PART I: Ex Ante Assessment and Ex Post Evaluation of Risk Finance Measures

PART I: Ex Ante Assessment and Ex Post Evaluation of Risk Finance Measures - StateAidHub blogpost23



The European Commission has approved, with decision SA.40991, amendments to two existing aid measures: Enterprise Investment Scheme [EIS] and Venture Capital Trust [VCT] in the UK.[1] These measures had been authorised by decision SA.33849.

The two measures are textbook examples of well-designed interventions. Because their annual budget exceeds EUR 150 million, they are also subject to ex post evaluation. This means that not only is the ex ante assessment for intervention convincingly shown, but also that much thought has gone into how the ex post results can be credibly measured and compared to the hypothetical results of no intervention.

For these reasons, these two measures deserve to be reviewed in detail. This article is divided into two parts. Part I, which is published this week, considers the objectives of the measures and the Commission’s assessment of their compatibility with the internal market. Part II, that will come next week, presents that ex post evaluation plan.

Part I: Objectives and compatibility

The main features of the existing measures

Under the EIS, investments are made by private individuals directly into qualifying companies, the “target company”. In addition, investments can be made via collective investment vehicles managed by specialised fund managers that invest on behalf of investors in a portfolio of target companies.

An EIS fund is a “transparent vehicle” and not a legal entity owning assets in its own right. The ownership of underlying shares in the target companies remains with the individual investors. In this way it satisfies the requirement of investing directly into individual companies. In its original decision the Commission concluded that an EIS fund was not an undertaking and therefore did not benefit from State aid.


Under the VCT, investments are made collectively by individuals via investment funds, whose managers invest on behalf of investors in a portfolio of companies. There are no restrictions regarding the region in which the investee company must be based in. The only requirement is permanent establishment in the UK. In its original decision the Commission could not exclude the possibility that VCTs were undertakings but it found that they did not receive any state resources and therefore did not benefit from State aid.

The investors that benefit from the tax incentives provided by these measures must be independent of the target company. The tax incentives are not available to individuals who own more than 30% of the company or who work for the company. The tax reliefs are granted automatically, on a non-discretionary basis.

The main tax incentives provided by the EIS and VCT are the following:

  • Income tax relief at 30% of the amount invested, up to a maximum of GBP 1 million per year.
  • Relief from capital gains tax on gains from sale of shares.
  • Exemption from tax of dividends received on shares held in a VCT fund.

The target company must be an unquoted company with gross assets of maximum GBP 15 million and with fewer than 250 full-time employees. It must also have a permanent establishment in the UK.

The annual investment tranche which each target company can obtain under the existing EIS and the VCT rules is limited to GBP 5 million.

The notified amendments

The amendments take into account the new rules on State aid for risk finance in the GBER and the Risk Finance Guidelines [RFGs]. The main amendments are the following:

  • Extension of the duration of the schemes from 2017 to 2025.
  • A new budget allocation.
  • New eligibility criteria for investees.
  • Higher maximum volume of investments into each final investee.
  • New definition of “independent investor” aligned with the requirement of the new RFGs.

The cost of the schemes is forecast to be around GBP 580 million in 2015 and rising to GBP 690 million by 2021. The budget exceeds the threshold defined in the Article 1(2)(a) of the GBER [EUR 150 million] for “large schemes”. According to points 170 and 171 of the RFGs, the EIS & VCT schemes need to be subject to ex post evaluation.

Ex ante study

In order to justify these amendments, and in compliance with the requirements of point 47 of the RFGs, the UK authorities notified an ex-ante assessment, conducted with the help of independent consultants, whose objectives were the following:

  • Definition of the relevant market failure.
  • Identification of the characteristics of the firms that suffer from this specific market failure, including their age (based on the number of years following their first commercial sale) and the knowledge-intensive nature of their core activities.
  • Quantification of the funding gap for this category of companies.
  • Demonstration that the design of the measure is appropriate to address the relevant market failure and covers the specific funding gap affecting the target companies.

Companies invested in

With respect to the eligibility criteria for investees, the UK intended to replace the previous criteria based on the concepts of “seed”, “start-up” and “expansion” capital with two new categories of eligible investees:

  • Non-knowledge intensive SMEs up to 7 years after their first commercial sale.
  • Knowledge-intensive SMEs and mid-caps up to 10 years after their first commercial sale.
  • For knowledge-intensive SMEs and mid-caps, no age limit will apply if the required risk finance is higher than 50% of their average annual turnover.

