Industrial Policy via Venture Capital: Unpacking the Implications for Europe
“Industrial Policy via Venture Capital” (Jun 2025) - By Martin Aragoneses and Sagar Saxena
Despite abundant talent, savings, and public investment, Europe lags behind the United States in productivity, business dynamism, and high-tech output. The 2024 Draghi Report underscores this "puzzling gap," attributing it partly to undercapitalized venture capital (VC) markets, where European firms receive fewer deals and smaller funding volumes than their American counterparts.
“On the supply side, the EU has fewer and less equipped large-scale VC funds. Since 2013, there have been 137 VC funds larger than USD 1 billion in the US compared to only 11 in the EU. This poses challenges for financing start-ups and allow them to scale up to their full potential.”
Amid calls for coordinated industrial policy, a new study by Martin Aragoneses and Sagar Saxena, "Industrial Policy via Venture Capital" (2025), dissects one promising lever: government-backed VC intermediated through private funds. By analyzing the European Investment Fund (EIF), the authors reveal how public money can amplify private expertise to bridge funding gaps. Yet, their findings expose a critical misalignment: while interventions shine brightest for young firms, policy tilts toward mature "scale-ups." This tension, reconciled with broader critiques like the report summarized in Contextual Solutions' blog (2024), signals a path forward for Europe's innovation future—one prioritizing early-stage, bottom-up support to unleash disruptive potential.
“Reduced-form regressions show government-linked financing via private VCs has stronger effects when focused on young firms. Despite being much less effective when targeting older firms, we find government-linked VC funds are biased towards later-stage investments in so-called ‘scale-ups’.”
The paper's empirical backbone draws from digitized EIF annual reports, matched to PitchBook deal data and Orbis firm panels, tracking over 61 pages of granular evidence. Strikingly, one-third of new VC investments in Europe originate from government agencies, with the EIF alone committing €5.6 billion in equity in 2023 — rivaling SoftBank's global outlays. This indirect model, where the EIF passively funds active private VC funds, leverages market savvy to select and nurture portfolio companies. The results are transformative: EIF-backed funds have swelled into a market mainstay, delivering funding volumes per firm that mirror U.S. levels, even after controlling for age, sector, or region. European firms backed by EIF-linked VCs raise substantially more capital than purely private peers, suggesting "additionality"—public dollars crowd in private co-investors without displacement.
However, efficacy hinges on timing. Reduced-form regressions show EIF interventions spur stronger post-investment growth (sales, employment, productivity) when targeting young firms under five years old. For these startups, government-linked financing eases early bottlenecks, enabling rapid scaling akin to U.S. trajectories. In contrast, effects wane for older firms, where frictions are less acute. This life-cycle asymmetry is puzzling: PitchBook data reveals the EIF finances nearly 40% of European firms with 20-250 employees under five years, yet its portfolio skews disproportionately toward later-stage deals. Policymaker interviews confirm an intentional "scale-up" bias, premised on persistent late-stage gaps despite early progress. Echoing global patterns documented in other research, Europe's public VCs (unlike top private ones) shun early risks, favoring mature bets. The paper benchmarks this against U.S. data, where early-stage deals outnumber late-stage ones, underscoring Europe's "middle technology trap."
Performance of EIF investments versus non-EIF investments
To unpack this, Aragoneses and Saxena build a structural model blending macro-development frictions with VC dynamics. Heterogeneous entrepreneurs face borrowing constraints, financed by specialized funds at life-cycle stages, intermediated by a mandated institutional investor like the EIF. A novel ingredient: funding depends not just on firm-specific needs but aggregate equity supply, endogenizing "gaps" across stages. Calibrated to EIF allocations and European moments (firm age distribution, leverage), the model rationalizes policy choices contextually. In high-friction environments, i.e. underdeveloped regions or sectors, later-stage focus maximizes aggregate total factor productivity (TFP), as public capital unlocks untapped scale-up potential without early-stage overload. Counterfactuals confirm: entering "new markets" yields outsized gains, but only if supporting mature firms first, aligning with Cole et al. (2020) on impact investing in capital-scarce frontiers.
