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News : Innovation Last Updated: Nov 29, 2010 - 3:18:51 AM

Europe has less dynamic business environment than US; European firms grow/ shrink at slower pace
By Michael Hennigan, Founder and Editor of Finfacts
Nov 26, 2010 - 3:40:25 AM

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Europe has a less dynamic business environment than the US, underlying long-held concerns about Europe"s productivity gap, according to study published this month by the UK's National Endowment for Science, Technology and the Arts (NESTA). European firms grow and shrink at a slower pace than American counterparts.

In the most detailed analysis to date of the growth characteristics of six million businesses across Europe, the US, Canada and New Zealand between 2002 and 2005, the report Growth Dynamics finds that European firms grow and shrink at a slower pace than their American counterparts. This lack of dynamic movement in Europe means that innovative, high growth businesses find it harder to penetrate the market whilst companies which stop innovating continue to exist.  

The key patterns of firm expansion and contraction across Europe and the US revealed by the research show that:

  • Europe has fewer high growth firms[1] than the US (4.3% vs. 5.9%). The three-year employment growth rate of a firm at the 95th percentile of the growth distribution (i.e. a business that grows faster than 95% of businesses in its country) is 86% in the US, compared to only 71% in the average European country.
  • The shortfall is not limited to only the fastest growing firms. The share of medium-growth firms[2] in European countries is also lower. Firms at the 75th percentile of the distribution grow 19% faster in the US than in Europe (18% vs. 15%)
  • There are more steady-state businesses in Europe. Almost half of European firms with ten or more employees are effectively stable (46% of all surviving companies), neither growing nor shrinking[3]. This compares with 37% in the US.
  • Greater dynamism also means more failure. US firms at the 25th percentile of the growth distribution shrink 27 per cent faster than in Europe (-24% vs. -19%). The analysis also shows that the faster the firms at the top grow the faster firms at the bottom shrink.

The study says this has implications for both innovation and productivity since a more dynamic business landscape allows for experimentation, new products, services, and processes to rise to prominence, and for resources to be relocated from less to more productive businesses.

Jonathan Kestenbaum, chief executive of NESTA, says: "Whilst large established firms are critical to any economy, our research shows that innovative growth businesses are responsible for the majority of job creation. European markets need to be more open and nimble to these businesses if we are to achieve economic growth."

Kestenbaum added: "Zara, Autonomy and Skype demonstrate the power of European ingenuity but if we want to see more of these businesses then we have to make sure that we have the right environment to allow them to flourish".

Bruegel, a European economic policy think-tank based in Brussels has shown that the US and Europe have a similar number of companies in the world's 500 largest companies by market capitalisation. However, only 2% of the European companies were founded after 1975, in sharp contrast with 14% in the US.

The growth of companies differs significantly between Europe, the US and emerging markets.

Europe’s corporate landscape is dominated by older, established companies. Few large companies have emerged in Europe since the second world war. Of the world’s 500 largest companies only three were started in Europe after 1975, compared with 23 in the US and 21 in emerging markets. Many new firms are created in Europe, but after creation they tend to grow less briskly than in other economies. As OECD research has illustrated, among those firms that survive in the years following their creation, the pace of growth is much quicker in the United States. While in Europe the largest companies are likely to stay long at the top of their world, in the US they are vigorously challenged by new entrants, and by their own shareholders who often force them to divest non-core activities or to split into separate entities.

Bruegel says the US financial system has evolved quickly to provide such new corporate finance solutions. More research is needed to prove how much of the difference in the growth of emerging firms between the US and Europe is due to differences in financial systems, rather than other factors (such as barriers to entry and imperfect competition in markets for goods and services, as well as labour market constraints that discourage hiring in a risky environment).

However, there is no contradiction between recognising the undeniable impact of non-financial factors and emphasising the importance of adequate corporate finance. The academic literature in the last 10 years has established a solid causal link between an economy’s financial development and its growth potential.

Where Will Europe's Next Champions Come From? (pdf)

The NESTA research has important implications for policymakers across Europe, suggesting the need to combine an improved venture capital climate to support high growth firms with reforms to encourage competition, entrepreneurship and labour market flexibility. It would also need to remove barriers to entry, expansion and contraction; and remove barriers that stop businesses, especially in service industries, operating across borders.

NESTA says it and its partners will examine the specific drivers of business growth, with a view to providing more detailed evidence to support policymakers in tackling Europe"s growth challenge.

US companies better at exploiting IT; Better managers

Research published by the Centre for Economic Performance at the London School of Economics in the UK in 2005 showed that the US productivity miracle of the previous 10 years was not explained by the US business environment being better; rather, US companies were simply better at using computers and other technology to drive productivity higher. The effect explained most of the gap in productivity growth between the US and the UK and other European countries over the previous decade.

US output per hour grew by 2.5% a year on average between 1995 and 2004 compared with 1.5% in the 15 members of the EU before the 2004 enlargement.

Professor John Van Reenen together with Nick Bloom and Raffaella Sadun of the Centre for Economic Performance (CEP) at the London School of Economics, published a joint investigation with the UK Office for National Statistics (ONS). The research paper titled It ain't what you do, it's the way that you do I.T.: testing explanations of productivity growth using US affiliates (pdf) indicated that investment in new information and communications technologies (ICT) improves the productivity of UK businesses.

