Think Small First – LSEG Response to the long-term financing Green Paper 25 June 2013

LSEG response to the European Commission‟s Green Paper on the long-term financing of the European economy

We suggest that the Commission’s long-term EXECUTIVE SUMMARY: financing strategy should be guided by the following principles and recommendations: The London Stock Exchange Group (LSEG) welcomes the opportunity to respond the 1. Offer support for SMEs across the funding Commission’s long-term financing Green Paper. escalator: address the “educational gap” through programmes which prepare firms to grow (e.g. LSEG’s ELITE programme) and the We agree with the Commission’s assessment “financing gap” through access to a diverse that growth is the single most important issue range of non-bank funding options including for the Union. LSEG believes two elements are public markets (e.g. LSEG’s AIM, ORB, MOT crucial to creating jobs, growth and innovation in and ExtraMOT platforms) the EU economy: 2. Embed a “Think Small First” approach to 1. the ability of Europe’s 22 million SMEs and dossiers across the Commission: assess the M+ companies to access long term financing impact of reform on SME and M+ firms to from institutional and retail investors avoid unintended consequences; in particular, on access to capital, liquidity and innovation.

2. the ability of capital markets to facilitate this 3. Act to reduce the cost of capital and the fiscal long term investment, to complement bias against equity: create a positive existing bank lending channels environment for companies seeking growth capital, and incentivise the use of equity for In our view, well functioning capital markets, long-term financing by investors and SMEs. within an appropriate regulatory regime, can fill the long term “financing gap” that the 4. Offer the right incentives for savers to invest Commission identifies. in growth: ensure that retail investors, insurers, pension funds, venture capital funds and companies are able to invest in SMEs; Capital markets are particularly important given encourage innovative ways to facilitate long that banks and governments, which have term investment (e.g. through FTSE ESG traditionally led the provision of long-term benchmarks, the Social Stock Exchange etc.) financing, are now faced with an inevitable period of deleveraging, balance sheet adjustments and fiscal consolidation. In making these comments, LSEG draws on its experience as an operator of multiple neutral, A focus on capital markets will provide a more well regulated, fair markets in equity and fixed diverse and sustainable business finance income that contribute to the ecosystem of long- landscape in the EU, and help unlock growth. term company finance. We look forward to working in partnership with the Commission and other stakeholders on these key issues.

London Stock Exchange Group plc. Registered in England & Wales No 05369106. Registered office 10 Paternoster Square, London EC4M 7LS.

Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

LSEG’s suggested principles and policy recommendations To enable SMEs and M+ firms to access LTF from investors through capital markets

PRINCIPLE 1: Offer support for SMEs across the first step to creating an attractive SME asset class for funding escalator investors. However, the parameters – e.g. median market capitalisation – must be appropriate, and it must retain flexibility at the market operator level to cater for RECOMMENDATION 1: Enact policies at a European level the varying needs of growing businesses. that address the “education gap” and encourage companies to grow; in particular programmes like LSEG’s RECOMMENDATION 6: Ensure flexibility around the ELITE, which train and prepare SMEs to grow their application of conflicts of interest requirements in MiFID businesses, raise new financial resources and connect in the context of investment research for issuers on SME them to a network of advisors and investors, should be markets, to improve the level of information available on supported and considered at an EEA level. quoted SMEs and profile them with investors. RECOMMENDATION 2: Support the development of public capital markets for SMEs and M+ firms – including equity markets like AIM and electronic corporate bond PRINCIPLE 3: Act to reduce the fiscal bias against markets like ORB and ExtraMOT PRO – through a flexible equity, and reduce the cost of capital regulatory approach and market-led initiatives.

2a. Consider a cross-directorate approach and a specific RECOMMENDATION 7: Consider measures to reduce the working group to explore ways of enhancing IPO markets bias against equity through its tax treatment and for SMEs (complementing the work of DG Enterprise). incentivise the use of equity finance

2b. Consider that the SME Growth Market regime in RECOMMENDATION 8: Amend the EU Risk Capital MiFID-2 applies to bonds, and therefore ensure that Guidelines to recognise the role of “replacement capital”, unlisted SMEs can access these markets. along with “new capital”, in ensuring an effective equity financing environment for start-up firms.

PRINCIPLE 2: Embed a “Think Small First” approach to dossiers across the Commission PRINCIPLE 4: Offer the right incentives for investors and savers to invest in growth RECOMMENDATION 3: Adopt a “think small first” approach; i.e. any review or proposals for change to RECOMMENDATION 9: Stimulate investment in SMEs to capital markets regulation in the EU must take into widen the pool of capital available to growing businesses, account the potential impact on SMEs and M+ firms, and by making an SME asset class attractive to investors, avoid any unintended consequences. including retail, buy-side and companies with cash, over the longer term. We welcome the Commission’s decision 3a. Recognise the importance of risk capital/ market to further analyse the impact of the Solvency II rules on making for investment in SMEs, and the need for a pension funds before including them within IORP. proportionate regulatory regime. 9a. For retail investors, issue guidance on the MiFID RECOMMENDATION 4: Increase the consideration limit conduct of business standards, specifically on client (currently at €5m) under the Prospectus Directive that suitability, that seeks to encourage investment in SMEs. triggers the requirement to produce a prospectus – to make a real difference to SME fundraisings. For example RECOMENDATION 10: Recognise the use of capital under the US JOBS Act, a comparable provision increased markets as a tool to raise the profile and facilitate long- the threshold of exempt offerings from $5m to $50m. term investment into sustainable and responsible projects and companies. E.g. through benchmarks like RECOMMENDATION 5: The proposal to create an SME FTSE ESG and portals like the Social Stock Exchange. Growth Market classification under MiFID-2 is a welcome

Page 2 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

INTRODUCTION

1. The Commission’s long-term financing (LTF) Green Paper presents a crucial opportunity to engage in a debate on the role of financial services in providing funding to the wider economy.

2. LSEG particularly welcomes the Commission’s focus on creating growth. In our view, all Single Market measures and their subsequent development in the institutions, especially those in the financial services sector, should concentrate on the potential benefits to the real economy. The protection of investors and management of risk as part of post-crisis reform are legitimate concerns, but the approach should be proportionate to economic benefits and the risks presented.

3. Within this debate, the ability of SMEs and M+ firms1 to access long-term investment from the investment community will be crucial, and capital markets will need to play a key role to facilitate this. There are c.22 million EU SMEs representing 68% of total employment and 58% of the value added in the economy2 – their ability to invest and grow will define the future of the economy.

A NOTE ON “SME DEFINITIONS” At the outset, we note that the focus of our response is on a wide range of SMEs and M+ firms. We note that a number of EU definitions exist for SMEs – each designed for a different purpose (e.g. state aid, accounting, transparency etc.). In our view, with regards to access to finance, a wide definition based on market capitalisation or turnover is most appropriate – to provide opportunities for a diverse range of companies and investors to participate. In this regard, we suggest that a threshold of at least €500million/€1 bn is required. This is similar to a provision of the US JOBS Act that seeks to tailor IPO requirements on the basis of a $1 bn market capitalisation threshold.

4. Through our response, we aim to provide the Commission:  Commentary on the key issues faced by SMEs and M+ firms, investors and capital markets – on their ability to participate in the long term-financing of the EU economy;  Policy recommendations to improve the ability of capital markets to provide long-term finance;  Evidence from LSEG’s markets, including our close work with policy makers in Europe, UK and Italy in seeking to improve and facilitate the access of small firms to capital markets.

5. We believe that an effective funding environment requires a coordinated and consistent effort by all involved stakeholders - regulators (to set a fiscal, competitive and regulatory framework), the investment community (to invest in SMEs as an asset class), capital markets providers and issuers.

6. We suggest that the focus should be on behavioural and cultural changes – to create a positive environment for financing; and legislative action secondarily – to address any unintended consequences of capital markets reform on SMEs. The Commission is best placed to coordinate and implement such action.

STRUCTURE OF LSEG’s RESPONSE 7. Our response is provided in three parts:  In Part A, we provide a short overview of why the focus of the Commission’s LTF strategy should focus on channelling investment into SMEs through capital markets;  In Part B, we detail our principles and policy recommendations (provided on page two of our response). We also prove some evidence and expertise from our markets;  In Part C – we provide comments to specific questions, and reference paragraphs in our response which answer specific questions that the Commission raises.