Yet, for Europe writ large, with milder frictions per calibration, history flips. Reallocating a fixed budget toward early-stage funds rivals the TFP boost of a "Big Push" doubling spending overall. This cost-effective pivot exploits young firms' higher returns, where constraints bind tightest, echoing Howell (2017) on U.S. grants crowding in VC for innovation. The model thus demystifies mixed empirical evidence (De Haas and González-Uribe, 2024): outcomes vary by friction degree, funding volumes, and stage focus, urging ex-ante simulations over ex-post audits.
These insights resonate deeply with the Bocconi-Ifo report, "Funding Ideas, not Companies" (2024), which criticises EU innovation policy (€100 billion via Horizon Europe) for favoring incumbents over disruptors. Both works diagnose a funding misfire: the paper's scale-up tilt mirrors Horizon's 60-80% allocation to large consortia and corporate-linked SMEs, yielding fleeting growth (vanishing post-grant) rather than sustained dynamism. "Over half of Horizon funding goes to mid-tech firms with limited breakthrough potential," trapping Europe in incrementalism, much like the paper's observation of later-stage biases stifling early vitality. Reconciliation emerges in shared prescriptions: rechannel resources bottom-up.
The Aragoneses and Saxena paper advocates early-stage VC reallocation for mild-friction Europe, paralleling the Bocconi-Ifo report’s call to redirect from "ineffective collaborative instruments" to EIC's "Challenge" programs for independent, high-potential SMEs—only 7.5% of current SME funds reach truly constrained innovators. Where the Bocconi-Ifo report decries a €4 billion "consultancy industry" siphoning grants without tech creation, the paper's indirect VC model sidesteps this by outsourcing selection to private funds, preserving expertise. Contrasts are subtle: the Aragoneses and Saxena paper validates late-stage aid in frictional niches (e.g., Southern Europe), while the blog urges blanket curbs on incumbent repeats, viewing them as perennial low-impact drains. Yet, the alignment is clear — both finger financial frictions' uneven bite, with the blog noting: "Over 60% of SME funding goes to those... less likely to be financially constrained," echoing the paper's endogenous gaps. Together, they indict top-down mandates, advocating agile funding to more early-stage opportunites.
For Europe's innovation ecosystem, these findings offer an opportunity: First, amplify EIF-like vehicles, but recalibrate mandates: 50-70% to early-stage in core economies (Germany, France), reserving late-stage for peripherals (Greece, Poland). This could close the VC deal gap, fostering 10-20% productivity gains, per Draghi's dynamism goals. Second, hybridize with Bocconi-Ifo-inspired grants: EIC "Challenges" paired with VC matching, ensuring 35%+ funds hit independent startups, not corporates. Pilot in high-friction hubs like Eastern Europe, scaling successes continent-wide.
Politically, this demands resolve against capture; lobbyists peddling "scale-up security" must yield to evidence. Spillovers abound: cheaper factor prices from young-firm booms could curb inequality (a model extension), while bottom-up ethos invites a more diverse base of talent, countering U.S. brain drain. Risks linger, such as an over-reliance on public LPs which might stifle private risk-taking — but calibrated pushes ought to mitigate this.
In sum, Aragoneses and Saxena's work, harmonized with the Bocconi critique, lays out a blueprint: fund ideas early, via savvy intermediaries, attuned to the frictions of cross-border activity. Europe's €8.3 billion annual public VC commitments are potentially transformative, and could ignite a high-tech surge across the continent if allocated intelligently. The Draghi era should not be met with the sledgehammer grand political gestures and big promises, but targeted activity — taking a scalpel to reshape capital allocation to the right places, enabling tomorrow’s breakthroughs.