system failures that are at the source of credit rationing. On the other side, CGSs are seen as capable of opening new access to credit, although they can be effective only under a well-specified set of conditions concerning their operations (Holden, 1997 and Levitsky, 1997). Against this background, this essay investigates whether Italy’s state-funded guarantee scheme for SMEs (SGS) is an effective means to overcome the main difficulties faced by small firms in accessing the bank credit market. This means THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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assessing whether SGS is able to increase credit access for SMEs, to reduce credit cost and to achieve financial sustainability. Accordingly, in the following section an outline of the Italian guarantee system is presented, highlighting its operating features. Next, an analysis of its activities, focusing on their magnitude and on the disadvantaged groups of firms that have benefited from the scheme, is presented. In the fourth section, the analysis focuses on the costs inherent to this scheme, while in the fifth and sixth sections, an econometric test is presented concerning the SGS’ role in easing SMEs’ financial constraints. In the concluding section, it is underscored that this analysis lends support to the contention that such a scheme had a positive, albeit limited, impact. The limited effect is, however, attributable to the particular features that govern the guarantee scheme.

The Italian guarantee system Italy’s universe of credit guarantee institutions tends to form a multi-pillar and multilayer system based on a mix of private and public funding. It is not an outright system because no specific network agreement or legal constraint exists in order to bring together all these entities within the framework of a system. Three pillars can be identified: a) the mutual guarantee institutions (MGI), that are associations of small entrepreneurs willing to mutually share their debt risk as a way to improve their access to credit market; b) the banks and other financial companies, that provide guarantee services to the enterprise sector; and c) the public funds, set up at state and regional government levels, for the purpose of offering guarantees, i.e., insurance and/or reinsurance services, to institutions that lend to SMEs or to MGIs. As private, mutual guarantee schemes are expensive and risky, public money is the true engine of the entire system. The government gives financial support through two channels: by contributing to the funding of MGIs and by financing the public guarantee schemes, at both central and regional levels, with the primary objective of allowing for a counter-guarantee (namely, a re-insurance) in the MGIs’ guarantees. The system actually works as a multi-layer structure. At the grassroots level, both MGIs and banks provide guarantees. But MGIs fulfil a special function. They act as a facilitator in the bank-SME relationship by providing potential borrowers with both a guarantee and the benefit of an interest rate reduction. At the same grassroots level, there are also banks that sell credit insurance to firms on their own. The particular value of a MGI guarantee derives from three features: the deep assessment that the guarantor can make on the firm’s creditworthiness due to its access to inside information, the close monitoring of the firm’s business conditions after the loan, and the mutual responsibility of all participating firms. At present, more than 1 000 MGIs are officially registered, but around 600 are actually operational. They are spread throughout the country and constitute a network that covers almost all economic sectors (Zecchini, 2002). At the second level of the guarantee system, there are second-tier MGIs, that are set up by groups of the same institutions. Their function is to reinsure (i.e., to counterguarantee) MGI guarantees in order to reach a broader sharing of the financial risk involved, as each MGI covers a narrow range of enterprises. At the same level, there are reinsurance entities that are funded by regional governments. Banks can, however, bypass THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

108 – PART II: SELECTED PAPERS second-tier MGIs and these regional entities, and apply for a direct guarantee from a state-supported guarantee fund. Three such funds are in operation and constitute the system’s third level: one is the central “Fund for Guarantee to SME” (SGS), that aims at SMEs in general, another aims exclusively at the craft sector, still another at the agricultural sector. Each of them acts as a sort of guarantor of last resort for a specific enterprise category. The focus of this analysis is just on the SGS, that is the largest one among the three and is funded only by the central government1. A number of strict conditions apply to the SGS’ operations as to the beneficiaries and the nature of the guarantee (Table1). Table 1. Characteristics of the fund Degree of discretion in lending Eligibility conditions

Guarantee coverage rates

S S S S S S S S

Fees

S Types of guarantee

Priority sectors

Nature of the guarantee Funding

S S S S S S S S S S S S S

The fund decides on bank’s and MGIs’ proposals, according to a pre-specified scoring system, or set of indicators.

Only small and medium-sized firms, as defined by EU regulations, and SME consortia. Sound economic and financial conditions. The following sectors are excluded: coal and steel, shipbuilding, synthetic fibres, automobile, transport. Guarantee ceilings are applied to the following sectors: car components, food industry and related trade. In less developed areas: up to 80% loan for direct guarantees; up to 90% for MGIs’ guarantees, that cannot, however, go beyond 80%of the loan. In rest of the country: up to 60% of loan for direct guarantees; up to 90% for MGIs’ guarantees, that cannot, however, go beyond 60% of the loan. No fee in the less developed areas. In areas in economic decline, once only: 0.125% of loan for micro firms; 0.125% for equity and participatory debt, and 0.25% loans to small firms; 0.25% for equity and participatory debt, and 0.50% of loans to medium firms and consortia of firms. In the rest of the country, once only: 0.25% of loan for micro firms; 0.25% for equity and participatory debt, and 0.50% loans to small firms; 0.50% for equity and participatory debt, and 1.00% of loans to medium firms and consortia of firms. Direct guarantee to banks Counter-guarantee to MGIs. Co-guarantee with MGIs. On equity participation or participatory debt. MGIs. Southern regions. Women entrepreneurs. Micro firms. Start-up. Digital economy firms. Subsidiary, after debt recovery procedure is completed. Direct since 2006. Annual allocations from state budget and levied fees.

Overall, from the regulatory standpoint, it appears that the scheme tends to be rather stringent in selecting its beneficiary firms, but without going as far as to target the most disadvantaged among the SMEs. The priority status that the regulations grant to some

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categories of firms (those of industry, trade and services, those guaranteed by MGIs, those owned by women, micro firms, start-ups) are in fact so broad as to be tantamount to covering the vast majority of potential demand. There is no attempt to reach those small firms that are mostly constrained in financing their investment projects, because of the risk element involved. Only in 2005, a special section of SGS was dedicated to innovative and risky sectors, such as the ICTs. Furthermore, the stringency of scoring parameters that are applied to the guarantee applications, leads to skimming the best credit risks among the eligible SMEs, making it particularly difficult to assess whether the most disadvantaged groups of firms, such as start ups and those operating in R&D fields, can actually rely on this scheme for gaining better access to credit. Of particular significance is that the SGS regulation does not give any strong preference to MGIs vis-à-vis banks and other financial institutions. Both groups are on the same level playing field. This is justified by the importance of banks in SME financing. However, it deprives the fund of a possible incentive effect, that could be achieved by giving priority to MGIs. Such a priority could induce more SMEs to resort, first, to MGIs for acquiring a guarantee. This would strengthen the sense of mutual responsibility among borrowing firms, since it would lead them to take part in institutions that aim at mutually sharing part of the financing risk, rather than shifting it directly to public funds.

The economic performance of the fund for guarantees to SMEs The fund’s guarantee capacity is currently EUR 233.5 millions. By applying a gearing ratio over its capital base, the fund has guaranteed loans amounting to 4.6 billions in its 6 years of operation. This corresponds to just around 3% of total lending that small enterprises belonging to the sectors covered by the fund were granted in 2005. Given the relative modesty of these figures, it is apparent that this mechanism is in no position to have a significant impact either on the economy, or on promoting entrepreneurship to a significant scale. The fund has, nevertheless, a strong potential to direct credit to certain disadvantaged sectors and enterprises that deserve credit, since it is run according to tight criteria aimed at reducing the risk of resource misuse. The guarantee coverage rate was actually limited to such an extent as to reduce the risk of sizeable losses. For the period 2000-04, the guarantee coverage was about 50% of the debt principal, with narrow yearly fluctuations around this average. In contrast, there was a large dispersion of coverage rates (from 25 to 88%) both, across firms of different size and across regions. This reflects a tendency to provide larger support to smaller borrowers. Medium-sized firms were the largest beneficiaries, with a 40.6% share exceeding their contribution to national product (16%). Small firms also obtained a share of guarantees (36.8%) that goes far beyond their 16% quota in Italy’s value added (Table 2). Some preferences were given to some disadvantaged groups, such as women in business (5% in 2004 and 3.8% on average), while a larger support was accorded to startup firms (12%) that are generally among the most credit-rationed firms because of their lack of a financial track record. Only 4.4% of guarantees went to firms in the highest admissible risk category. This allocation pattern can be interpreted as evidence that the fund showed a significant degree of risk aversion and paid more attention to banks’ credit supply THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

110 – PART II: SELECTED PAPERS preferences than to the unmet demand of more financially constrained firms. Guarantee allocation actually approaches an increasing function of firm size. Overall, the fund appears to have been used to support what already existed in industry and services, more than to open up new opportunities in technology, investment and production that involve higher risks and more innovative enterprises. What emerges is the picture of a public guarantee instrument that has served the purpose of giving assistance to an industrial sector under stress and to backward regions. It has not, however, promoted entrepreneurship and risk taking in innovative sectors to a significant scale. In any event, its effectiveness must also be measured in terms of its financial sustainability and its ability to add to the amount of loanable funds made available to small firms, as well as to lower their cost compared to other firms. Table 2. Allocation of guarantees and default distribution 2000-04 (percentages) Guaranteed loans

Guaranteed loans in default

100.00 40.59 36.84 22.45 0.12

100.00 50.39 29.39 20.22 -

100.00 49.00 27.00 24.00 -

0.19 25.43 3.79 11.76 28.82 29.49 0.52

4.51 36.86 3.89 12.75 19.13 22.86 0

35.56 24.44 0 24.44 4.44 11.11 0

MATURITY: - Short-term loan - Medium-term loan - Long-term loan - Equity participation

100.00 23.26 48.18 28.37 0.19

100.00 22.86 49.92 22.55 4.67

100.00 9.09 40.91 13.64 36.36

TYPE OF GUARANTEE: - Direct guarantee - Counter-guarantee - Co-guarantee

100.00 37.71 60.78 1.52

100.00 41.37 58.16 0.47

100.0 43.00 57.00 0

ECONOMIC SECTOR - Industry & Construction - Tourism - Trade & other services

100.00 70 11.14 17.98

100.00 74.00 11.00 15.00

100.00 85.00 10.00 5.00

BY AREAS: - North-West - North-East - Centre - South (Mezzogiorno)

100.00 45.74 14.31 13.65 26.3

100.00 55.21 13.53 9.95 21.31

100.00 64.00 2.00 17.00 17.00

Distribution by

SIZE: - Medium-sized firm - Small firm - Micro firm - Consortia of firms CATEGORIES OF FIRM: - Equity participation - SMEs (with lower credit score) - Women entrepreneurship - Start-ups - SMEs (with higher credit score) - MGIs (top of the group) - Micro credit

Fund’s loan repayment

Source: Elaborations based on fund’s data.

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Costs, subsidies and financial sustainability of the Guarantee Fund To be financially sustainable, a guarantee scheme has to break even by balancing costs with revenues, without shifting a significant portion of moral hazard and financial risk from the lender and the borrower to the taxpayer. From this vantage point, the fund’s performance has been satisfactory, as it can be seen by analysing costs and revenues. On the cost side, there are three main components: loan losses, administration expenses and the cost of servicing public debt that is incurred by the Government to endow the fund with its capital and to cover any fund’s losses2. The debt service component is particularly appropriate in Italy’s case, as the Italian Government has run a budget deficit for decades and has to cover them by borrowing in the financial markets. The degree of fund’s financial sustainability over the 5 year period can basically be assessed by drawing on the following equation: [1] L + A + I = F + O + S Where L = loan losses; A = administration expenses; I = public debt service cost (cost of use of borrowed capital); F = guarantee fees; O = other income, such as the return from the investment of reserves; and S = the amount of public subsidy to cover any losses. The subsidy component is the balancing item that allows the fund to avoid exhausting its capital base as a result of both annual losses due to the firm’s failure to repay the guaranteed loan and the fund’s operating expenses that are not covered by the fees. As to the losses deriving from non-repayment of loans, the fund’s performance is appreciable and much better than that of similar schemes in other European countries. Default losses as a ratio to fund’s guarantees3 are 0.25% for the period 2000-04 (Table 3), against percentages ranging from 2% in Germany to 10% in Spain (Oehring , 1997). Although the loss ratio shows a sharp upward trend after the first two years of the fund’s operations (Table 3), it remained at a relatively low level in 2005, hinting that at cruising speed it should not exceed 0.50% by far. After all, the guarantee system passed unscathed a period of serious economic stagnation, such as the first half of the current decade. The default ratio (i.e., defaulted loans as a ratio to guaranteed loans) is also much lower than that of Italy’s banking system, being 1.83% against 5.89% for banks’ loans to the private non-financial sector 4 (Table 3). The fund’s losses are heavily concentrated in loans to medium-sized enterprises (49%), while the lowest rate is among the micro firms (24%). This is consistent with data showing that loan default rates are an increasing function of the loan size, as well as of the guarantee size (Figure 1). The only exception is found in the smallest loan category (up to EUR 10 000), where there is the highest default rate but a relatively low loss rate, because the guarantee coverage rate was rather low. This might reflect the high risk involved in micro credit and the consequent cautious attitude adopted by the fund. By comparing guarantee distribution with default distribution, small firms appear to be less risky than bigger ones within the same SME group. Correspondingly, mediumsized firms experience a much higher share of defaults than their guaranteed loan share (Table 2). Defaults and losses also appear to rise with the loan maturity, but with a concentration in the second year of the loan, for both short- and medium-long term loan groups. As THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

112 – PART II: SELECTED PAPERS expected, the largest percentage of defaults is among the guarantees with longer maturities: 59% occur after the first two years of the loan. But this cannot be attributed just to the risk content inherent to the financed investment projects because 69% of the defaults are vis-à-vis loans for working capital needs. Table 3. Fund for Guarantees to SMES (Percentages)

Guarantee coverage ratio (1)

2000

2001

2002

2003

2004

Total

55.78

48.9

53.94

54.77

44.91

50.16

Loan default rate (2)

0

0.47

1.36

1.51

3.63

1.83

Repayment /Guarantees (3)

0

0

0.11

0.38

0.47

0.25

Loss/Loans (4)

0

0

0.06

0.19

0.21

0.12

Repayment rate (5)

0

0

4.3

12.29

5.8

6.81

1. Guarantees/guaranteed loans 2. Guaranteed loans in default/guaranteed loans 3. Fund’s loan repayments/guarantees 4. Fund’s loan repayments/guaranteed loans 5. Fund’s loan repayments/guaranteed loans in default Source: Elaborations based on fund’s data.

The largest portion of defaults pertains to industry, but in relative terms the default distribution by economic sectors is close to the corresponding guarantee distribution. Overall, size and economic sector of the firm matter more than other factors in explaining both guarantee allocations and default distribution. However, the assumption of smaller firms being riskier is not confirmed in the case of the fund, since medium-sized firms have a worse record. Such a result might reflect the fund’s approach to loan selection. Interestingly enough, the type of guarantee also seems to matter. Direct guarantees to banks present a higher delinquency rate than guarantees to MGIs. This appears in line with the assumption that MGIs have a better monitoring capacity over the participating firms and can therefore reduce lending risk. Such an effect has actually offset the impact of the high risk concentration that characterises these guarantors, since each MGI operates in a limited territory and with firms belonging mostly to the same economic sector or to complimentary sectors.

Credit additionality and interest cost reduction: Cross-section estimates To test for the fund’s role in widening credit access for SMEs and lessening borrowing cost, two econometric techniques are applied using financial data concerning a sample of SMEs. This is composed of both, firms that received the guarantee, and those that did not. The latter were split into two large groups: potential appliers (eligible) and non potential appliers (non eligible), according to their ATECO (sectoral) codes. Attempts to estimate the effects of Government credit programmes are not new in economic literature. They were carried out by Gale (1991), NERA (1990), Pieda (1992), KPMG (1999), Boocock and Shariff, (2005), Riding and Haines (2001), among others. Differently from these authors, this analysis is based neither on surveys, nor on an ad hoc model, but on the consolidated econometric literature of causal effects estimation. For a THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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technical discussion of this approach, please refer to the Technical Appendix and to Wooldridge (2002). The data for the econometric tests comes from those SMEs that received the fund’s guarantee for the full period of the fund’s existence5. As a simple OLS estimation does not allow to detect the presence of a causal relationship, a different approach is applied, i.e., the one by Angrist (1990) and AngristImbens-Rubin (1996). They prove that by resorting to a suitable instrumental variable (IV), under certain conditions, it is possible to “locally” insulate causal effects (see the Technical Appendix). The IV approach can single out the Average Treatment Effect (ATE) for some treated units, but not for the whole economy. In particular, it gives the average treatment effect for those units that are sensitive to the instrument, i.e. those firms that have changed status from non guaranteed to guaranteed because they were eligible. This local effect, called Local Average Treatment Effect (LATE), is actually relevant to our purpose. For this estimate, the dependent variable is measured in terms of the (log of) the ratio of the firm’s financial costs to its bank debt, since these are the most clearly identifiable cost figures in the AIDA data bank. Of course, a better choice would be the ratio of bankrelated financing costs to bank debt, but this requires a level of detail that is not available in our data set. Our indicator is, however, a good proxy because the bulk of SMEs’ financing is provided by banks. The following equation is estimated on the basis of a cross-section of the sampled SMEs for each year under consideration (indicated as time t). (1) rt = α + β1x1t + β 2 x 2 t + β 3 x 3t + β 4 x 4 t + .... + β 7 x 7 t + δd t + u t where rt Nx1 vector of (log of) the ratio financial costs/bank-related debt in year t x1t Nx1 vector of (log of) number of employees at time t x2t Nx1 vector of (log of) sales at time t x3t Nx1 vector of (log of) fixed assets at time t x4t Nx1 vector of (log of) intangible assets at time t x5t Nx1 vector of (log of) non bank-related financial debt at time t x6t Nx1 vector of (log of) net worth at time t x7t Nx1 vector of (log of) earnings at time t dt dummy variables, equal to 1 in the case of guaranteed firms at time t, and to 0 otherwise ut error term. Among the regressors, the firm’s size (measured by the number of employees) is a proxy of the degree of information available to allow an adequate appraisal of credit worthiness. Likewise, the fixed asset variable is introduced as an element that can influence banks’ expectations of loan recovery in case of default (Pozzolo, 2004). The earnings variable and the guarantee dummy are instrumented, by using for the earnings the data lagged 1 period in order to overcome simultaneity, and for dt, another dummy THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

114 – PART II: SELECTED PAPERS that takes on the value of 1 for the firms that are eligible for the fund’s guarantee, regardless whether firms received it or not, and zero otherwise. The cross-section OLS and IV estimates are reported in the following table for each year of the 2000-04 period. Table 4. Dependent variable: (log of) financial costs/bank debt Method Year α No. of employed Sales Fixed assets Intangible assets Non banking debts Net worth Earnings dt

# Obs

OLS 2000

OLS 2001

OLS 2002

0.25 (0.926) 0.16* (0.056) -0.14*** (0.082) -0.25* (0.047) -0.01 (0.023) 0.10* (0.030) 0.07 (0.049) 0.07** (0.028) -0.23** (0.117)

-0.75 (0.739) 0.02 (0.060) -0.12** (0.056) -0.16* (0.046) 0.02 (0.023) 0.10* (0.027) 0.04 (0.042) 0.06* (0.022) -0.24* (0.082)

-1.91* (0.608) 0.00 (0.061) -0.04 (0.058) -0.14* (0.042) 0.01 (0.023) 0.11* (0.022) 0.01 (0.046) 0.09* (0.023) -0.35* (0.081)

- 0.83 (0.713) 0.01 (0.059) -0.19* (0.063) -0.16* (0.045) 0.04 (0.026) 0.14* (0.026) 0.08 (0.057) 0.06** (0.024) -0.28* (0.105)

1 080

1 140

916

944

OLS 2003

OLS 2004

6

IV 2000

IV 2001

IV 2002

IV 2003

IV 2004

-0.64 (1.032) 0.05 (0.072) -0.15*** (0.076) -0.23* (0.062) 0.06** (0.026) 0.13* (0.027) 0.08 (0.065) 0.04 (0.036) -0.34* (0.089)

0.58 (1.075) 0.21* (0.074) -0.15 (0.099) -0.32* (0.070) 0.02 (0.029) 0.09** (0.037) 0.15** (0.072) 0.01 (0.059) -1.22 (1.258)

-0.44 (0.916) -0.01 (0.077) -0.18* (0.070) -0.22* (0.062) 0.06** (0.032) 0.13* (0.034) 0.03 (0.058) 0.16* (0.054) -0.11 (0.502)

-1.38** (0.692) 0.01 (0.054) -0.14** (0.072) -0.09** (0.044) 0.02 (0.028) 0.08* (0.025) 0.06 (0.066) 0.07 (0.059) -1.11** (0.541)

-1.16 (0.897) 0.00 (0.073) -0.24* (0.077) -0.18* (0.052) 0.08** (0.032) 0.15* (0.027) 0.14*** (0.078) 0.08 (0.057) -1.22* (0.476)

-0.10 (1.062) 0.13*** (0.070) -0.28* (0.083) -0.18** (0.072) 0.08* (0.028) 0.12* (0.030) 0.07 (0.105) 0.10 (0.086) -1.49* (0.580)

832

725

796

860

748

622

Note: Heteroskedasticity robust standard errors in parenthesis. “***” indicates a significance level at 10%, “**” significance level at 5% and “*” significance at 1%. All variables are in log, except the dummy. The instrumented variables are “earnings” and “treated” respectively with earnings at time t-1, for sake of simultaneity, and a dummy variable which takes on value 1 when the firm is eligible, namely, potentially admissible to the treatment on the basis of its ATECO code, and 0 otherwise.

For our purpose, the estimate of δ coefficient is the most relevant element, since it signals the impact of the guarantee on the guaranteed firm’s borrowing cost, as compared to the other firms. According to this estimate, it took two years, since the beginning of the fund’s operations, for the cost reduction effect to become apparent and significant. After 2001, the point estimate of the δ coefficient shows significant values that rise over time. In the year 2004, the guarantee is estimated to have lowered bank debt cost for the guaranteed SMEs by 1.49% (see the last column in Table 4). This finding seems consistent with evidence gathered by some MGIs for the same year. In its annual survey of its guaranteed firms, Federconfidi (2005) reports an average reduction of bank interest charges by about 1.7% for short-term loans and by 1.1% for medium-term loans. Another MGI, Fedart Fidi (2005) reports average charges for their members that are lower than average market interest rates, by 1.2% for medium-term loans. Nevertheless, the estimated coefficients might overstate the guarantee impact if they were also to capture the effect of other variables related to the firm. In order to rule out this possibility, following De Galdeano-Vuri (2004), the same equation is estimated for the year 1999 that is prior to the first guarantee operation. In this case, the dummy takes on the value of 1 for all firms that received a fund’s guarantee in the following years, and zero otherwise (as specified in Table 5).

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Table 5. Instrumental variable estimates of the δ parameter using data prior to 1999 for firms receiving the Fund’s guarantee in the following years Guarantee years δ

# Obs

2000

2001

2002

2003

2004

-0.67 (0.682)

-0.38 (0.381)

-0.31 (0.317)

-0.29 (0.293)

-0.29 (0.290)

11 111

11 111

11 111

11 111

11 111

Note: Robust standard errors in parenthesis. “***” indicates a significance level at 10%, “**” significance level at 5% and “*” significance at 1%. Standard errors are computed through the white correction to account for heteroskedasticity. All regressions include a constant. The dependent variable is the (log of) financial costs over bank debt in 1999. The regressors are the (log of) number of employees, sales, fixed assets, intangible assets, non bank debt, net worth, all for the year 1999. Their estimates are not reported for brevity and because they are not interesting. Different regressions in each column have been run by changing the dummy accounting for the guaranteed firms in different years. For instance, in column 3, the paper reports the estimated δ coefficient related to the 1999 financing cost for firms that received a guarantee only in year 2001.

The lack of significance of the δ coefficient in all the estimates in Table 5, can be interpreted in the sense that in the year 1999, those firms that received a fund’s guarantee years later, did not perform any better than those firms that never received the guarantee, although they were eligible. This result goes in the direction of ruling out the possibility that the estimated effects may overstate the guarantee’s impact, catching both the effect of the guarantee and the effect of unobservable firms’ characteristics. Still, another distortion might be possible in the estimates of Table 4. Since the estimated coefficient linearly increases (in absolute terms) over time (from 0 statistic in 2000 to -1.49 in 2004), one might suspect that it could be affected by temporal variation. The latter might pertain to changing macroeconomic conditions, such as a decrease in official interest rates, or to factors that allow firms to systematically save on financial costs over time because of improvements, for instance, in financial management due to technological advances. To account for this possibility, all data related to the cross-sections of sampled firms for the period 1999-2004 are pooled together in order to take advantage of the properties of a panel data approach within the context of a Difference-in-Difference (DID) estimation procedure.

Panel data estimate The DID approach is based on the notion that treated units and non treated ones are not directly comparable when there are reasons to believe that they differ in unobservable characteristics that are associated with the potential outcome. This is so even after controlling for differences in observed characteristics. To deal with such a shortcoming, an impact analysis of outcomes could be made for the same treated units by comparing their performance in the two periods, before and after treatment. In other words, the treated units’ outcome before treatment is used as a control variable for the treated units’ outcome after treatment. Such a comparison could, however, be contaminated by time trends in the outcome variables, or by the effect of events, other than the treatment, that occurred over the two periods. When only a fraction of the population is exposed to the treatment, an untreated comparison group can be used to identify temporal variations in the outcome that are not due to the treatment. In other words, the DID estimator relies on the assumption that the average outcomes for treated units and control ones would have followed parallel paths over time in the absence of the treatment. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

116 – PART II: SELECTED PAPERS In this case, this assumption can be considered quite realistic, since the temporal variation in the outcome variable, i.e., the financial cost, is basically affected by changing macroeconomic conditions. But such assumption could be violated if firms eligible for the fund’s guarantee would react to it in anticipation of the guarantee (see in the same sense: Blundell et al, 2003). The test carried out on the 1999 data and reported in Table 5 allows one to rule out an anticipation effect. The lack of significance of the δ estimate in all of the estimates of Table 5 can mean that, in the period before the guarantee, guaranteed firms did not perform better than non guaranteed firms. On the basis of these assumptions, a fixed-effect panel version7 of equation 1 for the years from 1999 to 2004 is estimated (Table 6). Following Abadie (2005), Blundell et al (2003), De Galdeano-Vuri (2004), the coefficients in the pre-guarantee year (1999) are estimated separately from those for the other years by applying a time dummy variable to all regressors. Table 6 - DID estimate of the causal effect of the guarantee on the (log of) financial cost/bank debt α No. of employed Sales

Year 1999

Fixed assets Intangible assets Non bank debt Net worth Earnings No. of employed Sales

post 1999

Fixed assets Intangible assets Non bank debt Net worth Earnings Guarantee dummy R2 # Obs Prob(F-stat)

OLS -0.78* (0.302) 0.03 (0.043) -0.10** (0.047) -0.19* (0.036) 0.00 (0.025) 0.07* (0.021) 0.09* (0.030) 0.07* (0.016) 0.05* (0.021) -0.13* (0.034) -0.18* (0.021) 0.02*** (0.011) 0.12* (0.008) 0.05* (0.016) 0.07* (0.011) -0.31* (0.040) 0.05 5 835 0.00

Fixed Effects (DID) -3.14* (0.571) 0.02 (0.059) 0.11 (0.116) -0.13** (0.058) -0.07* (0.025) 0.07* (0.021) 0.05 (0.078) 0.05** (0.020) 0.02 (0.048) 0.15** (0.070) -0.20* (0.036) -0.04** (0.020) 0.09* (0.014) 0.03 (0.063) 0.03*** (0.013) -0.11** (0.053) 0.75 5 835 0.00

OLS -0.79* (0.266) 0.05 (0.042) -0.06 (0.037) -0.18* (0.040) -0.02 (0.020) 0.07* (0.025) 0.11* (0.036)

Fixed Effects (DID) -2.52* (0.503) 0.03 (0.044) 0.08 (0.061) -0.12* (0.042) -0.07* (0.024) 0.04 (0.025) 0.06 (0.040)

0.05** (0.022) -0.11* (0.024) -0.21* (0.018) 0.02** (0.009) 0.12* (0.010) 0.11* (0.016)

0.02 (0.047) 0.11** (0.051) -0.16* (0.027) -0.06* (0.016) 0.08* (0.013) 0.05 (0.040)

-0.33* (0.033)

-0.07*** (0.042)

0.05 8 130 0.00

0.71 8 130 0.00

Note: Robust standard errors in parenthesis. “***” indicates a significance level at 10%, “**” significance level at 5% and “*” significance at 1%. S.E: are computed through the SUR (PCSE) coefficient covariance matrix to account for both crosssection heteroskedasticity and correlation.

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The first estimates report the earnings variable among the regressors. Given the strong presumption of a simultaneity bias for this variable with the dependent one, the second estimates remove this variable from the set of regressors. The underlying rationale is that to instrument the earnings variable through earnings at time t-1 would imply dropping the first time observation, thereby missing the pre-guarantee period and making it impossible to carry out a DID estimate. This exclusion does not greatly alter the results, as the estimate of the δ coefficient slightly decreases from -0.11 to -0.07, and its significance moves from 5 to 10%. The estimate shows a negative and significant coefficient for δ, as expected. This supports the contention that the fund’s guarantee indeed plays a significant, albeit small role in reducing debt cost for the borrowing firm. The small magnitude of the estimated effect should be considered in the light of the slight overestimation of financial costs, due to the inclusion of a small cost component that is not related to bank debt. Should more detailed data be available to correct such an overestimation, the resulting coefficient estimate could most likely be higher. Turning to the question of credit additionality, the same DID approach is adopted using the (log of) ratio of bank debt to total assets as the dependent variable. This is a proxy of a financial leverage ratio, and is consistent with a loan additionality test since a credit rationed firm should have a relatively lower debt leverage ratio. The results are in Table 7. Simultaneity problems might affect both earnings and sales, and the dependent variable and non-bank debt that is included in the denominator of the dependent variable. For this reason, different combinations of regressors are used, by removing in turn, earnings, non-bank debt, and both. In all the estimates, the effect of the guarantee is found to have the expected (positive) sign and to be significant, but it is very small. According to these estimates guaranteed firms receive on average between 0.10 and 0.13% more bank loans than non guaranteed firms. The fund’s relevance for widening credit access is, however, confirmed.

Conclusions All advanced economies have established publicly-funded guarantee schemes to help SMEs in overcoming their financing difficulties due to imperfect or incomplete financial markets. Conflicting assessments of their effectiveness, however, come out of the empirical evidence gathered so far trough various analytical tools. The evidence presented here is based on standard econometric techniques, and is mainly aimed at checking whether or not a causal relationship can be established between Italy’s statefunded guarantee scheme and the levels of credit supply and its cost to SMEs. On both grounds, this analysis shows that Italy’s scheme has reached a measure of effectiveness in easing the SMEs’ financing constraints. But there are also some critical areas that require attention. On the positive side, our econometric tests provide evidence that the public guarantee raised the amount of credit SMEs received from the banking system and lowered their borrowing cost to a substantial extent. On the other side, this scheme did not necessarily manage to target the most financially-disadvantaged firms within the SME group. The pattern of guarantees seems to reflect credit supply factors, notably banks’ lending decisions, more than SMEs’ potential credit demand. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

118 – PART II: SELECTED PAPERS

post 1999

Year 1999

Table 7 - DID estimate of causal effect of the guarantee on the (log of) bank debt/total asset

OLS

Fixed Effects (DID)

OLS

Fixed Effects (DID)

OLS

Fixed Effects (DID)

OLS

Fixed Effects (DID)

α

-2.96* (0.346)

-0.83 (0.646)

-2.76* (0.319)

-1.04** (0.439)

0.99* (0.218)

0.16 (0.402)

-2.74* (0.240)

-0.92** (0.439)

No. of employed

-0.04 (0.043)

0.03 (0.049)

-0.05 (0.033)

0.00 (0.043)

0.05 (0.032)

0.04 (0.035)

-0.05** (0.025)

0.00 (0.036)

Sales

0.34* (0.045)

0.13 (0.114)

0.28* (0.034)

0.12** (0.056)

0.00 (0.000)

0.00 (0.000)

0.27* (0.031)

0.10*** (0.057)

Fixed assets

0.23* (0.049)

0.12** (0.055)

0.22* (0.043)

0.13* (0.034)

0.25* (0.032)

0.16* (0.047)

0.23* (0.033)

0.14* (0.034)

Intangible assets

0.05** (0.024)

0.07* (0.022)

0.07* (0.019)

0.07* (0.021)

0.07* (0.018)

0.05* (0.014)

0.07* (0.014)

0.04* (0.010)

Non bank debt

-0.10* (0.028)

-0.14* (0.025)

-0.10* (0.015)

-0.10* (0.022)

Net worth

-0.32* (0.053)

-0.25* (0.071)

-0.38* (0.041)

-0.23* (0.037)

-0.40* (0.043)

-0.32* (0.042)

-0.47* (0.040)

-0.29* (0.028)

Earnings

-0.14* (0.021)

-0.04** (0.016)

-0.11* (0.032)

0.00 (0.013)

No. of employed

-0.04 (0.031)

-0.01 (0.044)

-0.05*** (0.026)

0.00 (0.049)

0.11* (0.021)

0.02 (0.029)

-0.06* (0.017)

-0.03 (0.029)

Sales

0.42* (0.033)

0.16*** (0.087)

0.36* (0.026)

0.12** (0.050)

0.00* (0.000)

0.00 (0.000)

0.32* (0.022)

0.09** (0.037)

Fixed assets

0.24* (0.029)

0.20* (0.039)

0.26* (0.026)

0.19* (0.022)

0.25* (0.016)

0.22* (0.024)

0.24* (0.014)

0.18* (0.023)

Intangible assets

0.02** (0.010)

0.05* (0.016)

0.03* (0.007)

0.05* (0.015)

0.07* (0.006)

0.04* (0.010)

0.04* (0.005)

0.04* (0.007)

Non bank debt

-0.12* (0.008)

-0.12* (0.013)

-0.14* (0.008)

-0.12* (0.014)

Net worth

-0.40* (0.026)

-0.30* (0.054)

-0.45* (0.023)

-0.29* (0.034)

-0.43* (0.024)

-0.31* (0.031)

-0.51* (0.017)

-0.33* (0.022)

Earnings

-0.13* (0.013)

-0.05* (0.012)

-0.09* (0.010)

-0.05* (0.012)

Guarantee dummy

0.53* (0.067)

0.12** (0.058)

0.57* (0.071)

0.10** (0.047)

0.47* (0.052)

0.13* (0.038)

0.49* (0.059)

0.11* (0.037)

R2

0.16

0.82

0.14

0.80

0.14

0.79

0.16

0.76

# Obs Prob (Fstat)

5 852

5 852

8 154

8 154

11 704

11 704

16 158

16 158

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Note: Robust standard errors in parenthesis. “***” indicates a significance level at 10%, “**” significance level at 5% and “*” significance at 1%. S.E: are computed through the SUR (PCSE) coefficient covariance matrix to account for both crosssection heteroskedasticity and correlation. Source: Elaborations on AIDA-MCC data.

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Overall, the fund showed a high degree of caution in risk taking. This helped to contain default rates to a very low percentage, thereby maintaining the fund’s operations close to financial sustainability. On the basis of our evidence, a public guarantee scheme appears to be one of the most effective tools a government can use to promote SME financing because of its relatively small cost for public finances and its high capacity to mobilise private capital. But to also be effective from the point of view of economic development, several conditions must be met. In particular, any risk taking due to a guarantee must be shared with other financial institutions and with the SMEs themselves, in order to lessen moral hazard and adverse selection problems. This should lead governments to use this tool to foster the emergence of a spirit of mutual risk-sharing among firms, by inducing them to take part in mutual credit guarantee schemes. A publicly-funded guarantee scheme should specifically serve the purpose of providing only a counter-guarantee to a portion of the guarantee that consortia of firms grant to their participants.

Technical appendix Cross-section analysis The set of instruments used to estimate the equations reported in Table 4 is composed of: earnings at time t-1 in order to instrument earnings at time t, and a dichotomic variable, that takes on the value of 1 when the firm is eligible on the basis of ATECO economic sectors, and zero otherwise, in order to instrument the dummy dt. The earnings variable must be instrumented because it has a problem of simultaneity with the numerator of the dependent variable. As in Pozzolo (2004), its lagged value allows to have an instrument uncorrelated with the dependent variable and at the same time correlated with the regressor at time t. The chosen instrument for the dt variable must fulfil the following requirements by Angrist-Imbens-Rubin (1996) in order to estimate the causal effect. Exclusion restriction hypothesis: this requirement is met since EU rules aimed at excluding some sectors from the fund’s guarantee do not lead over time to a systematic difference in financing cost between eligible firms and non eligible ones. In other words, EU rules affect other domains of firm’s performance. Such a hypothesis was tested through the following equation8: (2)

rt = α + β 1x 1t + β 2 x 2t + β 3 x 3t + β 4 x 4t + β 5 x 5t + β 6 x 6t + β 7 z + β 8 (1 − z ) + u t where z refers to a dummy that takes on the value 1 in the case of an eligible firm and 0 otherwise. Hence, it should be tested whether β7=β8 . This hypothesis is accepted as a result of F(1;1247)=0.97. Moreover, as expected, the two coefficients are significantly different from zero. Stable Unit Treatment Value Assumption (SUTVA): this requirement is met since there is no reason to assume that the guarantee assigned to some firms might also benefit non-guaranteed firms in terms of lower borrowing costs and larger credit access, as it is THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

120 – PART II: SELECTED PAPERS the case for guaranteed firms. In other terms, it is quite reasonable to assume the absence of a general equilibrium effect. Monotonicity assumption: this requirement for the LATE effect is met since no firm can be assumed to be charged higher rates by lending banks because of the guarantee. This assumption is also supported by the negative sign of the estimated coefficients in all OLS and IV estimates.

DID estimates Estimates reported in tables 6 and 7 are based on the following equation:

y i = ci i T + I T γ + SX i β + (I T − S) X i β + δ (I T − S)d i + u i for i=1…N Broadly speaking, this equation is a standard DID regression equation, where all regressors are treated with a dummy variable to distinguish the two periods. For its algebraic derivation, this paper refers the reader to Abadie (2005), Blundell et al (2003), De Galdeano-Vuri (2004). Given that our data set is made out of a number of cross-section data related to different years, the authors of this paper may rewrite the panel equation regression as a pool of cross-sectional equations. Each equation’s observations are actually stacked on top of the others. In the above equation, iT is a T-element unit vector, IT is the T-element identity matrix, ci is a cross section fixed effect, γ is a vector containing all of the period effects, γ’=(γt, γt+1,…. γT), β is a kx1 coefficient vector, Xi is a Nxk matrix of explanatory variables, S is the corresponding matrix (TxT) form of the usual temporal dummy variable, that takes on value 1 for all t belonging to the first period, and 0 otherwise. In matrix form, S takes on value 1 in the t-th element of the principal diagonal for all t belonging to the first period. In our case, the paper is interested in distinguishing between data prior and next to the treatment, i.e. 1999 is the first period and 2000-04 belong to the second, thus S takes on value 1 only in the first element of the principal diagonal. Our parameter of interest is δ, since it captures the effect of the guarantee on the dependent variable. The dummy di captures the guaranteed firms, taking on value 1 in the year(s) of guarantee for the guaranteed firm, and 0 otherwise. From another standpoint, it can be regarded as the staked interleaved form of the dt vectors of equation (1). Obviously, it takes on value 0 for all firms in 1999. The same estimation procedure was applied both to estimate the effect of the guarantee on the financial cost and the credit additionality effect.

