[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 24.10.2006

SEC(2006) 1347

COMMISSION STAFF WORKING DOCUMENT

Annex to the : Proposal for a COUNCIL DECISION on the Community participation in the capital increase of the European Investment Fund [COM(2006) 621 final]

Ex-ante evaluation report The capital increase of the European Investment Fund

TABLE OF CONTENTS

1. Introduction 4

2. Problem analysis and needs Assessment 5

3. Objectives and Related Indicators 7

4. Alternative options and risk assessment 9

5. Added value of Community involvement 11

6. Lessons learned from the past 11

7. Monitoring and evaluation 12

8. Achieving cost-effectiveness 12

INTRODUCTION

1. European Investment Fund

As at 31 December 2005, the EIF's tripartite shareholding includes the European Investment Bank (61.65%), the European Community represented by the European Commission (30%), and a number of financial institutions (8.35%). The EIF's authorised capital amounts to EUR 2 billion, of which EUR 400 million are paid in. The EIF is rated at the highest possible credit rating, AAA/Aaa/AAA, by the rating agencies Standard & Poor's, Moody’s and Fitch.

In accordance with its Statutes, the EIF's objective is to contribute to the pursuit of Community objectives while achieving an appropriate return for its shareholders. The policy objective has been reinforced in recent years through the active support of the Lisbon strategy for growth and employment, of which enhancing SMEs' access to finance, and the financing of research and innovation are key issues. With regard to the return objective, the EIF has constantly paid 40% of its net income as dividends to its shareholders. Return on equity has been steadily increasing over the past five years, reaching 7.4% in 2005.

2. EIF's operations

The EIF operates through some 330 venture capital funds and financial institutions, using its own resources as well as those entrusted to it by the EIB, the European Commission, the German Ministry of Economics and Labour (ERP[1] mandate) and the Spanish Ministry of Industry's CDTI and other Spanish investors. The EIF's activity is centred upon two main areas:

- The EIF's venture capital instruments which mainly consist of equity investments in venture capital funds and business incubators that invest in SMEs, particularly those that are early stage and technology-oriented or that have a regional focus. Since inception (and as at 31/04/2006), the EIF has been responsible for EUR 3.2 billion in equity participations in around 220 funds. Its own resources have been mainly used to co-invest alongside the EIB's Risk Capital Mandate. In 2004, the EIF broadened its investment policy to include mid- and later-stage funds, but its portfolio continues to be focused on early-stage technology (primarily ICT and life sciences). The EIF has also participated in a small number of fund-of-funds investments.

- The EIF's guarantee instruments consist of providing guarantees to financial institutions that cover SME loan and leasing portfolios. It offers two main product lines for its guarantee activity: credit enhancement (securitisation) and credit insurance/re-insurance (including for micro loans). Transactions involving own resources mainly support securitisation operations which may significantly enhance SMEs' access to debt finance. Since inception (and as at 31/04/2006), the EIF has provided EUR 9.8 billion in SME portfolio guarantees to some 110 banks and specialised institutions in 29 countries.

The scope of the EIF activities has deepened in the wake of the Lisbon Strategy; EU enlargement has also broadened its geographic coverage. While the EIF has been successful in meeting the challenges posed by these two developments, its resources have been stretched accordingly. In fact, it will run out of own resources by mid-2007.

Problem analysis and needs Assessment

3. SMEs' access to equity and debt finance

Small and medium-sized enterprises (SMEs), defined as having fewer than 250 employees, make up a large part of Europe’s economy: there are some 23 million of them in the European Union, providing around 75 million jobs and accounting for 99% of all enterprises.[2] While their importance as an engine for growth and jobs cannot be underestimated, it is largely recognised that many of these enterprises face difficulties in accessing finance[3].

The joint working group on venture capital[4] established between the Commission and the US administration stated that there is a fundamental market failure in the provision of early-stage financing. Due to the expected risk-return objectives, venture capital funds are concentrating on larger transactions and leave the small and risky early-stage deals aside. Therefore, public sector investment is required to contribute to the efficiency and long-term sustainability of venture capital markets. The conclusion of the analysis is that the best results are achieved when the public sector invests in well-managed venture capital funds, where only part of the funds raised come from public resources.

The study conducted by the Commission[5] confirms the conclusions of the joint working group as follows: "The late expansion of European venture investment in technology could have been a contributing factor to the disappointing performance of early stage investing. A relatively high share of European early stage investment could have been made during the period leading to the bursting of the technology bubble. This would mean that high prices would have been paid for investments, which only matured after the values of technology assets had collapsed leading to low investment returns.

