“Europe 2020 and Varieties of European Capitalism: Complementary or Contradictory.” Presented at the Annual Meeting of the American Political Science Association, Seattle, WA, Sept 1-4, 2011.
Richard Deeg Temple University Philadelphia, PA 19122
[email protected]
Abstract: A central ambition of the Lisbon Agenda and Europe 2020 is promoting greater innovation in Europe. This paper investigates three questions: How have EU efforts to foster innovation affected innovation finance? How has European financial market integration affected innovation finance? And, are some kinds of capitalist (innovation) systems favored by financial market integration and EU policies? We find is that, overall, there has not been a clearly sustained increased in R&D spending by governments or firms in Europe. National capitalisms and their innovation systems have nonetheless changed in important ways, one of which is the emergence of strong segments for radical innovation and finance in some coordinated market economies. But rather than finding convergence across national capitalisms and innovation systems, we find increased diversity within national economies and blurring across national boundaries.
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1. Introduction A central ambition of the Lisbon Agenda and Europe 2020 is promoting greater innovation in Europe. Innovation is viewed as a central mechanism for raising European competitiveness and long-term economic growth that, in turn, should help Europe achieve the complementary goals of green and equitable growth. In the Europe 2020 Strategy, this ambition is captured in the Innovation Union concept. As reflected in the broad goals and initiatives in the Innovation Union, there are many factors that lead to successful innovation, not least of which is financing of R&D and entrepreneurship. But how have EU efforts to foster innovation affected innovation finance? More importantly, how has European financial market integration affected innovation finance? The headline goal of Lisbon and Europe 2020 has been to achieve investment in R&D across Europe equal to 3 per cent of GDP. While close to half of R&D spending in Europe comes from governments, achieving and sustaining this target relies primarily on decisions by firms to invest in R&D and, equally important, the willingness of investors – whether shareholders, bondholders or bankers – to finance that R&D. Thus to succeed, Lisbon and Europe 2020 must increase willingness of both firm managers and their financiers to invest more risk-oriented capital in innovation projects. Has this happened? The answer to this is ‘yes’ and ‘no.’ On one hand, European financial market integration stimulated the expansion of riskoriented investors such as private equity funds and venture capital that have become more prominent in many European countries. And one can certainly point to many innovation successes financed by such firms. On the other hand, financial market integration in Europe is
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associated by many scholars with the rise of ‘shareholder value’ (SV) ideology in financial markets and corporate governance over the past fifteen years. One implication of a shareholder value approach to firm management is that firm owners and managers focus more on short-term profitability. This, in turn, raises questions about the willingness of firm managers and investors to finance innovation projects that are inherently uncertain in their payoffs and require a longterm focus in order to be realized. Thus, EU efforts to foster innovation appear to have possibly contradictory effects; arguably promoting some kind of innovations (or innovative firms) but possibly stifling others. Another way to think about these questions is through the varieties of capitalism lens. In this paradigm, Europe is characterized by several ‘varieties’ or national systems of capitalism, reflecting distinct configurations of institutions regulating firms, financial markets, labor markets, and the like. One of the principle tenets of the varieties of capitalism (VoC) paradigm is that distinct institutional configurations produce comparative advantage in different patterns of innovation – radical versus incremental. Radical innovation entails more dramatic leaps in technology or processes, often signified by the short-hand of ‘high-tech.’ A number of scholars in the VoC paradigm argue that radical innovation is best supported in so-called liberal market economies because they, inter alia, support greater amounts of risk-oriented capital. Incremental innovation, marked by more modest but continual improvement in products, services and processes, is associated with coordinated market economies. One question that follows is whether European financial market integration has fostered both kinds of innovations and, by extension, the competitiveness of both LMEs and CMEs within Europe? How the Lisbon Agenda would affect these innovation patterns was not clear a priori. On one hand, because Lisbon rested on Member States defining specific programs within the 3
broader goals set by Lisbon, Member States can be expected to have devised programs consistent with national patterns and strengths in innovation. On the other hand, Lisbon aimed to create a broadly competitive Europe based on deeper integration, and the Commission advanced proposals that potentially favored certain institutional configurations over others. If the first situation prevailed, then one might argue that Lisbon enhanced (or did not alter) the distinct varieties of capitalism in Europe by reinforcing existing patterns of innovation finance found in Member States. If the second situation prevailed, then Lisbon and integration processes may have eroded distinctions among different national patterns or (inadvertently) favored some varieties of capitalism over others. A number of scholars have suggested that European integration is eroding the institutional foundations of CMEs (Höpner and Schäfer 2007; Callaghan and Höpner 2005), which potentially threatens their ability to compete based on incremental innovation. The evidence suggests that Lisbon Agenda initiatives per se had little direct impact, and Europe 2020, given its similar character, is likely to produce the same (non-) results. However, behind the headline symbolism of Lisbon and Europe 2020 lie real processes of financial market integration and change which have had substantial effects, including the expansion of riskoriented capital across Europe, but also the growth of institutional investors who may affect innovation decisions. In general what we find is that, overall, there has not been a clearly sustained increased in R&D spending by governments or firms in Europe. National capitalisms and their innovation systems have nonetheless changed in important ways, one of which is the emergence of strong segments for radical innovation and finance in some coordinated market economies. But rather than finding convergence across national capitalisms and innovation systems, we find increased diversity within national economies and blurring across national 4
boundaries (as capital now moves much more freely across Europe). Increasing the diversity of innovation financing modalities available to firms may, in fact, be a good long-run path to increasing innovation in Europe. If that is true, then the Europe 2020 decade may well see more marked progress toward this goal than the Lisbon decade. The next section of the paper briefly lays out the theoretical connections between financial systems, corporate governance and innovation by firms. The third section summarizes key EU efforts to promote financial market integration and innovation. The fourth section will provide empirical material on changes in risk-oriented finance, corporate governance, and innovation in Europe. The final section returns to the more general questions posed and explores some practical and theoretical implications of the findings.