The new risk finance aid rules [GBER and RFGs] have replaced the concepts of seed, start-up and expansion capital of the previous Risk Capital Guidelines [RCG] with more operational criteria based on the age of the investees as a proxy for market failure.

The definition of knowledge intensive SMEs and mid-caps corresponds to the definition of innovative company set out in the RFGs.

The total investment that can benefit non-knowledge intensive SMEs is GBP 12 million [about EUR 15 million], while the funding for knowledge-intensive SMEs and mid-caps amounts to GBP 20 million [about EUR 24 million].

The Commission noted that i) extending support to knowledge intensive SMEs and mid-caps, that are older than 7 years, ii) raising the limit of total investment to GBP 20 million [i.e. beyond the EUR 15 million threshold] and iii) the no age limit when risk finance exceeded 50% of the annual turnover were parameters of the measure that went beyond what was permitted by the GBER. Therefore, the measure had to be notified for prior authorisation before its implementation.

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Compatibility with the internal market

The Commission first observed that the amendments concerning non-knowledge intensive SMEs were in line with the Article 21 of the GBER. The envisaged support was limited to SMEs which were not older than 7 years after their first commercial sale and which, in total, could benefit from risk finance investments up to GBP 12 million, corresponding to the EUR 15 million ceiling set by the GBER. Therefore, the Commission concluded that the part of the EIS & VCT for risk finance aid to SMEs younger than 7 years was in conformity with Article 21 of the GBER.

Interesting the Commission considered that if the EUR 15 million ceiling were exceeded due to monetary fluctuations solely, it would not put into question the compatibility of the scheme. This is because the impact on competition would result not from the funding amount itself but from the exchange rate of the currency.

Then the Commission identified the changes that went beyond the requirements set by the GBER and which required an assessment under the RFGs:

  • Support to knowledge intensive SMEs and mid-caps up to 10 years after their first commercial sale.
  • Total investment up to GBP 20 million, which was above the EUR 15 million limit set by the GBER, for knowledge-intensive SMEs and mid-caps.
  • The no-age limit for investments in SMEs which required risk finance higher than 50% of their average annual turnover. Although this was allowed by Article 21(5)(c) of the GBER, it would also be applied to knowledge-intensive mid-caps.

Application of the common assessment principles

Contribution to a common objective

The purpose of the schemes is to help business finance and venture capital markets to operate more efficiently and competitively across the UK and the European Union. This is a legitimate public policy objective.

Need for state intervention

Point 72 of the RFGs recognises that mid-caps, in certain circumstances, may also face financing constraints comparable to those affecting SMEs. Point 73 of the RFGs acknowledges that certain types of undertakings may be regarded as being in their expansion or early growth stages, even after a 7-year period, if they have not yet sufficiently proven their potential to generate returns and/or do not have a sufficiently robust track record and collateral. Point 75 of the RFGs mentions that where the upfront research or investment costs are relatively high, the GBER cap on the total amount of risk finance per undertaking of EUR 15 million may not be sufficient.

Extending the application of the EIS & VCT to knowledge-intensive SMEs and mid-caps up to 10 years after the first commercial sale

The ex ante study has shown that the UK is particularly affected by problems faced by knowledge intensive companies, as the population of knowledge-intensive companies is higher in the UK than the European average.

UK SMEs invest heavily in R&D both using internal funds (third behind Finland and Netherlands) and external funds (fourth behind Finland, Cyprus and Poland).

The dominant feature of knowledge-intensive companies is that they have a high proportion of intangible assets (such as human capital, consumer or research networks or intellectual property rights), which are crucial for these companies’ ability to build knowledge and consequently market value. The intangible assets do not typically constitute good collateral to obtain external funding as they would have limited value in case of bankruptcy (in contrast with physical assets)

The higher level of intangible assets and the innovative nature of activities undertaken by these knowledge-intensive companies also create more difficulties in valuing an undertaking. As a result of adverse selection and moral hazard, projects with positive net present value may not at all be successful in attracting sufficient external financing (“equity gap”).

Increasing the risk finance investment limit to GBP 20 million for knowledge-intensive SMEs and mid-caps

An important contributing factor to this situation is represented by the specific characteristics of the banking sector in the UK which, in comparison to other EU countries, remains concentrated, thereby exacerbating the significant risk aversion of banks to lend to early-stage, knowledge-intensive companies.

The effects of the crisis have been such that banks have continued to cut back net lending, making it difficult SMEs and small mid-caps to get funding.

