Director of
Development
Ministry of Trade
and Industry
Finland
11 May 2001
Cesme
OECD ROUND TABLE
CONFERENCE: SME COMPETITIVENESS
CURRENT STATE OF
THE VENTURE CAPITAL SECTOR IN FINLAND
The private
equity capital market provides capital to non-quoted enterprises for
development of products and technologies, for acquisitions and other ownership
arrangements or just for working capital and for strengthening the balance
sheet. Of this, the venture capital refers to equity investments for the seed,
start-up launch and expansion of a business. The other private equity
investment areas are replacement capital and management buy-outs or buy-ins.
Venture capital
financing is quite a specialised area of SME financing. The main form of
external financing used by SMEs is of course loans. And the main part of the
public SME financing measures are in the form of loans, loan guarantees or
grant programmes. But there are areas in which venture capital financing has
clear advantages and an important role in SME financing.
Typically, a
company in an initial or a growth phase can use only restrictedly loans; the
need for collaterals limits the supply and while future profitability is
difficult to estimate, commitment to large terminable loan payments is very
risky to the company itself. Here risk-sharing venture capital provides an
answer to this.
The growth of ICT
has boosted demand for venture capital. Costly development together with short
product cycles demand prior financing ready to take great risks in hope of
great future profits. Instead, traditional SMEs are wary of dividing control in
a firm. Actually, the interest of venture capital financiers in these firms is
typically low, too. Different attitudes to growth and management practices
often lead to this.
Besides
financing, private equity participation gives other advantages, too. In a
recent study by EVCA, the European VC Association, the finding was that
venture-backed management buy-outs and buy-ins lead to better performance than
on average. The survey confirmed that a venture capitalist also provides
strategic advice and acts as a sounding board for management ideas.
In recent years,
the supply has grown rapidly in most countries, while financing institutions
have learned this business. But the supply depends heavily on the general
economic development, too. So changes in economic situations have immediate
effects on the supply of private equity capital.
The development
of venture capital market in Finland has been fast in recent
years. The Finnish Venture Capital Association FVCA collects statistics from
Finnish venture capital investors twice a year. These statistics show that the
amount of funds managed by Finnish private or public funds were around € 100
million in 1991 and € 325 million in 1995, but last year the amount was already
€ 2290 million. In addition, there are significant amounts of capital available
from funds and balance sheets of foreign venture capital companies. According
to this statistics, the supply of public VC funding has grown nearly six-fold
during that time, but the growth of private funding has been 39-fold. So, now
public funds has clearly complementary role in the equity market.
The Finnish VC
investors made last year 420 investments in 350 companies, totalling € 400
million. The investment rate slowed down a bit at the end of the year, but the
total annual growth was 38%. Nearly 2/3 of the investments were made in new
customers. The market share of private funds continues to grow, and only11 % of
the capital for last year’s investments came from public funds.
The development
stages of investing companies describe well the type of business risks taken by
investment funds. The stage distribution of the Finnish equity market shows
that the largest shares of capital are used in buyout and expansion
investments. These are areas in which investments are relatively large and in
which there is earlier information available for risk evaluations. So private
investors often favour these investments.
If we look at a
number of investments, the main areas are expansion and start-ups. Financing of
start-ups and even early seed stage financing has grown in recent years quite
favourably. This development has been strongly promoted by public funds, too.
These are often high-risk and long-term investments. They are also often quite
small, bringing on relatively high administrative costs to the investor. Thus
they are not favoured by the equity market as such. But these types of
innovative investments are in the long term very important for renewing
national economy. Therefore there is a good reason to encourage private
investments at these stages by public funds’ co-financing.
Division of our
venture capital investments by branch highlights emphasis on technology,
especially on ICT, projects. This is quite natural, because that has been in
recent years the area for innovative and fast growing firms needing external
financing. On European level, about half of the VC investments have been made
in the technology sector. But another half of the investments are made in
other, “old economy” sectors. It is interesting to see how much the share of
these sectors will grow now when the technology fever of the stock markets has
fallen.
The divestment
phase is a problem to investors on the relatively small equity market of
Finland. Last year the number of exits grew to 140, much by courtesy of the
positive stock market situation in the beginning of the year. But now again
investors must look for other solutions for exits. On the European market,
about a half of the divestments are made by trade sale, which is twice as
common a type of exits than Initial Public Offerings and sales of quoted
equity.In Finland last year most important ways of exits were in monetary terms
sales of quoted equity, trade sale and IPO. In number of exits loan payment and
trade sale were largest groups.
The effects of
venture capital financing on the SME sector are difficult to measure. The total
number of companies’ start-ups and investments co-financed by VC capital is of
cause quite limited compared to the total numbers of start-ups and enlargement
investments. But the effects on a country’s economic development made by these
projects are often remarkable. They can work as “spear heads” renewing the
structure of industry. They are also often fast growing in figures of
production and new jobs.
Industrial policy
measures are also used for activating VC financing and for development of these
markets. The supply of private equity capital is often promoted by such
government industrial policy measures that allow risk sharing of private equity
investments. Those SMEs eligible for and suitable for the use of VC financing
are often very interesting targets for the Government’s industrial policies.
They are typically innovative and have good growth prospects. Therefore most
OECD countries have taken policy measures to promote venture capital financing
and private equity market development.