The study concludes that the volume of funds raised for European venture capital investment in 2001-2003 shows a declining trend for venture capital in general and for early stage venture investment in particular. During the same period, fund-raising for buyouts was able to withstand downward pressures much better.

It is essential to ensure access to external sources of finance for SMEs at different stages of development. This also concerns access to loans, guarantee mechanisms and other financial instruments. Access to bank loans and leasing can be particularly difficult for SMEs when they have insufficient collateral or lack a sufficient track record. As a consequence a significant number of viable, innovative and profitable investment projects may not be financed. In those cases SMEs and, in particular, micro-enterprises and start-ups need external support in the form of collateral, which may be provided by a guarantee scheme. Guarantee schemes have played an important role in facilitating SMEs access to finance and have provided important leverage of the capital available for lending[6]. Furthermore, financial innovations such as securitisation are increasingly used as they represent a further step towards more complete and perfect markets. Securitisation is no longer just a housing finance tool, but also a corporate finance technique for entrepreneurial financing. The pace of innovation in the EU appears to be continuing with the introduction of the securitisation of private equity, micro-credit receivables and multi-country transactions.

Since its establishment in 1994, the EIF has supported through its own funds over 270 000 SMEs in traditional and high-technology sectors and in all SME development stages from seed, early stage to expansion and transfer of business throughout the European Union and accession countries. The EIF has thus demonstrated an important and successful role in the implementation of the EU’s SME policy for growth and employment.

4. EIF's capital increase

The guarantee and venture capital operations of the EIF may not exceed the ceilings set by Article 26 of the Statutes or by the General Meeting of the EIF (the GM)[7]. The own resources of the EIF amount to around EUR 614 million. As of 31 December 2005, EUR 505 million have been utilised as capital allocations for venture capital and provisions for guarantee operations so that only EUR 109 million are available to cover the EIF’s business activity. Based on the EIF's corporate operational plan 2006-2009, these remaining EIF's own resources will be exhausted by mid-2007. Following an exhaustive examination of the outlook and alternative options, the EIF's Board of Directors proposes to issue 1000 new shares which would mean, in nominal terms, an increase of the total subscribed share capital from EUR 2 billion to EUR 3 billion and, maintaining the current paid-in ratio of 20%, an increase from EUR 400 million to EUR 600 million of the paid-in capital. Overall, the capital increase would allow the EIF to receive a cash amount of around EUR 330 million as new own resources (capital paid-in and share premium).

The Commission, on behalf of the Community, holds 30% of the EIF's shares. Consequently, in order to maintain this percentage, the Commission would purchase up to 300 new shares over the four-year period 2007-2010, at an expected cost of around EUR 100m, of which nearly one quarter is to be financed from dividends payable by the EIF to the Commission as a shareholder.

OBJECTIVES AND RELATED INDICATORS

5. Objectives

The EIF's objective is to support EU policies while generating an appropriate return for its shareholders.

The EIF has distinguished itself by being the only Community institution which has a specialised focus on SME financing, pursuing relevant EU objectives particularly innovation, research and development, entrepreneurship, growth, and job creation. Such objectives, which are also major objectives of the Lisbon strategy and the successful EU enlargement, are highly topical and their pursuit remains a key EU priority, as underlined in the spring 2005 and 2006 Council conclusions.

The EIF's operations have to be further developed to respond to the changing needs of all types of SMEs and to shifting market circumstances. The EIF has an important role to play in addressing in a flexible way the persistent and well-identified market gaps that limit SMEs' access to finance, thus impacting negatively on their growth potential. The new resources will also be used to leverage the finance available under Community SME financial instruments. The EIF aims to target its support in the EU25, accession, candidate countries and certain third countries to all development stages of financially viable SMEs, from seed through early stage, development and expansion.

6. Results expected and indicators needed to measure them

In terms of economic results, the EIF will facilitate the supply of venture capital for innovative and fast-growing companies and the supply of debt finance to SMEs, thus allowing more SMEs to have easier access to finance.

