Financing the Missing Middle:
Transatlantic Innovations in
Affordable Capital
Glenn Yago
Director of Capital Studies
Milken Institute
Washington, DC
October 22, 2007
Outline of Presentation
I. Introduction: Bringing Affordable Capital to SMEs
in Emerging Markets
II. A Survey of Selected Innovators
III. Analysis: Key Aspects of the Models Surveyed
IV. Discussion Points & Open Questions
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MSME Employment (% of total)
MSME Employment in Emerging Markets
As % of Total Employment
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Source: Micro, Small, and Medium Enterprises: A Collection of Published Data, IFC, 2006
SME’s Contribution to Employment and GDP
70%
60%
50%
40%
Employment
30%
GDP
20%
10%
0%
High
Income
Middle
Income
Low Income
Source: Ayyagari, Beck, Demirguc-Kunt, "Small and Medium Enterprises across the Globe: A New Database," World Bank, August
2003
Cost of finance
Tax rates
Macroeconomic instability
Economic policy uncertainty
Corruption
Access to finance
Anti-competitive/informal practices
Tax administration
Electricity
Crime, theft, disorder
Skills of available workers
Legal system
Customs and trade regulations
Access to land
Licensing and operating permits
Labor regulations
Transport
Telecommunications
Growth Obstacles Reported by SMEs
.4
.3
.2
.1
0
Fraction of of
small/medium
reporting constraint
as major/very
severe
Source: Beck, Thorsten. “Financing Constraints
SMEs in firms
Developing
Countries:
Evidence,
Determinants, and Solutions.” Working Paper.
Source: Enterprise Surveys (The World Bank)
World Bank, April 2007.
Capital Access & SME Sector
9.00
Capital Access Index 2005
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
0.0
20.0
40.0
60.0
80.0
100.0
120.0
MSMEs per 1000 people
Source: Milken Institute Capital Index 2005; Micro, Small, and Medium Enterprises: A Collection of Published Data, IFC, 2006.
SME Sources of Financing In Emerging Markets
70
60
small (<20)
medium (20-90)
50
large (100 and over)
40
30
20
10
0
Internal Funds
Banks
Equity
Leasing
Trade Credit
Development
Financing
Informal
Sources
Source: Beck, Thorsten. “Financing Constraints of SMEs in Developing Countries: Evidence, Determinants, and Solutions.” Working Paper.
World Bank, April 2007.
The Enterprise Financing Gap
Source: Dalberg Global Development Advisors, From Talk to Walk: Ideas to Optimize Development Impact, Report of the Task Force on
Capacity for Program Delivery: A Clinton Global Initiative Commitment, September 2006.
The Missing Middle
Source: Sanders, Thierry amd Carolien Wegener. “Meso-finance – Filling the Financial Service Gap for Small Businesses in Developing
Countries.” NCDO, September 2006.
Financing Constraints of SMEs in
Developing Countries (Beck 2007)
Key Findings:
 Capital access and costs are ranked as one of the most constraining
features of SMEs;
 Smaller firms report higher financing obstacles along the capital
structure spectrum than larger firms;
 Banking systems systematically underserve the SME sector relative
to larger firms (30% of large firms use bank finance to finance new
investment relative to 12% of smaller firms);
 Smaller firms’ financing obstacles have almost twice the effect on
their growth as larger firms’ capital constraints;
 Export, leasing, and long-term finance are also scarcer for SME
firms.
Source: Beck, Thorsten. “Financing Constraints of SMEs in Developing Countries: Evidence, Determinants, and Solutions.” Working Paper.
World Bank, April 2007.
Institutional Constraints of SME Financing
• The greater the level of competition within the local financial system, the
greater the access of SMEs to financial alternatives;
• State-owned banks have limited SME lending and investment due to size
bias to larger firms;
• Increased banking and non-bank competition have pushed domestic
banks downmarket and increased lending;
• Development of credit bureaus and other independent credit analysis
facilitates SME lending;
• Inefficient judiciary systems and other institutional barriers explain the
lion’s share of variation in risk spreads of developing country and firm
financial costs.
