Small and medium-sized enterprises, banking relationships, and the use of venture capital

1. Small and medium-sized enterprises, banking relationships, and the use of venture capital 11th ECB-CFS Conference, Prague, Czech Republic Allen Berger Klaus Schaeck Moore School of Business Bangor Business School University of South Carolina University of Wales Wharton Financial Institutions Center CentER, Tilburg University

2. SMEs, banking relationships, and the use of venture capital Introductionand Background – Hypothesis – Data – Empirical Analyses - Conclusion • What the paper does: • We formulate and test hypotheses about the determinants and performance • effects of venture capital (VC) using data for SMEs in Italy, Germany, and the UK. • We focus on the strength of the bank-firm relationship and how this affects firms’ choice of VC. The idea is to examine if firms substitute VC for multiple bank relationships. We find that the data are consistent with this hypothesis. • As part of this analysis, we also analyze the drivers of the use of VC for SMEs in Europe. We find that younger and larger SMEs are more likely to use VC. • 3. We employ matching estimators to examine if the use of VC affects firm performance, and compare these performance effects with performance effects arising from multiple banking. We find that VC-funded firms exhibit higher growth, and spend more on R&D. Such effects do not follow from the use of multiple banking.

3. SMEs, banking relationships, and the use of venture capital Introductionand Background – Hypothesis – Data – Empirical Analyses - Conclusion The rationale behind this paper: VC can play a critical role for SMEs, not only to close a possibly emerging funding gap, but also for firms that might otherwise face impediments attracting funding due to information asymmetries, the absence of a convincing track record, and the lack of assets that can be pledged as collateral for bank loans (Gompers and Lerner, 2001). • Venture capital organizations contribute to small and innovative firms in a number of different ways. • VCs may be more effective than bank in monitoring investments in firms with few tangible assets (Lerner, 1995; Gompers and Lerner, 1996), and VCs increase firm efficiency (Chemmanur et al., 2008). • VCs enhance a firm’s reputation to receive better terms when applying for financing (Black and Gilson, 1998) • VCs professionalize the firms in which they invest (Hellmann and Puri, 2000, Bottazzi et al., forthcoming).

4. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Main Hypothesis: SMEs choose between single and multiple bank lending relationships. One reason for multiple banking is that an exclusive relationship can give rise to hold up problems, where the bank extracts rents from the firm (e.g., Sharpe, 1990; Rajan 1992). However, there is also a possibility that SMEs turn to non-banks as providers of financing in place of multiple banking. We propose that SMEs may use VC as a substitute for multiple banking as a way to offset the market power of the main bank. Venture capital providers may be less likely to engage in rent extraction since they hold equity or equity-linked ownership rights and benefit significantly from firm performance in the long run. This argument is also supported by the venture capital literature.While venture capital providers have access to private information arising from their role as active investors, Kaplan and Strömberg (2003,p. 281) stress that venture capitalists “receive few or no private benefits of control”.

5. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Our dataset - Overview: We use a unique dataset from the Centre for Business Research at the University of Cambridge (Martin et al., 2001). Dataset contains information on VC funds obtained by SMEs in Italy (Emilia-Romagna), Germany (Bavaria), and the UK (South-East), and the strength of the bank-firm relationship. • Survey data – characteristics: • postal questionnaire , sent out in 2001 to over 800 SMEs, response rate > 60 percent. • survey covers two (Germany and the UK) of the three largest European private equity markets (Bottazzi et al., 2004). • three regions in these countries have in common that they are rich in innovative firms, and VC providers are well represented. • regions are characterized by both small, local single-market banks and large, nationwide active multi-market banks. NB: Outside of the US, the term VC is used to describe private equity investments. In particular in Europe, VC is different from the US because the term VC also comprises what is commonly referred to as private equity in the US, including management buy-ins, and management buy-outs.

6. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Our dataset - Details: The questionnaire is divided into five sections. Section I – Basic information: Size in terms of employees and turnover, the main markets served, if the firm invests in R&D, and employment growth. Section II – Financing (general): Methods of financing, the purpose of the funds raised. Section III – Bank finance: If the firm used bank finance, the reasons for doing so, the type of banks, type of the main bank, bank role and influence, whether the firm maintains more than one bank lending relationship. Section IV – VC: Use of VC, the reasons for choosing or not choosing VC, volume of VC, how the entrepreneur found out about VC, and what the advantages and disadvantages are of having access to VC. Section V – Other finance: Use of other types of finance.

7. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Our dataset – Representativeness: • Extraordinarily high response rate (> 60 percent) • Survey taken at the peak time of European VC investments (2000/2001) • VC investments in regional clusters – these clusters are covered in the survey data (e.g., London alone accounts for 60 percent of UK VC investments, over 20 percent of German VC investments take place in Bavaria,...) • Survey data exhibits similar distributions in terms of VC deals relative to the total population of VC deals in these countries. There are also similar age distributions between the sample and the population. • Public policy awareness in all three countries towards VC occurring in late 1990s

8. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Our dataset – Details (cont’d): • UK dominates the dataset with about 47 percent of the observations, followed by Italy (31 percent), and Germany (22 percent). • More than 6 percent of the 524 firms in the sample report that they have obtained funds from venture capitalists. • SMEs in the UK make up the bulk of the firms that obtained VC (50 percent), followed by SMEs in Germany (47 percent), and in Italy (3 percent). Italian firms are considerably less likely to be financed by VC than SMEs in either the UK or Germany (Bottazzi et al., 2004). The key advantage of the data is that it provides information on the strength of the relationship between SMEs and their banks on the one hand, and on the use of VC on the other hand. Thus, this survey is ideally suited to investigate what drives firms to use VC, and how the strength of the bank-firm relationship affects their use of VC.

9. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Why do SMEs use VC? • State funding is either not sufficient or not available (50 percent). • Bank loans are not appropriate (36 percent), insufficient (36 percent), or not available at all (29 percent). • VC expertise is the key reason for the choice of venture capital (28 percent). • What type of VC is used by the SMEs in the sample? • VC provided by financial institutions is the dominant type (70 percent). • VC provided by “business angels” ranks second (42 percent). • VC contributed by local or regional governments is less important (7 percent).

10. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • What is the role of the venture capitalist (besides funding)? • Sits on the firm’s board (64 percent) • Provides management advice (38 percent) • Provides sales and marketing advice (26 percent) • Provides technical advice (6 percent) • In sum, these descriptive statistics are aligned with Hellmann and Puri (2000), Jeng • and Wells (2000), and Bottazzi et al. (forthcoming) about the involvement of venture • capitalists as providers of support and governance of small firms.

11. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Differences in firm characteristics The analysis highlights that firms that use VC are younger and larger. These firms are also less likely to maintain multiple bank relationships than their non-VC funded counterparts.

12. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Determinants of the use of VC (Logit analysis, marginal effects) Our dependent variable is a dummy variable that takes on the value 1 if the firm used VC.

13. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Determinants of the use of VC - Key results • Our findings indicate that firms with multiple banks are less likely to use VC. • This is consistent with the argument that VC-funding may serve as a substitute for multiple banking as a way to offset the market power of the main bank. • This finding is robust to the way multiple banking is measured. • This finding is robust to instrumenting multiple banking and use of funds for new product development. • b) Also, we find a negative, but not always significant effect for the main bank being a national bank. • This may point towards one or both of the following two hypotheses: • i) national banks provide more sophisticated services than do local banks • ii) local main banks may wield more market power than national main banks. • c) The younger the SMEs, the more likely the firms are to use VC. • d) Data also indicate that larger firms are more likely to use VC, and that use of funds for new product development is positively associated with VC.

14. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Determinants of the use of VC - Sensitivity analysis • Our findings are insensitive to changes along a number of different dimensions using • alternative samples, and a different measure of firm size. • We use a set of dummy variables for the number of employees to test measurement of firm size. • We remove Italian firms from the sample, because Italian firms tend to have a large number of bank relationships (e.g., Detragiache et al., 2000; Ongena and Smith, 2000). • We constrain the sample to SMEs that existed 20 years or less (start-ups and young firms). • We omit the largest firms. • We remove observations where the VC provider was recommended to the firm by the bank. • We drop observations when VC is also used for MBIs and MBOs. • We drop observations where the provider of VC funds is sponsored by the government. We conclude that our results are materially unaffected by sample selectivity or measurement problems.

15. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Does VC matter for firm growth and R&D expenditure? We use matching methods based on propensity scores to investigate to what extent SMEs that obtain VC funds benefit economically. The propensity score can be defined as the probability of receiving venture capital, conditional on a set of pre-treatment characteristics. We ask if VC-funded firms systematically spend more on R&D, and if there are systematic differences in terms of firm growth, measured by changes in the number of employees. Matching based on propensity scores: We match the firms based on the nearest-neighbor with replacement propensity score methodology (Dehejia and Wahba, 2002) to compare and contrast firm performance along the dimensions of employee growth and R&D expenditure. This method allows examining the counterfactual of what would have happened to the performance of a small firm that in fact obtained VC if it would not have had VC by averaging the performance of the most similar firms that did not obtain VC in the sample. For every firm that has had VC, the nearest-neighbor matching technique chooses a group of non-VC funded firms with propensity scores closest to the VC funded firm propensity score.

16. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Does VC matter for firm growth and R&D expenditure : Results • What is the effect of VC on the firms in our specific sample? (SATT) • What is the effect of VC in the three regions: Emilia-Romagna, Bavaria, and the south- • east of the UK? (PATT)

17. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion • Does VC matter for firm growth and R&D expenditure : Results (cont’d) • Using VC has a causal effect on performance of small firms. • Sample average treatment effect (SATT) • We find that SMEs that have had VC observe significantly higher employee growth than they would if they had not received funds from VC providers. • Firms that have had VC also invest a higher proportion of their revenues into R&D. • Our results confirm assertions by Hellmann (1998), Hellmann and Puri (2000), and Bottazzi et al. (forthcoming), and underscore the beneficial effect of VC on firm performance. • The findings also matter in terms of the economic significance. For instance, using venture capital is associated with a more than 21 percent increase in the probability of an increase in the number of employees. • Population average treatment effect (PATT) • We can infer that the choice of VC on another set of small businesses from the same population would likely yield positive performance effects.

18. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Does VC matter for firm growth and R&D expenditure: Results (Horserace) We conduct a ‘horserace’ using again matching methods to compare firms that use VC with firms that use multiple banking to investigate which of the two methods of offsetting the market power of the main bank is most effective in promoting firm performance. Step 1: We estimate the propensity score of the use of VC, using as covariates all the variables used for the estimation of propensity scores but without the dummy variable for multiple banking. This exercise confirms our previous findings. Step 2: We calculate propensity scores for the use of multiple banking instead of the use of VC.

19. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Does VC matter for firm growth and R&D expenditure: Results (Horserace cont’d) We then match firms based on the propensity scores for multiple banking with those firms that do not maintain multiple banking relationships, we find neither a significant difference in terms of employee growth, nor any significant difference in terms of R&D investments. This analysis lends further support to the idea that the involvement of VC providers yields observable positive performance effects, effects that do not follow from the use of multiple banking relationships.

20. SMEs, banking relationships, and the use of venture capital Introduction and Background – Hypothesis – Data – Empirical Analyses - Conclusion Do these findings have implications for public policy? Given the lively debate about the funding of small and medium-sized firms in Europe, our results also point towards an implication for policy making. The availability of venture capital can benefit the performance of SMEs. In that sense, government policies that nurture the venture capital industry are likely to positively affect SMEs.

21. SMEs, banking relationships, and the use of venture capital Questions & Answers