Volumes of operations

The EIF's activity forecasts for its own resources are shown below (indicative ranges based on EIF's data):

Volumes (EUR m) |

Products | 2006-2009 | 2010-2013 |

Venture capital operations | 120 / 140 | 120 / 140 |

Venture capital operations in relation to the JEREMIE initiative and technology transfer accelerators | 65 / 85 | 80 / 120 |

Hybrid products (operations linking venture capital and guarantee operations) | 800 / 1 000 | 900 / 1 100 |

Guarantee operations | 2 300 / 2 500 | 2 300 / 2 500 |

Guarantees in relation to the JEREMIE initiative | 100 / 130 | 150 / 180 |

EIB Group joint operations | 300 / 400 | 450 / 550 |

Possible new products | 100 / 130 | 150 / 180 |

TOTAL | 3 800 / 4 000 | 4 400 / 4 600 |

Venture capital investments currently require 100% coverage by own resources whereas guarantee operations only need a percentage of the signature volume to cover the risk taken, i.e. the capital allocation. The capital increase now sought, together with additional ordinary resources such as retained earnings and venture capital repayments, will be sufficient to cover the forecast signature volumes until 2013.

Venture Capital

Venture capital operations are expected to support the creation and expansion of SMEs, notably in the high-technology sectors. Own resources will also be used to finance technology transfer, thus contributing to the commercialisation of research.

It may not always be desirable for venture capital funds to restrict their operations to one country, in particular in the case of small countries, so to a certain extent the EIF will continue to invest in multi-country funds. The broadening of the EIF's investment focus to include mid- and later stage funds should also help to enlarge the geographic spread of the portfolio to countries not yet sufficiently represented.

With regard to job creation, an EVCA study of 2005[8] revealed that venture capital companies have shown an average annual employment growth rate of 30.5% between 2000 and 2004. Small companies with up to 20 people and those in biotech, health care & medical devices and ICT sectors have demonstrated the strongest growth rates. One may reasonably expect similar growth rates for the EIF-backed venture capital companies. A further important finding of the EVCA study was that some 60% of the companies stated that they would not exist today without the contribution of venture capital. 95% responded that they could not have existed or would have developed more slowly. The EIF conducted in 2004 an impact study on a selection of funds in its portfolio which also included the mandates. The average EIF participation in venture capital funds amounted to 20%, and, by June 2004, the EIF had supported an estimated 10 660 jobs including almost 4 400 newly created jobs.

Guarantee operations

The guarantee operations will mainly support traditional SMEs' access to debt finance, including access to micro-credit and leasing.

The growing securitisation market represents substantial potential for the EIF, with the SME segment remaining a relatively small niche, amounting to some 20 transactions per year, over half of which involve the EIF. Recently, the EIF supported two multi-country securitisation transactions in the new Member States. Furthermore, through securitisation, the EIF has successfully supported micro-credit institutions in obtaining new funding thus allowing these institutions to continue their micro-credit activity. In fact, the EIF's policy is specifically to continue targeting less experienced issuers, smaller and regional banks as well as supporting structures that, due to their complexity, are intrinsically more difficult to place with standard investors.

The EIF's credit enhancement operations, totalling EUR 2.5 billion as at 31/03/2006 have catalysed the issuance of securities of EUR 53.4 billion hence achieving a leverage effect of almost 22. The portfolios consist mainly by SME loans, numbering over 300 000.

Indicators

The EIF's in-house analysis will continue to focus on employment and innovation, with the aim of detailing the level and quality of jobs supported, the cost of this job creation and also information in terms of patent development and licensing.

The EIF will aim to increase the investment volumes of risk capital funds in order to support a large number of SMEs. This objective will be measured by the leverage effect taking into account the type of the fund (the vintage of the fund, early or later stage, specialist or generalist fund, etc) and their geographic focus. One of the ways by which to measure success on the venture capital fund level would be the percentage of first-time venture capital funds that raise follow-on funds. The number of companies supported, the sector, the age, the size and the geographic location of the companies will measure the impact of EIF's support to SMEs. Important economic measures with regard to the SMEs supported are also the number of successful exits, i.e. IPOs (initial public offering), the number of trade sales and the number of jobs created or maintained by the SMEs.

With regard to its guarantee operations, the EIF will continue to aim to increase the volume of debt finance available to SMEs. This objective will be measured by the leverage effect taking into account the type of the guarantee operation (securitisation operation, direct guarantee, etc) i.e. the volume of debt made available to SMEs. The EIF will specifically continue targeting less experienced issuers, smaller and regional banks as well as supporting structures that, due to their complexity, are intrinsically more difficult to place with standard investors. The number of operations supported and their geographic focus provide an important performance indicator measuring EIF's support to the less experienced, but SME oriented market players. The number of companies supported, the sector, the age, the size and the geographic location of the companies will measure the impact of EIF's support to SMEs. Finally, important economic measures with regard to the SMEs supported are also the number of jobs created or maintained by the SMEs.

