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

Established in 2020 as a business-to-business marketplace connecting African producers to global buyers, Kwely quickly established traction with a revenue-generating model. But within 18 months it was caught in the “missing middle” funding gap, a challenge faced by small and growing businesses that are too big for microfinance and too small or risky for traditional bank lending.

Fortunately, Kwely secured an investment from WIC Capital (a former grantee of ours at FMO) in 2022, in the form of a Simple Agreement for Future Equity (SAFE) note to support its efforts to continue scaling. But without suitable early-stage financing, businesses like Kwely risk failing before they ever have a chance to reach scale, with the wider economy losing out on a key source of innovation, employment and growth.

The challenge of serving businesses like Kwely is well-known and widely discussed in the development finance sector. But though emerging fund managers and other capital allocators are playing a vital role in addressing the missing middle financing gap in many underserved markets, the demand for this funding vastly outweighs the current supply. In this article — the first in a two-part series exploring the uses of technical assistance (TA) in development finance — we’ll explore how development finance institutions (DFIs) can leverage technical assistance to meet the earlier-stage financing needs of missing middle businesses and improve the pipeline for later-stage investors.

The Challenges of Funding Missing Middle Businesses

The IFC estimates that 43% of formal SMEs in developing countries are financially constrained, representing a total funding gap of almost $4.1 trillion. Emerging capital allocators — including some accelerators, incubators and funds operating in frontier markets, as well as donor-supported grant-making mechanisms — can play an important role in filling this gap, particularly for earlier-stage businesses. This is because they understand local market dynamics and capital constraints, and are often physically close to the businesses they work with, which supports both pipeline development and ongoing investment monitoring.

Evelyne Dioh Simpa, Managing Director of WIC Capital, the first investment fund in West Africa that exclusively targets women-led small and growing businesses, explains this role as follows: “We’re not just providing capital, we’re deeply involved in the field. We understand the unique challenges businesses face here and step in when traditional financing falls short. Our close involvement allows us to guide new ventures and keep track of progress. In brief, we don’t just fund — we’re partners at every step.”

Despite this potential, emerging capital allocators still face significant challenges, resulting in uneven distribution of their capital among businesses across different growth stages and geographies. And higher-risk markets — arguably those in the greatest need — are often the least well-served, with around three quarters of deals in Africa historically going to Nigeria, Kenya, Egypt and South Africa, according to the Africa Investment Report 2022.

So what is holding these investors back from reaching more businesses? Part of the answer relates to fund economics. Traditional fund structures aren’t geared towards supporting higher-volume, lower-ticket size transactions (often in the range of US $50,000 – $1 million), since their transaction costs as a percentage of deal size are often too high to be viable. In addition, fund manager compensation — often based on a “two and 20” model where fund managers charge 2% of total asset value for management fees and 20% of profits as performance fees — fails to reflect the true cost and risk of operating in frontier and growth markets.

An added challenge is that traditional equity investment instruments tend to focus on businesses already operating at scale, with alternative products like venture debt (i.e., loans to early-stage businesses) still nascent. To compound the problem, the lending practices of many financial institutions still call for high levels of collateral and detailed financial records, both of which early-stage businesses often struggle to provide.

Innovative Approaches to Development Finance Technical Assistance

With these challenges in mind, how can development finance TA play a meaningful role in increasing the reach and relevance of early-stage financing?

One way is by supporting innovation and experimentation to identify, test and scale alternative models that better meet the needs of early-stage capital providers and the businesses in which they invest. Since 2021, FMO’s Ventures Program has supported the Collaborative for Frontier Finance, a multi-stakeholder platform providing mentoring and peer-to-peer exchange to over 100 early-stage capital providers across 30 countries, including first-time and women fund managers — two groups that are historically underrepresented. FMO partnered with the Collaborative on the initial round of the LAUNCH Capital Provider Program, which provided 10 funds with customized TA support and to date has enabled eight of these emerging fund managers to raise nearly $15 million in total, with 35 investments made. Some of these innovative funds include:

• FIVE35 Ventures: a high-volume, pan-African gender lens equity fund closely linked to the continent’s STEM ecosystem;
• Mirepa Capital: a closed-end fund based in Ghana and focusing across Africa that’s raising capital from local funds of funds (FoFs) and pension funds using a mixture of debt and equity to invest;
• The above-mentioned WIC Capital: an open-ended fund seeded by the Women’s Investment Club (WIC) and receiving TA from WIC Academy, with significant input from female mentors in Senegal.

