Of the 30 or so professional venture capital (VC) funds currently present on the Hungarian market most are Western European and North American institutional investors, meaning domestic sources are marginal. While VC investors in Hungary have mainly brought expansion capital to large businesses in Hungary due to the successful buy-out opportunities they promised, there is a far greater demand for financing for start-up and early stage capital.

While western VC investors are more interested in the highest profit, state-owned VC funds are more focused on industry growth. A typical VC would rather invest in enterprises promising higher returns faster than in start-ups or early-stage small and medium enterprises (SMEs), where it can take anything up to 10 years to see any returns. SMEs also present a higher risk to large investors; their size alone indicates a management more dependent on its individuals, less diversification, and fewer exits for investors (secondary sales to larger VC and private equity (PE) firms may become the only applicable exit route).

New legislation was introduced at the beginning of 2006, which analysts predicted would smooth the way for an increase in the number of local VC and PE market participants. They were mistaken. However, although private capital did not move, state financial institutions announced their mission to help small and medium enterprises (SMEs) become competitive in Europe, simultaneously establishing venture capital funds to this end.

The ratio of early-stage investments to the total value of investments in Hungary in 2006 was only 0.31%, in comparison to 2.7% in Central Europe and 10% in Europe. This trend showed no signs of abating throughout most of 2007. The ratio of early stage investments to the total value was 0.3%.

However, the overall value of invested capital increased nearly five-fold on the Hungarian market in 2006 in comparison to the previous year. The ratio of VC- and PE-invested enterprises reached 0.6% of the Hungarian GDP in 2006, which saw Hungary ranked fifth in Europe. The volume, value and frequency of investment transactions were all on the up. The same year saw the investment of state-owned funds in enterprises in the early or expansive stage (medium enterprises) reaching E23.5bn (£18.6bn). In the first 10 months of 2007, this figure reached E27bn (£21.3bn).

A solution to this slow growth comes from the European Commission's Directorate General for Regional Policy and the EIB Group (European Investment Fund and European Investment Bank). The Joint European Resources for Micro to Medium Enterprises initiative, known as JEREMIE, assures E40bn-E50bn (£32bn-£40bn) between 2007 and 2013 for the Hungarian VC and PE market. The fund will be divided to further funds, each of which will need 30% of private financing.

This will also solve a further problem of state funding. In contrast with professional investors, the state cannot decide which transaction will best recover its costs. It is expected that, with this extra 70% state funding, many business angels on the market currently sitting in the wings would have sufficient capital to flourish a medium-sized enterprise with their means, cash and industrial knowledge where they would otherwise be unwilling to enter the market. Without the JEREMIE programme, these private investors would certainly not be able to undertake the long-term capital demand of medium-sized enterprises.

The effect of the JEREMIE fund on the Hungarian market could be extremely favourable to investors, particularly taking into account the fact that Hungary was the first country in Eastern Europe to initiate privatisation and establish VC and PE funds. Executives, therefore, have a great deal of longstanding experience in the industry and are familiar with the country's prosperous legal framework, which is fully harmonised with the European legislation.

The concept of venture capital was once non-existent for companies in Hungary. The first legislation on VC and PE funds in 1998 was chaotic and even hindered the creation of funds. However, an amendment to the Capital Markets Act (Act CXX of 2001) in 2006 replaced this unsuitable legislation. Most significantly, the amendment also opened the VC and PE market doors to national institutional investors.

According to Chapter XXXI/A of the amended Capital Market Act, venture capital fund management companies:

• may operate only in the form of public limited liability companies or branches;
• shall be entitled to establish and manage one or more venture capital funds;
• shall manage and keep the assets of venture capital funds separately from its own assets and from those of other venture capital funds; and
• must have at least one executive officer with five years of professional experience.

Venture capital funds shall be deemed established when registered by the State Supervision of Financial Organisations, and shall be terminated when taken off the register.

Venture capital funds may only be established for:

• fixed periods by the private offering of non-redeemable venture capital fund certificates; and
• a specific term of not less than six full calendar years, which can be extended (if so allowed by the venture capital funds operating regulations) by a period of time not exceeding the original term.

The subscribed capital of a venture capital fund shall be no less than HUF250m (£791,000). Ten percent of the entire subscribed capital but at least HUF250m must be contributed up front, and the excess amount must be contributed within six years to accord with the schedule of the investments of the fund. This scheduled payment was a significant liberalisation compared to the former rules, which requested the contribution of the entire subscribed capital at the time of foundation. The subscribed capital must be paid up in cash only and may be increased or decreased during the fund's original term, but must not drop below HUF250m in any case. A venture capital fund may not purchase real properties from its assets.

Statistics show that state VC funds are currently behind nearly three-quarters of all VC transactions (albeit low-value transactions). The availability of venture capital for the development of SMEs on the Hungarian market shows great potential in this segment, even despite the fact that private VC only seems to be drawn to high-value investments in business seeking expansion capital and suggesting great buy-out opportunities.

With the JEREMIE fund, it would be the state's role to fly to the SMEs' assistance while in start-up or early stage, nurture them, and help them grow to the expansion stage – helping them eventually to attract more private investment through buy-outs.

Judit Budai is a partner and Gyorgy Wellmann a lawyer at Szecskay in Budapest.