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Seed and early stage equity capital in short supply Back  
The financing environment is a continuing source of competitive disadvantage for Ireland writes William Beausang
T he National Competitiveness Council’s Annual Competitiveness Report (ACR) published last May concluded that there were several weaknesses in the financing of the business sector and in particular small and medium enterprises (SMEs) in the Irish economy. The report emphasises that notwithstanding some significant improvements in the financing environment for enterprise in recent years these weaknesses continue to constitute a clear source of competitive disadvantage to the economy particularly in the context of accelerated economic integration in EMU. The main issues identified in the ACR were:

l problems in the provision of finance by banks in Ireland
l high lending margins for SMEs
l a lack of competition in the provision of banking services
l the absence of long-term fixed rate lending
l gaps in the provision of seed and venture capital investment available to start-ups and emerging firms
l the absence of specialised public/private financing mechanisms such as mutual guarantee and refinancing schemes, available to SMEs in other European countries, places them at a competitive advantage vis-?-vis Irish SMEs
l the convergence of capital markets within the eurozone may impede Irish SMEs in accessing equity finance

High interest rate margins for SMEs

That high interest rate margins continue as a fact of life for Irish SMEs is clearcut. Both the ACR and the Council’s Report on Costs published in June highlighted the significant premium (between four and seven percentage points) on lending rates to smaller businesses over wholesale rates. Indeed in 1997 (the latest year for which internationally comparable data was available for the ACR) the gap between the lending rate for small business and the rate paid by banks on demand deposits was in the bottom quartile of 21 advanced economies. This was not a cyclical aberration reflecting the tight stance of monetary policy maintained by the Central Bank right up to Ireland’s entry into EMU but rather a long-established pattern that has seen Ireland languishing on the bottom rungs of the EU league table at least since the late 1980s.

Successful trade diversification into euro area requires competitive provision of finance
Irish business is benefiting significantly from the current configuration of very low nominal interest rates in the euro area and relatively high Irish inflation (by EU standards) resulting in exceptionally low real interest rates for Irish business given the continuing buoyant state of the economy. However, to date the benefits of low interest rates have been skewed towards larger corporate borrowers. As international interest rates begin to edge upwards it is essential that Irish SMEs be able to avail of bank finance on similar terms as their eurozone competitors, particularly given the likely intensification of competition for Irish business within the Single European Market. Competitive financing is essential to ensure that Irish SMEs are equipped to diversify into core eurozone markets in line with market opportunities - a major strategic need for the Irish economy.

More competitive provision of banking services essential

This points strongly to the requirement for a more competitive banking system with the capacity to provide long-term loans to SMEs at competitive fixed rates of interest in place of a high dependence on overdrafts and short-term loans at variable rates of interest that are close to those charged to personal borrowers.

It can be argued that specialised financing mechanisms available to small business in other continental European countries including long-term fixed rate lending and public/private mutual guarantee and refinancing schemes reflect complex differences in structural and institutional characteristics of national banking systems. However the basic purpose of international benchmarking as undertaken in the ACR is to identify ‘best practice’ internationally and highlight the contribution its adoption could make to Ireland’s competitiveness.

EMU could accentuate financing constraints for business

The ACR argued that as a result of increased integration of European capital markets in EMU, enterprise in a small, peripheral eurozone economy such as Ireland might become disadvantaged in accessing financial resources. This possibility was flagged in the 1996 ESRI study Economic Implications for Ireland of EMU. The report highlighted the risk of a rise in the cost of equity capital for the SME sector notwithstanding the prospect of increased portfolio diversification within the euro area given thin trading volumes and relatively high levels of stock specific risk in Ireland.

Irish investors diversifying abroad

There is an evident threat that the entrenched national pattern where
stock market turnover is dominated by a small number of high quality and highly liquid stocks will be replicated at euro zone level. This would be to the detriment of prospects for plugging
the “equity gap” in the economy.