Fostering SME Growth: Criteria for Impact
• Sustainability and scalability
• Replicability
• Degree of leverage (in terms of capacity to catalyze
additional donor funding or financing)
• Efficiency (i.e., lowering costs of capital)
II. A Survey of Selected Innovators
The surveyed innovators can be grouped into the following categories:
1. Direct Investment
• Examples: Agora Partners, Ecologic, KfW, E+Co, Aureos,
Acumen, SEAF, Business Partners of South Africa
2. Remittance Facilitators
• Examples: INTENT, Microfinance International Corporation (MFIC)
3. Service Providers
• Examples: Bidnetwork, Technoserve, Shared Interest, DeRisk
4. Information Providers
• Examples: Microrate, GEXSI
Overview of Capital Providers
Company size
Loan range
Type of financing
Target Industries
Geographical Focus
E+CO
>25 employees
>$1,5m turnover
$25,000-$750,000
Debt (-5-8yrs) 85%
Quasi-equity 15%
Clean energy
Africa, Asia, Latin
America
SEAF
< $2 million turnover
$100,000-$5million
Debt
Equity
Quasi-equity
All
Eastern Europe, Latin
America, Asia
ECOLOGIC
10-200 employees
$25,000-$75,000
Short term debt (8-9
months) 80%
Long term debt (2-5 yrs)
20%
Coffee
Nuts
Beans
Cakao
Mexico and Central
America
AGORA
5-10 employees
$25,000-250,000
Equity 50%
Debt +royalties 50%
Agriculture
Nicaragua
ACUMEN
Less than 20
employees
500,000-1,5 million
Debt 50%
Equity 50%
All
India, Pakistan, Tanzania,
Kenya and South
Africa,
Uganda,Egypt.
BUSINESS
PARTNERS SA
N/A
$50,000-$1million
Debt+royalty
Debt+royalty+equity
All,
except agriculture
South Africa,
Mozambique,
SHARED
INTEREST
5-15 employees
Up to banks
Guarantees on debt
All
South Africa
AUREOS
N/A
Average
$3-4 million
Equity
Quasi-equity
All
Central America, Africa,
South East Asia
KFW
Less than 100 employees
2,000-500,000 euros
Equity
Debt
Mezzanine financing
All
Asia, Africa, Latin
America, Eastern
and Central Europe
III. The Models Surveyed: Key Aspects
• Metrics And Accountability
• The Capital Spectrum: From Debt to Equity
• Managing Risk
• Credit Scoring and Human Capital
Metrics and Accountability
•A common set of metrics and evaluations is needed to:
• Evaluate the financial, social and environmental impact of
an investment
• Determine whether targeted investments into SMEs have
long lasting effects for emerging markets
Solution: Transatlantic institutions should pool resources in
order to achieve lower costs and economies of scale.
The Capital Spectrum: From Equity to Debt
• Equity and quasi-equity instruments provided by varies types
of investors can be a valuable and often times disregarded
alternative to debt instruments.
Source: Emerson, J., J. Spitzer, et al. “Blended Value Investing: Capital Opportunities for Social and Environmental Impact.” World
Economic Forum 270306 (March 2006).
Quasi-equity Instruments
• A broader mix of debt and equity products (often referred to as
quasi-equity) enables entrepreneurs with access to lowering
overall costs of capital in some cases.
Examples of Quasi-equity Instruments:
• Convertible Subordinated Debt: A loan that carries standard
interest payments as well as the option to convert the loan into a
share at a predetermined price.
• Royalty Financing: A loan against future sales. Typically the
lender collects a part of the revenue at a determined interval up until
a predetermined amount.
• Long Term Debt with Warrants: A long-term loan that carries a
standard interest payment as well as the right to buy a share at a
predetermined price after the loan is paid off.
Emerging Markets Private Equity
Fundraising (By Region, 2003-2006)
Source: Emerging Markets Private Equity Association, Quarterly Review, Volume III, Issue 1, Q1, 2007.
Is Equity Financing Commercially Viable?
• Equity investments in SMEs in emerging markets have not
proven to be commercially viable on a large scale without donor
money of some form.
• The existing SME equity funds in developing economies are
either fully or partially funded by:
• a governmental organization (e.g. Swedfund)
• an international organization (e.g. SEAF)
• a state bank (e.g. SIDBI Venture Capital Limited)
• OR a combination of the above entities
A VC Fund for East Africa
Investment
Flows
Realization
Flows
Source: Alan Patricof. “Venture Capital for Development: Establishment of an East African Venture Capital Fund.” Concept paper. 2007.
Managing Risk
Measures to increase the flow of private capital to SMEs in
emerging markets:
• Country and credit risk mitigation
• Cost-effective
currency hedging
• Possible Solution: DeRisk Advisory Services has suggested that existing flows of
inbound bilateral aid, direct budget support, corporate inbound flows through global
corporations, and project lending could serve as a natural currency hedging
capacity.
