How capital market finance can boost European businesses

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Kalin Anev Janse, Chief Financial Officer and Member of the Management Board, European Stability Mechanism (ESM), Rolf Strauch, Chief Economist, Member of the Management Board, European Stability Mechanism

• An integrated European capital market is critical to provide small and medium-sized enterprises (SMEs) and startups with better access to diversified financing options beyond traditional bank lending.
• Regulatory reforms and innovative financial instruments, such as European long-term investment funds, are important to attract private investment into SMEs.
• Initiatives are needed to improve SME visibility to investors and facilitate cross-border lending and investment within the European Union.

As economic resilience and growth become crucial, the European Union (EU) recognizes the need to forge a unified and integrated capital market – a cohesive network that facilitates seamless access to financing across all member states.

By breaking down barriers and harmonizing regulations, such a market could unlock capital for businesses, especially small and medium-sized enterprises (SMEs) and startups that are the lifeblood of Europe’s economy.

Financing SMEs

SMEs account for 99% of EU businesses and employ around 100 million people – they are vital for innovation and Europe’s economic sovereignty. However, an ECB survey highlighted that SMEs faced greater obstacles than large firms, with 14% reporting financing constraints.

Bank lending, traditionally the primary source of finance, is less accessible for these smaller entities, especially for startups needing more adaptable financing, such as risk capital, which is often the stage before a public offering of shares. This gap in funding mechanisms hinders startups from scaling up, exacerbated by the loss of London as the EU’s venture capital hub, despite some existing efforts to improve access to capital markets for SMEs.

For instance, the European Commission has prioritized such access, while Germany and France have initiated a roadmap for the Capital Markets Union (CMU), emphasizing the importance of capital markets for startups. However, more actions are needed to strengthen the risk capital sector, diversify SME financing sources and support growth.

Here’s what proposals could look like:

• Simplify European long-term investment fund rules.
• Make public listing conditions more flexible for SMEs and startups.
• Improve company visibility to investors through centralized information.
• Harmonize insolvency regimes to encourage cross-border investment.

These measures would create a more favourable environment for SME and startup growth, crucial for Europe’s competitive and innovative advancement.

Financing reliance on banks

Bank loans are the main funding source for EU firms but are less suitable for SMEs and startups. Accessibility has declined since 2020 amid rising rates and tighter lending criteria. Banks’ strict capital requirements limit their risk appetite, leading to conservative loan pricing for SMEs and startups.

Market financing in the EU lags behind the United Kingdom and the United States. The Association for Financial Markets in Europe (AFME) reports that risk capital comprised 2% to 5% of total SME financing since 2018, compared to over 10% in the United Kingdom. Risk capital in the United States was five to 7.5 times higher than in the EU over the past decade. Meanwhile, the EU’s risk capital sector is fragmented, with significant variations among member states.

Risk capital to initial public offering (IPO) transitions are less frequent in the EU than in the United Kingdom or United States. The European market in 2023 saw a 72% drop in volumes year-on-year, far below the United States and issued equity volumes remained similar to the previous year.

The business angel, venture capital, private equity and IPO funnel are also more efficient in the United States and the United Kingdom, often leading European startups to seek public listings there to succeed. Europe needs to adapt to support these businesses’ growth and innovation.

Improving SME access to capital markets

Developing tools to attract more private investment into SMEs is crucial to bolster the European risk capital industry. European long-term investment funds aimed at channelling investment into SMEs must be more targeted towards these enterprises. Enhancing investor accessibility by aligning passporting rules, lowering entry barriers, and introducing flexible investment repayment options could be beneficial, for example.

A new framework, effective from 10 January 2024, aims to simplify investment guidelines and broaden asset eligibility, indicating that progress abounds regarding regulatory evolution.

The EU’s regulations for company listings provide strong investor protection but can be burdensome for SMEs considering public offerings. In response, the European Commission has implemented reforms to ease the listing process for SMEs.

These reforms include different voting rights for innovative companies, reduced free float requirements, simplified prospectuses, and improved investment research remuneration. The effectiveness of these measures remains to be seen.

Enhancing SME financing and transparency

Further enhancements, such as a pan-European stock market index for SMEs, could improve visibility and attract investors. Introducing a transitional regulatory relief for newly listed companies could reduce compliance costs.

The planned European single access point for financial information by 2027 aims to consolidate and simplify access to corporate data, boosting SME visibility.

Meanwhile, harmonizing EU insolvency regimes could facilitate cross-border lending and securitization, offering a unified standard for handling failing businesses. However, more could be done to provide the EU with common minimum standards in terms of the insolvency framework.

If we want to make CMU a reality and enhance Europe’s economic development, we must boost the financing choices to harness the potential of these innovative powerhouses in Europe.

A longer version of this blog was originally published here.