ALTERNATIVE OPTIONS AND RISK ASSESSMENT

7. Alternative options

In the absence of a capital increase, the EIF would have to gradually scale back all new operations funded by its own resources. Without a capital increase the EIF would only be able to manage funds assigned to it under mandates by the Commission, the EIB and third parties. Due to its co-investment obligations under certain mandates, there could be also an impact on this activity. Based on EIF's projections, a capital increase below 50% is not sufficient for it to carry out its operations until 2013. With the 50% capital increase and expected further build-up of its reserves, the EIF should be in the position to operate its own resources until 2013.

The Board of Directors assessed the feasibility of borrowing by the EIF, but it concluded that it is not desirable to use borrowing either to cover venture capital investments which have high risk profiles and where return flows are uncertain and the timing of returns unpredictable, or as cover for the capital to be allocated in support of a guarantee transaction. The Board of Directors also assessed various other options, such as sale of assets or hedging, but came to the conclusion that these do not provide appropriate alternatives to the capital increase due to the risk-profile, liquidity requirements and the long-term character of EIF's operations. Based on the EIF's business projections, the Board of Directors considers that a 50% capital increase in nominal term is sufficient to allow the EIF to continue its operations until 2013.

The CIP targets SMEs with growth potential with the objective of facilitating their access to equity and debt finance. However, the CIP does not provide an alternative to the capital increase as it has only a rather small amount available for the different operational windows, such as securitisation. The EIF may offer a complementary range of actions which are not available under the CIP.

In light of the limited EU budget, the leverage effect will become increasingly important. Failure to ensure that the EIF has sufficient resources will severely curtail its ability to support EU policies.

8. Risk assessment

The nature of the risk related to the Community's shareholding in the EIF does not change as a result of this proposal. Both the investment and risk management structures of the EIF remain the same. Further developments of this risk management function are made in accordance with best market practice, applicable standards, law, and Basle II requirements, which are being put in place this year.

The Board of Directors assesses the EIF's individual operations and monitors the venture capital and guarantee portfolios. It also ensures that the EIF is managed in accordance with its Statutes and the specific guidelines adopted by the Board. The recently created Compliance Function of the EIF ensures that appropriate checks are in place with regard to Community legislation and policies. The Risk Management and Monitoring Department of the EIF promotes effective and efficient operations, reliable financial and regulatory reporting.

Furthermore, the EIF's annual accounts are audited by external auditors under the mandate of EIF's Audit Board. These accounts have to be approved by the shareholders at the Annual General Meeting (the AGM).

The internal audit function is outsourced to the EIB, and evaluates the relevance and effectiveness of the internal control systems and the procedures involved. It is introducing an internal control framework based on BIS[9] guidelines. Internal audit also reviews and tests controls in information technology and administrative areas.

The EIF is rated AAA/Aaa/AAA by the three major rating agencies, Fitch, Moody's and Standard & Poors.

The EIF Anti-Fraud Procedures were implemented on 22 January 2002 in order to ensure that appropriate measures are in place in case of detection of fraud or fraudulent behaviour.

In addition, the EIF Board of Directors adopted in June 2004 "OLAF: Decision on measures to combat fraud" which sets out the terms and conditions for investigations in relation to the prevention of fraud, corruption and any illegal activity detrimental to the Community's financial interests.

Finally, the Tripartite Agreement between the EIF, the Court of Auditors and the Commission covers the arrangements for providing the Court with the documents and information relating to the Community participation to the capital of the EIF in order to control the value of the Community participation.

ADDED VALUE OF COMMUNITY INVOLVEMENT

This is the first capital increase since the inception of the EIF in 1994. The EIB and the Commission are dedicated to providing the resources deemed necessary to make EU policies work, notably in the fields of the Lisbon agenda, innovation, SME growth and job creation. The maintenance of a 30% shareholding by the Community helps to ensure that the EIF remains focused on evolving Community policies. Within the context of the reorientation of the EIB Group's priorities by the Board of Governors in June 2005, which placed emphasis on innovative products making use of Group-level synergies, the EIF has been called upon to reinforce its support for EU policies. The Governors' request for extended activity is reinforced by the EIF's ongoing discussions with the Commission on a number of important new business initiatives. The EIF will use its own resources for venture capital and guarantee operations to increase financing available for SMEs and growth-enhancing investments by SMEs in innovation and R&D.

