Financing the Missing Middle: Transatlantic Innovations in

Affordable Capital

Glenn YagoDirector of Capital Studies

Milken Institute

Washington, DCOctober 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

MSME Employment in Emerging Markets As % of Total Employment

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Source: Micro, Small, and Medium Enterprises: A Collection of Published Data, IFC, 2006

SME’s Contribution to Employment and GDP

Source: Ayyagari, Beck, Demirguc-Kunt, "Small and Medium Enterprises across the Globe: A New Database," World Bank, August 2003

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sFraction of small/medium firms reporting constraint as major/very severeSource: Enterprise Surveys (The World Bank)

Source: Beck, Thorsten. “Financing Constraints of SMEs in Developing Countries: Evidence, Determinants, and Solutions.” Working Paper. World Bank, April 2007.

Capital Access & SME Sector

Source: Milken Institute Capital Index 2005; Micro, Small, and Medium Enterprises: A Collection of Published Data, IFC, 2006.

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Internal Funds Banks Equity Leasing Trade Credit DevelopmentFinancing

InformalSources

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large (100 and over)

Source: Beck, Thorsten. “Financing Constraints of SMEs in Developing Countries: Evidence, Determinants, and Solutions.” Working Paper. World Bank, April 2007.

SME Sources of Financing In Emerging Markets

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)

Source: Beck, Thorsten. “Financing Constraints of SMEs in Developing Countries: Evidence, Determinants, and Solutions.” Working Paper. World Bank, April 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.

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 DebtEquityQuasi-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%

CoffeeNutsBeansCakao

Mexico and Central America

AGORA 5-10 employees $25,000-250,000 Equity 50%Debt +royalties 50%

Agriculture Nicaragua

ACUMEN Less than 20employees

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+royaltyDebt+royalty+equity

All,except agriculture

South Africa, Mozambique,

SHAREDINTEREST

5-15 employees Up to banks Guarantees on debt All South Africa

AUREOS N/A Average$3-4 million

EquityQuasi-equity

All Central America, Africa, South East Asia

KFW Less than 100 employees 2,000-500,000 euros EquityDebtMezzanine 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

Source: Emerson, J., J. Spitzer, et al. “Blended Value Investing: Capital Opportunities for Social and Environmental Impact.” World Economic Forum 270306 (March 2006).

• Equity and quasi-equity instruments provided by varies types of investors can be a valuable and often times disregarded alternative to debt 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.

Quasi-equity Instruments

Source: Emerging Markets Private Equity Association, Quarterly Review, Volume III, Issue 1, Q1, 2007.

Emerging Markets Private Equity Fundraising (By Region, 2003-2006)

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

Investment Flows

Realization Flows

Source: Alan Patricof. “Venture Capital for Development: Establishment of an East African Venture Capital Fund.” Concept paper. 2007.

A VC Fund for East Africa

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.

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).

Managing Risk

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

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gyago@milkeninstitute.org

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