Does public funding have a halo effect? Evidence from Finnish SMEs

One commonly mentioned rationale for public funding is its positive signaling effect, often called the “halo-effect”, to the private sector financial institutions about the quality of the firm. This is based on the market failure argument based on the existence of asymmetric information between the financier and the firm, and lack of transparency, particularly in smaller firms. This paper empirically explores the effects of public funding on firms’ willingness and ability to gain access to private sector financing. Overall, the results indicate that market failures based on asymmetric information exist, and that firms do take active steps in trying to make their firms more transparent and signal their quality to the financiers (e.g. by using internationally recognized auditors). This does seem have a positive effect on the firms’ ability to raise external market finance. What kind of role public funding plays in reducing this asymmetry remains unclear. The crucial question that remains in interpreting the results in this paper is the order of moves: is it the public sector funding that induces further private sector financing, or is it the other way around?