1 SMEs and M+ firms are defined as businesses with turnover of up to €/£500 million (based on the definition in the UK Government‟s Breedon Review). We use the term “SME”s in this response to refer to SME and M+ firms collectively 2 As of June 2013. Source: Eurostat http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database Page 3 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

PART A: Why the focus of the Commission’s LTF strategy should be on capital markets

1. Growth is the single most important issue for the EU, and its LTF needs are substantial

BOX 1: DEFINITION OF LONG TERM FINANCING (in response to Q1 and Q2) We agree with the Commission that there is no However, we are cautious of making a distinction single uniform definition for LTF. A number of between LTF and shorter term finance (e.g. credit, institutions have tried to characterise the features working capital etc.). It is important to recognise that of LTF, based on asset classes, investor type, level these sources complement each other, and a company of intermediation and purpose of financing. We will choose a mix of funding across each source. suggest that a broad definition along the lines Further, it is also important to recognise that liquidity suggested by the Group of Thirty and OECD would (in the securities that firms use to get LTF) does not be suitable – this describes LTF as sources of mean short-term markets, and is fundamentally finance with maturities of at least five years (loans linked to the cost of capital for both investors and and bonds), or no specific maturity (e.g. equity). companies. (see box 2 for additional details)

1.1. We agree with the Commission’s assessment that growth, job creation, building on areas of competitive advantage, and enhancing competitiveness are Europe’s most pressing challenges.

1.2. A number of studies project that substantial investment will be needed to achieve growth. For example, the G-30 and McKinsey Global Institute3 forecast that nine major global economies will need between $17 trillion and $21 trillion of annual long-term investment in real terms (33-35% of their GDP) by 2020 – which is an excess requirement of $5-$9 trillion annually. It also projects that Western Europe will require $2.7 trillion annually by 2020, at a cumulative annual growth rate of 2.1 per cent, to support modest growth projections, see figure 1 below.

Figure 1: Long-term investment needs – by sector and region 1.3. The UK government and the Confederation of British Industry (CBI) estimate that c.€280 billion is required for infrastructure investment by 2015 in the UK alone.

3 Group of Thirty, Long-term Finance and Economic Growth, March 2013: http://www.group30.org/images/PDF/Long- term_Finance_hi-res.pdf Page 4 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

2. Governments and commercial banks have been traditional providers of LTF – but are now facing severe pressure from the crisis

2.1. Traditionally, LTF has been provided by governments and commercial banks. Studies estimate that 25-30% of LTF is provided by governments, and 30-33% is provided through bank lending. Only 0- 10% of all LTF comes from capital markets.

2.2. The EU is particularly dependent on bank lending – up to 75-80% of external LTF is provided by banks in the EU. However, in the United States banks only provide 19% of all LTF – the remaining is provided through capital markets.

2.3. In some cases, bank lending may not be the most appropriate form of LTF, particularly for SMEs. The average maturity for a bank loan in developed economies is 4.2 years. This is far shorter than the average maturity of investment grade corporate debt (8.0 years) or high-yield bonds (7.7 years). SMEs are also more likely to pay higher rates on loans than larger companies, and higher rates on loans than corporate debt of a similar tenor, see figure 2.

Figure 2: Bank lending may not be the appropriate form of LTF for SMEs – maturities (L) and spreads (R)

2.4. At a fundamental level, bank finance creates a mismatch for SMEs that are high risk and support innovation, i.e. between the level of risk that entrepreneurs take and that which is shouldered by the investor (in this case, the bank, which obtains a fixed return). Policy should incentivise the use of funding for SMEs that aligns the interests between investor and the owner, allowing less personal risk to the entrepreneur and a greater upside for the investor.

2.5. The financial crisis has also reduced the ability of banks and sovereigns to finance long term investment, as a natural consequence of deleveraging and balance sheet consolidation. It is clear that lending to businesses has reduced across the EU. The ECB has consistently reported a net tightening of credit standards by euro area banks for loans to enterprises from 2008 – for example, in 4 Q1 2013 , euro area banks reported a stable but pronounced net decline in the demand for loans to enterprises (-24%, from -26% in the fourth quarter of 2012). Borrowers have also reported that credit agreements are taking longer to approve, the maturity of loans has shortened and terms and conditions associated to loans (e.g. collateral requirements, rates etc.) have worsened.5 See figure 3.

4 ECB Bank Lending Survey Q1 2013: http://www.ecb.int/stats/money/surveys/lend/html/index.en.html 5 ECB SME Access to Finance October 2012 to March 2013: http://www.ecb.int/stats/money/surveys/sme/html/index.en.html Page 5 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

Figure 3: Tightened credit conditions – change in credit demand (L); net EU lending to PNFCs (R)

2.6. LSEG is not arguing for a reversal of the new capital regime, which is needed to ensure the stability of the banking system. Rather, we point this out as evidence for the need for a pro-active and comprehensive approach by policy makers to develop of new, sustainable, and secure sources of finance, beyond bank lending, for SME and M+ firms businesses.

2.7. Financial systems are likely to become more resilient with a broader range of long-term finance sources and instruments. If properly implemented, these developments should make the LTF environment efficient and robust; supporting growth and job creation, without undermining the stability of the financial system.

3. Capital markets can help fill the “financing” gap

3.1. Compared to the US, EU capital markets are less liquid, provide shorter tenors and offer a lower variety of financial instruments, see below. This restricts the range of financing instruments available to borrowers and savers.

Figure 4: A comparison of equity capital markets in the EU and US

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3.2. We suggest that fostering the development of capital markets would be a positive step, so that it plays a bigger role in the long term financing of the EU economy, and helps provide a more diverse and sustainable business finance landscape.

3.3. Thus, the main objective of an EU long-term financing strategy must be to ease the access of SMEs to capital markets, and offer the right opportunities for savers to invest in innovative products, projects and growth stories.

3.4. In our view, the purpose of capital markets is twofold – to provide access to finance for companies, and to generate returns for savers and investors. To facilitate this, markets provide a means of financial intermediation between savers and companies, which reduces risk and permits the time horizons of savers to differ from the time horizons of companies, enabling efficient use of capital in the economy.

3.5. For effective and well functioning capital markets that serve SMEs and investors, an appropriate regulatory regime with the right focus is required. A stable, proportionate and balanced regime is needed for companies and investors to back investment over 5, 10 or 20 year horizon.

3.6. We suggest that policy needs to address regulatory and behavioural issues on both the demand (SME and M+ firms) and supply (investor) side. The focus should be on helping companies transition on the funding escalator, increasing access to all forms of public finance and reducing the cost of capital, creating an “SME asset class” for investors, and offering the right opportunities to invest in growth.

3.7. In our view, there are four critical principles that should guide this strategy:  Offer support for SMEs across the funding escalator: address the “educational gap” through programmes which prepare firms to grow (e.g. LSEG’s ELITE programme) and the “financing gap” through access to a diverse range of non-bank funding options including public markets at the top of the escalator (e.g. LSEG’s AIM, ORB, MOT and ExtraMOT platforms)  Embed a “Think Small First” approach to dossiers across the Commission: assess the impact of reform on SME and M+ firms to avoid unintended consequences; in particular, on access to capital, liquidity and innovation.  Act to reduce the cost of capital and the fiscal bias against equity: create a positive environment for companies seeking growth capital, and incentivise the use of equity for long- term financing by investors and SMEs.  Offer the right incentives for savers to invest in growth: ensure that retail investors, insurers, pension funds, venture capital funds and companies are able to invest in SMEs; encourage innovative ways to facilitate long term investment (e.g. through the Social Stock Exchange, FTSE ESG benchmarks etc.)

3.8. We detail these principles in Part B, along with policy recommendations and evidence from our markets.

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PART B: LSEG’s PRINCIPLES AND DETAILED RECOMMENDATIONS To enable SMEs and M+ firms to access LTF from investors through capital markets

4. PRINCIPLE 1 – Offer support for SMEs across the funding escalator

RECOMMENDATION 1: Enact policies at a European level that address the “education gap” and encourage companies to grow; in particular programmes like LSEG’s ELITE, which train and prepare SMEs to grow their businesses, raise new financial resources and connect them to a network of advisors and investors, should be supported and considered at an EEA level.

