Financing of SMEs – the missing middle.

There is a widespread recognition of the importance of small and medium

enterprises (‘SMEs’) but also of the difficulties they face.. How to identify their
needs, what are the constraints to their growth and what can be done better to
support them to fill the gaps in the service that they can access.

In many developing countries, large businesses use formal, bank-based credit

and capital markets for their financing needs, while households and micro-
entrepreneurs have access to micro-loans. SMEs are often stuck in the middle
without reliable access to either, and they are often therefore largely absent
from the formal economies of many of these countries.

One of the first uses of the useful phrase ‘the missing middle’ can be found in
the following passage.

“Africa’s private sector consists of mostly informal micro-enterprises, operating alongside

large firms. Most companies are small because the private sector is new and because of
legal and financial obstacles to capital accumulation. Between these large and small
firms, SMEs are very scarce and constitute a “missing middle.” Celine Kauffman, OECD
Policy Insights no.71

SMEs are weak in Africa because of small local markets, undeveloped regional
integration and very difficult business conditions, which may include cumbersome official
procedures, poor infrastructure, dubious legal systems, inadequate financial systems and
unattractive tax regimes. Many firms stay small and informal and use simple technology
that does not require great use of national infrastructure. Their smallness also protects
them from legal proceedings (since they have few assets to seize on bankruptcy) so they
can be more flexible in uncertain business conditions. Large firms have the means to
overcome legal and financial obstacles, since they have more negotiating power and
often good contacts to help them get preferential treatment. They depend less on the
local economy because they have access to foreign finance, technology and markets,
especially if they are subsidiaries of bigger companies. They can also more easily make
up for inadequate public services.2

Access to finance is often a major problem. SMEs in developing countries face the
challenge of finding a financier who will assess entrepreneurs on the viability of their
business, as there are very few organisations offering this service. Access to quality
business services where the entrepreneur can gain knowledge and improve management
skills is also limited. Without access to both capital and business support, the growth of
the small and medium enterprise sector is hampered.3

In many emerging markets, the SME sector is one of the principal driving forces for
economic growth and job creation. And this holds particularly true for many countries in
Africa where SMEs and the informal sector represent over 90% of businesses, contribute
to over 50% of GDP, andaccount for about 63% of employment in low income countries3.

1 Policy Insights No. 7 is derived from the African Economic Outlook 2004/2005, a joint publication
of the African Development Bank and the OECD Development Centre

2 ibid.

3 GroFin statement of aims

Despite these opportunities, SMEs in Africa face many obstacles including corrupt
governance structures, unfavourable macroeconomic environment, debilitating physical
infrastructure, and administrative challenges. However, inadequate access to financing
continues to be one of the most significant impediments to creation, survival, and growth
of SMEs in Africa4
It is worth remembering that even countries that can be considered highly
developed have at an earlier stage identified the ‘missing middle’ and acted to
fill the gap. Both the US and Britain addressed the problem in slightly different
ways. It is noteworthy that in both cases there was strong government
intervention to set up the schemes. In the case of Britain the commercial banks
had their arms twisted to become shareholders in and financiers of the new
institution, described below, and in the US Small Business Investment Companies
was enabled to borrow federal funds at favourable rates. Both initiatives in effect
primed the pump that eventually created a flow of private sector venture capital
and private equity finance.

In Britain an early recognition of such a gap was tentatively put forward by the
Macmillan committee in the early 1930s, which published its report during the
depression, in 1931. This highlighted a perceived structural failure within the
financial system, which meant that unquoted small and medium sized firms
requiring long-term investment capital were unable to afford an approach to the
capital market and were poorly catered for by the banks. This hypothesis
became popularly known as the "Macmillan Gap".

The committee found that public equity issues of less than £200,000 were too
small to be of interest to existing financial institutions, and recommended that
the gap should be filled by a new type of capital-raising agency, specialising in
the small business sector. There was no immediate response from the City of
London. During the closing years of the Second World War, plans were made by
the government to manage the transition to a peacetime economy; and at the
end of the war the commercial banks, under pressure from the Bank of England,
reluctantly agreed to set up a new, jointly owned institution, the Industrial and
Commercial Finance Corporation (ICFC), with a remit to supply risk capital to
smaller firms. This institution was founded in 1945 and later changed its name to
3i (Investors In Industry), currently Britain's largest development and venture
institution. Today 3i is capitalised at £3.4 billion, and is listed on the stock
exchange, forming part of the FTSE-100 Index of leading shares. It has also
created a number of listed specialist investment funds, also listed on the stock
exchange, including an infrastructure fund and a private equity fund.

