EN Official Journal of the European Union C 100/15

Opinion of the European Economic and Social Committee on the Communication from the Commission to the Council, the European Parliament, the European Economic and Social Committee and the Committee of the Regions Removing obstacles to cross-border investments by venture capital funds

COM(2007) 853 final

2009/C 100/03

On 21 December 2007 the European Commission decided to consult the European Economic and Social Committee, under Article 262 of the Treaty establishing the European Community, on the

Communication from the Commission to the Council, the European Parliament, the European Economic and Social Committee and the Committee of the Regions Removing obstacles to cross-border investments by venture capital funds

The Section for the Single Market, Production and Consumption, which was responsible for preparing the Committee's work on the subject, adopted its opinion on 1 October 2008. The rapporteur was Mr MORGAN and the co-rapporteur was Mr DERRUINE.

At its 448th plenary session, held on 21, 22 and 23 October 2008 (meeting of 22 October), the European Economic and Social Committee adopted the following opinion unanimously.

1. Conclusions and recommendations

1.1. The Communication from the Commission brings together two important strands of the Lisbon Programme. One is the focus on the formation and growth of innovative small companies. The other is the integration of EU capital markets as a means of financing employment and productivity growth. The catalyst for the convergence of these two policies is the need to develop a pan EU venture capital industry.

1.2. This Communication represents work in progress. Close cooperation will be needed between Member States, the European Commission and the VC industry to implement the next steps detailed in paragraph 3.6. Following this work, the Commission will report again in 2009.

1.3. The availability of venture capital is not a universal panacea. VCs are interested in big deals because a small deal can be as time consuming as a big deal. Accordingly they tend to be more interested in providing funds for the expansion of growing companies rather than providing seed money for start ups. Insofar as VCs deal with seed, start up and expansion capital, they are an important element of the Lisbon strategy and the EESC supports this initiative from the Commission. It is important to improve access to venture capital in those Member States where it is less developed.

1.4. It is vital for the VCs that they be able to liquidate their investments. To do this they must find either a trade buyer, i.e. a larger company, or alternatively sell the company to investors via a stock market listing. Looking at the EU as a whole, it is a problem that there is not enough appetite for investing in small young companies. The EESC recommends that Member States use the taxation system to create incentives for private individuals to invest in small companies. This will then encourage the development of stock markets in which small company shares can be traded. For the time being the only such markets in the EU are the Alternative Investment Market (AIM) in London and the Entry Standard of Deutsche Börse, although there is now an initiative from Euronext.

1.5. Because AIM provides the ideal transition from unquoted to quoted status, it makes venture capital investment in unquoted companies very attractive. AIM provides the VC firms in the UK with the exits they need. Something like AIM in other Member States would provide an exchange in which to raise capital for SMEs and make a market in their shares. It could be an important factor for the development of Venture Capital in hitherto undeveloped EU markets.

1.6. While Venture Capital is necessarily focussed on stock market exits, it should not be assumed that a stock market flotation is the best exit for every small company. Public companies have the benefit of equity capital and their shares provide an acquisition currency, but in exchange they lose a certain freedom of action, particularly in the long term perspective, because of the demands of the market. Accordingly, Venture Capital does not provide a sensible way forward for every small company. Where an SME which is already supported by a VC is not well adapted to an IPO, Replacement Capital can provide an alternative.

1.7. Venture capital will not meet all the demand for start-up capital because VC firms will only invest selectively in early stage businesses. To help fill this gap, publicly funded venture capital providers can play their part but this, in turn, will still leave a gap to be filled by families and friends of the entrepreneur and by business angels. The requirement to encourage the provision of start up capital is a second reason why the EESC commends to the Commission and to Member States the provision of tax incentives for private investment in start-up businesses.

1.8. As is explained in Section 2 (Definitions), venture capital is technically a subset of private equity. The EESC is insistent that the removal of obstacles to cross border activities of VCs should not facilitate without proper safeguards, other private equity activities such as leveraged buy outs.

1.9. In a previous opinion (1) the EESC has already stated its concern about the potential threat posed to employment (quality of jobs included) by private equity transactions. It is essential that any such transactions are conducted within the negotiating framework agreed with social partners in each Member State. Accordingly the EESC asks the Commission, in the context of this venture capital initiative, to ensure that social dialogue continues to prevail and that the Directive on information and consultation of workers applies in those cases. Further, the EESC urges again the Commission to submit a proposal in order to update the ‘Acquired Rights’ Directive in the way that transfers of undertakings resulting from operations to transfer the shares are also covered (2).

1.10. This concern is of paramount importance since ‘the most common exit route is trade sales to another corporation, accounting for 39 % of all exits. The second most common exit route is secondary buyouts (24 %), which have increased in importance over the last decade consistent with anecdotal evidence’ (3).