4.1. SMEs are key to growth: there are c.22 million EU SMEs representing 68% of total employment and 58% of the value added in the economy

4.2. As businesses develop, SMEs’ financing needs, and therefore, their set of investors can be very different. Businesses need access to a mix of finance sources to fund their short term needs and long term growth. In our view, bank lending, debt financing tools and external equity investment can complement each other as LTF sources for business.

4.3. As well as gaining access to a mix of finance sources, a key issue is facilitating the transition from start-up to SME to mid-cap i.e. a transition across the funding escalator. For example, venture capital, private equity and bank funding for a fast-growing start-up can provide a stepping stone to the capital markets once the company has matured. We agree with the Commission that companies require LTF throughout this transition.

4.4. Between different stages of growth, companies face “financing gaps”, i.e. in handing over financing to a different set or type of investor and “education gaps”, i.e. in terms of the skills, organisational capability and professional advice needed to transition across the escalator. Gaps are therefore not of a specific quantum or at one specific level; rather businesses face multiple gaps as they seek to match their structure to their stage of development.

Figure 5: the Funding Escalator and Capital Markets – LSEG’s markets, in fixed income and equity, contribute to the ecosystem of supporting SMEs and M+ companies by helping them to match their financing needs to the right set of investors and facilitating their transition in the funding escalator. Page 8 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

4.5. An SME’s ease of access to external capital – seed capital, business angels, venture capital and public markets – depends on the ability of these sources to work together as part of the financing escalator for enterprises to access at each stage of their development. Investors at each level have to be confident that they can realise their investment at a later stage, so they can re-invest their capital.

4.6. For early stage companies, addressing the education and financing gap is important. Evidence from the UK and Italy suggests that smaller businesses in need of external finance face three specific behavioural barriers:  lack of awareness of alternative sources of finance outside of the existing relationships with their banks;  a lack of the financial expertise required to assess the appropriateness of alternative sources for a borrower; and  a lack of confidence in their ability to secure these alternative forms of finance.

4.7. The UK Government’s Breedon Review on non-bank finance6 also found that:  Only one in four (23%) of those responsible for making finance decisions in SMEs has a financial qualification or financial training; for SMEs as a whole, a minority have a financially trained person.  Alongside a lack of in-house expertise, there is a failure to source external advice: only 9% of SMEs sought advice when seeking an overdraft and 16% when seeking a bank loan. SMEs are also unaware of the many support schemes and initiatives that the government has in place.

4.8. Thus, SMEs have low access to funding and the specialised competences (i.e. legal, financial, business advisory, strategy etc.) to support their growth. Policy must deal with this educational gap, and support the development of SMEs with a strong growth potential.

4.9. The ELITE programme, launched by LSEG and Borsa Italiana in April 2012, is one such initiative. ELITE is a three-phase programme of integrated services, which offers SMEs the capabilities, training and networks to build an organisation for growth. Launched in partnership with the Italian Ministry of Economy and Finance, the Italian advisory community and academic institutions, ELITE aims to open routes to new sources of funding for companies – through private equity, private placements, public debt or IPOs – by the end of the programme. ELITE has been highly successful in Italy, and has 100 members within one year of launch, at a time of subdued markets and macroeconomic conditions. (see Case Study 1 on the next page for additional details).

4.10. Europe’s 22 million SMEs face similar challenges and share the same business needs as Italian SMEs – access to finance, organisational and business development, communication and visibility building, and access to networks. We believe that ELITE is highly scalable and can address the educational gap that SMEs face on the funding escalator at a pan-European level. However, we note that ELITE infrastructure needs to be deeply rooted to each domestic market that it caters to, to serve the local needs of EU SMEs. Partnerships with local governments, advisers and academic institutions will also be crucial to its success.

4.11. Recommendation 1 above serves this purpose.

6 The Breedon Review, Boosting Finance Options For Business, March 2013, Department for Business, Innovation and Skills, UK government http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-668-boosting-finance-options-for- business.pdf Page 9 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

CASE STUDY 1: ELITE PROGRAMME

Phase 1 – Get Ready – a training program for Key numbers: founders and managers on management and organisational structure; Phase 2 – Get Fit – progressive adoption of best practices (transparency, structure etc.) with the support of a dedicated virtual advisory team (including audit, legal, financial, strategy and communication services); and Phase 3 – Get Value – access to new business opportunities and funding options (e.g. IPO,  As of April 2013, 100 companies are members private placement, PE, debt issuance, etc.)  Over 28 institutional investors registered as What are the entry requirements? potential “ELITE investors” ELITE is designed for SMEs with a strong  Over 70 advisors on board ready to play the growth potential. Companies need to show a role as official “ELITE advisors” minimum turnover of €10 million (or less, if there ELITE is a unique programme of integrated services is a high growth rate) and a plausible growth  ELITE companies are clear outperformers - offered by LSEG/Borsa Italiana to help SMEs realise projection; and profit in the last financial year, median revenues of €47m; growth rates of their goals for growth. Launched in collaboration with with an EBITDA margin > 5 per cent to 23%; substantial international business with a the Italian government and the key Italian financial demonstrate a sustainable business model. median of 50% revenues being export related. associations in April 2012, ELITE’s goal is to build “middle national champions” and support non bank To retain membership of ELITE, companies:  Multiple companies have announced plans for channels. It reached 100 members in April 2013. Actively participate in the training – 8 days further funding – including multiple possible IPOs in the medium term; deals with a How is ELITE structured? organised in 4 modules and managed by LSEG Academy and Bocconi University Private Equity firms; possible bond issuances ELITE is a three-phased program (between 18-36 ELITE at a European level? months) where a company is assisted with a dedicated Meet transparency requirements – advisory team. Through ELITE, companies receive periodically update the company profile, Whist the ELITE infrastructure needs to be deeply industrial, financial and organisational capabilities publish a half-yearly/ annual report with rooted to the domestic market it caters to, ELITE needed to grow and meet the challenges of comments to the accounts is a flexible, scalable concept which can be international markets. Deliver an organisational transformation – elevated to an EU level. Partnerships with local governments, advisors and academic institutions The three phases of ELITE are: compile a business plan, define an appropriate corporate governance model and will also be crucial to its success. implement a management control system See Appendix 1 for a list of ELITE companies.

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RECOMMENDATION 2: Support the development of public capital markets – including equity markets like AIM and electronic corporate bond markets for SMEs, like ORB and ExtraMOT PRO – through a flexible regulatory approach and market-led initiatives. 2a. Consider a cross-directorate approach and a specific working group to explore ways of enhancing IPO markets for SMEs (complementing the work of DG Enterprise). 2b. In particular, the Commission should consider that the SME Growth Market regime in MiFID-2 applies to bonds, and therefore ensure that unlisted SMEs can access these markets. 4.12. LSEG also believes it is important to develop an SME’s ability to access non-bank finance from all (public) capital markets. This is the focus of recommendation 2 above.

4.13. Vibrant and liquid equity markets at the top of the funding ladder are not only an aspiration for entrepreneurs and early stage businesses, they are also an important platform for earlier stage investors to realise their investments. LSEG has substantial experience with these markets - as the operator of AIM, Europe’s largest equity market for SMEs, in the UK and AIM Italia-MAC in Italy.

4.14. AIM7 is LSE’s equity market for SME and M+ companies, launched in 1995. It looks at younger, faster- growing companies at the initial stages of accessing public markets and offers a balanced regulatory framework, access to an international investor base and an expert advisory and peer-group network, visibility and profile with customers, suppliers, investors and analysts.

CASE STUDY 2: LSE’s AIM market for SME and M+ companies

AIM is Europe’s most successful growth market and has seen over 3,360 companies admitted and raised over £80 billion in capital since launch. As of March 2013, AIM has c.1,100 companies with a total market value of £66 billion. Median market capitalisation is £20 million and over 1,000 companies have a market cap of less than £250 million. AIM has a diverse base of investors, with large funds and retail clients investing in the market. How is AIM structured?  As an MTF, AIM is an exchange- regulated market.  There are two sets of rulebooks, one for companies, and one for Nominated Advisors (Nomads). The AIM Rules for Companies (the ‘AIM Rules’) are tailored to the needs of businesses joining AIM, and are designed to be easily understood.  The market offers a different model from LSE’s Main Market (the Regulated Market), which includes: no minimum market capitalisation requirement, no minimum free float requirement (i.e. prescribed level of shares in public hands), and a Nominated Advisor is required at all times.