In the US one of the first steps toward a professionally-managed private equity

and venture capital industry was the passage of the Small Business Investment
Act of 1958. The 1958 Act officially allowed the Small Business Administration
(‘SBA’), originally founded in 1953 to license private "Small Business Investment
Companies" (‘SBICs’) to help the financing and management of the small
entrepreneurial businesses in the United States. Passage of the Act addressed
concerns raised in a Federal Reserve Board report to Congress that concluded

4 Innovative Financing for SMEs in Africa UNEP FI 2008

that a major gap existed in the capital markets for long-term funding for growth-
oriented small businesses. Additionally, it was thought that fostering
entrepreneurial companies would spur technological advances to compete
against the Soviet Union. Facilitating the flow of capital through the economy up
to the pioneering small concerns in order to stimulate the U.S. economy was and
still is the main goal of the SBIC program today. The passage of the Small
Business Investment Act of 1958 by the federal government was an important
incentive for would-be venture capital organizations. The act provided venture
capital firms structured either as SBICs or Minority Enterprise Small Business
Investment Companies (‘MESBICs’) access to federal funds which could be
leveraged at a ratio of up to 4:1 against privately raised investment funds. The
success of the Small Business Administration’s efforts are viewed primarily in
terms of the pool of professional private equity investors that the program
developed.

Ways to provide finance for SMEs

There is no disagreement, therefore, among any of the agencies quoted above

that lack of adequate SME finance is one of Africa’s greatest growth challenges.
But there is disappointingly little progress towards solutions. This paper suggests
one, based on an idea that is neither radical or innovative, but which is well tried
and tested in developed markets.

SMEs in any country need access to short term bank finance for short term
needs, typically financing sales and debtors domestically and financing trade
internationally. But they also need longer term finance, for which short term
bank borrowing is inappropriate.

But one finds that many of the initiatives designed to help SMEs to finance
themselves consist of various forms of debt or guarantees, soft loans, improving
access to commercial banks and very few involve equity or long term loan
finance.

Debt finance alone is not enough

There is a limit to the amount any company should or can borrow, as many
companies in developed markets are discovering to their cost. There are
advantages in debt finance:

No dilution of existing shareholders interests: leverage of equity holders’ value: cost of

capital (interest) usually tax deductible: simpler and quicker to raise.

But there are disadvantages too:

It has to be repaid, often at an inconvenient time in the cycle: repayment has to be

budgeted for: high interest costs raise breakeven point: need to provide collateral:
restrictions on other financing activities

This is not to suggest that debt financing is not useful, rather that it cannot on its
own create a financial platform for stability throughout a cycle. What is needed
in addition is in our view is equity finance.
Equity finance is usually only available for large investments

While there are a number of sources of this, most of them are targeting
investments well above the size needed by the typical SME. Few envisage
investments of less than $250,000, as the following illustrates.

AEM3 will be used to build a diversified portfolio of between 30 and 40 investments

across Africa, China, India, Latin America and South East Asia, typically investing a
minimum of US$50 million of equity capital in buyout and growth transactions.5

Ethos Private Equity Fund VI (“Ethos VI” or “the Fund”) is a private equity fund that will
invest in high growth companies in Sub-Saharan Africa. The Fund, a follow-on fund of
Ethos V (a $750m fund in which IFC invested $ 25million), is expected to make privately-
negotiated equity and equity-related investments between $ 25-75 million in 10-12
African companies6

This is not in any way to decry the activities of the above, which were selected
anecdotally, rather to illustrate the lack of equity finance at the lower end of the
scale on which investments of $25-$75 million represent the top end. We
understand that the costs of due diligence can be high in relation to the amounts
raised at the lower end of the scale. But companies that attract investments of
$50 million or more for minority stakes can hardly be described as SMEs. For
comparison the average amount raised on PLUS (a London based facility for
SMEs) was £500,000.

This is not universally true, and some funds indicate preparedness to consider
smaller investments - for example the GroFin Africa Fund and African
Development Partners.

Where should smaller SMEs go to seek equity finance

Issuers usually only use public capital markets when they cannot use private
ones, since in general raising money through the former is more time-
consuming, more expensive and involves greater transparency and more
external accountability. The vast majority of enterprises worldwide are financed
privately: reputedly only 0.1% of the 10 million enterprises in America raises
finance in public capital markets. In China, for instance, large companies have
developed that are wholly privately financed.

Banks are not by their nature providers of equity finance and domestic
investment institutions often lack the capacity to make smaller equity
investments.

Almost all the funds we have looked at are specialised private equity funds, well
supported with investments from such organisations as IFC and EIB together with
international institutional investors and emerging markets specialists. The target
market for such funds is indicated by the stated aim of the African Venture

5 Actis Emerging Markets 3 (AEM3)

6 IFC Investment projects

Capital Association’s 8th Annual Private
Equity Conference

“This conference presents a formidable opportunity for General Partners to meet Limited
Partners who have yet to invest in Africa. The conference promises to bring LPs from
markets as diverse as the Middle East, Europe and the United States.”

Few such investment opportunities, if any, are available to African institutional

investors, of which there is a growing number as more countries introduce formal
second or third pillar pension schemes. These may well be constrained by their
own investment powers and by capital controls., but at the same time they find
that they have problems finding suitable investments as increasing contributions
cause their available funds to outgrow domestic investment opportunities.

What we suggest is that a fund or funds should be set up to enable domestic as

well as international portfolio investors to invest in diversified portfolios of local
SMEs using the same logic as caused the ICFC and the SBIC to be created in the
UK and the US respectively.