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Bibliography Abadie A. (2005), “Semiparametric Difference-in-Difference Estimator”, Review of Economic Studies, vol. 72 no 1. Angrist J.D. (1990), “Lifetime Earnings and the Vietnam Era Draft Lottery: Evidence from Social Security Administrative Records”, American Economic Review, 80, p. 313-336, June. Angrist J.D., Imbens G., Rubins D. (1996), "Identification of Causal Effects Using Instrumental Variables" Journal of the American Statistical Association, 91, 444-472, June. Angrist J.D., Kruegen A.B., (1991), “Does Compulsory School Attendance Affect Schooling and Earnings?” Quarterly Journal of Economics, November. Banca d’Italia (2005), Relazione del governatore sull’esercizio 2004, Roma Blundell R., Costa Dias M., Meghir C., Van Reenen J. (2003), “Evaluating the Employment Impact of a Mandatory Job Search Programme”, CEPR d.p. 3786 Boocock, J. and Shariff, M. (2005), “Measuring the Effectiveness of Credit Guarantee Schemes: Evidence from Malaysia”, International Small Business Journal, 23, 4, pp. 427-454. Bound, John, David A. Jaeger, and Regina M. Baker. (1995). "Problems with Instrumental Variables Estimation when the Correlation between the Instruments and the Endogeneous Explanatory Variable is Weak” Journal of the American Statistical Association 90:443-450 De Galdeano A. S., Vuri D., (2004), “Does Parental Divorce Affect Adolescents’ Cognitive Development? Evidence from Longitudinal Data”, IAZ dp, 1206, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=569164 FEDART Fidi (2005), “Il sistema dei confidi artigiani aderenti alla Fedart Fidi”, Anno 2004, 9a edizione. Federconfidi (2005), Indagine congiunturale, Dec.-Jan . Gale W. (1991), “Economic Effects of Federal Credit Programmes.” American Economic Review. 81:1. 133-52. March Holden P. (1997), “Collateral without Consequence: Some Causes and Effects of Financial Underdevelopment in Latin America”, in the Financier vol.4, n. 1 &2, Feb./May . Ichino A., Winter-Ebmer R., (2004), “The Long-Run Cost of World War II”, Journal of Labour Economics, 22(1)

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122 – PART II: SELECTED PAPERS KPMG (1999), An Evaluation Of The Small Firms Loan Guarantee Scheme. London: DTI Levitsky J. (1997), “Best Practice in Credit Guarantee Schemes”, in the Financier vol.4, n. 1 &2, Feb./May . Llisterri J.J. (1997), “Credit Guarantee Systems: Preliminary Conclusions”, in the Financier vol.4, n. 1 &2, Feb./May . National Economic Research Associates (NERA) (1990), “An Evaluation of the Loan Guarantee Scheme”, Research Paper no. 74. London: Department of Employment Oehring E. (1997), “The FUNDES Experience with Guarantee Systems in Latin America: Model, Results and Prospects”, in the Financier vol.4, n. 1 &2, Feb./May 1997. Pieda (1992), “Evaluation of the Loan Guarantee Scheme”. London: Department of Employment Pozzolo A.F. (2004), “The Role of Guarantees in Bank Lending”, Banca d’Italia, Temi di Discussione, 528, December. Riding A.L., Haines G. (2001), “Loan Guarantees: Cost of Default and Benefits to Small Firms” Journal of Business Venturing, v.16, No 6, November, p.565-612. Staiger, D., Stock J.H., (1997), “Instrumental Variable Regression with Weak Instruments” Econometrica, 5(65), 557-586. May Vogel R. C., Adams D.W. (1997), “Costs and Benefits of Loan Guarantee Programmes”, in the Financier vol.4, n. 1 &2, Feb./May . Wooldridge J.M. (2002), “Econometric Analysis of Cross Section and Panel Data”, MIT press Zecchini S. (2002), “Una nuova finanza per far crescere le PMI”, in Attività dei Confidi, Federconfidi.

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Notes 1 This was established in 1996 with the generic mandate of providing guarantees to banks and financial institutions, against their loans to SMEs, as well as against their minority equity participations in small and medium-size companies, and to MGIs, against their guarantees for SME borrowing. Hence, the SGS offers direct guarantees to lending banks, co-guarantees together with other guarantor institutions, and guarantees of last resort to MGIs. 2 The debt service cost, being equal to the state’s average borrowing cost, could be considered as a proxy for the opportunity cost of funding the Fund. 3 The default loss ratio can be decomposed as the product of the default loan rate, the repayment rate and the reciprocal of the guarantee coverage rate. These ratios are presented in Table 3. 4 The default rate for banks’ loans to micro enterprises is 9.82%, (Banca d’Italia, 2005). 5 These data originate from the Fund’s books. Information on SMEs’ financial statements was drawn from AIDA balance sheet data bank. From the latter, a random sample was drawn of 11 61 SMEs, including firms that were eligible for the Fund’s guarantee (3 952) but did not apply for it, and firms that were not eligible (6 066), because of the EU exclusion of some economic sectors from the guarantee. 1 243 of sampled firms received the Fund’s guarantee. The sample period is 1999-2004. Financial data comprise financial costs, earnings, net worth, fixed and intangible assets, long/short term bank-related debt, long/short term bonds, long/short term non bank-related financial debt, sales, number of employees, depreciation allowance, and total assets. 6 According to Bound et al (1995), instrumental variables estimates may be biased in small samples. A correct practice is to report a statistic that measures this possible bias. Staiger and Stock (1997) prove that when the instrumented variables are no more than 1, the reciprocal of the F-test of the first stage approximates the fraction of the OLS bias, with respect to the LATE of which IV still suffers in a finite sample. Unfortunately, when instrumented variables are more than 1, a measure of the IV bias becomes a rather complicated expression. For this reason, the F of the first stage is omitted in the tables. For an example of the inclusion of the F of the first stage in a LATE estimate (see Ichino and Winter-Ebner, 2004). 7 On the basis of a Hausman test, one can reject the null hypothesis of consistency of both fixed and random effects. 8 Equation 2 must be estimated on the basis of 1999 data, since the Fund was not yet operational in that year. The earnings variable is omitted from equation 2 because no lagged data are available.

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Workshop B: Equity Financing for SMEs and the Role of Government

The objectives of Workshop B were to gather additional evidence relating to difficulties for SMEs in gaining access to equity finance, to report on policies and programmes to address these difficulties, the lessons learnt in applying policies and programmes, and to provide guidance to Governments, as well as to SMEs, on the options for intervention to improve SME equity financing. The sessions considered the following issues: First Session: The Nature of the Market Failure/Distortion x

Are the problems of financing for innovative small and medium-sized enterprises (ISMEs) most visible at any particular point in the life cycle of the firm? Is the absence of activity in formal risk capital (business angels) a particularly serious problem?

x

Why do rates of return differ so much among countries? In particular, to what degree do low rates of return on early stage innovation finance represent impediments to ISME financing in Europe?

x

What are the lessons of the technology bubble burst in 2000 and the more recent rebound of innovative finance?

x

Where can government intervention be most effective in promoting ISME development and finance?

Second Session: What Role for Government? This session built on the outcomes from Session 1 on the Nature of the Market Failure/Distortion and, in particular, looked at the lessons learnt from an assessment of past and current government policies and programmes related to private equity. x

What are the lessons of the most effective programmes to stimulate ISMEs? Can one specify best practices with respect to incentives and risk sharing in ISME finance?

x

How important is taxation in determining ISME finance?

x

To what degree does the lack of suitable legal vehicles impede the expansion of venture capital?

x

What can government do to facilitate exits by venture capital backed firms

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Equity Financing for SMEs: “The Nature of the Market Failure”

Mr. Jean-Noel Durvy Head of Unit, European Commission, Enterprise and Industry DirectorateGeneral, Innovation policy, Financing SMES, entrepreneurs and innovators Improving access to finance for enterprise, and especially SMEs, is crucial in fostering entrepreneurship, competition, innovation and growth. The “Community Lisbon Programme” noted that: “the limited availability of finance is an obstacle to set up and develop business in Europe. Company financing in Europe is currently based too much on lending, with many firms having too little equity (European Commission, 2005) and the European Commission might adopt an important communication: “Financing growth – The European way” in May 2006. The diagnosis would certainly be relatively different in the United States, where there is a more entrepreneurial and equity-oriented culture, which makes venture capital a wellknown and well-regarded financing alternative at least in the key cluster regions (US & EC, 2005). There is also, nevertheless, empirical evidence of market failure resulting from an asymmetry of information between demand and supply.

The equity financing life-cycle The sources of finance evolve as firms grow. At the seed stage, the riskiness of the firm and its profitability contribute to the “valley of death” over which less than half of firms survive. As firms move on from seed to early stage, risks are often slightly lower as the prospects of the firms become clearer and as revenues start coming in. But, debt finance is still unsuitable at this early stage. x

First, the lack of collateral and the uncertain prospects of young technology firms, in particular, make bank financing often unobtainable.

x

Second, borrowing is inappropriate because principal and interests payments would limit the cash flow flexibility of an expanding company at crucial times.

x

Third, the usual information asymmetries between entrepreneurs and a bank are more pronounced because of the skills needed to evaluate the activities (mainly high-tech) of start-ups.

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At the same time, entrepreneurs can be reluctant to dilute their ownership or cede a share of control to equity investors. Private equity is also considered as one of the most expensive forms of finance and issuers are generally firms that cannot get financing from the debt markets. Figure 1. Stages of equity financing Seed

Expansion

Early-stage

?

Entrepreneur, family, friends, business angels, public sources

IPO, strategic investors

Public markets, banks

Venture capital funds

Mezzanine rd

3 round

2

Breakeven point

nd

round

st

1 round Valley of death

Note: Definitions for most of the concepts used in SME finance are not universal. Source: Graph adapted from Cardullo: Technological entrepreneurism. European Commission – DG Enterprise and Industry – Best practices of public support for early stage equity finance – Brussels – September 2005.

However, the use of debt or equity depends on the needs and on the development phase of a company. Sufficient equity base will facilitate a firm’s access to loans. Bank lending can be an attractive source of investment when there is a low interest rate and a revenue stream to serve the loan. Public equity markets are also an alternative which could be attractive for both investors and entrepreneurs at a later stage of development of a company. Exit mechanisms (trade sales and IPOs) are also important to achieve good returns and justify venture capital (VC) investments. For instance, Europe has too many small illiquid national growth oriented stock markets. This lowers return expectations and growth opportunities, and consequently, leads to the best firms being floated or sold outside Europe. Without a liquid exit market that would have a critical mass of advisory services around it, venture capital funds will not be able to fulfil the hopes placed upon them.

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The private equity industry In the broad sense, private equity means a security that is not registered and not publicly traded on an exchange (Meyer & Matkonet, 2005).The venture capital and private equity industry is a global one. Venture capital can be considered as a subclass of equity that poses specific challenges, mainly because of the difficulties of valuing such investments, in particular, in early stages. It is possible to distinguish between: x

Informal investors: “family, friends and fools” which are generally the main investors in the more risky and early phases of the life of the company. The “business angels” are another category of informal investors, which are in many cases the only active seed investors. Angels are flexible investors who can lower the riskiness of their deals by providing hands on advice based on personal experience to entrepreneurs. The visibility of business angel has increased as more and more angels have joint networks that facilitate the matching of angels and entrepreneurs.

x

The organised private equity and venture capital market, where professional management is provided by intermediaries, generally the fund management companies.

There is a lack of information, but it is estimated that the informal private equity market is probably several times larger that the organised private equity market. However the development of angel investment market in Europe is uneven and further work is needed to attract more investors to become business angels. The venture investment cycle (see Figure 2) starts with fundraising from investors (for instance institutional investors: banks, insurance companies, pension funds, etc.) goes through investments in growth companies and terminates with exits that returns funds back to investors so that the cycle can start again. Figure 2.The venture investment cycle

Fundraising

Fund Management companies (General partner + limited partner)

Investments in companies Exits: sales, IPOs

Return of funds to investors, liquidities … and new investments

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In 2004, EUR 27.5 billion funds were raised in Europe and EUR 37 billion were invested but only 10.3 billion in venture capital. Table 1. Fundraising and fund invested in Europe

2000 2001 2002 2003 2004

Fundraising (in billion EUR) 48.00 40.00 27.60 27.00 27.50

Fund invested (in billion EUR) Total VC 34.9 19.6 24.5 12.2 27.7 9.8 29.1 8.4 36.9 10.3

Source: Source EVCA

Private equity, largely illiquid, is a long term commitment, and return expectations are difficult to predict, notably for early stage investments. This clearly contributes to explain the market gap.

The market gap The private equity market is showing solid growth in Europe. But, “buy out” investments represent the majority (nearly 65%) of all investments in the segment. “The flipside of the buy-out dominance is that financing for early stage activity (product development, start-up and product launch) has declined drastically since 2000. Practically no money is going into seed financing any more” (Schaff, 2005). Despite difficulties of direct comparison, the difference in the profitability of US and European venture capital industry for early stage investments explain the importance of the market gap in Europe. US early stage investment is profitable having produced a pooled IRR (Internal Rate of Return) of nearly 20% over the twenty year time horizon of 1984-2004 (EC, 2006). In Europe, an investor would only have reached a break-even point, a clearly inadequate outcome to sustain private sector interest in this type of investment (Figure 3) (EVCA, 2004). This marks a clear difference with the US, even if there is no consensus on the real performance of the US VC Industry. In the new Member States, there were no seed investments and a significant reduction of start-up investments in 2004. There is no doubt that there is an equity market gap, concerning seed and early stage investments and to a certain extend at expansion stage. The reasons for this equity gap are linked to the insufficient supply of funds, the market fragmentation and to inadequacies on the demand side (investment readiness issue). The existence of an equity gap was noted in the United Kingdom already in the 1930s. The size of the gap and its location in terms of investment size depends on the presence of early stage informal investors (friends, family and fools) and the focus of VC funds in each country. Regarding market structure and market situation, the following comments can be made on the basis of European figures:

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Informal investors remain very important for financing start-ups, but are mostly providing limited amounts (less than EUR 250 000 in continental Europe), higher amounts are provided by formal VC investors.

x

The various analyses consistently confirm that there is currently a significant gap for the seed and early stages but also at the lower level for expansion stage. It is mainly the case for innovative companies. Figure 3. Early stage and expansion investments in Europe

14.000

12.000

Expansion

Millions of euros

10.000

Early stage

8.000

6.000

4.000

2.000

0 1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

The gap can go from an investment size of less than EUR 100 000 to over 2 million. In Germany, the gap extends to around EUR 5 million (KFW Bankengruppe, 2005). On the UK, the gap has been estimated to be between 0.4 million to 3 million (HM Treasury, 2003). There are, in fact, important differences in the equity gap between countries. Countries with little or no local VC Industry may have problems attracting investments from abroad, for instance the equity gap is even more severe in the new Member States from central and Eastern Europe.

Conclusions The European Union is focussing efforts in improving risk capital markets as stated in the recommendations of the Risk Capital Summit which took place in London in October 2005. The EU is also open for international co-operation and has already worked with the US Department of Commerce to come up with ideas about global policy cooperation in risk capital.

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To conclude, the following recommendations can be suggested to reduce the market gap: x

Convene countries to eliminate legal and fiscal obstacles in order to allow venture capital funds to invest across borders without red tape.

x

Favour the emergence of larger and more professional venture capital ventures, when implementing public-private partnerships [“big is beautiful” – venture capital is an activity where scale and scope effects are extremely important (Murray, 2005)].

x

Spread good practices in the design, implementation and evaluation of programmes. Europe has good practices to show in some Member States.

x

Avoid two kinds of risk attached to public funding: the risk of crowding out potential private investors and the risk of promoting publicly supported measures that do not provide any specific advantage for enterprises.

x

Provide incentives for formal and informal investments in seed capital and encourage co-investment schemes associating business angels and VC funds.

x

Examine the potentialities of other financial instruments like mezzanine finance to reduce the gap concerning expansion and development stages.

References European Commission (2005), “Common actions for growth and employment: the Community Lisbon programme”, Communication from the Commission. European Commission (DG Economic and Financial Affairs) (2006), Venture Capital investment in Europe in 2004. EVCA (2004), Research note in association with Thomson Venture Economics “Pan European survey of performance from inception to 31.12.2004”. HM Treasury (2003), “Bridging the finance gap: next steps in improving access to growth capital for small businesses”. KFW Bankengruppe (2005), Eigenkapital für den breiten mittelstand. Meyer, T. and P.Y. Matkonet (2005), Beyond the J curve – Managing a portfolio of venture capital and private equity funds, Wiley finance. Murray, G. (2005), “The Financing of early stage, high technology businesses” The Risk Capital Summit, London. Schaff, J. (2005), Deutsche Bank Research. United States (Department of Commerce, International Trade Administration), European Commission (DG for Enterprise and Industry) (2005) “Final report – Working group on venture capital.”

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A Review of Access to Finance Matters Related to the Development Finance Institutions of the DTI [paper excerpt]

Mr. Don Mashele Channel Manager, Khula Enterprise Finance, South Africa The Department of Trade and Industry (“the DTI”), through four of its Development Finance Institutions (“the DFIs”): 1) Khula Enterprise Finance Ltd (Khula), 2) National Empowerment Fund (NEF), 3) Industrial Development Corporation (IDC) and 4) APEX Fund, seeks to address the access to finance needs of SMMEs (Small, Medium and Micro Enterprises) and SMEs in South Africa. The DTI mandated KPMG to perform a desktop study focussing largely on: the role played by the Provincial Development Corporations (PDCs); the performance of the DFIs; their capacity and case for merger (if any); the partnering arrangements with the private sector that should be sought by the DTI; and issues of service access, outreach and integrated service delivery and how they can be addressed under the Small Enterprise Development Agency (SEDA) approach. The study did not cover the APEX fund, except for highlighting its target market. The study was undertaken between 1 October 2004 and 30 November 2004. The current paper presents an extract from this evaluation.

Introduction From the study undertaken, it appears that of the Provincial Development Corporation (PDCs) the Eastern Cape Development Corporation, Ithala Development Finance Corporation (KZN), and the Free State Development Corporation are more advanced than the other PDCs with regard to funding of SMEs. The Western Cape Government recently introduced a new programme (RED), while plans for a dedicated SME desk at the Gauteng Development Agency are at an advanced stage. The DFIs target funding ranges are indicated in the table below. Table 1. DFIs target funding ranges DFI Apex Fund Khula NEF IDC

Lower limit ZAR Million1 0.003 0.003 0.25 100.00

Upper limit ZAR Million 0.01 3.00 50.00 500.00

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In terms of their funding range, the DFIs cover the broad spectrum of funding needs, from as little as ZAR 300 to ZAR 500 million, with cases of funding range overlaps between the DFIs. The DFIs are however considered to have different core objectives and risk appetites, which provide a level of differentiation. Potential overlaps between Khula and the Apex Fund will decrease when the micro financing side of Khula transfer to the Apex Fund. The performance of the DFIs expressed in terms of the value of funds disbursed to SMEs and/or SMMEs (Small, Medium and Micro Enterprises) over the past three years is summarised below. Table 2. Performance of the DFIs DFI

Total

Apex Fund Khula NEF IDC

848.3 4049.0

2002 ZAR million 264.7 2135.0

2003 ZAR million 254.1 1010.0

2004 ZAR million 329.5 904.0

Notes: 1. The Apex Fund was officially launched in December 2004 and it has a 31 March year end; 2. 31 March year end; 3. Includes authorised guarantees of ZAR 479.6 million, and LREF approved loans of R64.5 million; 4. 31 March year end; 5. 30 June year end.

In terms of geographical performance, 57% of the IDC’s funding approvals between 1995 and 2004 went to Gauteng, KwaZulu-Natal and the Western Cape whilst Northern Cape, Limpopo and the Free State received a combined 11.9%. Geographical performance information for the other DFIs was not available. All three DFIs have their head-offices in Gauteng, with the bulk of their activities in Gauteng and to a lesser extent Western Cape and KwaZulu-Natal. The IDC has satellite offices in the Eastern Cape and KwaZulu-Natal, whilst the NEF and Khula have no infrastructure of their own outside of Gauteng. It is a challenge for all the DFIs to spread their outreach appropriately on a national basis. It appears that each DFI is following its own strategy with regards to its national capacity and outreach. The IDC is attempting to improve national outreach through the creation of developmental agencies in the local government sphere and has established (in 2002) a department to work with Local and Provincial Government. Agencies have already been created in the Eastern Cape, Limpopo and Northern Cape provinces. As part of its new strategy, Khula is attempting to improve national outreach by partnering with PDCs, Business Partners and commercial banks, whilst utilising fewer, but higher quality, Retail Financial Intermediaries (RFIs). The results of this approach are being monitored closely so that lessons learnt can be shared across the DFIs. To establish a national infrastructure that matches the local government footprint would be very costly and clearly such an initiative should be a joint effort between the DFIs to achieve overall cost savings and integration of service delivery. It is understood that Small Enterprise Development Agency (SEDA) plans to establish a national infrastructure matching the local government footprint. The outreach of the DFIs could be improved significantly by working with SEDA in an integrated fashion to provide a “one-stop shop” for SMMEs. The infrastructure of the Land Bank and the Post Bank could also be used to improve the national outreach of the DFIs and this option should be investigated in more detail.

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Developmental finance institutions of the Department of Trade and Industry, South Africa Type of programmes and products Apex Fund This fund was launched in December 2004 with its target primarily being SMMEs requiring micro business loans of between ZAR 300 to ZAR 10 000. The initial plan is to capitalise this fund with more than ZAR 400 million over the next three years.

Khula Enterprise Finance Ltd (Khula) Following the promulgation of the National Small Business Act (Act No. 102 of 1996), Khula Enterprises was established in 1996 as a provider of wholesale finance with the mandate of creating and developing SMMEs, by providing loan and equity capital, particularly to SMMEs owned by Previously Disadvantaged Individuals (PDIs). As at the time of finalising this study, Khula’s strategic plan stated that in terms of market segmentation, Khula aims to have 66% of their loan and equity financing covering customers requiring funding amounts of between ZAR 300 and ZAR 250 000, while the remaining 34% covers customers requiring funding of between ZAR 250 000 and ZAR 3 million. Khula’s product range includes: x

Loans – this product provides debt financing (business loans), seed loans, and capacity building to RFIs. Business loans to RFIs are interest-bearing (although at rates lower than the prime lending rate of banks), and are intended to be “onlended” to SMMEs. Seed loans are intended to cover the operational shortfall of emerging (start –up) RFIs, and are non-interest bearing. Capacity building can also be provided to RFIs to assist with training, management, and systems for emerging RFIs. Loans provided to the RFIs range from ZAR 10 000 to ZAR 2 million. Generally, Khula extends loans to the RFIs, which they then on lend in smaller sums to the SMMEs.

Going forward, Khula will not be developing new RFIs in order to enhance its outreach countrywide. Instead, plans are underway to forge working relationships with commercial banks, PDCs and business partners as a means of distributing Khula products. The RFIs will only be established as stop-gaps in cases where there is no other entity that can be used. With the establishment of the Apex fund, Khula intends to transfer the smaller RFIs and those that largely disburse micro finance loans, to the Apex Fund, pending the finalisation of the necessary internal procedures within the DTI. x

Private Equity – this product is aimed at providing risk capital to SMEs. The investments made by Khula range from ZAR 250 000 to ZAR 2.5 million, and are disbursed through private equity firms.

x

Credit Guarantee – this scheme is aimed at start-up businesses that require business funding from a participating bank for expansion or acquisition of a new or existing business. The guarantees provided are for up to 80% of the loan value, THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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for a maximum loan value of ZAR 1 million, and are disbursed through the participating banks. As at the time of this review, Khula management indicated that the participation of ABSA bank was the most significant amongst the participating commercial banks. x

Land Reform Empowerment Facility (LREF) – the aim of the LREF is to redress the skewed distribution of land and associated assets in the high value commercial agricultural, agro-processing and eco-tourism sectors. This facility caters for the financing needs of these sectors, in which the start-up and expansion investments are characterised by high initial development cost outlay, followed by gradual growth in the productivity and income streams.

x

Mentorship – this programme is intended to provide capacity building to SMMEs in terms of pre-loan support (i.e. business plan development and advisory service) and post-loan assistance (i.e. rescue services and “after care” or mentoring) to small and medium entrepreneurs applying for commercial bank loans. The programme was set up to stimulate and increase commercial banks’ use of the Khula Credit Guarantee Scheme.

National Empowerment Fund Trust (NEF) The NEF was established by the National Empowerment Fund Act 105 of 1998, for the purposes of promoting and facilitating economic equality and transformation. The NEF exclusively targets SMEs that are owned by HDPs, with financing requirements of between ZAR 250 000 and ZAR 50 million. In exceptional cases, the financing commitment may exceed ZAR 50 million. Following a review of its initial product range, the NEF launched a new set of products on 31 May 2004. The original product range was as follows: x

Venture Funding – seeks to provide equity and quasi-equity finance for economic empowerment transactions involving HDPs. It aims to encourage investments involving HDP management, board positions, and distributed ownership, through equity sharing vehicles such as joint ventures that encourage technology transfer between non-HDP and HDP firms.

x

Private Equity – the aim is to provide equity finance in larger amounts than the venture funding programme, encouraging similar outcomes as the NEF Venture Fund.

x

Asset Management Services – focused on the provision of capital for listed empowerment securities and the warehousing of assets for HDPs on an active basis.

x

Investor Education – seeks to encourage and promote a savings culture among black people1, and to provide educational programmes on investments. It therefore will develop innovative investment products designed to limit downside risk, with attractive returns, and encourage these new investors to adopt a longterm investment outlook.

The new product range includes: x

Entrepreneurship Support – its purpose is to assist with the establishment of new BEE businesses, the expansion of existing BEE businesses, the acquisition

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136 – PART II: SELECTED PAPERS by BEE entrepreneurs of shareholdings in the existing businesses, and the establishment of income generating infrastructure to benefit rural communities. The target investment size ranges from ZAR 250 000 to ZAR 10 million. x

Market Making Products – its purpose is to assist HDP sellers of equity, by acquiring and temporarily warehousing their shares before on-selling those to new HDP shareholders. It is also aimed at the funding of large strategic projects, with the intention of acquiring equity and assuming the role of the BEE partner, which investment can then be sold to HDP investors once the initial investment risk has been reduced to acceptable levels. The target investment size for this product ranges from ZAR 1 million to over ZAR 25 million.

Industrial Development Corporation (IDC) With more than six decades of existence, the IDC is the most established and the largest funding implementing agency of the DTI. It offers a large variety of products, primarily aimed at the upper end of medium-sized businesses, with financing requirements of between ZAR 1 million and ZAR 500 million. The IDC provides its product range through the Sectors Division and the Projects Division. Both divisions are organised into strategic business units to provide an industry specific focus, and the delivery of high quality and innovative services to both traditional and new customer bases. The IDC offers the following products: x

Private Equity – this product provides assistance to small and medium-sized enterprises that require minimum funding of ZAR 1 million for expansions and new developments, for financing property, plant and equipment, and the fixed portion of working capital requirements.

x

Wholesale Finance – aimed at providing wholesale funding to intermediaries, which manage and administer finance on behalf of the IDC, and on-lend to individual entrepreneurs. The intermediary could be a reputable franchisor, company, or non-governmental organisation. The minimum total loan requirement is ZAR 1 million for on-lending to at least ten projects. Intermediaries are expected to have a strong financial position and good record of business development, while businesses to be financed must show economic merit. In addition, there must be some financial contribution from underlying entrepreneurs.

x

Bridging Finance – the scheme addresses the needs of entrepreneurs who have secured fixed contracts (excluding construction contracts). The minimum loan size is ZAR 1 million, with a maximum loan repayment term of 18 months. The applicant should be able to demonstrate the capability to deliver on the contract/tender and the asset base of the company should reflect that of an SME.

x

Import/Export Finance – aimed at providing short term facilities to SMMEs involved in the import and export sectors to improve their competitiveness, increase their capacity, and create employment. The minimum total loan requirement is ZAR 1 million.

x

Guarantees – provided as part of the package for big projects that are funded by the IDC. The minimum total loan requirement is ZAR 1 million.

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Conclusions A summary analysis of the coverage of the different business lifecycle stages by the DFIs’ products is presented below. Table 3. DFI coverage of the different business lifecycle stages

Funding requirement DFI

Business lifecycle stage Growth Private Equity Loans Khula, IDC, NEF

Start-up Venture Capital Loans Khula, Apex

Maturity Private Equity Loans NEF, IDC

The DFIs’ products cover the life cycle stages of SMEs. They are also developing products for specific client needs instead of only referring them to the currently available products.

Performance analysis Khula Khula RFI loans Since its inception in 1996, Khula has operated as a wholesale financier providing its products to small and micro-sized enterprises only through banks, private equity firms, and RFIs. In the past, Khula experienced a widespread collapse of RFIs that were ascribed to poor governance, inefficient management information systems, mismanagement, and fraud (FinMark, 2004). In order to address these problems, Khula developed programmes to ensure that its RFI partners had more reliable capacity in areas such as accounting, debt collection, risk evaluation, marketing, and administration. It provided its associates with technology to help them monitor loans more effectively and control their own finances. In addition, Khula reduced the number of RFIs that it supports so as to have a more manageable and reliable number (FinMark, 2004). Table 4. The performance of the RFIs

RFI Programme Total Facilities Approved (ZAR ’m) Total Facilities Disbursed (ZAR ’m) No of RFIs No of loans disbursed by RFIs to their clients Females Black Rural

Total from inception to 31 March 2004

2002

2003

2004

684.4 504.8 12

97.4 75.2 16

105.5 75.2 16

99.3 85.1 12

259 495 70% 96% 30%

10 138 80% 97% 30%

10 138 80% 97% 30%

93 615 55% 97% 35%

Source: Khula 2004 annual report

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Khula Start Programme The Khula Start programme focuses on micro enterprises with credit facilities needs of below ZAR 5 000 using group lending methodology (this is essentially the micro finance lending component of Khula). It targets historically disadvantaged communities, particularly women in rural and peri-urban areas. To reach the targeted borrowers, it partners with Micro Credit Outlets (MCOs) that meet its requirements (it does not lend directly to the ultimate borrowers). The requirements that the MCOs are required to adhere to include: x

Be based in rural and peri-rural areas.

x

Have links with local communities.

x

Are associated with established Non Governmental Organisations and Community Based Organisations, which support SMME activity.

x

At least 70% of their lending should be to women.

x

Use group based lending (lending to groups of three (3) to ten (10) persons). Table 5. The performance of Khula Start

Khula Start MCO Programme Total Facilities Disbursed (ZAR ’m) No of Khula Start MCO relationships established No of loans granted by MCOs to their clients Females Black Rural

Total from inception to 31 March 2004

2002

2003

2004

42.6 17 Not available 87%

6.9 22 20 060 85%

9.9 17 26 233 88%

14.3 17 14 484 87%

100% 95%

100% 95%

100% 95%

100% 95%

Source: Khula 2004 annual report

With the establishment of the Apex Fund, which targets micro enterprises requiring funding of less than ZAR 10 000, it is envisaged that all MCOs, including RFIs whose loan facilities are less than ZAR 10 000, will be funded in the future by the Apex Fund. This means that Khula will be able to focus on small to medium-sized enterprises requiring funding of between ZAR 10 000 to ZAR 3 million.

Credit Guarantee Scheme The Credit Guarantee Scheme supports businesses that would otherwise not obtain finance from a commercial bank due to inadequate collateral or security. Khula does not extend loans to SMMEs directly, but covers a portion of the bank’s risk on the SMME’s behalf. In this way, the security requirements of the bank are covered, even when the SMME cannot provide enough security on its own for the full amount. When the commercial banks receive loan applications from SMMEs, and if they believe that the risk profile of an applicant is acceptable taking into account the potential credit guarantee from Khula and other securities, they will send the application to Khula for approval. Once Khula approves the deal, it is sent back to the bank for further processing. This arrangement has had its shortcomings in that the banks have not THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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adequately focused their attention towards identifying potential SMME parties that can benefit from the Khula guarantee scheme. In order to increase the uptake by banks of this programme, Khula has revised its approach in partnering with the participating commercial banks. The new approach, included in Khula’s 2004-2007 strategy, envisages a situation where Khula will use one or two large banks and a maximum of four smaller niche banks. The agreements with the banks will in future be based on a performance driven approach, focusing amongst others, on Khula’s target market and providing facilities to the target market at an affordable price (Khula Corporate Strategy 2004 - 2007). Table 6. The performance of Credit Guarantee Scheme Total from inception to 31 March 2004

Credit Guarantee Scheme

2002

2003

2004

1 053.6 343.7

166.6 166.6

133 133

180 180

Claims Paid (ZAR ’m) No of active participating banks No of guarantees authorised No of guarantees committed

65.8 5 6 544 1 565

7.3 9 797 797

19.70 9 532 532

24.2 5 628 628

Females Black (was 10% during SBDC ) Rural

40% 46% 15%

54% 60% 15%

70% 56% 15%

57% 53% 15%

Total authorised guarantees (ZAR ’m) Total committed guarantees (ZAR ’m)

Source: Khula 2004 annual report

Khula Private Equity Fund The Khula Private Equity Fund provides funding for BEE enterprises that require equity-type funding ranging from ZAR 250 000 to ZAR 2.5 million. Its focus is on developing new economic capacity through the financing of start-ups and expansions. The performance of the Equity Fund is outlined in the following table. Table 7. Khula Private Equity Fund Performance

Equity Fund Programme

Total from inception to 31 March 2004

2002

2003

2004

Rand Value of deals (ZAR ’m) Rand value of bad debts (ZAR ’m) No of approved deals Females Black

37.6 5.3 19 20% 90%

2.8 0 3 0% 100%

15.2 0 8 13% 87%

19.6 5.3 7 25% 88%

Rural

37%

0%

25%

63%

Source: Khula 2004 annual report

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140 – PART II: SELECTED PAPERS Listed below are two examples of Khula Private Equity Funds: x

The Anglo-Khula Mining Fund – the Fund seeks to empower the South African mining and related sectors, and focuses mainly on investing and adding value to viable small and medium-sized black-owned and black-empowered businesses. The total capitalisation of this fund will be ZAR 40 million, with equal contributions from Anglo American PLC and Khula.

x

Shoprite-Khula Joint Venture – this is a ZAR 20 million joint venture fund with equal contributions from the two parties with the objective of funding OK franchises owned by PDIs.

During 2004, the operating model for the equity fund was reviewed, including a review of the investment criteria, the provisioning policy, the fund management contract, and the overall return requirements of the fund. As per the discussions with the managing director, plans are underway to consolidate this equity fund into a still to be established joint venture between Khula, business partners, and the Public Investment Corporation’s (PIC) Isibaya Fund. An amount of ZAR 300 million is earmarked for the capitalisation of this venture.

IDC The IDC Board of Directors set the following output targets for the 2004 financial year:x

BEE – 35% of the number of approvals and 30% of the value of approvals. The actual result achieved was 53% of the number of approvals and 35% of the value of approvals.

x

SMEs – 45% of the number of approvals. The actual result achieved was over 70% of the number of approvals.

x

Outreach to poorer provinces - 20% of approvals value to the Eastern Cape, Northern Cape and Limpopo. The actual result achieved was 32% (ZAR 1.5 billion) of the total approvals value.

As per its 2004 results, the IDC met the BEE and SMEs financing targets that were set by its board of directors. In its 2004 annual report, the IDC states that the majority of its clients are SMEs with total assets of less than ZAR 30 million, a turnover of less than ZAR 50 million, and less than 100 employees. Additionally, the IDC’s financing approvals in 2004 will contribute to the creation of 19 518 job opportunities (2003: 17 551) and 31% of this number (5 958) will be created by SMEs. The importance of SME development is illustrated through the number of jobs created per ZAR 1 million of IDC financing. The SMEs financed by the IDC are expected to create 6.65 jobs per ZAR 1 million of IDC financing compared to the 2.74 jobs per ZAR 1 million of IDC financing by non-SMEs. From July 1995 to June 2004, the IDC approved SME transactions worth over ZAR 12.2 billion involving about 3 200 deals and over 870 BEE deals worth ZAR 9.8 billion. The SME approvals comprise approximately 25% of the total number of approvals financed for the period. Listed in the following table is an analysis of the IDC’s SMEs funding for the past three years.

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Table 8. IDC’s SMEs funding (2002-2004) Period Total Funds Disbursed to SMEs (ZAR ’m) Number of SMEs SMEs as % of Rand Value SMEs as % of Number

2002 2 135 426 44% 83%

2003 1 010 253 16% 73%

2004 904 189 15% 73%

Source: IDC 2004 annual report

In addition to its traditional product offering that requires minimum funding of above ZAR 1 million, the IDC provides loan and equity funding ranging from ZAR 500 000 to ZAR 15 million in selected sectors, for eight-to-ten-year periods. This is done through, among others, the Risk Capital Facility that is capitalised by the European Union for an amount of ZAR 550 million. The IDC co-administers the fund with the European Union Investment Bank. With over 6 decades of development finance experience, and an aggregate value of SME funding approvals of over ZAR 12 billion since 1994, the IDC remains the largest and the most established of the development financiers. During the same period (since 1994), the IDC approved over ZAR 9 billion in support of BEE deals.

Other DTI funded programmes The information for this section was sourced directly from SPII product brochures and was updated with the information from DTI discussions with the Innovation and Technology division of the DTI.

Support Programme for Industrial Innovation (SPII) SPII is administered by the IDC and funded by the DTI. It does not finance SMMEs directly, but assists in alleviating their cash flow burden by injecting grants into the projects they commission. The combined value of the SPII approvals for the 2003/2004 financial year was ZAR 70.8 million (55 projects) and ZAR 79.2 million (64 projects) in the previous year.

Technology Venture Capital The fund, established in December 2003, is a joint venture between the public and private sectors, i.e. IDC, Sanlam, the European Union, the DTI, and CSIR. The purpose of this fund is to assist viable business ventures and projects within the technology arena. As of November 2004, there were no projects that had yet been funded. According to the managers of the fund, the CSIR, they are still raising funds, with the DTI being the only party that has so far pledged funds (ZAR 10 million).

Technology Agency Transfer The fund was capitalised by the DTI to the value of ZAR 2 million to provide nonfinancial support to entities and project teams within the technology arena. The fund is managed by CSIR and will form part of the new SEDA agency.

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Technology Transfer Capital Guarantee The fund was capitalised by the DTI to the value of ZAR 2 million, to provide guarantees to entities and project teams within the technology arena. Guarantees, of up to 90% of the bank loans, are provided to qualifying candidates that do not have sufficient collateral to meet commercial banks’ lending criteria. The scheme is currently managed by CSIR, and was previously managed by Khula.

Overall summary on the Developmental Finance Institutions of the DTI There is a DTI DFI (Developmental Finance Institution) present in each of the sectors of the SMME market, and they have product ranges that cover the full funding spectrum of this market. The question is whether in practice SMEs in all the provinces have access to the full range of products available. The table below provides a snapshot of the funding levels and distribution channels used by the DTIs. Table 9. DTI funding levels and distribution channels Financing requirements ZAR 300 to ZAR 10 000 ZAR 10 000 to ZAR 250 000 ZAR 250 000 to ZAR 3 million

ZAR 3 to 10 million ZAR 10 to 50 million Above ZAR 50 million

DFI Apex Fund Khula Khula Khula NEF IDC NEF IDC NEF IDC IDC

Distribution Channel MCOs RFIs and MCOs RFIs Commercial Banks, Private Equity Firms Retail Retail and wholesale (above ZAR 1 million) Retail Retail and wholesale Retail Retail and wholesale Retail and wholesale

In addition to the DFIs, the DTI funds other developmental programmes within the technology sector. These programmes do not finance SMMEs directly, but assist in alleviating their cash flow burden by injecting grants into the projects they commission. They also provide non-financial support to entities (SMMEs included) and project teams within the technology arena. By putting its new strategic plan to work, Khula is hoping to address the issues that may have negatively affected its performance in the past. In particular, Khula is hoping to further improve on its outreach and capacity by creating stronger partnerships with its strategic partners. One may conclude that these are still early days, and the level of success of Khula’s new strategy will be proven in the coming years. For its part, the IDC is addressing the national outreach issue by opening agency offices in the poorer provinces and working with both the local and provincial government to increase investments in those areas. While the value of its SME funding has certainly reduced in recent times, its weight is certainly being felt in the BEE funding arena, where it has increased the number and size of deals funded. Since its inception to 31 March 2004, the NEF had approved one deal, with a value of ZAR 4.9 million. Subsequent to its year end and up until the time of the study, the NEF had approved an additional six deals totalling ZAR 16 million. Its performance, especially when compared to the other DFIs, indicates that an intervention is required.

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Conclusions Private sector relationships Based on this evaluation, the FinMark Trust study made the following recommendations and observations:x

The private sector needs to develop entrepreneurial and microfinance skills within their staff and management to better equip them to deal with, and understand, the financial needs of SMMEs. Consumer education was also identified as a priority. This was based on the need to address the mutual misunderstanding of each other’s requirements between bank staff and SMMEs.

x

The private sector should pursue or continue to pursue linkage strategies with village banks and cooperatives involved in providing informal financial services to the poor.

x

Further, the private sector should promote the provision of savings facilities for the lower end of the market for formal and informal institutions.

x

It also recommended that best practice case studies and research on small bank establishment in the sector should be developed to overcome negative perceptions regarding the role of small banks.

x

It was found that banks play a vital role in the SMME financing sector, simply by providing bank accounts to business owners in their individual capacity, which can then be used as a basis to access other financial services from non-banking institutions such as village banks, MFIs and commercial micro-lenders.

x

The need for better research and disclosure on the exact extent of banks involvement in the sector was identified.

x

In terms of the Venture Capital and Private Equity Funds, the main recommendation was the assessment of the feasibility of venture capital funds focusing on the lower end of the market: below ZAR 5 million;

x

The role of the insurance industry is crucial in the provision of services to the SMME sector to deal with risks faced by SMMEs, particularly risks associated with HIV/ AIDS. The insurance industry also has a role to play with respect to supporting the informal insurance industry. The Financial Sector Charter provides an opportunity to engage the insurance industry on this issue.

x

Commercial micro-lenders have played a relatively limited role in SMME finance and there has been little innovation in this area. Perhaps, through government support or other forms of subsidised funding, product innovation could be encouraged as commercial micro lenders represent a potentially large supply base for SMME finance.