On the supply side institutional investors in Ireland are estimated to have reduced the proportion of their assets invested in Ireland from almost three quarters in 1989 to just over 60
per cent in 1997. The elimination of exchange rate risk within the euro area has accelerated that process as Irish investors’ home country bias continues to dissipate.

Prospective trends in international diversification uncertain

However, on the supply side indications are that equity market
pan-Europeanism is not necessarily to work to our advantage at least in the immediate future. Recent developments have highlighted the likely influence of dominant blue chip indices in an environment of passive index based asset management.

Most large Irish companies are not sufficiently large to merit inclusions in European indices. The longer-term picture is more difficult to discern. Recent analysis of longer-term prospects for European shares has drawn attention to the positive prospects for Irish equities given the lower real interest rates in more rapidly growing (higher inflation) economies under the “one-size fits all” monetary policy in the euro zone. However, given the sensitivity of foreign investors to concerns regarding overheating, the prospect for a gradual convergence of Ireland’s inflation (and ultimately growth) performance towards the euro average (under the consensus ‘soft-landing’ scenario for the economy) and the blue chip preference of risk adverse investors, the future significance of this effect for Ireland is open to question.

Irish stock market must re-position itself to serve niche function
EMU is likely to accelerate the competition, consolidation and technological innovation that have characterised equity markets in recent years.

However although diversity of regulation and tax systems across member states is likely to delay the full integration of national exchanges in the longer-term, according to the experts, the future of national exchanges lies in specialising in trading low capitalisation companies. However, if the Irish stock market has not been particularly effective in performing this role in the past, why should it be more successful in the future?

Good progress in provision of venture capital but gaps remain Ireland’s venture capital market is reasonably strong by European standards - ranked 5th of 17 European countries in 1997 in terms of its size relative to GNP - but it lags well behind the world leaders such as the US and the UK. Cumulative venture capital funds raised amounted to ?477m in 1997. According to the Irish Venture Capital Association, Irish venture capital funds are currently in the process of raising a further ?200m

However, in common with many other European countries there are significant gaps in Ireland in the provision of venture capital at seed, start-up and early stage development. In 1997 for example - as can be seen from the table below taken from the ACR - there was no seed capital and little start-up venture capital investment in Ireland as compared to the US figure of almost
20 per cent for those categories. The figure for Europe overall was just 7.4 per cent.

In the UK pension funds accounted for one-third of venture capital funds raised, in Ireland the figure was less than 7 per cent with Government agencies accounting for 36 per cent. This high level of state involvement is in sharp contrast to the situation in countries such as the UK, the Netherlands and US where the venture capital market is considerably better established.

There has been encouraging progress more recently in Ireland in the provision of seed capital and venture capital financing to smaller enterprises under the current EU Operational Programme for Industry. This is providing sixteen different funds with some ?66m available for investment in smaller emerging firms through venture capital intermediaries. At the end of December 1998 these funds had made 44 investments amounting to ?16.5m in 39 companies. A high proportion (over 55 per cent) of the funds invested have been in start-up and early stage companies in particular in the high-technology area.

However, in view of the pervasive barriers to small-scale institutional investment there is a strong case for continuing Government intervention. This should continue to be undertaken in partnership with the private sector to address the shortage at the seed and early stage equity capital to fund the start-up and development of emerging companies with strong growth potential particularly in high-risk high-technology sectors such as biotechnology and e-commerce. Indeed, the ESRI in its recent report on investment priorities under the next National Development Plan recommended the provision of increased resources to improve the access for early stage companies to long-term capital in addition to significant changes in the delivery of those resources.

Competitive provision of finance will support competitiveness

The strong sales, employment and profitability performance of the indigenous enterprise has been an encouraging feature of Ireland’s economic performance over the 1990s. The growth and development of Irish SMEs to an internationally competitive scale must be the linchpin of Ireland’s economic development strategy for the future. The competitive provision of long-term finance to enterprises consistent with their changing needs at each step in their development has a central role to play in facilitating this objective.

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