Knowledge intensive companies, for reasons of longer incubation period and higher sunk costs linked to the R&D-intensive nature of their activities are in need of funding beyond the GBER requirements which the market cannot currently provide.

Application of the “no-age limit” rule to knowledge-intensive mid caps

Under the notified schemes, the “no-age limit” rule applicable to SMEs fulfilling the requirement set by Article 21(5)(c) of the GBER applies also to knowledge-intensive mid-caps. Article 21(5)(c) of the GBER extends the benefit of the exemption to investments in SMEs which, irrespective of their age require an initial risk finance investment which, based on a business plan prepared for the purpose of entering a new product or geographical market, is higher than 50% of their average annual turnover in the preceding 5 years.

Under the EIS & VCT, the definition of mid-caps goes beyond the GBER definition of SMEs only with respect to the headcount, as it covers mid-caps up to 499 employees. The scope of the rule at issue is furthermore limited by the application of the definition of “knowledge-intensive” mid-caps. The limited extent to which the EIS & VCT go beyond the SME definition, justifies the application of the same approach underpinning Article 21(5)(c) of the GBER also to the knowledge-intensive mid-caps.

The Commission considered that the narrowly defined category of knowledge-intensive mid-caps, requiring an initial investment 50% higher than their yearly turnover and aiming at entering a new market, was likely to be affected by the same market failure which was presumed to affect all SMEs which pursued the same business model [this kind of aid for SMEs is allowed under Article 21(5)(c) of the GBER]. Therefore, the notified extension of the eligibility criteria to include this category of firms was regarded to be in line with point 72 the RFGs.

Appropriateness of the aid measure

According to point 89 of the RFGs, in order to address the identified market failures and to contribute to the achievement of the policy objectives pursued by the measure, the envisaged risk finance aid must be an appropriate instrument, while at the same time causing the least distortion to competition.

The Commission accepted that it had been sufficiently demonstrated that the tax incentives provided under the EIS & VCT were adequate to stimulate access to finance, would have a wide effect in incentivising private investors in taking on the risks of investing in smaller and less-established companies, as well as stimulating the venture capital market.

Incentive effect of the aid

According to point 131 of the RFGs, risk finance measures must incentivise market investors to provide funding to potentially viable eligible undertakings above the current levels and/or to assume extra risk. A risk finance measure is considered to have an incentive effect if it mobilises investments from market sources so that the total financing provided to the eligible undertakings exceeds the budget of the measure. Hence, a key element in selecting the financial intermediaries and fund managers should be their ability to mobilise additional private investment.

The ex ante study showed that the proposed investment would not have taken place without the schemes. In fact, a significant proportion of funding for SMEs would be made available as a result of the tax incentives.

Proportionality of the aid

According to point 133 of the RFGs, State aid must be proportionate in relation to the market failure being addressed in order to achieve the relevant policy objectives. It must be designed in a cost-efficient manner, in line with the principles of sound financial management. For an aid measure to be considered proportionate, aid must be limited to the strict minimum necessary to attract funding from the market to close the identified funding gap, without generating undue advantages.

The Commission noted, first, that investments made under the EIS & VCT were to be made solely by private investors without any direct participation of public investors. All investment decisions would be commercially driven by the individual decision of private investors or venture capital funds in which the latter invest.

Second, private investors providing finance to eligible undertakings under the scheme benefit from an income tax relief which is capped at 30% of the amount invested in eligible undertakings. Furthermore, the relief is provided to investors who are independent from the company invested in. This is in line with the requirements of point 150 of the RFGs. Moreover, relief from capital gains tax and relief from tax on dividends on shares held in a VCT fund conform with points 151 and 152 of the RFGs.

Third, the overall ceiling on the total amount of risk finance investment into each knowledge-intensive SMEs or mid-caps is in line with the equity gap, determined on the basis of an ex-ante study.

Avoidance of undue negative effects on competition and trade

According to point 155 of the RFG the State aid measure must be designed in such a way as to limit distortions of competition within the internal market. In the case of risk finance measures, the potential negative effects have to be assessed at each level where aid may be present: the investors, the financial intermediaries and their managers, and the final beneficiaries.

The EIS & VCT focus on growth-oriented companies which suffer from a market failure by providing a fiscal incentive to investors to enable the market to operate efficiently.

The State aid provided through fiscal incentives to individual investors ensures that all resources invested under the schemes are private and that no crowding out of private investment takes place.

