Last week I reviewed the new State aid guidelines on risk finance. This week I will examine the provisions on financial instruments in the new structural and investment funds regulation. The regulation was published in the Official Journal just before Christmas. Both sets of rules have been updated on the basis of similar principles. The primary aim of both is to increase the flow of funds to SMEs and other innovative enterprises by incentivising private investors to assume more risk or to commit more of their own resources [this is the leveraging effect].
However, in this article I also identify a peculiar inconsistency between the two sets of rules. It concerns the possibility afforded to Managing Authorities to invest directly into enterprises. Since, as shown below, one of the requirements for mobilising structural and investment funds is compliance with State aid rules, I will suggest that the only way to effect direct investment is the removal of the State aid element from such investment.
The Financial Instrument Provisions of Regulation 1303/2013
Title IV of Regulation 1303/2013 laying down common provisions on the European Regional Development Fund, the European Social Fund, the Cohesion Fund, the European Agricultural Fund for Rural Development and the European Maritime and Fisheries Fund is devoted to financial instruments.
Article 37 lays down the basic rules on the deployment of financial instruments. When European structural and investment funds [ESI] are used to support financial instruments [FI], the implementing authorities must comply with State aid and public procurement rules. To underline its importance, this requirement is repeated at several points in the Regulation.
FI are primarily intended for SMEs but funding may be provided to any enterprise, including large enterprises.
The Regulation stipulates that FI must support investments which are expected to be “financially viable” but at the same time “do not give rise to sufficient funding from market sources.” This means that the investments must not be loss-making without, however, being profitable enough as to be able to attract private funding.
Support of FI must be based on an ex ante assessment which establishes evidence of market failure, the estimated level and scope of public investment needs and the types of FI to be supported. This ex ante assessment must cover the following:
(a) Analysis of market failure and investment needs;
(b) Assessment of the added value of the FI, possible State aid implications, the proportionality of the envisaged intervention and measures to minimise market distortion;
(c) Estimate of additional public and private resources to be potentially raised (expected leverage effect), including an assessment of the need and level of preferential remuneration to attract private investors;
(d) Assessment of lessons learnt from similar instruments and ex ante assessments carried out by the Member State in the past, and how such lessons will be applied in the future;
(e) The proposed investment strategy;
(f) Specification of the expected results and how FI are expected to contribute to the achievement of identified policy objectives;
(g) Provisions allowing for the ex ante assessment to be reviewed and updated during the implementation of any FI.
These conditions go beyond the State aid assessment principles in two respects. First, State aid rules do not explicitly require that past lessons are incorporated in the ex ante assessment. Second, they do not require the assessment to be updated during the implementation phase.
FI may be combined with grants, interest rate subsidies and guarantee fee subsidies. Final beneficiaries may also receive other aid [EU or national] in accordance with applicable State aid cumulation rules. However, grants may not be used to repay FI, nor can FI be used to pre-finance grants.
Article 38 defines the rules on the implementation of financial instruments. Managing authorities [MA] may contribute to the following:
(a) FI set up at EU level, managed directly by the Commission or indirectly via the European Investment Bank [EIB] or the European Investment Fund [EIF];
(b) FI set up at national, regional, transnational or cross-border level, managed by or under the responsibility of the MA.
When supporting FI, the MA may:
(a) Contribute to the capital of fund of funds or financial intermediaries;
(b) Entrust implementation tasks to the EIB or financial institutions controlled by Member States;
(c) Undertake implementation tasks directly, but only in the case of loans or guarantees.
When FI are implemented through bodies other than the MA, these bodies must also comply with the relevant State aid and public procurement rules.
Financial intermediaries must be selected on the basis of open, transparent, proportionate and non-discriminatory procedures, avoiding conflicts of interest. It is notable that intermediaries do not need to be selected on the basis of competitive procedures. It is sufficient that the procedure is open and transparent. This requirement of open selection does not apply to direct entrustment to the EIB and financial institutions controlled by the Member States.
National public and private contributions may be provided at the level of the fund of funds, at the level of the financial instrument or at the level of final recipients.
Article 39 gives to the Member States the option to use the ERDF and EAFRD to contribute to FI managed indirectly by the Commission via the EIB for the purpose of the following activities:
(a) Uncapped guarantees providing capital relief to financial intermediaries for new portfolios of debt finance to eligible SMEs;
(b) Securitisation of portfolios of debt finance to SMEs.
Article 39 goes on to define detailed rules on how the Commission, the EIB and the contributing Member States will work together to apply debt finance instruments.
Article 40 lays down rules on the management and control of FI. Article 41 deals with requests for payment and expenditure for financial instruments. Article 42 concerns the eligible expenditure at the closure of a programme.
Article 42 also refers to the management costs and fees charged by the body implementing the fund of funds or FI. Management costs comprise direct or indirect cost items reimbursed against evidence of expenditure. Management fees are an agreed price for services rendered established via a competitive market process, where applicable. Management costs and fees must be calculated according to a performance-based methodology. If any fees are charged to final recipients, they cannot be declared as eligible expenditure. In future the Commission will elaborate guidance how the fees should be calculated.