4.15. AIM has significant experience in tailoring the choice of capital market solutions for SMEs and their investors. For example, AIM provides issuers with a choice of trading platforms (order-driven, quote- based or hybrid) to help them maximise liquidity. Over the years, the dedicated market maker support offered on the trading services has allowed a strong network of specialist firms that facilitate access to liquidity, capital and research for these companies to develop. With dedicated market maker support in a transparent environment, which may not be available on a fully electronic order book, the smallest companies benefit from guaranteed liquidity. AIM strongly believes that trading solutions for small and mid cap securities need to consider the incentive and economics for

7 Further information at http://www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm Page 11 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

advisers/ brokers to provide the critical aftermarket support these companies require, particularly analyst coverage.

4.16. We suggest that Commission may consider establishing a working group for SME issues across directorates, as SME issues cut across Internal Markets, Competition Enterprise, Industry etc. In particular, the Commission should seek to explore ways of enhancing IPO markets for SMEs like AIM, complementing the work of DG Enterprise’s SME Finance Forum. This is the focus of recommendation 2a.

4.17. Further, we agree with the Commission’s assessment that there is a significant scope to increase the size of the corporate bond market in Europe, particularly for SMEs.

4.18. Whilst we do not completely agree with the Commission’s contention that SMEs cannot generally afford the costs of bond issuance, it is correct to say that SMEs face much higher costs (100-175 bps of total issuance) than mid- and larger-sized companies (30-60 bps of total issuance)8 for issuing bonds. Costs include professional fees (accountancy, legal, advisory, credit rating), documentation (prospectus), continuing obligations (disclosure), listing and admission fees etc.

4.19. A major restriction on the ability of SMEs to access the public bond markets is the need for institutional investors to invest in liquid securities. For bonds in the wholesale market to be liquid, issuances will typically need to be greater than €/£150m. Therefore, this sort of financing normally would not be available to borrowers with a much smaller borrowing requirement.

4.20. However, a number of small firms are gaining direct access to debt capital markets through platforms like the LSE’s Order Book for Retail Bonds (ORB).

4.21. Since 2010, ORB has raised over £3.4 bn of financing through 37 retail bonds. We believe it has opened up debt capital markets to a wider range of companies, including SME and M+ firms, who wish to raise capital in sizes ranging from £25-300 million. The median issuance size on ORB is £72.5 m, average maturity is 7 ¾ years, and average coupon is 4.7%. 26 of the issues have been smaller than £150m, and two unlisted companies have also issued debt.

CASE STUDY 3: LSE’s Order Book for Retail Bonds (ORB)

LSEG launched the Order Book for Retail Bonds Since launch, ORB has raised over £3.4 billion (ORB) in the UK in February 2010. ORB builds on through 37 dedicated retail issuances. the success of MOT, Borsa Italiana’s bond market There are over 170 existing retail size bonds for retail and wholesale investors. ORB was set up available - c.60 gilts, c.110 corporate and 4 to 1) develop a transparent secondary market in supranational bonds. bonds, 2) establish a primary market where retail investors participate, 3) enable companies access a ORB has seen several blue chip retail bond new source of capital and diversify their funding offerings, including Tesco Bank (raising £125m), National Grid (raising £260m) and Lloyds TSB How is ORB structured? (raising £125m) The market has also worked for  ORB is an EU Regulated Market: all bonds the small cap and social sectors, with the housing admitted on ORB are listed with the UKLA and association Places for People raising £140 million must satisfy the requirements for retail in 2011, and a further £40 million in January 2012. investors set out in the Prospectus and Transparency directives

 Retail size: bonds admitted must be tradable in units of no larger than £10,000 (usually in denominations of £100 or £1,000), and of high credit standards.  Settlement: in Euroclear UK & Ireland.  Electronic order-driven trading: dedicated market makers are committed to quoting executable two-way prices; market surveillance monitors for disruptions and abuse.

8 Source: LSEG Fixed Income – study of issuances on ORB Page 12 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

4.22. To further develop the market for SME corporate bonds in the EU, In February 2013, Borsa Italiana launched the new Professional Segment of ExtraMOT market (ExtraMOT PRO9) dedicated to listing of bonds, commercial paper, project bonds. The new segment was created to offer to corporate and, in particular to SMEs, a national market flexible, and cost effective in which to take opportunities and tax benefits arising from a new regulatory framework in Italy (Decree-Law 83/2012).

4.23. Within 4 months, ExtraMOT PRO has admitted 12 bonds through 7 issuers. The total outstanding amount is €1.6 billion. Bonds have an average maturity of 6 years and an average coupon of 6.7%. A full list of bonds can be found here10.

4.24. These developments are positive. However, SMEs are highly heterogeneous, and as such, there is no “coverage” of this sector. Thus, for investors, analysing the risk of SMEs requires a high resource allocation that may not always be available. Some positive market led initiatives have started addressing this issue, with the development of specific credit assessment products from mid-cap firms and a focus by advisers on new corporate bond platforms.

4.25. We suggest that the Commission should help develop the use of electronic corporate bond markets for SMEs. A way of doing this could be to clarify that the SME Growth Market framework in MiFID-2 applies to SME bonds as well. As currently drafted, it focuses on equities, since the SME definition is linked to market capitalisation. We propose that bonds of unlisted companies should also fall into this regime, with an appropriate definition that focuses on SME and M+ companies (up to €500 million turnover may be an appropriate definition). This is the focus of recommendation 2b.

CASE STUDY 4: ExtraMOT PRO

ExtraMOT is an EU Multilateral Trading Facility for the secondary trading of corporate/s bonds listed on foreign EU RMs and branded bonds. ExtraMOT PRO is the professional segment dedicated to listing of bonds, commercial paper, project bonds. Trading on ExtraMOT PRO is restricted to professional investors. Features of the market: Proportionate disclosure requirements (publishing the annual financial statements for the past two years, the last of which audited and providing an admission document in Italian or in English). After the admission, the issuer is required to publish audited financial statements, the disclosure of the rating if a public rating is assigned, information concerning any changes in the bond holders’ rights, and any technical information related to the characteristics of the instruments (e.g. payment dates, interest coupons, sinking schedule).

9 Extra-MOT PRO: http://www.borsaitaliana.it/obbligazioni/segmento-professionale/extramot-pro/extramot-pro.en.htm 10 http://www.borsaitaliana.it/borsa/obbligazioni/segmento-professionale/lista.html?lang=en Page 13 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

5. PRINCIPLE 2: Embed a “Think Small First” approach to dossiers across the Commission

RECOMMENDATION 3: Adopt a “think small first” approach; i.e. any review or proposals for change to capital markets regulation in the EU must take into account the potential impact on SMEs and M+ firms, and avoid any unintended consequences.

3a. Recognise the importance of risk capital/ market making for investment in SMEs, and the need for a proportionate regulatory regime.

5.1. Since the financial crisis, the EU has seen a wave of regulatory reforms in financial services. In particular, the regulatory environment for capital markets is currently in the process of major overhaul - the impact of which has yet to be fully understood. The cumulative impact of a series of significant regulatory changes, including Solvency II, CRD IV, MIFID2, EMIR, FTT, CSD-R, R&R for banks and non-banks, Short Selling etc. has still to be tested. For example, capital requirements in Solvency II, IORP and CRD-IV may affect the ability of insurers and pension funds to invest in long term assets, or SME assets.

