Financing the Missing Middle: Transatlantic Innovations in Affordable Capital Glenn Yago

1. Financing the Missing Middle: Transatlantic Innovations in Affordable Capital Glenn Yago Director of Capital Studies Milken Institute Washington, DC October 22, 2007

2. Outline of Presentation • Introduction: Bringing Affordable Capital to SMEs in Emerging Markets • A Survey of Selected Innovators • Analysis: Key Aspects of the Models Surveyed • Discussion Points & Open Questions

3. MSME Employment in Emerging Markets As % of Total Employment Source: Micro, Small, and Medium Enterprises: A Collection of Published Data, IFC, 2006

4. 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

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

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

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

8. 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.

9. 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.

10. 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.

11. 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.

12. 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)

13. II. A Survey of Selected Innovators • The surveyed innovators can be grouped into the following categories: • Direct Investment • Examples: Agora Partners, Ecologic, KfW, E+Co, Aureos, Acumen, SEAF, Business Partners of South Africa • Remittance Facilitators • Examples: INTENT, Microfinance International Corporation (MFIC) • Service Providers • Examples: Bidnetwork, Technoserve, Shared Interest, DeRisk • Information Providers • Examples: Microrate, GEXSI

14. Overview of Capital Providers

15. III. The Models Surveyed: Key Aspects • Metrics And Accountability • The Capital Spectrum: From Debt to Equity • Managing Risk • Credit Scoring and Human Capital

16. 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.

17. 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 Forum270306(March 2006).

18. 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.

19. Emerging Markets Private Equity Fundraising (By Region, 2003-2006) Source: Emerging Markets Private Equity Association, Quarterly Review, Volume III, Issue 1, Q1, 2007.

20. 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

21. 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.

22. 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.

23. 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).

24. 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.

25. 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?

26. 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!

27. 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?

28. Financial Markets in the Developing World: What Can History Teach Us? • The bulk of financing for SMEs in the 19th century was in the form of loans, not equity • Financing came mainly from grass-roots local intermediaries with greater information on local markets than large banks • Financial markets developed faster where regulation was lower (e.g. New England) • 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 • Some Western European regions became “financial deserts” mainly because of regulatory barriers, high poverty levels, large income disparities and lack of entrepreneurship • 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.

29. 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?

30. 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?

31. 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?

32. Thank you www.milkeninstitute.org gyago@milkeninstitute.org (310) 570- 4640