Enture Apital For Evelopment: A J. P, A P J E. S
Enture Apital For Evelopment: A J. P, A P J E. S
Enture Apital For Evelopment: A J. P, A P J E. S
Introduction
The developing world, and Africa in particular, faces a dearth of risk capital that has and
will continue to constrain growth. Donors need to face the reality that the young
companies that can really move the needle on innovation, inspiration and employment
need high-risk, reasonably-sized, equity investments to grow, not the limited doles of
short-term, high interest debt currently provided.
In the developed world, the young growth companies critical to innovative capacity and
employment generation are financed with long-term, permanent equity capital. When a
company is growing rapidly, it cannot generate sufficient cash through its current
operations to support the investment required to generate future growth, nor can it
afford to pay current interest or amortize the principal associated with loans. Angel
investors and venture capitalists provide the equity capital that enables young
businesses to take risks, build plants, develop technology and implement their longterm strategies to compete on a global basis.
Yet, companies in the poorest countries of the world have almost no access to this type
of capital. Entrepreneurs struggle to build businesses with meager personal assets that
rarely allow them to achieve the scale of operations required to be competitive. When
entrepreneurs can get a loanthe only form of financing available in the marketthe
requirement to service the capital on a current basis puts undue pressure on their
balance sheet, their ability to re-invest in the growth of their business and their
willingness to take risks.
This past year has seen a renewed call to action to address persistent poverty in the
developing world, especially in Africa. The key message from most of the discussions has
been a call for an increase in development aid. But just spending more money is not
going to build the long-term functional economies that will create the employment and
wealth creation to get Africa and other poor countries out of their poverty trap. We need
to get money into the hands of entrepreneurs who can build the businesses to enhance
Africas global competitive advantage and produce goods and services affordable to the
worlds poor.
We propose a specific program, an equity investment initiative funded by donors, which
can have a real impact on business formation in the developing world. In partnership
with local governments and investors, the program would provide equity capital and
technical assistance to the subset of young Small and Medium Enterprises (SMEs) in
developing countries which are truly growth-oriented and which the capital markets are
not adequately supporting. These suggestions are offered as a beginning not an end; any
initiative must strive to create over time viable private capital markets that can provide
appropriate commercial instruments with reasonable financial rewards.
Size definitions vary by country and organization; small businesses or SMEs are typically defined as companies
with less than 100, 250 or 500 employees. Micro-enterprises are typically defined as less than 10 employees.
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their businesses and take risks to grow significantly. As a result, these types of
enterprises are unlikely to reach an economic scale to become globally competitive. On
the other hand, they can also usually generate enough cash flow to service some form of
debt. Many access working capital or trade finance through informal networks and a
number of specialized providers of debt financing for this type of company have recently
emerged.
A smaller segment of companies in this SME-size category, including high potential
start-ups, have the potential to grow and become modern, globally competitive
enterprises. These types of companies are run by opportunity entrepreneurs
committed to innovating, adding value to exports, applying technology, achieving scale
in production and re-investing profit in their business. And like their U.S. counterparts,
they can have a multiplier effect on employment and overall economic growth. If these
companies are successful in growing and reinvesting capital in their business, they can
continue to expand direct employment, increase indirect income generation through
sourcing local inputs, and pay taxes. Perhaps as important, successful companies and
entrepreneurs can have a powerful demonstration impact: seeding and stabilizing
clusters of related firms, inspiring other entrepreneurs to grow their businesses and
serving as role models for youth. Unlike their necessity entrepreneur brethren, the
impact of the capital invested in growth-oriented SMEs run by opportunity
entrepreneurs can continue to have a compounding development impact.
