Hard to get to Africa’s SMEs, time to finance the missing middle

Getting finance to small and medium sized enterprises remains a key challenge. Getting the support to the smaller businesses on the SME spectrum is even harder. And although banks see the segment as a business opportunity, the reality is that Africa’s entrepreneurial class remain largely underserved. Why is this the case and why is it so difficult to get Africa’s entrepreneurs the support (financial and other) they need? This was one of the key questions VC4Africa brought to the Making Finance Work in Africa conference.

Jason Wendle, a Dalberg Associate, makes the point, ‘The lack of collateral is the biggest challenge. Banks see the SME market as attractive but they have difficulty assessing the risk and there are few assets in place needed to secure the investment. SMEs on the other hand need fast loans to fill big orders.’ Gerry Monteiro, the Vice President of the Small Business Banking Network, expands, ‘Interest rates are high for SMEs. We have to look beyond lending products and look deeper at financial (and non financial) needs. Banks don’t necessarily appreciate the SME profit drivers.’ This lack of insight on the part of banks hinders the development of appropriate banking solutions. What they do offer doesn’t always meet the needs of the entrepreneurs. The lack of track record, credit history or tangible assets that can serve as collateral further hinder the process. As a result the cost of lending is high, SMEs run the risk of over leveraging their accounts, and there is a need for alternative financing solutions.

Private Equity does have a role in filling this gap. Working intensively with an SME they have the opportunity to raise the level of management, improve governance and scale operations for African business. As the company professionalizes its operations the business can start to compete on a nation, regional and international level. This process also opens African business for additional investment. But Private Equity firms, and the SMEs they support, require long term capital needed to reach their growth targets and here again access to finance is often lacking. Skander Khalil Oueslati, a Senior Partner at AfricaInvest, adds, ‘Sitting on the board of SMEs I get personally frustrated at the difficulty securing long term finance. It’s not available in a lot of African markets. If it is available then only at exorbitant fees. In Ghana for example a 5 year guarantee will require 28% to 30% interest. Uganda is the same but to a lesser extent.’ These might be examples from one end of the spectrum, Ghana having possibly the highest interest rates in Sub Sahara, but the point does highlight a key challenge for entrepreneurs and early stage investors. Access to long term capital remains a key area of focus and is essential to supporting the continued development of equity based alternatives. A key area of advocacy for the African Venture Capital Association is the need to engage African based pension funds. Unlocking local capital is essential for the continued development of the industry and engaging local capital helps mitigate the risk of capital flight when international markets sour.

What is then the role of Private Equity and why are they unable to service the S in SME? The key point for Private Equity players is to be close to the investment. Mr. Oueslati explains, ‘Investors don’t want to be more than an hour or two hours distance from the company. We require local teams and the business model can be quite costly.’ When operating on a 2-3 % fee the private equity firms are forced to focus on larger investments. Having six offices in six countries requires considerable resources. This hinders their ability to service smaller sized enterprise. Tshepidi Moremong, the Chairman of the African Venture Capital Association, explains, ‘There remains a real question on the S in SME. Mid cap is between one and five million dollars. S is everything below one million.’ She added, ‘there is a growing interest among private equity firms to service this segment but it’s not easy. Business Partners International and GroFin are early examples, but require different infrastructure needed to make it work.’

Clearly small business development remains a challenge. That said, private equity investments can still generate a positive impact on small business. For example, when an investment is made into a brewery there is a knock on effect for the rest of the value chain. As the brewery modernizes, improves its management, corporate governance and technology there is a healthy pressure placed on the network of suppliers. They are forced to improve and modernize their own operations as part of a spillover effect. In this way, private equity players don’t necessarily contribute through direct engagement with the bottom of the market but exert their influence via corporate vehicles. Eventually connecting to an international brewery like Heineken further serves to connect the local business ecosystem to international markets and standards.

It is clear that the challenge for small scale entrepreneurs remains. On one hand the banks struggle to service the market successfully. The lack of collateral on the part of the SME, and the lack of appropriate banking solutions, continues to hinder SME growth. On the other hand private equity players are constrained by their own business models and are forced to focus on larger deals. And although there is a knock on effect it remains a real challenge to engage smaller business. On the other end of the spectrum micro finance doesn’t offer the growth opportunities many entrepreneurs need. This leaves a space for much needed innovation and new approaches.