Special Report No 2/2012: Financial instruments for SMEs co-financed by the European Regional Development Fund - Montesquieu Instituut

 

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COUNCIL OFBrussels, 18 April 2012

THE EUROPEAN UNION

8427/12

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FIN 240 FSTR 27 REGIO 43 CADREFIN 174

COVER NOTE

from:

Mr Vítor CALDEIRA, President of the European Court of Auditors

date of receipt: 29 March 2012

to: Mr Nicolai WAMMEN, President of the Council of the European Union

Subject: Special Report No 2/2012: Financial instruments for SMEs co-financed by the European Regional Development Fund

Sir,

I enclose a copy of special report No 2/2012 "Financial instruments for SMEs co-financed by the European Regional Development Fund" together with the Commission's replies.

The special report, which is shortly to be published, was adopted by the Court at its meeting on 11 January 2012 and is accompanied by the replies from the Commission, which was notified of the preliminary findings on 17 October 2011.

(Complimentary close).

 

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Special Report No 2/2012

(pursuant to Article 287(4), second subparagraph, TFEU)

Financial instruments for SMEs

co-financed by the European Regional Development Fund

2

TABLE OF CONTENTS

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Paragraph

Glossary

Executive Summary I - VIII

Introduction 1 - 17

EU cohesion policy 4 - 5

EU financial engineering support to SMEs other than Cohesion policy

6

ERDF financial engineering support to SMEs 7 - 11

Financial instruments mechanisms 12 - 17

Audit scope and approach 18 - 25

Observations 26 - 115

Quality of the assessment of the SME financing gap 26 - 40

2000-2006: generally no gap assessments 29 - 30

2007-2013: significant shortcomings 31 - 40

The suitability of the ERDF framework for implementing financial instruments

3

Conclusions and recommendations 116 - 124

Quality of the assessment of the SME financing gap 116 - 118

Suitability of the ERDF framework to implement financial instruments

119 - 121

Effectiveness and efficiency of the financial instruments

in achieving results

122 - 124

Annex I Commitments and payments to financial engineering instruments

Annex II Schematic overview of the leverage concept as applied to equity,

loan and guarantee instruments

Annex III Examples of off-the-shelf instruments and vehicles

The Commission's replies

4

GLOSSARY

Business transfer A transfer of an undertaking, business or part of an undertaking or business by its owner to another person.

CEB Council of Europe Development Bank.

CIP Competitiveness and Innovation Framework Programme. See below EIP.

Amount determined in function of the relationship between the size of a fund and its return. With larger investments, a more favourable rate of return may be provided and the transaction costs are generally reduced.

Critical mass

In the context of this audit, failure of an SME to repay its credit under the contractual conditions. In the case of the guarantees, default is the moment when a guarantee is executed and the guarantee fund, the counter-guarantee fund, or both, take on the duty to pay the outstanding amount.

Default

DG Directorate-General

EBRD European Bank for Reconstruction and Development.

EIB European Investment Bank.

EIF European Investment Fund (EIB Group's specialist fund providing equity and guarantee instruments to SMEs).

5

European Recovery Programme. In the context of this audit, the German Marshall funds and their legacy funds. ERP has not been fixed by any programme period term and has not been implemented regionally. As an evergreen national fund for the benefit of Germany's enterprises, it is revolving; legacy funding cannot be transformed back into grants. KfW is the ERP funds' trustee and regional managing authorities are not involved in their management. More information on ERP and the Marshall funds in Germany is available on KfW's website.

ERP

ETF-Start-up European Technology Facility Start-up (see MAP).

Evergreen A financial instrument or fund without a fixed maturity or term.

Financial engineering instruments (or financial instruments) Term used by the Commision to designate various repayable instruments offered by the Structural Funds in order to improve SME access to finance, urban development and energy efficiency.

In the context of this audit, these instruments are equity, loan and guarantee instruments for SMEs.

Financial institution Firms whose financial activities are central to their business, such as taking deposits, investing funds or dealing. All financial institutions are financial intermediaries.

Financial intermediary Entity acting as an intermediary between sources of capital supply and demand (e.g. bank, holding fund, fund).

Mismatch between the demand and the supply of financial resources. In the context of this audit, the financing gap only concerns the gap in the different types of financial instruments for SMEs in a given area of the EU.

6

Member State public institution. Also referred to as "public subsidy".

In the context of this audit, an undertaking by a party (the guarantee fund) to bear at a predefined guarantee rate principal and interest due in case of default of a loan extended by a financial intermediary (a bank) to an SME. A guarantee always leaves some of the risk with the lender and the SME remains liable for the loan. Guarantees can take effect on first demand or not.

Guarantee

Holding fund Legally constituted fund that has a controlling interest in several subsidiary equity funds, guarantee funds or loan funds.

ISME Innovative SME active in high-technology activities.

Joint European Resources for Micro to Medium Enterprises (an Commision/EIB Group initiative for SME financing strictly using the Structural Funds).

JEREMIE

Kreditanstalt für Wiederaufbau is Germany's federal development bank experienced in SME financing. Notably acting as a sub- contractor of the Council of Europe Bank, it is active as an international financial institution on the Central and Eastern European SME finance market.

KfW

Leakage effect Any effect reducing the amount of money available to grant financial instruments to SMEs.

The prospective surplus of a fund attributable to the public sector contribution, which can, once available, be used to assist SMEs.

7

fees, as well as fund manager overheads. Interest payments and dividends are not considered as management costs.

Managing Authority The public authority of the Member State managing the Structural Funds (including the ERDF) on behalf of the Member State.

Multi-Annual Programme for Enterprise and Entrepreneurship, an SME programme of Enterprise and Industry DG managed by the EIF under the supervision of Economic and Financial Affairs DG. Following Decision 2000/819 and amended by Decision 1776/2005, this programme has been implemented via two SME facilities managed by the EIF: The ETF Start-up Facility (venture capital instruments, "ETF-Start-up") and the SME Guarantee Facility (guarantee instruments, "SMEG"). The successor programme of MAP is the CIP/EIP (see above).

MAP

Type of high-yielding debt finance often seen in leveraged buy-out transactions and often featuring an option or right to acquire shares in a firm at a preferential rate. Mezzanine finance often takes the form of subordinated convertible loans.

Mezzanine

In the context of this audit, small loans (usually up to EUR 25 000) granted to micro-enterprises (as defined by the EU). Usually, these micro-enterprises obtain free business advisory and mentoring as

well.

Micro-credit

MOITAL Ministry of Industry, Trade and Labour of the State of Israel.

MoU Memorandum of Understanding.

8

EU, the Member State, regional and local authorities and any similar expenditure.

Revolving The concept that contributions to financial instruments, after a first utilisation (or cycle), get revolving (or reutilised, recycled).

Small Business Investment Companies Program. SBIC is one of the financial assistance programmes available through the U.S. Small Business Administration (SBA). It was created by the U.S. Congress in 1958 to bridge the gap between entrepreneurs' need for capital and traditional financing sources. The structure of the programme is unique in that SBICs are privately owned and managed investment funds, licensed and regulated by SBA, that use their own capital plus funds borrowed with an SBA guarantee to make equity and debt investments in qualifying small businesses. It is a government-sponsored fund of funds which invests long term capital in privately owned and managed investment firms (licensees). The SBA does not invest directly into small business through the SBIC Program. The SBA provides support without any regional differentiation.

SBIC

Small and Medium-sized Enterprise (as defined by the Commission). In the 2007-2013 programming period, this could also be any small business.

SME

SME Finance Facility, a Facility under Enlargement DG's Phare programme ("Poland and Hungary: Assistance for Restructuring their Economies").

SMEFF

9

EXECUTIVE SUMMARY

I. Small and medium-sized enterprises (SMEs) are the backbone of the EU's

economy, generating employment, innovation and wealth. However, SMEs may

suffer from financing gaps, in that they cannot obtain access to the type and the

amount of finance they need at a given time.

II. To support entrepreneurship, the European Union (EU) mainly uses its

enterprise policy and its cohesion policy.

III. Cohesion policy mainly uses grants and increasingly, in the European

Regional Development Fund (ERDF) framework, financial instruments

IV. Financial instruments are repayable and revolving instruments that ensure

that successive waves of SMEs can benefit.

V. The Court's audit focused on the financial engineering measures co-

financed by the ERDF during the 2000-2006 and the 2007-2013 programming

periods. The audit findings are based on a direct review of a sample of projects

and on an examination of the Commission and Member States' management,

monitoring and information systems.

10

(c) Before funds reach SMEs, delays were significant and, compared with

other EU programmes for SMEs, the ERDF's ability to leverage in

private investments was poor.