But unlike in the United States and other developed economies, in most developing
countries these segments of growth-oriented SMEs are virtually absent. In high-income
countries, the SME sector has been estimated to contribute more than 50% to gross
GDP, not to mention being the engine of new job creation and a source of as much as
half of the innovation in these economies. In low-income countries, however, the
contribution of the SME sector to gross GDP has been estimated at 16% and, in most
African countries the SME sector has been estimated at less than 10%.2 This absent
segment of companies that are undergoing the risky but creative process of growing
from small to medium to large-scale could explain much of the weakness in the overall
economic growth of developing countries.
There are three basic explanations for the underdevelopment of the SME sector in
developing countries: a weak business environment, a lack of managerial or technical
capacity, and a lack of access to capital. We will not attempt to explain all three factors
but will focus on the access to capital for growth-oriented SMEs.3 It should be noted,
however, that without progress by local governments in creating an investment climate
and business environment that is supportive of entrepreneurship and growth-oriented
businesses, any policies related to increasing access to capital for SMEs will have limited
impact.
Source: Meghana, Demigurc-Kunt, Beck, Small and Medium Enterprises Across the Globe: A New Database,
World Bank Policy Research Working Paper No. 3127 (August 2003)
3
For a full discussion of all three factors see: Patricof and Sunderland, Big Ideas: Small is Still Beautiful, The
Milken Institute Review (2nd Quarter 2005) pp. 90-94
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Risk-Reward Imbalances
In developed country environments, young companies are financed by various types of
risk capital providers through a number of rounds of investment: friends and family
supplying very early capital; angel investors such as retired businessmen providing
start-up capital; and formal venture capitalists providing early-stage and growth capital.
Each of these types of investors has specialized skills and information to evaluate the
risks and rewards of the business plan at each stage of investment and to help the
entrepreneur build the business. By the time a successful young company has graduated
out of this risk capital market, it should have the cash flow and/or track record to access
more formal capital markets such as banks and public markets. These public markets
and mergers and acquisitions activity provide the critical high potential exit for the early
risk capital providers.
Almost all developing countries lack this early risk capital market. This does not reflect
neglect from development experts at the development finance institutions (DFIs).
Surveys of the SME sector in developing countries have consistently identified lack of
access to capital as a key constraint to growth.4 In response, over the last two decades a
range of schemes, from direct investments in the SME sector to venture capital
programs and SME loan guarantee programs, have been attempted.
Most of these DFI-funded programs, however, have had limited success. Loan programs
have often suffered from lack of utilization by the SME sector, high default rates and
currency devaluations. Equity investments in SMEs through the nascent private equity
and venture capital industry have generated mostly poor returns and many business
failures. As evidenced in recently gathered data on the emerging market private equity
industry, private equity funds in emerging markets (including a mix of both venture
capital and larger private equity transactions) have globally only returned capital to
investors, delivering a -0.3% IRR return over a 5 and 10 year horizon. Venture capital
investments have been shown to be even more difficult to manage. Data from EBRDs
analysis of its funds in Eastern Europe shows that investments of less than $2.5 million
didnt even return capital while investments greater than $10 million delivered returns
significantly above the emerging market private equity benchmark.5
There are numerous region and country-specific surveys of the dynamics of the SME sector and constraints to
growth. For a most recent general evaluation of the SME sector in 54 countries see: Beck, Demirguc-Kunt, and
Maksimovic, Financial and Legal Constraints to Growth: Does Size Matter? Journal of Finance (Volume 60 Issue
1 February 2005) p. 137
5
Statistical performance data from Cambridge Associates Emerging Market Venture Capital and Private Equity
Index have only recently been made publicly available. See Emerging Market Private Equity Newsletter (Volume 1,
Number 2, June 2005) for a summary of the data. The EBRD analysis of the performance of its investments funds
between 1992 and 2002 was presented in detail at the IFC Global Annual Private Equity Conference May 2004.
General performance data for the EBRD sponsored funds is available at www.ebrd.com/country/sector/fi/index.htm.