5.2. For example, a disproportionate regime for market makers in MiFID-2 coupled with a one-sized fits all settlement discipline regime in CSD-R may jeopardise the operation of less liquid/SME markets dependent on these participants. There must be a commitment to preserving the market maker model which is particularly important for SME securities. Market making enables asset managers, corporates, insurers, pension funds, and other end users of markets to buy and sell financial instruments with greater certainty and thereby creates deeper capital markets in which SMEs can raise finance. Market makers buy and sell when markets are imbalanced, and buy and hold inventory to meet future demand. In many SME securities, market makers provide the vast majority of the liquidity, and can be the only providers of liquidity in times of stress, when other market participants may withdraw. A disproportionate regime on market makers, which is not in line with SME/less liquid market structures could have the following unintended consequences:  It will cause market makers in these securities to have to increase spreads to compensate for the additional monetary risk that they take to provide the security, which will increase the cost of capital of investing in these firms for savers;  Market makers could withdraw from these markets altogether – which will reduce liquidity and inhibit the ability of SMEs to list and raise finance on public markets.

5.3. Thus, we suggest that for each legislative initiative that has been introduced or is forthcoming, there should be an assessment of its impact on SMEs and their investors. Such assessment would prevent additional barriers from being introduced for issuers and investors accessing capital markets and should help alleviate existing barriers. Cross-directorate collaboration to ensure a consistent approach towards SMEs would help foster an effective financing environment for these businesses for the longer term.

5.4. With this context, we make the recommendation 3 above.

5.5. We also note that financial intermediation is crucial to the functioning of capital markets. It allows savers to achieve diversification of their portfolios, and gives them the ability to enter/exit/switch investments through liquidity in the markets. Liquidity also enables investors to benefit from narrower spreads and reduced volatility, and consequently lower trading costs. This enables them to secure a better price, resulting in better returns on investment. Intermediation also allows companies to access a pool of capital provided by a diverse range of investors to support the growth of their businesses.

Page 14 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

5.6. Strong and robust liquidity is a necessary condition for capital markets to fulfil their purpose. Liquidity is vital as it reduces the cost of capital for both investors and companies by narrowing “spread costs” between buy and sell prices and thus reducing costs for savers and investors; and by reducing this liquidity premium demanded by investors, it then reduces the cost of capital for companies. 11

There is an extensive body of evidence on the link between liquidity and the cost of capital for companies. Domowitz and Steil (2001)12 estimated that a 10 per cent increase in transaction costs increases the cost of capital (as measured by the post-tax cost of equity) by between 1.4 per cent and 1.7 per cent. Research by Oxera has indicated a ‘small firm’ effect, which makes SMEs more vulnerable to market illiquidity. 13

5.7. We would advise the Commission to recognise the importance of risk capital and liquidity in SME markets – in particular a proportionate regime for market making is required. As mentioned in paragraph 4.15, the dedicated market maker support offered on AIM has allowed a strong network of specialist firms that facilitate access to liquidity, capital and research for these SMEs to develop. With dedicated market maker support in a transparent environment, which may not be available on a fully electronic order book, the smallest companies benefit from guaranteed liquidity.

BOX 2: Liquid markets do not mean “short-term” markets The economic significance of liquidity is the For example, 60 per cent of the London Stock ability of investors to realise significant stakes in Exchange Group’s share register is owned by a medium term time scale at realistic prices, shareholders who have consistently held their and to do so even in turbulent market shares for longer than three years – despite the conditions. However, trading in markets is LSE having a share turnover that in the last essential for this. Without liquid markets, the financial year peaked at 135 per cent (suggesting time horizon of savers would differ from the an average holding period of nine months). time horizon of corporations. This would increase the cost of capital for companies, and It would, therefore, be more appropriate to frustrate the use of capital in the economy for consider the turnover of beneficial ownership. long-term investment. Initial analysis of company share registers shows that in 2011, 83 per cent of investors turned their portfolio over less than once every two years. Of We would advise against using share turnover that number, 20 per cent turned their portfolio data as a measure to assess how long investors less than once every four years. This shows the hold shares. The turnover of beneficial skewed nature of share turnover data in ownership data, instead, is a more accurate calculating average holding periods, and the long- metric to use. term nature of many fund managers. The use of share turnover data as a proxy for Thus, companies can use short-term funding for average holding periods of shares is long-term investment. For companies, liquid inappropriate as this metric accounts for all capital markets offer the diversity of longer-term shares that trade, but does not represent change and shorter-term investors with their different of beneficial ownership in a company’s share strategies and motivations, and a mix of domestic register. Many registers remain reasonably fixed and international investment. This in turn lowers and stable, and only a small proportion turns the cost of capital and makes it easier for over quite quickly. companies to raise external finance (which is especially important for SMEs).

11 As a company‟s cost of capital is the return that investors demand for their investment in the company, it increases with costs borne by the investor which in addition to due diligence costs, includes any upfront or future taxes on investment and uncertainty over exit options. 12 Domowitz, I and Steil , B (2001), „Automation, trading costs, and the structure of the securities trading industry‟, 13 Grant Thornton, Economic Impact of AIM and the role of fiscal incentives, September 2010. Page 15 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

RECOMMENDATION 4: Increase the consideration limit (currently at €5m) under the Prospectus Directive that triggers the requirement to produce a prospectus – to make a real difference to SME fundraisings. For example under the US JOBS Act, a comparable provision increased the threshold of exempt offerings from $5m to $50m.

5.8. Policy should also allow SMEs to offer securities to a wider potential investor base at a lower cost. For example, The Prospectus Directive (PD) sets out the framework for companies to raise capital through the public markets. The Commission has recognised that the cost of producing a prospectus can be restrictive and overly burdensome for smaller companies (ranging from 7% to 12% for consideration levels below €10m) and is therefore disproportionate to the offer value. The additional time cost of seeking approval for the prospectus from the relevant competent authority is an additional expense on offers and can have a significant impact on the timing of transactions.

5.9. Thus, we suggest that increasing the consideration limit (currently at €5m) that triggers the requirement to produce a prospectus would allow smaller companies to offer securities to a wider set of investors and promote offers of securities to existing shareholders more cost effectively. It will also facilitate merger and acquisition activity amongst very small companies, helping them to gain scale and create value over the longer term. This is the focus of recommendation 4 above.

RECOMMENDATION 5: The proposal to create and SME Growth Market classification under MiFID- 2 is a welcome first step to creating an attractive SME asset class for investors. However, the parameters – e.g. median market capitalisation – must be appropriate, and it must retain flexibility at the market operator level to cater for the varying needs of growing businesses.

5.10. The Commission’s proposal to create a new classification for SME growth markets in MiFID II is a welcome step towards attracting a wider set of investors to small caps. Creating a distinct and separate SME market regime helps ensure that the evolution of EU financial services regulation does not adversely impact small caps, and also forms the basis for introducing new measures to improve the capital markets offering for such companies. It formally recognises the role SME markets play in the EU funding environment, providing clarity over their regulatory status, helping to lower their cost of capital, and therefore increasing market confidence.

5.11. The SME Growth Markets classification would:  allow market operators to create a tailored regulatory framework that balances the needs of companies with appropriate investor protection principles without impacting investor confidence in Regulated Markets  provide an attractive platform for smaller companies to increase their profiles with the widest range of stakeholders  allow for an infrastructure and network of advisers and intermediaries to develop that understands the needs of growing companies  provide a stepping stone towards Regulated Markets, allowing companies to develop public company accountability, reporting systems and governance structure.

5.12. However, for the proposed regime to yield these positive outcomes, flexibility must be maintained at a Member State and market operator level As the market operator of AIM and AIM Italia, we have defined the framework of these markets on the principle that one size does not fit all in the context of smaller, growing companies. Investor preferences and appropriate guidance from advisers and intermediaries, under our supervision, ensure the markets benefit smaller growing businesses. The flexibility around the size and sector of companies allowed on our SME growth markets has been critical to their success as it has allowed for suitable diversification in investor portfolios.

Page 16 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

5.13. The Commission’s current proposal that definition of an SME for the purposes of this regime at a threshold of €100m is inappropriate. The criteria must not be set too low as this would inadvertently cause many institutional investors and VCs to dismiss them as being too small for their mandates. This would significantly inhibit the development of the growth markets, diminish liquidity and result in many SMEs having to decide whether to apply for a “listing” or to return to other, less public, forms of funding. Over the long term, this would be damaging to Europe’s competiveness in global financial markets and would adversely impact the growth and innovation potential of its SMEs. A higher range would be more suitable (the US JOBS Act seeks to tailor IPO requirements on the basis of a $1 bn market cap threshold - a significantly larger threshold than companies eligible for any financial assistance from the US government (for example, under the US Small Business Act))

5.14. In addition, alongside creating the separate classification it is critical that the markets are promoted to improve investor understanding of smaller companies and to encourage fund managers to adopt an investment strategy that is better adapted to smaller companies.