Article 43 deals with interest and other gains generated by FI. Interest and other gains [e.g. guarantee fees, capital repayments, dividends, etc] from the operations of FI must be used for the same purposes, including the reimbursement of management costs and payment of management fees.
Article 44 requires that resources for or from FI are re-used until the end of the eligibility period. This is the revolving nature of the FI. These resources are to be used for:
(a) Further investments;
(b) Preferential remuneration of private investors, or public investors operating under the market economy principle, who provide counterpart resources to the FI or who co-invest at the level of final recipients;
(c) Reimbursement of management costs and payment of management fees of the FI.
Article 44 further states that the need for and level of preferential remuneration for private investors must be established in the ex ante assessment. The preferential remuneration may not exceed what is necessary to create the incentives for attracting private counterpart resources and may not over-compensate private investors, or public investors operating under the market economy principle. The alignment of interest must be ensured through an appropriate sharing of risk and profit and must, once again, be compatible with State aid rules.
Article 45 defines what happens to the resources after the end of the eligibility period. Member States must ensure that resources paid back to FI during a period of at least eight years after the end of the eligibility period are used in accordance with the aims of the programme. Article 45 does not specify what happens after the end of that eight-year period.
Finally, Article 46 lays down the reporting obligations of Member States.
Consistency with State aid rules
The updated provisions governing structural fund contributions to FI are very much in line with the innovations that have been adopted in the new State aid rules. Ex ante assessment, as well as the correct identification of market failure and the precise definition of the necessary state intervention and instruments, are now required by both structural and investment funds and State aid rules. Under both sets of rules, support can be offered only to “viable” investments or enterprises which encounter difficulty in attracting private funds because of their higher risk or lower profitability. Funding restrictions with respect to the stage of development and the size of the beneficiaries have been relaxed. Funding can now be given to non-SMEs. The objective of both sets of rules is not to provide outright subsidies to enterprises but to improve their access to finance by incentivising investors to assume more risk or contribute more of their own resources. The incentives to private investors can take several different forms such as providing portfolio guarantees, bringing the rate of investment return closer to acceptable levels, limiting losses or allowing private investors to have a first take on profits.
However, there is at least one element of the structural fund rules which appears to contradict State aid rules. Paragraph 20 of the Risk Finance Guidelines stipulates that:
“It is important to recall that risk finance aid measures have to be deployed through financial intermediaries or alternative trade platforms, except for fiscal incentives on direct investments in eligible undertakings. Therefore, a measure whereby the Member State or a public entity makes direct investments in companies without the involvement of such intermediary vehicles does not fall under the scope of the risk finance State aid rules of the General Block Exemption Regulation and these Guidelines.” In other words, it cannot be declared compatible with the internal market.
Article 20(13) of the draft GBER imposes a similar restriction: “The risk finance measure shall fulfil the following conditions: it shall be implemented via one or more financial intermediaries, […]”
By contrast, Article 38(4)(c) of Regulation 1303/2013 provides that:
“When supporting financial instruments […] the managing authority may […] undertake implementation tasks directly, in the case of financial instruments consisting solely of loans or guarantees.”
Given that the scope of the new State aid rules has been extended explicitly to make it easier for Member States to support SMEs via loans and guarantees, it should be expected that in the programming period 2014-20 more loans and guarantees will be used in FI. This raises an important question. If FI instruments can only be implemented via intermediaries, how will public authorities and in particular Managing Authorities be able to implement directly loans and guarantees without contravening State aid rules?
There are two possible answers. First, Managing Authorities will avoid granting loans and guarantees directly to SMEs or other enterprises. Direct implementation is an option offered by structural fund rules that Managing Authorities will not utilise in practice. Second, if they do grant loans and guarantees directly to enterprises, then they will have to structure them so that they do not contain any State aid.
Again there are two ways to avoid the granting of State aid. The first is to ensure that loans and guarantees conform to the market economy investor principle. Although this is of course feasible, it would rather defeat the purpose of mobilising FI to achieve results which are not achieved by the market. The second way is to ensure that any aid remains below the thresholds defined in the new de minimis regulation [Regulation 1407/2013].
The conclusion must therefore be that, in the case of funding provided directly to enterprises by Managing Authorities, the only realistic possibility of compliance with State aid rules is to limit any support to small amounts that do not exceed the threshold of de minimis aid. If this is the correct conclusion, then the de minimis Regulation 1407/2013, with its new provisions on loans and guarantees, will become an important instrument for the channelling of structural and investment funds to financial instruments which directly support enterprises.
 This is the link to the issue of the Official Journal [L347, 20/12/2013] in which all structural fund regulations were published:
 There is also a third possible answer, that I misread the provisions of structural and investment funds and State aid rules.