VIII. The Court recommends that:

(a) When proposing financial engineering measures, the Managing

Authorities should make sure that their proposal is duly justified by an

SME gap assessment of sufficient quality, including a quantified analysis

of the financing gap.

(b) When approving operational programmes including financial engineering

measures, the Commission should verify their consistency with the SME

gap assessment and make sure of the quality of the latter.

(c) When designing proposals for the Structural Funds Regulations, the

Legislator and the Commission should address the different specific

weaknesses mentioned in the Report (see paragraphs 48 to 77). More

generally, the Legislator and the Commission should provide a more

adequate regulatory framework so that the design and the

implementation of financial engineering measures do not suffer from the

11

(e) The Commission should explore the possibility of supplying to the

Member States off-the-shelf financial engineering structures and

instruments for SMEs (e.g. grants with royalties, dedicated investment

vehicles) in order to speed up implementation and reducing

management costs.

(f) Member States, with the support of the Commission, should aim at the

inclusion of all ERDF-cofinanced financial instruments for SMEs into a

single operational programme per Member State. This would rationalise

the planning process and remove one of the key delaying factors found.

(g) Apart from defining the concepts and definitions of leverage and

recycling in the Structural Funds Regulations, the Commission should,

depending on the type of holding fund or fund, require contractually

binding minimum leverage ratios, minimum revolving periods and data

for the calculation of leverage indicators.

(h) If the above recommendations cannot be implemented under the

Cohesion policy framework, the Court invites the Legislator and the

Commission to consider alternative ways of pursuing SME support

through financial engineering instruments. In such a case, such

12

INTRODUCTION

• 1. 

  Small and medium-sized enterprises (SMEs)2 are the backbone of the EU

economy, representing 99 % of all enterprises3. However, the financial markets

are wary of investing in SMEs because they are perceived as riskier than large

companies, especially if the SMEs are in innovative markets (ISMEs).

• 2. 

  According to the Observatory of European SMEs4, limited access to finance

is a problem for SMEs in Europe. Recent financial crises, which have hit some

Member States particularly hard, have worsened the situation.

• 3. 

  As the public sector has an important role to play in supporting SMEs, in

particular the provision of suitable financing, the Commission has provided

access to finance in various ways.

EU cohesion policy

• 4. 

  The EU Cohesion policy aims at strengthening economic, social and

territorial cohesion within the EU by reducing disparities between the EU

regions. In the framework of Cohesion policy, the ERDF explicitly provides for

the possibility to contribute to SME access to finance by using overwhelmingly

13

• 5. 

  In the 2000-2006 ERDF programming period and, to a greater extent, in the

2007-2013 ERDF programming period, financial engineering instruments

(repayable instruments) have been used by the Commission and most Member

States in the context of the EU Cohesion policy. It is the development of these

ERDF financial instruments, which is the subject of this performance audit.

EU financial engineering support to SMEs other than Cohesion policy

• 6. 

  As securing and improving access to finance for SMEs is so important, the

EU has supported SME access to finance by two major means:

(a) The development of specific programmes, the Multi-Annual Programme

for Enterprise and Entrepreneurship (MAP), which was succeeded by the

Entrepreneurship and Innovation Programme (EIP). The MAP and EIP

combined represented 1,6 billion euro, from 2001 to 2013. They are

implemented by the European Investment Fund (EIF). The SME

Guarantee Facility (SMEG), which is a part of the MAP and the EIP, has

recently been the subject of an audit by the Court5.

(b) The European Investment Bank (EIB) has implemented loan programmes

amounting to approximately 70 billion euro (2001-2010) aiming at

14

ERDF financial engineering support to SMEs

• 7. 

  Over the last two programming periods, in the context of the Cohesion

policy, the Commission has encouraged repayable forms of assistance through

financial engineering instruments. According to the Commission, this

represents about 12 billion euro of the EU budget committed in favour of

financial engineering measures across the EU Member States7: 1,6 billion euro

(2000-2006) and 10,4 billion euro (2007-2013), out of which, respectively, 1,5

billion euro and 7,9 billion euro in payments to holding funds or funds

contributing to financial engineering instruments.

• 8. 

  Figures are indicative and should be treated with care8, in particular, for the

2007-2013 programming period9. This is mainly the result of the Commission

not having detailed information on the funding of financial engineering

instruments10. In addition, it remains unknown to what extent SMEs actually

benefited from the amounts granted to holding funds and funds.

• 9. 

  A brief summary of the total amounts involved per programming period is

available in Annex I .

• 10. 

  Currently, the Regulation11 specifies that financial engineering instruments

15

SMEs, urban development funds and funds for the promotion of energy

efficiency.

• 11. 

  The same Regulation foresees that Member States may involve the EIF in

the implementation of financial engineering instruments in three different ways:

• - 

  Preparing evaluations, i.e. the SME financing gap assessments.
• - 

  Acting as a holding fund; this is currently the case for eight Member States

and three regions12.

• - 

  Acting as an adviser to national or regional authorities.

Financial instruments mechanisms

• 12. 

  The implementation of access to finance programmes requires the active

involvement of financial intermediaries, which transform public funds into

financial instruments for SMEs. Additional funds provided by the private sector

may be added to the public funding, increasing the total amount available for

investments in SMEs; this is how the Court defines the leverage effect. The

leverage effect is schematically explained per category of financial instrument

in Annex II .

16

Figure Flow of funds from operational programme down to the SME

(simplified illustration)

Operational Programme

ERDF National

ContributionContribution

Holding Fund(Optional)

EquityandLoanandGuarantee

Fund/Fund/Fund

oror

FundingLending

VehicleInstitutionBank

17

• 16. 

  In the case of guarantees, only in case of default is money actually being

spent. If there is no default, the amounts contributed can be released when the

underlying contractual conditions have been met.

• 17. 

  According to recent strategic papers published by the Commission, it is very

likely that financial engineering instruments will be developed further in the next

programming period13. Indeed, the responsible department at the Commission,

Regional policy DG, considers the leverage and revolving effects as the main

advantages of financial instruments as opposed to grants. Other advantages of

financial instruments often put forward are that they can:

(a) supply sustainable SME funding on market-friendly terms.

(b) increase the financial expertise and know-how of public authorities and

SMEs.

(c) provide greater upfront financing for SME investment projects as

compared to grants.

AUDIT SCOPE AND APPROACH

• 18. 

  The main objective of the audit was to assess whether ERDF spending on

18

(c) The effectiveness and the efficiency of the financial instruments in

achieving results.

• 20. 

  The audit was carried out at the Commission and in five Member States

(Germany, Hungary, Portugal, the Slovak Republic and the United Kingdom).

Based on figures provided by the Commission, these five Member States

represent approximately 46 % and 30 % of the ERDF allocations to financial

engineering instruments, respectively during the 2000-2006 and the

2007-2013 programming periods. In selecting these Member States, attention

has been paid to ensure sufficient diversity of financial instruments, funding

structures and geographical balance.

• 21. 

  A sample of 34 operations co-financed by the ERDF was assessed, 24 from

the 2000-2006 programming period and 10 from the 2007-2013 programming

period. Annex I gives an overview of the total amounts committed and paid

covered by this Report, including their proportion out of the total of the ERDF.

• 22. 

  Audit work included documentation review and meetings with

representatives of various public authorities and financial intermediaries

responsible for the design, implementation and management of the financial

engineering measures and instruments for SMEs.

19

• 25. 

  In the context of its benchmarking exercise, the Court has considered as

good practice certain internationally reputable programmes16, as well as certain

comparators found among centrally managed EU programmes17. Indeed, all

these programmes follow a similar intervention logic as SME access to finance

programmes under Cohesion policy (except for the broad territorial cohesion

objective). Indeed, they all have in common the pursuit of economic growth and

job creation objectives by the development of enterprises through financial

instruments.

20

OBSERVATIONS

Quality of the assessment of the SME financing gap

• 26. 

  The mismatch between the demand and the supply of the different types of

financial instruments for SMEs, called financing gap, constitutes the rationale

for public intervention in the market. To be effective in meeting the real needs

in terms of SME finance, ERDF operations should be based on a sound

assessment of the financing gap18.

• 27. 

  The Court examined the quality of the gap assessments and, in particular,

whether the gap assessments:

(a) identified and quantified a need for public sector action in favour of financial

engineering measures for SMEs;

(b) were linked with the related operational programmes;

(c) were made available sufficiently in advance to all stakeholders concerned.

• 28. 