There is also growing interest from DFIs and the donor community in supporting more FoF models targeting the missing middle, particularly those operating at a local level. Leveraging funding or TA from DFIs, this new breed of FoFs can support non-traditional, impact-driven venture capital approaches by making use of blended finance, providing training and guidance to emerging fund managers, and offering financial “warehousing,” which allows fund managers to start building a portfolio before launching a full-scale fund. These kind of FoFs can also offer early-stage capital providers access to large-scale sources of capital — including local pension funds such as the South African SME Fund, which raised capital from South African pension funds using a USAID first-loss guarantee, without which it would not have been able to invest in the missing middle.

Another way DFI TA can support early-stage capital providers is by rethinking the TA “toolbox” to provide more relevant support to these funders. TA is traditionally not used to cover “business as usual” costs — for example, management salaries — because this weakens the case for additionality and has the potential to compromise sustainability, raising the question of who will keep paying for those staff salaries after the intervention finishes. But what if this type of subsidy encouraged a high-potential fund manager to enter a new and challenging geography, or helped establish a revolving fund with high operating costs that will operate in an underserved market? Taking these potential uses of TA into account, the Collaborative for Frontier Finance has highlighted emerging alternative approaches to compensation, including grant-supported management costs — as exemplified by Nyala Venture — and the potential for cross-subsidisation between funds.

In another innovative approach, DFI TA can be clearly linked and granted alongside investment capital, with the aim of extending DFI investments to earlier-stage fund managers or those working in the most challenging markets. Smarter use of grant capital, for example concessional or interest-free loans, offers an opportunity to take on riskier but more impactful investments. TA can also help to offset structuring expenses associated with blended finance mechanisms, as demonstrated by Teranga Capital in its first fund.

Thinking beyond the level of an individual firm or fund manager, development finance TA is also increasingly being used to help strengthen entrepreneurial ecosystems. One example of this is the aforementioned FMO Ventures Program Technical Assistance Facility, which fits into FMO’s market creation remit as part of a broader strategy supporting longer-term investable pipeline opportunities for FMO. Another is the IFC’s Startup Catalyst, which has supported 19 accelerators, which in turn have invested in nearly 1,200 startups in emerging markets.

However, to maximise the effectiveness of these TA innovations, the sector needs more and better data. More regular sector-wide studies would provide a signal to the market, highlighting sectors and geographies with pressing financing gaps and untapped potential. Establishing transparent benchmarks for fund economics would enable actors from across the ecosystem to make more informed decisions and set realistic expectations on risk and returns. And improved results measurement would highlight what types of TA are yielding the most promising results, directing resources to the areas of greatest potential.

The key role that emerging fund managers and other early-stage capital providers can play in addressing the missing middle financing gap is increasingly recognised and understood. As momentum builds, there has never been a better opportunity for DFI TA to support innovative, scalable models, and direct attention towards the markets in greatest need.

Note: In late 2022, Boost Africa Technical Assistance Facility, a European Investment Bank initiative co-financed by the European Union and implemented by Adam Smith International, facilitated a series of conversations that aimed to support coordination efforts and the sharing of best practices between DFIs and development partners providing technical assistance to fund managers and the early-stage investment ecosystem in emerging economies, particularly in sub-Saharan Africa. This is the first article in a two-part series that shares key insights from participants in these conversations — the second article can be read here.

Robert Haynie is an impact investing consultant focusing on frontier and growth markets. Justin van Rhyn is an independent consultant with a background in delivering large-scale TA programming.

Photo courtesy of UN Women/Ryan Brown