2. The Linkages between Corporate Governance, Finance and Innovation. Over the past two decades a literature has developed around the concept of national innovation systems (Lundvall, B-A, 1992; Nelson, R.R, 1993). There are two essential premises contained within this analytical framework: First, that a significant number of institutions shape each country’s extent and patterns of innovation, these include not only the basic scientific system (who conducts R&D and how), but also the education system, labor markets, industrial relations and financial systems. Second, each country’s institutional solution to overcoming the key barriers to successful innovation is distinctive (though similar patterns can be identified across nations). These key institutions can vary not only by country, but by sub-national region and economic sector. The financial system is important to innovation through its capital allocation function – which projects get funded and under what conditions? Financing 5
innovation is riskier than financing other business activities because outcomes are uncertain, payback is usually long-term, and the technical nature of innovation often means there is high information asymmetry between the financier and innovator (the latter’s greater knowledge gives them a much better sense of a projects’ riskiness and potential profitability). Firms can finance innovation through external sources of capital – bank loans or equity investments (either via private equity or stock markets). In such cases financiers have direct effects on innovation decisions by firms and various institutional solutions can be employed to overcome information asymmetries. The alternative to external finance is internal finance. Indeed, most firm-based R&D is financed by firms’ own cash reserves. But even in this case the influence of financial markets may be significant. If shareholder value, for example, has become the leitmotif in corporate governance, firm managers may be more constrained by financial market considerations (maintaining profitability, cash-flow targets, etc) and thus less willing to engage in long-term R&D projects. The literature on national innovation systems can be nicely linked with the varieties of capitalism literature, suggesting we can usefully think about two generic forms of innovation systems which coincide with the radical versus incremental innovation distinction (HirschKreinsen 2010; Tylecote and Visintin 2008). Incremental innovation is the dominant form associated with an institutional framework of ‘insider-domination’ (i.e., coordinated market economies using the VoC appellation). In the ideal-type, these systems are characterized by networked corporate governance, i.e., close, long-term linkages among firms and banks based on industrial cross-ownership, interlocking directorates, and long-term equity linkages. Corporate governance is dominated by a ‘stakeholder approach’ in which managers focus less on maximizing profit and more on long-term growth in revenue and employment which benefits 6
workers. This also gives managers more latitude in using cash flow to finance long-term R&D projects. In these systems innovation is largely financed by internal cash flow but, where external finance is used, bank loans are the primary source of funds. The reliance on banks, with which firms have long terms relations, allows banks to reduce the information asymmetry inherent in innovation through long-term cooperation and monitoring of firms’ innovation projects. External investors thus use ‘participation’ and’ voice’ rather than ‘exit’ to safeguard their investments (see also Deeg 2005). Such investors (again, usually banks) develop sectoral and company-specific expertise that further reduces asymmetries and thus enhances their willingness to finance innovation. This system is geared toward incremental innovation, in part because banks are inherently more risk averse than other forms of investors (e.g., venture capitalists or stock investors) and require higher predictability of innovation outcomes. In contrast, ‘outsider-dominated’ institutional frameworks (liberal market economies in the VoC typology) are associated with greater success in radical innovation (but not necessarily more R&D spending or innovation success). In this case Hirsch-Kreinsen (2010) distinguishes two segments of the finance-innovation system: The first segment is marked by a more armslength relationship between innovating firms and external investors. Rather than banks as the dominant external investors, in this system a wide variety of institutional investors – mutual funds, pension funds, insurance companies, and private equity funds – are active. These investors generally focus on shorter-term return targets and are thus less willing to finance longterm innovation investments with uncertain returns. They prefer to ‘exit’ from investment relationships that are no longer meeting their objectives rather than to exercise voice and participation. For this reason, such investors are generally less interested in developing firmspecific knowledge that would encourage long-term R&D investment. While many private 7
equity firms take a longer-term and more involved role in their innovating firms, their aim is to invest only to the point that maximizes a return on their investment within a specific timeframe. The shorter-term focus of investors and the dominance of shareholder value ideas constrict firm managers in their innovation decisions. Innovation by firms in this segment is therefore focused on projects with more immediate payouts and underinvestment in innovation is predicted (also Lazonick and O’Sullivan 2001). The other segment is the high-tech, risk-oriented system characterized by venture capital. These investment pools specialize in identifying high-risk but potentially highly-profitable innovation investments, with a particular focus on new or young firms. Venture capital is typically a long-term form of investment, with venture capitalists often closely monitoring their invested firms (and frequently getting involved in corporate governance). This segment does bear more resemblance to the insider-dominated systems of CMEs, as venture capitalists establish a close relationship with their innovating companies and rely on voice and participation mechanisms. But this segment still has strong outsider elements in that venture capitalists intend to sell their investments within predetermined time periods and aim for extremely high overall profitability, and this is facilitated by the existence of a strong stock market system. One of the important inferences from the literature on finance, corporate governance and innovation is that there is no one best innovation finance system. Different kinds of technologies and sectors appear to work better with different modes of finance and corporate governance. Consistent with this, the Lisbon Agenda and Innovation Union do not aim to promote any specific kind of innovation, but more innovation of all kinds. Yet though the EU’s financial market integration efforts have not explicitly pursued convergence, there are many who argue that this has been an outcome of integration (Höpner and Schäfer 2007; Lütz 2004; Rajan and 8
Zingales 2003; Streeck 2009). To the extent this may be true, convergence across Europe on a single financial and corporate governance model may enhance some kinds of innovation and innovative firms while hindering others. The next section briefly reviews some of the critical EU efforts at financial integration and some of the core changes in European financial markets.