LESSONS LEARNED FROM THE PAST

In 1996, the EIF was permitted to invest its own resources in equity participations for which a 30% ceiling was decided. At the same time, the Council requested a report when venture capital operations would reach 20% of EIF's own resources. This report was presented to the Council by the Commission and the EIB in summer 2001[10]. The report concluded that in order for the EIF to properly fulfil its role as the European risk capital institution, it was necessary that its own resources venture capital activity not be undermined by a lack of resources. Therefore, a new limit for venture capital operations was set at 50% of EIF's own resources. In order to have a meaningful impact, the EIF, besides executing the mandates, needs to utilise its own resources so as to underline its commitment and highlight credibility. Indeed, individual investments by EIF's own resources should also be pursued in order to better respond to unpredictable market developments.

The Strategic Evaluation of Financial Assistance Schemes to SMEs of December 2003[11] which was carried out on behalf of DG BUDG, noted that the EIF has become a substantial force in the European venture capital market and has played the role of cornerstone investor in many new funds, particularly in the early stage and technology segments of the market. The added value comes from its ability to distribute substantial amounts of mainly public sector money in a commercial manner. Furthermore, the report concluded that the EIF is generally well-respected and appreciated for its professional service and for its relative proximity to the market. Having its own legal personality and operational independence the EIF is fully accepted as a market player by the private sector, which is essential if it is to play its role as a “cornerstone” investor in many European financing vehicles.

The external evaluation[12] conducted on behalf of DG Enterprise and Industry noted that EIF's professional standards were highly praised by financial intermediaries which use Community funds under the ETF Start-up Facility or the SME Guarantee Facility. The evaluation concluded that both facilities are implemented efficiently through the “chain” consisting of Commission services and the EIF. A key advantage is that the EIF does not have to follow a “one-size-fits-all” approach: it can adapt its financial products to different and evolving market conditions.

M ONITORING AND EVALUATION

9. Monitoring

The EIF's Annual Report and the Activity Report of the Audit Board will continue to be submitted to the Council as foreseen in Council Decision 1994/EC/375 and this should be restated in the new proposal. Furthermore, the new proposal should foresee that these documents, when they have been approved by the GM, are submitted directly by the EIF to the European Parliament and the Council.

10. Evaluation

An evaluation of EIF's activities funded by its own resources will be carried out by 2012.

ACHIEVING COST-EFFECTIVENESS

The Commission is proposing that the Community purchases up to 300 new EIF shares during the period 2007-2010. The commitments and payments would be made in four tranches. It is envisaged that a first tranche would be released as soon as appropriate after the Council has adopted the proposal, and the EIF's GM has approved the capital increase. The share price is a function of the net asset value of the EIF; hence the price is variable over time. In order to take into account any price uncertainties and to maintain the Community shareholding targeting 30% by 2010, the Commission also proposes to use all the dividends received during the period 2007-2010 to cover part of the costs of the capital increase.

The capital increase will be financed from commitment appropriations in 2007, 2008, 2009 and 2010 under budget line 01 04 09 (European Investment Fund) with payments starting in spring 2007. The amount allocated under the budget line to cover the expenditure of the capital increase amounts to EUR 100 million. The indicative amount of dividends that may possibly be earned during this period is estimated to around EUR 20 million. The maximum Community participation will thus not exceed the amount of EUR 100 million and the amount of dividends earned during this period.

This action will not involve an increase in the number of Commission staff.

[1] European Recovery Programme

[2] COM(2005) 551 Communication from the Commission on Implementing the Community Lisbon programme 'Modern SME policy for growth and employment'.

[3] Flash Eurobarometer 174 survey, September 2005 states that 14% of the 23 million SMEs registered in the EU encounter still difficulties in accessing debt finance.

[4] Final report of the working group on venture capital, US Department of Commerce, International Trade Administration; and European Commission, Directorate-General for Enterprise and Industry, October 2005.

[5] Directorate-General Economic and Financial Affairs, "Profitability of venture capital investment in Europe and the United States ", Economic Paper No. 245.

[6] BEST Report to the Commission by an Independent Expert Group on Guarantees and Mutual Guarantees, January 2005.

[7] The overall commitment for guarantee operations may not exceed three times the amount of subscribed capital. For equity participations the amount shall be decided by the General Meeting. Currently, the venture capital commitments shall not exceed 50% of EIF's own resources.

[8] "Employment contribution of private equity and venture capital in Europe", European Venture Capital Association EVCA, 11/2005.

[9] Bank for International Settlements in Basel.

[10] COM(2001) 405 of 18 July 2001.

[11] This evaluation covered the Community financial instruments, EIB global loans and EIF own resources venture capital and guarantee activity.

[12] External evaluation of the multiannual programme for enterprise and entrepreneurship, and in particular for small and mediumsized enterprises (SMEs) 2001-2005.