  Although all EIF gap assessments followed a standard methodology (i.e. a

common template), they markedly showed uneven levels of quality. However,

the Court identified the EIF's gap assessment for Sweden as good practice and

21

Box 1 EIF's gap assessment for Sweden, a case of good practice

The EIF's gap assessment finalised in January 2007 included:

• - 

  a full analysis of nationwide demand and supply of SME finance by type of

financial instrument and, where applicable, taking regional specificities into

account;

• - 

  areas where the existence of financing gaps could or could not reasonably have

been established;

• - 

  references to previous ERDF support or other EU access to finance schemes,

including on the role of the EIB Group;

• - 

  information on the intended structuring of the cofinanced funding of SME finance

(fund allocation), including a link with the operational programme submitted to the

Commission for approval;

• - 

  information on which potential financial intermediaries could be capable of

implementing the funding.

2000-2006: generally no gap assessments

• 29. 

  During the 2000-2006 programming period, the Commission and the

22

2007-2013: significant shortcomings

• 31. 

  For the 2007-2013 programming period, there are no specific legal

requirements for the existence and the use of SME financing gap assessments

at operational programme level. However, the Commission, aware of their

usefulness, decided in partnership with the EIF to cofinance gap assessments

carried out at the request of Member States and free of charge20. These would

be used for the preparation of operational programmes in order to set out

objectives and resources to improve SME access to finance.

• 32. 

  Between 2006 and 2009, the EIF prepared 55 gap assessments at the

optional request of 20 Member States, out of which 18 were reviewed during

the audit. Apart from the gap assessments concerning audited Member States,

additional gap assessments made for Spain, France and Poland were

reviewed, as these three Member States represented the bulk of the gap

assessments.

The EIF identified and quantified a need for public sector action

• 33. 

  For all gap assessments reviewed, the EIF quantified the financing gap and

concluded that there was a need for public sector actions in favour of financial

23

assessments prepared by the EIF were conducted independently from the

operational programme process, often subject to delays and leading to a sub-

optimal fund allocation from operational programme measures to financial

instruments.

• 36. 

  As a result, when subsequent framework agreements (between Member

States and holding fund managers) had to be negotiated, considerable

operational programme constraints (e.g. allocation between different types of

instruments, territorial constraints, monitoring and reporting requirements), not

addressed in the gap assessments, resurfaced.

• 37. 

  For instance, the Polish regional authorities were not satisfied with the level

of quality of five regional gap assessments21. In other cases, the gap

assessments were largely ignored in the context of the implementation of the

operational programmes (e.g. Andalusia, Hungary).

• 38. 

  The Commission did not require an independent evaluation or quality review

of the gap assessments it ordered from the EIF. However, the EIB conducted

an evaluation, which rated the gap assessments to be "partly unsatisfactory",

mainly criticising the delayed gap assessment process and a "variety of

external problems", including regulatory problems22.

24

well as various SME interest groups and networks with the full gap

assessments at the same time as the Managing Authorities.

• 40. 

  Against the provisions of the Memorandum of Understanding23, in the

majority of cases, the full reports were not published, but the Commission only

published executive summaries.

The suitability of the ERDF framework for implementing financial

instruments

• 41. 

  An adequate regulatory and administrative framework is a critical success

factor in delivering SME access to finance effectively and efficiently for the

Member States and the numerous regions and financial institutions involved.

• 42. 

  The Court examined whether:

(a) The legal and management frameworks took sufficient account of the

specific nature of the different financial instruments.

(b) The use of the ERDF as a mechanism for the delivery of financial

instruments was conducive to sound financial management.

(c) Commission monitoring and information systems were fit for purpose.

25

They do not include any additional specific provisions on equity, loan and

guarantee funds, which are fundamentally different, both from non-repayable

instruments (grants) and between each other. The Financial Regulation25 is not

specific to financial instruments either.

• 44. 

  As a result, the Commission manages repayable assistance to SMEs under

the same legal framework as non-repayable grants.

• 45. 

  The Commission has recognised that this causes problems. For instance, a

2010 internal audit report26 found that the design of the regulatory and strategic

framework was not best suited to achieving objectives, and that the inadequate

system design might have strong adverse impact on performance and the

reputation of the Commission.

• 46. 

  With the aim of helping Member States understand how the Structural

Funds Regulations should apply to support financial instruments, the

Commission first issued two interpretative notes, limited in scope, in July 2007

and December 2008. Not until February 2011, four years after the start of the

current programming period, did the Commission issue a comprehensive and

relevant interpretative note on financial engineering instruments, which

distinguishes the main types of financial instruments.

26

• - 

  Possibility for unjustified recourse to preferential treatment of the private

sector.

• - 

  Unclear eligibility conditions for working capital.

Insufficient leverage and fund revolving provisions

• 48. 

  A first deficiency is the absence in the Structural Funds regulations of clear

reference to leveraging funds and revolving legacy funds in general and, in

particular, as to how and until when these concepts are applicable27. As

reiterated by the Commission on many occasions, these are key features of

financial engineering instruments and even of the Structural Funds in the

current programming period28.

• 49. 

  The Structural Funds Regulations do not stipulate a specific duration (10,

20, 30 years) or recycling factor (at least once, twice, three times) for the re-use

of legacy funding where the latter has not been exhausted. In addition to that,

the way in which equity, loan and guarantee funds leverage funding is

fundamentally different, which has not been reflected in the Regulations.

• 50. 

  Whilst the February 2011 note acknowledges differences in the type of

financial instruments, it makes little reference to their leverage effect, referring

27

• 51. 

  Regarding the revolving nature of the funds, the interpretative note provides

guidance by encouraging the "reallocation for the same type of action in the

same region covered by the operational programme" of public resources

returned after a first investment cycle30. Nevertheless, Managing Authorities

could always apply considerable discretion in the re-utilisation of legacy funds,

if any, as these could always be transformed back into non-reimbursable

grants31, reducing the potential benefits of financial engineering instruments.

• 52. 

  In Andalucia, for instance, the winding-up provision just mentioned that the

remaining liquidated funds should be transferred to the regional treasury and

then freely be used by the regional government. This meant that the legacy

funding could be used to cover regular expenditure of the regional government

or in the form of grants to other economic operators than small enterprises32.

• 53. 

  Additionally, as explained later in paragraphs 78 to 83, the monitoring and

information systems in place do not allow verification of whether an investment

strategy, an exit policy and the winding-up provisions33 effectively set out the

terms and conditions under which legacy funding could be revolving. As a

result the Commission does not receive sufficient information to monitor the

revolving nature of the funds.

28

• 54. 

  A second deficiency is that under the current Structural Funds Regulation34,

Member States that have implemented holding funds are not subject to

automatic decommitments during the life of the operational programme when

holding fund disbursements have not taken place.

• 55. 

  As mentioned in paragraph 32, Member States were not obliged to

undertake SME gap assessments. Hence, the Legislator offered the possibility

to make over-sized allocations to financial instruments.

• 56. 

  It is only at the closure of the programme, more than two years after the end

of the seven-year programme period, that the Commission will be in a position

to regularise the situation.

• 57. 

  One telling example of such an over-sized fund allocation is a guarantee

fund in Italy (see Box 2 ).

Box 2 Case of over-sized fund allocations: ERDF guarantees in Italy (Sardinia)

The Managing Authority of Sardinia did not request any gap assessment. Considering

the target financial leverage of 10 combined with an average guarantee rate of 65 %

laid down in the Managing Authority's business plan35, the 233 million endowment of

the fund would result in new guarantees to be issued of at least 3 585 million euro, i.e.

29

This represents approximately 38 % of the outstanding loan stock of all Sardinian

enterprises (currently at 11 803 million euro), which is unrealistic. By mid 2011,

1,5 million euro out of a total endowment of 233 million euro had been pledged against

this fund. This excessive endowment is not subject to automatic decommitments.

Possibility of unjustified recourse to preferential treatment of the private sector

• 58. 

  A third deficiency is that Structural Funds Regulations36 allows, without

further specification, the recourse to preferential private sector treatment over

the public sector, in this case, the Structural Funds. This preferential treatment

effectively occurs when contracts do not grant the ERDF the same repayment

rights as the private co-funders (i.e. non-pari passu).

• 59. 

  Preferential treatment may be justified to attract private investors or lenders

by increasing their chances of getting reimbursed and receive a better

risk/return reward. However, its use must be carefully justified as it restricts the

capacity to raise sufficient legacy funding for the next wave of SMEs.

• 60. 

  For this reason, Managing Authorities should assess whether preferential

treatment exists and whether it is justified37. However, the current Structural

Funds Regulations do not specify this further, nor do the Commission's

30

• 62. 