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For investments of less than $250,000 the challenges to delivering net returns to
investors becomes even greater. Analyzing the portfolios of leading global SME funds
shows that, without even taking into account transaction costs, the gross realizations
and valuations on these investments barely return capital to the funds, compared to
healthier multiples on larger investments. When even small transaction costs are
incorporated into the returns calculations, the base capital on the small investments is
quickly eroded.6
The result of these historical returns is that commercial investors in developing
countries necessarily migrate toward larger deals. Even the leading global SME funds,
reacting to pressure from their primarily DFI investor base to demonstrate commercial
returns, have increasingly abandoned smaller SME equity investments and migrated
toward minimum size investments from $500,000 to $1M, and most frequently to $2M,
with a large component of their investments structured as interest bearing securities.
With the renewed focus on private sector development and the importance placed on
the SME sector, however, the development finance industry is desperately seeking a
scaleable solution for delivering capital to the SME sector. As evidenced in the returns
data, the difficulty with such a model is that, in most cases, the challenges of building
growth-oriented companies in these markets mean that equity investments cannot
deliver returns that justify the risks on a commercial basis.
There are a number of reasons for this:
Early Stage of Investment. In many of the most promising developing countries,
a stabilized economy and adequately functioning business environments have
only been a condition of the past decade. Unless a product of privatization, high
growth potential companies will often be start-ups or early stage companies with
unproven products and marketing strategies, and limited track records. Investing
in start-ups is notoriously difficult and riskyeven commercial venture
capitalists in the sophisticated U.S. market like to have some proof of a business
plan and as a result leave the earliest stages of investment to angel investors.
Weak Managerial Capacity. Many developing countries have extraordinary raw
entrepreneurial talent -- as evidenced in the traders who effectively move large
flows of goods across borders. But building and managing a modern enterprise
that can add value and compete in international markets requires significantly
different business language, contacts, and technical skills to which few of these
raw entrepreneurs have access. For example, the stringent needs for quality
control and timely delivery on contracts can be challenging for a businessman
accustomed to the chaotic African trading environment to understand.
The Authors have worked closely with leading SME funds, including evaluating the underlying portfolios of the
funds and the key factors affecting returns. The Authors wish to acknowledge the support of these fund managers in
contributing to the development of the ideas in this paper.
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See Beck 2005 cited above. See also: Mead and Liedholm, The Dynamics of Micro and Small Enterprises in
Developing Countries, World Development (Vol. 26, No. 1 1998), pp. 61-74, for a discussion of the relationship
between firm growth, failure rates and macro-economic conditions.
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disbursements of capital, the DFI investors also rarely get excited by the volume of
capital appropriate to the SME segment.
This does not mean that DFI investors should abandon the sector. Rather, it is time for
the DFI investors to be realistic about what effective investing in this sector really takes,
and adjust their thinking and benchmarks accordingly. We strongly believe if the DFI
community wants to build young, growth-oriented SMEs in these markets , they will
need to accept the risk-reward imbalance and begin to promote models for SME
investing that take into account the high risks, high transaction costs, low volume, and
below market rates of returns endemic to the sector.
A Balancing Act
This type of reorientation in approach sounds simple in concept but is difficult to
execute in practice because it requires a careful balancing act between creating marketdriven incentives that enforce commercial discipline at the investment and company
level and achieving the development objective of building businesses. Distorting capital
markets with too much cheap capital or creating uncompetitive companies is always a
danger when providing below-market funding to the private sector. Therefore, any
initiative must strive to create over time viable private capital markets that can provide
appropriate commercial instruments with reasonable financial rewards.
We propose, therefore, a program to create a pool of capital to invest equity or equitylike instruments in growth-oriented SMEs. The funds would, as much as possible in a
given market, seek to leverage and build the nascent commercial risk capital market.
Capitalization. Capital for the funds would be sourced from DFI investors, from
local governments, and, crucially, with some participation, however modest, from
private local sources. The donor investors and governments should be willing to
accept very modest rates of return and directly support operating and transaction
costs, allowing local private investors to manage the investments and take a
disproportionate amount of the returns.