2. Definitions

2.1. The Communication from the Commission is supported by a Working Document. The Document contains an extensive glossary. The following are some of the key terms in the language of Venture Capital.

2.2. There are six generally recognised investment formats used in the VC industry:

— Seed capital is financing provided to study, assess and develop an initial concept.

— Start-up capital is provided to companies for product development and initial marketing.

— Expansion capital provides the financing for the growth of a firm.

— Replacement capital involves the purchase of shares in an existing company from another private equity investor or shareholder.

— A buy-out involves the purchase of all or part of a firm from existing shareholders. This may involve taking a company from quoted to unquoted status, i.e. taking it private. In a management buy-out the current managers are the buyers, usually with the support of private equity or venture capital.

2.3. Venture Capital describes investment in unquoted companies (i.e. companies not listed on a stock exchange) by venture capital firms which, acting as principals, manage individual, institutional or in-house money. The main financing stages are early stage (covering seed capital and start-up), and expansion. Venture capital is thus professional equity co-invested with the entrepreneur to fund an early stage or expansion venture. Offsetting the high risk the investor takes is the expectation of higher than average returns on investment.

2.4. Strictly defined, venture capital is a subset of Private Equity. Private equity firms may engage in venture capital activities but their scope goes beyond the venture capital subset to include the provision of replacement capital and the financing of buy-outs. The EESC is concerned about the potential social impact of these private equity activities.

2.5. Business angels are wealthy private individuals who invest directly in new or growing unquoted businesses. Their capital can complement the venture capital industry by providing early stage finance.

2.6. Institutional investors are financial institutions such as insurance companies, pension funds, banks and investment companies which collect savings from (usually) private investors and then invest them in the financial markets. They have substantial assets and are experienced investors.

2.7. Private placement is a sales method for financial investments allowing the buyer and seller to conclude a transaction subject to an exemption from many or all of the statutory requirements that would apply in the event of a public share offering. Private placement regimes generally specify criteria for entities which are eligible to conclude transactions under these conditions. This regime typically applies to investments made by institutional investors (which are, by definition, knowledgeable) into funds managed by venture capital firms.

2.8. The prudent person rule allows pension funds to include private equity/venture capital funds in their portfolio of investments, while respecting the risk profile of their clients. In other words, the pension manager is obliged to invest for his clients as he would do on his own behalf. This would involve sensible portfolio diversification when venture capital is included.

3. Gist of the Communication from the Commission

3.1. According to data of the European Venture Capital and Private Equity Association (EVCA), venture capital contributes significantly to job creation. Companies in the EU receiving private equity and venture capital created one million new jobs between 2000 and 2004. Over 60 % of these jobs were created by venture capital backed companies and employment in these companies grew by 30 % per annum. In addition, innovative and growth oriented firms backed by venture capital spend on average 45 % of their total expenses on R&D. (The EESC is concerned that the Commission has not been able to find independent data sources to verify this analysis. We comment further in paragraphs 4.10 and 4.11 below.)

3.2. The potential of EU venture capital markets is not fully exploited and markets do not provide sufficient capital to innovative SMEs at early growth stages. The lack of an equity investment culture, informational problems, fragmented market, high costs, untapped synergies between firms and the academic world are among the main reasons for this market failure. Divergent national policies create significant market fragmentation which affects adversely both fundraising and investing in the EU.

3.3. While public authorities can go some way to support the financing of innovation, the scale of the global challenge means that only increased investment by private investors can provide a long term solution. For this, the Commission and the Member States have to act to improve the framework conditions for venture capital and one of these conditions involves removing unjustified barriers to cross border operations.

3.4. The strategy for improving cross border conditions involves free movement of capital, improved conditions for fund raising, improving the regulatory framework, reducing tax discrepancies and progressing with mutual recognition.

3.5. The glossary and expert group report which accompanies the Communication contains an analysis of the problems and possible solutions (see Table I).