Role of non -commercial providers In the case of village banks, MFIs, and mutual banks, both the public and private sector play a vital role in ensuring the success of this sector, as highlighted above. The state plays a role particularly with regard to providing appropriate enabling legislation, supporting capacity building and in subsidising operations during the slow, painstaking THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

144 – PART II: SELECTED PAPERS business of institution building. The private sector can also play a facilitating role, particularly with regard to making accessible transaction services and providing insurance services.

Where should government intervene? The private sector has over the years introduced different financing products for SMMEs without significant success. The general perception is that the SMME market is associated with high risks and low returns. Accordingly, government should investigate possibilities of reviewing legislation that impact on SMME financing to ensure increased participation of the private sector in this market space. The introduction of the financial services charter has already contributed in this respect. The FinMark Trust study made several recommendations as to how the government can intervene to ensure that there is increased participation in the financing of the SMME market by the private sector. One such recommendation relates to the review of legislation that impacts SMMEs. The FinMark Trust study further recommended that the government’s procurement programme could be made more effective by developing specific products for SMMEs that have been awarded contracts, using the contract to provide a guarantee for those with a lack of collateral. This could also be applied to SMMEs that have been awarded contracts by private sector companies in line with BEE targets. It was also recommended that government should consider other types of SMME financing partnerships with the private sector beyond the current partnerships with banks in the Khula Guarantee model. Other potential private sector partners could include commercial micro-lenders and venture capital funds. Additionally, Investigations should be made as to whether the recently launched Mzansi Account can be used as a basis to access financial services from non-banking institutions such as village banks, MFIs, and commercial micro lenders.

Notes 1 “Black” refers to African, Indian and Coloured South Africans.

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GBS Venture Partners, Australia – A Case Study in Government Programmes to Kick Start a Venture Capital Industry

Ms. Brigitte Smith Managing Director, GBS Venture Partners, Australia GBS Venture Partners was established in 1998 as a result of an Australian federal government programme (the Innovation Investment Fund Programme) that aimed to start the venture capital industry in Australia. GBS is now one of the largest players in the Australian venture capital sector, with AUD 300m under management, a significant team of professionals, and a purely private sector group of investors (Limited Partners). The case study will explore how Australian government programmes enabled the establishment and development of the firm, and more broadly, the Australian venture capital industry. The case study will also explore specific examples of the financing of individual technology-based SMEs in the global capital market, using Australia as a base. Finally, the case study will take stock of how much further the Australian venture capital industry needs to go in order to become sustainable.

Introduction GBS Venture Partners is Australia’s largest life science specialist venture capital investor, with AUD 300 million under management in a series of funds raised between 1998 and 2005. GBS has been involved in founding and invested in more than 25 companies based on novel Australasian life science technologies. The firm would most likely not exist had the Australian Federal government not made some timely intervention to jump-start the Australian venture capital industry. The management team is largely composed of Australian nationals who have spent several years working in the United States with technology-based firms or venture capital firms in the life sciences, and returned to Australia in order generate returns for Australia from Australian life science technologies.

History of GBS and the role of government programmes In 1998, when the team tried to raise a small first time fund in Australia, superannuation funds (equivalent to US pension funds) were not interested. A late 1980s tax driven scheme1 to stimulate the Australian venture capital industry had been a failure, and investors in the first funds that were the products of that scheme had not made satisfactory returns. While a small number of highly successful firms were created during this programme (including global market share leader in Cochlear Implants, Cochlear, innovator in flu treatment, Biota, global market share leader in sleep apnoea, ResMed, THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

146 – PART II: SELECTED PAPERS and membrane filtration technology leader, Memtec), there were no venture capital fund managers who had generated satisfactory consistent fund level returns, and there were very few early stage venture capital managers. The Australian Government’s Innovation Investment Fund (IIF) Programme sought to address this funding gap and build expertise in a small number of venture capital managers. The programme, developed after international benchmarking and review, sought applications from potential managers for one of nine IIF licenses offered under two funding rounds held in 1998 and 2001 respectively. Successful applicants were able to secure private capital by leveraging the government’s investment. The group that became GBS, then a wholly owned subsidiary of NM Rothschild & Sons (Australia)2, secured a round one license after a process that was managed by independent “gate-keepers”. Private investors NM Rothschild & Sons (Australia), CSL (a large Australian life science company), TESS (the pension fund of university staff around the country), and a high net worth family, invested AUD 15 million, matched by AUD 27.5 million government money in a just-in-time 10 year unit trust structure. Returns are: x

Capital return to all investors.

x

A 6% simple interest return to all investors.

x

Surplus distributed 10% to government, 72% to private investors, and 18% to the manager.

This structure provides the private investors with the potential for significant returns if the fund is successful in compensating for the risk of investing with a first time manager in the unproved Australian venture capital sector. Management fees are front end loaded, scaling from 4% of funds under management to 2% of funds under management over the life of the fund. No more than 10% of the fund can be invested in any one company, to ensure diversification. Investment decision making is 100% in the hands of the manager, as long as investments are in Australian owned technology and the diversifications limitations are respected. From 1998 to 2001, GBS made investments in a variety of new enterprises that are commercialising new medicines, medical devices, and health information technology. In 2001, the portfolio was performing well, and the GBS team was able to raise a new AUD 64.5m fund3, this time simply from private investors (Limited Partners) who were able to consider the track record of the management team and the companies from the original IIF fund. At this point, none of the investments from the earlier fund were realised, but the tech bubble made most superannuation funds more receptive to considering risky asset classes and interested in holding assets involving new Australasian technology. In 2002, the Australian Government considered that while there were now managers able to make early stage venture capital investments, there remained a funding gap at the very early seed stage. The Pre Seed Fund (PSF) Programme sought to address this funding gap through encouraging the private sector to take a more active role in funding and managing the commercialisation of research from universities and Australian Government research agencies. Again, GBS was fortunate in securing a license to manage a AUD 30m Pre Seed Fund, with AUD 7.5m private capital from superannuation funds and high net worth individuals, and AUD 22.5m from the Australian Government. This time the leverage THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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was even greater, capital was returned, and thereafter, all the upside returns are shared between the manager and the private investors. In addressing the pre-seed funding gap, the conditions of investment are however more onerous: a total of only AUD 1m per investment is allowed, and all investments must commercialise research that is majority owned by a federally funded research institute (usually universities). This programme increased GBS’ funds under management, and with 3% management fees enabled GBS to hire another two investment professionals from the pharmaceutical sector to build up the team and train more people in venture capital. With close to AUD 150m under management, GBS was now in a position to spin-out of Rothschild and create GBS Venture Partners, with separate offices, back office and a manager owned and operated business.4 The independently owned and operated manager is the model preferred by institutional investors (Limited Partners), but it is difficult to make it work for first time fund managers due to high fixed costs, including insurance and salaries. The incubation of GBS by Rothschild together with the IIF and PSF licenses enabled GBS to create critical mass before steeping out as an independent group.

What went wrong, what went right While the IIF and PSF funds enabled GBS to be created, there have been some small problems along the way. First, as there was no venture capital industry in Australia when GBS started, and our fund could only invest up to AUD 4m per company, there were limited options for follow-on funding of our portfolio companies. While GBS was able to provide the first round of funding, GBS found it very challenging to secure follow-on venture capital investment for its investees. In planning for the absence of capital for later rounds of funding, GBS’ initial investments in underlying companies were of the order of AUD 2m or less, with the balance held in reserve for future rounds. GBS was very fortunate in being able to raise a subsequent fund that was sometimes able to invest in follow-on rounds of funding (with appropriate management of conflicts of interest), and also fortunate that it is relatively easy to list companies on the Australian Stock Exchange (ASX) and raise money from public market investors. Second, the tech wreck happened. This made it likely that GBS would need to finance investments for longer, and for greater amounts, before GBS could approach the realisation of the assets, and it depressed the value that acquirers would pay for assets. Funds raised in the 1998 – 2000 period are experiencing some of the worst returns ever seen in the venture capital industry globally, and it requires a leap of faith from investors to raise subsequent funds. Third, the AUD 1m cap on investment for seed fund investments in the PSF is very challenging in the absence of follow-on funding. Overall in GBS’s experience, its portfolio companies have raised AUD 5 for every AUD 1 raised from us, so GBS has succeeded in syndicating its investments with Australian and US based groups, taking companies public, and acting as a catalyst to find the equity financing our companies need. Extremely generous Federal and State Government Grants to some of GBS’ portfolio companies have also helped their R&D programmes. Despite these obstacles, GBS investee companies have largely met their milestones, secured follow-on funding, and some look poised to be significant Australian technology based companies of the future. In 2005, GBS went back to its private investors, and some THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

148 – PART II: SELECTED PAPERS new ones, and raised a AUD 150m fund, which will be able to do some of the later stage funding its earlier and smaller funds were not able to do. Together with some direct investments in GBS’ portfolio companies by its investors, this brings GBS to AUD 300m under management.

The Australian Venture Capital Sector Turning now to the Australian venture capital sector more broadly, GBS has been very fortunate. The venture capital industry is still very new, and there are very few managers with the depth of experience and track record that institutional investors want. The following figure shows that GBS is one of the very few managers that have raised more than two funds (Figure 1). Figure 1. Funds per Manager 30

Number of Venture Capital Managers

25

20

15

10

5

0

1 fund

2 funds

3 or more funds

Source: GBS, Quay Partners, Access Economics

Almost no funds have been fully realised, given fund life is usually ten years and the earliest funds were raised in 1997-1998. So institutional investors are trying to project who will be the successful manager as they make their investment decisions. A large proportion of Australian superannuation funds do not invest in venture capital at all, as there is insufficient data to support the case that strong returns can be made in this sector. There is a clear need for continuing government intervention to bring new managers into the market. The immaturity of the sector and the small number of venture capital managers give rise to a shortage of venture capital, particularly in the later stage and in follow-on capital, after the early stage capital has been supplied by state and federal government supported funds. As the Figure 2 shows, there is now a later stage (Series B/Series C) funding gap for Australian technology based companies.

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Figure 2. Capacity venture capital funds

60

Number of deals

50 40 30 20 GBS 10 0 Seed

First Investment stage

Mezzanine

Unless the seed and first round investment opportunities are of poor quality, one can anticipate that there will be worthy companies seeking follow on financing, for which there is no supply in years to come. In fact, one can see this gap in several of GBS’ investments from our earlier funds, and anticipate this gap for investments GBS is currently making.

Financing paths for SMEs in the Australian context Two examples serve to illustrate how Australian companies have addressed this later stage venture capital funding gap with some success. The first, Pharmaxis Pty Ltd, was a 1999 investment of GBS’ IIF fund, and the second, OPAL Therapeutics, was a 2005 investment of its AUD 30m seed fund, and the second AUD 64.5m fund. Pharmaxis is a Sydney based company that is developing novel therapies and tools for the treatment of respiratory diseases like asthma, cystic fibrosis, and bronchiectasis. Pharmaxis is currently running more than ten large late stage clinical trials for its products around the world, and manufactures its own products in a facility in northern Sydney. Pharmaxis raised AUD 2m from GBS in 1999, AUD 9m from GBS and another IIF fund in 2002, and then listed on the Australian stock exchange (ASX) in 2003, raising AUD 25m, then AUD 19m in 2004, listed on NASDAQ and then raised AUD 86m in November 2005 in a joint ASX/NASDAQ offer. While the Australian venture capital markets were insufficient to meet the company’s operating requirements, the company has remained Australian owned and operated while tapping the Australian and NASDAQ public markets. The company has been fortunate in timing its public capital raisings at times when there was appetite for a company that was still pre-revenue, and has a strong management team that has met milestones and had the ability to attract investment from good public market investors. OPAL Therapeutics is a Melbourne based company that is taking a very different approach to financing what it knows will be a lengthy development process for its immunotherapy medicine for AIDS, HCV and other infectious diseases. OPAL THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

150 – PART II: SELECTED PAPERS Therapeutics was funded for the first time by venture capital investors in 2005 based on promising results in monkeys with SIV/HIV. At the time of the first investment, GBS syndicated the investment with two large US West Coast based life science specialist venture capital investors, Alta Partners, and Alloy Ventures. The company was established as a Delaware incorporated entity with a wholly owned Australian subsidiary. Much of the development and clinical work will occur in Australia, particularly in the first few years of operations, but it is GBS’ experience that US investors will not invest unless it is a US based entity and under US law. OPAL is thus assured access to the world’s biggest capital market for new technologies, the US. Australia will benefit from this access to capital and expertise as the company develops. GBS believes that both models have the potential to deliver superior returns to the investors in its funds, but have learned that GBS needs to plan from the first stages of its investments for the follow-on funding stage, give the dearth of venture capital that continues to exist in Australia.

Summary In summary, the Australian Government has launched several programmes to support the development of the venture capital industry, and these programmes have contributed in a significant way to the success of GBS Ventures. The Australian venture capital sector is still in its infancy, but these programmes have enabled several firms to get established, and there is a beginning of an industry. While the industry matures, in order to achieve superior returns for its investors, GBS and its investee companies need to think through their long term financing strategies, and plan to either raise money from the public markets or from off shore venture capital markets to ensure sufficient capital to meet the companies’ longer term needs.

Notes 1 The MIC scheme. 2 NM Rothschild & Sons had invested globally in life science venture capital for two decades. 3 This fund is called GBS Bioscience Ventures II. 4 The management buy-out was completed in November 2003, with the support of all of the investors in all the Funds managed by the group.

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Technical Workshop on Private Equity Definitions and Measurements

In striving to develop common definitions, the Workshop considered the following issues: x

How many stages are useful for the international comparison of data? It is possible that just three may be preferable (early, expansion and late)?

x

Where should the boundary line of venture capital be drawn? (e.g. Should all expansion capital be considered as venture capital, or should some later stage expansion capital be considered beyond venture capital?)

x

What categories should be adopted for funds raised?

x

Could either the PEIGG Guidelines or the International Guidelines be adopted (or endorsed) in valuing all private equity deals?

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Private Equity Definitions and Measurements: Issues Paper Prepared by Australia (Ms. Margaret Crennan, Mr. Brendan Morling & Mr. Michael Ng) United States (Mr. Mario Cardullo & Mr. Randy Mitchell) European Investment Fund (EIF) (Mr. Thomas Meyer) European Venture Capital Association (EVCA) (Mr. Georges Noël). The purpose of the Workshop for Private Equity Definitions and Measurement is to promote discussion and seek agreement from participants to the development of standard definitions for venture capital. The workshop will also consider the two broad frameworks for measurement that have developed: those promoted by the Private Equity Industry Guidelines Group and international guidelines based around the work of several European venture capital associations. This paper will consider the key concepts underlying the two sets of valuation guidelines with a view to drawing out similarities and key differences. This paper was prepared to frame the discussions held at this workshop. It was sent in advance to all speakers and discussants of the Workshop.

Introduction The flow of international venture capital has been the subject of ongoing international (including OECD) study and analyses, as has been the many comparisons of the growth in international venture capital investment. The OECD working paper, STI Working Papers (2000)7, “The Internationalisation of Venture Capital Activity in OECD Countries: Implications for Measurement and Policy – Baygan and Freudenberg” identified five specific issues that have contributed to measurement difficulties in this area. x

There is a tendency for a number of countries, but not the United States, to include buy-out activity in their venture capital statistics.

x

Data on venture capital activity differ substantially for some countries depending on sources.

x

Statistics only cover the formal market – i.e. funds raised and investments made through recognised intermediary funds – there are no comparable data on direct investments, e.g. by business angels.

x

Funds raised and investments made are broken down in different ways – most often funds raised are broken down by investor (e.g. pension funds, banks) while investments are broken down according to stage (e.g. early, expansion).

x

Data does not generally refer to country of management of the fund surveyed and does not necessarily capture funds raised from investors in one country and invested in another. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Part I: Definitions Introduction A lack of agreed definitions, comparable statistics, and transparency in valuation methods could be major impediments to the detailed and informed examination of the venture capital sector by both domestic and international institutional investors (and asset consultants). Governments depend on reliable data when considering and developing venture capital policy and programmes to assist early stage business development. These impediments may also impinge on the ability of asset advisors and gatekeepers to recommend venture capital as an asset class to domestic and international investors.

Issues Diversity of terminology and definitions In recent years, there has been a tendency for the terms “venture capital” and “private equity” to be used interchangeably in many countries outside the US that have lesser developed venture capital markets. For many countries, this may be recognition that to exclude later stage investments, such as buy-outs would make their market appear very small. It may also be recognition that in lesser developed markets some funds undertake both venture capital and later stage buy-out deals. Where a distinction is made, venture capital is usually considered a sub-set of private equity, whereas in other situations (especially the US) the two are regarded as separate markets and data are collected and reported separately. Furthermore, in some cases, ‘private equity’ may include investment in infrastructure and other large scale investment transactions that do not involve listed entities, but are outside the scope of the generally accepted definition of ‘private equity’. Without broadly agreed definitions, these transactions may not be consistently classified across countries, and international comparisons of venture capital statistics may be less effective (or possibly misleading).

Stages of Investment Clarity of definitions is also important in government policy development to assist small and medium-sized enterprises (SMEs) gain access to finance. In these policy activities, it is important to differentiate between earlier stage venture capital and the later-stage private equity investment activity. It is more likely that early stage and higher risk activity, is being disadvantaged through a lack of reliable and uniform data. Generally, seed, start-up and early-stage expansion are considered venture capital. Later stage transactions, for example management buy-outs (MBOs), management buyins (MBIs) and leverage buy-outs (LBOs), are regarded as private equity transactions. However, there may be uncertainty with the classification of transactions involving the expansion of established businesses. It is generally recognised that transactions classified to the expansion stage can have characteristics of both the venture capital and later stage private equity sectors.

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The European Private Equity and Venture Capital Association (EVCA) The EVCA has been working with PricewaterhouseCoopers to improve the consistency of the data collection and analysis. The EVCA Yearbook 2003 reported that PricewaterhouseCoopers conducted a detailed survey amongst private equity and venture capital companies. The survey was conducted across 28 European countries, including 11 central European countries. The survey attempted to identify all companies that participated in private equity activity during 2002, regardless of association membership. The survey contained a glossary of key terms to ensure that all respondents had the same understanding of the questions. The Yearbook also sets out the definitions used to identify financing stages that correspond to the stage of development of an investee company. Seed: Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase. Start-up: Financing provided to companies for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially. Other Early Stage: Financing to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit. Expansion: Financing provided for the growth and expansion of an operating company, which may or may not be breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. Bridge Financing: Financing made available to a company in the period of transition from being privately owned to being publicly quoted (usually debt finance). Secondary Purchase/Replacement Capital: Purchase of existing shares in a company from another private equity organisation or from another shareholder(s). Rescue/Turnaround: Financing made available to an existing business, which has experienced trading difficulties, with a view to re-establishing prosperity. Management Buy-out: Financing provided to enable current operating management and investors to acquire existing product line or business. Management Buy-in: Financing provided to enable a manager or group of managers from outside the company to buy-in to the company with the support of private equity investors. For the purposes of reporting the results of its survey, the EVCA has grouped these stages into five broad categories - Seed, Start-up (includes Other Early Stage), Expansion (includes Bridge Financing, Rescue/Turnaround), Replacement Capital (includes Secondary Purchase, Refinancing Bank Debt) and buy-out s.

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The US experience There is a lack of consistent definitions in the United States on various stages of venture capital. The National Venture Capital Association has the following definition: “Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies […]. Recently, some investors have been referring to venture investing and buy-out investing as "private equity investing." This term can be confusing because some in the investment industry use the term "private equity" to refer only to buy-out fund investing.” However, the academic community agrees that venture capital is a portion of the private equity cycle. Most economies, other than the United States, agree that venture capital is a portion of private equity. The U.S. Government does not collect data on venture capital, buy-out and merger and acquisition financing. At the present time, these asset classes are unregulated. The only data is provided on a volunteer basis to institutional investors, “gate-keepers” and several data collection companies. At this time, the U.S. Government does not have any plans to regulate these industries or collect data.

The Australian experience Until recently, when the Australian Venture Capital Journal/PricewaterhouseCoopers (AVCJ) survey of activities ceased, there had been, for a number of years, three different entities collecting and reporting venture capital statistics in Australia. Each of these three entities – the Australian Bureau of Statistics (ABS), the Australian Venture Capital Association Limited (AVCAL) and the AVCJ - while using broadly similar terms, collected Australian venture capital data from different populations with the result that the terminology and statistics reported are not always directly comparable

The Australian Bureau of Statistics The ABS, the Australian Government’s statistical agency, conducts an annual survey of venture capital funds in Australia. The survey is in fact a census of venture capital vehicles that the ABS is able to identify from a variety of sources (mainly the industry association – the Australian Venture Capital Association Limited). The ABS has statutory authority to require participation in its surveys and censes. For the purposes of its annual survey of venture capital (and buy-out activity) the ABS defines venture capital as “[…] high risk private equity for typically new, innovative or fast growing unlisted companies. Venture capital investment is usually a short to medium-term investment with the potential of high capital gains on divestment (rather than long-term investment involving regular income streams)”. The ABS further notes that while most venture capital involves, new, innovative, or fast-growing private companies, the scope of the survey does not exclude other high risk activity such as turnaround investment. (However, turnaround investment is typically a small proportion of total venture capital investment.) The following definitions are used by the ABS to describe the various stages of business activity at which a venture capital vehicle may make investments.

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156 – PART II: SELECTED PAPERS Seed: product is in development. Usually in business less than 18 months. Early: product in pilot production. Usually in business less than 30 months. Expansion: product in market. Significant revenue growth. Turnaround: current products stagnant. Financing provided to a company at a time of operational or financial difficulty. Late: new product or product improvement. Continue revenue growth. Although data is collected on buy-out investment (LBO, MBO, MBI) for the survey, the ABS considers this investment to be outside the scope of venture capital.

AVCAL (Australian Venture Capital Association Limited) This private equity and venture capital industry association – on its website1 defines private equity/venture capital funds as: “Independently managed, dedicated pools of capital that focus on equity or equitylinked investments in privately held, high-growth companies”. “Many venture capital funds, however, occasionally make other types of private equity investments. Outside the United Sates, this phrase is often used as a synonym for private equity. Private equity includes organisations devoted to venture capital, leveraged buy-outs, consolidations, mezzanine and distressed debt investments, and a variety of hybrids such as venture leasing and venture factoring.” There is an annual industry benchmarking survey conducted by Thompson Venture Economics and endorsed by AVCAL. AVCAL members are required to support this survey, and must use the AVCAL valuation guidelines when reporting information. Venture Economics has been commissioned by AVCAL to seek to develop internationally comparable data. In the AVCAL 2003 year book, Thompson Venture Economics defines venture capital as: “Long-term, hands on, equity investment in high-potential companies by professional investors. The primary use of venture capital funds is for the growth of the company’s valuation. Thompson Venture Economics uses the term to describe the universe of venture investing. It does not include buy-out investing, mezzanine investing, funds of funds investing or secondaries. Angel investors or businesses angels would also not be included in the definition”. The term Private Equity is used by Thompson Venture Economics to describe the universe of all venture investing, buy-out investing, mezzanine investing, funds of funds investing or secondaries are also included in this broadest term.

The Australian Venture Capital Journal The AVCJ provides an independent publication reporting on the industry – in its Australian Venture Capital Guide, 2001 — defined a venture capital investment as: “…An equity investment in a private company”. Venture capitalists invest for three to seven years. Venture capitalists invest for capital gain. However, a venture capital

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investment can have a higher level of risk for the investor than other forms of investment. Until June 2004, AVCJ conducted an annual voluntary survey of both venture capitalists and private equity funds. It had a wide coverage of industry participants and a robust data collection and analysis methodology.

Part II: Measurement - valuation guidelines Introduction The Private Equity Industry Guidelines Group (PEIGG) was formed in February 2002. Its mission is to promote increased reporting consistency and transparency, and improve the operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information. The PEIGG Guidelines were finalised in March 2005. The guidelines are designed to be consistent with US GAAP and are endorsed by Institutional Limited Partners Association (ILPA). NVCA recommended that the PEIGG guidelines be considered the basis for their member’s valuation procedures and methodology. The International Private Equity and Venture Capital Valuation Guidelines were developed by the Association Française des Investisseurs en Capital (AFIC), the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA) with input and endorsement from other 27 associations (including regional and national associations in Europe, Russia, Africa, Australia and Hong Kong). The International Valuation Guidelines were finalised in 2004. The Group also created an independent board reporting and accountable to a general assembly. It will monitor market practices in the use of the guidelines along with the evolution of global accounting standards. The guidelines were launched in March 2005 and can be found at www.privateequityvaluation.com. The Guidelines are designed to be consistent with International Accounting Standards and are endorsed by EVCA, BVCA and AFIC, ILPA and 27 other associations.

International (EVCA/BVCA/AFIC) valuation guidelines As part of the reporting process to investors, fund managers have to value their venture capital and private equity investments on a regular basis. The valuation process is complex as it involves ascribing values to illiquid companies. Inconsistencies in industry guidelines create uncertainty for both fund managers carrying out these valuations and investors interpreting reports about their investments. For example, EVCA’s valuation guidelines of March 2001 recommended a conservative value and a fair market value, while the BVCA used a fair value approach for all unquoted investment. In view of the variety of valuation guidelines, EVCA, AFIC and BVCA launched a consultation process in December 2004 based on their jointly drafted international valuation guidelines for venture capital and private equity investments. The aim was to encourage a consistent valuation methodology and practice across Europe for the benefit of both fund managers and investors. Final guidelines were published in March 2005 to apply across a whole range of investment types including seed and start-up venture capital, buy-outs and growth/development capital. The guidelines adopt “fair value” as their starting point as it has increasing currency in international accounting practice and THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

158 – PART II: SELECTED PAPERS takes account of International Accounting Standards, which have been in force for listed companies since January 2005. The central theme of the guidelines is an assumption that the valuation of investments will be based on the amount for which they could be sold, assuming knowledgeable, willing parties in an arm’s length transaction. The assumption, however, raises certain practical difficulties in respect of valuation methodology. The guidelines seek to identify and describe ways of identifying fair value, including: cost of investment, earnings multiples, net assets and, with some caution, discounted cash flow of either the underlying business or the investment. The guidelines acknowledge that subjective judgements are necessary in estimating fair value and that sometimes fair value estimates will be unreliable. In such circumstances, they recommend that the investment should be reported as its carrying value at the previous reporting date, unless there is evidence of impairment. The joint guidelines also offer guidance on which valuation methodology is most appropriate for particular fair value investments, such as early stage enterprises or enterprises without or with insignificant revenues and without profits or positive cash flows; enterprises with revenue but without significant profits or positive cash flows; and enterprises with revenues, maintainable profits and/or maintainable positive cash flows. The guidelines also warn that methodologies should be used consistently from one period to another, unless a change would result in better fair value estimates.

US Private Equity Industry Group valuation guidelines Reporting standards in the private equity industry have always been problematic. Wide disparities can exist in how different funds account for the same investment. Valuation issues came to the fore in the fall out from the end to the dot-com boom. In December, 2003, after almost two years of work, the PEIGG released its “U.S. Private Equity Valuation Guidelines”. The U.S. Private Equity Valuation Guidelines have been formally endorsed by the Institutional Limited Partners Association (ILPA), but the National Venture Capital Association (NVCA) has not endorsed PEIGG guidelines but it has suggested that that its members review PEIGG’s guidelines when evaluating current valuation procedures or developing new approaches. The main thrust of PEIGG’s guidelines is to provide a framework for greater consistency in the valuations of investments in non-listed and listed companies, via fair market value estimates, quarterly reporting valuations to Limited Partners (LPs) and independent valuation committees. Also, fair value has to be consistent with the General Accepting Accounting Principle (GAAP).

Benefits of valuation guidelines Valuation guidelines provide a framework for valuing investments or companies at ‘fair value’ in a consistent, transparent and prudent manner. Valuation guidelines enforce a discipline on private equity fund managers to take a more rigorous approach to valuing their existing portfolios. The need for the principles underlying valuation guidelines was illustrated in the bull market for technology and telecommunications start-up companies in the late 1990s and the subsequent fall out in the following years. Substantial write-ups were quickly followed by dramatic falls. For example, JP Morgan Chase was forced to write down USD 1.9bn on its private equity investments (mainly because of its high THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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exposure to the telecommunications and high tech sectors). Merrill Lynch saw its pre-tax profits fall from USD 4 bn to USD 2.5 bn partly because of its private equity loss. Deutsche Bank reported EUR 1.4 bn of write-downs due mainly to its private equity portfolio.

Comparison of valuation guidelines Category

United States Private Equity Industry Guidelines Group

Underlying Principles

Fair value, GAAP, consistency, transparency, prudence.

Period of Valuation

Update on a quarterly basis and perform a rigorous review of valuations on an annual basis – or more frequently when required by the fund agreement.

Definition of Fair Value

“The amount at which an investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale”

Use of Cost Basis

Valuation Methodology (brief definition)

Cost (or most recent financing) “may approximate fair value for some time period” unless a “material change in value” has occurred. Example: When there is a significant improvement or deterioration in performance or market condition, consideration should be given to review and adjust carrying values upwards or downwards. Prescribed hierarchy of methods: Comparable company transactions - examination of third party investments/transactions in comparable equity securities. Comparable performance multiple – application of most appropriate and reasonable multiple derived from market based conditions or recent private transactions. Other methodologies including discount cash flow (involves amount, time value and appropriate discount rate), net asset (deriving value from tangible assets rather than performance) and industry-specific benchmarks (e.g. multiple of revenue, price per subscriber, etc)

International (EVCA/BVCA/AFIC) Fair value, IFRS and GAAP, consistency, best practice. At least every 6 months and fund manager can elect for a quarterly reporting. [In practice. in Europe, the quarterly reporting is the most applied.] “The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.”

Cost (or most recent financing) remains “appropriate” typically for a period of one year.

More flexibility in selection of method to fit context but preference for methods “that draw on market based measures of risk and return” (e.g. comparable public company multiples).

Marking down impaired investments

“Decreases in value may be more easily identified and justified than increases in value.”

If fair value of such investments cannot be reliably measured, estimation of impairment can be based on “an intuitive rather than analytical” reasoning and may involve reference to broad indicators of value change (e.g. stock market indices)

Discount for restricted shares – Public securities

Typically range from 0% to 30%

Range from 0% to 25%

Comments on the differences in emphasis on keys elements of valuation guidelines Fair Value The definition of ‘fair value’ for both sets of guidelines differs slightly. The U.S. guidelines differ from the International guidelines by not including the word ‘knowledgeable’. The key important elements are ‘willing and knowledgeable’ between buyer/seller, in an arms’ length transaction (this is implied), and based on a goingconcern assumption. Investors that are willing but not knowledgeable may, depending on THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

160 – PART II: SELECTED PAPERS market conditions, be induced to pay over and above a reasonable estimate of company worth. It may be that that part of the problem around the technology boom during the late 1990s was an increasing number of inexperienced participants entering the market and rapidly bidding up asset prices.

Use of cost basis The treatment of carrying at cost reflects the value of the company at the time at which it was purchased adjusted through the passage of time for are any material changes in its performance or changes in the economic environment. Compliance with any changes in international regulations or accounting standards is also taken into consideration. The treatment of carrying at cost, as outlined in U.S. Valuation Guidelines, reflects changes in circumstances while the International Valuation Guidelines, and states that the valuation will typically be for a period of one year. The length of the period for which the valuation methodology would remain appropriate is as long as the valuation is still relevant and depends on the specific circumstances of each case.

Methodology Both guidelines adopt a similar valuation methodology and express a strong preference for methods that “draw on market-based estimates of risk and return”. However, the US uses a prescribed hierarchy of methods while the International Guidelines are more flexible in selecting the approach to fit the context. There is no right or wrong answer in valuation as long as the methodology used is appropriate, consistent and transparent, and is carried out prudently in light of the nature, facts and circumstances and its materiality in the context of the investment.

Marking down impaired investment On the issue of marking down impaired investments, if there is evidence that investments have been impaired since the last valuation, then the carrying value should reflect the estimated extent of impairment. Write-downs would happen if a company either failed or fell short of delivering on its business plan or if the business environment deteriorated. Write-ups would occur when there was an outside round of financing, an IPO or a third party put an independent seal of approval on the new higher valuation. There is more likelihood of writing down the carrying value of an investment if one has paid well above what the investment is really worth, or if there is a change in market conditions or a material change impacting on the investment value. Arriving at a fair value, the assessment should be based in light of the nature, facts and circumstances and its materiality in the context of the investment rather than by intuition as suggested in the International Guidelines.

Valuation methodologies A brief definition of each methodology is as follows: Price of recent investment: price paid recently provides a basis for the valuation and also a good indicator of fair value. Earnings multiple: it involves the application of an earnings multiple to the earnings of the business to derive a value for the business. Earning multiples include price/earnings THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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(P/E), enterprise value/earnings before interest and tax (EV/EBIT) and enterprise value/ earnings before interest and tax and depreciation and amortisation (EV/EBITDA). Net assets methodology: value is derived from the underlying value of their tangible assets rather than their performance. Discount cash flows methodology: it involves deriving the value of a business by summing the present value of expected future cash flows. It involves three variables – amount, time value and discount rate. Industry valuation or specific benchmark: for example, price per bed (for nursing home operators), price per subscriber (for cable TV companies). This is based on the assumption that investors are willing to pay for turnover or market shares and that the normal profitability of businesses in the industry does not vary much. Comparable company transaction: it involves deriving the value of a company through examination of third party investments in comparable equity securities of the company, transactions in equity securities of comparable companies and direct comparisons to similar companies. Performance multiple: it involves applying a relevant multiple or the most appropriate and reasonable multiple derived from reference to market based quoted companies or recent private transactions to the performance of the company being valued to derive the value of the company.

Notes 1 Prepared by Venture Economics/Thomas Financial.

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162 – PART II: SELECTED PAPERS

…Damn Lies, Statistics and Venture Capital Statistics

Mr. Victor Bivell Founder and Publisher, Private Equity Media Established in 1992, Private Equity Media is Australia’s oldest venture capital publisher. It is based in Sydney, and all of its publications are market leaders in their fields. This paper presents its views private equity definitions and measurements and the possibility and need for accuracy and consistency.

The need for accuracy as well as consistency Consistency in global venture capital statistics is a worthy goal, and while this paper believes it is attainable, it is not an easy ambition and the degree of difficulty may be underestimated by some. Producing good venture capital statistics is particularly hard, so this paper will begin by outlining a few key principles that it believes are crucial for good statistics. As laudable as it is, the achievement of global consistency in private equity data is not sufficient to guarantee quality. Accuracy is equally or more important. Consistency based on an inadequate or defective methodology will lead to consistent inaccuracy. The goal should be consistent accuracy. By “accuracy” this paper does not mean only having a correct number instead of an incorrect number, but also a “complete” or “relatively complete” picture and stating how complete that picture is. Historically, “accuracy” and “venture capital statistics” have not been terms often associated, except in the minds of the naive. Most private equity data sets do not lend themselves to the level of absolute accuracy achievable in other financial asset classes, such as listed equities. There is a long list of reasons for this, among them: x

The complex and changing nature of private equity with many variables and new precedents.

x

Political and business issues associated with data gatherers.

x

The issues and difficulties in defining the population of data providers.

x

Inconsistent definitions of key concepts between countries and data gatherers.

x

Variability in the level of public disclosure by data providers.

x

Variability in the quality of data by data providers.

x

Competitive pressures between data providers.

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x

Precedents that encourage the acceptance of incomplete data.

x

Lack of experienced data gatherers and an undervaluation of the task

x

The lack of public debate about methodology.

Within private equity the degree of achievable accuracy varies between data sets. For example, calculating funds raised by private equity firms is relatively straightforward, while defining the population of private equity firms requires some judgement. In the more difficult data sets, the best that can be achieved is either a relative accuracy or a partial view. This can be very acceptable where the data is accompanied by a discussion of its methodologies and limitations. It should never be acceptable where it is not. Fortunately, most data sets share a number of common issues so that resolving a key issue can improve the quality of several data sets. For example, an acceptable methodology for identifying and defining the group of private equity firms to be surveyed can improve data sets on total capital, fund raising, capital invested, exit activity, and fund performance.

Focus needed on the data consumer Some data gatherers underestimate the readers of venture capital statistics, who bring their own perspective on the quality of data. Most data consumers know exactly what they want, but often they do not get it. This is because most venture capital data is usually compiled for the benefit of the data gatherer, e.g. a venture capital association that wishes to use it for marketing purposes, rather than the benefit of the consumer of the data. The main users of private equity data are institutional investors, governments, private equity practitioners, other industry professionals such as service providers, entrepreneurs and capital seekers, and the media. This paper thinks a refocus on the needs of the data consumer would expose the superficiality of some data sets and radically improve the design and quality of most data sets. An example of providing data from the consumers’ point of view was the Private Equity Media’s policy of always publishing the raw data for all its surveys. Often there is as much or more interest in the raw data than in the data summaries, shown by the commercial success of venture capital directories and limited partner directories, and in the interest in deals by breakdowns of investments and divestments. Where there is genuine user interest, raw data has a commercial value. In regard to accuracy, publishing the raw data is an excellent quality control mechanism. For example, respondents know that the data will be made public and seen by their friends and their competitors. Thus, they are under pressure to give credible data. Private Equity Media’s experience was that occasionally someone will query a datum or entry, and it would then have to either satisfactorily explain away the client’s concern or contact the data provider to check the issue. No such peer-based quality control exists in anonymous surveys, which are more focused on the requirements of the data provider, for example “confidentiality”, or in protecting the reputation of the data gatherer, for example, by disguising a low response rate to the survey. Private Equity Media’s experience over many years is that making raw data public also leads to an increase in the number of respondents, not a decrease. Private Equity THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

164 – PART II: SELECTED PAPERS Media consistently had a higher response rate to our surveys than our competitors, which promise confidentiality and do not publish their raw data. Apart from performance fees, confidentiality is rarely a critical requirement for private equity firms. In fact, many seek publicity. As mentioned above, the experience of Private Equity Media for investment surveys was only 1 to 2 percent of data was of real concern to firms. The percentage was higher for divestment data, more often in regard to losses than successful exits, but nonetheless Private Equity Media was able to access and publish massive amounts of data on cash in, cash out, IRRs and cash back multiples for many hundreds of successful and unsuccessful exits - by name - that showed a very high level of disclosure, and hence maturity, by the private equity firms.

Methodology Consumers of venture capital statistics are invariably intelligent, well-educated and critical people. They want, and need, to know on what basis statistics have been prepared. Yet often data sets have little or no discussion of their methodology and scope. The level of methodological disclosure can be a certain measure of whether the statistics have been prepared for the benefit of the data user or the data gatherer. The strong view of this paper is that any data set that does not discuss its methodology is not to be trusted. Such statistics can be called “trust me statistics” because they tell the readers nothing about the methodology - who was surveyed, who responded, how they responded, any problems encountered, etc. Such data sets with no methodological discussion say nothing to the reader except “trust me”. Two examples of poor disclosure of methodology: One is that of a large venture capital publishers that, on its website, discusses a very long list of methodological points but about three years ago the list concluded by saying to the effect, if not in exact wording, “This methodology may or may not apply to any particular product”. These days the disclaimer says the methodology is “not always specific to our products”. The point here is that data users want to know what specific methodology applies to the data of their interest. The rest is simply a statistician’s wish list, and potentially misleading if the data set does not state specifically which methodological points do and do not apply to each survey. The second example is an Australian one. For the 2003-04 financial year, Private Equity Media was able to reliably ascertain that the top 20 private equity managers earned in total around AUD 400 million in performance fees. Yet one of its competitor’s surveys said that only AUD 11 million in performance fees was earned and paid. When this was queried for a news story, Private Equity Media was informed that although 137 firms were surveyed, only nine firms answered that particular question. In such a case, where the number of respondents to the question differed so materially to the number surveyed, the very low number of respondents to the question should have been made clear. This paper would like to suggest that if the OECD is to authorise the publication of a manual on venture capital statistics, that it formulate a minimum set of essential methodological explanations that every data set should contain. Certain key minimum disclosures for methodology should be: the number of firms approached, the number of firms that responded, response level for key questions, definitions of key concepts, and THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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any specific issues and problems relating to the data set. The point should be to place the data in context so that users can use it knowing both its strengths and weaknesses.

