Passing the Entrepreneurship Test
Kenya boasts one of Africa’s healthiest economies. Yet FSD Kenya estimates only 20% of the country’s businesses have received credit from a formal source.
These entrepreneurial ventures, which encompass up to 80% of the total employment opportunities in Kenya and similar developing countries, comprise what is commonly known as the “missing middle.” They face intractable structural barriers to finance due to the inability of existing financing models (venture capital, banks and MFIs) to properly assess risk, and therefore reach this critical segment.
It’s in this economic and geographic context where, for the past year, I have been deeply involved with the Entrepreneurial Finance Lab (EFL). Since 2007, and initially through the Harvard Kennedy School’s Center for International Development (CID), EFL has attempted to solve this crucial finance gap. EFL’s co-founders, Drs. Bailey Klinger and Asim Khwaja, found that the lack of funding to this indispensable sector in developing economies was a result of an informational asymmetry, not a lack of high returns to capital in this segment. Put another way, the enormous monetary and social opportunities of lending to these enterprises required better information about risk and potential, while traditional ameliorating factors such as collateral, formal documentation, and rich credit histories simply don’t exist in these markets.
With initial support from Google.org and SNV, we tested thousands of banked entrepreneurs, ranging from rural-Andean micro borrowers to urban South African venture capital investees. (You can find a list of our partners here.) From this rich and diverse sample, EFL was able to classify dimensions, from academic research on entrepreneurship and the pre-employment screening industry, which predict entrepreneurial success or failure. Specifically, EFL created a test that could identify entrepreneurial traits across loan sizes, cultures and industries, which enabled us to forecast risk to a very high degree of accuracy – on par with corporate credit models, but without typical informational requirements, (e.g. ameliorating factors mentioned above). The test’s power to identify and separate risk is such that, had these institutions utilized the EFL test following their evaluation process, each could reduce defaults by 25% to 40%. Thus, the EFL tool benefits financial institutions along three dimensions: reducing risk, lowering costs and, perhaps most importantly, expanding markets.
Now and Beyond
Armed with a 30 to 45-minute, automated assessment, borrower data spanning seven countries and eight languages, and the interest of flagship financial institutions across Latin America and Africa, EFL spun out of the university to scale its solution in 2010. Initially focused on the SME segment, we were soon contracted by one of Africa’s largest banks to fuel its aggressive and innovative expansion plans across the continent. In the upcoming months, this partnership, combined with several other early implementations, will provide more than 30,000 entrepreneurs with access to business credit products for the first time.
The magnitude of the data from a handful or partners will help increase the accuracy of the global EFL model, spur R&D to widen the breadth of its usage, and most importantly, demonstrate the financial viability of lending into this segment. Additionally, the Entrepreneurial Finance Lab Research Initiative at the Harvard Kennedy School CID continues to drive a strong research agenda into evaluating further tools on access to finance and economic growth globally.
EFL was founded to make a large-scale impact through an innovative approach to solving inefficient business environments in developing countries. As such, we’re committed to achieving scale through its for-profit customers. However, we have also pursued partnerships with innovative, and often smaller-scale non-profit organizations across three continents to help enable good people do good work.
We look forward to providing frequent updates on our expansion, and will be looking to the NextBillion readership for feedback and support.
Editor’s note: EFL was recently recognized for its approach, having recently been voted as a winner of the G-20/Ashoka SME Finance Challenge. You may follow EFL’s efforts via Twitter @EFinLaB.