Financing innovation during a credit crunch

We spend a lot of time discussing the need to cut Government debt. While this is legitimate, we keep forgetting that in every 6 SMEs in Portugal, one has failed its debt repayment or interest payment obligations.

If you think that companies are adjusting to the crisis by reducing their debt, think again. The debt/GDP ratio for private, non-financial companies was on the increase until 2012 and only recently has there been a change in this trend.

Debt of non-financial private companies in Portugal as a % of GDP, 2009-2013. Source: Bank of Portugal (2014)

The difficulty here is that this lack of credit creates a bottleneck for the financing of innovative projects. The credit market has been affected by the economic crisis. The main problem of the commercial banks is to restrict the concession of credit at all costs, to manage their loan portfolio. This means that innovative companies are unable to get access to bank credit to finance their expansion. It is difficult for the banks’ existing clients to draw credit, let alone for new projects which are inherently risky.

Sources of financing for a sample of start-ups based in Lisbon (2014). Source: Macrometria

In a recent survey, Macrometria found that bank financing accounts for 2.8% of total financing sources for a representative sample of start-ups in Lisbon. As banks seek to cut their credit exposure, and existing funds are used to re-finance over-indebted companies, the true losers are start-ups and ultimately, innovation itself.

On the other hand, bank debt is not being used to finance start-ups and this can be seen as a positive. The current business culture relies excessively on debt. The next stage of recovery will be sustainable if companies learn how to grow using equity. If the excessive levels of debt as a source of financing were one of the reasons for the anemic growth of the last decade.

5 lessons I learned from Américo Amorim

Some lessons I learned by working with Américo Amorim:

1. Never rely on anyone. You should not depend on a single supplier, bank, or person. If you offer someone the chance to influence your actions, you are effectively exposing yourself and this will become a source of weakness sooner or later. We live and work in a market economy, you should only depend on the system. Use the system to your own advantage;
2. Walk the talk. Working in a company (or a bank) is a choice and a lifestyle. Some chose to become an artist, a politician or a civil servant – you made your own choice. You will meet people from all walks of life: understand what they expect from you and walk the talk;
3. It is often physical. No-one ever seriously developed a business just by sitting in an office. If you work in an industrial company, you need to talk with people on the shop floor. If you sell a service, you need to meet your clients. Travel if you need to. Spreadsheets are good, being on the ground is absolutely fundamental;
4. Keep your promises, and ask others to keep their own. While some people are good at delivering on what they promised, most are not. Remember what you were promised and demand it. Conversely, you should make a real effort to honour your promises;
5. Talk with everyone – including politicians. While you may have your own political views, you cannot afford to alienate a group of people based on their political views, as you may need their support further down the road. This is more tricky to carry out than you might think, since you should make yourself scarce at the same time. Find that balance.

Stop obsessing about the next black swan and innovate

This post was written with Sónia Pereira Coutinho and published in the M&A Portal.  

Financial models have been hailed as the ultimate investor and management tools for decades but may have lost some of their shine following the unpredicted crisis and the onset of an “innovate or die trying” paradigm.

 Financial modelling is done by companies, investors and financial intermediaries in the context of investment projects. Financial forecasts are used by management teams to ensure that a project’s returns are adequate and that all the critical aspects have been covered.  Financial intermediaries use financial models to decide whether, for instance, a loan should be extended to finance a project or an acquisition.

 The popularity of financial models has grown in line with the increase and easier access to data. Modelling the complex reality of an investment project (or an acquisition) makes it easy for everyone involved to understand the critical drivers. In doing this, the analysts behind the models use a minimum number of assumptions that are supposed to capture the key elements of the project or the company being analysed. This is an appealing concept which often leads to dangerous simplifications.

 In the case of innovative projects, there are various drawbacks to building financial models and forecasts to support an investment decision. Innovation (and in particular disruptive innovation) is tough to measure. Either the market does not exist or the company’s cost structure is changed in a profound way. Models usually lack the flexibility to reflect the changes that take place when a company innovates. Many innovative projects are abandoned due to the inability to show their benefits in a financial model.

