On 12 July 2024 the IMF published a working paper with the title Stepping Up Venture Capital to Finance Innovation in Europe, written by N.G. Arnold, G. Claveres and J.Frie.
The paper notes that the EU is lagging behind other locations such as the US in the level of productivity growth and investment in research and development (R&D). In the EU it is more difficult to finance and scale up innovative startups. As a result of this, many successful EU start-ups go to other locations for financing. This means that the EU loses the direct growth benefits and the positive spillovers from the innovative firms.
Part of the reason for the problem is Europe’s fragmented economy and financial system. There is still too much friction in the single market for goods, services, labour and capital. This makes it more expensive and difficult for successful start-ups to scale up their operations. Also, Europe’s bank-based financial system has difficulty in taking a decision to make a loan to a project when the risks associated with a start-up are difficult to assess. This can be the case with high-tech start-ups that may develop new technologies and business models. A start-up may have high quality people, ideas, and other intangible assets, but may be short of tangible assets to use as collateral for a bank loan.
Measures are needed to strengthen the EU’s venture capital markets and remove cross-border financial obstacles to pension funds and insurers investing in venture capital. Venture capitalists invest heavily in high-risk research and development activities that are important for increasing innovation and growth. They are able to identify promising start-ups and channel resources to the potentially high performing companies.
The IMF working paper argues that well-designed preferential tax treatment for equity investments in start-ups and venture capital funds could compensate for market failures in the sector. These tax schemes would need to be correctly designed, limiting the available tax benefits to equity investments below a specified size and requiring minimum holding periods.
Governments could reduce regulatory and tax obstacles to investing in venture capital. For example, venture capitalists investing across borders within the EU emphasise that harmonization and simplification of tax regimes is important.
Further development of private pension funds could expand domestic capital pools available to invest in capital markets and venture capital.
National public financial institutions could expand capital availability and provide other types of support to venture capital funds and innovative start-ups. By investing on commercial terms, they can help to attract more private capital from institutional investors including pension funds and insurers.
The EU could adapt the rules for insurers and other investors in larger venture capital funds, taking away obstacles to investing in venture capital, especially to support growth financing. They could expand the capacity and instruments of the European Investment Fund (EIF) and the European Investment Bank to provide more resources to venture capital funds and innovative start-ups. Also, the EIF could be encouraged to develop a fund-of-funds aimed at attracting capital from institutional investors throughout the EU to finance large venture capital funds with a pan-EU focus.
