Methods of support 1: Social investing

On-the-ground investigation proves there are a number of ways investors can support SMSEs, while securing a return.

Lending

Most of the entrepreneurs we talked to said they wanted loans for expansion.

But not all enterprises planned to borrow to fund their expansion. Some sectors are able to pay for their expansion from retained earnings (agricultural machinery case study), especially where they have small capital needs. Utilities (such as water supply or local energy suppliers) or housing projects are more likely to need credit.

While there is no shortage of credit for SMSEs in Sri Lanka in urban areas (see the milling and pharmacy case studies), credit is generally not available in rural areas where fewer banks have penetrated and customers do not have formal documentation (water supply case study). Even in Sri Lanka, which has a high banking concentration, there are opportunities for specialist providers of SMSE credit for rural areas.

For example, credit is rarely available for agriculture inputs, such as seed and fertiliser, especially for paddy farmers (microfinance case study). This is because banks are wary of lending when there are no regular repayments and when all the borrowers in the sector are likely to fail when there is a bad season - it creates to large a systemic risk for the bank.

Social investors need to determine the best way to support the lending market. Generally it is better to work with established banks, helping them innovate and address markets not yet covered, rather than create new institutions. Local banks will have lower costs, will continue after the investor decides to move to another country and will be more trusted by customers.

Given the complexity and insecurity of SMSEs in developing countries, banks may need to find new ways to evaluate loans that takes account of the many risks and allows the lender to keep innovating. Few of the entrepreneurs we talked to could estimate the returns on their investments, but were confident that when a market was making money and growing, they would be able to also get a return. Perhaps banks' loan evaluations should to take the same approach, analysing the overall market dynamics and a borrower's record. This analysis can be backed up in most cases by collateral - contrary to expectations, many of the (existing) entrepreneurs who we talked to were happy to provide security for loans.

Start-up funding

As predicted by SANASA's evaluation of the market potential, most of the sectors we investigated had a significant number of entrepreneurs already active. There was little need for start-up funding.

SANASA's prioritisation did identify some sectors where there appeared to be significant opportunities, but few entrepreneurs. Often these were in more capital intensive sectors where market entry barriers are higher, such as the water sector, rubbish collection or small-scale energy production. Investors could supply start-up funding in these sectors and funders could provide business development assistance.

Also, there is a shortage of companies that provide inputs for SMSEs. New suppliers could help SMSEs overcome their small scale, by sharing experience, reducing risk or spreading investment across many different enterprises. For example, a company that rents medical equipment to pharmacies on a daily basis would allow the pharmacies to trial a new business and also avoid the risk of expensive equipment not being well utilized. Similarly, there may be opportunities to support networks or associations that serve existing SMSEs, perhaps through a franchise model.

Consolidation funding

There may well be opportunities for investment funds that consolidate existing sub-scale enterprises. Currently, there is little funding available for consolidation and in many sectors there is little dynamic competition, leading to a large number of sub-scale enterprises. A 'merger-fund' run in partnership with a local bank could create more efficient industry structures in a number of sectors where SMSEs predominate, such as milling. It could be implemented in partnership with a funder who could supply technical assistance and training support, and may have lower transaction costs than other forms of equity investment.

Risk reduction instruments

Business in developing countries is risky, especially for SMSEs. Profits are often determined by forces outside of their control, such as weather, government intervention or conflict.

This creates demand for risk reduction mechanisms, either insurance or derivatives. International agencies could again work with local banks to implement these instruments. Risk reduction products could be sold directly to farmers, or to other enterprises that rely upon agricultural product prices such as rice mills.

Project ideas

Provide long-term liquidity loans for on-lending to local banks. While local banks often have access to ample short-term capital, they may not be able to raise long-term deposits, creating a matching issue. Bundling a loan with technical assistance will also allow the external agency to ensure that quality is protected.

Set up or provide liquidity to a bank focused on SME lending to rural areas in countries where these loans are not available, using simple risk evaluation processes to reduce transaction costs

Create a consolidation fund focused on a sector where there are many sub-scale SMSEs such as milling, local water supply systems or rural buses.

Provide equity funding to set up a network of water supply companies, which can then act as a vehicle to lend for water system renovation

'Buy the risk' of seasonal farming from local banks, allowing them to on-lend to paddy farmers. Alternatively, sell price fluctuation insurance directly to farmers giving banks more security in lending

Pointers

Work with local banks and institutions wherever possible, as they have lower costs
Focus on services that allow an external investor to leverage its scale, for example by sharing best practice and sharing risks
Blend investment with non-financial support, such as training, best practice sharing, international contacts, etc.
Expect to experiment and work with a client company before identifying a winning business model
Focus on capital intensive sectors which need investment
Consider costs - costs of independent lending and equity investment to SMSEs may outweigh any returns. Use networks where possible
Consider changing market structure through investment. This may release considerable value