Capital investments and financing structure: Are R&D companies different?

TUT Economic Research Series Department of Economics and Finance Tallinn University of Technology tutecon.eu Capital investments and financing structure: Are R&D companies different? Kadri Männasoo, Heili Hein

Capital investments and financing structure: Are R&D companies different? KADRI MÄNNASOO*, HEILI HEIN Abstract Research and development (R&D) activities place elevated demands on hightechnology equipment and infrastructure, and this requires sizable investments. However, returns on R&D investments are time-lagged, highly uncertain and subject to appropriability problems, causing private R&D investment to fall below the socially desirable level. Market imperfections such as financing constraints are also reasons why R&D may be insufficient. This short, descriptive analysis compares the funding structure of the capital investments of R&D and non-r&d companies over rounds IV (2007-2009) and V (2012-2014) of the Business Environment and Enterprise Performance Survey. We find that R&D companies invest more relative to sales, and that they are more reliant on credit from banks and other financial intermediaries. Although the share of internal funding increased for all companies after the crisis, the strong selection of companies into R&D and innovation activities has made R&D companies less vulnerable to credit contraction with fewer marked changes in their financing structure than has been seen by non-r&d companies. Department of Economics and Finance, Tallinn University of Technology Corresponding author: Kadri Männasoo, kadri.mannasoo@ttu.ee

Investeeringud põhivarasse ja rahastamisstruktuur: Kas T&A ettevõtted eristuvad? KADRI MÄNNASOO*, HEILI HEIN Kokkuvõte Teadus- ja arendustegevusega (T&A) kaasnevad kõrgenenud nõuded kõrgtehnoloogilistele seadmetele ja taristule, mis nõuavad suuri investeeringuid. Samas on tulud T&A investeeringutest ebakindlad, pika viitajaga ning teadustegevuse omapära tõttu seotud riskiga, et ettevõte ei saa endale kogu tulu, mis tehtud investeeringutest tõukub. Nimetatud põhjustel on T&A investeeringute tase madalam, kui oleks sotsiaalselt optimaalne. Turutõrked nagu ebapiisavad rahastamisvõimalused pärsivad samuti T&A investeeringuid. Käesolev lühike kirjeldav analüüs võrdleb T&A-ga hõivatud ning ülejäänud ettevõtete investeeringuid põhivarasse ja nende rahastamise struktuuri kasutades Business Environment and Enterprise Performance küsitlusuuringu voorude IV (2007-2009) ja V (2012-2014) andmeid. Analüüsist järeldub, et T&A ettevõtted investeerivad suhtena müügimahtu rohkem kui muud ettevõtted, olles samas enam sõltuvad pankade ja muude finantsvahendajate laenudest. Kuigi kriisijärgselt suurenes investeeringute omafinantseerimise osakaal kõigis ettevõtetes, siis T&A sektoris toimunud konsolideerumis- ning selektsioonimehhanismide tõttu muutus T&A ettevõtete rahastamisstruktuur võrreldes ülejäänud ettevõtetega vähem ning laenude osakaal finantseerimises säilitas märkimisväärse osakaalu. Majandusanalüüsi ja rahanduse instituut, Tallinna Tehnikaülikool Autorite kontaktisik: Kadri Männasoo, kadri.mannasoo@ttu.ee 2

Capital investments and financing structure: Are R&D companies different? KADRI MÄNNASOO*, HEILI HEIN Introduction R&D companies generally have higher demand for investment than companies that are not engaged in R&D do, and it is widely known that the level of R&D investment falls below the socially optimal level (Brown et al., 2017). Private incentives for R&D do not just emerge from the frictionless operation of market mechanisms, as they also need institutional support (Nelson, 1986). Generating lucrative R&D output requires extensive investment in cuttingedge technologies, equipment and human capital. Moreover, the returns of R&D investments are strongly time-lagged and highly uncertain, making them sensitive to credit frictions and cyclical fluctuations. Männasoo and Maripuu (2015) and Maripuu and Männasoo (2014) show that productivity-enhancing long-term investments in tangible assets improve company performance if the economic outlook is positive, but equally that this effect is absent in downturns and crises. Although the frontiers of knowledge and technology move forward without being overly constrained by regulation, there are several policy measures that legislators could enforce that could impact R&D engagement and investment positively. These include measures that let R&D companies appropriate their R&D returns better by protecting intellectual property effectively and regulating patents appropriately. An ethical and prudent business environment that is free from corruption and red tape is also critical for encouraging R&D. Financing constraints impeding R&D investments and innovation has been an issue of particular research interest, with the dominant evidence confirming that financing and credit constraints have an adverse and restraining effect on R&D (e.g., Hall and Lerner, 2010, Department of Economics and Finance, Tallinn University of Technology Corresponding author: Kadri Männasoo, kadri.mannasoo@ttu.ee 3