Political and business issues associated with data gatherers Often the quality of a data set can, to varying extent, be predetermined by the type of organisation that undertakes the survey, so it is worthwhile to consider the main types of data gatherers and their strengths and weaknesses.

Independent publishers Most private equity data gatherers are also private equity publishers: examples being Dow Jones, Incisive Financial Publishing, Asian Venture Capital Journal, Asia Pacific Private Equity Review, and Private Equity Media, among others. The strengths of publishers who do the surveys on their own are: x

Independence.

x

Understanding of the sector.

x

The trust of their subscribers and readers which gives access to data.

x

Freedom to develop their methodology.

x

Their ability to publish and disseminate the data widely to the appropriate audience.

Characteristics that are both a strength and a weakness are: x

Their need to operate the data service on a commercial basis.

x

Where publishers compete, they may be reluctant to make public their methodology, although some may see making their methodology public as a means of competitive differentiation.

Weaknesses of such publishers are: x

Not all countries have a private equity publisher.

x

The level of resources to operate the service may be dependent on the commercial success of the service, which in turn is likely to be dependent on the size of the country’s private equity industry.

Governments Some Governments undertake private equity surveys. The strengths are: x

Independence.

x

Freedom to develop their methodology.

x

Ability to disseminate the data.

A strength and weakness is: x

The legal ability (of say, the Australian Bureau of Statistics) to require private equity firms to provide information. It would be interesting to know if or how

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166 – PART II: SELECTED PAPERS many times this power has been used. It would also be interesting to know whether, once used, it could alienate practitioners. Weaknesses can be: x

Lack of in-depth industry understanding with employees who only have a once a year or a part time role in the data sets.

x

Potential naivety about the political issues around the private equity sector.

x

Practitioner concern about revealing data to a government office.

Institutional investors Many institutional investors in the sector maintain their own statistics. Strengths are: x

Independence.

x

Freedom to develop their methodology.

x

Generally rigorous methodology - they are looking after their own money.

x

Very good access to managers and their data.

x

Performance data is particularly good.

But institutions have weaknesses: x

Their focus is on institutional grade managers only and sometimes subsets of these who are of interest.

x

They do not cover other types of firms such as captive balance sheet investors and private investment groups.

x

Their focus is on performance and they do not do major annual whole-of-industry datasets such as industry size and investment and divestment activity.

x

Dissemination is weak as data is usually for internal use or confidential.

Private equity and venture capital associations A number of industry associations undertake venture capital surveys, some times on their own or in conjunction with another organisation such as a publisher or an accounting firm. The main strength of associations is in small markets where a commercial service is not viable. However, associations have a number of weaknesses: x

Many data consumers, including many institutions, do not see them as independent. Rather, associations are often seen as marketing organisations. Nor does entering an alliance with an outside organisation necessarily resolve this, including where the outside organisation pays the association so that it may do the survey on the association’s behalf. The association can then be beholden to the outside organisation to provide it with value for money, which can lead to quality compromise through, for example, some form of exclusivity or the discouragement of competitors, and thus, discouragement of a true market.

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For an outside organisation, being affiliated to an association can mean that its client is the association or the private equity firms it wishes to impress, not the data user. Being associated with an industry association can also compromise the outside organisation, if it becomes hostage to the methodology preferred by the association, for example, by only surveying association members. The surveying of only association members, as a policy, is usually detrimental for accuracy. By way of example, the Australian Private Equity and Venture Capital Association surveys only its members, about 50 respondents; in contrast, the Australian Bureau of Statistics in its 2004-05 survey covered 140 firms. x

Association data sets can get caught up in the marketing needs of the association;

x

Association data sets can get caught up in the political needs of the association, such as wanting to impress governments that it represents all industry participants.

x

Some associations have a poor response rate to surveys and have had to mandate participation as part of membership.

x

Association’s often give data away for free, thus encouraging the view among data readers that they can get something for free and discouraging the development of a commercial market for data.

x

As markets get larger they can outgrow association data sets, and commercial data providers who may be seen as competitors can arise. How these transitions and processes are handled is dependent on the quality or otherwise of the association’s management.

In the view of this paper, associations have a number of inherent flaws as data gatherers, and in many cases should be data gatherers of last resort.

Other association models Some venture capital associations have overcome some of these inherent weaknesses with good methodology, such as the European Private Equity and Venture Capital Association, which has had a longstanding partnership with PricewaterhouseCoopers. For many years, the EVCA has also surveyed private equity firms that are not members. Another strength of EVCA is its ability to collect data from a large number of countries. The level of methodological disclosure in EVCA surveys is also very high and has been for many years.

Academics Academics also survey private equity firms. Academics’ strengths are: x

Independence.

x

Freedom to develop their methodology.

x

Wide range of topics.

But they have weaknesses: x

Surveys tend to be ad hoc or one-off studies that focus on a particular issue rather than major annual data sets.

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168 – PART II: SELECTED PAPERS x

They can find access to private equity firms difficult.

x

Except for media summaries, dissemination is often to a focused academic readership rather than the wider industry.

Summary The key factors from the above are that accuracy and consistency are best served by encouraging data sets that: 1. Focus on the information needs of the data consumer rather than the needs of the data gatherer or data provider. 2. Data gatherers should be independent and seen to be independent. 3. The preferred model for a data gatherer is a publisher operating on a commercial basis. 4. All data sets should have an adequate explanation of their scope and methodology. 5. Data gatherers should be free to develop their methodology in response to real world statistical problems that arise. 6. Making raw data public, whether as part of the survey results or on a commercial basis, is an excellent quality control mechanism. 7. Making raw data public can lead to an increase in response rates. 8. Data sets should not be limited to venture capital association members, but if this should be the case then it should be clearly stated as part of the data set’s scope and methodology. 9. The OECD should require a minimum level of methodological disclosure for every data set and also outline and encourage additional and full levels of disclosure.

Key statistical definitions The paper will now discuss definitions of key concepts that can be used as a basis for global consistency.

What is Venture Capital, Private Equity, and Unlisted Infrastructure? One of the conference issues is the demarcation and definition of venture capital, expansion capital, buy-out s and infrastructure. For many years, the Australian Venture Capital Guide has worked on potential definitions for these and this paper will present the discussion to date before commenting on it.

Terminology It is worth clarifying the usage of key terminology in private equity as the international industry is yet to agree on standard definitions, and many terms are used slightly differently around the world. Private equity as an asset class is investment in unlisted businesses. It does not include investment in major listed companies, property and real estate, fixed interest securities and other well established asset classes. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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In the United States, where the formal industry began, a distinction is made between venture capital and buy-out s, which are seen as separate markets and activities. The National Venture Capital Association of the USA says, “Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors.” There is a view in Australia that in the US “venture capital” is used only to describe early stage investing, but in practice, the term is used to refer to equity investment in both early stage and expanding established businesses. The European Private Equity and Venture Capital Association (EVCA) has recently begun using private equity as a generic term for the industry and includes, within private equity, the sectors of venture capital, buy-out s and unlisted infrastructure. Previously, the EVCA has used “venture capital” as a generic term for the industry and while this is still common, usage of “venture capital” is gradually shifting closer to the US usage, where it does not include buy-out s. The trend is for “venture capital” to refer to early stage and expansion investment and for “private equity” to refer to buy-out s. However, both “venture capital” and “private equity” are also used generically to refer to the whole industry. The British Venture Capital Association has long used “venture capital” as the generic term for the industry, while “private equity” can be used both generically and for buy-out s. In Asia, the Hong Kong Venture Capital Association has also long used “venture capital” as the generic term, and this includes investment in early and late stage, buy-out and unlisted infrastructure businesses. “Private equity” can be used both generically and for later stage buy-out s. In Australia, the industry began with the term “venture capital” as the generic descriptor. However, by the early 1990s, the term was also in part being used to denote investment in start-up and early stage companies only and the term “development capital” to denote later expansion stage investment. In the mid to late 1990s, “venture capital” again became the accepted generic term for the industry. However, a push by the buy-out sector in the early 2000s to differentiate itself from early stage investing has seen greater use of the US terminology of venture capital for early and expansion stage activity and the European terminology of “private equity” for buy-out s. For many years, the variety of usages on different continents sometimes led to confusion, especially for those not familiar with the industry. The key understandings are that “venture capital” can be used both generically for the industry and also for early stage investing, while “private equity” can also be used generically for the industry and also for later stage buy-out s. The Australian Venture Capital Guide uses the term “venture capital” in the broad generic sense, and interchangeably with the term “private equity”, to mean equity investment in unlisted companies that may range from seed and start-up operations through to established businesses and buy-out s. The Australian Venture Capital Guide and its sister publication, the Australian Venture Capital Journal, believe that international usage should be standardised with “private equity” as the key generic term for the industry as it is the most accurate descriptor and “venture capital” as a supplementary generic term due to its high recognition factor by the public.

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170 – PART II: SELECTED PAPERS This paper believes that the definitions should read: x

x

x x x

Private Equity. 1.) A generic term that can be used interchangeably with “venture capital” to describe the investment asset class that comprises unlisted equities. Its main elements are venture capital, buy-out s, and, sometimes, unlisted infrastructure; and 2.) Investment in later stage businesses, principally through leveraged buy-outs, including management buy-out s and management buy-ins. Venture capital. 1.) A generic term that can be used interchangeably with “private equity” to describe the private equity asset class and industry; 2.) Investment in unlisted early stage and established businesses including buy-out s and restructurings; and 3.) Investment in formative and early stage businesses. Expansion capital and development capital. Interchangeable terms for investment in established unlisted businesses. Buy-outs. Management buy-outs, management buy-ins and leveraged buy-out s. Infrastructure equity. Investment in essential fixed economic and social assets such as roads, power stations, airports, schools, etc. Infrastructure assets may be listed or unlisted.

Other common private equity industry terms are: x x x

Private capital. Private equity and private debt assets. Direct investment. 1.) Investment in unlisted equities; and 2.) Where an investor holds assets directly rather than through an investment manager. Alternative assets. A broad term that refers to all non traditional assets classes including venture capital, leveraged buy-out s, turnarounds, special situations, infrastructure, private debt, farmland, timber plantations, commodities, and others.

From Australian Venture Capital Guide 2006 To these definitions, this paper would now add: “Unlisted equities: the asset class that includes venture capital, established capital, private equity, unlisted infrastructure and other types of unlisted equity assets.” Several years ago, the author had hopes that “private equity” could become a very good generic term for the whole industry but given that the term has been hijacked by the buy-out sector that are unlikely to give it back, one needs to look for an alternative term. At this stage, this paper proposes that “unlisted equities” is the best of the terms that are currently available. If this paper can use this term for the present, the industry looks something like this. Unlisted Equities Asset Class: x

Venture Capital - early stage businesses

x

Established Capital - capital for minority positions in established businesses. (Private Equity Media has for a long time called this “expansion capital” but something like “established business capital” or “established capital” may more appropriate, if perhaps also more wieldy).

x

Private Equity - buy-outs, buy-ins, etc.

x

Unlisted Infrastructure - fixed economic and social assets.

x

Others - other categories can be added as required. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Expansion Capital - Venture Capital or Private Equity? The question of whether “expansion capital” or “established capital” should be part of venture capital or private equity has pros and cons. Established capital is similar to venture capital in that it usually involves the investors taking minority or significant minority positions. It is different to venture capital as the businesses are established rather than formative. Established capital is similar to private equity as the businesses are established, but it is different as the investors do not take control positions, and invest alongside the owners who may not be the managers. All of these are key similarities and differences. Time may solve this issue, but in the meantime I see no harm in treating “established capital” as a separate asset strategy. This paper has illustrated one way how this can be done in an example later in the paper. The example breaks out “established capital” while also allowing it to be included with venture capital, private equity and unlisted infrastructure when appropriate.

Definitions of business stages The conference also hopes to standardise statistical definitions for business stages. This paper offers the definitions developed and used by Private Equity Media. These were developed over the 12 years of Private Equity Media’s statistical work and refined to accommodate the variety of private equity practitioners and the great variety of statistical situations that were encountered. These definitions have stood the company in good stead and have been robust enough to handle all situations that we encountered. These categories can be further developed over time. Meanwhile, it seems practical to consider business stages within each sector of “unlisted equities”, so they are arranged so.

Venture capital stages x

Seed capital: funding for a pre-revenue business to support business formation and product and service development. The seed stage starts with the idea for a business and ends when it is ready for its first commercial sales and revenue. In recent years, the terms “Pre-Seed” and “Early Seed” have arisen to describe the very earliest steps in the seed capital stage when research and development moves into commercialisation. Thus seed capital can be divided into early seed and late seed.

x

Start-up capital: funding to commence commercial business operations. Start-up is a commercial start-up when a business starts taking and fulfilling commercial orders.

x

Early expansion capital: growth funding for a business which has revenue but is still relatively new.

x

Pre-IPO or Pre-listing: where a company plans to list on the Stock Exchange, usually within a period of a few months to two years.

x

Initial public offering (IPO): when a company offers shares to the public and lists on the Stock Exchange.

x

Divestment: completion of total exit, not partial exit. Methods may include: trade sale, on market, write off, liquidation, IPO, buyback by existing owners, MBO,

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172 – PART II: SELECTED PAPERS MBI, sale to private investors, repayment of loan, etc. and any combination of these, particularly where there has been a sell down process.

Established capital stages x

Expansion capital or sometimes development capital: growth funding for an established business.

x

Turnaround capital: funding to enable an established but faltering business to be rejuvenated or rescued.

x

Special situations: includes under-performance, restructurings, transitions, shareholder disputes.

x

Pre-IPO or Pre-listing: where a company plans to list on the Stock Exchange, usually within a period of a few months to two years.

x

Initial public offering (IPO): when a company offers shares to the public and lists on the Stock Exchange.

x

Divestment: as outlined previously.

Private equity stages x

Management buy-out (MBO): funding to enable a current management team to buy-out a business.

x

Management buy-in (MBI): funding to enable a new management team to buy-in to a business.

x

Leveraged buy-out (LBO): a buy-out that is funded with both equity and debt. LBOs include, but need not be, MBOs and MBIs.

x

Public to private: funding to take over a listed company and make it privately owned by delisting it from the stock exchange.

x

Secondary management buy-out: funding to enable a current management team to buy-out a business from a private equity fund or consortium.

x

Secondary management buy-in: funding to enable a new management team to buy-in to a business from a private equity fund or consortium.

x

Divestment: as outlined previously.

Unlisted infrastructure stages x

Greenfields: capital for start-up activities such as project and market feasibility, construction, etc.

x

Expansion Capital: growth funding for a new stage of the business.

x

Mature: acquisition of an interest in a mature business.

x

Privatization: funding to privatise a government asset.

x

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x

Divestment: as outlined previously.

With infrastructure, it is important to differentiate between listed assets (such as a roadway) and unlisted assets held in a listed fund. Infrastructure funds can be listed in the same way as venture capital and private equity funds can be listed, yet still hold unlisted assets.

An example of investment data presentation based on stages Below is an example of how the above methodology and definitions, as applied to investment data, would look in practice. All of the data is real and comes from the Private Equity Media/ PricewaterhouseCoopers Australian Venture Capital Investment Survey for the June quarter 2004. This template is easily applied to other datasets. Unlisted Equities Investment Activity

Investments Venture Capital Established Capital Private Equity Unlisted Infrastructure

Percent

AUD m

Percent

Companies

Percent

80 38 7 7

60.6 28.8 5.3 5.3

39.2 70.6 100.2 1187.6

2.8 5.1 7.1 85.0

73 33 4 6

63.0 28.4 3.4 5.2

132

100.0

1397.6

100.0

116

100.0

Venture Capital Seed Start-up Early Expansion

33 25 22

41.0 31.0 28.0

10.43 12.19 16.59

27.0 31.0 42.0

32 23 18

44.0 31.0 25.0

Subtotal

80

100.0

39.21

100.0

73

100.0

Established Capital Expansion Turnaround Loan

33 1 4

86.8 2.6 10.6

64.96 3.50 2.18

92.0 5.0 3.0

28 1 4

84.9 3.0 12.1

Subtotal

38

100.0

70.64

100.0

33

100.0

Private Equity MBO MBI LBO PTP

5 0 2 0

71.4 0.0 28.6 0.0

92.65 0 7.56 0.0

92.5 0.0 7.5 0.0

3 0 1 0

75.0 0.0 25.0 0.0

Subtotal

7

100.0

100.21

100.0

4

100.0

Unlisted Infrastructure Greenfields Expansion Mature Privatization Secondary

1 0 3 0 3

14.2 0.0 42.9 0.0 42.9

100.0 0 733.5 0 354.12

8.4 0.0 61.8 0.0 29.8

1 0 3 0 2

16.7 0.0 50.0 0.0 33.3

Subtotal

7

100.0

1187.62

100.00

6

100.0

Totals

Totals

132

1397.68

116

Source: Private Equity Media/ PricewaterhouseCoopers (2004), Australian Venture Capital Investment Survey: June Quarter 2004.

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Who should be surveyed? While having acceptable definitions of venture capital and private equity is desirable and would be useful, in practical terms another way of approaching the issue is to develop a methodology for identifying the population of firms that should participate in industry surveys. In Private Equity Media’s case, the method was in the first instance based on its annual directory - the Australian Venture Capital Guide. The clients for this product are mostly capital seekers and their corporate advisors. Thus, there was an incentive to actively search out new and potentially new entrants to the Guide - an inclusive approach to provide as many potential sources of capital as possible. This is balanced by quality issues such as: x

Is each firm a bona fide supplier of equity capital for unlisted businesses?

x

Is it a financial investor rather than a strategic investor?

x

Does the firm have available capital and is it actively seeking deal flow?

x

Where the firm invests in listed small capital companies does it do so with new equity rather than on market share purchases?

x

Does it have or is it developing a portfolio of direct investments?

x

Is it the principle investor rather than an agent?

x

Can Private Equity Media, in good faith, refer its clients to this firm?

When undertaking data sets for total industry capital, investment and divestment activity, the population was supplemented by asking: x

What additional firms and portfolios are fully invested or in wind down mode?

x

What additional firms keep a low or non existent public profile?

In regards to international firms, Private Equity Media’s approach from the beginning in 1993 was to ask - does it have an office in Australia? If so, only investments and capital invested are included in Australia. Local investments and portfolios by international firms that did not have an office in the country were not included. For such instances I think there is a case for creating a separate supplementary category of information. In regard to private, captive and government organizations, we identified and included only their private equity portfolios. Another issue is where to draw the line between formal investors and informal investors? Many private investors and business angels have wealth and private equity capacity comparable to some institutions and large fund managers. Private Equity Media’s policy was that private investors must invest through a formal vehicle, usually but nor always, a private company or trust, and have a private equity investment style, i.e. portfolio approach, capital gain rather than yield focus, etc. The above is a case by case approach to defining a population of private equity firms and the key is a good understanding of each firm. Overall the experience is that, unless the economy is tiny, there are usually more potential candidates for inclusion in an unlisted equities population or subset than most people believe. Private Equity Media’s

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on-going experience is that the more it looked the more it found. This paper finds that it would be very rare for someone to be able to say at that any given time they have identified ever single possible candidate.

Performance data Private Equity Media did not undertake systematic data collection of fund performance, so this paper will no go into depth on this issue. However, given the importance of fund performance to the sector, this paper will make several observations. Gathering performance data and subjecting the results to public scrutiny can be a difficult task, particularly with so much at stake for so many groups. Despite this, most publicly and freely available performance data does not satisfy the information needs of data readers. Anonymous numbers that give a headline performance figure for a country’s supposed “industry” or for supposed sub groups of the industry, while a start, do not address the real needs of data consumers. At best, they are media marketing material for a venture capital association or a fund manager in fund raising mode. They are “entry level statistics” only. They may serve to kindle a potential investor’s interest in the sector, but no institutional or other serious investor will make an investment decision based on a set of anonymous numbers that do not give the names of the managers and funds. Some of these performance statistics are also very slight on the disclosure of methodology, which can frustrate, antagonise or alienate industry professionals and others who would like to have an intelligent understanding of the data. A failure to provide a full methodological explanation can mean the data user is left totally in the dark on such crucial issues as, for example, survivor bias. The view of this paper is that the importance of much current performance data is overrated by the private equity firms and the data gatherers and is lowly rated by the data user. Performance data is often cited as an area where firms actively avoid a direct comparison, so that confidentiality is necessary. Yet such comparative data is regularly given to institutional investors. Furthermore, Private Equity Media’s experience is that many private equity firms do provide it with fund performance for public use in the Journal, including results that are modest. While Private Equity Media did not undertake performance surveys, at one point the author designed a theoretical system that he believes would have presented fund data from the readers’ point of view while also being fair to the private equity firms by comparing like with like. Had it proceeded, it would have been based on full disclosure and the methodology would have had an excellent chance of success in the opinion of this paper. It would certainly have given the data readers the type of information they want, which current publicly available performance data more often does not. From such a basis, it would be possible to create a system for industry and country performance that approaches the rigor and disclosure levels of listed equities. Ideally, one should have a system of performance measuring and reporting that is equal in quality and public disclosure to that of, say, managed equity funds, the names and performance of which are published regularly in major newspapers. The data consumer wants nothing less and one day the industry will need to provide it.

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Conclusions There are many other aspects to private equity statistics and many other topics worth discussing, particularly in regard to the myriad situations that arise and how these can be translated into meaningful data. The OECD idea of a manual for data collectors is a very good one. Such a manual could contain many more issues than have been discussed here, particularly in regard to the peculiarities of each type of survey and data set. Such a manual could continue to grow for many years, particularly as it grows it methodologies for each type of data set and comes to an acceptable statistical solution for each new situation as it arises. To summarise the key points of this paper from the above discussion: 1. Focus on the information needs of the data user, rather than the needs of the data gatherer or data provider. 2. Data gatherers should be independent and seen to be independent. 3. The preferred model for a data gatherer is an independent publisher operating on a commercial basis. 4. All data sets should have an adequate explanation of their scope and methodology. 5. Data gatherers should be free to develop their methodology in response to real world statistical problems that arise. 6. Making raw data public, whether as part of the survey results or on a commercial basis, is an excellent quality control mechanism. 7. Making raw data public can lead to an increase in response rates. 8. Data sets should not be limited to venture capital association members, but if this should be the case then it should be clearly stated as part of the data set’s scope and methodology. 9. The OECD should require a minimum level of methodological disclosure for every data set and also outline and encourage additional and full levels of disclosure. 10. Definitions of “venture capital” and “private equity” will sort themselves out with usage over time and meanwhile should be inclusive and flexible rather than rigid. 11. “Unlisted equities” may be a good generic term for the broader private equity industry. 12. There are arguments and advantages to treating expansion capital or established capital as separate from venture capital, private equity and unlisted infrastructure and letting time help sort the issue. 13. The concept of “start-up” as a stage should focus on commercial start-ups and initial revenues. Other interpretations are less precise and difficult to utilise with consistency. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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14. A good methodology for identifying the population of firms to be surveyed is key for achieving a relative completeness for most key datasets. 15. Each private equity firm is an individual and needs to be understood as such. 16. Anonymous numbers for headline performance of an industry or country have some, but limited value. 17. The lack of full methodological discussion can frustrate performance data users. 18. The unlisted equities sector should move away from performance disclosure on the current need-to-know basis or can-afford-to-invest basis, and move towards full disclosure at the fund level and macro level comparable to that of managed equity funds. 19. Except for performance fees and a very small amount of other data on an ad hoc basis, confidentiality is generally overrated and not a requirement of private equity firms. Where so, many over time are able to learn to appreciate the benefits of disclosure. Disclosure should always be encouraged.

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Standard Definitions and Valuation Methods for the Measurement of Private Equity

Mr. Jeong Min Kim Managing Director, Hanmi Venture Capital Corporation, Korea In recent years, there has been a tendency for the terms “venture capital” (VC) and “private equity” (PE) to be used interchangeably in many countries, including Korea. Unlike other countries, Korea legally defines venture business, venture capital and venture investment in the SME Promotion Act. Still, there are tendencies for VCs to consider PE style VC deals as PE investment. To identify standard definitions and valuation methods for the measurement of private equity, the term VC is redefined here. It is concluded that VC investments share similar mechanisms with those of PE when it associates itself with M&A and restructuring. However, VC always involves emerging businesses; industries or companies whereas PE normally involves existing, bigger industries or companies. Primary exit mechanisms for VC are either an IPO or M&A as a young company. Like many other investors, Korean VCs tend to interchangeably use the terms VC and PE in many cases. There are several reasons that they use the terms VC and PE interchangeably. While VC has similar characteristics as PE in many ways, such as controlled investments, MBO etc, VC should be regarded as a sub-set of PE. Before this paper addresses the confusing problem of VC and PE, let me explain the current situation in Korea. Unlike most other countries, Korea has defined the terms ‘venture company’, ‘venture investment’ and ‘venture capital’ in the SME Promotion Act. Theoretically, there should not be any confusion between VC and PE especially in Korea, because almost any data regarding VC can be calculated. SME Promotion Act defines VC related terms as follows: x

Venture (business)1

A company that uses unconventional business. The legal term ‘venture’ can be awarded if a company belongs to any of the following criteria:  Using its intellectual properties (patent, etc.).  Displaying heavy R&D expenditure rates.  Being backed by venture capital.  Passing a technology assessment by authorised government institutions.

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x

Venture Capital

According to the SME Promotion Act, a Korean VC should be registered to the Small and Medium Business Administration (SMBA) with some qualifications required: minimum paid in capital and accredited venture capitalists. According to the Korean VC Association (KVCA), there are 102 registered VCs in Korea as of December 2005. Any investment by other players such as angels or PE investors cannot be regarded as venture investment. x

Venture Investment

Literally, venture investment is an investment by an accredited ‘venture capital’ or partnership of ‘venture capital’. Because the government provided for a 30-year roll over fund called “MOTAE Fund,” which plays such an important LP role along with some other major LPs, such as National Pension Fund, etc., “decent” Korean VCs raise venture funds with these LPs as anchor investors. The ‘Motae Fund’ pursues both the political goal of venture encouragement as well as providing financial returns. The statistical data regarding ‘venture’ can be easily calculated through the SMBA because all the registered VCs should report their investment activities to the SMBA as well. Because of the legal definitions of ‘venture’ and ‘VC’, there are almost no problems in calculating VC investment in Korea, though PE and VC are still somewhat confused in everyone’s minds (See Appendix 1). The term PE has become familiar to many Koreans following the financial crisis of 1997. Because PE investment in Korea by foreign investors, such as Lone Star, Newbridge Capital and Goldman Sachs, invested in the restructuring big deals of banks or established large companies, there had been less confusion concerning VC investment. When the Korean Government established legal instruments for PE investment by Korean financial entities, domestic PE investors realised two things: difficulties in raising funds due to lack of PE experience and lack of attractive deals remained among the large deals. Historically, PE did not come from VC but rather, it has a separate and distinct origin. Though VC and PE share many common traits such as proactive and hands-on investment styles, MBO or MBI, the fundamental origins are different. VC is said to have started in the 1940s, while PE became known in the late 60s when Warburg Pincus raised a private equity fund called a buy-out fund. Compared with PE, VC can be relatively small in many aspects: deal size, number of professionals engaged and returns per deal (See Appendix 2). In fact, VC can be more labour intensive, while returns from a successful exit remain small. One of the easiest ways to increase the return per deal is to increase the size of the deal as well as the size of the fund for the given human resources available. It is the belief of this paper that investors looking for bigger deals and larger funds resulted in VC activities that resemble PE. Though VC is different from PE, VCs can also apply almost the same investment strategies as PE. During the course of venture capital investment, VCs can experience lots of management buy-out (MBO) or restructuring opportunities that are believed to be major investment themes for PE. However, the most significant difference between VC and PE is the difference of the risk that they bear. VC invests in companies of new industries or in new companies in existing industries. The growth potential in the short term is the major reason to invest. The major exit mechanisms will be IPOs or qualified THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

180 – PART II: SELECTED PAPERS mergers and acquisitions (M&A) with bigger counterparts. On the other hand, PE normally involves itself with the post-expansion period of the industry development cycle. Investees are either big or already listed. Therefore, this paper suggests that the standard definition of PE should be understood as the complementary set of VC in all PE investment. VC investment should be defined as a risk taking investment for explosive growth due to burgeoning industry or an innovative way of doing business in an existing industry. In addition, the primary exit mechanisms for VCs are either by IPOs or by M&A as a young company. Any PE investments that are not considered as VC investments can be defined as PE investments. Regarding the standard valuation method for the measurement of a PE or VC fund, conservative methods should be adopted in order not to mislead the investor as to the overall performance of the fund. Applying net asset value (NAV) for early stage VC investment may mislead investors as to the inherent value of the deal. Applying comparable PER for unlisted stock of unpredictable IPO timing will end up with over an estimation of value as well. The table below shows the suggestions for the valuation methods proposed by this paper. Valuation methods suggestion Type of Investment

Timing

Valuation Method

Initial investment ~ 2 years

Book Value or 3rd Party Transaction Value

Interim

Book Value or 3rd Party Transaction Value

1 year before IPO

Discounted PER of comparable listed companies

(Listed)

Mark to market

(Unlisted)

Discounted PER of comparable listed companies

Venture Capital

Private Equity

Notes 1 Once a company has been designated as ‘venture’, the company can enjoy certain advantages in many aspects such as IPO qualification and tax rates. The Korean Government recently simplified ‘venture’ categories to venture capital backed companies.

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Appendix 1

Venture Investment by Stage Unit: USD in millions

2004

Stage

2005

End of 2005(Balance)

Investee Amount % Investee Amount % Investee Amount Early

Expansion

Later

Total

%

<1year

13

8

12

49

42

7.31

62

49

7.22

2~3 year

14

18

27

114

124

21.37

97

94

13.71

sub total

27

25

39

163

167

28.68

159

144

20.93

4~5 year

21

14

21

172

211

36.28

112

121

17.66

6~7 year

23

21

32

107

121

20.85

235

273

39.75

sub total

44

35

53

279

332

57.14

347

394

57.41

8~14 year

5

3

4

54

61

10.46

119

121

17.60

over 14 year

2

2

3

14

22

3.72

22

28

4.06

sub total

7

5

7

68

82

14.19

141

149

21.66

78

65

100

510

581

647

686

100

Source: SMBA

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Appendix 2 Private Equity Investment Cases Financial Sector: Debt Buy-out s-Non Performing Loan (Unit: USD in millions) Target (Name of NPL Pool)

Investor

Date

KAMCO 98-1 KAMCO Secured NPL 98 KAMCO 99 KAMCO Secured NPL 99 KAMCO 99 KAMCO Secured NPL 99 KAMCO 2000

Goldman Sachs Lone Star Goldman Sachs Consortium Lone Star Goldman Sachs Consortium Morgan Stanley Consortium Goldman Sachs & Lone Star

9/1998 12/1998 5/1999 6/1999 11/1999 12/1999 7/2000

Transaction Value 177 483 660 888 693 874 938

Remarks Outright Sale Outright Sale Outright Sale Outright Sale Outright Sale Outright Sale Outright Sale

Source: KTB Networks

Financial Institute Buy-out s (Unit: USD in millions) Target (Name of Institute)

Investor

Good Morning Securities* Korea Exchange Bank** Koram Bank Korea First Bank Kookmin Bank Korea Exchange Credit Card Hana Bank LG Card

H&Q, Lombard Commerzbank AG Carlyle Group Newbridge Capital Goldman Sachs Olympus Capital Allianz AG Warburg Pincus

Note:

Date 5/1998 7/1998 9/1998 12/1998 5/1999 12/1999 4/2000 10/2000

Transaction Value 82 667 385 427 500 118 150 370

Remarks (equity stake) Buy-out (48%) Buy-out (32%) Buy-out (40%) Buy-out (50%) Minority Stake (11%) Buy-out (54%) Minority Stake (12%) Minority Stake (19%)

*

In May 2002, H&Q Consortium disposed their equity holdings to Shinhan Financial Holdings, which delivered USD 411 capital gain to the consortium participants **

In August 2003, Lone Star agreed to acquire 55% equity share from Commerzbank AG, the largest shareholder and others with the transaction value of USD 1.06 billion

Corporate sector Buy-out Investors’ Acquisitions (Unit: USD in millions) Target (Name of Institute)

Investor

Winia Mando Mando Corporation Haitai Confectionery Pantech & Curitel Kumho Tire Hanaro Telecom Daewoo Precision

UBS Capital Consortium JP Morgan Partners Consortium UBS Capital Consortium KTBnetwork Consortium Military Mutual Aid Newbridge-AIG Consortium KTBnetwork Consortium

Date 11/1999 1/2000 7/2001 11/2001 5/2003 11/2003 Present

Transaction Value 201 470 410 111 1 100 1 100 190~200

Remarks Asset Deal Asset Deal Asset Deal Asset Deal Asset Deal Stock Deal Ongoing Deal

Source: KTB Networks

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Towards Practical Valuation Approaches for Venture Capital Funds

Mr. Thomas Meyer Head of Risk Management & Monitoring, European Investment Fund, Luxembourg1 There is a broad consensus on the importance of venture capital (VC) for institutional investors and its impact on the overall economic development, but VC funds are highly difficult to value. Based on our experience, the negative impact of the J-curve, the workload associated with validations and a range of conceptual questions may be the main obstacles to attracting institutional investors to venture capital.

Summary There is a broad consensus on the importance of venture capital (VC) for institutional investors and its impact on the overall economic development, but VC funds are highly difficult to value. The negative impact of the J-curve, the workload associated with validations and a range of conceptual questions may be the main obstacles to attracting institutional investors to venture capital.2 EIF has just produced its first accounts under the International Financial Reporting Standards’ (IFRS) fair value regime for its private equity fund investments3, and the experience suggests that the practical and methodological problems related to the valuation of VC funds are often underestimated. x

Despite the introduction of the AFIC/BVCA/EVCA “International Private Equity and Venture Capital Guidelines” (“fair value guidelines”) for private equity, currently established practices for VC fund valuation approaches do not remove the J-curve for young funds.

x

Uncertainty remains about the validations to be conducted by limited partners. A look-through for young VC funds with valuations reviews for start-ups creates a high workload, and is of limited usefulness and is conceptually doubtful.

This, together with the J-curve, effectively creates barriers for investors considering an entry into the venture market. Additional problem areas are: x

The current practices for VC fund valuation cannot fully capture the risks to which limited partners are typically exposed.

x

The J-curve does not only have a conservative bias, but it can lead to the misinterpretation that “it is just the J-curve” and that a VC fund is doing better than it is in reality.

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The economic reality of, and the real risks inherent to, VC fund investments require valuation models. However, validation and acceptance of such models pose dilemmas.

The structuring of the investments in limited partnerships, which are the predominant form of VC funds, at least in the early years, have more in common with loans than with typical direct investments in equity, and, in fact, there have already repeatedly been proposals to introduce a “rating” for private equity funds. This paper’s focus is on the practical valuation questions related to VC funds rather than their proper accounting treatment.

Motivation Over the last years, EIF has intensively researched valuation techniques for VC funds. The recently issued fair value guidelines4 have established a convincing framework for the valuation of individual unquoted companies. These valuation guidelines have found broad endorsement and are likely to be widely accepted. However, there is still a high degree of uncertainty and confusion regarding valuation and accounting for limited partnership shares. So far, EVCA together with PricewaterhouseCoopers has released two discussion papers on this still on-going debate.5 In the context of private equity, fair value does give rise to questions and problems. There is a still ongoing conceptual debate in the auditing industry around the application of the fair value option (choice between “cost-minus-impairment” or “fair value” accounting) to instruments lacking liquid markets. In the absence of market prices, valuations depend on judgment. Estimates can be significantly off the mark and they are also easy to manipulate. The reliability of valuations is the main concern of the auditing profession and creates considerable uncertainty for limited partners who have to draw up IFRS-compliant accounts. Quoting one anonymous industry player, “a mistake made by a large number is acceptable, not a mistake made by one auditor”. This is probably true and, as a corollary, auditors will most likely reject what is correct but not widely applied. Reliability of valuations has two main drivers: 1. The soundness of the valuation model – an ineffective valuation model will skew otherwise accurate input information. 2. The quality – precision, consistency, appropriateness – of information and judgment of the input for the valuation model. The purpose of this paper is to raise awareness that work is still required on valuation techniques addressing the needs of investors in VC funds and that the current approaches do not always give the economic reality of a fund investment, cause significant and often superfluous workload, and may even create entry barriers for investors into this important sector of the economy. The arguments brought forward here relate to the mainstream modus operandi for institutional activities in venture capital, i.e. investors that follow a buy-and-hold approach and invest exclusively through fund intermediaries structured as limited partnerships.

Current practices The fair value guidelines relate to direct investments and not to funds.6 The “Net Asset Value (NAV) method” for fund valuation has the advantage of simplicity, but it has THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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to be kept in mind that this traditional market practice was not developed for addressing the question of a yet emerging fair value regime that would be expected to capture the economic substance of an investment. Current market practice is to use the NAV method to determine the valuation of a VC fund. This method is recognised and broadly used by market participants for valuation of funds-of-funds when referring to the IFRS accounting framework.7 The general hypothesis underlying the NAV method is that the fair value of investments in a VC fund is represented by the NAV as advised by the fund manager (general partner). This valuation method implicitly assumes that the NAV of a fund can be considered as compliant with fair value accounting requirements if the fair value guidelines have been followed for the portfolio companies. However, it has to be kept in mind that VC fund valuations are derived from portfolio company valuations yet they are not always equivalent.

Problem areas The negative impact of the J-curve Even if portfolio companies are fairly valued, the development of the VC fund’s NAV will continue following the J-curve. This happens for two reasons. Firstly, even if no write-offs of portfolio companies happen, upward valuations take time. Management fees paid to the fund manager are not reflected in the NAV and result apparently in a “loss”. Secondly, the J-curve is the result of an incomplete valuation model that is only connected to the investment already done. A major tangible component of a VC fund – the undrawn commitment in relation to the prospective deal flow – is not reflected and an important intangible – the fund manager’s value – is left out entirely. Assessing the impact of these components requires a high degree of judgment. Indeed, practitioners admit that this treatment does not always give the fair value for young VC funds,8 and therefore, auditors occasionally allow keeping such funds at cost. Deciding on whether or not a VC fund is still “young” cannot be done by looking at its age alone.9 Judgment is required to some degree, but generally funds would be considered as “young” when having no or an insignificant number of portfolio companies years away from their realisation or with significant undrawn commitments. On the other hand, a VC fund would be seen as “mature” in cases where a sizable portfolio exists, portfolio company valuations are reliable, and the fund manager impact on undrawn commitments is insignificant compared to the NAV. If one interprets the objective of a valuation method as being to capture the economic substance of an investment, the NAV method currently in use for VC funds can be problematic. It does not always capture the economic reality from the viewpoint of a limited partner of an investment into a VC fund, as some risks are exaggerated while others are left out entirely. Risk models particularly need to reflect the economic substance of an investment. In other words, if an investment is “good”, than it should not show an accounting loss. While if there is an accounting loss, readers of the accounts should draw the conclusion that an investment is “bad”. To base risk strategies on a fund’s NAV rather than on its economic reality leads to short-term thinking. A valuation approach that is truly “fair” should not follow the J-curve, but interim valuations should move randomly around the “true” value with a decreasing error as the VC fund is approaching maturity. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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The high workload associated with valuation reviews Documentation of the fair value measurement methodology and the disclosure of the associated methods are crucial. Auditors require a number of checks to address consistency with IAS 39 valuation principles and guidelines used by the general partners in the calculation of: the NAV, the quality of the valuation reporting, or the timeliness of the VC funds’ valuation. It is indisputable that auditors should ask for relevant validations, but they should not ask for irrelevant and highly expensive checks. For example, one of the most common features of venture capital investing – and more pronounced than in later stage private equity – is staged financing. In situations of high uncertainty, making new financing dependent on the achievement of defined milestones helps aligning interests and providing incentives to entrepreneurs to perform. Starting with a high number of start-ups, and quickly pulling the plug where milestones are not met, is integral to the venture capital business model. Accounting for this as a loss of the fund’s value or even as impairment does not always reflect economic reality. Moreover, in such a situation a “look-through” approach where start-ups are assessed individually is neither meaningful nor practical, as valuations need to take the fund manager’s financing strategy into consideration. In a situation of high uncertainty, auditors want limited partners to thoroughly check valuations provided by general partners and document the reviews undertaken, but for investors with a high number of investments in VC funds the associated work can be considerable. In any case, under uncertainty, even unlimited efforts cannot render valuations more reliable, and it is neither practical nor meaningful for a limited partner to check or second-guess how a general partner assigned a fair valuation to the start-ups. A practical problem is that, in the majority of cases, limited partners do not have access to the insights that would allow them to make material adjustments to portfolio valuations. It appears conceptually questionable for investors in VC funds to review valuations. Unless there is a co-investment programme, limited partners have no access to financial statements of a VC fund’s investee companies. They do no due diligence on investee companies, do not monitor them and have less information than a VC fund’s management and or its auditors. This approach does not appear to be meaningful for venture capital as an appraisal-based asset class and most limited partners would feel uncomfortable taking responsibility for adjustments.