American firms continue to have the best management practices in the world: only 1 in every 50 can be described as ‘very badly managed’, compared with roughly 1 in 12 in the UK and more than 1 in 5 in Greece and India. These are among the conclusions of a 2007 survey of over 4,000 firms across the UK, continental Europe, the United States and Asia.

The research by the CEP, McKinsey & Company and Stanford University used an innovative approach to surveying management practices. The results of the study revealed that:

US firms are on average the best managed, with Swedish, Japanese and German firms also very well run. Greek and Indian firms are the worst managed, and UK firms are in the middle of the pack alongside France and Italy.

These differences across countries are largely driven by the ‘tail’ of badly managed firms. Fewer than 2% of US firms are ‘very badly managed’, while the UK has 8%, and the Greeks and Indians have over 20%.

Managers are very poor at self-assessment:

  • Over 85% of managers say that their firm is better managed than average.

  • Self-assessed management has almost no link with actual firm performance or the management ‘scores’ that the researchers calculate.

Four factors help to explain management practices:

  • Tougher competition – which weeds out the badly run firms and spur existing firms to improve.

  • ‘Traditional’ family firms – those that appoint the eldest son as the CEO – are usually worse managed.

  • Education of both workers and managers – which improves management practices.

  • Strict labour market regulations impair the ability of companies to improve their people management.

The UK-US management gap is driven predominantly by the UK’s high share of ‘traditional’ family firms and lower levels of education of workers and managers.

There are also differences across countries in relative management strengths:

  • UK, US and Indian firms are relatively stronger at people management (for example, performance rewards and merit-based promotion).

  • Japanese, German, French, Italian and Swedish firms are relatively stronger at shopfloor operations management (for example, monitoring and continuous improvement).

Multinationals tend to achieve excellent management practices wherever they are located.

Professor Nick Bloom commented: "These results are worrying for US and European firms. While the typical Indian firm is badly managed, they also have some extremely well run firms. In fact, the top 30% of Indian firms are better managed than the average UK firm. Combined with their cheap labour costs, this makes them formidable competitors."

"Family firms that hand down the CEO position to the eldest son are typically very badly managed. Imagine if we picked the England team as the eldest sons of the 1966 World Cup winners - - I doubt we’d ever win a match."

Raffaella Sadun commented: "The US supremacy in management practices appears to be driven by some simple ingredients: free markets, low regulation and merit-based promotion."

"Private equity owned firms are some of the best managed while traditional family firms are some of the worst. So, private equity firms may play an important role in preserving UK manufacturing when they buy out traditional family firms."

Professor John Van Reenen commented: "It is surprising just how bad managers are at assessing their own firm’s management. The average manager’s self-assessment is "well above average," bearing almost no relation to either their firm’s performance or actual management practices. Maybe this is why so many people find David Brent so painfully realistic in The Office."

Summary Report: Management Practice and Productivity: Why they Matter (pdf)

...on the other hand

Newsweek Magazine reported last April that contrary to the widespread cliché of American dynamism versus European economic stagnation, over the past decade Europe's top companies have beaten America's (not to mention Japan's) by an often substantial margin. Despite the rise of China and the rest, Europe has held roughly steady, at about 17%, its share of world exports since 2000, while America's has fallen by more than a third, from 17 to 11% - - a crude but significant indicator of global competitiveness. Since the early 1990s, Europe has steadily expanded its share of the world's 100 biggest multinationals compiled annually by the UN Conference on Trade and Development, from 57 in 1991 to 61 last year, while the U.S. number has dropped from 26 to 19.

Europe has moved up these and other corporate rankings with new and fast-expanding companies in such sectors as energy (Germany's E.On and France's GDF Suez), finance (Britain's HSBC and Italy's UniCredit), and telecommunications (Spain's Telefónica and Britain's Vodafone) - - while America's roster of large global companies has been mostly static and declining, with new stars like Google the exception, not the rule.

What's more Newsweek said, Europe's growth has been highly profitable. According to a study of the top 3,000 global companies by the German business consultancy Roland Berger, the European companies in the group grew profits at an average rate of 13% a year over the decade from 1998 to 2008, almost double the 7% rate for their US rivals. Berger CEO Burkhard Schwenker said corporate Europe now has higher earning power than America Inc., with gross earnings in the Berger sample averaging 19.8% of 2008 revenues in Europe, versus 13% in the US. " Some of these numbers must obviously be taken with a grain of salt—for example, 2009 earnings (a compilation of which Berger plans to release next month*) show a significant rebound for U.S. companies versus their European rivals, who were hit later and harder by the recession," the report says.

*We haven't been able to locate an update.

[1] High growth firms are all enterprises with 10 or more employees in the beginning of the observation period with average annualised employment growth greater than 20% over a three year period.

[2] Medium growth firms are defined as all enterprises with 10 or more employees in the beginning of the observation period with average annualised employment growth between 10% and 20% over a three year period.

[3] Stable firms are defined as all enterprises with 10 or more employees in the beginning of the observation period with average annualised employment growth between -5% and 5% over a three year period.

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