Brown and Peterson, 2009, Cincera and Ravet, 2010, Czarnitzki and Hottenrott, 2011). The evidence from transition countries is considerably more limited. Männasoo and Meriküll (2014, 2015), use company-level data from Central and Eastern Europe (CEE) and find significant evidence of prevailing credit constraints hindering R&D activity. In line with the Schumpeterian opportunity-cost argument, Aghion et al. (2005, 2010, 2012) argue that during an economic downturn, the long-term gains from productivity-enhancing long-term investments like those in innovation and R&D are more worthwhile than the rewards from short-term investments. When there are financing and credit constraints however, the higher liquidity risks of long-term investment reduce R&D investment and render its inherently countercyclical nature cycle-neutral or even pro-cyclical. The current study aims to give some insight into the multifaceted issue of R&D investment by comparing the investment intensity and financing structure of the capital investments of R&D and non-r&d companies. The brief analysis uses firm-level data dating from the Global Financial Crisis and its aftermath. Data and sample The study uses data from the Business Environment and Enterprise Performance Survey (BEEPS), a firm-level survey conducted jointly by the European Bank for Reconstruction and Development and the World Bank. This survey aims to cast light on several aspects of the business environment and is based on face-to-face interviews with company managers. Our sample draws on 1109 observations from CEE manufacturing companies in survey round IV from 2007-2009, and 1140 observations in survey round V from 2012-2014. The sample companies are from eleven newer member states of the European Union (EU) that joined in 2004 or later. These are Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia, also known as the CEE-11. The median size for the companies sampled was small with fewer than thirty full-time employees and average annual sales of around one million euros over the two survey rounds. To provide a comparative perspective, we separate R&D and non-r&d companies across the variables of interest. We consider a company to be engaged in R&D if it has had expenditure on R&D activity, either in-house or outsourced, over the last three years. R&D is 4

defined as creative work undertaken on a systematic basis in order to increase the stock of knowledge (see the appendix for the full definition of R&D activity as presented by the interviewers to the managers, and the related survey question). The percentage of manufacturing companies engaged in R&D in BEEPS round IV (2007-2009) was 31.6%, but it was significantly smaller during round V (2012-2014) at 19.6%. Moreover, the percentage of R&D firms dropped in all the sample countries, as illustrated in Figure 1, with all the observations falling below the 45-degree line. The share of R&D companies dropped most in Croatia, Lithuania, and Slovenia, while the smallest falls were in Romania and Hungary. Figure 1: Percentage of R&D companies by countries in BEEPS rounds IV (2007-2009) and V (2012-2014). Analysis of the financing structure of R&D and non-r&d companies The BEEPS round IV (2007-2009) data provide no statistical evidence of significant differences in the ratio of fixed asset investments to sales between R&D and non-r&d companies; the ratios were 14% and 12% respectively. A significant divergence appeared over round V (2012-2014), when the investment to sales ratio of non-r&d companies was measured at 16%, while that of R&D companies was 85%. This shows that R&D companies were not significantly different from non-r&d companies in their physical capital intensity (physical capital 5

including machinery, vehicles, equipment, and land and buildings) in the first period, but a remarkable difference emerged between the two company groups during the post-crisis period. Furthermore, the financing structure of these investments in fixed assets is noticeably different for the two types of company, as illustrated by Figure 2. Figure 2: Financing structure of fixed assets for R&D and non-r&d companies across BEEPS rounds IV (2007-2009) and V (2012-2014) R&D companies in the CEE-11 are significantly more dependent on bank credit than non- R&D companies are, and a lower share of their fixed asset investment is financed by internal funds or the issuance of new equity. This pattern is consistent over both rounds of the survey, though during round V (2012-2014) both types of companies cut their dependence on bank credit substantially from the level of round IV (2007-2009). This sharp drop in the share of bank credit in the financing structure could reflect the tightening of the credit market in the aftermath of the Global Financial Crisis. While non-r&d companies sought trade credit in the form of credit from suppliers and advance payments from customers to replace their bank debts in part, R&D companies reported a higher share of other financing sources such as credit from non-bank financial institutions. Primarily however, the companies have reduced their reliance on bank debt by 6