The development
of business environment favourable to new technology-based enterprises is the
main area of industrial policy, at least in our case. The two main elements
here are public financing measures for promotion of research activities on the
one hand, and attitudes and structures for co-operation between enterprises and
universities or other innovative organisations, on the other hand. These have
an important effect on the supply of such new business ideas that are suitable
for venture capital financing.
There are mainly
two public units, the Finnish National Fund for Research and Development,
Sitra, and the Finnish Industry Investment Ltd, that promote venture capital
financing in Finland. Sitra is an independent public foundation under the
supervision of the Parliament. VC financing is one of its activities. Industry
Investment Ltd is a Government-owned company. It operates only for venture
capital financing, mainly co-financing VC funds.
Sitra works as direct venture capital investor. Its portfolio consists of about one hundred technology companies that have the opportunity, ability and desire to grow on international markets. Over half of these are at the seed phase and the others at a growth stage.
Sitra also participates in financing and administration of regional venture capital funds. It owns wholly or in part five regional management companies. Each of these is working for several regional or local VC funds. This makes it possible to offer competent management services with reasonable costs even to smallish regional funds. Now Sitra will sell the majority of shares in all of these management companies to their managers within a couple of years.
Sitra has also a matching service to join private equity investors and SMEs interested in this financing. This is considered also as an effective way to get mentors for SMEs; minority ownership is an effective motivation for helping that entrepreneur in his business.
Industry Investment Ltd invests in equity capital on commercial principles. The main objectives are to develop the VC industry in the private sector, to promote export-oriented innovative industries and to develop secondary equity markets as well as co-operation between VC investors. Industry Investment’s main purpose is to work as an efficient “fund of funds”. Today it has investments of about € 60 million in over 20 funds working with different investment strategies at different stages and in different branches of firms. Thus it mainly uses an indirect financing scheme.
We have financed
a study of SME financing schemes used in some countries. According to this
study, public venture financing units in France use indirect financing (CDC’s
SME Employment Programme for seed funds and FPCR for funds with foreign
capital). In Canada (BDC’s VC department) and in Norway (SND Invest) they
mainly use a direct financing scheme. In Germany (equity programmes of DtA/tbg
and KfW), mixed systems are used, which involve private sector investors, too.
These special
financing schemes have typically been financed and granted tax exemptions by
Governments. In Finland Sitra’s activities are financed primarily from the
yield of its original endowment. Industry Investment Ltd’s resources are based
on earlier privatisation of state-owned companies. In deviation to the other
countries studied, the Finnish special financing institutions are not exempted
from normal taxation.
The main
financing vehicle is direct share capital in minority SME ownerships or/and
investments in national or regional funds. The institutions in Finland, Canada,
France and Norway each assume at least to some extent a position on the Board
of Directors in companies, or in the case of indirect investments, they have
active relationships with fund managements. In Germany tbg assumes a “silent
partner” status and the private co-investor participates in management, while
KfW does not deal directly with SMEs but refinances investments to private
venture capitalists.
Public VC
financing institutions have a tendency to favour technologically oriented
companies, which are young and at their start-up or development phase. They
have also an interest to attract additional private investors to the market and
to develop the venture capital market regionally balanced within the country.
Therefore their major objectives are the industrial development of economy and
the development of equity markets.
Both public
approaches, direct and indirect venture capital financing, have merits of their
own. The direct financing approach gives the possibility of forming a clear
target profile for financing and of following it. Direct contact with customers
also gives opportunities to those expert services that are expected from a VC
financier.
On the other
hand, direct financing is quite labour-intensive. Of investment requests, about
90% are already rejected in the first assessment and finally maybe 3 to 4% are
eligible for financing. Administration and counselling during financing time
are costly, too. As a result, the number of investments is quite limited.
Especially in the case of small projects, there is need to find easier ways to
work with. Here regional and local funds provide one way, while they can use
the expertise of such local networks as incubators, science parks etc. One
element of danger in direct public financing schemes is that if financing is
not channelled strictly to those areas where there is not enough private
capital available (the seed stage and collaboration in risk sharing), that
results in negative competition effects on the market.
The indirect
financing approach via privately managed funds has lower administrative costs,
and it allows financing of a large number of enterprises. And while this
financing increases the size of funds, they can finance large projects. So this
approach gives a clear advantage to participating private financiers.
Therefore, if the policy target is more general investment risk sharing, then
this approach is effective. Instead, the possibilities of channelling financing
to those policy targets that are outsider interests of the private equity
markets are here more limited.
Current
development in the world’s stock markets has been depressing
especially for stocks whose value has been based on great growth expectations.
The slowdown especially on the U.S. market has crumbled expectations of
continuing very fast growth, at least for the moment. And impaired thrust to
future development has led to lower flow of capital to stock markets in general.
Therefore even other stocks have suffered to some degree.
There seem to be
at least two kinds of implications of the current stock market situation on the
future availability of venture funding in general. The supply of financing is
likely to be more meagre until a change occurs in main economic trends. But
while the more traditional branches find favour with investors, their relative
financing situation will gain strength. This will favour regions and countries
with more traditional production structures, which will compensate at least
partly the general contraction of venture financing available.
In our
experience, foreign direct investments start quite typically following the
principles of VC financing; an investor first buys a minority share in a
company and decides later on if there is ground for future investments in the
company. So this is quite a slow process, which can take years. Therefore
short-term economic fluctuations do effect in timing but not so much in the
long-term trend of investments. These are largely determined on the basis of
business environment in general: the qualities of administrative structures,
labour markets and business climate.