3. European Market Integration and Changes in Financial Markets While there were some important efforts to integrate European financial markets prior to the Single European Act, integration really took off under the Single Market program. Thus in the late 1980s and early 1990s the cornerstones for advancing financial market integration were laid, most importantly with the 2nd Banking Directive of 1989 which established the allimportant single passport principle (enabling a bank authorized in any Member State to conduct business throughout the EU); the 1989 Solvency Ratio; and, in 1993, the Investment Services Directive and Capital Adequacy Directive. In general these directives provided for a minimum of harmonized prudential regulation and supervision while relying primarily on mutual recognition and the single passport to facilitate the rise of cross-border financial activity. The next activist phase of EU financial integration occurred around the turn of the millennium, marked by the adoption of the Financial Services Action Plan in 1999 – an ambitious legislative agenda to further integration in wholesale and retail banking, as well as further prudential rules and supervision. Following the adoption of the Lisbon Agenda in 2000, it was decided that the process of financial market integration needed to be accelerated through institutional reform as well. Thus, the Lamfalussy procedure was initiated. Lamfalussy made a distinction between framework legislation (done through the usual legislative process using the 9
co-decision procedure) and implementing rules which were delegated to two further levels of intergovernmental committees. Lamfalussy started with securities market rules and then in 2005 moved to banking and insurance as well (Kudrna 2009). By 2005, the Lamfalussy procedure was judged a success, as four major (and numerous minor) financial market directives were adopted under it: Transparency (2004/109/EC); Market Abuse (2003/6/EC); Prospectus (2003/71/EC) and Markets in Financial Instruments (2004/39/EC). The financial crisis of 2008-10 revealed both some of the achievements of the EU’s financial integration ambitions and its shortcomings. The crisis revealed that – as hoped by many – financial markets and financial institutions had become highly integrated in numerous respects and highly interdependent across member states. However, with this integration or interdependence a new level of Europe-wide systemic risk had been created. But this new level of systemic interdependence was not matched by an adequate degree of a centralized capacity to monitor and manage that risk. Thus it was apparent to all that greater financial regulatory coordination and supervision was now necessary to manage this and future crisis. Toward that end, in late 2008 Commission President Barroso formed a committee led by de Larosiére to make recommendations for supervisory reform. This led to a report published in February 2009 and subsequently adopted by EU (Kudrna 2009). To monitor system-wide or macro risks to financial stability, the European Systemic Risk Council (ESRC) was created and managed under the auspices of ECB and chaired by its president. To strengthen coordination and monitoring of micro risks (presented by individual markets or financial institutions), the level three committees of the Lamfalussy procedure were turned into European authorities with formal status, known collectively as the European System of Financial Supervision (ESFS) (also Perez and Westrup 2010). 10
Alongside these extended efforts to integrate financial markets, the EU also increasingly turned to corporate governance legislation. Again in response to the Lisbon Agenda’s goals, the Commission announced in 2003 a plan titled, ‘Modernizing Company Law and Enhancing Corporate Governance in the European Union—A Plan to Move Forward.’ Though the EU had pursued and adopted corporate governance directives in the past, the new Plan represented a stepped-up effort to modernize and harmonize aspects of corporate governance seen as vital to the broader goal of market integration, including financial market integration (and ultimately relevant to innovation financing). The EU’s push for corporate governance reform included both recommendations based on voluntary compliance (codes of best practice) coordinated by the Commission-led European Corporate Governance Forum, as well as formal legislation. In general, the broad aim of corporate governance reform was to increase shareholder control and rights, especially in listed firms. Some of the major directives adopted during this period include the Takeover Directive (2004/25/EC), intended to facilitate cross-border mergers among corporations and restructuring of firms, and the Transparency Directive (2004/109/EC), intended to increase the financial transparency of listed firms vis-à-vis external investors. Perhaps even more consequential was the decision in 2002 to require all listed firms in the EU to use International Accounting Standards (IFS) and International Reporting Standards (IFRS) beginning in 2005. These standards are developed by an independent global body (International Accounting Standards Board) and then subsequently adopted by the EU (often with some modification) and issued as EU Regulations, thus giving them an immediately binding character. The adoption of IAS/IFRS has several consequences; first, it harmonizes to a considerable degree accounting and financial reporting practices across the EU, thus giving investors greater ability to compare the relative financial strength and performance of firms 11
