Grants vs. Loans, but Equity is the Need of the Hour

Marti Subrahmanyam
By Arnoud Boot, Elena Carletti, Johannes Kasinger, Hans-Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, and Marti Subrahmanyam
After lengthy and intense discussions, European leaders have struck a major deal on a €750 billion coronavirus recovery package. Without any doubt, this remarkable development is a landmark for the future of the European Union (EU) – inconceivable just months ago. Negotiations and media coverage have centered on the breakup of the package between grants and loans. In the event, the European Council members settled on €390 billion in loans and €360 billion in grants, a sharp reduction from the €500 billion grant component envisioned in the initial “next generation” proposal by the European Commission. However, focusing only on the split between grants and loans is narrow in perspective and misses the broader picture.

Current efforts fail to rejuvenate businesses by essentially providing only loans and guarantees, since doing so would leave firms over-indebted and unable to grow, accentuating their incentive problems. The considerable grant component to national governments is probably not going to mitigate this problem, in part to the perverse incentives it creates through moral hazard. A real economic recovery demands entrepreneurship and a dynamic energy – a kindling of the animal spirits in businesses across Europe. For this to happen, firms need equity, i.e., risk-bearing funding that permits them not just to survive the hardship of the coronavirus crisis today, but motivates them to seize business opportunities in the world of tomorrow. As the European Commission proposal states, “…..more and more companies that would otherwise be viable will face solvency problems and the liquidity support will not be sufficient. […] loans […] can further weaken corporate balance sheets as many companies witnessed a steady increase in leverage in recent years.”

The proposed Solvency Support was a step in the right direction; however, it was still a tentative one, and one that deserves an even more prominent role in Europe’s recovery plan. To that end, we propose an ambitious European Pandemic Equity Fund (EPEF) to provide equity to hitherto profitable businesses all across Europe. As an equity investor in businesses, the EPEF would not just hand out money, but would expect reasonable returns in the future. Of course, there is risk, as there is with any investment.

The EPEF should be targeted where it can add real value at the core of the European economy: its small- and medium-sized businesses. This true backbone of Europe accounts for the vast majority of its employment, accounting for much of the economic growth of the last decades. We are talking about private firms, mostly with less than 250 employees, covering up to 80% of employment in the member states.

By designing a broad-based European equity-like participation scheme, the EPEF will not only help create a joint perception of shared responsibility and solidarity across Europe, but also, at least as important, a strong perception of shared success. It would offer a way out of the recent paralyzing North/South discussion with Southern member states accusing the North of a “bookkeeping mentality,” whereas the Northern states fear wasteful spending by the South, and being drawn into a transfer union. The equity structure allows for the sharing of risks and rewards.

In that sense, the EPEF fits perfectly into the narrative of an emerging European capital markets union and may indeed be one of its defining moments. In the words of Jean Monnet, one of the founding fathers of the European Union: “Make men [and women] work together, show them that beyond their differences and geographical boundaries there lies a common interest." We encourage the EC to revisit their initial plans and move to a European Pandemic Equity Fund.

Marti Subrahmanyam is the Charles E. Merrill Professor of Finance, Economics and International Business