Table I

Problem Possible solution Fund raising and distribution (between investors and VC funds) Different national standards to determine qualified investors in private equity — VC (institutional versus private investors) Common EU definition for a qualified investor (for institutional and private investors) Different national regimes concerning where institutional investors can invest (country-specific restrictions) Using a prudent person rule (implementation of the prudent person rule as defined by the pension fund Directive 2003/41/EC) Difficulties in marketing private equity and VC funds in different Member States due to different national approaches to private placement/exemptions from public offer rules Common EU approach to ‘private placements’ Tax neutrality (between VC funds and the country of investment) Complex fund structures depending on investors’ home countries and investee company countries (aiming at avoiding double taxation) Taxation of capital gains in the home country of the investors; equal treatment of direct investors and PE investors; equal treatment of quoted and unquoted equity Different rules and requirements for private equity funds to benefit from tax treaties Tax transparency: list of mutually recognised PE fund structures (or common criteria for Member States to determine tax transparency); Tax neutrality: PE funds established as limited companies (not transparent) should benefit from double taxation treaties; common requirements for benefiting from these treaties Professional standards (for VC funds) Different local rules for valuation and reporting (increased costs and a lack of comparability) Encouraging use of industry self-imposed professional standards (i.e. those of EVCA) Problems in applying IFRS (International financial reporting standards) to PE funds: in particular the consolidation requirement Permanent establishment (for the general partner or fund manager) Risk of the general partner (VC management company) to have permanent establishment in the investee company country (resulting in adverse tax consequences) — Mutual recognition of management companies; or passport for management companies; — in the long term, a ‘passport’ for a management company

3.6. In response the Commission has put forward the following next steps and recommendations:

3.6.1. To improve fundraising and investing across borders, the Commission will:

(a) analyse national approaches and barriers to cross border private placement. A report on the possibilities for establishing a European private placement regime will be issued in the first half of 2008 (now delayed to Q3 2008);

(b) identify, together with experts from Member States, cases of double taxation and other direct tax obstacles to cross-border venture capital investments; the expert group will report by the end of 2008;

(c) analyse, based on these reports, the possibilities of defining common features in order to move towards an EU-wide framework for venture capital;

(d) study possible ways of assisting Member States in the process of Mutual recognition.

3.6.2. To reduce market fragmentation and improve conditions for venture capital fundraising and investing, the Commission invites Member States to:

(a) extend, where it is not yet the case, the ‘prudent person rule’ to other types of institutional investors, including pension funds;

(b) create a common understanding of the features of venture capital funds and qualified investors and consider a mutual recognition of the national frameworks;

(c) overcome regulatory and tax obstacles by reviewing existing legislation or by adopting new laws;

(d) enable cooperation and mutually acceptable levels of supervision and transparency;

(e) encourage development of competitive clusters (along the lines of science parks);

(f) promote liquid exit markets.

4. General remarks

4.1. Outside observers of the venture capital industry tend to focus is on VCs as providers of investment capital whereas the VCs themselves are as much concerned about raising funds as they are about investing them. Accordingly the integration of venture capital financing across the EU must facilitate investments into VC funds as well as disbursements from them.

4.2. Because the venture capital industry depends on delivering good returns to its investors, the modus operandi is to raise a fund, invest the fund and then in due course liquidate the investments of the fund to deliver the expected return to the fund's investors. The life of each fund would typically be seven years.

4.3. It is vital for the VCs that they be able to liquidate their investments. To do this they must find either a trade buyer, i.e. a larger company, or alternatively sell the company to investors via a stock market listing. Looking at the EU as a whole, it is a problem that there is not enough appetite for investing in small young companies. The EESC recommends that Member States use the taxation system to create incentives for private individuals to invest in small companies. This will then encourage the development of stock markets in which small company shares could be traded. For the time being the only such markets in the EU are the Alternative Investment Market (AIM) in London and the Entry Standard of Deutsche Börse, although there is now an initiative from Euronext.

4.4. The availability of venture capital is not a universal panacea. VCs are interested in big deals because a small deal can be as time consuming as a big deal. Accordingly they tend to be more interested in providing funds for the expansion of growing companies rather than providing seed money for startups. A case in point is 3I, the long established UK venture capital firm. It announced at the end of March 2008 that it was pulling out of early stage investments — its worst performing sector since the collapse of the dotcom bubble in 2000. Its exposure to venture capital assets had already reduced significantly with start-up investments representing only a tenth of its portfolio — down from half in 2000. 3I stated that there was more value in later-stage financing and that the group will focus on buy-outs, growth capital and infrastructure.

4.5. Venture capital will not meet all the need for start-up capital because VC firms will only invest selectively in early stage businesses. To help fill this gap, publicly funded venture capital providers can play their part but this in turn will still leave a gap to be filled by families and friends of the entrepreneur and by business angels. The requirement to encourage the provision of start-up capital is a second reason why the EESC commends to the Commission and to Member States the provision of tax incentives for private investment in start-up businesses such as those provided by the UK Enterprise Investment Scheme. In this scheme, capital invested attracts income tax relief while capital gains from the venture are free of tax. These tax incentives make the risk reward ratio rather favourable for private individuals who invest in early stage companies.

4.6. In the UK scheme, similar incentives apply to investments by private individuals into collective investment funds which take stakes in small new companies quoted on the AIM market. These funds are known as Venture Capital Trusts. Investments attract income tax relief and the capital invested is free of both gains tax and inheritance tax.

