Episode 14: Quasi-equity finance – а new ERDF model financial instrument

Hello and welcome to the new fi-compass Jam Sessions podcast. I am Anna Zurek from the fi-compass team at the European Investment Bank, and I am pleased that you have joined us for today's podcast, in which we are going to discuss quasi-equity as a financial instrument product and answer your questions about the ERDF quasi-equity model financial instrument, which is published on the fi-compass website. We will link the publication in the transcript of this podcast episode for those who would like to read it. We presented the ERDF quasi-equity model financial instrument during the fi-compass event in October 2022, and we received some really good questions, which we took as an occasion to prepare this podcast episode. By the way, the video recording of this fi-compass conference, including the session about the quasi-equity model financial instrument, is available on our website and we will link this as well in this episode's transcript. And now I am pleased to welcome two great guests for this episode. Our first expert joining us today is Sara Dagostini, policy officer at the Financial Instruments and International Financial Institutions Relations Unit at DG Regio. Welcome, Sara.

Sara Dagostini: Thank you, Anna. Good morning, everyone. Thank you very much for inviting me. It's a pleasure for me to be here today and talk about the new model of quasi-equity finance for SMEs.

We are also joined by Markus Lehmann, finance director at IBB Ventures, the fund manager of the ERDF co-financed VC funds in Berlin, who has kindly agreed to share his practical experiences with quasi-equity investments. Welcome, Markus.

Markus Lehmann: Anna, I'm happy to be here.

So before we turn to our questions, Sara, could you please give us a quick introduction to the ERDF quasi-equity model financial instrument, as well as a definition of what equity and quasi-equity are as financial instrument products? What is their purpose?

Sara Dagostini: Sure. First, let me explain the idea of this model. So, the idea of focusing on a quasi-equity model came in the context of the COVID-19 pandemic. During the crisis, liquidity was abundant, but during and especially after, the SMEs clearly needed equity capital. The equity market has remained overall quite stable during the crisis and has proven resilient. The few existing equity ecosystems continued to function in Europe, but at the same time the need of expanding the number of equity ecosystem has grown. Now equity and quasi-equity usually coexist as product, as they are provided by the same financial providers. From ERDF experience, the implementation of an equity instrument has proven effective for the development of the ecosystem in a few member states. For example, Greece, Sweden, and probably not least in the Berlin area. In the previous programming period, we had an off the shelf instrument focused on equity. In this programming period, our choice fell on the quasi-equity finance for SMEs. Now, what is an equity instrument? Equity is the provision of risk capital and management expertise in return for ownership. What is quasi-equity? Quasi-equity is an instrument with some equity feature and also some debt feature. For example, in our model we have focused on subordinated loans, not in the form of convertible debt. They bear a higher interest rate than standard loans, but lower than equity. They rank junior to standard loans but senior to equity in case of liquidation. Subordinated loans bear therefor a higher risk than standard loans, but lower than equity. The condition of our model refers to non-convertible subordinated loans and might not be necessarily applied to other quasi-equity instruments. In our model, the loans may have a duration of 5 to 10 years. They will bear a favourable interest rate. There is no need of collateral, and they are mainly targeting SMEs and mid-caps. These loans are meant to support new enterprises, early-stage SMEs, expansion of capital, capital support in general activity and so on. So, full details can be found in the procedure in the fi-compass website.

So, you mentioned already a number of features of quasi-equity instruments, and one of the clear messages from the presentation at our conference in October 2022 was that quasi-equity financial instruments may take many different forms from subordinated loans to preferred shares. Can you confirm that this is correct? And how do you deal with this in the model?

Sara Dagostini: Indeed, as you said, quasi-equity instruments are not standardised products and they can take different forms, closer to equity or to debt. All this is left to the negotiation of the parties. In addition, there is no predefined taxonomy in the market for this type of instrument. In our model, within the different type of quasi-equity, we felt subordinated loan was better suited for early stages. Subordinated loans tend to be deployed in very early phases of innovative enterprises as the investor can have an approach: ‘Invest, wait and see’. If the investment is successful, they can decide to proceed with subsequent equity investment, otherwise they can simply stop investing.

Thank you very much, Sara. So, the model is based on a subordinated loan product, but other types of quasi-equity models can also be set with ERDF resources, correct Sara?

Sara Dagostini: Correct. Actually, this is a very good question, Anna. Indeed, we have given preference to subordinated loans in our model to ease the design and implementation of this very specific type of quasi-equity. However, with ERDF any other type of quasi-equity can be deployed, such as, for example, venture capital or participatory certificate, this model can be used to get inspired for the design and implementation of other type of quasi-equity. But in this case, not all feature of this model can be directly applicable.

Thank you very much, Sara and Markus. I think your quasi-equity product in Berlin is a convertible loan. Could you please describe how you use this type of product with your portfolio companies?

