Addressing the funding gap
Small and medium-sized enterprises (SMEs) find it difficult to attract capital as they seek to expand, and are overwhelmingly reliant on bank funding. In its Action Plan for Capital Markets Union (CMU), the European Commission noted that bank lending accounted for 75 per cent of SME funding, while venture capital represents only 1 per cent of SME funding (versus 8 per cent in the US). Further, 35 per cent of SMEs did not get the financing they applied for. In addition, unlisted start-up companies typically do not have the size or structure to access the capital markets for debt or equity.
CMU is intended to move the EU closer towards a situation where, for example, SMEs can finance in the capital markets as easily as large companies; costs of investing and access to investment products converge across the EU; obtaining capital markets-based finance is increasingly straightforward; and seeking funding in another Member State is not impeded by unnecessary legal or supervisory barriers.
SMEs are one of two groups of funding recipients focussed on in the Action Plan for CMU (the other group being infrastructure-related undertakings). The Action Plan looks at the entire life cycle of a business, from angel investors and start-up funding at the outset, to early expansion funded by venture capital, and mature growth funding by cross-border debt and equity financing in the capital markets.
SMEs look to gain from the new prospectus regime
In response to the Commission’s consultation on the Prospectus Directive (PD), market participants including SMEs have said that prospectuses are overly long documents that are neither read nor understood by retail investors. The Commission found that participation by SMEs in the debt capital markets remained very low, as the process of drawing up a prospectus and getting it approved by national regulators is perceived as expensive, complex and time consuming.
In December 2015, the Commission put forward a draft new Prospectus Regulation with the intention of broadening the attractiveness of offering and listing securities across the European Economic Area (EEA). The draft new Prospectus Regulation has reached the final stages of the legislative process. On December 20, 2016 the European Parliament, Council and Commission came to a political compromise as to what the draft legislation will say. Once in force, the Prospectus Regulation will replace the existing PD regime completely. This proposal forms a major part of the CMU agenda, and may be one of the first and most significant CMU initiatives to see completion.
A ‘proportionate disclosure’ regime for SMEs was brought into the revised PD framework (PD II) in 2012, with the intention of encouraging participation by SMEs in the debt capital markets. Sadly, the expected take-up did not happen, and the Commission realised it needed to go further in order to boost growth. The Prospectus Regulation expands on this concept with a new ‘EU growth prospectus’, which impose a lighter disclosure burden.
SMEs with a market capitalisation of up to €200m and mid-sized companies with a market capitalisation of up to €500m will be able to take advantage of the lighter disclosure rules, and in either case the maximum size of eligible issues will be €20m. SMEs that already have securities admitted to trading on a regulated market will not be eligible to use the lighter disclosure rules, in order to avoid a ‘two-tier’ disclosure standard. In other words, investors should be able to review one set of disclosure documents without worrying that there is more comprehensive disclosure available elsewhere. Currently, a prospectus is not required for securities listed on multilateral trading facilities, provided that they are not offered to the public. This exemption has been re-introduced into the December 2016 compromise text of the new Prospectus Regulation.
What information will be required in EU growth prospectuses will not be fully known until the Commission publishes new regulatory technical standards in 2017. The compromise text of the new Prospectus Regulation states that at minimum an EU growth prospectus will include a summary, registration document and securities note. The Commission will be empowered to calibrate the growth prospectus disclosure requirements depending on the size of the issuer.
The Commission believes that the EU growth prospectus will be more attractive to SMEs than the proportionate disclosure regime under PD II, because SMEs will be able to passport an approved EU growth prospectus into all Member States. While the EU growth prospectus may be more accessible, it remains to be seen whether a new set of prescriptive rules and prospectus summaries with their tight page limits are in fact ‘user friendly’.
Whether the new rules encourage SMEs and others to issue more will depend ultimately on whether the disclosure is in fact lighter. SMEs will, presumably, need to have underwriters or placement agents to sell their securities. We suspect that such underwriters or placement agents will want legal advice as to the suitability of any given disclosure document.
When adopted, the Prospectus Regulation will have direct effect without needing implementation at the national level. Except for some specific provisions that will apply earlier, it appears that the Prospectus Regulation will apply 24 months from the date of entry into force. That means if as expected the Prospectus Regulation is adopted in the first half of 2017, the bulk of it will apply in the first half of 2019. For more information please see our comprehensive briefing on the Prospectus Regulation on our CMU site.
As an alternative to PD-compliant publicly listed securities, private placements may have the potential to offer investment opportunities for long-term investors and to broaden financing options for SMEs. In its Action Plan, the Commission acknowledges the potential for growth in European private placements, and identifies a lack of standardised processes and documentation as barriers to further development.