  A fourth case was found in Hungary, where equity investors secured their

return using a yield restriction clause at the expense of the public contributor

and limited their risk by using a loss mitigation clause. As a result, the public

contributor bears the full risk, but not the upside in the reward.

Unclear eligibility conditions for working capital

• 63. 

  A fourth deficiency is the eligibility conditions for working capital, which has

not been addressed in the Structural Funds Regulations. In the interpretative

note of February 2011, the Commission considers that the financing of working

capital that is not associated with a plan for the creation or expansion of an

enterprise should not be supported through financial instruments38.

• 64. 

  The use of the ambiguous term "expansion capital" and the many

exceptions to the use of working capital caused confusion among the financial

institutions in the Member States. Indeed, the Commission took the view that

working capital eligibility "must be examined and implemented on a case by

case basis, taking properly into account and respecting applicable state aid

legislation and rules"39.

• 65. 

  The consequence of this legal uncertainty could, for instance, be felt in

31

Current characteristics of the ERDF hampered the sound financial

management of financial instruments

• 66. 

  The characteristics of the ERDF that hampered the sound financial

management of financial instruments are mainly its territoriality and its

insufficient critical mass (scattering effect). These characteristics affected the

ERDF throughout the different programming periods.

ERDF: territoriality with far-reaching consequences for SME funds

• 67. 

  The first inherent characteristic of ERDF is its territorial approach. For its

implementation, the 27 Member States have been divided into 271 statistically

defined regions, i.e. usually at the level of NUTS 240.

• 68. 

  This approach is in contradiction with a Commission statement that the

competition, which European firms face, is increasingly global and innovation is

seen as a global phenomenon that is not successful and sustainable in a

closed environment41. Indeed, unlike ERDF-co-financed repayable assistance,

other SME financial instruments (e.g. ETF Start-Up, GIF, SME Finance Facility

(SMEFF), SMEG, etc.) managed by the Commission are not subject to such

territorial restrictions within the EU.

32

Box 3 Good practice found in other SME programmes

In Germany, the European Recovery Programme (ERP) has not been fixed by any

programme period term and has not been implemented regionally. As an evergreen

national fund for the benefit of Germany's enterprises, it is truly revolving, as legacy

funding cannot be transformed back into grants.

The Small Business Investment Companies Program (SBIC) in the United States of

America and the Ministry of Industry, Trade and Labour of the State of Israel

(MOITAL)42 R&D Fund, Yozma and Technological Incubators programmes in Israel

provide access to finance to small businesses without applying regional differentiation.

For SBIC, the focus is the accreditation and control of financial intermediaries,

whereas for MOITAL, it is the strict focus on high-technology SMEs.

All these programmes emphasise other main factors, although important regional

differences exist in Germany, the United States and Israel.

• 70. 

  This regional split-up prevents the use of typical indicators pertaining to

financial instruments such as the percentage of foreign equity in SME balance

sheets, banking intermediation rates, default rates, loan rejection rates or

equity-to-debt ratios. Indeed, such statistics, in many instances, do not exist at

regional level or, at least, at the level of the regional split-up underpinning

33

• 72. 

  Providing access to finance with fund sizes below critical mass is very likely

to be unsustainable. This is because the overhead costs and the risks

associated with investments or loans cannot be spread over a sufficient

number of SMEs43.

• 73. 

  In the United Kingdom and Germany respectively, 433 and 204 million euro

were scattered during the 2000-2006 programming period across 31 regions in

the United Kingdom (c. 14 million euro per region on average) and 21 regions

in Germany (c. 10 million euro per region on average). In particular, 14 regional

funding structures had less than 10 million euro to finance SMEs in the

developed and populated regions of Berlin, London, North Rhine-Westphalia

and the West Midlands through several financial instruments. Moreover, in the

case of Berlin, the funds had to distinguish SMEs according to their business

location in five different territorial units44.

• 74. 

  Table 1 shows fund sizes, including the private contribution, where

applicable, in four different EU regions.

34

Table 1 Fund sizes in the ERDF regions of Berlin, North Rhine- Westphalia, London and West Midlands (fund names have been anonymised)

Fund Size

(in million

CountryRegionFund Name

euro)

BerlinLoan Fund A (Objective 1 compartment) 4,52

BerlinLoan Fund A (Objective 2 compartment) 7,22

GERMANYBerlinEquity Fund A (Objective 1 compartment) 1,26

BerlinEquity Fund A (Objective 2 compartment) 4,17

NRWEquity Fund D 0,41

LondonEquity Fund O (Objective 2) 7,98

LondonEquity Fund N (Objective 2) 5,95

LondonLoan Fund H (loans operation) 3,62

LondonLoan Fund G 1,88

LondonLoan Fund H (mezzanine operation) 0,82

UNITED KINGDOMWest Midlands Equity Fund P 13,12

West Midlands Equity Fund L 13,08

West Midlands Loan Fund J 7,08

West Midlands Equity Fund Q 6,23

West Midlands Equity Fund M 3,46

West Midlands Loan Fund I 1,00

Note : ECB GBP/EUR rate as of 31.12.2008 (payment closure date): 1,0499.

• 75. 

  In the case of three funds, respectively covering the regions of London,

North Rhine-Westphalia and the West Midlands, the combined risk profile and

the small fund size actually put the entire fund portfolio at risk, because of an

insufficient diversification of the risk taken by the fund.

35

context of compliance with EU State aid rules and are unrelated to the concept of the

SME financing gap.

In order to secure a national exemption from State aid rules, the Slovak authorities

defined Bratislava as a "non-assisted region". A third of all Slovak SMEs and half of

Slovakia's potential in research and development are based in the capital region. As a

result, numerous SMEs have been excluded from the benefit of guarantee instruments

and were allocated a very small amount in equity instruments.

• 77. 

  Conversely, the setting up of holding funds and funds with sufficient critical

mass is facilitated when, according to its national laws, a Member State can

consider its territory as a single region (Lithuania) or earmark financial

engineering measures for one specific operational programme at multi-regional

level (Portugal). At the same time, this facilitates implementation, since only

one Managing Authority has to be involved.

Commission and Member State monitoring and information systems do

not address the specificities of financial instruments

• 78. 

  The combined complexity of financial instruments, shared management and

the State aid and Structural Funds rules called for specific information,

communication and monitoring systems between the Commission, the

36

findings, these desks were affected by a poor flow of information and limited

transparency45.

• 80. 

  During the 2007-2013 programming period, the Commission set up a unit

with responsibility, inter alia, for SME financial instruments supported by the

ERDF. However, most staff were assigned to other unit activities.

• 81. 

  In practice, only three full-time equivalent staff were assigned to SME

financial engineering instruments. With internal calls for sharing knowledge and

expertise with other Directorates-General not having been followed46 and no

specific information technology application accessible to Member States and

stakeholders, the Commission may not have the means to provide appropriate

guidance and advice.

• 82. 

  The standard cohesion policy monitoring instruments put in place for the

ERDF47 are inadequate or not adapted for the purpose of financial instruments.

(a) Annual Implementation Reports, with the exception of the United

Kingdom, do not report specifically on the performance of financial

engineering instruments.

37

(c) Operational programm indicators do not make the distinction between

financial instruments (repayable instruments) and grants (non-repayable

instruments)49. As a result, most of the indicators used - output-oriented

"macro-indicators of development50" are not helpful for assessing the

progress of financial engineering instruments.

• 83. 

  Aware of this weakness, in its interpretative note of February 2011 the

Commission recommended to the 27 Member States that they report on over

100 suggested indicators51.

Effectiveness and efficiency of the financial instruments in achieving

results

• 84. 

  When assessing the effectiveness and efficiency of the ERDF in delivering

financial instruments, the Court examined whether and to what extent:

(a) SME finance was subject to delays.

(b) Unjustified management costs reduced funds actually available for SME

financing (leakage effects)52.

(c) The public funds leveraged private funding.

38

Widespread delays

• 85. 

  The timeliness of delivering SME access to finance could be assessed as

compared with the start of the respective operational programmes,

respectively, in 1999/2000 and 2007.

• 86. 

  Apart from the reputational risk that delays to access to finance

programmes may cause, the likely knock-on effects of delays would affect the

capacity of the Commission to recycle funds in the 2007-2013 programming

periods and in the following programming periods.

• 87. 

  Whenever delays in delivering SME access to finance occur, funds cannot

spend the money SMEs could be entitled to in the form of financial instruments.

From the point of view of the Managing Authority, this entails that the

alternative, using grants for SMEs, becomes more attractive.