5.15. We summarise these points in recommendation 5.

RECOMMENDATION 6: Ensure flexibility around the application of conflicts of interest requirements in MiFID in the context of investment research for issuers on SME markets, to improve the level of information available on quoted SMEs and profile them with investors.

5.16. Finally, LSEG does not believe significant changes are required to alleviate regulatory obligations for companies accessing public markets. The costs of being on a public market generally represent important investor protection measures and aim to mitigate some of the inherent risks associated with investing in earlier stage companies, although varying on a company-by-company basis. Reducing requirements on companies may result in reduced investor protection, cause a loss of investor confidence, and therefore reduce the pool of available capital for investment.

Instead of assessing costs for issuers on a stand-alone basis, it is important to recognise that companies are willing to incur the costs of being on a public market as long as the benefits of being on market outweigh the costs. These benefits are measured through having a set of long term investors, regularly traded shares and an ability to raise further capital at a reasonable cost. Ultimately, this is achievable by extending the base of investors willing to invest in SMEs, and in the context of capital markets, by increasing the level daily trading in their securities.

5.17. Reducing information asymmetry: we agree with the Commission that policy developments should focus on ways in which the profile and visibility of quoted SMEs could be improved. One way to do this would be to make it easier for them to put copies of sponsored research or broker-written research onto their investor relations website.

5.18. Quoted SMEs often have to pay for investment research to ensure adequate information in the marketplace. However, due to the conflicts of interest requirements in the context of investment research under Article 13(3) of MiFID and Article 25 of the MiFID and the costly process under which the content of research reports needs to be checked and approved by an authorised investment firm, the production of high quality independent research on SMEs is currently restricted. As a result, most research is produced as ‘marketing communication’ which cannot be widely distributed or generally published on a company’s website.

5.19. Given the already limited information available on smaller companies, this inability to share research with a broad range of investors exacerbates the situation. Recommendation 6 focuses on increasing the visibility of information on quoted companies.

Page 17 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

6. PRINCIPLE 3: Act to reduce the fiscal bias against equity and the cost of capital

RECOMMENDATION 7: Consider measures to reduce the bias against equity through its tax treatment and incentivise the use of equity finance.

6.1. Tax regimes have a critical impact on investment and, as the Commission has identified, it can be a key lever to incentivise or disincentivise the use of certain channels of LTF.

6.2. LSEG believes that the Green Paper is right to consider the impact of tax on investment and savings. Whilst our view is that specific tax policies are best addressed at a national level, we would welcome an evidence-based assessment led by the Commission on the impact of tax policy on investment behaviour.

6.3. As noted in the Green Paper, LTF can be provided through both debt and equity financing, and we believe it is important both as complementary sources of financing for the economy. However, we agree with the Commission when it notes that the current tax treatment of equity in a number of Member States creates a disincentive to use equity. A number of international organisations agree with this assessment, including the IMF, OECD, Group-of-Thirty, KPMG, Grant Thornton etc.

6.4. It is clear that equity finance, which is often a more suitable and stable form of finance for high growth SMEs, is underused in the EU. Equity finance is often best suited to growing enterprises that require external capital prior to revenue generation and that may not be at the stage to maintain regular loan repayments. However, in the UK, only 3% of SMEs use equity whereas 55% use credit cards14. Whilst its tax treatment is not the only reason for this, it undoubtedly increases the cost of equity for both SMEs and investors. Thus, we suggest that seeking to level the playing field between debt and equity is therefore important to boosting equity investment.

6.5. We suggest that the guiding principle should be not to enact any reforms that could increase the costs of capital for small businesses, and in particular removing the bias against equity when making changes. Removing the double/triple taxation of equity, offering some sort of tax deductibility on dividend payments or to an allowance for the cost of corporate equity are simple measures which may address this bias without unintended consequences.

6.6. The UK Government has enacted some measures to reduce this distortion. For example, the abolition of stamp duty on shares on Growth Markets like AIM and ISDX, will make equity finance more readily available15, without increasing the cost of debt finance, a move widely supported by the industry. Research carried out by Deloitte for the London Stock Exchange has suggested that scrapping Stamp Duty and giving preferential tax treatment to AIM company dividends could together: lower the cost of capital for high-growth companies by up to 25%; increase their valuation by 32% (£24 billion); enable these companies to facilitate the creation of up to 38,000 new jobs (a 20% increase in current employment by UK AIM companies); and be tax-neutral over the medium term16.

6.7. We also agree with the Commission that tax deductibility of interest payments does incentivise the use of debt for funding. This problem is not unique to the EU; the extent of the bias and the adverse consequences were assessed by the IMF in 201117. The bias is affected by how the recipient of either dividends or interest is taxed, especially if they are located in lower-tax jurisdictions.

6.8. The case, in principle, for removing this bias is widely accepted. We think that governments should push for the case for coordinated action at an international level to address this issue, whilst recognising that policy needs to be unobtrusive to current financing arrangements and will take a long time to implement.

14 Small Firms in the Credit Crisis: Evidence from the UK Survey of SME Finances www2.warwick.ac.uk/fac/soc/wbs/research/csme/research/latest/small_firms_in_the_credit_crisis_v3-oct09.pdf/ 15 http://www.londonstockexchange.com/about-the-exchange/media-relations/press-releases/2013/stampduty.htm 16 Deloitte 17 For a good summary see Sir George Cox Review, Overcoming Short-termism within British Business, March 2013 available here Page 18 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

6.9. Thus, we think policy makers should recognise this bias, and assess if taxation treatment should be changed to attract SMEs to use equity and long-term investors back into the equities market. Reducing some of the taxes associated with investing in small caps would help attract a wider set of investors, improve liquidity and ultimately the cost of capital of EU businesses. Recommendation 7 above summarises this view.

RECOMMENDATION 8: Amend the EU Risk Capital Guidelines to recognise the role of “replacement capital”, along with “new capital”, in ensuring an effective equity financing environment for start- up firms.

6.10. We also suggest that creating a favourable fiscal framework for small cap investors is important. We suggest that the Commission should also look at the EU framework that impacts any incentives offered at a Member State level to SME risk capital providers – the EU Risk Capital Guidelines.

6.11. On this point, we agree with the Commission that the provision of risk capital to SMEs especially in the start-up phase should be in the form of new/ initial capital. The early stage investors providing this risk capital will need to plan and execute an exit strategy, in order to generate a risk-adjusted return on investment.

6.12. As a business reaches the expansion phase it will seek new investors that not only provide additional capital but also an exit (or at least a partial exit) to the earlier stage investors. The ease with which a business is able to do this impacts its cost of capital and long term business success. We believe the provision of capital to replace existing investors (defined as ‘replacement capital’ in the guidelines) is a critical form of risk capital for smaller companies and for ensuring the effectiveness of the financing escalator.

6.13. Thus, we propose, in recommendation 8, that provision of “replacement capital” should be permitted in the EU Risk Capital Guidelines.

Page 19 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

7. PRINCIPLE 4: Offer the right incentives for investors and savers to invest in growth

RECOMMENDATION 9: Stimulate investment in SMEs to widen the pool of capital available to growing businesses, by making an SME asset class attractive to investors, including retail, buy-side and companies with cash, over the longer term. We welcome the Commission’s decision to further analyse the impact of the Solvency II rules on pension funds before including them within IORP.

9a. For retail investors, issue guidance on the MiFID conduct of business standards, specifically on client suitability, that seeks to encourage investment in SMEs.

7.1. Investor participation in the markets depends on a range of factors including investment size, risk appetite, investment horizon, understanding of the investment proposition, access route to market, and costs for investors. Our recommendations focus on addressing these factors to gain investor interest, improve liquidity and help lower the cost of capital for SMEs accessing public markets.

7.2. In our view, one of the key reasons for the current limited use of external LTF by SMEs and the significance of the funding gaps experienced by growing enterprises is the limited supply of willing investors. The Commission’s efforts to create an integrated and efficient financing environment must seek to introduce measures that enable a wider population of investors to invest in small and mid cap companies.