4.7. Similar incentives apply to private individuals who make direct investments into any companies listed on the AIM market. The existence of the AIM market and the tax reliefs associated with it have provided a significant impetus to company formation in the UK.

4.8. AIM specialises in initial public offerings (IPOs) of shares in small new companies. This makes venture capital investment in unquoted companies very attractive in the UK because by such IPOs AIM provides the VC firms with the exits they need. Development of facilities like AIM in other Member States, serving either single or multi-country markets, would provide exchanges in which to raise capital for SMEs and make a market in their shares. It could be an important factor for the development of Venture Capital in hitherto undeveloped EU markets.

4.9. The EESC is very aware that demand for venture capital needs to be created to provide the opportunity for the VC industry to flourish. This, in turn means that company formation must increase across the EU, with a commensurate increase in enterprise and innovation. The EESC simply registers this concern. It is not the purpose of this opinion to discuss aspects of enterprise and innovation except to repeat the point that if tax incentives are made available, there will be an upsurge in small company formation.

4.10. While the EESC is supportive of the proposals to facilitate VC activities across borders, it regrets that there is no reliable and impartial data available as the basis for its assessment. Indeed, independent studies suggest caution in this context given the ‘failure to distinguish cleanly between employment changes at firms backed by venture capital and firms backed by other forms of private equity’ (4).

4.11. In a previous opinion (5) the EESC has already stated its concern about the potential threat posed to employment (quality of jobs included) by private equity transactions. Private-equity backed companies create about 10 % less jobs than similar companies in the wake of the buy out (5 years) (6). Further, it is essential that any such transactions are conducted within the negotiating framework agreed with social partners in each Member State. Accordingly the EESC asks the Commission, in the context of this venture capital initiative, to ensure that social dialogue continues to prevail and that the Directive on information and consultation of workers applies in those cases. Further, the EESC urges again the Commission to submit a proposal in order to update the ‘Acquired Rights’ Directive in the way that transfers of undertakings resulting from operations to transfer the shares are also covered (7).

5. Specific comments on the proposals of the Commission

5.1. It is important to develop statistical instruments that will give a better picture of the hedge fund and private equity industries and to develop indicators for corporate governance, all of which are subject to harmonisation, at least at European level (8).

Commission proposals to improve fund raising and investing across borders

5.2. The establishment of a European Private Placement regime is fully supported by the EESC. It is a fundamental requirement of cross border venture capital.

5.3. The barrier of double taxation must be removed. Otherwise, cross border venture capital will not be sufficiently profitable for VC firms to get involved. The EESC awaits with interest the report from the working party set up by the Commission to consider the taxation issues.

5.4. The concept of a European wide framework for venture capital is attractive if it results in Member States accepting VC firms regulated by other states. This will help mutual recognition and facilitate cross border activities by VCs without excessive bureaucracy. However, recalling the importance of coordinating fiscal policy more closely, the Committee deems it necessary to set minimum requirements concerning the taxation of the funds’ managers in order to avoid fiscal dumping and economic inefficiency.

Proposals for Member State actions to reduce market fragmentation and improve conditions for venture capital fundraising and investment

5.5. Extending the Prudent Person rule is a fundamental requirement for fund raising because the investing institutions are the primary source of funds. It is important that Member States create regulatory frameworks which will facilitate prudent participation in venture capital funds by investing institutions, especially pension funds.

5.6. Member State cooperation in work on regulation and mutual recognition is needed for the Commission's initiatives to proceed.

5.7. The idea of competitive clusters relates to policies in support of enterprise and innovation. The idea is that clusters of innovative firms would be spun out of and co-located with universities. Such developments are very attractive to VCs.

5.8. The issues relating to liquid exit markets are discussed in Section 4 above.

Brussels, 22 October 2008. The President of the European Economic and Social Committee Mario SEPI

(1) OJ C 10, of 15.1.2008, p. 96.

(2) Directive 2001/23/EC of the Council of 12 March 2001 relating to the safeguarding of employees’ rights in the event of transfers of undertakings, businesses or parts of undertakings or businesses, OJ L 82, 22.3.2001, pp. 16-20.

(3) Globalisation of Alternative Investment: the global economic impact of private equity (p. viii), study published by the World Economic Forum, 2008.

(4) WEF, p. 43.

(5) OJ C 10, of 15.1.2008, p. 96.

(6) WEF, p. 54.

(7) Directive 2001/23/EC of the Council of 12 March 2001 relating to the safeguarding of employees’ rights in the event of transfers of undertakings, businesses or parts of undertakings or businesses, OJ L 8, 22.3.2001, pp. 16-20.

(8) OJ C 10 of 15.1.2008, p. 96.