• 88. 

  The main causes of delays in both programming periods have been

summarised in Table 2 . Delays have been widespread across Member States.

Some causes of delay have re-occurred in the current programming period

and, apart from "obtaining private sector contribution", delays are less related to

volatile financial circumstances than to administrative, legal, organisational or

39

• 89. 

  A few telling examples have been set out in the following paragraphs, one

taken from the previous and three from the current programming period.

• 90. 

  In Germany, funds started very late in the 2000-2006 programming period,

causing at least three funds in Berlin and North Rhine-Westphalia to be unable

to spend the foreseen amounts of SME financing of, respectively,

24,4 million euro, 13,6 million euro and 2,6 million euro. This represented

under-utilised funds ranging from 18 % to 87 % of the amount originally

planned.

• 91. 

  In Greece, the holding fund agreement was signed in June 2007 and well

before that Member State's sovereign debt crisis unfolded. As of 30 June 2011

only 0,21 % of the 250 million euro holding fund, has effectively been paid out

to SMEs. It is only since April 2011 that Greek SMEs started receiving ERDF

support. As the Hellenic Republic and the EIF signed the holding fund

agreement early, calls for tenders could have been issued directly by the

holding fund manager if only the Member State had not delayed the holding

fund's governance arrangements, notably by making these dependent on

appointments within Managing Authorities involved and in the fund's investment

board.

40

system of management costs. The Polish Ministry of Regional Development

referred to the legal and organisational difficulties of the Joint European

Resources for Micro to Medium Enterprises (JEREMIE) Initiative and, in

particular, to the need to widely interpret the Structural funds regulations in

view of their complexity53.

Leakage effects

• 94. 

  It is normal market practice that SMEs can be charged management costs

by financial intermediaries. However, in the context of the ERDF, such costs

are generally paid directly from the operational programme to the financial

intermediaries as reimbursement or compensation for managing the funds54.

Additional charges to the SMEs...

• 95. 

  Commission guidance (including two interpretative notes of 2007 and 2011)

does not set the terms and conditions, which would prevent SMEs being

charged costs that are not based on actual SME risk taken or service provided

by the financial intermediaries.

• 96. 

  In Saxony-Anhalt (Germany) and Estonia, the financial intermediaries

41

declarations at closure is currently being investigated by the Commission as

part of audit inspections conducted in the English regions.

... not always very transparent

• 98. 

  Because the Commission does not legally consider the SME to be the

beneficiary and because Member States do not always report management

costs correctly, there have been instances where management costs borne by

the SMEs are unknown.

• 99. 

  Out of the 16 equity funds audited, the management costs of four of them

could not be estimated due to a lack of available data at the time of the audit.

• 100. 

  For instance, in North Rhine-Westphalia, neither the Managing Authority,

nor the appointed fund manager, could provide information about the

management costs actually incurred by the region. Indeed, documentation on

the calculation of the interest rate charged, including the margin for financing

management costs, could not be provided. Additional costs for supporting

SMEs (including costs of external consultants) were financed through the funds

in the case of one early stage equity fund, but an overview of these costs could

not be provided either.

42

financial instruments55. As a result, the Court defines leverage as the extent to

which private funding has been attracted as set out in Box 5 :

Box 5 Leverage

The Court calculated leverage as follows:

Finance to final recipients

Public contributions56

Using the Court's calculation method, Annex II gives a schematic overview of how

leverage works for each main category of financial instrument and, in the context of

the ERDF, how the concept of leverage is to be understood. For instance, a leverage

ratio of 1,00 means that no private funding was raised at all.

In August 2011 the Commission formalised the concept of "multiplier effect", which

corresponds to:

Finance to final recipients

EU contribution

The numerator of both the Court's leverage ratio and the Commission's multiplier ratio

are identical. Regarding the denominator, while the Court sums up all public funding,

43

• 103. 

  When public funding is limited to the EU contribution (like in EU centrally

managed programmes) both calculations give the same result. However, the

situation is generally different in the context of Cohesion policy. Member States'

co-financing of operational programmes generally constitutes public funding;

they may be national, regional or take other forms of public aid57.

• 104. 

  Whereas the Commission includes Member State co-financing to an

operational programme as a contribution in the multiplier effect, the Court's

ratio does not consider this as a contribution to the leverage effect. Indeed,

Member State co-financing is not specific to financial instruments. Such

Member State co-financing exists for any Cohesion policy action, including also

traditional non-reimbursable grants.

• 105. 

  At the level of the holding funds, the audit did not come across significant

leverage from the private sector. This was true for both programming periods.

Indeed, there are typically no explicit leverage requirements in the funding

agreements between the Managing Authorities and the financial intermediaries,

except for certain equity funds in the United Kingdom, which had binding

leverage requirements for private co-investors.

• 106. 

  For equity and loan instruments, the Court found that the leverage

44

Table 3 Leverage of equity instruments audited (fund names have been anonymised)

Member StatesFund nameProduct descriptionLeverage

ratio

High-technology funds

GermanyEquity Fund BVC (high-tech)2,26

United KingdomEquity Fund LVC equity (high-tech)2,01

United KingdomEquity Fund MVC equity (early stage high-tech)1,95

United KingdomEquity Fund NVC equity (early stage high-tech)1,89

GermanyEquity Fund DVC (early stage high-tech)1,33

Other funds

GermanyEquity Fund ARisk capital (multi-sector)2,75

PortugalEquity Fund GVC equity fund-of-funds2,22

PortugalEquity Fund HVC equity (multi-sector)2,12

United KingdomEquity Fund OVC equity (early stage creative)1,89

GermanyEquity Fund CRisk capital (multi-sector)1,88

United KingdomEquity Fund PFilm fund1,78

HungaryEquity Fund EVC equity (multi-sector)1,72

HungaryEquity Fund FVC equity (multi-sector)1,43

PortugalEquity Fund IVC equity (tourism sector)1,33

United KingdomEquity Fund QVC equity (early stage creative)1,09

SlovakiaEquity Fund JVC equity outside Bratislava region -

SlovakiaEquity Fund KVC equity in Bratislava region -

Notes: - Figures for Equity Funds J and K are forecasts based on EIF estimates and have not been considered in the following analysis.

45

generating revenues for the Commission58. More specifically, in Germany,

Portugal and the United Kingdom, where the ERDF was equally active,

leverage ratios achieved by the ETF Start-Up Facility were, respectively, 4,88,

5,93 and 5,0359. On the other hand, from April 2000 until June 2010, leverage

ratios achieved by the ERDF for the audited funds (in Table 3 ) ranged from

1,09 to 2,75.

Leverage of ERDF loan instruments

• 111. 

  Irrespective of any benchmark Table 4 shows that five out of the 10 loan

funds did not leverage any private funding at all, whereas the other loan funds

showed very limited leverage.

Table 4 Leverage of loan instruments audited (fund names have been anonymised)

Member StatesFund nameProduct descriptionLeverage

ratio

Other funds

United KingdomLoan Fund GLong-term senior loans to social enterprises1,67

United KingdomLoan Fund H (2 operations)Senior loans (multi-sector)1,67

United KingdomLoan Fund ISenior loans (multi-sector)1,41

HungaryLoan Fund BMicrocredits, small loans1,33

HungaryLoan Fund CMicroloans (multi-sector)1,10

GermanyLoan Fund AMicroloans, Loans1,00

46

• 112. 

  As a benchmark, the Court has used the SME Finance Facility (SMEFF),

which was used in Central and Eastern European countries that joined the EU

in 2004 and 2007 before they achieved that status. The SMEFF provided

grants (mainly performance fees, but also so-called "technical assistance") to

networks of local financial intermediaries through international financial

institutions60. These grants were conditional to the effective set-up and the

revolving of SME debt portfolios of a pre-defined size.

• 113. 

  The EU's SMEFF leveraged private funding achieving leverage ratios

usually exceeding 5 and reaching up to 12,5 and 19,261. From 1998 until June

2009 and depending on the implementing financial intermediary, SMEFF

achieved leverage ratios ranging from 2 to 12,5 in Hungary and from 4 to 10 in

Slovakia.

Leverage of ERDF guarantee instruments

• 114. 

  Fewer guarantee funds were subject to the audit (six, see Table 5 ), as the

United Kingdom and the regions audited in Germany generally do not use

ERDF guarantees.