residing in different Member States. Second, the IAS/IFRS generally enhances corporate financial transparency in comparison to prior existing national standards, thus giving investors and stock markets more information – and potential influence – over corporate managers. Third, these standards embody a shift from using historic cost to Fair Value Accounting in how firms book their assets. For some scholars this represents a shift from a ‘producers’ perspective on accounting to a financier’s perspective, i.e., a different paradigm (discourse) for evaluating a firm that adds more pressure on managers to make decisions according to financial criteria, i.e., maximize shareholder value (Nölke and Perry 2007). The potential implications of such a shift for innovation financing and investment were already noted. So what have been the major changes in European finance and corporate governance as a result of integration efforts? Painting with a broad brush, across most of Europe one can see the relative growth in the importance of securities markets (stocks, bonds, derivatives, etc.) for channeling savings into investments. In other words, in many countries banks are less central within the financial system generally, and less important for firm financing (especially for large firms), than in the past. The most vivid representation of this trend is the relative growth of stock market capitalization in many European countries. Across much of Europe, non-bank financial institutions – mutual funds, pension funds, insurance firms, private equity funds – are increasingly important as sources of capital for firms and as owners of corporate shares. These ‘institutional investors’ are more likely to be focused on ‘shareholder value’ principles when making investment decisions. Because most of them follow portfolio diversification strategies, they typically make relatively small investments in any given firm, in other words, they are frequently passive investors who prefer steady, reliable returns and may be less willing to support risky innovation projects. 12
Integration across borders of financial markets is quite extensive in some areas, notably interbank business and wholesale finance, less so in retail banking. Overall, the market share of banks from other EU countries in national bank markets increased from 15 to 20 per cent from 2001 to 2007 (Schäfer 2009). Financial market integration has spurred considerable consolidation among banks in Europe, but mostly within national economies: There have been relatively few major mergers or acquisitions among banks across borders. The notable exception to this are the economies of Central and Eastern Europe, where foreign bank share ranges from fifty to nearly one-hundred percent of total bank sector assets (Schäfer 2009). In corporate governance, there has been considerable change and convergence around formal rules, and ‘shareholder value’ has become a common mantra or ideology in corporate management, especially among large firms (Barker 2009). But in reality the extent to which firms have adopted real shareholder value principles varies considerably, both within and across Member States (Deeg 2009). Market integration also brought out intense competition among financial centers in Europe where each sought to attract more foreign capital and financial service firms, largely through deregulation of markets. Over the past decade numerous new exchanges for securities have opened in Europe (such as the New Market wave of the mid-1990s, which mostly failed), while conventional exchanges have frequently merged in order to achieve the scale economies necessary for competing for global investment capital. The integration of markets in Europe has also led to the concentration of investment banking and hedge funds in London: In 2007, the UK accounted for 64 per cent of the European hedge fund market and one-quarter of European investment banking revenue (IFSL 2008). This reflects in part the fact that the UK financial sector is much more reliant on markets than are continental financial sectors, but also
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the fact that many continental European banks do much of their investment banking activities in London. In sum, looking across Europe one can credibly argue that there has been a shift – of varying degrees, for sure – from banks to markets. In regards to innovation financing, this implies that banks are less important as financiers (via loans and equity stakes) of innovation while markets have become more important. ‘Markets’ in this context means the financiers whose strategies are closely connected to stock markets, i.e., institutional investors, including venture capitalists, private equity, and activist hedge funds. While these financial actors may take longer term ownership stakes in firms, ultimately they are buying and selling their ownership interests primarily via the stock market. More market finance for firms also means that firms are increasingly obligated to meet investor expectations (as well as credit rating agencies’ expectations) for financial transparency and risk-adjusted returns. Several scholars (as well as policymakers) see this shift from (‘conservative’) banks to markets (where there is both a stronger supply and demand for risk-oriented capital, i.e., capital willing to undertake high risk in exchange for the potential of high returns), as an essential requisite for increasing innovation in the European economy (Eichengreen 2006; Rajan and Zingales 2003). This is presumably because ‘markets’ are better than banks at identifying and nurturing promising innovations, but also at quickly abandoning unpromising projects and redirecting resources rapidly toward more promising innovations. But how much has risk-oriented capital in Europe grown, and what effects has the rise of institutional ownership had on business spending on innovation? These questions are pursued in the next section.