Managing Risk
Source: Karius, Oliver and Andrew Gaines. “SIRIF – A Study of Risk Mitigation of Development Investments: Development and piloting of
risk mitigation mechanisms for investors in emerging market SMEs and social enterprises.” The Global Exchange for Social Investment and
VantagePoint Global: 21 (November 2006).
Credit Scoring and Human Capital
• Information asymmetries hinder capital flow to SMEs
•Solution: Rating agencies, private credit bureaus, and
methods of credit scoring.
• These innovations can provide a substitute for ineffective state
institutions.
• However, no credit scoring technique can replace the role of
human capital in assessing the viability of a business and the
quality of its management.
IV. Discussion Points & Open Questions
 Targeting the Missing Middle: Is Direct SME Financing an
Effective Tool to Alleviate Poverty?
 SME Financing Provided by Evolving MFIs : An
Alternative Approach?
 Historical Financing of SMEs: What Can History Teach
Us?
 The Central Role of Commercial Banks: Can Donors
Exert More Influence?
 Technical Assistance: Key to Success or Waste of
Resources?
 Financial Structure: Should Commercial Rates Prevail?
Is Direct SME Financing an Effective
Tool to Alleviate Poverty?
• It is somewhat controversial that a greater percentage of SMEs
in a country is linked to higher economic growth rates.
(Compare e.g.: Beck, Thorsten, Asli Demirguc-Kunt, and Ross Levine. “SMEs,
Growth and Poverty: Cross Country Evidence.” Journal of Economic Growth
10, no. 3 (September 2005):199-229.)
• Should we focus on funding firms with the highest potential for
growth irrespective of size?
• However, smaller companies, even if more innovative and
promising, have more difficulty accessing funds!
SME Financing Provided by Evolving
MFIs : An Alternative Approach?
•
Perhaps, a more promising way to reach the missing middle is from
the bottom up - from microfinance institutions (MFIs) moving up
market.
•
Many of the most efficient MFIs are able and willing to make bigger
loans, in the $10,000-$50,000 range, entering de facto into the SME
arena.
•
Some big international banks finance/buy MFIs.
•
Microfinance’s success - coupled with new technologies - has
contributed to building credit scoring databanks, which cover the
previously unbanked population.
•
Can joint ventures between MFIs and commercial banks could prove
beneficial for SME financing?
Financial Markets in the Developing
World: What Can History Teach Us?
1. The bulk of financing for SMEs in the 19th century was in the form
of loans, not equity
2. Financing came mainly from grass-roots local intermediaries with
greater information on local markets than large banks
3. Financial markets developed faster where regulation was lower
(e.g. New England)
4. Big urban banks eventually bought stakes in profitable local
intermediaries, mitigating the risk, fostering the evolution of the
financial sector and in turn the development of a strong SME
sector
5. Some Western European regions became “financial deserts”
mainly because of regulatory barriers, high poverty levels, large
income disparities and lack of entrepreneurship
6. Credit information sharing and joint liability loans were effective
tools in increasing the flow of capital to SMEs
Source: Cull, Robert, Lance Davis, Naomi Lamoreaux and Jean-Laurent Rosenthal. “Historical Financing of Small and Medium-Sized
Enterprises.” NBER Working Paper. October 2005.
Technical Assistance: Key to Success
or Waste of Resources?
• Virtually all surveyed organizations stressed the key
importance of technical assistance in helping small enterprises
access capital.
• TECHNICAL ASSISTANCE can take the form of:
 Helping entrepreneurs develop a business plan,
understand and evaluate growth opportunities,
overcome legal and regulatory issues, and present a
financial plan to potential investors, among others.
 After financing is disbursed, assisting and monitoring
the progress of the enterprise, and to help securing
additional funding.
• However some experts call technical assistance a waste of
resources. Where is technical assistance appropriate?
Financial Structure: Should Commercial
Rates Prevail?
 Poverty alleviation is the crucial tenet in the investment
strategy of most development institutions committed to SMEs in
developing countries.
 Therefore projects are expected to deliver social and/or
environmental returns in addition to financial return (double or
triple bottom line).
 Are market-based rate of returns the true measure of a projects
viability?
 Can an investment be scalable and/or sustainable if the
projects are subsidized?
The Central Role of Commercial Banks:
Can Donors Exert More Influence?
• Regulations and an uncompetitive banking sector are some of
the reasons why loans are unaffordable for SMEs in developing
countries.
• If, and how, can IFIs, NGOs or other institutions committed to
alleviate poverty best encourage commercial banks to increase
lending to SMEs?
Thank you
www.milkeninstitute.org
gyago@milkeninstitute.org
(310) 570- 4640