increasing the share of internal funds in their financing portfolios 1. The share of internal funds has grown so significantly that the companies overall reliance on external funding has decreased. Another external source of financing the issuance of new equity was less important in round V than it was in round IV. The drop in the share of equity in the financing structure has been the dominant feature of non-r&d companies. The particular characteristics of R&D investment, which is long term and has unpredictable returns, make the companies engaged in R&D vulnerable to cyclical turbulence, which is seen in the marked increase in the share of internal funding in the post-crisis years. Interestingly however, the financing structure of non-r&d companies underwent an even sharper change, with a very large increase in the share of internal funding, which mainly replaced the owner s contribution and new equity issuance. This last point is likely to be an indication that there is a strong selection mechanism into R&D that retains stronger companies in the research and development business, a trend that has also been observed by Lee and Noh (2009), Hirschey et al. (2012) and Rammer and Schubert (2016). Conclusions The purpose of this brief, explorative analysis was to study the capital investments and financing structure of R&D and non-r&d companies in eleven new EU member states from Central and Eastern Europe. We found that the investment-to-sales ratio grew by a notable 71 percentage points for R&D companies in the post-crisis period of 2012-2014, whereas the growth for non-r&d companies was only four percentage points relative to the survey years 2007-2009. The share of bank credit in the financing structure of R&D companies is considerably higher than it is for non-r&d companies, and though internal resources gained in importance over the last survey round for all companies, R&D companies remained more reliant on bank credit over the post-crisis years. This descriptive study, although insightful, has its limitations. First, our analysis relies on fixed asset purchases for its assessment of the financing structure of investments, but we do not know explicitly what share of such investment goes directly to R&D, and neither do 1 This may be partially due to the heterogeneity of corporate tax systems (see Hazak, 2007, 2009) as well as differences in company ownership (see Avarmaa et al., 2011), among other factors. 7

we observe R&D-related investment in knowledge and human capital. Second, the binary variable for R&D engagement is not able to account for the intensity of R&D, which might have some significant implications for the current study context (see e.g. Czarnitzki and Hottenrott, 2011). Nevertheless, we still observe considerable differences between R&D and non-r&d companies both in investment intensity and in the financing structure of capital investments and in the dynamics of these measures over the two survey rounds. Following the implications of the analysis, we suggest that the strong selection of companies into R&D seems to be the reason that changes were less marked in the financing structure of R&D companies than in that of non-r&d companies. Acknowledgments This project has received funding from the European Union s Horizon 2020 research and innovation programme under the Marie Skłodowska-Curie grant agreement No 734712 Institutions for Knowledge Intensive Development (IKID). Support from the Estonian Research Agency grant PUT315 Towards the Knowledge Economy: Incentives, Regulation and Capital Allocation is gratefully acknowledged. References Aghion, P., Angeletos, G. M., Banerjee, A., & Manova, K. (2010). Volatility and growth: Credit constraints and the composition of investment. Journal of Monetary Economics, 57(3), 246-265. Aghion, P., Angeletos, M., Banerjee, A., & Kalina, B. K. Manova (2005), Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment. NBER Working Paper, (11349). Aghion, P., Askenazy, P., Berman, N., Cette, G., & Eymard, L. (2012). Credit constraints and the cyclicality of R&D investment: Evidence from France. Journal of the European Economic Association, 10(5), 1001-1024. Avarmaa, M., Hazak, A., & Männasoo, K. (2011). Capital structure formation in multinational and local companies in the Baltic States. Baltic Journal of Economics, 11(1), 125-145. Brown, J. R., & Petersen, B. C. (2009). Why has the investment-cash flow sensitivity declined so sharply? Rising R&D and equity market developments. Journal of Banking & Finance, 33(5), 971-984. Brown, J. R., Martinsson, G., & Petersen, B. C. (2017). What promotes R&D? Comparative evidence from around the world. Research Policy, 46(2), 447-462. Chen, Y. F., Funke, M., & Männasoo, K. (2006). Extracting Leading Indicators of Bank Fragility from Market Prices Estonia Focus (No. 1647). CESifo Group Munich. Cincera, M., & Ravet, J. (2010). Financing constraints and R&D investments of large corporations in Europe and the US. Science and Public Policy, 37(6), 455-466. 8