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4. Changes in Innovation Finance and Spending in Europe Arguably the boldest ambition of the Lisbon Agenda and Europe 2020 is to raise R&D spending in Europe to three percent of GDP. One advantage of such a goal is that virtually everyone supports it in principle, the other is its clear measurability. During the Lisbon decade there was modest progress at best toward this goal: Figure 1 shows that only two member states actually achieved the three per cent target, and the large majority of them are far from this target. More troubling, for sure, is that these percentages increased very modestly for Europe as a whole, and in several cases declined. At first glance, the picture in Europe does look somewhat promising; from 1995 to 2009, gross R&D spending as a percent of GDP rises from 1.85 to 2.1 per cent for the EU15 (Eurostat). However, virtually all of this increase comes in 2008 and 2009 when GDP declined substantially throughout Europe. Because R&D spending is often committed over long time periods, the rise in R&D ratio is most likely due to declining GDP rather than increased R&D spending (indeed, R&D spending may even have declined in absolute terms): If this is correct, then R&D spending relative to GDP has increased only very marginally since the mid-1990s. If we examine the four largest economies in Europe, which collectively account for the lion’s share of European GDP, we see clearly a lack of progress. Germany looks best, with R&D spending relative to GDP rising from 2.47 per cent in 1991 to 2.82 per cent in 2009; but if we exclude the last two years which show a spike in the data, R&D spending in Germany in 2007 is only slightly higher than in 1991. In Italy, R&D spending in 2009 is virtually the same as it was in 1990. In France, R&D spending as a percent of GDP declines from 2.32 per cent in 1990 to 2.16 per cent in 2010. In the UK, R&D spending also declines from 2.1% in 1990 to 1.85 per cent in 2010. In sum, over the last two decades there has been little measurable
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progress toward increasing R&D spending relative to GDP, and no clear uptick in trends after the Lisbon Agenda is adopted.1
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These R&D data are from Eurostat.
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Figure 1
Source: http://epp.eurostat.ec.europa.eu/portal/page/portal/science_technology_innovation/introduction
The two major sources of R&D funds are government and business. Given the fiscal constraints on governments over the past two decades, and even greater constraints going into the future, increasing business spending on R&D (which means increased private innovation 17
finance) seems critical to meeting the EU’s goals. Unfortunately the data here are not that encouraging. If we take the EU15, for example, business’ share of total R&D spending only increases marginally, from 53.1 per cent in 1993 to 55.3 per cent in 2008. Several EU countries did show a marked increase in business’ share of R&D spending, but during the 1990s, not the 2000s (indeed, during the 2000s business’ share was typically flat or even decreasing). In Denmark, for example, business’ share of total R&D funds jumped from around 50 per cent in the 1990s to 60 per cent during the 2000s; Belgium shows a downward trend during the 2000s, as do Spain and Poland. A select group of countries have a relatively high percentage of R&D funds from business (60-70 per cent range), including Germany, Finland and Sweden. Over the twenty years from 1990 to 2010, UK business’ share of R&D funding declines from around 50 per cent during the 1990s to around 45 per cent during the 2000s. Given that the UK has the most market-based financial system, this is prima facie evidence supporting the hypothesis that increased use of markets for innovation finance and shareholder value may be a hindrance to firm-based R&D spending.2 Altogether, then, it appears that neither governments nor business are prepared to increase substantially their R&D spending over the long-term trends of the past two decades. What, then, explains business’ decision to spend on R&D? Answering this question is well beyond the scope of this paper, but here we can take a first cut at it by looking some indicators of whether investors have become more or less willing to finance innovation.
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Ireland, also a county that moved to strong market finance, especially during the 2000s, also shows a steady decline in business share of R&D from a 60-‐66% range during the 1990s to 50% by the end of the 2000s. All data on business R&D from Eurostat.