7.3. Increasing the diversity of investors interested and able to invest in SMEs is critical to ensuring vibrant markets. A mix of institutional and retail investors allows businesses to raise significant amounts of capital on a continuing basis and provides investors with confidence in their ability to trade in and out of their investments. Thus, we would ask the Commission to focus on both institutional and retail investors, as both sources are important for the long-term financing of the EU economy. This is the focus of recommendation 9.

Institutional investor issues

7.4. We believe that in order to reduce regulatory obstacles to long-term financing, EIOPA should be given the opportunity to examine the calibration of capital requirements under Solvency II; for example in relation to investment in SME.

7.5. Solvency II (applicable insurance funds) and any proposals to introduce similar regulation for pension funds must not place conditions that adversely impact the ability to invest in small caps. The capital and liquidity requirements under Solvency II are likely to exacerbate the tendency of institutions to only hold the largest and most liquid blue-chip equities and deter any existing appetite for smaller companies. An appropriate exemption for investment in small cap securities should be implemented.

7.6. The Commission may also consider exempting venture capital (VC) funds from the Alternative Investment Fund Managers Directive (AIFMD) to encourage them to gain scale. The AIFMD does not apply to funds under €100m and is therefore not likely to impact the majority of European VC funds. However, the potential to be caught by AIFMD will deter funds from gaining scale which is ultimately needed to allow a fund to diversify and achieve attractive returns. US VC funds tend to be larger and therefore are able to back more enterprises and generate good returns. For example, Germany has only four independent VC funds > €100m compared to 227 in the US.

7.7. The review of UCITS directive should be used as an opportunity to identify ways to attract dedicated UCIT funds for small caps. For example, creating a new category of UCITS dedicated to investment in SME markets with specific conditions and ability to be marketed to retail investors.

7.8. Further suggestions on how institutional investment can be channelled in to long term financing are provided in Part C.

Page 20 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

Retail investor issues

7.9. Retail investors can be critical contributors to liquidity. APCIMS, a retail investor and broker association in the UK, 18 estimates that the potential size of the untapped retail market in the UK could be as much as £20bn annually.

7.10. However, regulation – including MiFID – continues to disenfranchise these investors from participating in small and mid cap securities.

For example, as a result of economic conditions, investment firms across Europe are consolidating and are increasingly adopting a passive investment approach. Recommending small and mid caps for investment requires extra due diligence on specific stocks and documentation as evidence of client suitability assessment (as mandated under MiFID). Consequently, firms are defaulting to only recommending larger company stocks where analyst research is readily available. This has caused liquidity in smaller company securities to fall, reducing the economic incentive for analysts to write research on them, thereby further reducing the liquidity and analyst coverage and exacerbating the investment flows out of these companies.

7.11. Further, on the debt side, retail bond exchanges, like MOT and ORB, have the potential to offer smaller companies the possibility to issue publicly traded bonds and the ability to stimulate retail investment. Sovereigns like Italy and Belgium have used retail bond markets to directly place public debt with retail investors, see box 3 below. The Commission should consider further developing electronic bond markets like ORB and MOT to tap retail investment.

7.12. Thus, we believe that the Commission’s LTF strategy should stimulate retail investment. Recommendation 9 summarises this proposal.

BOX 3: BTP Italia – stimulating retail investment

An example of the success of electronic bond markets stimulating retail investment for LTF was BTP Italia – 4 separate issuances of 10-year Italian government debt issued using the MOT platform of the Borsa Italiana, instead of the traditional auction mechanism, directly to retail investors. The BTPs issued could be purchased at issuance not only at a bank, but also through any home-banking system equipped with an on-line trading feature. Four different BTP Italia issuances were conducted on MOT, providing retail investors an attractive middle-term investment for their savings, and raising the following amounts:  March 2012: Raising €7.3 billion  June 2012: Raising €1.7 billion  October 2012: Raising €18.0 billion  April 2013: Raising €17.0 billion

18 The Association of Private Client Investment Managers and Stockbrokers Page 21 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

RECOMENDATION 10: Recognise the use of capital markets as a tool to raise the profile and facilitate long-term investment into sustainable and responsible projects and companies. E.g. through benchmarks like FTSE ESG and portals like the Social Stock Exchange.

7.13. Finally, LSEG believes that capital markets offers policy markers a useful policy tool to channel investment into projects and company that are sustainable and add social value.

7.14. We believe that capital market portals, benchmarks, ratings etc. can perform this function - – this will help develop the infrastructure of social and public markets, and increase the analyst coverage of the sector, attracting the crucial institutional and retail support it needs.

7.15. This is our suggestion in recommendation 9. We provide examples from two initiatives that have involved LSEG to show how this can work in practice.

CASE STUDY 5 – Tracking companies that do “good” through capital markets – FTSE benchmarks19 and the Social Stock Exchange20

The International • 743 companies in the FTSE4Good Global Index at Energy Agency has launch; 894 as of March 2011 estimated that • 60% success rate of companies meeting new adapting to and criteria with FTSE support mitigating the effects of climate change over the next 40 years will • 5 original industry exclusions (Tobacco, require around USD 45 tn or around USD 1 tn a year. Weapons, Nuclear power, Infant formula, Uranium mining), now down to 2 existing industry Capital markets can help channel investment from exclusions (Tobacco and Weapons) savers into such “responsible” long-term investment needs, which will make our economy sustainable and The Social Stock Exchange efficient in the long run. E.g. FTSE, LSEG’s index (SSE), launched on 6 June provider, was involved in helping the United Nations 2013, is a new initiative backed international investor-led initiative, designed to help drive investment into Social Principles for Responsible Investment (PRI), build a Purpose Businesses (SPBs). framework by which investors can incorporate environmental, social and corporate governance Launched with the support of LSEG, the SSE is the (ESG) issues into their decision-making practices. In first capital markets information portal (website) 2011, over $10.1 trillion of global assets under to showcase publicly listed social impact management tracked ESG issues; and FTSE provides businesses on EU Regulated Markets. It aims to benchmarks, research and analytics to facilitate this. connect investors with growth companies in the FTSE’s Responsible Investment indices include the social arena, for raising capital and improving FTSE4Good Index Series (which tracks companies on liquidity, and increase the publicity, visibility, their ESG practices, and has shown a 52.3 per cent credibility and status of SPBs with investors and return since 2001), the FTSE Environmental advisory community. The establishment of the Opportunities Index Series (which tracks companies SSE is a key step in boosting EU’s status as a home providing products which offer solutions to for social finance and investment. environmental challenges – and have at least 20% of  It bridges the information gap between their business derived from environmental markets investors and SPBs, enabling a degree of and technologies) and the FTSE CDP Carbon Strategy comparability previously not available Index Series (which helps incorporating climate change risk in investor’s strategies) among other  It helps professional and individual investors custom indices. to make better investment decisions that are aligned with their values FTSE4Good in numbers since 2001:  It feeds a virtuous cycle: more information, • 52.3% return for FTSE4Good Global Index (USD more investment, more growth, more impact total return since launch) LSEG is working with the SSE to promote it to • 288 companies deleted for failure to meet companies and to build a pipeline of future social inclusion standards; 793 companies added impact businesses.

19 http://www.ftse.com/Indices/FTSE4Good_Index_Series/Downloads/FTSE4Good_10_Year_Report.pdf 20 http://www.socialstockexchange.com/ Page 22 of 28 Think Small First – LSEG response to the long- term financing Green paper 25 June 2013

PART C – ANSWERS TO SPECIFIC QUESTIONS

Q1. Do you agree with the analysis out above regarding the supply and characteristics of LTF? Q2. Do you have a view on the most appropriate definition of long-term financing? Please refer to our comments in Box 1, page 4

Q3. Given the evolving nature of the banking sector, going forward, what role do you see for banks in the channelling of financing to long-term investments? Please refer to our comments in paragraphs 2.1-2.6, page 5-6

Q6-9. Institutional Investors Please refer to our comments in paragraphs 7.1-7.8, page 20. In addition, we strongly support the setting up of a new European investment vehicle (LTIF) that specialises in long-term financing for growth, and which is easily identifiable as such by institutional investors.