Coe, D. T., Helpman, E., & Hoffmaister, A. W. (2009). International R&D spillovers and institutions. European Economic Review, 53(7), 723-741. Czarnitzki, D., & Hottenrott, H. (2011). Financial constraints: Routine versus cutting edge R&D investment. Journal of Economics & Management Strategy, 20(1), 121-157. Hall, B. H., & Lerner, J. (2010). The financing of R&D and innovation. Handbook of the Economics of Innovation, 1, 609-639. Hazak, A. (2007). Dividend decision under distributed profit taxation: investor s perspective. International Research Journal of Finance and Economics, 9, 201-219. Hazak, A. (2009). Companies' Financial Decisions Under the Distributed Profit Taxation Regime of Estonia. Emerging Markets Finance and Trade, 45(4), 4-12. Hirschey, M., Skiba, H., & Wintoki, M. B. (2012). The size, concentration and evolution of corporate R&D spending in US firms from 1976 to 2010: Evidence and implications. Journal of Corporate Finance, 18(3), 496-518. Kerikmäe, T., & Chochia, A. (Eds.). (2016). Political and legal perspectives of the EU Eastern Partnership policy. Cham: Springer. Lee, C. Y., & Noh, J. (2009). The relationship between R&D concentration and industry R&D intensity: a simple model and some evidence. Economics of Innovation and New Technology, 18(4), 353-368. Männasoo, K., & Maripuu, P. (2015). Company Performance, Investment Decision, and Cyclical Sensitivity: A Dynamic Estimation on Company Microdata. Eastern European Economics, 53(1), 25-38. Männasoo, K., & Meriküll, J. (2014). R&D, Credit Constraints, and Demand Fluctuations: Comparative Micro Evidence from Ten New EU Members. Eastern European Economics, 52(2), 49-64. Männasoo, K., & Meriküll, J. (2015). The impact of firm financing constraints on R&D over the business cycle (No. wp2015-3). Bank of Estonia. Maripuu, P., & Männasoo, K. (2014). Financial distress and cycle-sensitive corporate investments. Baltic Journal of Economics, 14(1-2), 181-193. Nelson, R. R. (1986). Institutions supporting technical advance in industry. The American Economic Review, 76(2), 186-189. Nelson, R. R. (1986): Institutions Supporting Technical Advance in Industry, The American Economic Review, Vol. 76, No. 2, pp. 186 189. Rammer, C., & Schubert, T. (2016). Concentration on the few?: R&D and innovation in German firms 2001 to 2013. ZEW discussion papers, 16. 9

Appendix. Excerpts from the BEEPS questionnaire 2 H. INNOVATION Innovation activity H.6 During the last three years, did this establishment spend on research and development activities, either in house or contracted with other companies (outsourced)? (INTERVIEWER: Research and development (R&D) is defined as creative work undertaken on a systematic basis in order to increase the stock of knowledge. For example, laboratory research for a new chemical compound of paint would be research and development while market research surveys or internet surfing would not be research and development.) Yes 1 No 2 DON T KNOW (SPONTANEOUS) 9 K. FINANCE K.5 Over fiscal year [insert last complete fiscal year], please estimate the proportion of this establishment s total purchase of fixed assets that was finance from each of the following sources: SHOW CARD 19 Percent DON T KNOW (SPONTANEOUS) Internal funds or retained earnings % -9 Owners contribution or issued new equity shares % -9 Borrowed from banks: private and state-owned % -9 Borrowed from non-bank financial institutions, which include microfinance % -9 institutions, credit cooperatives, credit unions, or finance companies Purchases on credit from suppliers and advances from customers % -9 Other (moneylenders, friends, relatives, bonds, etc.) % -9 100% 2 Business Environment and Enterprise Performance Survey, Questionnaires: Manufacturing Module (2012). Available at: http://ebrd-beeps.com/wp-content/uploads/2013/09/beeps_v_q_mnf.pdf. 10

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