Entry barriers for new investors in venture capital Is the J-curve of relevance? It depends – if you are an established player in the industry it may not matter too much. Experienced investors are familiar with the phenomenon and factor it into their considerations. Moreover, reflows stemming from mature funds compensate for downward value adjustments for young funds. However, new investors are concerned about the J-curve. For investors considering setting up a VC fund investment programme, the J-curve forms one significant entry barrier as portfolios of young funds follow a steeper and more prolonged J-curve. An analysis conducted by EIF on larger diversified VC fund portfolios showed that historically the maximum impact of the J-curve was 40% unrealised value loss when the undrawn commitments are not taken into consideration and 22% when undrawn commitments are factored in. If you compare the unrealised loss in value against the overall amount of resources dedicated to venture capital, the J-curve impact was never higher than 14%. One may argue whether this is then really an issue, but for pension THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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trustees it is more than just a question of psychology. This, in combination with a number of conceptual problems and the workload associated with this exercise, could make those institutional investors who are subject to regulatory capital requirements question their activities in venture capital.

Current valuation techniques do not capture risk Valuations and the associated risks measures need to reflect realistic assumptions in line with the investor’s intention and his ability to hold an investment until maturity. One could argue that implicitly underlying a NAV-based valuation is the assumption of a break-up, as future management fees and the use of undrawn commitments are not considered. If there is no intention to sell, investors are not exposed to the ups and downs of the underlying portfolio, and what happens to interim valuations is a matter of indifference. VC funds are not just portfolios of unquoted assets, but as primary investments, they are “blind pools” where funding is committed to a specialist manager who will go out, identify and build investee companies. A fund portfolio valuation (expressed by the NAV) is only one input relevant for a fund share valuation and the impact and relevance of this input changes over time. In the beginning of a VC fund’s lifetime, there is no portfolio at all and the fund share valuation depends entirely on the fund manager’s history and on judgment. There is simply no material on NAV and the undrawn capital, i.e. the sum of all open and not drawn obligations to fund start-ups, is not captured in the NAV. Notably, the NAV ignores the fund manager’s role in growing start-ups or, unfortunately not seldom enough, destroying capital. A fund portfolio valuation is meaningful as a proxy for the fund share valuation only for mature funds. A study on the risk profiles of private equity and venture capital undertaken by EIF demonstrate that the risks of investing in a diversified fund-of-funds portfolio are much lower than usually perceived.10 An investor who does not have the intention to sell is not exposed to the intermediate changes of investee companies’ valuations. Economically, a fund is different from a pool of direct investments, looking at changes in interim valuations of investee companies may exaggerate risks as it introduces an artificial volatility that is in contradiction to the view taken in the study, which takes the perspective of a buy-and-hold investor. As a measure of risk, the authors used the standard deviation of the average return because it is not possible to measure the risk of VC funds as the volatility of a time series. While these results led to a reduced risk weighing for venture capital under CAD III (the European Union directive to implement the Basel II Accord in the EU that is designed to reflect specific European economic objectives), the corresponding accounting treatment remains unchanged and takes a different point of view.

The J-curve creates a false sense of security “It is the J-curve” is an expression somehow equivalent to the accounting malpractice of “taking a big bath”. Later on “spectacular gains” give short-term oriented (or forgetful) investors the impression that high returns are typical for VC funds, while all the bad news is history. If, in accounting terms, a good fund looks like a bad one there will be an inclination not to take action even if experts judge a fund a troubled case.11

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188 – PART II: SELECTED PAPERS EIF’s experience with the development of NAVs for a portfolio of more than 200 VC funds revealed no clear differences between “good” and “bad“ funds during the first four to five years. The major relevant information was found in non-quantitative indicators.

Models can be abused According to the fair value guidelines the “objective is to estimate the exchange price at which hypothetical market participants would agree to transact.” Despite the notions of “market participants”, for venture capital fair transactions that lead to observable prices occur too seldom. Limited partners hold shares in VC funds as financial instruments. The fair value of these fund shares depends not only on the current portfolio valuations, but also on expected future cash flows that are not necessarily limited to investee companies within this portfolio. Indeed, in practice such valuations are often done with the help of cash flow libraries for comparable VC funds. In principle, a model-based valuation approach relies on financial data provided by a VC fund’s general partner, market statistics, and on judgment in the form of assumptions and predictions. Some auditors are challenging the marking-to-market for the “more esoteric items”, as it is in reality a marking-to-model approach.12 To address fair value under IFRS, there is a problem when trying to value financial instruments where no market value is available – as it is the case for VC funds – and where valuation models therefore need to be used.13 At the heart of the argument is that marking-to-model can produce very different results when quite small changes are made to the underlying assumptions and predictions. How audit concerns can be addressed still needs to be seen, but these arguments put forward appear to be shared by many in the profession and pose a series of dilemmas for the venture capital industry.

Conceptual questions VC funds themselves are long-term and illiquid assets for which no market prices exist. One could argue that VC funds are always marked-to-model as the NAV is just a very simplistic model. It leaves out too much information, and therefore, may represent an occasionally highly distorted view of the economic substance of an investment into a VC fund. Values derived by a marking-to-model are certainly not observations. Indeed, the value of any long-term and illiquid asset is unobservable – only prices can be known. Assuming that the concept of “fairness” in valuations is implying a kind of “market consensus”, then for an alternative asset like venture capital by definition there will be little consensus, and an expert will come to an appraisal-based valuation that will usually not be shared by the majority of other market players as they lack the specific insights or experience and cannot understand the assumptions. Therefore, the “fair value” of a young VC fund is an artificial construct that does not “exist” in reality and consequently cannot be tested.

Can one do without judgment? Usage of more sophisticated models for valuing VC funds for accounting purposes is not documented. For VC funds, the reporting entities are the fund managers themselves. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Such reported valuations – that are marked-to-model as mentioned – are definitely not free from bias. Limited partners know – or should know – what are the good and what are the bad funds in their portfolio. They could theoretically mitigate biases and make these valuations more consistent; for example, through a “rating” for the funds, if so permitted. To EIF’s knowledge, for accounting purposes, this is not current market practice as this requires a high degree of judgment. However, one can mislead by withholding judgment as much as one can by giving wrong judgment. Currently, if it is early days, readers of accounts are regularly told that this is the “J-curve” and it is “too early to tell” – basically saying, “forget our accounting figures”. Whether the new valuation guidelines will change, this is yet to be seen, but certainly comments and disclaimers in financial statements do not increase institutions’ confidence in such investments. For alternative assets, in general, the quality of the fund managers is key. To pretend after two to three years of monitoring not to have any idea whether a fund manager is good or bad could even be misleading. It is certainly misleading to say “too early to tell”, if you know that a fund manager is inept or to hide that for the bad performing funds there is still a contractual obligation to “throw good money after bad”. Also, the readers of accounts should be told that only second tier funds were invested in, given situations where the top teams were inaccessible. In alternative assets, expert judgment is required; at the end of the day “mainstream institutions” often delegate this task as they lack the necessary in-house expertise. A non-specialist reader of accounts will not know whether the fund manager was conservative or whether the portfolio is not doing well, but the limited partner should know and communicate this. Specialist investors in VC funds should be able and willing to give their views on the economic “true and fair” value of their assets, which is not possible without some modelling, and it is a fair assumption that most use such models in their day-to-day management.14

Is there a pragmatic way forward? An “as true and fair as possible” view of the financial situation of companies would improve the investors’ ability to make informed decisions. One has to accept that there are diminishing returns of time and work spent on valuing start-ups and that, in alternative assets, there are limits to reliability and verification. As discussed, this poses dilemmas for the accounting treatment. Auditors want reliability, but reliability does not exist in the world of venture capital with its high uncertainty. In light of the problems discussed above, the question is whether one nevertheless tries to determine a fair value or, as some auditors advocate15, one should restrict the “fair value” concept to deep market assets. A clear downside of using a model-based approach that it is difficult to understand and that it can be only as good as the underlying assumptions. As models are to some degree “black boxes”, the potential for abuse is very high.16 A practical approach will be a trade-off between sophistication and credibility. Models cannot be fully avoided, and – as there are a number of structures to facilitate investing in venture capital – a “one size fits it all” should not be imposed. Limited partners need to choose the valuation technique best suited to their specific situation and modus operandi. For example, the specific characteristics between VC funds, buyout funds, emerging market private equity funds and young and old funds merit different techniques and models.

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Differentiate between young and mature VC funds There should be stronger differentiation between young and mature VC funds, and tailored fund valuation approaches for different stages in their lifecycle. As accounting rules should be used to determine the financial circumstances of decisions, EIF proposes for young VC funds a “fair value” approach similar to credit ratings that may often reflect economic reality better than the net asset value based valuation technique used traditionally.17 For mature VC funds, the traditional NAV-based approach should be followed. This may not be an “ideal” approach but in an accounting framework that increasingly moves towards fair value across the board, it is still preferable to a fair value method that, for young VC funds, gives investors a wrong picture.

Accept different standards for reliability Due to the private nature of the industry, there are limits to data availability; and a fair value option that depends on increased disclosure and reporting requirements for VC funds will be difficult or even impossible to implement. This creates a dilemma: how reliable can such valuations be? Any long-term asset valuation has by definition a high number of underlying assumptions and a wide range of outcomes, and valuations are generally appraisal-based. If one takes the precision of valuations as a measure of reliability, there is an inherent conflict between fairness and precision for illiquid assets. To only take into account precise data and to leave out judgment does not reflect the economic substance of a longterm oriented investment. On the other hand, a fair assessment that incorporates judgment cannot be sufficiently precise. If valuations for assets like VC funds were to be found precise and reliable by a larger number of market participants, in one way or another, real trading would also start – directly18 or indirectly19 – and the asset class would cease to be illiquid.

Assure reliability through valuation process reviews One way out would be to accept, depending on the depth of the market for an asset, different standards regarding reliability. There is no absolute truth in valuation, and any valuation is, at least to some degree, based on judgment. However, third parties can review the model used, the process leading to a valuation, and the consistency in its application. Although, in absence of prices, valuations for illiquid assets are not testable and their reliability therefore cannot be fully assessed, the process leading to valuations can be reviewed and found reliable. The review has to show that all available relevant information is systematically taken into account and, where judgment is applied, that it is structured and reasonable. Readers of such accounts can gain sufficient insights to form their own judgment from: comments on the model review, clarification that the model takes significant expert judgment into account and explanations on how the model is regularly recalibrated.

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Notes 1 Disclaimer: Many of the issues discussed here have been researched and developed in the course of the work with the European Investment Fund (EIF). However, statements made in this paper represent the personal opinion of the author and do not necessarily reflect the views of EIF. 2 See the European Venture Capital and Private Equity Association (EVCA) definition for the J-curve: “The curve generated by plotting the returns generated by a private equity fund against time (from inception to termination). The common practice of paying the management fee and start-up costs out of the first drawdowns does not produce an equivalent book value. As a result, a private equity fund will initially show a negative return. When the first realisations are made, the fund returns start to rise quite steeply. After about three to five years, the interim IRR will give a reasonable indication of the definitive IRR. This period is generally shorter for buyout funds than for early stage and expansion funds.” 3 See “New International Valuation Guidelines: A Private Equity Homerun!” by Pierre-Yves Mathonet and Gauthier Monjanel, May 2006. Available from SSRN: http://ssrn.com/abstract=901926. 4 Available on www.evca.com/pdf/valuation_guidelines.pdf. [Accessed 2 August 2005]. 5 “IFRS and the Private Equity Industry – Discussion Paper No 1”, April 2005; available on www.evca.com/images/attachments/tmpl_9_art_107_att_771.pdf. [Accessed 2 August 2005] and “IFRS and the Private Equity Industry – Discussion Paper No 2”, September 2005; available on www.evca.com/images/attachments/tmpl_9_art_116_att_892.pdf. [Accessed 17 November 2005]. 6 It has to be pointed out that it is convention, and not necessarily economic substance, that makes them acceptable under IFRS. Although the valuation guidelines had been undergoing a rigorous peer review, the EIF is not aware of any back testing of the valuations derived by these techniques as the basis of reliability. 7 See “IFRS and the Private Equity Industry – Discussion Paper No 1”: “Broadly, there are three generic methods for measuring the carrying value of an investee fund. The first is to use a price recently obtained in the secondaries market. However, this information is rarely available even where transactions have occurred and many would regard the price as a poor estimate of fair value because the transaction often involves a forced seller which does not meet the primary fair value test in IAS 39R. A second method is to use the fair value of the underlying investments and other net assets/liabilities of the investee fund. The method has very significant practical problems because, at present, few investee funds provide fully IFRS compliant fair value information on underlying holdings. Furthermore, many would argue that market participants would apply a discount to fair value of underlying holdings to arrive at a fair value, the discount representing future costs and a risk factor that any market participant would apply before entering a willing buyer/willing seller transaction. The third method is to use a cost less impairment basis. Supporters of this approach argue that is rarely possible to obtain sufficient fair value information on the investee fund and hence that the range of possible outcomes for fair value cannot be reliably measured.”

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192 – PART II: SELECTED PAPERS 8 See for example “IFRS and the Private Equity Industry – Discussion Paper No 2”. 9 For EIF, this was restricted to funds not older than one year. How to measure a possible impairment is another question. 10 See EVCA: “Further Comments to the Basel Committee: The Risk Profile of Private Equity and Venture Capital.” 6 February 2004. Available on www.evca.com/images/attachments/tmpl_26_art_94_att_498.pdf. 2005].

[Accessed

4 August

11 The philosophical question aside whether in an illiquid market one can do something about it. 12 Ernst & Young IFRS Stakeholder Series: “How Fair is Fair Value?” May 2005. Available from www.ey.com/global/content.nsf/International/Home [Accessed 16 June 2005] and Robert Bruce: “Is ‘Fair Value’ Good, Bad or Simply Ugly?” Financial Times, Thursday June 16, 2005. 13 Ernst & Young expresses its reservations with the subjective assessment and the associated calculations underlying such models: “In all these cases, ‘fair values’ will be determined by hypothesising what a market price would be if there were a market, very often based on management assumptions about the future and using a valuation model. We consider that it is inappropriate to refer to such calculated values as ‘fair value’”.

14 See “IFRS and the Private Equity Industry – Discussion Paper No 2”. 15 See for example E&Y: “Perhaps the answer lies in a return to reality and a limitation on the application of the fair value model to those assets and liabilities that have real and determinable market values.” 16 To back-test models for alternative assets is problematic or even impossible. The samples are too small to gain any credibility – for all cases exceptions can be found, while no statistically significant data can be compiled. Models probably would be more credible if applied by an independent party. This, however, may not be always feasible in the alternative investment industry that relies on judgment based on privileged insights. 17 For this purpose, EIF developed its own theoretical model to assess VC fund investments. In this approach, VC funds are graded taking qualitative and quantitative criteria into account, and based on the assigned grades, a range for likely growth rates are determined through comparisons. The range between minimum and maximum growth rates depends on the age of the VC fund. Scenarios for future cash flows are generated for the VC fund by scaling historical cash flow patterns for comparable funds according to the growth rates within the range. The VC fund’s value is determined by discounting these cash flows and averaging over the different scenarios. Details are published in “Beyond the J Curve - Managing a Portfolio of Venture Capital and Private Equity Funds” by Thomas Meyer and Pierre-Yves Mathonet. Published by John Wiley & Sons, July 2005. 18 Publicly quoted private equity does not contradict the argument. Normally, these vehicles are not “blind pools” but have built up a significant portfolio. Secondaries are occasionally described as the “advent of liquidity”, but constraints normally surrounding such transactions make prices paid diverge from fair values. Moreover, there are too few secondary transactions and negotiated prices are usually kept confidential, so this is not a practical means to routinely value VC funds. 19 For example, through certificates.

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Final Plenary Session: Financial Innovations for SME Credit and Equity Financing: The Contributions of Markets and Governments

The Plenary Session considered the following issues: •

How can the availability of equity finance improve the chances of getting loans?

•

Under what circumstances are SMEs likely to obtain both?

•

Are there learning opportunities between banks and risk capital investors?

•

What about banks as venture investors – has Basel II changed their willingness to invest?

•

Who can best provide mezzanine finance?

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Building a Better Understanding of SME Financing: Lessons learnt by Canada and New Zealand on SME Finance Data Collection Initiatives

Mr. Blair Robertson New Zealand Ministry of Economic Development, New Zealand Mr. Brad Belanger Industry Canada, Canada1 Difficulties in accessing finance are often cited as a barrier to SME growth. However, there is usually little empirical evidence to test this assumption. This paper presents the results of surveys of firms’ experiences in seeking debt and equity finance in Canada (2001) and New Zealand (2004). The paper covers four broad areas. Firstly, it discusses the issue of ‘finance gaps’ and explains the background to the two surveys. Secondly, it presents results on the financing experiences of firms, including the success rates and the amount of debt and equity finance requested and the key sources of financing currently in use for both New Zealand and Canada. Comparable data between the two countries is presented where possible. Thirdly, the paper highlights the importance of evidence-based policy-making and the implications of the survey results for government programmes and government’s contribution to delivering financial innovations, particularly in defining market gaps. Finally, the paper presents the benefits of the data collection initiatives to policy development for improving access to finance for SMEs.

Introduction Efficient and transparent financial markets are widely recognised as a vital element of a country’s economic development. Research emphasises that expert financial intermediaries and well-functioning markets ameliorate information asymmetries and transaction costs and thereby foster efficient resource allocation and long-run economic growth. Governments’ have a key role in establishing the framework in which financial markets operate largely through enforcing a sound legal environment. However, Governments’ are also interested in addressing market ‘gaps’ in the demand and supply of finance to businesses. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

196 – PART II: SELECTED PAPERS Difficulties in accessing finance are often cited as a barrier to SME growth. However, there is usually little empirical evidence to test this assumption. Similar to most OECD countries, the New Zealand and Canadian economies have proportionally large numbers of SMEs. Both countries have undertaken quantitative research to better understand the demand for business finance and to test the extent of the ‘finance gap’. This paper presents the results of surveys of firms’ experiences in seeking debt and equity finance in Canada (2001)2 and New Zealand (2004)3.

Marketplace gaps Many of the public policy issues related to the financing of knowledge-based industries and SMEs in general, revolve around the concept of “gaps” in financial marketplaces. As used in the popular media, the word “gap” connotes the idea of a shortage: a sense that the supply of the commodity in demand is insufficient and that the demand cannot be satisfied. However, in economic theory, a shortage (surplus) exists when the price for the product/service is too low (high). In the case of a shortage, prices ought then to rise to the point that supply and demand clear. For a shortage to persist, some form of imperfection must interfere with the ability of the market to clear. If so, remedial measures ideally ought to be based on the nature of the imperfection. In the absence of an imperfection, intervention is not warranted. Marketplace gaps can be analysed from a number of different perspectives. Typically, they are considered to be demand, supply or information driven. Work conducted by the Angus Reid Group in 2000 on behalf of the Business Development Bank of Canada (BDC) suggested four perceived gaps that relate to the debt markets in which SMEs participate. According to the BDC4, Canadian SMEs face four types of financing gaps: •

A “size gap” such that business owners who seek small loans perceive that their borrowing needs are too small to be of interest to institutional lenders.

•

A risk gap whereby lenders do not price loans to reflect risk (rather, they reject loan applications if risk exceeds a particular threshold or if insufficient collateral is available).

•

A flexibility gap such that financial institutions do not provide flexible terms and conditions on their loans.

•

A knowledge gap based on the belief that “financial institutions do not understand knowledge-based businesses.”

However, the simple observations that firms that have lower-than-average authorisation rates is not evidence of a ‘gap’ in the marketplace. Some firms may, on average, be smaller or younger or riskier, rendering them lower authorisation rates. The real issue is whether these firms exhibit lower authorisation rates – as well as less favourable financing terms – after controlling for other relevant factors, such as size, age of business and sector. In this regard, there is often widespread belief in many countries that capital market gaps exist, which places policy makers under pressure to intervene with remedial measures. Financial institutions are also pressured to augment the supply of capital. In spite of this widespread belief, there is very little dependable research that documents whether gaps actually exist. There is even less research that specifies where – in the continuum of the financial markets – such gaps might be located. In the absence of

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independent rigorous research that specifies the nature and location of financing constraints, interventions have the potential to cause more harm than good.

Data collection initiatives in Canada and New Zealand Public policy initiatives are best served when they are based on clear evidence of market imperfections. Research that investigates the questions of whether market failures do exist and the capacity to document the nature of such failures is imperative to the success of policy decisions. To this end, both Canada and New Zealand have recognised the need to monitor SME financing on a regular basis and ensure there is a consistent, comprehensive and impartial approach to SME finance data collection. Below is a summary of how these data initiatives began in Canada and New Zealand.

Canada (SME financing data initiative) – Building a better understanding of SME financing The SME Financing Data Initiative (SME FDI) is a comprehensive data collection programme on the financing situation of SMEs in Canada and was initiated following a recommendation of the Task Force on the Future of the Canadian Financial Services Sector in 1999. Industry Canada, in partnership with Statistics Canada and the Department of Finance, work together in an on-going effort to establish and provide results on the most current and comprehensive data collection regime on SME financing in Canada. The information gathered by the initiative originates from a number of Statistics Canada surveys, as well as, additional research into niche areas of SME financing, particularly in the areas of risk capital and the attitudes and perceptions of SMEs in relation to their financial institutions. Industry Canada is mandated to report on the state of SME financing in Canada on a regular basis to the House of Commons Committee on Industry, Natural Resources, Science and Technology. Other products of the Initiative include profile papers on specific business owners (e.g. women entrepreneurs, visible minorities, youth, etc), research papers examining in more detail access to financing of a particular group of SMEs (e.g. market gaps in debt financing for innovative firms), and a myriad of data tables on debt, leasing and equity financing. Further information on the SME Financing Data Initiative and access to statistical findings and reports is available at http://strategis.gc.ca/fdi. The SME Financing Data Initiative The SME Financing Data Initiative (SME-FDI) is a world-class, cutting-edge programme, which builds a comprehensive knowledge base of timely and unbiased information on SME financing in Canada. This critical knowledge will help foster an environment that supports the growth of Canadian SMEs by fuelling the public policy debate and bringing clarity to the SME financing market. Founded on a consultative approach, this is done in an environment of professionalism, transparency and interdepartmental cooperation. Source: Mission statement, 2002

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New Zealand – Background to the Business Finance Survey The New Zealand Government’s economic development strategy, the Growth and Innovation Framework (GIF), recognises efficient financial markets as an important factor in the government’s goal of creating a more innovative and globally-connected economy. In particular, the GIF highlights the significant role of the venture capital market in financing the commercialisation of innovation. Therefore, the government decided to carry out research on the financial markets to test whether in fact firms, in general, experienced problems accessing finance and whether this was a constraint on business and economic growth. Conventional thinking on finance issues persuaded policy makers to research first the supply of business finance, including the financial system and its constituent parts (e.g. banking, stock market, and venture capital). However, as this research uncovered no major inefficiencies in the market, the government became increasingly aware of the need to address the demand-side knowledge gap about New Zealand’s financial system. While understanding supply-side issues is critical, it cannot provide a complete picture of the state of firm financing. That is because these studies do not highlight the relative importance of non-intermediated or “private” capital flows, which are an important source for all but the largest of firms. A survey was identified as the most efficient way to collect this information. The 2004 Business Finance Survey was the response to the government’s interest in empirical evidence on the demand for business finance and, in particular, the financing experiences of small businesses. The survey was developed jointly by the Ministry of Economic Development and Statistics New Zealand, the national statistics agency. A major driving force behind the Business Finance Survey was to help stakeholders (both public and private) to better comprehend the challenges and opportunities surrounding the provision of capital to New Zealand firms. Specifically, it was expected that the survey results would: •

Improve understanding of business financing needs and, therefore, form the basis for better informed public debate.

•

Give financing providers a more comprehensive understanding of their clients, thus better enabling them to design products and services that meet market needs.

•

Facilitate the assessment of whether firms’ financing needs are being addressed by the market, and help with gauging the effectiveness of government policies and programmes.

Learning from other jurisdictions also encouraged New Zealand to undertake a demand-side survey. For example, New Zealand observed that the SME finance data collected by U.K, Canadian and the U.S agencies generated a significant amount of further research and led to refinements in policy (New Zealand officials visited Industry Canada to learn more about their experiences). Importantly, the data appear also to stimulate debate in both the public and private sectors on wider access to finance issues.

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Results of the data collection initiatives in Canada and New Zealand Canada: SME financing in Canada, 2003 Small and Medium-sized Enterprise (SME) Financing in Canada, 2003 is a report on the state of financing for small and medium-sized enterprises in Canada. The information gathered in this report originates from a number of Statistics Canada surveys, including the Survey on Financing of Small and Medium-sized Enterprises, 2000 and 2001, and the Survey of Suppliers of Business Financing, 2000 and 2001. The data sets from these surveys focus on the supply of and demand for financing in Canada. These summary tables are currently available on-line at the Industry Canada Small Business Policy and Research Website (http://strategis.gc.ca/fdi). The report also includes results and data from other sources, including the Canadian Federation of Independent Business, the Conference Board of Canada and Macdonald & Associates Limited. For the purposes of the survey report, Industry Canada defines SMEs as firms with fewer than 500 full-time equivalent employees and less than CAD 50 million in annual revenue.

Part 1: Financing conditions for SMEs in 2001 The Canadian economy slowed in 2001, according to several key macroeconomic indicators — the growth rate of the gross domestic product (GDP), interest rates and consumer spending. It appears that these economic conditions influenced the requests (demand for) and approvals (supply of) commercial debt and leasing.

Commercial debt While only 18% of SMEs requested commercial debt in 2001, 80% of requests were approved. These figures are down from 2000, when 23% of SMEs requested some form of commercial debt and 82% were approved. While it may appear that the economic slowdown in 2001 lowered demand for commercial debt by SMEs, the effects of similar conditions over a number of observations would be needed to conclude which, if any, economic factors most influenced borrowers’ behaviour.

Leasing Although only 7% of SMEs requested lease financing in 2001, 93% were approved. These figures are down from 2000 when 9% of SMEs requested leasing and 98% were approved. While it may appear that the economic slowdown in 2001 lowered SMEs’ demand for leasing, more data collection and analysis will be needed to determine if this is a meaningful trend.

Part 2: Financial structure of Canadian SMEs SMEs financed their operations with a wide range of financial instruments in 2000, which can be broadly categorised as formal or informal. Formal types of financing are instruments obtained from external suppliers/sources which are in the business of providing financing. Informal types of financing are obtained from suppliers/sources that

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200 – PART II: SELECTED PAPERS are not in the business of financial lending or are funds acquired from the businesses’ activities (e.g. retained earnings) or derived from the owners (e.g. personal savings). In 2000, SMEs preferred commercial financing products (49%) over all other forms of financing. However, SMEs also made substantial use of informal personal financing instruments when access to financing was not particularly difficult. As seen in Figure 3, 35% of SMEs financed their operations with personal savings, followed closely by the businesses’ retained earnings (31%). These findings could indicate that SMEs use personal sources of financing to provide a “bridge” until more permanent financing is available, or they may be related to some financial institutions’ bundling of commercial and personal banking. Since start-up SMEs often lack both a credit history and the collateral needed to secure a loan, they represent a degree of risk many financial institutions are unprepared to take. As a result, start-ups typically use informal sources of external financing and rely on owners’ personal savings and credit to finance their operations. More than 66% of startup SMEs used personal savings to finance their company, compared with 35% of all SMEs. In fact, start-ups, more than other SMEs, used all forms of personal credit to finance their business. Only 29% of start-up SMEs used formal sources of external financing, such as commercial loans and lines of credit, compared with 49% for all SMEs. Informal sources of financing, other than personal financing instruments, are often difficult to identify and obtain, and may require non-standard terms for financing. Furthermore, access to formal sources of financing offers more transparency and allows small businesses to compare price and terms. Percentage of SMEs using Financial Instruments in 2000, by type1.

Note: 1. Includes any source used, regardless of whether is was authorised or obtained in a previous year. Source: Statistics Canada, Survey on Financing of Small and Medium-sized Enterprises, 2000.

A number of factors influence SMEs’ financial structure and use of formal and informal types of financing. The most significant factors are sector, size of business (by number of employees), and stage of business. Other business characteristics, such as gender of business owner, appear to be important (but less so than sector), while age of

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business owner and growth patterns of the firm appear to have less influence. Some key findings in 2000 included the following:

Stage of business development 66% of start-up SMEs used personal savings of the owner(s), compared with 35% of all SMEs. 29% of start-up SMEs used commercial loans and lines of credit, compared with 49% of all SMEs.

Sector of operation •

Resource-based and goods-producing sectors used more formal types of financing.

•

Service sectors used more informal types of financing (e.g. 37% of knowledgebased firms used retained earnings – the highest rate of all sectors).

Size of business •

36% of self-employed SMEs used personal savings. Smaller businesses used informal financing instruments, such as the business owner’s savings or personal credit facilities

•

Medium-sized firms used formal commercial instruments and the business’ resources(e.g. 86% used commercial loans and lines of credit, compared with 49% of all SMEs)

Part 3: Financial services sector – Providers of business financing This section adopts the perspective of authorisation size rather than size of business (by number of employees). As a rough proxy, authorisations of less than CAD 1 million represent lending to SMEs. Over the past decade, technical innovation, globalisation and increased competition from foreign suppliers have spurred rapid structural changes in the financial services sector. As a result, the financial services sector has become increasingly dominated by large financial groups that provide a variety of services, such as deposit taking, insurance, trusts and securities. These players operate alongside “monoline” or “niche” companies that focus on one or a few business lines, such as credit cards or Internet/telephone-based retail banking. This market structure influences SMEs’ access to financing, especially for businesses in specific regions and sectors.

Part 4: Profile of risk capital financing Risk capital is only one of many financing instruments available to Canadian SMEs. However, this instrument is not a panacea for economic development or for all SME financing challenges. Risk capital is often a more appropriate financing instrument for high-growth-potential and start-up SMEs, particularly for those in knowledge-based industries. Risk capital investors’ stringent criteria mean that fewer than 2% of firms will access this form of financing. However, these firms tend to be dynamic and innovative and represent the most interesting investment opportunities.

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202 – PART II: SELECTED PAPERS As businesses grow, they typically require several stages of financing, involving a combination of financial products. Risk capital follows the same pattern; what is appropriate at one stage of development may not be appropriate at another stage. Figure 5 shows risk capital financing through the various stages of a firm’s development. During the seed and start-up stages, technology-driven high-growth SMEs are often almost entirely dependent on risk capital from the owner’s personal resources and informal investors (family, friends, private individuals or business angels) to finance their initial operations, such as research and product development. In the seed stage, equity financing is initially obtained from entrepreneurs or from family and friends. Subsequently, financing may be supplemented by seed capital investment from informal private investors and, in a few cases, (e.g. high-growth-potential firms), by seed financing funds and venture capitalists. For high-growth-potential start-ups, informal investment and/or early-stage venture capital investment are the main sources of external financing. In the expansion stage, SMEs generally require increasing amounts of equity to maintain R&D and product commercialisation and to expand marketing and sales activities. Types and amounts of risk capital financing by stage of development Technology-driven businesses

Source: Western Technology Seed Investment Fund.

As companies continue to expand, they often require growing amounts of equity investment — amounts that are normally only available through initial public offerings (IPOs) on stock exchanges. Not only do IPOs supply growth capital, they provide exit avenues for venture capitalists and other early-stage investors. Timely exits allow

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investors to recuperate their original investments, realise their gains and reinvest in new, innovative, early-stage firms. Despite the tightening investment climate since 2001, the Canadian venture capital industry showed signs of vigour and enjoyed a stronger-than-expected year in 2002, investing CAD 2.5 billion in 677 firms. While this figure represented a sharp drop from the CAD 3.8 billion invested in 2001 and the CAD 5.8 billion invested in the peak year 2000, it was in line with the level of investment in 1999, CAD 2.7 billion.

New Zealand: Business Finance Survey, 2004 The Business Finance Survey was a postal survey, sent out in late August 2004. A sample of businesses with between 1 and 500 employees in a wide selection of industries were surveyed (businesses with no employees were not surveyed in order to limit respondent load for small businesses). The survey form was directed to the 'Managing Director'. The target population for the survey was live enterprise units on Statistics New Zealand’s Business Frame at the population selection date which: •

Were economically significant enterprises (those with an annual Goods & Services Tax (GST) turnover figure of greater than NZD 30 000).

•

Had between 1 and 500 employees inclusive.

•

Had been operating for six months or more.

•

Were not subsidiaries, more than 50% owned by another business.

•

Were classified to Australian and New Zealand Standard Industrial Classification.

The target overall response rate from the survey was 80% for questionnaires returned. The survey achieved this overall rate of return, which represented 4 775 businesses. Over 90% of the respondents were SMEs. Because of the large number of businesses surveyed it is possible to assume that the sample is fully representative of all New Zealand firms (with employees). The initial high-level results of the survey were released by Statistics New Zealand on 2 May 2005 and the full report in August 2005. For the purposes of the survey report, the Ministry of Economic Development defines SMEs as firms with 1-20 employees.

Part 1: Financing conditions for SMEs in 2004 Statistics New Zealand figures show growth in the New Zealand economy over the 2003/04 financial year period covered by the survey, with GDP growth and annual growth in the number of full time equivalent employees (FTEs) of over 3%. This may have some bearing on a business’s growth expectations and desire for expansion and also the willingness of finance providers to supply finance.

Requests for debt finance 33% of SMEs sought additional debt financing in the 12 months prior to August 2004. The vast majority of debt finance requests made resulted in finance being obtained. Overall, 90% of debt finance requests made by SMEs resulted in either some or the entire amount sought being received. Of those who did not receive the finance they had

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204 – PART II: SELECTED PAPERS requested, the main reasons were insufficient income or cash flow (31%) and insufficient collateral or security (31%). The most popular type of debt requested was bank overdrafts, which were requested by 36% of SMEs. Other common types of debt were long-term loans, leasing or hire purchase agreements and increased credit facilities or limits. Banks were the most common source of SME debt financing requests. 79% of SMEs requested finance from banks. Finance companies (including hire purchase or lending companies) were the next most common source. In the twelve months to August 2004, SMEs requested a total of NZD 3 820 million worth of debt finance and received a total of NZD 3 634 million. On an average per enterprise basis, SMEs requested NZD 186 000 worth of debt and received NZD 176 000.5

Requests for equity finance 5% of SMEs sought additional equity financing in the twelve months prior to August 2004. Overall, 83% of equity finance requests made by businesses resulted in either some or the entire amount sought being received. Of those that did not receive the finance they had requested, the main specified reason was insufficient income or cash flow (27%). The most common source of equity was from individuals in control of the business. They were a source of 83% of SME requests. Friends or family were the next most common single source (15%). In the twelve months to August 2004, SMEs requested a total of NZD 623 million worth of equity finance and received a total of NZD 426 million. On an average per enterprise basis, SMEs requested NZD 207 000 worth of equity and received NZD 150 000.6

Part 2: Financial structure of New Zealand SMEs The Business Finance Survey collected information on the current financial position of businesses. At the time of the survey, SMEs held NZD 22 154 million worth of outstanding debt. The most common type of SME debt was to trade creditors or suppliers followed by shareholders current account (24 and 22% respectively). As the following graph “Sources of current SME debt” shows, banks and business owners were the dominant sources of outstanding debt7. Total SME equity stood at NZD 16 204 million as at August 2004. Paid in capital accounted for 60% of total equity, with accumulated retained earnings and other sources accounting for the remaining 40%. Overall, the survey found larger businesses have a proportionally higher amount of accumulated retained earnings than smaller businesses. A breakdown of the sources of paid in capital for SMEs demonstrates the key role of business owners as suppliers of equity finance.

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Sources of current SME debt in 2004 3%

Other

1%

Overseas Businesses NZ Businesses Overseas Individuals

1% 0%

NZ Individuals

2%

Friends/Family

2% 29%

Existing Owners Trade Creditors/Supliers

23%

Finance Companies

10%

Banks

29% 0%

5%

10%

15%

20%

25%

30%

35%

Source: Business Finance Survey, 2004

Sources of current SME paid in capital in 2004

Other (businesses NZ & Overseas)

4%

Venture Capital

2%

Parent Company

2%

Individuals (NZ & Overseas) Employee(s) Friends & Family

4% 0% 2%

Individual(s) in control of business

86% 0%

20%

40%

60%

80%

100%

Source: Business Finance Survey, 2004

While the survey indicates venture capital forms a relatively small source of current paid in capital for SMEs, activity in the venture capital and private equity markets has steadily increased in recent years. In 2004, the amount invested in all private equity was NZD 158 million. The total number of deals undertaken was 59, up from 39 and 51 in 2002 and 2003 respectively. Investment in early stage has averaged NZD 13.4 million over the last 3 years. However, there has been a strong increase in expansion stage capital, increasing from NZD 14 million in 2002, to NZD 44 million in 2003 and NZD 96 million in 20048.

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Part 3: Expansion and Projected Turnover Growth 21% of SMEs invested in expansion during their last financial year representing a total of NZD 2 483 million in investment. Overall the survey found larger businesses were more likely to invest in expansion than smaller businesses and the manufacturing industry invested more than other industries. The survey also found the majority of SMEs (77%) expected positive turnover growth, including 18% that anticipate growth in turnover of 11% or higher in the next three years. The survey data also examined the extent to which the demand for finance relates to SME investment in expansion and growth projections. The results showed a positive association. SMEs that requested finance were more likely to invest in expansion and expect positive turnover growth.

Part 4: Business and Individual Characteristics New Zealand SMEs appear to have long-term relationships with their main bank or financial institutions. 70% of SMEs had a relationship of 4 or more years; 36% for more than 10 years. The survey found just 7% of SMEs was involved in franchising. Similarly, factoring, or the sale of accounts receivable, is an uncommon business practice amongst New Zealand SMEs. Less than 1% of SMEs used factoring as a form of finance. The survey also asked questions about the characteristics of people in the business who arranged finance (not necessarily the business owner). The results showed that these individuals were more likely to be older, experienced in business, male and New Zealand European. This is consistent with other business demography data from New Zealand. Most people arranging finance had some form of qualification and the type and level of qualification was strongly influenced by industry type.