47

Table 5 Leverage of guarantee instruments audited (fund names have been anonymised)

Member StatesFund nameProduct descriptionLeverage

ratio

PortugalGuarantee Fund BGuarantees171,00

PortugalGuarantee Fund CGuarantees114,00

PortugalGuarantee Fund DGuarantees80,00

PortugalGuarantee Fund ECounter-guarantees11,00

HungaryGuarantee Fund AGuarantees4,16

SlovakiaGuarantee Fund FFirst loss portfolio guarantees -

Notes: - Figures for Guarantees Fund F are forecasts based on EIF estimates and have not been

considered in the following analysis.

• - 

  Leverage ratios calculated on the basis of figures transmitted during the audit by the fund manager or the Managing Authority.
• 115. 

  The leverage ratios achieved varied greatly, with the highest being 171.

Even the lowest ratio (4,16) of a guarantee fund in Hungary and which started

operating in November 2008 is a higher leverage ratio than achieved by any of

the equity and loan funds. These levels of leverage compare well with the SME

Guarantee Facility (SMEG, see paragraph 6(a)) that cumulatively leveraged 67

times each euro of public money spent from 2001 until 200662.

48

CONCLUSIONS AND RECOMMENDATIONS

Quality of the assessment of the SME financing gap

• 116. 

  Generally, during the 2000-2006 programming period, gap assessments

did not exist at all.

• 117. 

  During the 2007-2013 programming period, where they existed, all SME

gap assessments concluded that there was a need for public sector

intervention in various forms and they quantified the SME financing gap.

However, in the 2007-2013 programming period, there are significant

shortcomings in the quality of the gap assessments. In particular, the critical

link between the different programme allocations and the financing gap

identified was not established.

• 118. 

  An independent review of the quality of the gap assessments and of their

underlying process did not take place.

Recommendation 1

(a) When proposing financial engineering measures, the Managing Authorities should

make sure that their proposal is duly justified by an SME gap assessment of sufficient

49

until February 2011, four years after the start of the current programming

period, did the Commission issue a comprehensive and relevant interpretative

note on financial instruments (see paragraphs 46 and 47).

• 120. 

  Delegating the implementation of co-financed financial instruments to a

large number of public authorities means that the same amount of ERDF

funding that could theoretically be available for all SMEs in a Member State

under a single framework has to be scattered across a large number of EU

regions, thus affecting the critical mass of the funds.

• 121. 

  Where they existed, suitable monitoring and information systems were ill-

equipped to inform on and monitor the sound financial management of the

funds. Despite the experience of the 2000-2006 programming period, this

prevented the Commission from reporting relevant information that was useful

to decision-makers and stakeholders operating in the context of the Cohesion

policy.

Recommendation 2

(a) When designing proposals for the Structural Funds Regulations, the Legislator and

the Commission should address the different specific weaknesses mentioned in the

50

Effectiveness and efficiency of the financial instruments in achieving

results

• 122. 

  The implementation of financial instruments for SMEs through the ERDF

has been affected by widespread delays. Some of the reasons for delays

during the 2000-2006 programming period have recurred in the 2007-2013

programming period.

• 123. 

  ERDF co-financed financial instruments have also been subject to

leakage effects in terms of management costs. In particular, some SMEs have

been charged additional costs not based on the SME risk taken and the

reporting of management costs has not always been transparent

• 124. 

  Except for guarantees, leverage ratios as defined by the Court

demonstrated for ERDF co-financed funds were poor.

Recommendation 3

(a) The Commission should explore the possibility of supplying to the Member States

off-the-shelf financial engineering structures and instruments for SMEs (e.g. grants

with royalties, dedicated investment vehicles) in order to speed up implementation and

reducing management costs. Examples of such structures have been described in

51

General Recommendation

If the above recommendations cannot be implemented under the Cohesion policy

framework, the Court invites the Legislator and the Commission to consider alternative

ways of pursuing SME support through financial engineering instruments. In such a

case, such instruments should either be supported by programmes centrally managed

by the Commission, dedicated investment vehicles in cooperation with the

Commission and the Member States or by the Member States directly.

This Report was adopted by Chamber II, headed by Dr Harald NOACK,

Member of the Court of Auditors, in Luxembourg at its meeting of 11 January

2012.

For the Court of Auditors

Vítor Manuel da SILVA CALDEIRA

President

ANNEX I

Commitments and payments to financial engineering instruments

2000 - 2006

Audited Member Commitments

States(in million euro)%Payments

(in million euro)%

Germany 20413 17011

Hungary -- -

Portugal 1067 886

Slovakia -- -

United Kingdom 43327 41027

Total - 74246 - 668100%45

EU Total - 1 596100 - 1 497100

2007 - 2013

Audited Member Allocations Payments

States(in million euro)%

(in million euro)%

Germany 1 37013 7109

Hungary 7707 6698

Portugal 2923 2333

Slovakia 30 27

United Kingdom 6146 2303

Total - 3 07510030 - 1 86824%24

EU Total - 10 393100 - 7 879100

ANNEX II

Schematic overview of the leverage concept as applied to equity, loan and

guarantee instruments

Equity

Operational Programme

ERDF ContributionNational Contribution

1 million euro+4 million euro

5 million euro

Equity Fund ABanks

Leverage ratio:

Funding available to SMEs: 20 M Operational programme funding: 5 M 10 million euro

Funding10 million euroEquity Funds B

Leverage Ratio = 4VehicleInvestors C, D

20 million euro

SMESMESMESMESMESME

Remarks: - This schematic overview is purely given f or illustration purposes.

Loans

Operational Programme

ERDF ContributionNational Contribution

1 million euro+

2 million euro

5 million

Leverage ratio:Loan FundeuroBanks

Funding available to SMEs: 18 M Operational programme funding: 3 M

8 million euro

Leverage Ratio = 6Lending10 million

Institution euroCapital Markets

18 million euro

SMESMESMESMESMESME

Remarks: - This schematic overview is purely given f or illustration purposes.

-The public contributions correspond to the operational programme f unding.

Guarantees

Operational Programme

ERDF ContributionNational Contribution

2 million euro +4 million euro

Leverage ratio:Guarantee

Funding available to SMEs: 120 M Operational programme funding: 6 MFundBanks

Guarantees for

6 million euro in portfolio losses

Leverage Ratio = 20(no money flow)

SME

Credit Risk120 million euro

Portfolio

120 million euro

SMESMESMESMESMESME

Remarks: - This schematic overview is purely given f or illustration purposes.

-The public contributions correspond to the operational programme f unding.

ANNEX III

Examples of off-the-shelf instruments and vehicles

Grants assorted with royalty payments: the example of MOITAL, Israel

In Israel, most aid schemes for SMEs (R&D Fund, Technological Incubators,

Heznek,...), even though they use non-reimbursable grants, condition the

payment of the grant to the commitment of the beneficiary SME to pay royalties in

case of success. Royalties are calculated on the basis of sales or profit. The

benefit of grants assorted with royalty payments is that they are less complex than

financial engineering instruments, whilst focussing on SMEs with potential in

research and development. For more information, see: http://www.moital.gov.il/

Dedicated Investment Vehicles

• - 

  European Recovery Programme: ERP is an evergreen national fund

managed by KfW for the benefit of Germany's enterprises with, as one of its main

characteristics, its revolving nature. For more information, see:

http://www.bundesfinanzministerium.de/

• - 

  Israel's Yozma Fund: When it was still a State-owned fund, its principle

enables microfinance institutions in the EU countries to increase lending to them.

This is done by issuing guarantees to microfinance institutions thereby sharing

their risk and by increasing their micro-credit volume through funded instruments

(i.e. loans and equity). For more information, see http://ec.europa.eu/social/

• - 

  The European Fund for Southeast Europe (EFSE): EFSE's main

investment activity is the refinancing of selected partner lending institutions in the

region of Southeast Europe and European Eastern Neighbourhood Region with

senior or subordinated credit lines, whereby the borrower obliges himself to on-

lend the funds to the final target groups, including micro and small enterprises and

low-income private households. A large sponsorship characterises this Fund,

which includes international financial institutions (e.g. EBRD, EIB, KfW, etc.), the

Commission, as well as public and private financial institutions. For more

information, see http://www.efse.lu.

REPLIES OF THE COMMISSION TO THE SPECIAL REPORT OF THE EUROPEAN

COURT OF AUDITORS

"FINANCIAL ENGINEERING INSTRUMENTS FOR SMEs CO-FINANCED BY THE

EUROPEAN REGIONAL DEVELOPMENT FUND"

EXECUTIVE SUMMARY

IV. The revolving character of financial instruments may not be present in financial instruments implemented under other policy areas, for which the resources returned to the financial instruments at the end of the investment period or at winding up must be returned to the EU budget. This specific feature embedded in the Structural Funds Regulations

63 will be continued in the future

64.

