Session 5: Capital Market Financing for SMEs

Abstract Growth Capital for SMEs

Lucia Cusmano, Senior Economist, OECD Centre for Entrepreneurship, SMEs and Local Development, lucia.cusmano@oecd.org
Firms with established business models, as well as those with low to moderate growth prospects, typically seek financing through bank credit, official loans and guarantees. However, such traditional financing techniques are of only limited applicability in the financing of certain kinds of SMEs, due to their peculiar risk profiles. These include: a) firms with high growth potential but newer business models, especially those utilising new technology; b) established firms seeking capital for expansion into new domestic or international markets; and c) firms seeking to effect other important transitions in their activities, such as ownership and control changes. While alternatives to traditional debt finance are particularly important for start-ups, high-growth and innovative SMEs, the development of alternative funding techniques may be relevant to the broader population of SMEs, which are often over-reliant on debt instruments. The thin capitalisation and excessive leverage (excessive reliance on debt financing compared to equity) impose costs, as loans to companies that already have considerable amounts of debt tend to have higher interest rates, and increase the risk of financial distress and bankruptcy. Different financing needs over the life cycle of firms demand different tools, but only a narrow range is generally available to SMEs and entrepreneurs. The growth capital gap that affects SMEs is an important issue for a sustainable recovery and long-term economic growth, since dynamic SMEs are often at the forefront in job creation, in the application of new technologies and in the development of new business models. Alternatives to traditional debt finance include: i) asset-based finance (Factoring, Leasing, Purchase Order Finance, Warehouse Receipts), whereby a firm obtains cash, based not on its own credit standing but on the value of a particular asset generated in the course of its business; ii) alternative debt (Corporate Bonds, Securitised Debt) in which investors in the capital markets, rather than banks, provide the financing for SMEs; iii) hybrid instruments (e.g. subordinated debt, participating loans, convertible bonds), which provide an alternative risk/reward structure; iv) equity finance (Private Equity, Venture Capital, Business Angels, Specialised Platforms for Public Listing of SMEs, Equity Derivatives), which typically targets riskier and newer activities and/or companies. In recent years, policy makers in some countries and in international organisations have sought to encourage the use of mezzanine finance, a financing technique that incorporates elements of debt and equity in a single investment vehicle (hybrid instrument), due to its potential to provide finance efficiently to key categories of SMEs. The traditional market for commercial mezzanine finance has been upper-tier SMEs, with high credit ratings. With the support of public programmes, it has become increasingly possible to offer mezzanine products to SMEs with lower credit ratings and smaller funding needs. Public intervention can take different forms: i) participation in the commercial mezzanine market by public entities, which create or participate investment funds targeted to certain categories of SMEs and award mandates to private investment specialists; ii) direct public financing to SMEs under programmes managed by public financial institutions or development banks; iii) Funding of private investment companies at attractive terms (US SBIC model). Although it has received less attention than other financing tools, mezzanine finance has been favourably received when tried. The early evidence suggests it represents a potentially useful addition to the range of financing vehicles available to SMEs, although wider use is hampered by lack of knowledge and expertise in SMEs, financial community and public agencies. At the same time, it should be emphasised that this technique is not suitable for all SMEs and cannot substitute for other financing techniques. Potential and limitations of new financing instruments should be further investigated, based on more and better data, and evaluation of early policy programmes. 1