 Financial models can also give a false sense of stability to a company’s management team. Even in the absence of innovation, the current economic and even political conditions make it difficult to use financial models as a tool to predict future developments. What happened in Europe since 2007 was unprecedented and strategies that assume that market conditions will be stable in coming years may be a recipe for disaster. Reality will be more volatile and the conclusions that result from a financial model always depend on the validity of assumptions (often time series). If these are wrong or change over the projection period, conclusions will no longer hold.

 In reality, few companies manage to build perfect forecasts or make steady profits over a number of years. Even established companies experience unexpected changes in their markets. Strategy must take into account these fluctuations, which can result from demography, technology, competition or any other market factor. Addressing innovation – whether on an incremental or disruptive level, looking for it in-house or on the market – is increasingly a matter of survival.

 This has obvious implications for M&A situations. Acquisitions can happen for a number of reasons. Usually the acquirer is looking to increase size, obtain synergies and economies of scale. In other cases, the target company is an innovative firm acquired by a larger rival. The chart below shows that acquisitions of small and mid-sized European companies in the Telecom, Media and Technology sectors (by larger acquirers) have been steady since 2009, which confirms that we are dealing with a long-term trend which has proven resilient to the crisis. Larger businesses are interested in smaller, innovative companies which provide the top line growth which they often lack.

 

Source: Bureau van Dijk Zephyr, March 2012.
(1) Data for all targets located in Western Europe in the technology, media and telecommunications sectors with revenues < EUR100 M acquired by companies with revenues > EUR500 M, between 1 January 2009 and 31 December 2011

 Acquiring smaller innovative companies offers various advantages from the perspective of larger, more established companies: breaking into a new market, gaining access to new technology. In these cases, the financial model that supports the decision to acquire should include not only the returns from the transaction but also the positive impact of the target’s integration. These aspects are difficult to measure and a number of acquisitions do not reach a conclusion as a result of the acquirer’s inability to quantify these positive outcomes.

 Management teams, banks and investors may have relied too much on soothing financial models and management metrics and taking unintended risk as a result. No-one questions the importance of using good numbers to take business decisions, but it can be argued that complicated quantitative models did not prevent European banks from taking substantial and unwanted risks in the years that preceded the financial crisis.

 What the crisis has shown is that European companies need to innovate to thrive. Investors and banks can benefit from supporting innovative companies (as their US counterparts already do) and while financial models provide a good basis for discussion, overall their credibility is questionable. We can only hope that innovative companies will find a way to finance themselves without being too constrained by spreadsheets.

[Updated May 2012 by Hugo Mendes Domingos]

Why Portugal needs a more effective innovation policy [hack]

There have been many accusations during the electoral campaign, focusing on the current Government’s mismanagement of the economy. Rather than pointing out what has gone wrong in the last years (and a lot has in fact gone wrong) it’s interesting to consider what would be some options available to the next Government to promote innovation and foster economic growth.

As far as Government-owned companies are concerned, the first and more basic means of promoting innovation would be to halt systematic losses and the accumulation of debt on balance sheets. Any company which turns in a loss year after year will almost certainly not embrace innovation. This is particularly the case for loss-making Government-owned companies. Management is usually too busy managing interest payments and running day-to-day activities to even think about improvements.

Aside from avoiding systematic losses in Government-owned companies, what else could be done? PSD, which is leading in the polls, wants to attract private equity investment, provide fiscal advantages to innovative companies and improve the links between universities and companies.

PS’s manifesto also mentions the link between universities and companies as one of the ways it will seek to promote innovation. But it does not seem to show a link between finance and innovation – rather the link appears to be between science and innovation.

One of the main reasons for the lack of innovation in the Portuguese economy is the low-level of education. This should be tackled however any improvements will not be felt for a long time. Which mechanisms could be used to achieve results more quickly?