Promoting evidence-based policy and uses of information by external stakeholders Although both Canada and New Zealand are in the process of analysing the information from the data collection initiatives and considering the implications for future policy development, some use of the information have been made when advancing new policy proposals. For example, in Canada, much of the work over the past year has been investigating business owner characteristics, and the profile characteristics and financial attributes of these various SME segments including women, youth and visible minorities. A key finding of this research is that the business owner characteristic is not a key determinant in accessing financing, but rather other factors such as size, sector, and to a degree their financial structure, influence their access to financing. So, for example, the hypothesis that women entrepreneurs are discriminated against compared to their male counterparts in terms of access to commercial debt due to gender has been investigated and new facts brought to light. The findings from the SME FDI suggest that women entrepreneurs operate in the services sector, are smaller and have a smaller financial structure than their male counterparts, which are all likely contributing factors to them not getting access to financing. A second policy area for the government of Canada is to understand further the role played by business angels and venture capitalists in growing high-growth and innovative firms. To this end, the results of the SME FDI have also allowed Canada, for the first THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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time ever, to investigate the supply of informal investment (including business angels) and estimate the amount of investment made by these players. In fact, the results of the SME FDI has allowed Canada to not only estimate the amount of investment made by informal investors (including business angels), but also the degree to which the rates of return differ between investments made by business angels versus friends and family and hence the value-added the former group brings to the success of a business. A third area in which the results of the SME FDI have been used in policy development is in evaluating the relevance of government programmes (e.g. The Canada Small Business Financing Act) or the roles of public institutions (e.g. Business Development Bank of Canada) have in the financial marketplace. For example, the Canada Small Business Financing Act (CSBFA) recently went through its five-year comprehensive review and in doing so, the results obtained under the SME FDI were instrumental in defending the relevance of the programme and the need to continue its operations. The information on the financing activities of start-ups (a key user of the CSBF Programme) and the data to support incremental studies gave a stronger product of evidence-based policy than had been developed in the past. In addition, the financial community has been able to use this information to transform their approach to serving the SME market. In New Zealand, since the results were only published in October 2005, work is still underway in analysing the information to consider its implications for policy development. However, the results tend to confirm the prevailing notion that firm financing issues are largely demand driven and that firms with sound investment opportunities usually find finance. Importantly, the high SME request and success rate in sourcing debt from banks suggests the banking system is providing adequate and acceptable services to small business. Research on bank lending practices also supports this claim9. The results demonstrate the very limited role of externally sourced equity finance, certainly at the aggregate level. Supply-side research shows small businesses appear to have less knowledge of equity, including a basic understanding of venture capital. New Zealand studies have found that many small business owners do not understand external equity finance, confuse it with debt and have a negative perception of their ability to attract external investment. Anecdotal evidence sourced from the administration of the Business Finance Survey found also that many SMEs have a poor understanding of equity. The minor role of informal equity finance uncovered by the survey is useful from a policy perspective because risk capital is essential to the success of some high growth firms and plays a key role in the commercialisation of innovation. A strong and vibrant venture capital market is important in developing New Zealand into a knowledge-based economy and the current market is considered less developed than other OECD countries. Recent research suggests venture capital markets take a long time to mature and are very sensitive to government intervention10. Thus, similar to Canada, the survey results indicate the need for policy makers to better understand the role of business angels and venture capitalists as part of the government’s ongoing economic development agenda. To date, the principal policy response to the under-development of the venture capital market is the establishment of the New Zealand Venture Investment Fund (NZVIF) in 2002. The VIF Venture Capital Funds select, invest in and assist the growth of innovative young companies early in their development. NZVIF also manages the recently announced Seed Co-Investment Fund (SCIF), which is designed to stimulate development THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

208 – PART II: SELECTED PAPERS of the angel investment market11. The SCIF was developed in response to the call to enhance the provision of equity finance to SMEs12. Data from the Business Finance Survey will assist in the ongoing policy development, monitoring and evaluation of NZVIF as well as other finance-related government programmes provided by New Zealand Trade and Enterprise and the Foundation for Research, Science and Technology.

Conclusions & recommendations Results from the New Zealand and Canadian surveys show that the majority of SMEs successfully access finance when required. To a certain degree, the results debunk the assumption that many SMEs in these countries struggle to raise capital and suggests the majority of profitable investment opportunities are being taken up. The results also demonstrate that scrutiny of the ‘financing gap’ should be analysed from both a demand and a supply-side perspective. Evidence from New Zealand and Canada of high success rates suggests that the reasons why some firms struggle to raise capital may be due to factors other than inefficiencies in the financial markets. Firms themselves may lack the capability to attract investment or are unable to take advantage of available finance because of their negative perception and lack of understanding of the products that are currently available. Thus, to show that a capital gap exists, we must be able to demonstrate that firms that are unable to obtain financing actually merit financing. This point was highlighted and reaffirmed by the OECD Istanbul Ministerial Declaration on Fostering the Growth of Innovative and Internationally Competitive SMEs, which stated that “policies should aim to ensure that markets can provide financing for creditworthy SMEs”13. Demand-side information facilitates more effective public policy by fostering the development of a widely accepted and empirically supported policy framework around the notion of capital market imperfections. The risk of not having this information is that anecdotally-based perceptions of specific types of financial market “gaps” may inappropriately drive public policy. Without comprehensive information on firm financing, it is very difficult for policy makers to assess the need for, and likely impact of, existing and potential government initiatives. Public sector initiatives to promote access to finance are best justified if market imperfections exist and result in the private sector not providing capital to firms on competitive terms. In the absence of market failure, government intervention may cause distortions – non-viable firms being subsidised at public expense. Thus, this kind of research can help policy makers determine the appropriate role, if any, for governments in addressing market imperfections. Demand-side surveys are particularly useful in identifying patterns in SME finance, such as the dominant sources and types of financial instruments preferred, and currently in use, by SMEs. The surveys can also uncover what SMEs do with their finance, why SMEs do not request finance and the reasons why finance requests are declined. The later point is critical in defining market gaps, by identifying the specific categories of firms (or individuals) with lower success rates than other firms and the expressed reasons for that lower success. For example, evidence from Canada suggests start-up and ‘collateral-poor’ SMEs have greater difficulties accessing finance than other firms. Economic conditions should also be taken into consideration when comparing data with previous domestic or with international surveys. That said, building a longitudinal element to the financing data is important in determining whether access to finance is affected by economic cycles and to analyse changes in SME financing over time. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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The New Zealand and Canadian experiences also demonstrate the value of undertaking the research in collaboration with national statistical agencies or their equivalents. This was important in maintaining the objectivity and integrity of the datasets as well as ensuring that the sample was sufficiently large and representative enough to draw conclusions across the economy as a whole. These agencies were also best placed to collect time series data, which is important in tracking longitudinal changes in SME finance experiences and structures over time. High quality finance data also permit countries to contrast demand-side information across different economies. This provides a useful benchmark of financing experiences and SME capital structures. Finally, the surveys are robust and compelling tools in which to engage the private sector, as experiences in Canada has shown. In conclusion, quantitative data from business finance surveys sharpens the focus of the finance debate and provides empirically based direction for policy makers and the wider business community. Data broken down by industry, age, region and growth stage provide yet further focus on where finance ‘gaps’ may lie. This analysis is vital in order for countries to concentrate resources in areas of their financial markets that need assistance. From this experience it is clear that better information about financing can affect not only the public policy response, but also how the market understands and serves SMEs. Therefore we recommend the OECD acknowledges the need for collecting and publishing these supply and demand data and that all member countries consider implementing data collection initiatives to provide market participants and policy makers with a better understanding of SME financing.

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Notes 1 Presented by Mr. Roger Wigglesworth, Director, SME Department, Ministry of Economic Development, Chair of the OECD Working Party on SMEs & Entrepreneurship, New Zealand 2 Small and Medium-sized Enterprise Financing in Canada, 2003, http://strategis.ic.gc.ca/epic/internet/insbrp-rppe.nsf/en/rd00912e.html.

3 Business Finance in New Zealand, 2004 www.stats.govt.nz/analytical-reports/businessfinance-2004.htm. 4 Angus Reid Group (2000), Financing Services to Canadian Small and Medium-sized Enterprises, Report to the Business Development Bank of Canada. 5 These figures refer to only those SMEs who knew the exact value of their debt requests. 6 These figures refer to only those SMEs who knew the exact value of their equity requests. 7 Both debt and equity figures relate to the last financial year for which the businesses had results available as at August 2004. 8 Data sourced from the New Zealand Venture Capital Monitor 2004. www.nzvca.co.nz. 9 PriceWaterhouseCoopers (2003), Bank Lending Practices to Small and Medium Sized Enterprises. www.med.govt.nz/irdev/ind_dev/access-to-finance/lendingpractices/index.html. 10 LECG (2005), A Study of New Zealand’s Venture Capital Market and Implications for Public Policy. www.med.govt.nz/templates/MultipageDocumentTOC____5422.aspx. 11 For more information go to www.nzvif.com. 12 See Small and Medium Businesses in New Zealand: Report of the Small Business Advisory Group 2004 www.med.govt.nz/irdev/ind_dev/sbag/ar/2004/index.html. 13 www.oecd.org/document/16/0,2340,en_2649_34197_32020176_1_1_1_1,00.html.

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Financial Intermediation: The Role of Information Production in Matching the Demand and Supply of Credit

Ms. Nadine Levratto Senior researcher, French National Council of Scientific Research, France This article enters in the debate on credit market and investment according to credit market imperfections and gives some examples of solutions implemented by French financial intermediation agents. Asymmetric information exists because one party to the debt - equity contract (the manager) knows the profitability of the project he or she wants to undertake that is relevant to, but unknown by the other parties (the principals). A moral hazard problem between banks and shareholders on one side, and borrowers on the other side, arises from the contract form of a bank loan under which the interest rate paid by the borrower is fixed when the loan is made. This paper shows how, besides the guarantee scheme, the entry of a third agent acting as an interface between lenders and borrowers may ease small firms financing producing and organising information in order to ease firms’ quality evaluation. There are several economic theories that try to explain the mechanisms of firm growth and firm size determination. The most basic of them are summarised by Kumar et al (1999) and combine different approaches to the determination of firm size into three main categories: technological, organisational and institutional theories. Technological theories concentrate on the production function or technology characteristics of the firm. In general, these models claim that firm size is restricted by the degree of specialisation of the firm and the size of the market it serves, the elasticity of substitution between labour and capital in the production function, or the balance between economies of scale of management and the possibility of losing control over the production process. Organisational theories tend to concentrate more on the control of the production process. In this field, the more robust way of analysis has been proposed by the so-called Critical Resource theories, which rests on the idea that a given economic agent (entrepreneur) has an initial access to critical resource with which he is going to produce. In case of physical assets as a critical resource, the number of employees depends on the amount of physical asset under the entrepreneur’s control. Thus, more physical capital intensive firms tend to be larger in employment size. Institutional theories are the last group of theories of the firm size that focus on deterministic power of institutional environment. According to this theory, the availability of external finance positively affects both the growth of the number of startTHE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

212 – PART II: SELECTED PAPERS ups and the increase of the average size of already existing firms. Both these effects have been found by Rajan and Zingales (1998), based on a survey of 43 developed and developing countries. Consequently, the development of the financial system from the theoretical point of view has an ambiguous effect on firm size structure of the economy since an increase in the ratio of de novo created firms tends to decrease the average firm size whereas the expansion of existing companies increases it. Economic growth is then related to the growth in industrial production and size: two thirds come from the expansion of existing firms, and one third from the creation of new ones. So, in order to stimulate and foster the economic growth of the economy authorities should reform the financial system to ensure efficient availability of different forms of external finance to enterprises. In order to understand better the core of the relationship between finance and small firm growth, the paper will focus on the third approach what will clarify the nature and origin of the problems faced by small firms in getting credit to expand their activity and to draw some possible issues. The first section presents the different relationships between finance and real activity with SMEs. The second part inquires if credit shortage can be at the origin of a growth deficit for SMEs and the third section sheds some light on the fundamental and instrumental solutions to bring to the system. Most of examples concern either EU or the French situation.

The relationship between finance and real performances Small firms, banks and indebtedness Despite the increasing role of financial markets, banking institutions remain the first provider for funds to European small firms. They continue to be the most important suppliers of funds to small businesses because costs of gathering and processing information are very high. A firm must reach a certain size before these costs can be recovered by underwriters of market securities. Some financing is affected through trade credit and franchises, but banks continue to be principal suppliers in most countries. They typically have a continuing relationship with individuals and firms that afford low cost surveillance. Also, because small businesses tend to do business locally, there are other information channels that a bank can easily monitor. Because small firms are ubiquitous and difficult to quantify, they may be unincorporated or registered as corporations. Even if firms’ assets are highly different from an entrepreneur’s wealth, in most concerns, proprietors borrow funds and use them both for personal consumption and business development. Moreover, small firms may be secretive in order to avoid taxes and regulations and in order to maximise returns from research and development. It is difficult to argue that small firms and their needs for bank loans are more frequent in one country or another. No comprehensive empirical evidence about this question exists across E.U. countries, but fragmentary information exists. The general picture seems to be that there is a tendency for the number of small firms to grow relatively to the number of other firms in European manufacturing. These trends in firm size suggest a possible growing advantage for banks as a source of funds.

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Graph 1 : Financial debt of enterprises in EU countries (in % of total liabilities)

Financial debt of enterprises in EU countries (in % of total liabilities) 60 50

Small Medium Large

40 30 20

United Kingdom

Sweden

Spain

Portugal

Netherlands

Luxembourg

Italy

Ireland

Greece

Germany

France

Austria

0

Belgium

10

Source: Wagenvoort, 2003

Graph 2 : Percentage of SMEs using debt financing in EU-15, by country 90 80 70 60 50 40 30 20 10 0 B

DK

D

EL

E

Overdraft

F

IRL

Leasing

I

NL

Facto ring

A

P

FIN

S

UK

EU

B ank Loan

Source: Grant Thornton, the European Business Survey, London, 2001.

The kind of external resources used are still very different according to the countries despite of a clear trend to financial integration. Even if it is no more valid to present the difference between overdraft and market economies as the main way of explaining the kind of credit provided by banks, it is still possible to identify some groups of countries. Basically, two financing systems can be observed in Europe. A bank-based system, as in Germany and Austria, where loans are the preferred source for financial investment, i.e. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

214 – PART II: SELECTED PAPERS banks play the most important role at providing finance. And, as in the United Kingdom, a market-based financial system characterised by competitive markets, where other forms of finance (e.g. equities and bonds) are more important than bank loans. The importance of bank borrowing varies in the different countries. However, the majority of European SMEs depend on bank financing and there seems to be a lack of alternative funding sources. Why is this so? Capital structure theory was initially established by the seminal work of Modigliani and Miller (1958), which provided a substantial boost in the development of the theoretical framework within which various theories emerged in the future. The broadly known “capital structure irrelevance” conclusion of Modigliani and Miller was about to be questioned and revised by several others who developed their own theoretical aspect provided their own piece in the capital structure puzzle. Yet the puzzle still remains unsolved; there is a wide variety of theoretical approaches but no theory is universally accepted and practically applied. The main ground upon which capital structure theory was initially developed concerned the large listed firms1. That is why most specific capital structure considerations cannot fit the SMEs context. For instance, Pettit and Singer (1985) have pointed out that tax considerations are of little attention for SMEs because these firms are less likely to generate high profits, and therefore, are less likely to use debt for tax shields. However, several authors have pointed out that the theoretical implications of capital structure can also be applied in the small firm context knowing that they are often opaque and have important adverse selection problems that are explained by credit rationing, and therefore, bear high information costs. These costs can be considered null for internal funds but are very high when issuing new capital, whereas debt lies in an intermediate position. Moreover, SMEs are often managed by very few managers whose main objective is to minimise the intrusion in their business and avoid the discipline inherent in other financing options than internal funds. That is why internal funds will lie in the first place of their preference of financing. In case internal funds are not enough, SMEs will prefer debt to new equity mainly because debt means lower level of intrusion and, most importantly, lower risk of losing control and decision-making power than new equity. The kind of debt used differs among the countries. Indeed, even if one may consider sometimes that a convergence path exist in Europe, Graph 2 shows that difference remains and that national specificity are still important. Two groups of countries may be identified: on the first hand, one finds countries in which firms prefer short term loans such as Italy, Denmark or UK traditionally described as countries where banks are reluctant to commit themselves on the long term; on the second hand, another group with Germany, France and Austria demonstrate the superiority of long term bank credit (see Delbreil et al, 2000 and Hall et al, 2004).

Why small firms pay more and get less credit? This section presents empirical evidence for finance constraints affecting SMEs in Europe. It focuses on a survey realised by the European Observatory of SMEs over 7 600 SMEs in 19 European countries. This report, which reflects the 1999 and 2001 survey results (European Commission 2000, 2002), indicates that about 15% of the firms with less than 50 employees feel that financing is the major constraint to the development of their business. About 9% of medium-sized firms (50-249 employees) consider insufficient access to financing as the main bottleneck. The results of the 2001 survey suggest that the financing situation of SMEs has remained largely unchanged in recent THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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years. It also reveals large disparities in the perception of finance constraints across EU countries. For instance, almost one quarter of the Greek SMEs report that financing is the major restriction for future growt,h whereas only 5% of the SMEs in the Netherlands express worries about finance. It is tempting to think that differences across countries reflect differences in the degree of financial sector development. However, a nonnegligible number of SMEs perceives finance constraints even in countries, such as the United Kingdom, with well-developed banking and capital markets. The surveys reviewed here do not provide overwhelming evidence that medium-sized firms also suffer from finance constraints, given that only less than 10% of the companies reply that financing is the major bottleneck. Factors other than finance seem to be more important. To illustrate this, the majority of SMEs - across all size classes – consider the lack of skilled labour the most important obstacle to business performance. That said, a survey carried out by Eurostat (2002) suggests that finance constraints could be more binding for particular SME activities: 28% of medium-sized firms report (in May 2001) that finance is the most important obstacle to innovation. Likewise, 24% of small firm respondents and 22% of large-firm respondents feel that a shortage of finance is holding back innovation in their enterprises. Therefore, in practice, finance constraints seem to be especially relevant to innovative firms, and among innovators problems of finance are felt across all size classes. Credit rationing apart, external finance tends to be more expensive for small firms than for large ones (see Graph 3). An obvious explanation is that fixed costs of lending which are not proportional to the size of the loan (e.g. administrative costs and the costs of collecting information about the borrower) - inevitably make small loans more expensive than large loans. Graph 3. Interest rates on credit market in France Discount rate

Short term credit

1st group : ≤ 15 245 € 2nd group : > 15 245€ & ≤ 45 735 € 3rd group : > 45 735 € & ≤ 76 225 € 4th group: > 76 225 € & ≤ 304 898 € 5th group: > 304 898 € & ≤ 1 524 490 € 6th group : > 1 524 490 €

Overdraft

Long and medium term credit

2004 Q4 2005 Q3 2005 Q4

Source: Banque de France.

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216 – PART II: SELECTED PAPERS One could argue that small firms are, on average, riskier for the lender than large ones, and thus, need to be charged a higher interest rate. But the argument is not as straightforward as it appears at first sight. It is true that small firms may have a higher probability of failing; in particular, start-ups have a high probability (more than 50%) of perishing within their first five years. Consequently, small, young firms are rightly perceived as riskier (OECD, 1997). But it is also true that simply comparing small and large firms individually is inappropriate since credit risk can partially be diversified away for smaller firms. A well-diversified basket of many small borrowers could be less risky than a portfolio of the same size comprising loans to large customers. To investigate this issue, this paper looked at a concept of risk that differs from default probabilities, namely the variance in the return on equity. However, this does not necessarily imply that lending to a pool of SMEs is less costly for credit institutions. In addition to the expected default probability and/or the variance in the return on equity, institutions need to account for the expected recovery rate when setting the lending rate. SMEs often have less collateral to underpin the repayment of the loan. Considering all these effects, even a diversified SME loan portfolio could be riskier than one consisting of loans to large companies. A more mundane explanation for relatively high costs of SME lending is a possible lack of competition among lenders, which enables them to charge interest rates that are in excess of what the underlying credit risk requires. In general, it is plausible to argue that SMEs have fewer options when raising external finance and this makes them depend more on a limited number of financial institutions. But there is also a specific dimension: small businesses are usually entirely dependent on the local bank market, whereas large firms can shop around on global financial markets. In this context, it is worth noting that there is evidence for a clear relationship between bank size and SME lending, with large banks devoting a lesser proportion of their assets to small business loans (see, among others, Berger and Udell, 1998) whereas local banks may have an advantage in offering SME finance because of their local knowledge and experience. However, not only this argument is everything but pertinent in a highly concentrated banking system but, more important, geographical proximity cannot be embedded as a factor decreasing the default risk in the new McDonough ratio. Anyway, it is possible to consider that customer relationships help to reduce information asymmetries and allow banks to extract rents from SMEs. To summarise, asymmetric information, limited competition in local banking markets, but also SME risks explain why one would expect that raising external finance is especially challenging for SMEs.

Is credit shortage responsible for the small size of SMEs? To put it in a more theoretical way, this paper will refer to the financial literature which distinguishes three streams of research exploring this phenomenon. Resting upon different assumptions, these streams have in common the fact that the imperfections of the financial market create a disparity between the cost of the internal funds (retained benefit) and the cost of the external funds (debt and new share issues). A way of considering the relationship between the investment and financing decisions is done, in the financial literature, by the analysis of the effects of the financing constraints on the capital expenditures, which is commonly called "The Investment-cash-flow sensitivity". The incidences of the informational asymmetries and the initiative mechanisms on the investment were explored by several authors (Bernanke and Gertler, 1989; Bernanke, Gertler and Gilchrist, 1999; and Kiyotaki and Moore, 1997). Although the models diverge THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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in their details, two principal results emerge from this literature (Shiantarelli, 1996). First, unless the loans are entirely collateralised, external funds remain more costly and expensive than the internal funds. Second, everything else being equal, the premium for risk required on external funds is an inverse function of a borrower’s net worth (assimilated to guarantees). Several criteria are used in the literature to categorise these companies into sub-groups according to the likelihood of being financially constrained: the affiliation with industrial groups and banks, the size, and the dividends policy.

The bank lending hypothesis This is mainly interested in the impact of the variations in credit availability on firm financing. In fact, the monetary policy can affect, via the "broad channel of the credit", the cost differentials of the various financing forms, mainly by influencing the net capital value of the company used as guarantee of its loans. This mechanism is a powerful action tool of the monetary policy on firms’ investment because a weak variation of the interest rates can strongly affect the value of collaterals, and thus, creating a rationing of the credit supplied to the company by the external partners.

The importance of generated cash flows Considering that financial markets are not perfect, the suppliers of funds can limit their offer, and thus, profitable projects can be rejected for lack of financing. This phenomenon of rationing is accentuated even more in the case of high tech entrepreneurial companies, which invest enormously in specific assets, such as the highly qualified human resources and R&D. The existence of these financing constraints and their implications for the investment and innovation at the firm level is an aspect which appears in several studies of corporate finance, but the concept of "financing constraints" was developed, and was explicitly put forward, with the works of Jaffee and Russell (1976), Stiglitz and Weiss (1981) and Fazzari, Hubbard and Petersen (1988). They initiated a substantial empirical study stressing the positive relationship between the firms’ generated cash-flow and their capital expenditures (especially on fixed assets), and also showed that this positive relationship is stronger in the case of firms with high growth and/or low levels of dividends. On the contrary, Kaplan and Zingales (2000) suggest this positive relationship is still stronger in the case of the companies which, theoretically, are not likely to be subjected to the financing constraints. They explain this result by the “excessive conservatism” of the managers who often prefer to be financed by internal funds than by external funds and/or quite simply by a non-optimising behaviour regarding investment decision (Hines and Thaler, 1995).

The governance system This system has an influence on the relationship between finance and investment (Hoshi et al., 1991). Adding to the Fazzari, Hubbard and Petersen model, the variables “nature” and “degree” of ownership concentration, they finds that firms belonging to groups (Keiretsu) are financially less constrained than more independent companies because Keiretsu plays, in fact, the role of informational asymmetries attenuator. In a continental Europe context (Germany), Audretsch and Elston (2002) introduced the size of the firm and the institutional specificity to analyse the relationship between THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

218 – PART II: SELECTED PAPERS liquidity and investment. The results show that the medium-sized companies seem to be financially more constrained than the smallest or largest ones. The econometric results show that ownership structure and control remains strong determinants of the firms’ dividend policy. They conclude that the publicly held and controlled firms often fix a higher level of distributed dividends than those of family businesses. From this point of view, it is worthwhile to take into consideration the role played by the so-called micro-groups in the French economic structure, for instance, since this kind of organisation plays a growing role in the economy preventing the direct application of the usual conception of the small independent firm as a typical empirical object. Indeed, as a member of a group, the small firm benefits from external effects that, according to the purpose of this paper, mainly consist in a greater availability of financial resources and a cheaper interest rate so that the two major components of credit rationing through prices and quantities are reduced. The available databases available at a European level do not fit perfectly with the need of international comparisons for this phenomenon. That is why this paper only refers to the French data (see Graph 4) in order to give an idea of this phenomenon, which is also supposed to result from a will to circumvent social and legal barriers. Graph 4: Number of firms according to the size and the property rights (%) 2003 100 80 60 40 20 0

1-19

20-49

50-249

250-499

+500 employees

Fully independent

Groups (weak property level)

French micro-groups

French groups (< 500 empl.)

French and foreign groups (> 500 empl.)

Source: DCASPL [A1]

How to facilitate better financing for SMEs Despite their problems in raising funds, it is generally admitted that SMEs constitute a key part of the economic system. The question is then to “convince” lenders to provide more funds to these firms knowing that not only their repayment level is not significantly worse than the average one but that they will also be able to produce spillover effects profitable to the whole economy.

Loan guarantee scheme as a short term solution to the credit shortage In general, loan guarantee schemes have been established to assist SMEs with respect to gaining access to debt capital. The Table below identifies the officially articulated reasons for the establishment of loan guarantees in several countries. A review of these objectives reveals that the goals of loan guarantee schemes are invariably stated in terms

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of improving access to debt capital so as to stimulate business growth and innovation among viable SMEs, even though it remains uncertain whether this is simply the outcome of banks’ “correct” assessment of businesses, or whether SMEs are more naturally victims of credit rationing. Nevertheless, it is not clear that capital rationing actually occurs (Berger and Udell, 1992) and, if it does, whether or not loan guarantee schemes are a suitable remedy for capital rationing (Vogel and Adams, 1997). Objectives of Loan Guarantee Schemes Country France

Objectives “guaranteeing the financial operations of SMEs” “the scheme is especially geared towards new firms and takeovers” “to support businesses which are in the most vulnerable stages of development, i.e., creation and transfer of ownership” “to strengthen the financial structure of firms and support investments made by SMEs, particularly those businesses producing highly innovative products”

Germany

“to strengthen SMEs in economy” “to target small businesses with viable business projects, who lack the adequate security necessary to obtain finance”

Netherlands

“to grant loans to SMEs who have ‘satisfactory future prospects’ but are unable to receive a conventional loan due to a lack of collateral” “to facilitate the supply of finance to viable small firms where conventional loans are not available, possibly due to lack of security or track record” “to give the lender experience of lending to businesses which have a viable proposal but do not satisfy normal banking security criteria, the objective being to encourage more emphasis on the appraisal of business projects”

UK

Canada

US

“to increase the availability of loans for the purpose of the establishment, expansion, modernisation and improvement of small business enterprises” (SBLA, 1991. P.2). “to bridge the gap between small, new firms and the type of secured lending traditionally sought from institutions” “to encourage lenders to provide debt financing to SMEs that the lenders would otherwise consider too small or too risky” “to increase the access of small businesses to credit and in so doing to stimulate growth in the small business sector”

Source: Christensen et al, 1999

Clearly, there is considerable potential for further work to examine these issues. Nevertheless, it is worth noting that some of the apparent inconsistencies may be related to the role of collateral in bonding debt finance. Theoretically, adequate collateral can mitigate problems of asymmetric information (Bester, 1987). The low-risk borrowers who leave the market in the Stiglitz-Weiss model can signal their status by a willingness to offer appropriate levels of collateral, and the taking of collateral by the banks can provide an incentive to ensure that the firm will perform to the best of its abilities in undertaking the project (Bester, 1987). However, this solution depends in turn upon the availability of collateral. If collateral is in limited supply, debt gaps may still exist, and there are reasons for believing that growing businesses may be particular vulnerable to this problem (Binks et al, 1992)

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The necessary improvement in the quality of information Besides collateral, the most common way for an “information-opaque” firm to reduce credit rationing is to signal their quality to bankers (Harris and Raviv, 1991). A good way to signal quality is to be financed by informed lenders such as the owners-managers themselves. Other informed lenders can be taken into account, like the family members, venture capital funds or firms that are commercial or industrial partners.

Shareable knowledge In fact, it would seem that the best way to reconcile the financing needs of small businesses with the security expectations of banks would be to examine the potential of a specific intermediary structure that would have specialised expertise and fill a particular niche in the credit market. A specialised agency that could provide sound and validated information for these purposes and that could also benefit from the learning curve would seem an excellent way to get around the financial constraints observed. First, there would be greater transparency surrounding potential clients. Second, such an agency dedicated to small businesses would give the banking system a single, and therefore, homogeneous point of reference. Finally, learning through practice and experimentation, which such an approach presupposes, will be made easier by concentrating codified knowledge (which can be stored electronically), together with tacit knowledge (which is based on experience and cannot be exchanged in the course of the normal market relations) within the same agency. From a generic viewpoint, the intermediation function involves putting knowledge, know-how, methods, techniques and tools to use for conducting business and establishing the associated relationship. In economic activity, this intermediation function can take various forms (financial, political, and commercial), but the most important aspect for the small business lending segment is informational mediation of a kind that will ensure a proper flow of information and knowledge. This conclusion points to a mission with three goals: providing access, refining, and providing benchmarks of information: •

Access for businesses and all economic players to the information and knowledge needed in their respective economic actions.

•

Refining the knowledge and information acquired so as to move from general data to an intellectual tool for resolving concrete problems facing the lender or investor.

•

Constant updating of information on the borrower's overall activity so that the players involved can position themselves appropriately.

It involves, then, a continuous process of transforming generic knowledge and information into operational tools and solutions for economic players, as well as producing a continuous overview (one might call it an up-to-date map) of the firm within its environment. To what extent would such a function improve the capacity of small businesses to obtain financing? For a lender to enter into a credit relationship he or she must have a means of evaluating and assessing the risk, which one might call the “enterprise risk”, in order for both to distinguish it from the credit risk and to stress the purpose of the relationship to enable the future creation of wealth. In this respect, “credit” will retain its original meaning -- it will be viewed as a wager on the future success of a productive activity.

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Within this notion of a commitment to the future, two distinct forms of enterprise risk: can be identified: •

The insolvency risk, to which banks and suppliers are no doubt the most sensitive, is the reverse side of the accumulation effort, which requires financing, in particular external and most often bank financing, and makes it possible to manage the competitiveness risk by providing the means to improve the firm’s competitive position.

•

The risk of losing competitiveness is less often considered because it is difficult to assign it a probability; it can be viewed as the downside of efforts to maintain sound financial health by foregoing needed investment in order to restore or maintain a certain level of solvency.

While in the case of widely traded firms, the rating agencies make all of this information available for portfolio arbitrage and investment decisions, data relating to competitiveness risk tend to be excluded from the field of analysis for small business risk. Making such data available would represent a real boost for developing this segment of the industrial fabric, in light of evidence (Paranque et al, 1999) that small businesses are doubly handicapped when it comes to financing: •

The aversion that they inspire stems less from concerns over their profitability than from doubts about their survival, and this issue relates directly to their ability to produce information on their likely durability. One may say that that the “small business risk” refers, in effect, to the additional cost of acquiring information on them, compared to large firms that are subject to the demands of the financial markets. An informational intermediary could thus play a key role in collecting, organising and disseminating information in the form of knowledge that can be shared to enhance players’ forecasting, and hence, their forward planning capabilities.

•

The growth and the liberalisation of financial markets have made performance more volatile, and consequently, banks and lending institutions are generally confronted by a “time lag” between the pace of those markets and that of firms' real activity. Lenders react to the cost of this lag either by increasing their spread or by being more selective about the loans they make. This selectivity affects both the volume and the nature of lending (short-term as opposed to medium or longterm) and/or the cost of the loan. Small businesses, then, are particularly handicapped in comparison to other firms, less because their solvency risk is unduly high (Delbreil i 2000) and more because lenders and borrowers are unable to communicate on the basis of shared information (Belletante and Levratto, 1995). Here again, an informational intermediary could help enhance the transparency of this class of businesses.

The challenge: improving the relationship between small businesses and lenders Before considering the best tools for reaching this objective, it is worthwhile discussing what needs to be built into the signal in order to meet the expectations and needs of loan officers2: •

Quality of the application: this purely formal dimension relates to the entrepreneur's capacity to follow the rules in presenting his or her project and highlighting its various aspects.

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Quality of the borrower: taking essentially the approach of a recruiter, the loan officer will seek information on the entrepreneur's experience, skills, staff, status and personality.

•

Quality of the financing package: often cited as a problem for entrepreneurs, this dimension looks essentially at the existence of a financing plan and its soundness, the statement of needs, and the availability of suitable guarantees.

•

Quality of the firm's performance: this element is assessed against various indicators that rely most frequently on experience (trends in the industry, familiarity with the business, etc.).

These different aspects should all be covered in the message about the firm’s quality that the informational intermediary transmits to banks and suppliers. In this case, the rating or score will not only help to improve communication between the firm and other parties, but will also provide the entrepreneur with a more thorough understanding of the characteristics of the firm. To make them fully transparent, these aspects must be grouped into a homogeneous evaluation scheme that will produce a score for each firm, in light of the production world to which it belongs. One may define two broad sets of economic criteria: quantitative and qualitative. •

Quantitative criteria: This implies, first, identifying the production model in which the firm operates, using the notion of the consistency of the firm's operations with the nature of its products. Next, on the basis of the production model (standardised or specialised), one can determine the profitability model (by the market or by the organisation) and evaluate the firm's performance – favourable or unfavourable – against the ratios of the model concerned.

•

Qualitative criteria: The intent here is to steer the principal banking practice towards economic analysis by stressing the importance of the nature of products and hence of production models (standardised and specialised).

Before an economic analysis of a firm's quality can be undertaken, however, the following two conditions must be met: •

First, the small entrepreneur must be made more aware of the importance of management by calculating the informational score. The score is then understood not only as a homogenous and consistent indicator of the quality of small businesses, but also as a heuristic device. The pedagogical dimension transforms the score into an indicator of quality and a device for achieving that quality.

•

Secondly, the informational score can facilitate access to credit if banks agree to relax their financial rules and, more specifically, the amount of guarantees they require. In other words, this means that the banks will reduce the weighting of the financial score in favour of the informational score.

Conclusions A financial constraint is said to exist, even if there are no externalities involved in the firm’s investment activity, when there is a wedge (perhaps even a large wedge) between the rate of return required by an entrepreneur investing his or her own funds and that required by external investors. There are many reasons postulated as to why such financial constraints might exist. These are reviewed in Canepa and Stoneman (2003) as THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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well as in Hall (2002). The existence of uncertainty, and thus, risk is a sine qua non of such constraints. Smaller firms may be relatively more tightly constrained because: i) the availability of internally generated funds may be more limited for smaller firms than larger firms; ii) problems of information asymmetries may also be more severe for such firms; iii) smaller, newer firms may have no track record upon which to base a case for funding and/or there may be fewer realisable assets to use as collateral; and iv) the costs (to funding providers) of searching may mean also that the supply of finance to smaller firms may be more severely limited. For many years, there has been a desire in Europe, both at a national and a community wide level, to improve the innovative performance of the SME sector. This has been reflected in a large number of national and EC wide policy interventions. The economic justification of such interventions has been on the grounds of two main arguments: i) network externalities, it being argued that the growth of SMEs encourages growth in the economy as a whole, and ii) market failures. Finance guarantee schemes issue government guarantees for debt finance to a wide group of intermediaries who support investment in SMEs. For example, under the scheme operated by the European Investment Fund (EIF) “loan guarantees support enterprises with growth potential with up to 1 000 employees. Under this window, the EIF issues partial guarantees (directly or indirectly) to cover portfolios of loans.”3 More fundamentally, the production of ratings or scores is considered as a potential contribution to the growth and survival of small businesses by improving their capacity to communicate with their financial environment. Taking a global approach to the firm and focusing on the fit between its internal organisation and its external market, the evaluation method proposed here supplements conventional default risk analysis by assessing the firm's durability. In doing this, it is useful to apply the notion of diversity inherent in the concept of worlds of production, which recognises from the outset that small businesses, by their very nature, may have many different forms of organisation and relationships with customers and suppliers. From there on, it is a question of statistical processing.

Notes 1 For instance Rajan and Zingales (1998) provide an extensive analysis of the determinants of capital structure by examining the financing decisions of public firms in the major industrialized countries. 2 The key elements are drawn from a survey of small-business loan officers as part of Levratto et al. (2001, 2002). 3 www.eif.org/Attachments/productdocs/sme_gf_summary.pdf (page 1).

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References Audretsch D.B. and J.A. Elston, 2002, Does Firm Size Matter? Evidence on the Impact of Liquidity Constraints on Firm Investment Behavior in Germany, International Journal of Industrial Organization, Vol.20, pp. 1–17. Belletante, B. and N. Levratto, 1995, Le financement des PME : quels champs pour quels enjeux ? [« SME financing : what fields for what issues? »], Revue Internationale des P.M.E., Vol. 8, n° 3-4. Berger A.N. and Udell F.G., 1998, The Economics Of Small Business Finance: The Roles Of Private Equity And Debt Markets In The Financial Growth Cycle, Journal of Banking and Finance, 22, 613-673. Berger, A N and Udell, G.F., 1992, Some Evidence on the Empirical Significance of Credit Rationing, Journal of Political Economy, 100 (5), pp. 1047-1077. Bernanke, B. and M. Gertler, 1989, Agency Costs, Net Worth, and Business Fluctuations, American Economic Review, Vol. 79, pp. 14-31. Bernanke, B., M. Gertler and S. Gilchrist, 1999, The Financial Accelerator in a Quantitative Business Cycle Framework, In: J.B. Taylor and M. Woodford, editor(s). Handbook of Macroeconomics. Volume 1C., Amsterdam, The Netherlands: Elsevier Science, North-Holland. Bester, H, 1987, The Role of Collateral in Credit Markets with Imperfect Information, European Economic Review, vol. 31 pp 887-899 Binks, M.R., C. Ennew and G. Reed, 1992, Information Asymmetries and the Provision of Finance to Small Firms, International Journal of Small Business, vol. 11(1), pp 3546. Canepa A., and P. Stoneman, 2003, Financial Constraints to Innovation in the UK and other European countries: evidence from CIS2 and CIS3, paper presented at a CIS user group conference, Modelling Innovation, DTI Conference Centre, London, June. Christensen, J. L., Jackson, S., Mensah, and A. Riding, 1999, Loan Guarantee Schemes in Six Countries, Working paper, Aalborg University. Delbreil, M. et al., 2000, Corporate Finance in Europe from 1986 to 1996, Report to the European Committee of Central Balance Sheet Offices Own Funds Working Group, 127 p. European Commission, 2000, The European Observatory for SMEs, Sixth Report, Executive Summary, Enterprise Policy, Brussels. European Commission, 2002, SMEs in Europe, including a First Glance at EU Candidate Countries, Observatory of European SMEs, n° 2, Brussels, Belgium.

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Fazzari S., R.G. Hubbard, B. Petersen, 1988, Finance constraints and corporate investment, Brookings Papers on Economic Activity, n°1, pp. 141-195. Hall G., P. Hutchinson and N. Michaelas, 2004, Determinants of the Capital Structure of European SMEs, Journal of Business Finance and Accounting, Vol.31, No.5, (June/July) pp. 711-728. Hall, B., 2002, The financing of research and development, Oxford Review of Economic Policy, n°18, pp. 35-51. Harris, M. and A. Raviv, 1991, The Theory of Capital Structure, Journal of Finance, vol. 46(1), pp. 297-355. Hines, J. and R. Thaler, 1995, The flypaper effect, Journal of Economic Perspectives, Vol. 9, n°4, pp.217-226. Hoshi, T., A. Kashyap, D. Scharfstein, 1991, Corporate Structure, Liquidity and Investment: Evidence from Japanese Industrial Groups, The Quarterly Journal of Economics, n°56, pp. 33-60. Jaffee, D. and T. Russell, 1976, Imperfect Information, Uncertainty, and Credit Rationing, Quarterly Journal of Economics, vol. 90 (November), pp. 651-666. Kaplan and L. Zingales, 2000, Investment – Cash flow Sensitivities are not Valid Measures of Financing Constraints, Quarterly Journal of Economics, pp. 169-215. Kiyotaki, N. and J. Moore, 1997, Credit Cycles, Journal of Political Economy, n° 105, pp. 211-48. Kumar, K.B., R.G. Rajan and L.Zingales. 1999, What Determines Firms Size?, NBER Working Paper, No. 7208 Modigliani F. and M. Miller, 1958, The cost of capital, corporation finance and the theory of investment, The American Economic Review, Vol.68, No.3, (June), pp. 261-297. OECD (1997) Government Venture Capital for Technology Based Firms, Paris Paranque B, E. Dubocage, D. Rivaud-Danset, R. Salais, 1999, Une étude comparée des entreprises non financières : formation de la rentabilité et structures financières, CREI-CEDI conference on the convergence of financial systems and finance-industry dynamics. Pettit R. and R. Singer, 1985, Small business finance: a research agenda, Financial Management, Vol.14, No.3, (Autumn), pp. 47-60. Rajan, R. and L. Zingales, 1998, Financial Dependence and Growth, The American Economic Review, No. 88, pp. 559-586 Schiantarelli, F., 1996, Financial Constraints and Investment: Methodological Issues and International Evidence, Oxford Review of Economic Policy, Vol. 12, n° 2, pp. 70-89 Stiglitz, J and A. Weiss, 1981, Credit Rationing in Markets with Imperfect Information, American Economic Review, vol. 71, pp 393-410. Vogel, R.C. and D.W. Adams, 1997, Costs and Benefits of Loan Guarantee Programmes, Financier, Vol. 4, pp. 22-29. Wagenvoort R., 2003, Are finance constraints hindering the growth of SMEs in Europe?, EIB PAPERS Volume 8 N° 2, pp. 23-50.