VII.

(a) The Commission agrees on the importance to provide funding to financial instruments corresponding to the needs as identified in a gap analysis.

The relevant observations by the Court are partly covered by the proposal for CSF Regulation COM(2011)662 final.

(b) The regulatory framework for the period 2007-2013 may have been insufficiently detailed to provide the necessary environment for a significant increase of the cohesion policy assistance delivered through financial engineering instruments.

The Commission proposals for the next programming period take into account the experience gained in the previous periods, providing a detailed implementation framework.

(c) Those delays were in most cases explained by the novelty of the instruments in cohesion policy and by the State aid related issues. Financial instruments financed from ERDF are implemented in shared management manner. There is a certain trade off between application of subsidiarity principle (implementation by Member States and their managing authorities at regional level as close as possible to the final recipients and in accordance with the diversity of their needs) and the slower implementation.

(b) For the future programming period the emphasis will be placed in ensuring that each financial instrument is "based on an ex ante assessment which has identified market failures or suboptimal investment situations, and investment needs". When approving the operational programmes emphasis will be placed on ensuring alignment with EU2020 strategic priorities, identification/fulfilment of ex-ante conditionalities and evaluation of the rationale for the form of support proposed.

(c) Given the expected increase in the importance of financial instruments in the future, the Commission's proposals for the future CSF Regulations include more detailed and clear rules regarding the use of financial instruments. These rules build upon the experience accumulated in the current programming period and will be further detailed in the implementing legislation.

(d) The Commission welcomes this recommendation which is already covered in the Commission's proposals for the new cohesion policy framework. These proposals also include specific provisions regarding monitoring and reporting of financial instruments. Furthermore, the Commission notes that already in the current programming period it managed to gather important monitoring information on existing financial instruments, and this without the legal obligation of the Member States to provide such information.

(e) The Commission welcomes the Court's recommendation regarding off-the-shelf instruments which is covered in the proposal for the new programming period.

(f) The Commission can concur with the aims of this recommendation In the proposals for new cohesion policy framework, the Commission has opened the possibility of Member States contributing to EU level instruments. Furthermore they include incentives where the whole priority axis is delivered through financial instrument

66.

However the implementation of cohesion policy programmes and the underlying actions (including financial instruments) under shared management and by national or regional authorities are fundamental elements of cohesion policy.

INTRODUCTION

• 8. 

  In July 2011 Member States did provide the Commission with data on their implementation of Financial Engineering Instruments on voluntary basis.

The proposed amendment of the current Structural Funds Regulations and the next generation of these regulations (2014-2020) will require Member States to provide this kind of information on a regular basis.

• 12. 

  The Commission has a different concept, measuring the multiplier effect of the EU contribution. See paragraph 102 and reply.

67

AUDIT SCOPE AND APPROACH

• 25. 

  The "internationally reputable programmes" identified by the report have limitations to be used as benchmarks for EU cohesion policy instruments since the cohesion policy objectives and the regulatoryframework have specificities not present in other programmes.

OBSERVATIONS

• 31. 

  The Commission agrees that there was no such legal requirement at the level of programming. However, at the level of each financial engineering instrument there is a legal requirement of gap assessment. The result of this assessment should be reflected in the funding agreement.

The Commission's proposal for 2014/-2020, include the requirement that the ex-ante evaluation should cover inter alia "the rational for the form of support proposed"

• 34. 

  At the time of preparing gap assessments, most of the 2000-2006 programmes were still on- going.
• 38. 

  The gap assessments were carried out by the EIF, the body of the EU with special expertise and responsibility in implementing EU budget support to enterprises, thus an independent assessment was not deemed necessary.

However, the proposed Structural Funds Regulations for the 2014-2020 programming period as well as the proposal for the revision of the Financial Regulation contain detailed provisions in that area.

In addition, the Commission made sure that both set of proposals are coherent with each others.

• 46. 

  The Commission made significant efforts to improve the guidance framework for the implementation of financial engineering instruments in cohesion policy. The Commission guidance notes issued in 2007 and 2008 addressed the issues which were identified at the time as needing specific clarification. The Commission guidance note issued in February 2011( is more comprehensive and covers a much wider range of issues which were raised by the national authorities and partners concerned as part of the process of the rolling out of financial engineering instruments throughout the vast majority of Member States and regions.
• 47. 

  Although the Commission guidance notes are not legally binding, they provide technical guidance to the attention of public authorities, practitioners, beneficiaries or potential beneficiaries, and other bodies on how to interpret and apply the EU rules in this area, on the basis of the applicable EU Law.

(first indent) The Commission refers to its replies to relevant paragraphs below.

(second indent) The Commission refers to its replies to relevant paragraphs below.

(third indent) The Commission refers to its replies to relevant paragraphs below.

(fourth indent) The Commission refers to its replies to relevant paragraphs below.

• 48. 

  For the 2014-2020 period the Commission intends to introduce provisions regarding leverage in the implementation framework, while ensuring sufficient flexibility to accommodate the characteristics of each product, each market gap to be addressed, beneficiaries targeted and financial intermediaries involved.

The Structural Funds regulations for the periods 2000-06 and 2007-13 allowed the reuse of resources for an indefinite period until exhaustion. However for the period 2014-20 the Commission's proposals foresee a minimum period of 10 years.

• 51. 

  The Commission agrees with the Court's observation . For the current period the Regulations require that resources returned to the operation from investments undertaken shall be reused by the competent authorities of the Member Sate concerned for the benefit of SMEs. For the 2014-2020 period the Commission proposes that Member States should have provisions in place to ensure the revolving nature of financial instruments for at least ten years.
• 52. 

  The point raised during a DAS audit by the Court has been followed-up. The relevant winding- up provisions have subsequently been amended to be consistent with Article 78(7) of Regulation 1083/2006.
• 53. 

  Under shared management and in line with the subsidiarity principle, the Commission does not monitor in detail the implementation of individual operations., It is the responsibility of national authorities to ensure that individual operations are implemented in accordance with the applicable legal provisions. In 2011 the Commission developed an audit framework shared with Member State audit authorities to verify the correct implementation of financial instruments until closure of the programmes.
• 54. 

  The holding fund needs to have certain liquidity to ensure smooth investments in enterprises. The investment strategy and/or business plan required by the regulations must give proper estimation of funds needed.

The Commission guidance notes of 2008 and 2011 recommended Member States or managing authorities to exercise restraint regarding payment of contributions into funds, namely by making such payments in phases in line with the underlying investment strategy and/or business plan.

The Commission's proposals for the 2014-2020 regulation provide for more strict discipline, imposing that amounts disbursed to FEIs be effectively invested in final recipient.

• 60. 

  The Commission guidance note

72 considers that on the basis of state aid legislation investment

shall be effected pari passu. However, different arrangements, subject to the approval of specific state aid scheme, are also possible.

Each managing authority must take a deliberate policy decision, as part of the investment strategy and business plan, as to the degree of private sector involvement in addressing public policy objectives and the level of legacy funds expected to be created.

• 61. 

  The cases mentioned by the Court cannot be considered as cases of unjustified preferential treatment of private investors. The first priority for the allocation of resources returned to the funds was the discharge of existing debt, with a view to reduce the funds liabilities (including interest on debt) and free liquid resources for onward investments.
• 62. 

  Yield restriction clauses are in line with the regulations.Preferential treatment is an important factor to attract private investors to co-invest with public funds in areas of high risk/low return, pursuing public policy objectives.
• 63. 

  Structural Funds should not be used just to finance a normal business activity for enterprises which do not correspond to the eligibility requirements of the Regulation
• 73. 

  The possibility of

financing working capital as part of the expansion of a business activity was already foreseen in the Commission guidance note of 16/7/2007 and was further developed in the Commission guidance note of 21/2/2011 to make clearer that financing of working capital in early stages, or as part of the seed capital for new enterprises is acceptable.

• 64. 

  The term "expansion" referred to in Structural Funds regulation is in line with the approach and the terminology of state aid legislation

74.

• 65. 

  The Commission guidance was further developed in 2011 to make clear that financing of working capital in early stages, or as part of the seed capital for new enterprises can be financed. In this respect, the Commission does not share the observation of the Hungarian managing authority that conditions were difficult to interpret.
• 69. 

  The Commission considers that the examples mentioned by the Court cannot be used as a comparator for financial engineering instruments implemented under cohesion policy. These cases do not share cohesion policy objectives, as expressed in the Treaty

76 .

• 71. 