Investment Activities. Capital from these funds should be available in amounts
ranging from $100,000 to $2 million to invest in SMEs with the demonstrated
ability to absorb capital and a growth strategy that can have a multiplier effect on
employment. Investments should be in the form of quasi-equity with no forced
amortization or current servicing required. Investors will receive returns from
appreciation in the value of equity ownership where possible but more often in
the form of payments linked to participation in increased revenues and free cash
flow as generated.
Linkages to Pure Commercial Markets. In addition to being managed by local
private investors, the funds should work closely with other local financial
institutions to graduate their companies for later stage financing from purely
commercial sources. This could be achieved through pre-financing of companies
referred by the banking sector, working closely with banks to get loan financing
for existing portfolio companies, and co-investing at later stages of financing with
commercial venture capital funds.
Technical Assistance. Capital alone will not be enough to develop growthoriented SMEs in these markets. These companies need management training,
advice from experienced business people, technical knowledge of equipment and
processes, market information and insights to build their businesses. A parallel
component of the funds will be dedicated to grant funding for technical and
managerial assistance to the portfolio companies through existing assistance
programs. The technical and managerial assistance component of the program
should be fully integrated into the investment activities.
Investment Skills. If local investors have appropriate skills and knowledge, they
are much more likely to understand the risks and rewards of the SME sector and
will be better placed to manage them on a day-to-day basis. Pairing local
investors with skilled international fund managers could transfer the necessary
knowledge and skills. Involving experienced venture capitalists in the overall
management of the program should also allow for transfer of knowledge and
skills.
Linking with the Diaspora. The flow of entrepreneurs from the Indian and
Chinese diasporas has had a significant impact on the quality of the young
companies in those economies. The African diaspora has also begun to generate
both the capital and the entrepreneurs that could significantly boost the SME
sectors potential. The program should provide incentives for investment by the
diaspora communities, encourage diaspora entrepreneurs to develop new
companies in their home countries and involve senior business people from the
diaspora in the program.
Commitment of the Companies. The companies themselves will also need to be
active participants in the program; in exchange for capital, they would commit to
produce audited statements, pay taxes and abide by the rules of corporate
governance.
The program will need to be adapted to the on-the-ground characteristics of the SME
sector, the human resources, and the financial markets in a given country or region.
Equity capital is not a one size-fits-all solution for the SME sector. In fact, in smaller or
less developed countries, it may only be appropriate for a few companies. Regional
funds therefore may be appropriate for regions with fragmented local markets and
limited deal flow. The risks associated with the investments will also vary by the
characteristics of the macro-economy and the financial markets. Smaller investments
with higher leverage rates may be needed in underdeveloped markets whereas larger
investments with lower leverage rates may be acceptable in more developed markets.
Conclusion
In all of the discussion of aid and poverty, we sometimes lose sight of the fact that
making the poor not poor requires employment, and preferably employment sustained
by productive economic activity rather than capricious donor funding. Foreign direct
investment can provide some of this employment and micro-enterprise activity can
support basic income generation. But a vibrant indigenous private sector presents the
best prospect for enduring progress in creating the employment and wealth creation
that will pull Africa and other poor countries out of poverty. A private sector, however,
does not spontaneously emerge from the pages of commission and consultant reports.
Rather, young businesses must grow to become the larger, established institutions that
can really move the needle on employment.
Apple Computer, Microsoft and Fedex did not start out with loans. If their founders had
been required to finance their early growth with the short-term, collateralized, high
interest loans currently available in developing countries, the businesses would not even
have gotten off the ground. Instead, friends and family, angel investors, venture
capitalists and even the U.S. Governments Small Business Administration provided risk
capital to build these successful U.S. companies.
In developing countries, we must similarly find a way to get equity capital into the hands
of entrepreneurs who have the capacity to build young businesses. We believe our
program provides a good place to start.