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Permanent Forum of Micro-Enterprises and Small Firms: Measures to Strengthen Credit in Brazil

Ms. Cândida Maria Cervieri Director of the Micro, Small and Medium Enterprise Department, Ministry of Development, Industry and Foreign Trade This paper describes the measures taken by the Permanent Forum to strengthen and develop micro and small enterprises (MSEs). The Forum is an innovative space made up of government bodies, support institutions and small firm associations aiming at proposing public policies to provide better opportunities for MSEs. The Forum has built a more favourable environment for business and better competitive conditions for enterprises in domestic and international markets. The study concentrates on Forum measures to improve access to credit.

Brazil and world trends to support small firms One of the most important current trends in public policies is the concern shown by governments and organisations all over the world to implement effective measures to support the development of micro and small enterprises (MSEs) and entrepreneurship. Countries are increasingly adopting integrated policies, involving various areas of support, to strengthen small firms and diminish their competitive disadvantages vis à vis large firms. Other actions involve incentives for the creation of small businesses in conditions that offer better chance of survival. This support is justified by the sector’s high job and income-generating capacity, and the other contributions these firms can make to a more balanced economic development. This support implicitly recognises that MSEs have begun to play a crucial role in reducing unemployment rates, after a considerable period of time during which hopes for employment generation had rested almost exclusively on large firms. Likewise, Brazil’s organised society and public authorities have become increasingly conscious of the need to accelerate initiatives to support small firms. Thus, one can observe an intensification of an entrepreneurial process, in which individuals set up their own business establishing formal and informal micro firms. However, a more dynamic process involves taking advantage of opportunities created by large firm outsourcing activities and other changes in the productive structure due to the globalisation of the economy. A brief analysis of the new opportunities for small business expansion in Brazil, reveals the following processes: i) the creation of small firms to provide services in areas THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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which are no longer part of the core business of large firms (outsourcing and sub contraction of goods production); ii) the supply of inputs and services to firms in privatised sectors or public utilities in the cell phone, oil platform, steel and energy sectors; iii) the appearance of various dynamic niches in information technology, internet and tourism sectors, and other growth areas such as the transportation of people and small cargoes, which are typically catered to by small firms; iv) creation of firms through franchise licenses; and v) finally, traditional sectors which, given the expansion of the domestic market for products aimed at the low-income population, are still a considerable source of small firm growth.

Importance of micro and small firms in Brazil Each year, 470 000 new formal firms of all sizes are registered in Brazil, of which 99.0% are micro and small firms. The country has 5.1 million formal firms, of which 4.7 million are micro enterprises, employing an average of 2 people, constituted largely by own-account entrepreneurs, and 326 000 small firms with an average of 18 employees. Growth figures for the business sector in industry, commerce and services between 1996-2003, the longest period for which data is available, show the following results, according to firm size1: •

The net number of new firms created attained 1.97 million new firms: 1.84 million micro firms, 120 000 small firms, 7 000 medium firms and 1 000 large firms.

•

Total employment rose from 21.5 million to 28.5 million, an addition of 7 million new jobs, distributed as follows: 3.2 million in micro firms, 2 million in small firms, 600 000 in medium firms and 1 million in large firms. Thus, 3.2 times more new jobs were created in micro and small firms than in other firms.

•

Total compensation and earnings paid to employees and owners, respectively, rose BRL 24 billion in real terms (from BRL 220 billion, in 1996, to BRL 244 billion, in 2003), distributed as follows by firm size: micro enterprises: increase BRL 8.6 billion; small firms: increase BRL 11.6 billion; and medium firms: increase BRL 4.3 billion. The total real value of compensation paid declined slightly in the case of large firms. The better results obtained by micro and small firms in the total payment of compensation and earnings is due to the segment’s higher employment growth.

Another significant group of firms in the urban environment is constituted by informal micro businesses, which do not pay federal taxes and are thus excluded from various growth opportunities such as government procurement, exports and nonearmarked credit. There are 10.3 million firms in this situation, with up to five employees, which provide employment for 14 million people, in the manufacturing, commerce, transportation, and civil construction sectors, amongst others. 8% are constituted by own-account businesses, with only one employee. Informal undertakings obtained an average profit of BRL 911.00, equivalent to around 3.8 times the minimum wage in 2003. Altogether, informal firms account for around 6% of GDP.2 MSEs’ exports are still far below their potential. The sector accounted for a mere 2.6% of business exports by Brazil in 2004, with medium firms exporting 8.1%, or a total share of 10.7% for micro, small and medium firms.3

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Origins of the permanent forum of micro-enterprises and small firms Despite the importance of micro enterprises and small firms, their historical development has been hampered by lack of adequate public policy support, involving measures that are crucial for their competitiveness and survival, such as reducing the tax burden, charging lower interest rates, and providing greater access to working capital and technological, management and accounting assistance. There are several reasons for the difficulties faced by small firms in getting the public authorities to listen to their needs. First of all, these needs cannot be satisfactorily assessed by the executive branch of government because the proposed measures are not formulated in a correct way. This is due to low technical capacity of small firm associations, unprepared to make proposals at the level of information required to assess policies. Another significant barrier is constituted by the MSEs limited capacity to organise a joint defence of their interests. Spread out all over the country, firms are organised according to similar lines of business and in state associations and federations, but are incapable of forming a large nationwide representative body to make its voice heard at the centres of power where decisions are made. Thus, small firms, unlike large ones, lack appropriate channels of representation. Due to these restrictions, small firms’ needs, which reflect the obstacles that lie in the path of their development, are rarely met. An example of the lack of implementation of the necessary measures can be seen in the case of the former MSE statutes approved under Laws 7.256/84 and 8.864/94, in 1984 and 1994 respectively, which provide for broad support in various areas. These statutes produced few concrete results, with the exception of the adoption of the SIMPLES, simplified tax regime, in 1996 that is currently used by 2.2 million MSEs to declare and collect federal taxes. It was in the context described above, the growing importance of small businesses and lacking adequate channels of representation, that the third Micro Enterprise and Small Firm Statute (Law 9.841) was promulgated in 1999, establishing directives regarding the differential treatment of small businesses in the administrative, tax, social security, labour law, credit and business development spheres. Many of these directives still need to be regulated before implementation, and this involves discussions and broad negotiations between the private sector, government and the Congress. It was exactly for this purpose that an important innovation was included in the Statute: the creation of the Permanent Forum of Micro Enterprises and Small Firms in order to assure the effective implementation of the support measures suggested in the law. The Forum was established in November 2000, under the coordination of the Ministry of Development, Industry and Foreign Trade. For the first time, a forum of national importance was provided for the discussion and formulation of measures designed to give micro and small firms a different and simplified treatment determined by the Federal Constitution, in articles 170, IX and 179, constituting the legal basis for the Micro Enterprise and Small Firm Statute.4 According to its profile and composition, the Forum has been designed to promote dialogue between the productive sector (businessmen and workers), the government and Congress, in order to discuss and seek a consensus regarding the problems, opportunities and challenges facing micro and small firms. After reaching a consensus, debates in the

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Forum focus on formulating measures aimed at overcoming bottlenecks and providing better opportunities for the development of MSEs.

Permanent Forum structure, attributions and principal measures The Permanent Forum is constituted by government bodies, support institutions and entities that represent micro and small firms. Government bodies include ministries, public foundations, research institutes, regional bodies, public sector banks, amongst others. Also, 57 entities that represent small firms and 52 government bodies are currently taking part. The entities that wish to take part in the Forum go through a qualifying process and have to fulfil the criteria defined in an edict. The president of the Forum is the Minister of Development, Industry and Foreign Trade. The Forum is structured around six thematic committees that deal with the following issues: Legal and Bureaucratic Rationalisation; Entrepreneurial Formation and Training; Investment and Financing; Technology and Innovation; Foreign Trade and International Integration; Information. The proceedings of the thematic committees have two coordinators, representing the private sector and the government. Public policy proposals and suggestions for measures after an advanced stage of assessment are implemented through decisions taken in Forum Plenary Sessions, which occur every six months, with the participation of federal government bodies involved in the matters dealt with, and the MSE principal representative entities. The joint work of federal bodies and entities representing small firms from all over the country increases the dialogue between the government and the private sector, and produces the integration needed to formulate consensual measures to support MSEs. The Forum’s main legal attributions are to: •

Monitor the effective implementation of support measures instituted by the Micro Enterprise and Small Firm Statute, by making proposals for the legal regulation of measures included in the Law’s articles and paragraphs.

•

Advise on the formulation of government support policies, proposing necessary adjustments and improvements.

•

Promote articulations between various government bodies and MSE support entities.

•

Promote the articulation of various government support programmes for small firms.

Based on its nationally prominent role as an institution, which coordinates interested party discussions on problems that affect small firms and their suggestions for solutions, the Forum has developed during its first five years a set of measures in various areas, following extensive debates with committee participants on different proposals for measures and public policies. The principal measures, excluding the credit area, were: stationery 1. Setting up Information and Business TeleCentres. The aim of this proposal is to insert the micro and small firm in the information society by creating TeleCentres to exploit businesses via Internet and train people to use information technologies. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

230 – PART II: SELECTED PAPERS There are currently 1616 qualified TeleCentres. The aim for 2006 is to have 3 000 TeleCentres operating nationwide by the end of the year. 2. Modification of regulations relating to the Promotion of the Competitiveness Guarantee Fund Law - FGPC, through Decree nº 3889, dated 10.08.2001, the established new limits for the definition of micro enterprises and small and medium-sized firms, in accordance with MERCOSUR criteria, and attributing competences for updating the MDIC (Ministry of Development, Industry and Foreign Trade). 3. Formulation and annual publication of a statistical bulletin by firm size – Two Statistical Bulletins have already been published. The Foreign Trade Secretariat of the MDIC is analysing a proposal for a quarterly edition. 4. Institutionalisation of the PROGEX and Creation of its Managing Committee through Interministerial Rule nº606, 09/20/05. The principal aim of the National PROGEX is to increase the export capacity of micro, small and medium firms that operate or intend to operate in international markets, by helping them to meet the technical product specifications of determined markets. 5. National Training Programme for Managers and Educators of Information and Business TeleCentres – An agreement has been signed with Brasilia University (UnB) to develop various courses for TeleCentre Managers and Educators. 6. Increase the limit of the Simplified Export Return (DSE) - Normative Instruction no. 611, published on 20.01.2006, increased the Simplified Export Declaration limit to USD 20 000, enabling increases to be made in the Post Office simplified export services (“Exporta Fácil”) and those provided by other courier firms.

Credit support initiatives Permanent Forum discussions regarding small firm access to credit are conducted by the Investment and Financing Committee. The present coordinators of the committee are the representative of the National Economic and Social Development Bank (BNDES), for the government, and the State of São Paulo’s Micro and Small Firm Association, for the private sector. The following institutions are committee members: the Central Bank of Brazil, the five Federal banks, financing and regulatory federal financial institutions, relevant Ministries and several associations representing MSEs. During its five years of work, the Investment and Financing Committee discussions have been guided by the following points, which represent bottlenecks in MSE access to credit: •

Increasing of federal bank working capital credit lines for small firms.

•

Studies to simplify information and documentation requirements for risk analyses.

•

Creation of a training programme for employees of federal banks.

•

Increase of credit insurance programmes.

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Other measures.

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Increase working capital In recent decades, given the lack of a private long-term credit market, the government has concentrated on providing credit for investment. Recently, however, the government has verified the need to increase public funds for working capital loans because of problems faced by small firms in accessing this type of credit, especially with the high current market interest rates. Permanent Forum actions led to the creation of a credit line under the auspices of the PROGER, a credit programme instituted in 1995 with funds from the Workers’ Assistance Fund (FAT),5 aimed at facilitating the access to credit of those MSEs and small businessmen who were having difficulties obtaining loans in the non-earmarked credit market. This credit line, provided by the federal government banks, added BRL 1.2 billion (USD 0.5 billion) in new funds for MSEs in 2003 and BRL 2.8 billion (USD 1.2 billion) in 2004. In the latter year, the new funds enabled 1.5 million loan contracts for working capital to be signed with formal firms, and 109 000credit contracts with informal entrepreneurs, irrigating the credit market with a credit line that was more accessible for small firms. As part of the same effort to increase access to credit, the Forum, together with the administrator of the Constitutional Financing Funds at the Ministry of National Integration,6 is studying ways of creating specific credit lines for working capital for small firms, increasing the supply of funds on more favourable terms, including lower interest rates and longer maturities for small firms in the Northern, North-eastern and Centre-west regions of the country. Federal banks, which transmit funds from the Constitutional Funds, are now estimating existing demand for working capital in the respective regions, before deciding whether to create credit lines for pure working capital.

Simplification of credit norms The Forum has requested studies from the Central Bank and official banks aimed at simplifying requirements and procedures related to risk classification and the definition of guarantees. The objective is to increase small firm access to financing by simplifying the documents they have to present to banks and credit analysis procedures, without tampering with Central Bank prudential regulation.

Training programme for the federal bank’s employees The Forum suggested the creation of a training programme for employees of official banks, to enable them to cater to the specific needs of small firms and facilitate the preparation of their initial credit proposals. The year 2006 should see the completion of technical studies and training modules prepared jointly with Brazilian Micro and Small Enterprises Support Service (SEBRAE), before starting the course.

Increasing support for the Sebrae guarantee fund (Fampe) The Forum has requested the Sebrae to analyse ways of increasing the share of Fampe funds in the composition of guarantees required in credit operations for MSEs. The value currently guaranteed by the Fampe funds covers up to 50% of the value of loans obtained from banks. Technical studies relating to this proposal will be carried out in 2006.

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Proposal to provide technical support for the “Credit Auction for Micro and Small Firms in Productive Chains” Project The proposal currently under discussion in the Forum aims at creating a “credit auction” mechanism to facilitate the access of MSEs located in Local Productive Arrangements (APLS) to working capital and investment credit lines. Credit intermediation with banks will be undertaken by “leader firms” that buy products and services from small firms. Bases for obtaining credit are the supply contracts between leader firms and MSEs, used as receivables that constitute collateral for the banks. To become feasible, the system requires a support structure involving the creation of databanks and the registering of the leader firm with regional development agencies. The databank will enable the financial intermediary to obtain online information for loan-risk analysis, thus reducing costs and credit risks. Loans for working capital will be provided through credit auctions, using a credit instrument developed specifically for MSEs. The auction process begins with the registering of loan candidates and the presentation of their receivables online to the development agencies, which then show them to registered banks. The latter can make offers of credit and interest rates. After choosing the bank, the MSE transfers the receivables as part of its credit guarantees. Considerable benefits are expected to flow from this credit auction system, such as the access to credit at lower interest rates, easier negotiations with banks, a reduction in the number of documents required, more credit for investments, more resources from venture capital funds and an increase in MSE sales. Financial intermediaries will profit from a larger loan market, new customers and less risky operations.

A discussion of micro credit objectives and official bank actions The Permanent Forum analysed government policy for micro credit and the main loan actions and programmes of the official banks in order to estimate the need for improvements. Since 2003, the government has given top priority to actions aiming at increasing the supply of credit to micro businessmen, facilitating low income population access to financial services and reducing interest rates. The most important measure has been a rule determining that private sector and public banks allocate 2 % of their current deposits to micro finance loans, for formal and informal businessmen and the low-income population of not more than BRL 1.000, at a maximum interest rate of 2 %. The aim is to increase the opportunities for job and income generation, in recognition of the intense population’s entrepreneurial activities. The following measures were implemented to facilitate access to financial services by the population excluded from banking services: the creation of simplified current and savings accounts to increase opportunities for credit and make small financial transactions more secure; encouraging cooperatives through the modification of restrictive norms, permitting the creation of free association cooperatives; allowing rural credit cooperatives and free association cooperatives to capture rural savings. Thus, cooperatives will become effective financiers of micro credit. Other wide-ranging measures involved creating the institutional framework to allow financial institutions to grant credit to employees and civil service retirees using the “credit fully backed by payroll payments” mechanism, a type of low-risk loan with lower interest rates. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Role of the Federal Banks The Permanent Forum assessed federal bank credit policies in recent years, which have aimed at increasing credit for small firms and micro credit. The new measures included increasing access to loans for working capital and exports, support for software firms, pharmaceutical drug production and for firms located in Local Productive Arrangements, and reducing the bureaucracy involved in obtaining financing for machinery and equipment through the BNDES Card. Regarding of the development of the handicraft sector, an agreement was signed between the Ministry of Development, Industry and Foreign Trade and the Caixa Econômica Federal to provide support for the Brazilian Handicraft Programme, mainly by supplying credit using the various lines offered by the Caixa.

Conclusions The Forum has fulfilled its mission of joining sectors interested in improving the legal and economic environment in which small firms operate. It has also promoted discussions and established a consensus to seek solutions for problems affecting small enterprise by bringing governmental bodies into the debate. With the Forum the government as a whole is able to obtain a clearer and more objective understanding of MSE needs. One of the most important points to be highlighted is that the Forum, as a permanent institution, can give continuity to its actions, thus constituting an appropriate mechanism for monitoring support measures and their constant improvement. Thus it should be emphasized that the measures adopted do not merely involve actions with a global impact, but also a great number of solutions for specific problems, such as the measures to simplify export and import procedures. The following actions have been achieved by the Permanent Forum during its five years of activities: 1. Eight plenary meetings took place, 55 proposals were approved, and 17 actions were adopted in support of micro and small firms. 2. Some 52 different government bodies took part in the decisions of the Forum and in the meetings of committees and work groups. 3. From establishment until February 2006, 182 meetings had taken place under the auspices of the six Thematic Committees to discuss the proposals presented. 4. Twenty work groups were constituted to study proposals and present solutions. The Forum has constituted a democratic and innovative space to formulate public policies in Brazil and provide micro and small firms with a more favourable environment for business and allowing for greater competitiveness in domestic and international markets.

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Bibliography Associação Brasileira de Instituições Financeiras de Desenvolvimento, apresentação na 6ª Reunião Plenária do Fórum Permanente: Leilão de Crédito para Micro e Pequenas Empresas em Cadeias Produtivas, 30.06.2004. Appy, Bernardo, “Microfinanças no Governo Lula”, apresentado na 6ª Reunião Plenária do Fórum Permanente, 30.06.2004. Fórum Permanente, 8ª Reunião Plenária e Balanço das propostas apresentadas pelo Fórum Permanente das Microempresas e Empresas de Pequeno Porte, Brasília, 01.12.2005. Fórum Permanente, Estatísticas: Microempresas e Empresas de Pequeno Porte no Brasil, 2005. Moraes, Cláudio Bernardo Guimarães, “Ações de Crédito dos Bancos Oficiais”, apresentado na 6ª Reunião Plenária do Fórum Permanente, 30.06.2004. Morais, José Mauro, The Access of Micro and Small Enterprises to Credit in Brazil, OECD Global Conference on Better Financing for Entrepreneurship and SME Growth, Brazil, 2006. Serviço Brasileiro de Apoio às Micro e Pequenas Empresas - Sebrae, Economia Informal Urbana, July 2005.

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Notes 1 Source: databases of the Brazilian Institute of Geography and Statistics – IBGE, Central Registry of Firms-CEMPRE (www.ibge.gov.br). The research adopted the European Union’s concept of firm size: micro-enterprise: 1 to 9 employees; small: 10 to 49; medium: 50 to 249; large: 250 and over. 2 Figures for 2003, vide “Economia Informal Urbana (The Informal Urban Economy), Serviço Brasileiro de Apoio às Micro e Pequenas Empresas - Sebrae, July 2005. 3 According to statistics of the Ministry of Development, Industry and Foreign Trade. 4 The institution of the Permanent Forum was authorized by article 41 of Law nº 9.841, dated 10.05.1999 (MSE Statute) and created by article 24 of Decree nº 3.474, dated 05.19.2000. The by-laws were instituted by Directive nº 59, dated 05.24.2001, of the Ministry of Development, Industry and Foreign Trade. The Technical Secretariat of the Forum is exercised by the Department of Micro, Small and Medium Firms. 5 The Workers’ Assistance Fund (FAT) is managed by the Deliberative Council of the Workers’ Assistance Fund (CODEFAT), at the Ministry of Labor, and is composed of representatives of workers, employers and the government. It establishes directives for the allocation of the Fund’s resources and administers the Unemployment Benefit Programme and the payment of the workers’ Wage Bonus, besides economic development and credit support programmes. 6 The Constitutional Financing Funds of the Centre-West (FCO), the Northeast (FNE), and the North (FNO), grant financing to firms, individuals and cooperatives in the agriculture and livestock, mineral, industrial, agro industrial, tourism, commercial, services, export and infrastructure sectors in the Northern, Northeastern and CentreWest regions. The funds were created in compliance with the provision of the 1988 Constitution that mandates the allocation of 3 % of income tax and industrialised product tax revenues to financing programmes for the productive sectors of the three regions through their respective regional financing institutions.

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Annex A: Conference Programme for OECD Global Conference on Better Financing for Entrepreneurship and SME Growth

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CONFERENCE PROGRAMME

OECD GLOBAL CONFERENCE ON BETTER FINANCING FOR ENTREPRENEURSHIP AND SME GROWTH

Jointly organised by the OECD and the Brazilian Ministry for Development, Industry and Foreign Trade

To be held in Brasilia, Brazil, 27-30 March 2006

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Background & Objectives Lack of access to financing continues to be one of the most significant impediments to the creation, survival and growth of small and medium-sized enterprises (SMEs), including innovative ones, especially in a time when enterprises operate in environments of high complexity and rapid change. In addition, globalisation and the shift to a knowledge-based economy have highlighted the vital need for innovative solutions for SME financing. SMEs form a broad spectrum as far as their relative size, sector of activity, seniority, location and performance are concerned. They can be innovative and growth oriented or basically subsistence-driven. Depending on the enterprise’s characteristics and stage of business creation and development, the financing needs and sources (e.g. family, banks, equity, etc.) are likely to differ. SMEs tend generally to have a high risk profile for a number of reasons: e.g. absence of track records, informational asymmetries, shortage of assets and collateral, insufficient management skills. Additionally, the disproportionately high administrative costs in relation to the financing amounts involved, as well as uncertainties about future performance generally make SME financing unattractive to potential funding sources. When SMEs are able to raise capital, they may still encounter higher interest rates, as well as credit rationing due to shortage of collateral. Consequently, SMEs experience difficulty in accessing long-term credit and risk capital, which are necessary for starting up, expanding or upgrading a business. Financing issues vary at different stages of business development, as well as country development. But overall, the greater variability in the perceived prospects for profitability, survival and growth of SMEs, compared to larger firms, accounts to a large extent for their specific problems with regard to financing. At the 2nd OECD Ministerial Conference on SMEs held in Istanbul, Turkey in June 2004, Ministers recognised in the Istanbul Ministerial Declaration “the need to improve access to financing for SMEs on reasonable terms […] policies should aim to ensure that markets can provide financing for credit-worthy SMEs and that innovative SMEs with good growth prospects have access to appropriately structured risk capital at all stages of their development. Policies should also contribute to increasing the managerial and technical expertise of those intermediaries whose role is to evaluate and monitor companies with a view to matching expanding small firms with investors.” Ministers underlined the importance of this issue by encouraging the OECD to organise a thematic conference in order to further discuss and seek more innovative solutions, and/or initiatives for facilitating SME access to the financing from creation to all stages of development. In pursuit of these objectives and at the invitation of the Brazilian Ministry of Development, Industry and Foreign Trade, the OECD Working Party on SMEs and Entrepreneurship (WPSME), in co-operation with the Committee on Financial Markets (CMF), decided to organise the OECD Global Conference on Better THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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Financing for Entrepreneurship and SME Growth in Brasilia, Brazil on 27-30 March 2006 in the framework of the OECD Bologna Process on SME and Entrepreneurship Policies.1 The Conference provides the key stakeholders — representatives of SMEs, the financial community and Governments — with an opportunity to: x

Discuss additional evidence relating to continuing difficulties encountered by SMEs in gaining access to both debt and equity finance at all stages of business development, in the context of a globalised economy;

x

Assess current policies and programmes aimed at addressing these difficulties, and highlight specific areas where changes and improvement are warranted;

x

Provide guidance to Governments, the financial community and SMEs on the options for improving SME financing; and,

x

Develop a tripartite dialogue among the key stakeholders.

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Monday, 27 March 2006 Official Opening 18:0020:00

Mr. Luiz Inacio Lula da Silva President of Brazil Mr. Luiz Fernando Furlan Minister of Development Industry and Foreign Trade Brazil Mr. Ali Coskun Minister of Industry and Trade Turkey Ms. Edmee Betancourt Ministra de Industrias Ligeras y Comercio Venezuela Mr. Federico Poli Under Secretary of State, SMEs & Regional Development Ministry of Industry, Trade and SMEs Argentina Mr. Alejandro Gonzalez Hernandez Under Secretary of State Ministry of Economy Mexico Mr. Andrzej Kaczmarek Under Secretary of State Ministry of Economy Poland Mr. Joan Trullén Thomás Secretary General of Industry Ministry of Industry Tourism and Trade Spain

Mr. Herwig Schlögl Deputy Secretary-General OECD KEYNOTE ADDRESS:

Mr. Takao Suzuki, Chairman, Organization for Small & Medium Enterprises and Regional Innovation, Japan

COCKTAIL RECEPTION

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Plenary Keynote Session

The SME Financing Gap: Theory and Evidence Tuesday, 28 March (9:00 - 13:00) Small and medium-sized enterprises (SMEs) are the engines of job creation and growth in most countries. Ensuring the health of this important group of businesses is a major priority for most governments. Many governments have intervened in the market to ensure SMEs have access to financing. The rationale for government intervention in financial markets is based upon the existence of “market failures” arising from information asymmetries, misuse of market power, or distortion in relative prices or interest rates. In addition, government policies may lead to distortions that may cause market failure. In the simplest case, excessive controls on interest rates will lead to excess demand for credit. In the case of SMEs, some analysts have postulated that a “financing gap” exists, but others deny that such a gap can be identified. There is no commonly agreed definition of the financing gap, but the term is basically used to mean that a sizeable share of economically significant SMEs cannot obtain financing from banks, capital markets or other suppliers of finance. Furthermore, it is often alleged 1) that many entrepreneurs or SMEs that do not now have access to funds would have the capability to use those funds productively if they were available, 2) but that due to structural characteristics, the formal financial system does not provide finance to such entities. The first plenary keynote session will focus on better understanding the SME Finance Gap looking at the issue from both a debt and private equity capital perspective, and providing new insights into the nature of market failure in SME finance. In so doing, it will provide the framework and broad overview for both Workshops A and B through covering both credit and equity issues. During this session, keynote speakers will present the perspectives of: SMEs, the Financial Sector (both debt and equity), Governments and international institutions, while the OECD will present a background paper. After each group of presentations, a discussion will take place led by selected discussants representing SME policy makers from OECD countries. This Plenary Keynote Session will consider the following issues: x

Does your country/company/institution feel that an SME financing gap exists? For which financing sources (credit and equity) does such a gap exist?

x

What are the main reasons for this gap?

x

What are the main policy actions which are (or have been) undertaken in your country to address this gap?

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Tuesday, 28 March 2006 – Morning PLENARY KEYNOTE SESSION: “THE SME FINANCING GAP: THEORY AND EVIDENCE” Mr. Herwig Schlögl, Deputy Secretary-General, OECD

9:00-9:05

CHAIR:

9:05 – 9:25

PRESENTATION OF THE OECD KEYNOTE PAPER Mr. André Laboul Head of Division Directorate for Financial and Enterprise Affairs - OECD Mr. John Thompson Consultant Centre for Entrepreneurship, SMEs & Local Development, OECD

9:25 – 10:30

THE PERSPECTIVE OF THE SME SECTOR: Speakers: Mr. Hugh Morgan Williams Chair CBI SME Council, Vice Chair Entrepreneurship and SME Committee Union des Industries de la Communauté Européenne (UNICE) Mr. Cuauhtemoc Martinez Garcia President of Camara Nacional de la Industria de Transformación (CANACINTRA) Mexico Mr. Hammad Kassal President of PME-PMI-CGEM Federation Director General, Rayane Morocco Mr. Stuart Wilson CEO, Breathe Communications, and Member of SME Advisory Group New Zealand Discussant: Mr. Roger Wigglesworth Director SME Department, Ministry of Economic Development Chair of the OECD Working Party on SMEs & Entrepreneurship New Zealand

10:30-10:45

Coffee Break

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10:45-11:15

THE PERSPECTIVE OF THE FINANCIAL SECTOR: CREDIT FINANCING Speakers: Mr. Roberto Luis Troster, Chief Economist of Febraban Brazilian Federation of Banks Brazil Ms. Fabiana Drummond de Melo Senior Advisor and Basel II Implementation Project Manager Banco Central do Brasil Basel Committee Brazil Mr. Enrique Garcia President & CEO Corporacion Andina de Fomento(CAF) Discussant: Mr. Raffaele Rinaldi Head of the Credit and International Department at the Italian Banking Association (ABI) Italy

11 :15-11:50

THE PERSPECTIVE OF THE FINANCIAL SECTOR: EQUITY FINANCING Speakers: Mr. Alvaro Gonçalves President of ABVCAP - Associação Brasileira de Venture Capital (Brazilian Association of Venture Capital) Brazil Mr. Jorma Routti Partner CIM Funds Finland Mr. Norbert Irsch Chief Economist – KFW Germany Discussant: Mr. Peter Webber Director Small Business Financing Policy Industry, Entrepreneurship & Small Business Office Delegate to the OECD Working Party on SMEs & Entrepreneurship Canada

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THE PERSPECTIVE OF THE GOVERNMENT Speakers: Mr. Alejandro Gonzalez Hernandez Under Secretary of State for SMEs Ministry of Economy Mexico Mr. Andrzej Kaczmarek Under Secretary of State Ministry of Economy Poland Mr. Joan Trullén Thomás Secretary General of Industry Ministry of Industry Tourism and Trade Spain Ms. Nguyen Hong Lien Director- General, Business Information Centre, Bureau of SMEs Ministry of Planning and Investment Vietnam Mr. Augusto de la Torre Senior Regional Financial Sector Advisor Latin America & the Caribbean World Bank Discussant: Mr. Serge Boscher Deputy-Director Ministry of SMEs Vice-Chair of the OECD Working Party on SMEs & Entrepreneurship France

12:50-13:00 Rapporteurs:

Closing Remarks by the Chair Mme Marie Florence Estimé Deputy Director Centre for Entrepreneurship, SMEs & Local Development, OECD

Mr. Marcos Bonturi Head of Private Office of the Deputy Secretary General OECD

Mr. Tim Davis Project Manager Entrepreneurship Indicators Statistics Directorate (STD)OECD

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Workshop A:

Credit Financing for SMEs: Constraints and Innovative Solutions First Session: The Nature of the Market Failure in Relation to Debt Financing Tuesday, 28 March (14:30-18:00) Although there has been an increasing diversification of SME financing sources in OECD countries in the last decade, the bulk of their funding still relies on credit. In this light, the aim of this workshop is to explore a number of critical aspects in credit financing, focusing on issues, case studies, and alternative solutions. This analysis and debate take place against the backdrop of major changes in the framework conditions for SMEs financing. New regulations are coming into effect, such as the new Basel Accord on bank capitalisation and the new International Accounting Standard (IAS) rules. The rising trend towards securitisation of enterprise financing has also opened new opportunities to SMEs. Furthermore, major advances have been made in supplying financial services to these enterprises. At the same time, globalisation of production and investment, with increasing recourse to outsourcing and spreading of enterprise operations beyond national boundaries, raises new difficulties for SMEs in their quest for funding their development. In tapping into international savings, SMEs are still at a disadvantage as compared to larger firms. Their credit-worthiness appraisal is subject to a wider margin of uncertainty, due to higher difficulties for lenders in gathering much needed information. Nor have SMEs benefited from a particular attention by credit rating institutions. By another token, lending to SMEs might be affected in some instances by recent trend towards concentration in the financial industry, which has led to fewer and larger institutions. The first Session “The Nature of the Market Failure in Relation to Debt Financing” will review two themes: the regulatory and institutional framework and Risk Evaluation, Mitigation and Sharing. This Session will consider the following issues: Regulatory and Institutional Framework x x x

Do the accounting framework and other mechanisms satisfy information needs? Does law or jurisprudence ensure appropriate conditions for creditor income? How do financial institutions ensure secure contractual arrangements between creditors and borrowers? Risk Evaluation, Mitigation and Sharing x x x x x

What is the perceived impact of international banking regulations (Basel II) on the assessment of risk represented by SMEs? How can risk be managed when debt cannot be securitised through the financial market? What practices have financial institutions developed to fund: innovation? creation? exports? high-growth SMEs? What are some alternative means in which borrowers can manage their relationship with financial institutions? What is the role of government and rating agencies in the management and sharing of information between partners?

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Tuesday 28 March 2006 – Afternoon WORKSHOP A: CREDIT FINANCING FOR SMEs: CONSTRAINTS AND INNOVATIVE SOLUTIONS Session 1: The Nature of the Market Failure in Relation to Debt Financing 14:30-14:35

CHAIR:

Mr. Peter Webber Director Small Business Financing Policy Industry Entrepreneurship & Small Business Office Delegate to the OECD Working Party on SMEs & Entrepreneurship Canada

14 :35-14 :55

Keynote Speaker: Mr. José Mauro Morais Expert, Applied Economic Research Institute IPEA, Ministry of Planning Brazil

14:55-16:00

Speakers: Mr. Sumant Batra Director Board of INSOL International India Mr. Claudio Giovine CONFAPI (SME Association) Italy Mr. Luis Humberto Parra Director of International Production Chains Nacional Financiera, (Mexican Development Bank) Mexico Discussant: Mrs. Doris Thurau Director of GTZ-Brazil Germany Speakers: Mr. Nobuo Tanaka Director Directorate for Science, Technology and Industry OECD 0U/DGLVODY'YR iN ýHVNiVSR LWHOQD&]HFK6DYLQJV%DQN Director of Special Programmes Department Czech Republic

16:00-16:15

Coffee break

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16:00-17:50

Speakers: Mr. Edgardo Alvarez General Manager Corporación Financiera de Desarrollo S.A. (COFIDE) Peru Mr. Matthew Gamser Program Manager SME Finance International Finance Corporation World Bank Group Discussant: Mr. Aurel Saramet Guarantee Fund Romanian Commercial Bank Romania Speakers: Mr. Iichiro Uesugi Fellow, Research Institute of Economy Trade and Industry Japan Mr. Michele Cincera Université Libre de Bruxelles Belgium Discussants: Mr. Federico Bonaglia Economist Development Centre, OECD Mr. Paul H. Dembinski Director Observatoire de la Finance Switzerland

17:50-18:00

Concluding Remarks by the Chair

Rapporteurs:

Mr. Stephen Lumpkin Principal Administrator, Directorate for Financial and Enterprise Affairs OECD

Mme Mariarosa Lunati Associate Professor of Research Methods at the European Business School of Sophia-Antipolis France

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250 – ANNEX A: CONFERENCE PROGRAMME Workshop A: Credit Financing for SMEs: Constraints and Innovative Solutions Second Session: What Role for Government? Wednesday 29 March (9:00-13:00) Where the financial markets are not meeting SMEs financing needs, Governments have developed new instruments and institutions aimed at improving SME access to financing. These have, however, shown differing degrees of effectiveness in reaching their targets. Moreover, they can only complement the private market for credit and should not be seen as a substitute for it. In such a context, it is no surprise that in the last decade, credit risk mitigation mechanisms and institutions have emerged, to an increasing extent, as a bridge to fill the gap between potential lenders and borrowing firms. Second Session: What Role for Government? This session will look at the lessons learnt for the future from an assessment of past and current government policies and programmes with regard to the issues addressed in the first session of Workshop A on the Nature of the Market Failure in Relation to Debt Financing. In particular, the session will look at the most effective and efficient SME financing schemes and incentives, taking into account policy targets/priorities, the various types of SMEs they serve and the overall budget constraints. This Session will consider the following issues: x

What are the most effective and efficient SME financing schemes and incentives, taking into account policy targets/priorities, the various types of SMEs they serve and the overall budget constraints and financial markets?

x

What are the best ways to encourage the active involvement of informed intermediaries, without which investors perceive high risks and low returns from investment and entrepreneurs find themselves unable to raise capital?

x

Session speakers are invited to share good and bad practices based on their country/institutional experiences.

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Wednesday 29 March 2006 – Morning WORKSHOP A: CREDIT FINANCING FOR SMEs: CONSTRAINTS AND INNOVATIVE SOLUTIONS Session 2: What Role for Government? 9:00-9:05

9:05-9:25

9:25-10:30

CHAIR:

Mr. Peter Webber Director Small Business Financing Policy Industry Entrepreneurship & Small Business Office Delegate to the OECD Working Party on SMEs & Entrepreneurship Canada Keynote Speaker: Mr. Salvatore Zecchini Economic Advisor to the Minister Ministry of Productive Activities Italy Speakers: Mr. Tamas Lesko Deputy Head of SME Development Department Ministry of Economy and Transport Delegate to the OECD Working Party on SMEs & Entrepreneurship Hungary Mr. Osamu Tsukahara Managing Director Japan Finance Corporation for Small and Medium Enterprise Japan Mr. Asdessalem Mansour Président Directeur général de la Banque de Financement des PME Tunisia Discussant: Mr. Bernd Balkenhol Director of the Social Finance Programme International Labour Organisation (ILO) Speakers: Mr. Juan José Llisterri Principal Financial Specialist Sustainable Development Department Private Enterprise and Financial Markets Division Inter-American Development Bank (IDB) Ms. Margaret Miller Senior Economist Financial Sector Operations & Policy Development IFC/ World Bank Group

10:30-10:45

Coffee break

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Speakers: Mr. Young-Sam Cho Research Fellow, Korea Institute for Industrial Economics & Trade Korea Mr. Fernando Nogueira da Costa Vice-president Caixa Econômica Federal Brazil Mr. Daniel Gabrielli Chef du Service d’ingénierie et de coordination statistique Eurosystème, Banque de France France Mr. Byron McDonald Development Bank Jamaica Promotions Corporation (JAMPRO) Jamaica Discussants: Mr. Steven Lumpkin Principal Administrator Directorate for Financial and Enterprise Affairs, OECD Ms. Miriam W. O. Omolo Programme Officer, Trade Information ProgrammeInstitute of Economic Affairs Kenya Speakers: Ms. Barbara Bartkowiak President of Management Board Polish Association of Loan Funds (PSFP) Poland Mr. Bruce Cameron Senior Loan Officer, the SME Finance Department Overseas Private Investment Corporation United States Discussant: Mr. Keith Martin Senior Marketing Specialist MIGA, World Bank Group

12:50-13:00

Concluding Remarks by Chair

Rapporteurs:

Mr. Stephen Lumpkin Principal Administrator, Directorate for Financial and Enterprise Affairs OECD

13:00-14:30

Lunch

Mme Mariarosa Lunati Associate Professor of Research Methods at the European Business School of Sophia-Antipolis France

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Workshop B:

Equity Financing for SMEs and the Role of Government First Session: The Nature of the Market Failure/Distortion Tuesday, 28 March (14:30-18:00) The justification for government intervention in the development of venture capital markets in a number of countries has been the existence of a finance or equity gap in which firms are unable to secure debt financing and need to access equity finance to substantially expand their businesses. OECD countries have had varied success in channelling funds, particularly venture capital, to early-stage firms in high-growth sectors. On the supply side, this may be due to a lack of funds, risk-adverse attitudes and/or the absence of an equity investment culture. On the demand side, there may not be a sufficient pool of entrepreneurs and investmentready small firms. Countries need to first determine where financing gaps exist and assess all possible supply and demand factors which may be contributing to market failures in terms of access to venture capital. In particular, the study highlights the specific issues related to young firms with rapid growth potential. The constraints faced by such firms would be different from those of small firms in general. A broader support structure is needed to ensure that small innovative firms have access to technology development and transfer programmes, high-skilled labour, and international markets. The objectives of Workshop B are to gather additional evidence relating to difficulties for SMEs in gaining access to equity finance, to report on policies and programmes to address these difficulties, the lessons learnt in applying policies and programmes and to provide guidance to Governments, as well as to SMEs, on the options for intervention to improve SME equity financing.