  The operational programme allocations were agreed in 2007. At that time in certain regions/countries the gap assessments and strategies did not exist. For many Member States this is the first attempt to develop financial instruments. This is why certain critical mass was not reserved in the relevant programmes.
• 72. 

  The Commission shares the view that it is necessary for a holding fund to have a critical mass but it considers that in some circumstances it is justified to have funds with smaller sizes to achieve cohesion policy objectives.

Common reply to 75-76

The managing authorities and fund managers decided and accepted to implement such funds on the basis of their potential viability.

• 78. 

  Under the policy and legal framework applicable to Structural Funds the approval, monitoring and control of individual operations fall within the responsibility of managing authorities. For its part the Commission must satisfy itself that the Member States set up adequate management and control systems.

The Member States sought and the Commission provided guidance on 2007-2013 provisions not only on financial engineering, but also on other important elements of implementation.

• 79. 

  The follow-up made by the same internal audit in 2011 considered that the advice given by the report mentioned by the Court had been addressed and therefore this matter was considered closed.
• 80. 

  The "financial engineering" unit set up within DG Regional Policy, has a broader mission.
• 81. 

  Following the Internal Audit report the situation described has been overcome. Namely comprehensive guidance has been provided to Member States, working arrangements with other DGs have been intensified as well as internal information sharing and training.
• 91. 

  The signature of JEREMIE Holding Fund Agreement between the EIF and Greece for the initial amount of EUR 100m took place in June 2007; while the related cost letter was signed in October 2008. In June 2009, Greece transferred the amount of EUR 100m from EU ERDF funds to the JEREMIE Fund , to be transformed into financial engineering to enhance access to finance to SMEs

in Greece.

On 5 October 2010, Greece and the EIF entered into a Funding Agreement, whose purpose was, inter alia, to restate and replace the initial funding agreement and cost letter, and increase the relevant amount from EUR 100m to EUR 250m. The additional funds of EUR 150m transferred to the Holding fund in early November 2010 are earmarked to support the ICT sector and ICT related projects, an area of significant strategic importance for Greece to foster innovation and improve its competitiveness.

• 92. 

  The funding agreement marking the start of the fund was signed in October 2009 after which the first payments to the holding fund took place.
• 93. 

  The delay in Poland was also related to issues of national regulatory framework, i.e. the requirement for all beneficiaries (incl. holding funds) to provide collateral in the amount of ERDF financing received to guarantee good performance of the contract. Since only BGK, the state owned bank, was formally exempt from that regulation, the Ministry of Regional Development needed to amend this legislation. This process, in consultation with the Ministry of Finance, took considerable amount of time.

However and in parallel to this process, the EIF worked with the regions on the implementation proposals and negotiated contractual arrangements.

• 95. 

  Common reply to 95-98

The Commission guidance note of 21/02/2011, did provide elements regarding possible conflict between costs and fees charged to final recipients and management costs and fees declared to the Commission as eligible expenditure. Whenever the Commission detected additional charges to SMEs, these were corrected. The Commission issued additional guidance to prevent the occurrence of this situation.

• 104. 

  In accordance with the applicable Regulations, Cohesion policy co-financing obligation is set at programme level. Individual operations (e.g. funds) may have national co-financing or not at all. Therefore the Commission does not agree with the approach used by the Court to calculate leverage for the ERDF.
• 106. 

  See reply to paragraph 25. The key objectives of the Cohesion policy as expressed in the Treaty are economic, social and territorial cohesion and the aim to reduce "disparities between the levels of development of the various regions and the backwardness of the least favoured regions ".

The Commission notes that the comparators used by the Court do not primarily reflect these objectives.

• 108. 

  Since ERDF financed equity instruments were mainly implemented in assisted areas and aimed to address sectors of market failure, the Commission considers that the achieved leverage ratio as measured by the Court is significantly positive

77.

• 109. 

  Applying the Commission's methodology for calculating the multiplier effect to both the Structural funds and the ETF would bring the ratios closer. However, the Commission considers that ETF has limitations to be used as a comparator for risk capital investments supported through the Structural Funds.
• 110. 

  Please refer to the reply to paragraph 102.
• 111. 

  See reply to paragraph 102.
• 112. 

  Common reply to paragraphs 112 and 113.

It is not appropriate to compare SMEFF with financial engineering instruments implemented under cohesion policy.

The SMEFF is a facility providing banks with financial incentives to promote bank lending to SMEs. The SMEFF did not co-finance loans, as did the ERDF funds covered by the report, therefore they are not comparable products.

• 117. 

  The Commission agrees on the importance to provide funding to financial instruments corresponding to the needs as identified in a gap analysis.

The relevant observations by the Court are partly covered by the proposal for CSF regulation COM(2011)662 final. More exhaustive provisions will be included in the secondary legislation.

The gap assessments should obviously have an adequate level of quality.

• 118. 

  Each gap assessment was provided to the managing authority concerned and to the respective services of the Commission to be taken account in programming of cohesion policy resources and in the identification and selection of operations to be funded. The gap assessments were carried out by the EIF, the EU body with special expertise and responsibility in implementing EU budget support to enterprises through financial instruments.

Recommendation 1

(a) The Commission welcomes this recommendation which is covered by the Commission's proposal for the new the cohesion policy framework

79

This requirement will be further detailed in the implementing legislation.

(b) For the future programming period the emphasis will be placed in ensuring that each financial instrument is "based on an ex ante assessment which has identified market failures or suboptimal investment situations, and investment needs". When approving the operational programmes emphasis will be placed on ensuring alignment with EU2020 strategic priorities, identification/fulfilment of ex-ante conditionalities and evaluation of the rationale for the form of support proposed.

• 119. 

  The regulatory framework for the period 2007-2013 may have been insufficiently detailed to provide the necessary environment for a significant increase of the cohesion policy assistance delivered through financial engineering instruments.

always have the option of implementing instruments at national or regional level, designed to meet their specific needs.

• 121. 

  The policy and legal framework applicable to Structural Funds is such that the approval, monitoring and control of individual operations fall under the responsibility of managing authorities
• 80. 

  For its part the Commission must satisfy itself that the Member States set up adequate

management and control systems.

The Commission underlines that, despite the lack of a legal basis, in the course of 2011 it carried out an extensive mapping of the financial engineering instruments in place, based on information provided by Member States and managing authorities on a voluntary basis.

Recommendation 2

(a) Given the expected increase in the importance of financial instruments in the future, the Commission's proposals for the future CSF regulations include more detailed and clear rules regarding the use of financial instruments. These rules build upon the experience accumulated in the current programming period and will be further expanded in the secondary legislation.

(b) The Commission welcomes this recommendation which is already covered in the Commission's proposals for the new cohesion policy framework. These proposals also include specific provisions regarding monitoring and reporting of financial instruments. Furthermore, the Commission notes that already in the current programming period it managed to gather important monitoring information on existing financial instruments, and this without any legal basis to do so.

• 122. 

  Those delays were in most cases explained by the novelty of the instruments in cohesion policy and State aid related issues. As demonstrated however by the mapping exercised carried out in 2011, on average the rate of progress in the implementation of financial engineering instruments is not lower than the rate of implementation of other actions financed through cohesion policy.

It is expected that in the next programming period, the development of "off the shelf" instruments will contribute to limiting significantly delays.

(a) The Commission welcomes the Court's recommendation regarding off-the-shelf instruments which is covered in the proposal for the new programming period.

(b) The Commission can concur with the aims of this recommendation. In the proposals for new cohesion policy framework, the Commission has opened the possibility of Member States contributing to EU level instruments. Furthermore they include incentives where the whole priority axis is delivered through financial instrument

81 .

However the implementation of cohesion policy programmes and the underlying actions (including financial instruments) under shared management and by national or regional authorities are fundamental elements of cohesion policy.

(c) In the 2014-2020 period, the concepts and definitions of leverage and revolving will be developed in the secondary legislation, which will also be aligned as much as possible with the concepts used for all instruments implemented with EU budget funding, as foreseen in the Commission communication COM(2011) 662 on the "EU debt and equity platforms" and which will also be regulated in the Delegated act regarding Title VIII of the amended Financial Regulation. However, achieving high leverage ratios must be balanced with public policy objectives of cohesion policy.

General Recommendation

The Commission welcomes the Court's recommendations for the improvement of the legal framework for implementing financial instruments as part of the Cohesion policy. With the experience in the current and previous programming periods and the improvement of the regulatory framework inline with the Court's recommendations the Commission considers that financial instruments should continue to be used as important instruments for the implementation of Cohesion policy, including their possible extension to new thematic areas, as more sustainable and efficient way of delivering EU resources to support Cohesion policy objectives.