Glenn Yago. Director of Capital Studies. Milken ... Sourc

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• Financing the Missing Middle Transatlantic
  Innovations in Affordable Capital
• Glenn Yago
• Director of Capital Studies
• Milken Institute
• Washington, DC
• October 22, 2007

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Outline of Presentation

• Introduction Bringing Affordable Capital to SMEs
  in Emerging Markets
• A Survey of Selected Innovators
• Analysis Key Aspects of the Models Surveyed
• Discussion Points Open Questions

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MSME Employment in Emerging Markets As of
Total Employment
Source Micro, Small, and Medium Enterprises A
Collection of Published Data, IFC, 2006
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SMEs Contribution to Employment and GDP
Source Ayyagari, Beck, Demirguc-Kunt, "Small and
Medium Enterprises across the Globe A New
Database," World Bank, August 2003
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Growth Obstacles Reported by SMEs
Source Beck, Thorsten. Financing Constraints of
SMEs in Developing Countries Evidence,
Determinants, and Solutions. Working Paper.
World Bank, April 2007.
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Capital Access SME Sector
Source Milken Institute Capital Index 2005
Micro, Small, and Medium Enterprises A
Collection of Published Data, IFC, 2006.
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SME Sources of Financing In Emerging Markets
Source Beck, Thorsten. Financing Constraints of
SMEs in Developing Countries Evidence,
Determinants, and Solutions. Working Paper.
World Bank, April 2007.
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The Enterprise Financing Gap
Source Dalberg Global Development Advisors, From
Talk to Walk Ideas to Optimize Development
Impact, Report of the Task Force on Capacity for
Program Delivery A Clinton Global Initiative
Commitment, September 2006.
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The Missing Middle
Source Sanders, Thierry amd Carolien Wegener.
Meso-finance Filling the Financial Service Gap
for Small Businesses in Developing Countries.
NCDO, September 2006.
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Financing Constraints of SMEs in Developing
Countries (Beck 2007)

• Key Findings
• Capital access and costs are ranked as one of
  the most constraining features of SMEs
• Smaller firms report higher financing obstacles
  along the capital structure spectrum than larger
  firms
• Banking systems systematically underserve the
  SME sector relative to larger firms (30 of large
  firms use bank finance to finance new investment
  relative to 12 of smaller firms)
• Smaller firms financing obstacles have almost
  twice the effect on their growth as larger firms
  capital constraints
• Export, leasing, and long-term finance are also
  scarcer for SME firms.

Source Beck, Thorsten. Financing Constraints of
SMEs in Developing Countries Evidence,
Determinants, and Solutions. Working Paper.
World Bank, April 2007.
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Institutional Constraints of SME Financing

• The greater the level of competition within the
  local financial system, the greater the access of
  SMEs to financial alternatives
• State-owned banks have limited SME lending and
  investment due to size bias to larger firms
• Increased banking and non-bank competition have
  pushed domestic banks downmarket and increased
  lending
• Development of credit bureaus and other
  independent credit analysis facilitates SME
  lending
• Inefficient judiciary systems and other
  institutional barriers explain the lions share
  of variation in risk spreads of developing
  country and firm financial costs.

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Fostering SME Growth Criteria for Impact

• Sustainability and scalability
• Replicability
• Degree of leverage (in terms of capacity to
  catalyze additional donor funding or financing)
• Efficiency (i.e., lowering costs of capital)

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II. A Survey of Selected Innovators

• The surveyed innovators can be grouped into the
  following categories
• Direct Investment
• Examples Agora Partners, Ecologic, KfW, ECo,
  Aureos, Acumen, SEAF, Business Partners of South
  Africa
• Remittance Facilitators
• Examples INTENT, Microfinance International
  Corporation (MFIC)
• Service Providers
• Examples Bidnetwork, Technoserve, Shared
  Interest, DeRisk
• Information Providers
• Examples Microrate, GEXSI

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Overview of Capital Providers
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III. The Models Surveyed Key Aspects

• Metrics And Accountability
• The Capital Spectrum From Debt to Equity
• Managing Risk
• Credit Scoring and Human Capital

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Metrics and Accountability

• A common set of metrics and evaluations is needed
  to
• Evaluate the financial, social and environmental
  impact of an investment
• Determine whether targeted investments into SMEs
  have long lasting effects for emerging markets
• Solution Transatlantic institutions should pool
  resources in order to achieve lower costs and
  economies of scale.

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The Capital Spectrum From Equity to Debt

• Equity and quasi-equity instruments provided by
  varies types of investors can be a valuable and
  often times disregarded alternative to debt
  instruments.

Source Emerson, J., J. Spitzer, et al. Blended
Value Investing Capital Opportunities for Social
and Environmental Impact. World Economic Forum
270306 (March 2006).
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Quasi-equity Instruments

• A broader mix of debt and equity products (often
  referred to as quasi-equity) enables
  entrepreneurs with access to lowering overall
  costs of capital in some cases.
• Examples of Quasi-equity Instruments
• Convertible Subordinated Debt A loan that
  carries standard interest payments as well as the
  option to convert the loan into a share at a
  predetermined price.
• Royalty Financing A loan against future sales.
  Typically the lender collects a part of the
  revenue at a determined interval up until a
  predetermined amount.
• Long Term Debt with Warrants A long-term loan
  that carries a standard interest payment as well
  as the right to buy a share at a predetermined
  price after the loan is paid off.

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Emerging Markets Private Equity Fundraising (By
Region, 2003-2006)
Source Emerging Markets Private Equity
Association, Quarterly Review, Volume III, Issue
1, Q1, 2007.
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Is Equity Financing Commercially Viable?

