by Debora Revoltella, European Investment Bank’s chief economist

We ran an experiment to better understand why only 1% of European firms want external equity to play a bigger role in their financing mix. These startling results point to the need for Europe to seriously rethink incentives for firms, with the goal of strengthening economic resilience and fostering innovation.

Europe is in denial. Firms finance investment predominantly through internal sources. External finance represents less than 40% of firms’ investment finance, with bank debt and leasing prevailing. Companies think they can invest and grow without diluting their ownership through external equity financing. The result: lots of firms are reliant on internal finance and bank debt, and they show a sluggish rate of growth.

The full experiment can be followed in a working paper we just published. We gave two different financing choices to a sample of 973 European companies, all of which were planning investments. The offers had varying sizes, interest rates, maturities, collateral requirements, and subordination/equity conditions.

The results were staggering. The premium on debt financing interest rates that companies were willing to take in order to avoid external equity financing that included voting rights was 880 basis points. Essentially, firms were willing to pay an extra 8.8% interest compared to the cost of equity so they wouldn’t have to offer shares. Even with a lending option requiring 100% collateral, firms were willing to pay some 5% more for a loan.

How much extra are firms willing to pay for different financing characteristics?