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Figure 2: Venture Capital for Early Stage Investme
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Figure 3: Venture Capital for Expansion and Replacement
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Since the 1990s the European Commission has demonstrated a strong interest in stimulating risk-oriented capital – notably venture capital and private equity – across Europe. Probably the most striking was the Commissions success in stimulating many European countries to create new stock exchanges during the mid-1990s targeted toward small firms (Posner 2005; also Jabko 2007). Inspired by the tech stock boom in the US, it was hoped that these markets would help stimulate the creation of innovative new firms and also the growth of venture capital, since venture capital firms like to exit their investments through initial public offerings. During the second half of the 1990s these efforts appeared quite successful, but the end of the tech investment boom led to the demise of many of these exchanges. And the number of listed firms in most European countries dropped back to the levels of the early 1990s (Deeg 2009). Despite EU and domestic efforts, the growth of venture capital and private equity has generally not met goals or expectations. Figure 2 shows the growth of early stage venture financing (investment for seed and firm startups) since the mid-1990s is up over the period, though with severe upward spikes in 2000 and 2006, reflecting two boom years. Despite this volatility, startup investment as a per cent of GDP for the EU15 is about three times the level at the end of the period as at the beginning, though the lasting gains are made in the 1990s, not during the Lisbon Decade. Similarly, Figure 3 shows data for later stage financing (expansion and replacement), which constitutes the bulk of venture capital or private equity financing, also rising over the period and again with similar spikes; though here too most of the gain is in the late 1990s. Despite this mixed picture, there is little question that private equity funds and venture capital have become much more significant in Europe since the onset of the Single 21
Market. Though there are two important caveats. First, only the small Nordic states, Belgium, and the UK come close to matching the United States, the birthplace of venture capital, in terms of percentage of GDP invested through venture capital. The other big European economies lag considerably behind, most notably Germany and Italy (early stage financing is virtually nonexistent in Italy). In terms of trends for early stage financing during the 2000s, only a few show a consistent upward trend, notably the Netherlands. In most countries expansion and replacement financing holds steadier during the 2000s.3 It is also worth noting that over the past decade the number of firms financed through venture capital has declined by more than half.4 This reflects a decline in the relative amount of financing going into early stage financing (startups), and probably also an increasing average size of investment. This mixed picture of success in stimulating the growth of risk-oriented capital begs the question of what leads to its expansion. Are liberal market economies and market-oriented financial systems more congenial to venture capital, as many would predict? In the relevant literature a number of factors argued to promote venture capital have been explored. Groh et al (2009), for example, cite six broad institutional factors considered favorable to the expansion of venture capital, including economic activity (the level of economic development, level of FDI, size of labor force) because bigger, faster growing economies are more attractive to venture capital, the depth of capital markets because larger markets increase opportunities for selling firms or going public, taxation favorable to VC, investor protection and corporate governance regulations that guarantee the rights of outside investors, the human and social environment (education and labor regulations; corruption) because labor flexibility increases attractiveness, 3
Data from Eurostat. From more than 10,000 in firms in 2000 to about 5,000 in 2009. This is based on data collected by the European Venture Capital Association (www.evca.com). 4
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and entrepreneurial culture (R&D spending, privatization, firm startup rates and the cost of starting businesses). In their study they construct indices of venture capital (and private equity) attractiveness based on these institutional scores for all European countries. They find that among these six factors, what matters most is the size of capital markets (especially the stock market) and investor protection and corporate governance rules. Given this, it is little surprise that the UK scores highest on the attractiveness index and also leads Europe by a margin in actual VC funds raised and invested. Other high scorers included Ireland, Denmark, Sweden and Norway; Germany is slightly above average while France, Italy, Spain and Greece are notable low scorers.
Consistent with the evidence discussed above, the Nordic countries not only score
well on the attractiveness index (largely because of their strong entrepreneurial cultures), they also show high levels of real venture capital investment as a percentage of GDP. The relative success of the Nordics, as well as Belgium – all regarded as coordinated market economies – suggests that CMEs can be consistent with a strong venture capital sector. Further suggesting that the institutional environment can only partly explain the growth of VC, Germany scores above average on the attractiveness index, yet is well below average in actual VC investment. Conversely, France is a low scorer on the index but has a relatively much larger VC sector than Germany. France may be explained by the fact that large stock markets are a clear factor favoring the growth of VC and France’s capital markets (and capital market financing for firms) have grown much more than Germany’s (Deeg 2009). Their study also highlights one other very important observation: Namely, that venture capital tends to concentrate in geographic hotspots characterized by existence of a professional community with expertise and where strong demand for this kind of capital can be expected. In short, there are significant agglomeration economies for venture capital and private equity. Spatial proximity between investors and investments is
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important since these investors typically engage in active monitoring of firm management. Put another way, geography matters for this kind of capital and it tends to cluster through selfreinforcing dynamics rather than spread evenly. Yet for all the attention given by policymakers to venture capital and private equity, the vast majority of R&D and innovation investment is still financed by more conventional sources, primarily internal sources and bank loans. And EU leaders have not ignored this fact: Beyond the indirect means of promoting more bank lending by increase market financial market integration and competition, the EU created a Risk-Sharing Finance Facility with the European Investment Bank to improve access to loans for R&D projects. But since cash within firms is fungible, it is difficult to say with any precision what the exact sources of innovation financing are. Thus the best proxy is to examine trends in firm finance in general. If firms are increasingly dependent on bank loans or securities (bonds and stock) for their financing, then we can deduce the potential consequences for innovation. In general, high rates of internal or selffinancing are favorable to greater innovation investment, since managers have greater leeway to manage firm assets and less pressure from external financiers (whether banks, bondholders, or rating agencies). Since the 1970s there is a widespread trend toward increased self-finance by European corporations, mostly by larger firms: In France, for example, the percentage of total capital formation self-financed by firms rose from about 65 per cent in the 1970s to more than 95 per cent in the 1990s; for German firms this number rose from about 72 to 86 per cent; for Italian firms from 38 to 73 per cent; and UK firms from about 87 to 97 per cent (Galizia 2003). High self-finance generally continued during the 2000s (Deeg 2009). To the extent that large firms use external financing, they have commonly shifted from bank loans to securities: By far the 24