Markus Lehmann: Yes, sure. First and foremost, we are a venture capital fund, so we are an equity investor, but we use quasi-equity in combination in certain situations and we use it also quite often. For venture capital investors, there are special situations where you do not want to record a valuation of a company. In this situation, it’ is mostly bridge financing, we use convertible loans, and we also used a lot of loans during the COVID-19 crisis because convertible loans are often faster and easier, less formal. You do not have to go to a notary to close a convertible loan. It's also the reason why many other states in Germany use convertible loan programs during COVID-19 crisis because fast help was needed by the companies, and they didn't want to negotiate a valuation in this situation, but to help them fast and postpone the valuation to a later point in time. That was the main reason why many convertible loans were used in this time.

Thank you very much. Markus. It is really interesting to hear how you used quasi-equity in Berlin and what kind of benefits it provided and how flexible this product was, actually. Without telling us your commercial secrets, how do you set the conversion rate? Do you use an interim valuation of the companies?

Markus Lehmann: Yes, that's not really a secret. It's very standard to negotiate a certain discount on a future valuation. So, the valuation is postponed to the future. When a new investor is joining the company in the next financing round, you have a valuation of an external party, and lenders of convertible loans usually get a discount on this future valuation. In most cases it is something between 20% or 30% of the valuation of the external investor because you have a higher risk, because you invest earlier. As a new investor who joins later has more information on the company, to compensate for the higher risk, you get this discount. Sometimes you also see contracts where there is not only a discount but also a valuation cap, meaning there is a ceiling for the valuation. So even if the new investor is accepting a higher valuation, the convertible loan lenders have this contractual cap and in some cases it's no external lender. There is also the possibility of a conversion. They often have a floor valuation, that's a lower valuation. In most cases, this will be the valuation from the last financing round before the loan was given. So, many variants, but you can have a standard contract where you always write in the 20% discount on the future financing round. So, this would be a possibility to use a standardised contract.

Thank you very much Markus. So, let's look at the questions that reached us regarding the quasi-equity model financial instrument at the conference. The first question is, how would financial intermediaries secure their part of the funding and what is the rationale behind their investing in such an instrument? This is a really interesting question for subordinated loans, for example, there will be little or no collateral. Is this reflected in the pricing, Sara?

Sara Dagostini: Sure. So, equity and quasi-equity instruments are usually provided by equity and venture capital funds. These intermediaries are different from conservative low credit risk banks. They target high risk, high return investment. Usually, they work with no collateral as the enterprises with high growth in early stages simply do not have collateral available. The rationale behind these investors, which are also defined as patient investors, are as the lifetime of an equity investment, which is usually 7 to 10 years. This investor waits until the enterprise reaches break-even and enter the profitability phase. One out of four might fail, but some other can also ensure a three, or four times return on investment. To conclude, as mentioned earlier, this instrument bears a higher interest rate to reflect the higher risk and the no collateral. Therefore, yes, it is reflected in the prices.

Thank you very much. Markus, would you like to complement?

Markus Lehmann: Yes, that's correct. There are usually no collaterals at all, we don't work with collaterals. You even have in many cases, also in the convertible loans a subordination clause, meaning that your loan ranks behind other external lenders, but before other equity investors. So, it's in between. And yes, we usually don't get payback of this loans, but the loans convert, at a future point in time, into equity. And with equity, you have the chance to recover much more than you have invested, if the company is very successful. But on the other hand, you have a high risk also. If the company fails, you don't get anything out of a collateral or something like this. So, it's risky like equity, but if it converts then into equity, you usually have an upside like in equity investment.

Thank you very much, Markus. This was really insightful. And now to the next question regarding the pricing of the subordinated loans. We received a good question about state aid treatment. A practitioner commented that the European Commission does not consider quasi-equity, such as subordinated loans, to be transparent aid, and this would mean that the minimis cannot be applied without notification. Is this correct? And what are the options to ensure state aid compliance for quasi-equity financial instruments, Sara?

Sara Dagostini: In our regulations, quasi-equity is listed as a financial product. The definition can be found either in the financial regulation and or in the GBER and subordinated zones should fit into the definition of quasi-equity. In our model, quasi-equity finance for SMEs, we have a detailed section about state aid rules that may apply for this type of product. In fact, state aid compliance should be ensured at financial intermediaries’ level and financial recipient level. Some possible grounds to ensure compliance with state aid rules are at the minimis regulation and the GBER provided that all conditions are respected, or also the risk finance guidelines, but subject to notification. But as I said, more detailed information can really be found in the fi-compass brochure about state aid.

This is very helpful. Thank you very much, Sara. Markus, how do you deal with state aid in Berlin? I think you always invest pari passu with market investors, correct?

