NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

How do we get more capital to the people who want to start their own SMEs? It is difficult to make a case for this “missing middle.” NextBillion has identified this problem in the past, and it seems like now the issue is beginning to unfold in the development debate: the Clinton Global Initiative is now discussing this very issue.

SMEs are good for the economy – they create wealth, create jobs and usually need financing so they can grow to scale. The financing gap exists for a layer of potentially high-growth SMEs that occupy a space between large MNC projects and micro-entrepreneurs. The World Bank has found a connection between the number of SMEs in a country and a country’s growth, and has posited that without SMEs, it’s difficult to sustain economic growth.The following videocast is of a session entitled “Filling the Finance Gap” at the Clinton Global Initiative’s Poverty Alleviation Working Group a couple weeks ago. The speakers: Alan Patricof, Sonal Shah and Hubertus van der Vaart, do an exceptional job of explaining the challenges of investing in entrepreneurs and SMEs in emerging markets; they debate about the financing gap, or the “mesofinance gap.”

Watch the videocast here

I find what Patricof says about the companies in the United States very interesting. He mentions Staples as an example of a company that started small and then scaled up to become a big U.S. corporation, thanks to the existing capital structure in the United States. There are similar companies with great potential in a multitude of emerging economies, but most face a consistent challenge: lack of financing tools.

Many talented, driven people in developing countries have great ideas and motivation but rarely are they able to find sources of capital willing to invest in their ideas or companies. It is even rarer that they find funds willing to provide equity capital, so usually these SMEs end up borrowing money from banks at very high interest rates and are obligated to secure these loans with everything they own. These stakes are discouraging, and few people are willing or able to take such high risks. The result is that entrepreneurs decide not to take risks and their companies end up staying small. This videocast explains why it is so difficult to enable the capital markets structures needed to help these types of businesses grow.

There are many challenges in the current capital structure; banks don?t want to take risks, they do not lend money without collateral; they either lend to large businesses or they do microfinance. Property rights also play a big role in the difficulties of securing financing. In the videocast, Hubertus van der Vaart mentions that it’s very hard to increase the productivity of a business if people are constantly focused on paying off the loan. Equity investment options alleviate this problem and also contribute to formality, which in turn increases a country’s tax base. Since microentrepreneurs many times are not part of the formal economy, they don?t pay taxes and big corporations are often able to find ways to evade paying taxes. On the other hand, since SMEs are easily located and don?t possess the power or technical and political savvy of the MNCs, they end up constituting an important part of the tax base and pay proportionally higher amounts of taxes.

Lastly, another challenge for investing in these SMEs is that the return cycle on investment is much longer than the return time for microfinance. Investors have to wait for about 10 years or so to see the returns, whereas with microfinance principal and interest are usually returned within 6 months to a year.

The good news is that there have been steps forward in financing the missing middle, and we have blogged about them on NextBillion: Endeavor, New Ventures, Technoserve, Acumen, Wulff Capital and others. Possibly now that the topic was brought up by the Clinton Global Initiative’s Poverty Alleviation Working Group, we may begin to see some other financing tools geared toward filling this ’finance gap.’