In order to stimulate long-term financing of strategic productive assets, we also suggest that dedicated listed investment vehicles could facilitate capital raisings across the different categories of investors, such as private, professional, institutional, households, high net worth individuals (HNWIs) and governments.

We suggest that the Commission may consider the idea of platform of investment vehicles at a country level. In this way a better mix of local public and private capital could be raised. In addition, the listing of these vehicles could give access to international private capital, which gives the advantage of reaching various pools of liquidity from emerging markets, sovereign funds and sector-focused investors. The investment vehicles could include closed-end funds, investment companies, special investment vehicles, fund of funds and feeder-master funds

We would suggest that the Commission should explore the idea of feeder-master funds, i.e. an arrangement in which an investment company (or fund) acts through multiple funds to achieve its investment objectives. The master fund works in conjunction with one or more feeder funds to achieve economies of scale in the investment markets. The master fund is in charge of making all of the investment decisions on behalf of the feeder fund. When profits are distributed, they go back to the feeder fund and then ultimately to the end investor. Characteristics of these funds are described below.

BOX 4: Characteristics of feeder-master funds

Feeder Master funds should be characterised by: . Though we suggest flexibility in the creation of . Creation of a definition of “flexible eligible assets”, these funds, investor protection should remain to include different kind of investment vehicles paramount and thus there should be key providing long term growth. requirements in place, such as: . The definition should be capable of capturing a wide . A clear, detailed and transparent investment range of different possible specialisations in this policy: field, such as the importance of the local and o with clear and detailed guidelines on the limits territorial dimension in linking long term financing and choice of investment assets and types of and institutional investors with a strong local investors. Account to be taken of retail investors; network. o providing an adequate degree of diversification, . Simplified authorisation procedure to accelerate for example at least three different assets, none their development and activity and to reduce costs. of which should account for more than 50% of the . Creation of a product label, serving to identify the company’s total assets. investment vehicles and that can be used also to o Executives and Directors with appropriate raise funds from a broad range of entities. experience (e.g. at least three years) in the . Favourable taxation, via lower capital gain taxation management of investments of the same size and at domestic level or through guarantees provided to type as those described in the investment policy investors by public bodies. o Corporate Governance in line with international best practices

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Q10. Are there any cumulative impacts of current and planned prudential reforms on the level and cyclicality of aggregate long-term investment and how significant are they? How could any impact be best addressed? Please refer to our comments in paragraph 2.4-2.6 page 5-6, and paragraph 7.4-7.5 page 20.

Q11-12. How can capital markets financing of LTF be improved in Europe? Please refer to our comments in Part B, page 8-22.

Q14. How could the securitisation market in the EU be revived in order to achieve the right balance between financial stability and the need to improve maturity transformation by the financial system? Q27. How could securitisation instruments for SMEs be designed? What are the best ways to use securitisation in order to mobilise financial intermediaries' capital for additional lending to SMEs? We would advise the Commission caution when considering the securitisation of SME credit obligations to tap the debt capital markets for funding. We note that some form of central guarantee and obligation for the securitisation entity to hold some equity would be key to ensure that these products are of good credit rating and suitable for all investors – particularly if these products are to be marketable to investors across tranches. We also recommended that a securitisation programme may work to ease SME access to credit, so long as it is focussed and not an extremely large programme. In our view, there are other instruments e.g. retail bond issuances and equity that are more suited as sources of LTF for SMEs.

Q16-19. CIT reform Please refer to our comments in paragraphs 6.1-6.13, page 18-19

Q21. What kind of incentives could help promote better long-term shareholder engagement? The Green Paper discusses the idea that long term shareholders should have enhanced voting rights. LSEG does not believe that a distinction between the rights of long term and short term shareholders would be helpful. In October 2010, and following public consultation, the UK Takeover Panel decided not to change the voting rights of shareholders who acquired shares in a company after an offer had been made. This would compromise the principle of ‘one share, one vote’, as well as affect the value of shares traded during the takeover process. Any potential changes to the EU’s corporate governance regime which restrict the perceived investment value of EU companies are likely to further reduce the attractiveness of equities as an investment class – to the detriment of the equity market as a whole.

Furthermore, it is the diversity of investment strategies (the interplay between short term and long term investors) that creates the liquidity needed for an efficient equity market. Also see Box 2, page 15 on liquidity and holding periods.

Q25. Is there a need to develop specific long-term benchmarks? Refer to our comments in paragraphs 7.10-7.13 and Case Study 5

Q28. Would there be merit in creating a fully separate and distinct approach for SME markets? How and by whom could a market be developed for SMEs? Refer to our comments in paragraphs 4.12-4.24 page 11-13 and paragraphs 5.10 -5.15 page 16-17.

26) What further steps could be envisaged, in terms of EU regulation or other reforms, to facilitate SME access to alternative sources of finance? 29) Would an EU regulatory framework help or hinder the development of this alternative non-bank sources of finance for SMEs? What reforms could help support their continued growth? Refer to our comments in Part B, page 8-22.

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Appendix 1 – ELITE companies

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Appendix 2 – LSE’s High Growth Segment

High Growth Segment

The High Growth Segment, launched in March 2013, is a new segment of London Stock Exchange’s Main Market.

Designed in consultation with the investor, advisory and issuer communities, the segment caters for the needs of fast-growing companies that are ultimately aspiring to be part of the Main Market’s Premium segment but may not be meet all the eligibility criteria.

HGS is an example of collaboration amongst market participants and the market operator to enhance the choice for high growth businesses seeking access to the UK’s capital markets. Not only does the segment provide access to capital but is a platform for growth companies to increase their visibility and business profile with their stakeholders.

Entry criteria for HGS

A company must:

 be incorporated in the European Economic Area  be a revenue generating, trading business  demonstrate growth in revenues (on a CAGR basis) of at least 20% over three year period prior to admission  have at least 10% of the number of securities admitted in public hands with a value of at least £30 million (the majority of which must be raised at admission)  appoint a Key Adviser in relation to admission  set out an intention to join the Listed segment of the Main Market over time

“We are delighted that London Stock Exchange is taking action to ensure that London’s public markets are organised to help these companies fuel their growth. The UK has a world leading crop of high growth businesses, and the announcement of the High Growth Segment by LSE is an important step in creating the right environment for them to IPO in London.”

Greg Clark MP, Financial Secretary to HM Treasury

Further information on: www.londonstockexchange.com/hgs

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Appendix 3 – STAR and AIM Italia

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About London Stock Exchange Group:

London Stock Exchange Group (LSE.L) is a diversified international exchange Group that sits at the heart of the world's financial community. The Group can trace its history back to 1801.

The Group operates a broad range of international equity, bond and derivatives markets, including London Stock Exchange; Borsa Italiana; MTS, Europe's leading fixed income market; and the Pan-European equities and derivatives platform, Turquoise. Through its markets, the Group offers international business, and investors, unrivalled access to Europe's capital markets.

Post trade and risk management services are a significant part of the Group‟s business operations. LSEG operates CC&G, the Rome headquartered CCP and Monte Titoli, the significant European settlement business, selected as a first wave T2S participant. The Group is also a majority owner of leading multi-asset global CCP, LCH.Clearnet.

The Group offers its customers an extensive range of real-time and reference data products, including Sedol, Unavista, Proquote and RNS, as well as access to over 200,000 international equity, bond and alternative asset class indices, through LSEG‟s world leading index provider, FTSE.

London Stock Exchange Group is also a leading developer of high performance trading platforms and capital markets software. In addition to the Group‟s own markets, over 30 other organisations and exchanges around the world use the Group‟s MillenniumIT trading, surveillance and post trade technology.

Headquartered in London, United Kingdom with significant operations in Italy, France, North America and Sri Lanka, the Group employs approximately 2,800 people.

Further information on London Stock Exchange Group can be found at: www.lseg.com

For further information contact:

Shrey Kohli, Government Relations and Public Policy, LSEG T: +44 (0)20 7797 4313; E: [email protected]

Odiri Obiakpani, Regulatory Strategy, London Stock Exchange T: +44 (0)20 7797 1886; E: [email protected]

Paola Fico, Borsa Italiana Regulation & Post-trading T: +39 0272 426 285; E: [email protected]

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