Markus Lehmann: Yes, if ever this is possible, we prefer this approach because it is less risky. So, if you have private investors that are giving the companies loans to the same conditions and the right amount, we always follow this path and do pari passu. So, no state aid in this situation. But as I mentioned before, during COVID-19, for example, we didn't always have these independent private investors because in most cases we invested together with investors that were already on board in the companies. They were not really independent. In these cases, we used the small aid scheme. It is no longer available, but this was very good regulation in this special situation during COVID-19. And if you look at the GBER, one thing that could be usable is this Article 22 for young companies. So, in the situation, you might use maybe this aid scheme because the whole amount of the loan has to be treated as a state aid if you don't have the pari passu. The minimis could be one option if the loan amount is below EUR 200 000 or GBER may be an option if you have a higher amount. What we do not use, is the reference rate approach. If you have a certain threshold for the reference rate, this might be a state aid conform, but we don't use this because if we are lending to start-up companies, to very young companies. You can come into a situation where subordination is required afterwards if you don't have this in the contract from the beginning or if the company doesn't develop estimated and they are not able to pay the interest rate, they may ask you for a postponement of interests. This could put you, as a lender, in a difficult situation where this loan that you have maybe regarded, not as being a state aid because you have a high enough interest rate, becomes a state aid later on. The best way is either doing pari passu, no state-aid from the beginning, or look for a stable state aid compatible approach. This would be my recommendation if you are regarding state aid.

Thank you very much, Markus. These are really interesting insights and recommendations. And now to the next question. We had one comment about a possible specific challenge with quasi-equity financing. Quasi-equity is often targeting start-up companies that are not yet profitable, and this can lead to difficulties due to their over indebtedness as quasi-equity is not regarded as equity. This can result in excluding them from ERDF financing. Sara, is this correct? And what is your view on this?

Sara Dagostini: Yes, quasi-equity is a financial product per se, which contains some features of both equity and some features of debt. I mentioned earlier the role of equity and quasi-equity, as special investor and the readiness to accept higher risk, including the lack of profitability at the very early stages. Quasi-equity as such, is in the list of the financial products mentioned in our regulation, not last in Article 2 (17) of the CPR 2021-2027, the same as loans guarantee and equity. So, quasi-equity as financial product can indeed be used for the ERDF financing through the financial instrument structure.

Thank you very much, Sara. Markus, do you have a view on this as well?

Markus Lehmann: Yes, we have this problem in some cases because ERDF excludes companies in difficulties from getting a financing. If you have start-up companies that are mostly using the money they are receiving either as equity or loans for personal costs, so not investing in machines or in goods, but in heads so to say, they are using up this money. And if you have a quasi-equity, it is in the state aid regulation or the definition for companies in difficulties, it is regarded as not being equity even if you have a subordination. So, by the point when you are signing the contracts, you have to make sure that there's enough equity left in the company so that you do not have a company in difficulties. One thing that might help is if it's a very young company. If the company is younger than three years, you have exemptions that you can give them. They do not count as a company in difficulties. You don't look at the balance sheet to make this assertion if it's a company in difficulties. This might be an option for very young companies, but if the company is older and you have this situation that there's not enough equity, you have to be careful.

Thank you very much. Let's move now to the last question from the conference. Another practitioner wondered if there were any guidelines to use quasi-equity instruments in less developed markets. An example was mentioned about Western Balkans. Is the small banking penetration rate in less developed markets a limiting factor to use quasi-equity instruments, Sara?

Sara Dagostini: When talking about this type of market, the high banking penetration is indeed a catalyst or even essential for the use of financial instruments such as loans or guarantees. Nevertheless, for equity and quasi-equity, the reference market is the equity market. Quasi-equity finance is usually provided, not by banks but by financial intermediaries like equity or a venture capital fund, the same as the equity providers. A functioning equity market is therefore important, more important than a banking system itself. We have mentioned earlier how the design and implementation of a first ERDF equity instrument has proven effective to support the development of such equity market. More specifically, it might represent the foundation to create a strong equity ecosystem or even reinforce when it's already existing.

Sara, Markus, thank you very much for sharing these insights with us.

Sara Dagostini: Thank you very much Anna for having me, and thanks for the very interesting questions from the audience.

Markus Lehmann: Thank you, too, from my side. Very good questions from your audience. And I was happy to share some of our experiences regarding these questions from Berlin.

And a big thank you also to the practitioners who raised those questions we discussed today at the conference and a big thank you also to all listeners for tuning in to today's episode of our fi-compass Jam Sessions podcast. We hope that this podcast will be helpful for many practitioners out there who may be considering implementing quasi-equity instruments in the 2021-2027 programming period. And if you have any further questions or remarks on this or any other topics, we encourage you to get in touch with us through email at contact@fi-compass.eu. We really look forward to hearing from you. And this brings today's episode to a close. Do not forget to follow us on social media and to look out for future editions of our podcast. Until next time, goodbye.