In the case of the VCT, there is no limit on the number of financial intermediaries which can operate under the scheme and, hence, the VCT scheme does not discourage any expansion of existing competitors. The Commission also observed that the UK authorities were not involved in the investment decisions of the VCT and did not place any limits as to the region of establishment for investee companies. In fact, the investment decisions under the EIS & VCT schemes are entirely left to the market and the selection of investments is based on commercial logic.

Finally, EIS & VCT schemes exclude companies which should be able to access finance by traditional routes (for example if the undertaking is clearly asset-backed), as they are likely to be unaffected by any potential information asymmetry problem.

Evaluation plan

The evaluation plan was also found to be compatible.


Some critical remarks

The EIS & VCT are textbook cases of how Member States should design their risk capital measures. Despite the fact that they deviated from the provisions of the GBER, the Commission did not have any significant difficulty in authorising them. The success of the UK in having its measures approved can be attributed to three factors.

First, UK authorities carried out a detailed and credible ex ante study that identified market gaps and determined both the type and amount of necessary support.

Second, the measures were designed to correspond to and, therefore, remedy the identified market failure.

Third, the measures were in conformity with the requirements of the RFG. Since the measures did not comply with the GBER conditions, particular care was taken so that sufficient justification together with supporting evidence were provided to the Commission to prove conformity with the RFG.

Yet, despite the apparent congruence between the measures and State aid rules, in a paradoxical way, for the following reasons these measures also reveal the weaknesses of State aid rules. But a warning is in order at this point. The remarks below are made on the basis of the information provided in the Commission decision and without the benefit of having first considered the ex ante study.

The RFG, and to a lesser extent the GBER, require that State aid is granted only when there is market failure. The main causes of market failure in this case are information asymmetries and lack of collateral. The indicator of these types of market failure is the apparent unwillingness of the market to provide funding. The market provides less funding to the companies that are targeted by the measures than what it provides to other companies.

However, any investment of any size by any company suffers from asymmetry of information between the independent investors and the investee company. This is the ever present principal-agent problem whereby the principal cannot observe in all situations how the agent acts. There are ways to reduce the severity of the asymmetry, but not to resolve it completely. Hence, state intervention may be necessary, but this market failure is so broad that in itself it does not really justify intervention in just one sector or for just one group of companies.

The same reasoning applies to the problem of access to finance of companies which do not have sufficient collateral to put up as security. In this case, the UK authorities made a convincing argument in favour of knowledge-intensive companies. But the same problem is encountered by any company that wants to embark on any large project or any project with long gestation period and long pay-back period.

The point of these observations is that finance involves intrinsic risk and such risk is not necessarily reduced by government intervention. It may only be shifted from private investors to the state and taxpayers.

Moreover, private investors, even with State aid, will still invest where they maximise the return on their investment. They will not necessarily put their money where it will generate the largest benefits for society. Ironically, by not limiting the sectors or areas where investments should be made, the UK ensured that competition was distorted as little as possible. The Commission shared that view. But in this way the social benefits of the two schemes would also be uncertain. Hence, we see a potential conflict between directing investment into sectors or areas with the highest possible social benefits and avoiding distortion of the market.

The scope of a properly designed measure should correspond to the extent of the market failure. Since the failure identified by the UK is indeed broad, the two schemes were also broad. But this also shows that addressing market failure is not the same as maximising social benefits from state intervention. Social returns may be higher in some sectors than others and the sectoral or regional variation in social returns requires sectoral or regional focusing of the state intervention.

It is obvious from its assessment of the impact of the two schemes on competition that the Commission favours broad measures. To reiterate, this minimises competition distortions but does not maximise social returns.

Lastly, the Commission observed that competition was not unduly distorted because there was no crowding out of private investment. All of the funds were private. Strictly speaking, this is not correct. If that were true, there would be no State aid. However, even if there was no crowding out, there was diversion. More private funds would be invested in the projects and companies that would be eligible for the tax credits. Therefore, distortion can occur in a different form but it can still be massive. The average annual budget – i.e. the loss of tax revenue – is expected to exceed GBP 0.5 billion per year. Since the tax credit is equal to 30% of the invested funds, it follows that the total amount of private investment that could be diverted into the two schemes could reach over GBP 1.5 billion per year. This is potentially a very large re-direction of funds.


[1] The full text of the Commission decision can be accessed at:



Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He is professor at the University of Maastricht and the University of Nicosia. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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