most common source is corporate bonds rather than shares, but in some countries shares have become a significantly more important source of finance (Murinda, Agung, & Mullineux, 2004). That said, banks are still the single most important source of external finance in most European countries, especially for small and medium-sized firm (SMEs). In Germany, for example, aggregate bank borrowing by firms has remained roughly steady over the last twenty years (Deeg 2009), but when broken down by firm size it becomes clear that large firms are borrowing less while SMEs continue to rely heavily on banks for external financing (Hackethal, Schmidt, & Tyrell, 2005, p. 9). For France, on the other hand, there has been a significant structural shift from bank to securities market financing for all size firms (O’Sullivan, 2007), though more for large than small firms (Schmidt et al, 2001). But most notable in France is the steep rise in selffinancing which has brought the general composition of firm financing (bank borrowing, selffinance, and shareholder equity) much closer to that of the UK’s (Byrne & Davis 2002). Following our earlier theoretical discussion, the effects of firm financing on innovation activity is likely conditioned by the structure of ownership of publicly listed firms. Many European firms have concentrated ownership among a few large, blockholding owners, though a number of large firms have moved to more dispersed ownership in which institutional investors – investment funds, pension funds, etc. – now comprise a significant portion of owners. In many cases, dispersal of ownership also includes a dramatic increase in foreign institutional ownership (this is especially striking in France). Privatizations and the decline of bank ownership of industrial firms in many countries have contributed to this trend (Culpepper 2005). In the case of dispersed ownership, firms may be more vulnerable to financial market pressures and faced with owners more averse to risky innovation investments (Hirsch-Kreinsen 2010, 12). But while there are many prominent examples of large firms in Europe shifting from concentrated to 25
dispersed ownership, aggregate data suggest that concentration levels have only come down modestly (Deeg 2009; also European Commission 2007). However, once we look beyond the top 30 or 40 listed companies, concentrated ownership and blockholding have proven remarkably robust. What this amounts to, then, is arguably an increased diversity of patterns of firm finance, ownership, and innovation. Looking closely at Germany, traditionally a CME or insiderdominated systems characterized by strong incremental innovation, Hirsch-Kreisen (2010) argues that the traditional innovation system has evolved into three emerging pillars: The evidence we have reviewed in this chapter suggests that this new pattern may be emerging or found in other European countries as well. In the first pillar, we find firms, mostly large and some SME firms that are publicly listed, operating in established sectors, some with intensive R&D though others working with simpler technology. These firms have a significant dependence on external finance and exposure to new institutional investors who often lack the knowledge to assess properly the proposed innovation investments by management (see also Lazonick and O’Sullivan 2001). These firms face further financial market pressures or constraints on innovation from newer rules about financial transparency, use of international accounting, and the pressure from investors, analysts, and credit ratings agencies to adopt shareholder value practices.5 Some of these firms may have private equity owners, but in this case private equity firms “invest to sell,” i.e., they look for short-term improvement in efficiency that can boost value; risky long-term innovation investments do not fit well into this approach (see also Lange and Becker-Ritterspach 2007). These firms continue to focus on incremental
5
It should be noted that corporate managers may also choose independently to reduce innovation investments in order to maximize their own financial gains.
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innovation but their vulnerability to various financial market pressures may be curtailing their innovation investments. At the other end, the third pillar is comprised of newer, smaller technology-oriented firms. These firms are highly dependent on external finance and the ones profiting from the growth of venture capital and private equity. These firms face significant financial market pressure, but also typically have close relations to their owners/investors who are specifically interested in financing innovation and typically have expertise to assess the prospects of innovation and guide firms in realizing their projects. Interestingly, the first and second pillars show some interesting linkages: Facing greater financial market pressures, large German pharmaceutical firms, while not reducing their overall R&D, had shifted their innovation strategies to focus on blockbuster drugs. At the same time, they have built closer relations to smaller, more nimble firms undertaking riskier research, especially in biotechnology. And many of these smaller firms are financed through venture capital, including venture capital often provided by the big pharmaceutical firms (Hirsch-Kreisen, 2010, 13-14). Thus, while the first pillar may be leading to less innovation, the third pillar is opening up new kinds of innovation. In between, there is the second pillar. This segment includes firms most closely following the traditional incremental innovation modes and relying on high internal finance (and to some extent bank loans). This group is primarily non-listed firms, family-owned firms and SMEs. And this segment of firm innovation is still quite substantial. A recent study on sources of German innovation finance showed 82 per cent of firms using internal sources to finance innovation, with half of those exclusively using internal funds (Rammer 2009, 41). However, it should be noted that even for non-listed firms there are growing financial constraints that may impinge on innovation financing by banks. With the adoption of stricter capital requirements 27
(Basel II and recently Basel III), German banks have implemented the use of credit rating systems to determine creditworthiness. In such systems financial performance of firms in terms of cash flow and profitability weigh more in banker’s lending decisions than in the past. As a result, banks have gained more influence over firms, especially SMEs and potentially more ability to curb innovation spending considered too risky. However, there is as yet no systematic evidence that this is occurring, nor that banks are lending less as a result (Bluhm and Martens 2008).
