How Are Public Investors And Donors FillingThe SME Financing Gap?

There is no doubt that Small and Medium Enterprise (SME) finance has become a “hot topic” especially in light of the public awareness raised by the G-20 and the creation of an SME sub-group.  While many studies have revealed the tremendous contribution of SMEs to economic development, the financing gap to better support them remains a challenge. The financing gap for formal SMEs (not including those in the informal sector) is estimated to be between $700 billion and $850 billion, or 21 to 26 percent of current outstanding SME credit, with important regional disparities in regards to the size of this gap.

Last year, CGAPs 2011 SME funding scan estimated that public donors and investors committed at least $24.5 billion in support to SMEs as of December 2010. The study identified more than 300 SME focused investment vehicles (SME funds) - most of which received significant funding from Development Financial Institutions (DFIs).  It is important to note that local sources, such as banks, provide the highest source of formal financing- accounting for more than 50% of external financing used to fund MSMEs as reported by IFC. 

As a follow-up study, CGAP recently explored DFI investments into SME funds. Some of the highlights from this research include:

• Most SME funds do not reach the smaller-end of the SME spectrum located in “frontier” markets.  Rather, most of their investments are focused on mid-cap size enterprises. There are limitations to investing in smaller SMEs, especially around the size of deals and the risk profile needed. In addition, some investors believe that the pure private equity model, that uses extensive leverage, is not suitable for smaller investments.
• Most public investors are “sector agnostic”. However, popular sectors that attract the most flows include: manufacturing, services, financial institutions.  Agri-business and renewable energy are also gaining interest.
• Regarding regions, Sub-Saharan Africa and South Asia attract most SME investments.
• Tracking developmental indicators is a challenge. For most DFIs, the main goal for supporting SMEs is economic development and job creation. However, DFI-supported SME funds do not collect and define impact indicators in a systematic way that would allow for suitable comparison. Commonly tracked indicators include job creation, women’s employment, rural coverage, annual sales, etc.
• Most DFIs delegate investment decisions to fund managers, retaining an oversight role rather than an operational one. DFI criteria for fund selection mostly include a focus on fund managers that would align with their vision. DFIs prioritize funds that work in markets where the local market regulatory framework is conducive.  They select funds that have sound corporate governance, strong management capacity, deep experience and track record of the General Partner, and strong staffing and internal controls. Some DFIs that are involved in setting up funds are more involved with strategy (as members of the board), capital mobilization, or provision of technical assistance.
• DFIs often have a long term perspective and see themselves as long term investors. DFIs are comfortable locking in their capital for 8-10 years and rely on fund managers to decide exits.  Overall, data on exits is limited and most DFIs do not disclose information on realized returns.  Initial findings reveal financial returns may not be   as optimistic as expected.

Our research revealed many gaps regarding DFI support to SME funds. The clear gaps in measurement of performance of SME funds emanate from a lack of standard indicators and benchmarks.  There are also limited efforts to promote transparency in reporting.

Questions emerged around the role of DFIs themselves in supporting SME funds:  should DFIs play a stronger role as catalyst investors going beyond the provision of financing? How could DFIs reach more frontier markets and aid in the development of the venture capital or private equity sector in those countries? Should public funders increase their focus on early stage funds and on the low-end part of the SME spectrum?

Clearly there is much that can be done to advance our collective understanding of the role of DFIs in supporting SME funds and in understanding the results of the investments already made.  There are some promising efforts to address the knowledge gaps.  For example FMO and MIF/IADB are currently carrying out external assessments on the performance of their  investments in SME funds.   Additionally, the IFC is leading efforts to harmonize SME finance indicators and the system of data collection. The objective is to establish a consistent framework to measure the development impact of investments in MSMEs and help bridge the SME funding gaps in the best way possible.  These efforts will certainly move us one step closer to understanding how DFIs can effectively support SME financing gaps.

----- The authors were part of CGAP's research team on SME.