Helping SMEs access capital in the developing world
On June 11 and 12, GMF held a conference on affordable capital in Paris focused on helping small and medium-sized enterprises (SMEs) access capital in the developing world, and to forge a cross-sector and transatlantic dialogue among practitioners on new approaches to providing risk capital and capacity-building for SMEs.
After 50 years and $2.3 trillion of aid, donors and emerging market countries are questioning the value and impact of the monies deployed through conventional foreign aid. SMEs continue to face unique and enormous challenges, such as barriers to market entry, expensive and time-consuming regulatory requirements, burdensome tax and legal structures, labor market rigidities, and, above all, limited access to affordable capital. In a thriving SME market, these firms offer a critical source of innovation and economic expansion by helping to create new jobs, build supply chains, and forge dynamic business clusters linked to global markets. Yet, SMEs remain underserved by financial markets, particularly in developing countries. There are also political and institutional implications from generating affordable capital for SMEs. In developing countries without well-functioning financial systems, closed groups of incumbents typically oversee the allocation of capital. Better functioning financial sectors, with transparent systems and a range of products, generally allocate capital for productive investment on a reasonably objective basis, according to creditworthiness and potential returns. This "democratization of capital" helps bolster the development of a vibrant middle class which, in turn, can foster political stability.
The head of the French Development Agency, Jean-Michel Severino, was the keynote speaker on June 11 and noted that this was a unique opportunity to explore new and alternative approaches to supporting SMEs, especially given the recent anniversary of the Marshall Plan (which in part funded SMEs in Europe).
On June 12, the conference continued to cover a wide range of issues. There was concern expressed over some research at the World Bank which is seen as having negatively influenced the interest among institutions and foundations in supporting SMEs. There was acknowledgement that the interests of the private sector, foreign investors, and SMEs are aligned, but, nevertheless, in a development context, larger domestic companies often have a vested interest in perpetuating dysfunctional business climates that penalize SMEs. Microfinance is important, but should not be overvalued. There are limits to scaling up microfinance. What matters most is developing a formal financial sector that includes local and foreign banks, leasing companies, and credit cooperatives. Business plan competitions have revealed a "boulevard of broken dreams for a lot of entrepreneurs." Many entrepreneurs that have failed are returning to the marketplace and continue to take risks on new ideas. On-line competitions are seen as scalable and can lead to greater deal flow despite some instances of fraud.
In the context of Africa, banks with SMEs on their books tend to focus on the larger enterprises and small ones have difficulty gaining access to credit. African banks have trouble growing their SME portfolios. By one measure, only 10% of Latin America's demand for SME credit is being met. Beyond debt, there is a severe shortfall in equity available to SMEs, exit options for investors are limited, and the cost of due diligence remains high. Progress is being made though as the development and investment community is rethinking the risk and reward equation for SMEs (e.g. investors seeking a development return in addition to a financial return). Focus should be on gauging the commitment of local bank management to SMEs as a "growth business," otherwise financial support to these institutions will end up in government paper. The challenge in Africa is not raising capital, but to find the institutions and managers in whom to invest. Attracting and training fund managers is also a critical issue.
The problems with SME equity finance are numerous. Funds have poor track records, most SMEs tend to minimize their value in order to avoid predatory taxes and there is a small pool of suitable investment banking talent for small, high-risk funds. Some organizations are having success by packaging and standardizing their investments to lower costs. Micro-equity investments are possible and small investments are heading toward a mix of debt, royalty, and quasi-equity. Nevertheless, high transaction costs and exit problems require alternative approaches. One recommendation was to standardize rules and regulations across countries as well as documentation for transactions. One successful domestic model would be the U.S. venture-capital community, which has over the years harmonized procedures.
There are some new developments in mainstream banking for SMEs underway. Credit Agricole helped found the Agriculture Cooperative Bank of Armenia (ACBA), which now engages in equity, loan, and microfinance activities and it expects to move into other financial services, such as insurance and private venture capital. India's ICICI Bank operations reveal both opportunities and challenges of rural banking. Crop cycles and weather pose risks to cash flow. Rural India often falls victim to weak bank penetration, a cash economy, illiteracy, the lack of collateral and political issues. However, the bank has been able to work with outsourced agents, relationship managers, and NGOs to reach these consumers. To overcome illiteracy, the bank has employed biometric banking terminals. To deal with limited collateral, it developed an escrowing mechanism for poultry farmers and feed companies. New innovations such as these are being tested and are worthy of further examination to help deepen financial opportunities for SMEs.