• Equity investments in SMEs in emerging markets
  have not proven to be commercially viable on a
  large scale without donor money of some form.
• The existing SME equity funds in developing
  economies are either fully or partially funded
  by
• a governmental organization (e.g. Swedfund)
• an international organization (e.g. SEAF)
• a state bank (e.g. SIDBI Venture Capital
  Limited)
• OR a combination of the above entities

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A VC Fund for East Africa
Investment Flows
Realization Flows
Source Alan Patricof. Venture Capital for
Development Establishment of an East African
Venture Capital Fund. Concept paper. 2007.
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Managing Risk

• Measures to increase the flow of private capital
  to SMEs in emerging markets
• Country and credit risk mitigation
• Cost-effective currency hedging
• Possible Solution DeRisk Advisory Services has
  suggested that existing flows of inbound
  bilateral aid, direct budget support, corporate
  inbound flows through global corporations, and
  project lending could serve as a natural currency
  hedging capacity.

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Managing Risk
Source Karius, Oliver and Andrew Gaines. SIRIF
A Study of Risk Mitigation of Development
Investments Development and piloting of risk
mitigation mechanisms for investors in emerging
market SMEs and social enterprises. The Global
Exchange for Social Investment and VantagePoint
Global 21 (November 2006).
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Credit Scoring and Human Capital

• Information asymmetries hinder capital flow to
  SMEs
• Solution Rating agencies, private credit
  bureaus, and methods of credit scoring.
• These innovations can provide a substitute for
  ineffective state institutions.
• However, no credit scoring technique can replace
  the role of human capital in assessing the
  viability of a business and the quality of its
  management.

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IV. Discussion Points Open Questions

• Targeting the Missing Middle Is Direct SME
  Financing an Effective Tool to Alleviate Poverty?
• SME Financing Provided by Evolving MFIs An
  Alternative Approach?
• Historical Financing of SMEs What Can History
  Teach Us?
• The Central Role of Commercial Banks Can Donors
  Exert More Influence?
• Technical Assistance Key to Success or Waste of
  Resources?
• Financial Structure Should Commercial Rates
  Prevail?

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Is Direct SME Financing an Effective Tool to
Alleviate Poverty?

• It is somewhat controversial that a greater
  percentage of SMEs in a country is linked to
  higher economic growth rates.
• (Compare e.g. Beck, Thorsten, Asli
  Demirguc-Kunt, and Ross Levine. SMEs, Growth and
  Poverty Cross Country Evidence. Journal of
  Economic Growth 10, no. 3 (September
  2005)199-229.)
• Should we focus on funding firms with the highest
  potential for growth irrespective of size?
• However, smaller companies, even if more
  innovative and promising, have more difficulty
  accessing funds!

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SME Financing Provided by Evolving MFIs An
Alternative Approach?

• Perhaps, a more promising way to reach the
  missing middle is from the bottom up - from
  microfinance institutions (MFIs) moving up
  market.
• Many of the most efficient MFIs are able and
  willing to make bigger loans, in the
  10,000-50,000 range, entering de facto into the
  SME arena.
• Some big international banks finance/buy MFIs.
• Microfinances success - coupled with new
  technologies - has contributed to building credit
  scoring databanks, which cover the previously
  unbanked population.
• Can joint ventures between MFIs and commercial
  banks could prove beneficial for SME financing?

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Financial Markets in the Developing World What
Can History Teach Us?

• The bulk of financing for SMEs in the 19th
  century was in the form of loans, not equity
• Financing came mainly from grass-roots local
  intermediaries with greater information on local
  markets than large banks
• Financial markets developed faster where
  regulation was lower (e.g. New England)
• Big urban banks eventually bought stakes in
  profitable local intermediaries, mitigating the
  risk, fostering the evolution of the financial
  sector and in turn the development of a strong
  SME sector
• Some Western European regions became financial
  deserts mainly because of regulatory barriers,
  high poverty levels, large income disparities and
  lack of entrepreneurship
• Credit information sharing and joint liability
  loans were effective tools in increasing the flow
  of capital to SMEs

Source Cull, Robert, Lance Davis, Naomi
Lamoreaux and Jean-Laurent Rosenthal. Historical
Financing of Small and Medium-Sized Enterprises.
NBER Working Paper. October 2005.
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Technical Assistance Key to Success or Waste of
Resources?

• Virtually all surveyed organizations stressed
  the key importance of technical assistance in
  helping small enterprises access capital.
• TECHNICAL ASSISTANCE can take the form of
• Helping entrepreneurs develop a business plan,
  understand and evaluate growth opportunities,
  overcome legal and regulatory issues, and present
  a financial plan to potential investors, among
  others.
• After financing is disbursed, assisting and
  monitoring the progress of the enterprise, and to
  help securing additional funding.
• However some experts call technical assistance
  a waste of resources. Where is technical
  assistance appropriate?

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Financial Structure Should Commercial Rates
Prevail?

• Poverty alleviation is the crucial tenet in the
  investment strategy of most development
  institutions committed to SMEs in developing
  countries.
• Therefore projects are expected to deliver
  social and/or environmental returns in addition
  to financial return (double or triple bottom
  line).
• Are market-based rate of returns the true
  measure of a projects viability?
• Can an investment be scalable and/or sustainable
  if the projects are subsidized?

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The Central Role of Commercial BanksCan Donors
Exert More Influence?

• Regulations and an uncompetitive banking sector
  are some of the reasons why loans are
  unaffordable for SMEs in developing countries.
• If, and how, can IFIs, NGOs or other
  institutions committed to alleviate poverty best
  encourage commercial banks to increase lending to
  SMEs?

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• Thank you
• www.milkeninstitute.org
• gyago_at_milkeninstitute.org
• (310) 570- 4640