5. Discussion Returning to the themes set out at the beginning of this chapter, we ask now how these empirical observations about innovation finance correspond to the diverse institutional settings or models of capitalism. In other words, is the shift to market-based finance facilitated by the EU’s promotion of financial market integration – including the promotion of risk-oriented capital providers and markets – hindering or helping the expansion of innovation investments by firms? Is financial market integration leading to convergence across national systems in patterns of innovation and innovation finance? First, there is little evidence to suggest a convergence in innovation systems or innovation finance. The use of venture capital, for example, still varies widely across Europe. Business’ contribution to national R&D spending also varies widely and shows no sign of convergence. To some extent, however, boundaries between national systems are blurring due to the rise of new forms of finance and the internationalization of finance (Hirsch-Kreinsen 2010, 19). A lot of private equity invested in Europe, for example, originates in the UK or US. Circumstantial 28
evidence suggests that in many countries there may two or three innovation systems or ‘pillars’ emerging, with one pillar showing financial market constraints on a set of firms and another opening up new kinds of innovation finance. While some scholars believe that firm-based innovation is greater when financial market pressures are lighter (Lazonick and O’Sullivan 2001), there are others who argue that different forms of innovation and different kinds of technology appear to benefit from diverse forms of financing (Tylecote and Visintin 2008). Thus increased diversity of innovation financing may in fact boost overall innovation and R&D spending across Europe. But rather than convergence, this represents a process of institutional layering that enables firms to choose different forms of innovation financing, or to combine different forms in new ways that foster innovation (see Hirsch-Kreisen 2010). The evidence examined in this chapter also indicates that ‘success’ in developing venture capital and private equity (measured by indices and actual investment) does not correlate so well with CME-LME distinctions, even though one would predict that LMEs are more conducive to risk-oriented capital. This suggests there is greater looseness of fit among the institutions that constitute distinct models of capitalism. CMEs can develop strong private equity and venture capital as well if they develop at least some of the institutional conditions shown favorable to their emergence. It is Scandinavia’s entrepreneurial culture, for example, rather than high market-based finance, that helps explains its relative strength. Put another way, Member States of the EU do not have to become full-fledged LMEs in order to develop the capacity to support radical innovation. A related point is that simply increasing the mobility of capital across European borders (which is now largely unhindered), does not mean that risk capital will spread evenly or proportionately across the EU. Local institutional conditions clearly matter a great deal and these still vary considerably. Given the importance of agglomeration economies and 29
the advantages of co-locating the sources of capital with its investment, venture capital and private equity need to be largely homegrown. In principle, increasing innovation can be done in all kinds of firms, whether listed firms, family-owned, or SME. Improving innovation finance requires reducing the information asymmetry that exists between potential financiers and the innovating firms. There are a number of institutional solutions to this challenge. One essential ingredient for this is to have either owner-managers or engaged shareholders with the incentive to develop the necessary knowledge to understand the innovation projects undertaken by firms. Engaged shareholders are more likely to be either venture capitalists or private equity investors, or blockholding owners of publicly listed firms. Such blockholders may be banks, other firms, families, or the state. But where firms ownership lies in the hands of passive investors (even institutional) and are exposed to financial market pressures, innovation investment is likely to be less than in the case of engaged owners, leaving promising opportunities unfunded. The exceptions to this are cases where, because of other institutional conditions, corporate managers have a high level of autonomy from shareholders (see Tylcote and Visintin, 2008, 19) and thus free to invest more in long-term innovation projects. Finally, we come back to the issue of the EU’s efforts to foster greater innovation in Europe. This paper advanced the argument that the EU’s promotion of financial market integration has had mixed effects, promoting new kinds of innovation financing while likely hindering other kinds of innovation. In some countries, R&D spending by both governments and business has risen significantly during the Lisbon decade, while in others spending has been stable or even declined. In aggregate then, there has been little progress toward the EU’s goal of achieving R&D investment equal to 3 per cent of the European GDP. Looking forward, what are 30
the chances that the EU can reach this target by 2020? Unfortunately, the conditions of the next decade look decidedly worse than those of the Lisbon decade. Following the huge banking crisis toward the end of the past decade, heavy losses by banks and new capital requirements and regulations mean that banks will likely be much more conservative lenders for many years to come. Venture capital and private equity will (sooner or later) likely grow again during the coming decade, but this will remain a relatively small portion of R&D or innovation financing. The severe fiscal problems faced by nearly all European governments mean we can hardly expect states to increase their R&D spending. What this all suggests is that innovation financing may have to rely even more on firm’s internal sources of funds. Thus the best prospects for making progress toward Europe 2020’s goals are generating overall economic growth, exports, encouraging tax policies which foster innovation spending by firms, and ensuring that European market integration does not backslide.
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Appendix R&D as % of GDP, 1992-2010
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Business R&D as % of Gross Domestic Expenditure on R&D, 2000-2010
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VC in Europe (% of GDP), 1999-2009
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