Recent developments include the publishing of standardized transaction documents by industry associations. For example, the Loan Markets Association has published a set of private placement bond documentation governed by English law, and the French Euro Private Placement Working Group (including Banque de France, the French Treasury and the Paris IDF Chamber of Commerce and Industry) has published a set of private placement documents governed by French law. In addition, the International Capital Markets Association have collaborated with institutional investors and key industry bodies to produce a pan-European corporate private placement market guide, which is generating more interest in the European private placement market.
A clear advantage to private placements is that they to avoid the need for a prospectus and ongoing disclosure requirements that accompany public offers. As a result, private placements often have a short turnaround time and are less costly to set up.
The draft Prospectus Regulation proposes to remove the €100,000 (or equivalent) exemption from what constitutes an ‘offer to the public’ and removes one of the safe harbours for making an offer without filing a prospectus. However, the remaining safe harbours (e.g. issuers offering debt securities solely to qualified investors, to fewer than 150 non-qualified investors or with a minimum commitment of €100,000 per investor) will still exempt issuers from the prospectus requirement.
SMEs that intend to only access the private placement market under the new regime will find that the available safe harbor options are more fact and conduct specific than the €100,000 (or equivalent) denomination option was. Accordingly, additional effort will need to be spent on compliance to ensure that private offers fall within those safe harbors. For more information please see our briefing on private placements.
Overcoming SME information barriers
Investors may view SMEs without a record of performance or access to a large pool of assets as a riskier investment compared to large multinationals. As a result investors generally require more, rather than less disclosure. On the other hand, SMEs are more sensitive to transaction costs if they do not benefit from a broad resource base. Any CMU initiatives will need to strike a balance between the two.
Credit scoring provides investors and lenders with information on the creditworthiness of SMEs. While credit scoring for loans has traditionally been done in-house by banks, institutional investors often lack the resources to analyse the credit risk of small companies. As a result, around 25 per cent of all EU companies and around 75 per cent of owner-managed companies do not have a credit score. The Commission wants to develop a standardised set of comparable information for credit reporting and assessment that could help to attract funding to SMEs.
CMU singles out search costs as a barrier to investors identifying and assessing SMEs for investment. Possible CMU initiatives could include private or public sector-led schemes to promote the availability of advisory services and market-based funding options.
Possible measures to overcome SME information barriers could include:
- working with European banking federations and business organisations to structure or disseminate feedback given by banks declining SME credit applications
- working with the Enterprise Europe Network to map local or national support and advisory services to promote best practices on helping SMEs find alternative funding
- working with the European Central Bank (ECB) and national governments to develop an EU-wide information system and bring together SMEs with finance providers.
European Venture Capital Funds
Since their adoption in 2014, European Venture Capital Funds (EuVECA) are alternative investment funds (AIFs) that target start-ups and other SMEs within an EU-wide legal framework (the EuVECA Regulation). Currently only smaller fund operators managing asset portfolios below €500m can manage these funds. Changes to the EuVECA Regulation being introduced under CMU may allow larger institutional fund managers to participate. By encouraging take up of EuVECAs, the Commission hopes to encourage investment in new businesses that are generally small and in the initial stages of expansion.
By providing finance and advice to SMEs, EuVECAs aim to stimulate economic growth, contribute to the creation of jobs and capital mobilization, increase investment in research and development and facilitate innovation and competitiveness.
The Commission will also study ways to redress what it sees as regulatory and tax bias towards the debt versus equity. It sees equity finance as source of stability because it has loss-absorption capacity and can prevent build-up of leverage in the financial system. By diversifying sources of financing for SMEs and reducing dependency on banks, CMU aims to encourage longer-term SME growth and promote the resilience of the financial system.
Tax treatment is often a significant consideration in deal structuring, and withholding tax is an important driver. In addition, transfers of debt securities may attract stamp duty. The applicability of withholding tax on bond payments may depend on the location of the issuer and investors, and availability of exemptions. Tax treatment of private placements is determined largely along national lines, and as a result the European market for private placements remains fragmented. CMU takes a longer term view, with aims including harmonisation of corporate taxation and the creation of tax incentives to support start-up and SME funding.
Asset-backed securities (ABS) that are backed by loans made to SMEs and guaranteed by multi-lateral trading organizations (e.g. credit export agencies) may receive a preferential capital treatment under the currently proposed Securitization Prudential Regulation relating to credit institutions and investment firms. If adopted, banks’ balance sheets should be freed up to increase bank lending to SMEs.
Preferential capital treatment for multilateral bank-guaranteed SME loan-backed ABS, if adopted, will complement efforts on the fiscal side, where the Commission is pursuing public-sector risk sharing under its much lauded "Investment Plan for Europe." Through this initiative, European multilateral organisations such as the European Investment Bank and the European Investment Fund provide guarantees and strategic investment in order to unlock private sector funding for SMEs.