One of the most promising areas of development is related to capital goods and it could result in fast improvements. Countries such as Germany have developed a proven ability in capital goods. This has various economic benefits: not only do capital goods producers innovate by themselves, but the machines produced are then used by clients to boost productivity, creating yet another layer of innovation. The development of  the capital goods industry would certainly bring benefits to the economy. This view has been supported by the Innovation Agency (AdI).
Another option would be to reconsider business models to meet the needs of emerging markets – which is a different subject, to be developed in another post.

Why Portugal needs an effective innovation policy [hack]

Any Government would be in favour of improving a country’s productivity. Improving productivity is the key to economic growth and development. But productivity itself a result, not something that you can act on. Sadly, Portugal’s new Government will not be able to push a button and improve productivity.
The country may blame its politicians, the IMF or the EU for the current crisis but the real cause seems to lie elsewhere. Innovation, technology and entrepreneurship are the real factors behind productivity improvements.

Innovation is not a theoretical concept. It’s about responding to novel customer needs, using new technology to improve a product line – it’s also common practice in many companies globally. The progressive decadence of some (or most) companies in Europe is related to their lack of innovation. Portugal is part of a trend, not an outlier.Technology-based businesses are rare in Portugal. Most companies are SMEs which offer low added value services or commodity products.

From my experience, I believe (although I have no quantitative data to back it up) that Portuguese companies are good at controlling costs. Cost cutting is a good principle in itself but will only get you that far when you are trying to enter into new markets or facing new customer needs. A company that thrives only be cutting costs will face a difficulty sooner or later when its markets change or when emerging economies start producing the same products at an even lower cost.

There are of course alternatives and solutions to foster innovation and increase productivity.

One of the first practical reforms which the new Government could undertake would be to restructure InovCapital, the state-owned venture capital fund. InovCapital has invested over 130 million Euros in the past years. The fund takes minority positions and has over 150 companies in its portfolio – there could be more as the exact number is not known.

One of the first odd facts about InovCapital is its investment policy in terms of sectors. A number of its investments are in industries such as textiles and the production of footwear. These are in general low added value industries which are under pressure from emerging markets competitors. Innovation takes many forms and there are innovative companies in mature industries. However, should textiles and footwear constitute investment priorities?

Seen from the outside, InovCapital’s structure hardly seems appropriate to its mission. It has about a dozen “analysts” and a five-man Board. That’s more than 15 companies per analyst. In fact, none of the analysts seem to be involved in the management of portfolio companies. Can anyone even understand and control 15 businesses without any support? I would say that InovCapital’s contribution to the development of its portfolio companies is probably limited.

So we have a Government-sponsored fund making equity investments into a large number of companies and then making limited contributions to their development… That sounds like subsidies. It would seem that InovCapital “invests” about 1 million Euros per company. This is a small amount in terms of supporting any company in its development.

One of the fund’s priorities should be to improve its investment policy: it should be more focused in terms of sectors, which would develop its own internal competencies and sector knowledge.

InovCapital should also consider making fewer bets of a larger size. This would improve the chances of the portfolio companies and would enable the fund to bring some value to the table and take part in portfolio company development.

InovCapital does not release any real information to the press about its investments. This opacity extends to its financial statements and the returns from its investments. Some of InovCapital’s projects are in fact innovative, for instance its investment into Principal Power and Vestas’ offshore test wind turbine off the coast of Portugal. However, no-one knows about the investments as the details are rarely disclosed.
In fact, one can question whether a Government-sponsored venture capital fund should exist at all.

Is it naïve to think that companies invest in breakthrough products? It would seem that, in the majority of cases, companies spend R&D money to enhance their product line. Most breakthrough products are developed by stand-alone entrepreneurs, as part of University research programmes or using funding from non-profit organisations. Clayton Christensen has the full explanation in his book “The Innovator’s Dilemma“.

From this perspective, Government should be funding Universities and non-profit organisations to foster innovation. This could be more productive than throwing disguised subsidies at companies that operate in traditional sectors with a history of low productivity.