First Session: The Nature of the Market Failure/Distortion This Session will consider the following issues: x

Are the problems of financing for innovative small and medium-sized enterprises (ISMEs) most visible at any particular point in the life cycle of the firm? Is the absence of activity in formal risk capital (business angels) a particularly serious problem?

x

Why do rates of return differ so much among countries? In particular, to what degree do low rates of return on early stage innovation finance represent impediments to ISME financing in Europe?

x

What have we learnt since the technology bubble burst in 2000 and the more recent rebound of innovative finance?

x

Where can government intervention be most effective in promoting ISME development and finance?

x

How are trading platforms for SMEs vehicles like to develop in the next few years? What are the most serious barriers to successful exits by ISMEs?

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Tuesday 28 March 2006 – Afternoon WORKSHOP B: EQUITY FINANCING FOR SMEs AND THE ROLE OF GOVERNMENT Session 1: The Nature of the Market Failure/Distortion 14:30-14:35

CHAIR:

Mr. Christian Motzfeldt Director of the Danish Growth Fund (Vaekstfonden) Denmark

14 :35-14 :55

Keynote Speaker: Mr. Jean-Noel Durvy Head of Unit Financing SMEs, Entrepreneurs & Innovators DG Enterprise and Industry European Commission

14:55-16:00

Speakers: Ms. Brigitte Smith Managing Director GBS Venture Partners Australia Mr. Gui Liang Director Administration Center for Innovation Fund for Technology-Based SMEs China Mr. Peter Jungen President European Enterprise Institute Discussant: Mr. Peter Fritz Managing Director, TCG Group Australia Mr. Claudio Vilar Furtado Executive Director of the Center for the Study of Private Equity and Venture Capital of FGV-EAESP Editor Brazil

16:00-16:15

Coffee break

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16:15-17:50

Speakers: Mr. Don Mashele Khula Enterprise South Africa Ms. Susan Strommer CEO National Association of Seed and Venture Funds, Inc. United States Ms. Katrina Reid Economist Small Business Service United Kingdom Ms. Kimberlie Cerrone Chief Financial Officer Feeva Tecnology United States Discussant: Mr. Joseph Badevokila Fonder and Director of KYOCI Capital Luxembourg and SOYO Business Partner The Republic of the Congo

17:50-18:00

Concluding Remarks by the Chair

Rapporteurs:

Mr. Sergio Arzeni Director Centre for Entrepreneurship, SMEs & Local Development, OECD

Mr. John Thompson Consultant OECD Centre for Entrepreneurship, SMEs & Local Development OECD

Mr. Alain Dupeyras Administrator Centre for Entrepreneurship, SMEs & Local Development, OECD

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Workshop B:

Equity Financing for SMEs and the Role of Government Second Session: What Role for Government? Wednesday 29 March (9:00-13:00) Previous OECD work on venture capital stressed that taking into account the global downturn in technology and financial markets, which affected OECD in the early 2000s, countries need to re-evaluate and redirect government venture capital initiatives to assure their continuing contributions as market conditions change. And as the market becomes more global, countries need to enhance their ties to international venture capital flows, which are a source of both finance and expertise.

Second Session: What Role for Government? This session will build on the outcomes from Session 1 on the Nature of the Market Failure/Distortion and, in particular, look at the lessons learnt from an assessment of past and current government policies and programmes related to private equity. This Session will consider the following issues: x

What have we learnt about the most effective programmes to stimulate ISMEs?

x

Can we specify best practices with respect to incentives and risk sharing in ISME finance?

x

How important is taxation in determining ISME finance?

x

Why have countries with relatively high capital gains taxes (US, UK and Sweden) had more success in ISME finance than countries where such taxes are low?

x

To what degree does the lack of suitable legal vehicles impede the expansion of venture capital?

x

What can government do to delay exits by venture capital backed firms?

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Wednesday 29 March 2006 – Morning WORKSHOP B: EQUITY FINANCING FOR SMEs AND THE ROLE OF GOVERNMENT Session 2: What Role for Government? 9:00-9:05

CHAIR:

9:05-9:25

Keynote Speaker:

Mr. Christian Motzfeldt Director Danish Growth Fund (Vaekstfonden) Denmark

Ms. Susana Garcia-Robles Investment Officer Mercosur Central America and Mexico Multilateral Investment Fund Inter-American Development Bank 9:25-10:30

Speakers: Mr. Edmundo M. Oliveira Executive Manager of ABDI Brazilian Agency for Industrial Development Brazil Mr. Michel Bergeron Director Strategic and Business Solutions Business Development Bank Canada Mr. Marko Seppä Founding Director of EBRC Joint E-Business Research Center Tampere University of Technology Finland Mme Hélène Clément Chargée de mission Entreprises Cabinet de M. le Président du Sénat France Discussant: Mr. Henry Savajol Directeur des Etudes BDPME France

10:30-10:45

Coffee break

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Speakers: Mr. Jung Hyun Cho Deputy General Manager Korea Venture Investment Company Korea Mr. David Quysner Chairman Abingworth Management Limited United Kingdom Mr. Dinand Maas Ministry of Economic Affairs Netherlands Mr. José Fernando Figueiredo CEO SPGM (IAPMEI - Institute for Support to SMEs and Investment) Portugal Discussant: Mr. Pertti Valtonen Counsellor Finance Policy Division Ministry of Trade and Industry Finland Speakers: Mr. Philippe Jeanneret Head of SME Policy Ministry of Economics Switzerland Mr. Georges Noël Director of Research Public Affairs and Development European Venture Capital Association (EVCA) Ms. Jhitraporn Techacharn Director General of the Office of small and medium enterprises promotion, Thailand

12:50-13:00 Rapporteurs:

13:00-14:30

Concluding Remarks by Chair Mr. Sergio Arzeni Director Centre for Entrepreneurship, SMEs & Local Development, OECD

Mr. John Thompson Consultant OECD Centre for Entrepreneurship, SMEs & Local Development OECD

Mr. Alain Dupeyras Administrator Centre for Entrepreneurship, SMEs & Local Development, OECD

Lunch

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TECHNICAL WORKSHOP ON PRIVATE EQUITY DEFINITIONS & VALUATION METHODS Tuesday, 28 March 14:30-18:00 This Technical Workshop on Private Equity Definitions will gather experts and key stakeholders to discuss the elaboration of common definitions and valuation methods related to private equity and venture capital. This Workshop will be divided into two themes: 1) Equity Capital Definitions – The Need for International Consistency; and 2) Valuation Guidelines – What is the Current Situation? A lack of agreed definitions, comparable statistics, and transparency in valuation methods could be major impediments to the detailed and informed examination of the venture capital sector by both domestic and international institutional investors (and asset consultants). Consequently, these impediments may impinge on their ability to recommend venture capital as an asset class to their clients. Governments also depend on reliable data when considering and developing venture capital policy and programmes to assist early-stage business development. The purpose of this Technical Workshop is to promote discussion and seek agreement from Workshop participants for the development of standard definitions for venture capital with the objective of improving the comparability of venture capital statistics across countries. The Workshop will also consider the two broad frameworks for measurement, the PEIGG (Private Equity Industry Guidelines Group) Guidelines and the International Guidelines, which have developed by several European venture capital associations. In striving to develop common definitions, the Workshop will consider the following issues: x

How many stages are useful for international comparison of data? It is possible that just three may be preferable (early, expansion and late)?

x

Where should the boundary line of venture capital be drawn? (e.g. Should all expansion capital be considered as venture capital, or should some later stage expansion capital be considered beyond venture capital?)

x

What categories should be adopted for funds raised?

x

Could either the PEIGG Guidelines or the International Guidelines be adopted (or endorsed) in valuing all private equity deals?

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Tuesday 28 March 2006 – Afternoon TECHNICAL WORKSHOP ON PRIVATE EQUITY DEFINITIONS & MEASUREMENTS Session 1: Equity Capital Definitions – The Need for International Consistency & Valuation Guidelines – What is the Current Situation? 14 :30-14 :40

Co-Chairs: Mr. Randy Mitchell, Venture Capital / Private Equity Specialist, Department of Commerce United States Mr. Thomas Meyer Head of Risk Management and Monitoring European Investment Fund

14:40-16:00

Speakers: Mr. Victor Bivell Editor and Publisher Australian Venture Capital Journal Private Equity Media Australia Mr. Dhruba Gupta Managing Director and CEO of EM Capital India India Mr. Jeong Min Kim Managing Director Hanmi Venture Capital Corporation Korea

16:00-16:15

Coffee break

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16:15-18:00

Speakers: Ms. Barbara James Managing Director African Venture Capital Association Mr. Georges Noël Director of Research Public Affairs and Development European Venture Capital Association (EVCA) Mr. Ghyanendra Nath Bajpai Chairman Securities and Exchange Board of India, SEBI India Mr. David Quysner Chairman Abingworth Management Limited United Kingdom

Rapporteurs:

Mr. Tim Davis Project Manager, Entrepreneurship Indicators, Statistics Directorate (STD) OECD

Mr. Alvaro Gonçalves President of ABVCAP Associação Brasileira de Venture Capital (Brazilian Association of Venture Capital) Brazil

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Plenary Session Financial Innovations for SME Credit and Equity Financing: The Contributions of Markets and Governments Wednesday 29 March, 14:30 – 18:00 This plenary session will bring together participants from each of the parallel workshops in order to bridge the gap between the bank lending side and the risk capital side in order to find innovative instruments and solutions to the obstacles facing entrepreneurs and SMEs when access financing. With the goal of proposing innovative approaches to government intervention and market responses, this Plenary Session aims to set the path towards the development of a new public/private partnership. At the same time, the Session should also look at any limitations brought about by different cultural approaches across countries and the implications this may have for policy and programme learning and transferability. The Plenary Session will consider the following issues: x

How can the availability of equity finance improve the chances of getting loans?

x

Under what circumstances are SMEs likely to have both?

x

Are there learning opportunities between banks and risk capital investors?

x

What about banks as venture investors – has Basel II changed their willingness to invest? And,

x

Who can best provide mezzanine finance?

At the end of this Plenary Session for the Parallel Workshops, the General Rapporteur of the Conference will report on the discussion and identify the proposed financial innovations that could be retained for the draft Recommendations of the Conference. 1.

The OECD Bologna Process on SME & Entrepreneurship Policies, i.e. the follow-up to the first OECD Ministerial Conference on SMEs held in Bologna in June 2000, is a dynamic political mechanism which: fosters the entrepreneurial and SME agenda at the global level through extended analytical work; promotes high-level dialogue on SME and Entrepreneurship policies worldwide; and encourages co-operation between OECD countries and non-member economies, other international organisations and/or institutions, and non-governmental organisations in the field of SMEs and entrepreneurship. It involves at present more than 80 economies, including all OECD countries and APEC economies, and a number of African and Latin American countries, including Brazil. The OECD enjoys an undoubted edge in this domain, as the only institution that effectively deals with these issues horizontally and applying a global perspective and approach.

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Wednesday 29 March 2006 – Afternoon PLENARY SESSION: FINANCIAL INNOVATIONS FOR SME CREDIT AND EQUITY FINANCING: THE CONTRIBUTIONS OF MARKETS AND GOVERNMENTS 14 :30-14 :40

CO-CHAIRS: Workshop A Chair: Mr. Peter Webber Director Small Business Financing Policy Industry Entrepreneurship & Small Business Office Delegate to the OECD Working Party on SMEs & Entrepreneurship Canada Workshop B Chair: Mr. Christian Motzfeldt Director Danish Growth Fund (Vaekstfonden) Denmark

14:40-16:00

Speakers: Mr. Ciro de Falco Executive Vice President Inter-American Development Bank (IDB) Mr. Dave Thomas General Director Intel Capital Latin America Discussant: Mr. Steven Maken Small Business Development Corporation Ministry of Trade and industry Papua New Guinea Speakers: Mr. Roger Wigglesworth Director SMEs Department, Ministry of Economic Development Chair of the OECD Working Party on SMEs & Entrepreneurship New Zealand Mme Nadine Levratto Chargée de recherche au Centre National de la Recherche Scientifique France

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264 – ANNEX A: CONFERENCE PROGRAMME Discussant: Mr. Ivan Ornelas Diaz Director of International Relations General Direction of Exportable Goods, Ministry of Economy Vice-Chair to the OECD Working Party on SMEs & Entrepreneurship Mexico 16:00-16:15

Coffee break

16:15-17:45

Speakers: Mr. Brendan Morling General Manager Industry Policy Branch Department of Industry Tourism and Resources Australia Ms. Simonetta Iannotti Economist Bank Supervision Dept Banca d’Italia Italy Discussant: Mr. Luboš Lukasík MBA, CzechInvest Director of Company Competitiveness Division Czech Republic Speakers: Mr. Allan Riding Deloitte Professor of Growth Enterprises Canada Mme Cândida Maria Cervieri Diretora do Departamento de Micro Pequenas e Médias Empresas (DMPME) Secretaria do Desenvolvimento da Produção Ministério do Desenvolvimento, Indústria e Comércio Exterior Brazil Mr. Carlos Alberto dos Santos Gerente Unidade de Acesso a Serviços Financeiros Serviço Brasileiro de Apoio às Micro e Pequenas Empresas (SEBRAE) Brazil

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Discussant: Mr. Eli Bentata Deputy Director General ISMEA-Israel SMEs Authority Israel

17:45-18:00

Summary by the General Rapporteur: Mr. Thomas Andersson President Jönköping University Sweden

Rapporteurs:

Mme Marie Florence Estimé Deputy Director Centre for Entrepreneurship, SMEs & Local Development, OECD

Mr. Marcos Bonturi Head of Private Office of the Deputy Secretary General OECD

Mr. Tim Davis Project Manager Entrepreneurship Indicators, Statistics Directorate (STD) OECD

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FINAL PLENARY SESSION: CONCLUSIONS AND RECOMMENDATIONS Thursday, 30 March (9:00-12:00) The final Plenary Session on Thursday, 30 March 2006 will be co-chaired by Mr. Luiz Fernando Furlan, Minister of Development, Industry and Foreign Trade, Brazil, and Dr. Herwig Schlögl, Deputy Secretary General, OECD On this occasion, the chairs of the three workshops will present the conclusions of their respective workshops to the plenary audience. In bringing the Conference to an official close, Minister Furlan and OECD Deputy Secretary General Schlögl will present the final Recommendations and the OECD Action Statement for SME & Entrepreneurship Financing.

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Thursday 30 March 2006 – Morning FINAL PLENARY SESSION 9:00-10:45

CO-CHAIRS: Mr. Luiz Fernando Furlan Minister of Development, Industry and Foreign Trade Brazil Mr. Herwig Schlögl Deputy Secretary-General OECD PRESENTATION OF THE WORKSHOP CONCLUSIONS AND RECOMMENDATIONS BY THE CHAIRS Workshop A Chair: Mr. Peter Webber Director Small Business Financing Policy Industry Entrepreneurship & Small Business Office Delegate to the OECD Working Party on SMEs & Entrepreneurship Canada DEBATE WITH THE AUDIENCE Workshop B Chair: Mr. Christian Motzfeldt Director Danish Growth Fund (Vaekstfonden) Denmark DEBATE WITH THE AUDIENCE Technical Workshop Co-chairs: Mr. Randy Mitchell Venture Capital / Private Equity Specialist Department of Commerce United States Mr. Thomas Meyer Head of Risk Management and Monitoring European Investment Fund DEBATE WITH THE AUDIENCE

10:30-10:45

Coffee Break

10:45-12:00

THE OECD ACTION STATEMENT FOR SME & ENTREPRENEURSHIP FINANCING PRESENTED BY: Mr. Luiz Fernando Furlan Minister of Development, Industry and Foreign Trade Brazil Mr. Herwig Schlögl Deputy Secretary-General OECD

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

268 – ANNEX A: CONFERENCE PROGRAMME COUNTRIES / ECONOMIES INVITED TO PARTICIPATE IN THE OECD GLOBAL CONFERENCE ON SME AND ENTREPRENEURSHIP FINANCING OECD MEMBERS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31.

Australia Austria Belgium Canada Czech Republic Denmark Finland France Germany Greece Hungary Iceland Ireland Italy Japan Korea Luxembourg Mexico Netherlands New Zealand Norway Poland Portugal Slovak Republic Spain Sweden Switzerland Turkey United Kingdom United States European Commission

NON-MEMBERS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43.

Albania Algeria Antigua & Barbuda Argentina Azerbaijan Bahrain Bangladesh Barbados Belarus Belize Bolivia Bosnia - Herzegovina Brazil Brunei Darussalam Bulgaria Cambodia Chile China Colombia Congo Costa Rica Croatia Djibouti Dominican Republic Egypt Ecuador Estonia Ethiopia Georgia Ghana Guatemala Haiti Honduras Hong Kong, China India Indonesia Israel Jamaica Jordan Kazakhstan Kenya Kuwait Kyrgyz Republic

44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80. 81. 82. 83. 84. 85. 86. 87.

Laos Latvia Lebanon Lithuania Former Yugoslav Republic of Macedonia (FYROM) Madagascar Malaysia Moldova Philippines Mongolia Morocco Namibia Nicaragua Nigeria Oman Pakistan Palestine National Authority Panama Papua New Guinea Paraguay Peru Qatar Romania Russian Federation Saudi Arabia Senegal Serbia & Montenegro Singapore Slovenia South Africa Syria Chinese Taipei Tajikistan Thailand Trinidad and Tobago Tunisia Turkmenistan Ukraine United Arab Emirates Uruguay Uzbekistan Venezuela Vietnam Yemen

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ANNEX A: CONFERENCE PROGRAMME – 269

INTERNATIONAL ORGANISATIONS / INSTITUTIONS INVITED TO PARTICIPATE IN THE OECD GLOBAL CONFERENCE ON SME AND ENTREPRENEURSHIP FINANCING I. INTERNATIONAL ORGANISATIONS (PART OF THE UN SYSTEM)

III. NON-GOVERNMENTAL INTERNATIONAL ORGANISATIONS / INSTITUTIONS (NGOs)

1.

13. Arab Business Council (ABC) 14. Arab International Women’s Forum (AIWF) 15. Association Internationale de Recherche en Entrepreneuriat et PME (International Association for Research on Entrepreneurship and SMEs) (AIREPME) 16. Association of European Chambers of Commerce and Industry (EUROCHAMBRES), Brussels 17. Association of Small and medium Enterprises (ASME), Singapore 18. Business and Industry Advisory Committee to the OECD (BIAC) 19. The Business Council Europe-Africa Mediterranean, Brussels 20. The Competitiveness Institute (TCI), Barcelona 21. Center for International Private Enterprise (CIPE) 22. “Dirigeantes” International Association 23. EURO-MED Trade, Distribution and Service Initiative, Rome 24. European Association of Craft and Small and Medium-Sized Enterprises (UEAPME) 25. European Banking Federation (FBE), Brussels 26. EuroCommerce (Confédération Européenne du Commerce de Détail) 27. European Council for Small Business (ECSB), Halmstad 28. European Development Finance Institutions (EDFI), Brussels 29. European Network to Promote Women’s Entrepreneurship (WES) 30. European Private Equity and Venture Capital Association (EVCA) 31. Les Femmes Chefs d’Entreprises Mondiales (FCEM) 32. International Accounting Standards Board (IASB) 33. International Chamber of Commerce (ICC) 34. International Council of Small Business (ICSB) 35. International Electrotechnical Commission (IEC), Geneva 36. International Organisation for Knowledge Economy and Enterprise Development (IKED)

Economic and Social Commission for Asia and the Pacific (UNESCAP), Bangkok 2. Economic and Social Commission for Western Asia (UNESCWA), Beirut 3. Economic Commission for Africa (UNECA), Addis Ababa 4. Economic Commission for Europe (UNECE), Geneva 5. Economic Commission for Latin America and the Caribbean (UNECLAC/CEPAL), Santiago de Chile 6. International Labour Organisation (ILO), Geneva 7. International Monetary Fund (IMF), Washington 8. United Nations Conference on Trade and Development (UNCTAD), Geneva 9. United Nations Development Programme (UNDP), New York 10. United Nations Industrial Development Organisation (UNIDO), Vienna 11. World Bank, Washington 12. World Intellectual Property Organisation (WIPO), Geneva

II. OTHER INTERNATIONAL ORGANISATIONS AND INSTITUTIONS 53. African Development Bank, Abidjan 54. African Union (AU) 55. APEC Business Advisory Council (ABAC) 56. Asian Development Bank (ADB), Manila 57. Asia-Pacific Economic Co-operation (APEC), Singapore 58. Association of Southeast Asian Nations (ASEAN), Jakarta 59. Caribbean Community (CARICOM) 60. Central European Initiative (CEI), Trieste 61. Euro-Mediterranean Network of Investment Promotion Agencies (ANIMA/EURAID)

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

270 – ANNEX A: CONFERENCE PROGRAMME 62. European Bank for Reconstruction and Development (EBRD), London 63. European Central Bank (ECB) 64. European Economic and Social Committee, Brussels 65. European Investment Bank (EIB), Luxembourg 66. European Investment Fund (EIF) 67. Inter-American Development Bank (IADB), Washington 68. League of Arab States 69. New Partnership for African Development (NEPAD) 70. Organisation Internationale de la Francophonie (International Organisation of French-Speaking Communities) (OIF) 71. Pacific Economic Co-operation Council (PECC), Singapore 72. Pacific Islands Forum (PIF) 73. Trans Atlantic Business Dialogue (TADB), Brussels 74. World Trade Organisation (WTO)

37. International Organisation for Standardisation (ISO), Geneva 38. International Network for Small and Mediumsized Enterprises (INSME) 39. International Small Business Congress (ISBC) 40. International Union of Crafts and Small and Medium-sized Enterprises (UIAPME) 41. Islamic Financial Service Board (IFSB) 42. Latin American Venture Capital Association (LACVA) 43. Organisation Internationale des Employeurs (International Organisation of Employers) (OIE), Geneva 44. Quantum Leaps, Inc., A Global Accelerator for Women’s Entrepreneurship, USA 45. Trade Union Advisory Committee to the OECD (TUAC), Paris 46. Union of Industrial and Employers' Confederations of Europe (UNICE) 47. World Association of Investment Promotion Agencies (WAIPA) 48. World Association of Industrial and Technological Research Organisations (WAITRO), Malaysia 49. World Association of Small and Medium Enterprises (WASME) 50. World Economic Forum 51. YES for Europe, European Confederation of Young Entrepreneurs 52. Young Entrepreneurs of the European Union (JEUNE)

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ANNEX B: OECD BRASILIA ACTION STATEMENT – 271

Annex B: The OECD Brasilia Action Statement on SME and Entrepreneurship Financing

1. On the invitation of the Brazilian Government, the OECD Global Conference on Better Financing for Entrepreneurship and SME Growth, took place in BRASILIA on 27-30 March 2006. Convened in the framework of the OECD Bologna Process on SME & Entrepreneurship Policies1, the meeting brought together the key stakeholders – Small and medium-sized enterprises (SMEs), the financial community, and government participants at senior levels – from OECD member countries, as well as from nonmember economies. 2. Taking into account the perspectives of SMEs, the financial community and governments, the Conference assessed to what extent the potential contribution of SMEs is held back by various constraints. Access to financing represents an important issue for SMEs. Financing gaps may arise due to agency problems2, asymmetric information and other market and policy imperfections that can give rise to incomplete financial markets and constrain SMEs access to financing. Analysis reveals not one, but several kinds of financing gaps. Many OECD countries have partial gaps, which tend to be severe especially in the early-stage firms. However, financial gaps are more pervasive in emerging, transition and developing economies. The Conference particularly examined issues related to two types of SME financing: Debt and Credit and Risk Capital. Taking stock of current facts, practices and issues, the Conference proposed ways forward to improve statistical data, and to identify and diffuse innovative and appropriate solutions for SME financing, spanning the role of markets, governments and international organisations while recognising the need to develop further work. 3. Access to appropriate types of financing structures and facilities are especially required to allow SMEs and entrepreneurs to take advantage of the opportunities provided by innovation, notably through the diffusion of information and communications technology (ICT). They are also needed for SMEs with new business models and high growth prospects, as they make a very important contribution to economic growth accompanied by job creation and social cohesion. 4. Building on the outcome of the first OECD Conference for Ministers responsible for SMEs on "Enhancing the Competitiveness of SMEs in the Global Economy: Strategies and Policies", held in BOLOGNA on 13-15 June 2000, and the second on “Promoting Entrepreneurship and Innovative SMEs in a Global Economy” in ISTANBUL on 3-5 June 2004, which provided major opportunities to advance the global policy dialogue on enhancing entrepreneurship and SME innovation, Participants recommended this Action Statement.

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272 – ANNEX B: OECD BRASILIA ACTION STATEMENT

Main findings and actions required: 5. The financing gaps are not insurmountable and can be mitigated by a series of actions. Participants considered a number of issues that can create problems, some of which are discussed below. Examples of initiatives that respond to these programmes are also provided for consideration in the context of the proposed actions. Put in place the appropriate broader framework

The overall economic, legal, institutional and regulatory framework is a critical determinant of SME financing. A predictable and stable macroeconomic policy environment is fundamentally important, along with reliable governance, tax, regulatory and legal frameworks that provide a level playing field for all economic entities irrespective of size. For law enforcement to be efficient, national and regional administration - including tax authorities - must possess the appropriate competencies to address SMEissues, and adopt rationalised and trustworthy practices. Of key importance is an environment that supports entrepreneurship, protects intellectual capital, and fosters science/industry linkages that promote high-tech commercialisation.

Strong focus on early stages while maintaining flexibility

SMEs in mature stage have often been able to access finance through a broad range of financial instruments, including asset-based SME-lending, leasing, non-financial sector loans, securitization and trade credit. In early stages, however, access to finance is often lacking, suggesting a need for public policy to focus on firms in formative stages. Appropriate and timely financing can nonetheless be an issue at all stages of SME-development, which calls for some degree of flexibility.

Bolster early stage finance to innovative SMEs (ISMEs)

A lack of appropriate financing notably represents a hindrance to the creation and expansion of innovative SMEs (ISMEs), putting a drag on job creation and hurting economy-wide competitiveness. Comprehensive efforts are needed to bolster the early stages (i.e. pre-seed, seed and start-up) of ISMEs, which are marked by negative cash flows and untried business models. This can be done by entrepreneurs themselves leveraging the capital lying dormant in their personal assets, or by “business angel networks” or venture capital markets. Efforts to integrate mutually supportive activities include for instance the New Zealand Venture Investment Fund which assists growth in early stages, while also managing a Seed Co-Investment Fund designed to stimulate investment by business angels. Successful approaches to developing early stage venture capital markets include both tax-based programs and programs that use government’s ability to leverage private risk capital.

Encourage SMEs to join the formal sector

Whereas informal sources of funding are greatly important, especially in transition and developing economies, incentives are needed to induce SMEs to move into the formal sector. One approach, applied by Brazil in its SIMPLES program, is to simplify procedures and facilitate tax compliance for micro and small businesses. Another is to induce closer collaboration between MFIs (micro-credit schemes and micro-finance institutions) and banks, which can serve both to enhance the financial sustainability of the former, and to provide a basis for transferring clients to banks as their financing needs increase.

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ANNEX B: OECD BRASILIA ACTION STATEMENT – 273

Reduce barriers to cross-border funding

Financial markets are becoming increasingly global but remaining regulatory and institutional compartmentalisation continues to hamper financial crossborder collaboration, the internationalisation of SMEs and associated resource and knowledge flows. This has a special impact on SMEs from emerging, transition and developing countries, which have difficulty in accessing foreign financing. In these countries, SMEs receive a small share of overall domestic credits, with the majority dependent on informal channels operated outside the formal financial system. New instruments and mechanisms are needed for handling risk associated with the cross-border funding of SMEs.

Use principle of risksharing and apply assessments to guide public programmes

Public policies aimed at promoting SMEs should be focused, aimed at making markets work efficiently and at providing incentives for the private sector to assume an active role in SME finance. The principles of risk sharing should guide public programmes, with official contributions encouraging partnership with entrepreneurs, banks, businesses, and universities. Assessments and evaluations should be applied rigorously to phase out ineffective public policy, and where market activities are maturing and prepared to take over.

Inform SMEs of financing options through targeted programmes

Informing SMEs of the range of financing options available, e.g., public guarantee programmes, business angels, and bank loans will ensure greater take-up of schemes. Awareness- and competence-building should spur qualified demand for financing among SMEs. Special targeting and adaptation of communication is needed to bridge between regional, sectoral, ethnical and cultural divisions, or special features of entrepreneurs (gender, age, educational profile, etc.).

Measure and value intellectual assets more effectively

Methods of measuring and disclosing intellectual capital should be developed, diffused and linked to the upgrading of financial services especially for ISMEs. These methods need to be developed in ways that can enable their widespread application. Intellectual assets, if better measured and valued, can be used as collateral, thus underpinning the development of financial services that are more effective in supporting ISMEs. Innovative approaches, such as enabling knowledge economy societies which examine ways to evaluate and develop comparable reporting of intangibles, could make a valuable contribution.

Better leverage social capital

Trust, tacit knowledge, and reputation matter in the development of entrepreneurship. Better leveraging of social capital, e.g. embedded in local networks of entrepreneurs, can help strengthen SMEs’ access to finance. Approaches such as those developed by the CONFIDI consortia in Italy could be further applied.

Use a pluralism of tools adapted to specific needs

Each stage of firm development requires an appropriate financing tool. Public policy must recognise the need for flexibility, including a plurality of tools in relation to the specific needs of the local and regional context. At the same time, it is important to recognize the role of cooperative credit banks and savings banks in addressing the financial need of handicraft, the selfemployed, and micro enterprises. Specialised financial institutions, such as Shorebank in Chicago, are playing a crucial role in urban regeneration programmes creating sustainable communities.

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274 – ANNEX B: OECD BRASILIA ACTION STATEMENT Engage SMEs in policy design

Entrepreneurs and SMEs are agile and flexible but vulnerable to fixed costs such as those caused by heavy administration, excessive bureaucracy, reporting practices, and intermediation rates by banks. Improving access to financing for SMEs requires removing unduly barriers to entrepreneurship and innovation, e.g. by cutting red tape, reducing transaction costs, and improving contractual conditions. Often, entrepreneurs and SMEs are not sufficiently represented in traditional policy-making, nationally and internationally. In order to make reforms less reactive and more appropriate, SMEs should be engaged in the design of relevant policies from the outset, to ensure that their perspectives and needs are well understood and taken into account.

6. Furthermore, Participants concluded that innovative approaches should be adopted to overcome constraints and diffuse viable solutions in SME-financing through debt and credit, and through risk capital. On debt and credit financing, actions include: Ensure that banking systems are market based and well functioning

Banking regulatory systems should be reformed based on market-principles, barriers to foreign competition should be dismantled, and other measures introduced as needed to ensure healthy competition in these markets.

Improve SME financial knowledge and management

Expertise and working practices should be advanced at firm level, e.g., to improve knowledge on funding techniques, raise credibility and elevate bargaining strength vis-à-vis banks. Processing of lending to SMEs should be improved within banks while government policies that increase costs to banks should be minimised in order to make small business lending profitable. Creation of private sector credit bureaus could increase collaboration among lending institutions. This would benefit all parties as credit-risk information compiled in the credit bureau would be available to help mitigate problems of fixed costs hindering lending to SMEs, while maintaining an adequate degree of diversity in credit risk measurement methods. There is a rationale for speeding coordinated use of new technologies, including ICT, while countering common problems as regards privacy, authentication and fraud.

Enhance guarantee funds and make better use of related public funds

Guarantee schemes are among the most effective instruments governments can use to ease SMEs’ access to credit financing. However, measures have to be taken to promote appropriate risk sharing with private lenders and SMEs themselves. Initiatives which help reduce the risks assumed by guarantee funds may be applied to facilitate the access to a guarantee. As in the case of FOGAPE in Chile, appropriate regulation and supervision can be applied to induce banks to compete in using the guarantees provided by the funds. Another example is the Counter-Guarantee System run by the European Investment Fund (SME Guarantee Facility). The Polish guarantee fund POLFUND, like the Spanish Guarantee System, significantly improved access to guarantees for entrepreneurs after obtaining EIF counter-guarantees in 2005.

Keep fees and guarantee schemes affordable

Fees paid by SMEs for guarantees can usefully be differentiated to balance selectivity and financial sustainability. Fee levels should take into account market imperfections and other considerations that lower affordability for SMEs. The Italian State Fund for guarantees to SMEs has managed to keep default rates and operating costs low by exploiting the risk balancing effect and economies of scale in the scheme. THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

ANNEX B: OECD BRASILIA ACTION STATEMENT – 275

Expand the scope of micro-credit and micro-finance schemes

Micro-credit and micro-finance institutions (MFIs) fill important gaps, especially in developing countries, based on proximity to local entrepreneurship and the adoption of a flexible formula. An example is Novobanco, active in Africa and Latin America, which provides credit to micro-businesses based on no-fees account with no minimum balance, informal guarantees (house assets and a guarantor), and a continued relationship with loan officers. Agreements between MFIs and private providers of non-financial services should be promoted to ease capacity constraints, whereas regulatory barriers that often prevent MFIs from extending their lending activities to micro-businesses should be dismantled. In emerging and developing economies, ICT can help diffuse the use of MFIs and counter costly fragmentation in rural markets.

7. In most economies, only a very small percentage of SMEs seek risk capital. However, it is a form of financing of particular importance to high-growth ISMEs. In this regard, Participants stressed the need of the following actions in the area of risk capital: Promote awareness among SMEs of the value of equity finance Facilitate access to institutional capital

There is a need to promote enhanced awareness, educate and communicate more broadly the value of equity financing, including raising the recognition among entrepreneurs of fair value and transparency in valuing investments. The channelling of further funding by institutional investors should be facilitated through flexible regulation consistent with prudent investment management principles

Ensure that the regulatory framework is neutral among different sources of finance

The combined legal, tax and regulatory framework should ensure that risk capital is not discriminated against, including by safeguarding orderly, equitable and transparent exit routes. Taxes should not put SMEs, entrepreneurs or their financial backers at a disadvantage. There should be neutrality between alternative sources of risk capital, such as domestic versus foreign venture capital funds. Maintaining neutrality between debt and equity should also be an aim for tax policies.

Steps should be taken to improve the exit environment

The exit environment in many countries is not favourable to venture capitalists. Liquid stock markets either do not exist or are too fragmented, and listing requirements may be too stringent. Also, local specifics hinder trade sales/mergers and acquisitions, and barriers to these activities should be removed.

Use public schemes to leverage competencies and serve as catalysts for private equity funding

Public programmes can make an important contribution by enhancing SME skills in accessing and using risk capital, as practiced by Vaekstfonden in Denmark. With appropriate incentives for management, public equity funds can operate so as to help catalyse and leverage the provision of private risk capital. Measures strengthening market access for SMEs, for instance along the lines of the US SBA programmes, should be further developed.

Provide additional guidance on the application of fair value guidelines for

While venture capital associations have developed credible fair value guidelines for private equity investments (AFIC/BVCA/EVCA and PEIGG), valuing venture capital remains judgemental and approximative. Further guidance and training on applying such guidelines can increase investors’

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276 – ANNEX B: OECD BRASILIA ACTION STATEMENT venture capital investments

confidence in the consistency and reliability of valuations of venture capital investments. The valuation of investments in venture capital funds for accounting purposes is one of those areas that should be more clearly examined.

Help venture capitalists and business angels flourish

There is no venture capital without venture capitalists and business angels greatly enhance the effectiveness of informal finance. Representing an evolving entrepreneurial breed, these actors thrive on their ability and courage to assume risk. Obstacles should be identified and eliminated. Effective role models can also be promoted to spur the dynamism of these actors. Ways should be explored to facilitate the establishment of “business angel networks”, which may greatly enhance information and capital flows.

Reduce obstacles to cross-border risk capital markets

Efforts should be made to reduce obstacles to the creation of cross-border markets for private equity and venture capital. Cross-border venture capital and private equity funds could be encouraged as a means to strengthen information exchange and enhance the competitiveness of SMEs in global markets.

8. Finally, Participants called upon the OECD to work further in developing better data and statistical information as a basis for measures to address the issues of SME financing. Gaps in data and statistical information, and the huge variation between countries, make it difficult to determine to what extent a financing gap hampers SMEs and entrepreneurship in a general sense. A new partnership should be put in place to overcome current obstacles to SME financing. More focus needs to be brought to improving the availability of statistical data, and identifying and diffusing best policy practices in financing of SMEs and entrepreneurship. Building on the valuable work of the OECD Working Party on SMEs and Entrepreneurship and the OECD Committee on Financial Markets, Participants invited the OECD to further develop the following areas (subject to the availability of resources):

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ANNEX B: OECD BRASILIA ACTION STATEMENT – 277

Recommendations for further work by the OECD In order to improve the availability of data and statistics, as well as the understanding of outstanding issues in financing of SMEs and entrepreneurship, the OECD should:

x

Prepare a handbook of definitions (including what constitutes a “financing gap”), indicators and statistical methodology for gathering data on the supply of financing available to SMEs and the demand for financing by SMEs.

x

Encourage use of this handbook to survey SMEs and suppliers of finance on a regular basis to provide policy-makers and market actors with more accurate and detailed information, help them determine if and where a financing gap exists, better understand the functioning of the national, regional and global financial markets as they pertain to SMEs, and to identify deficiencies or impediments in their operations.

x

Take the lead in developing better data and statistical information, thereby allowing the establishment of international benchmarks to facilitate comparisons of the relative performance of markets in providing financing to SMEs and entrepreneurs; and, to shed light on outstanding financing gaps and issues.

In order to support the adoption and diffusion of best policy practice for financing SMEs and entrepreneurship, the OECD should inter alia:

x

Analyse and assess current policies relevant for SMEs and entrepreneurship, including the related financial regulatory and policy landscape, and promote the sharing of experience among policymakers on best policy practice (and on policies which have proven less successful) to address funding gaps.

x

Explore appropriate mechanisms for the development of stronger public/private partnerships in SME financing and of appropriate instruments for furthering the role of institutional investors.

x

Examine the fragmentation of markets resulting from inconsistent tax/regulatory regimes and improve conditions for cross-border capital formation programmes.

x

Examine how training, skills transfers, and programmes promoting financial education, better accounting practices and awareness more generally, best underpin the information and competencies within SMEs that are required for effective access to finance. Strong involvement of non-member economies should be sought in this project.

x

Examine how to develop further information flows and transparency on SMEs.

In order to build a new partnership to address the existing obstacles to SME financing, the OECD should work with non-member economies and the key stakeholders to:

x

Establish an OECD Global Forum for Tripartite Dialogue, convening Governments, the Financial Community and SMEs in OECD and non-OECD economies, to periodically review progress in strengthening SME and entrepreneurship financing. The work would be jointly conducted by the relevant OECD bodies, i.e. the Working Party on SME and Entrepreneurship and the Committee on Financial Markets, in co-operation with other international organisations/institutions.

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278 – ANNEX B: OECD BRASILIA ACTION STATEMENT

Notes 1 The OECD Bologna Process on SME and Entrepreneurship Policies is a dynamic political mechanism that:

x

Fosters the entrepreneurial and SME agenda at the global level through extended analytical work;

x x

Promotes high-level dialogue on SME and Entrepreneurship policies worldwide; and Encourages co-operation between OECD countries and non-member economies, other international organisations/ institutions, and non-governmental organisations in the field of SMEs and entrepreneurship.

2 There is no precise generally accepted definition of a financing gap, but the term implies that a sizable share of economically significant SMEs are unable to obtain adequate financing. Agency problems arise because it is impossible to write complete contracts and the interests of the contracting parties may not coincide. See further the OECD Keynote Paper on “The SME Financing Gap: Theory & Evidence”, OECD, 2006.

THE SME FINANCING GAP VOLUME II: PROCEEDINGS OF THE BRASILIA CONFERENCE 2006 – ISBN 978-92-64-02944-6 © OECD 2007

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The SME Financing Gap VOLUME II PROCEEDINGS OF THE BRASILIA CONFERENCE

The SME Financing Gap

27-30 MARCH 2006

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VOLUME II – PROCEEDINGS OF THE BRASILIA CONFERENCE

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VOLUME II PROCEEDINGS OF THE BRASILIA CONFERENCE The SME Financing Gap

A significant number of entrepreneurs and small and medium-sized enterprises (SMEs) could use funds productively if they were available, but are often denied access to financing. This impedes their creation and growth. The “financing gap” was the subject of the OECD Global Conference on “Better Financing for Entrepreneurship and SME Growth”, held in Brasilia, Brazil in March 2006. This book presents a synthesis of the Conference discussions on the credit and equity financing gaps, as well as on private equity definitions and measurements. It also offers a selection of papers given by some of the key stakeholders (SMEs, government and financial institutions) confronting these important issues.

27-30 March 2006

RENEU

REP S ENT T SME

RS

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