< Reaching the other, neglected 1%

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Reaching the other, neglected 1%

Probably everyone in international development knows two things about small businesses: 1) they fail often 2) small business owners are entrepreneurs par excellence and provide 60-70% of the jobs in many countries. Contributing editor Peter Hulm fills in some obscurer details about companies with fewer than 100 workers in developing countries.

Apart from the two obvious truths, there are other, lesser known paradoxes about small and medium enterprises(SMEs). Asset managers are desperate to find profitable investments in developing countries at a time of historically low interest rates in the industrial nations. But they put less than 1% of the tens of trillions of dollars they control into small and medium enterprises in the developing world.

Big money for small businesses

With its report Big money for small businesses, the Geneva-based International Trade Centre (ITC) tries to map out a way to change that situation. It admits that investing abroad can entail complex risks for private investors, there can be regulatory, political and macroeconomic risks to investing in developing countries, and investing in SMEs or start-ups is often riskier than investing in large firms.

But international organizations such as the World Trade Organization (WTO) and Organisation for Economic Cooperation and Development (OECD) or the United Nations Conference on Trade and Development (UNCTAD) are working on the first two problems.

They don’t need millions

Nevertheless, as Ashok Khosla, Indian co-founder of the Development Alternatives non-governmental organization and a former President of the Club of Rome think tank, observes: most international aid institutions work in terms of millions of dollars, while local initiatives need just a few thousand.

ITC’s Director-General Arancha González notes in her foreword to the report: “It is not unusual for the small and medium-sized enterprises (SMEs) that we work with to have challenges accepting a large order, because they are unable to borrow a few thousand dollars to invest in scaling up production. We frequently work with start-ups that have excellent business ideas, yet are unable to find the funding required to turn these ideas into reality.”

200 pages on an overlooked aspect of investing

ITC’s 200-page report, published in June as its flagship SME Competitiveness Outlook, looks at the practical side of such investing. Who invests in SMEs and why? How do they invest and how do they assess risk? “These aspects of investing in SMEs have thus far received little attention at the global policy level,” the ITC team points out.

First it separates SME investors into three groups: start-up investors, foreign direct investors, and specialized investment funds. “Each type approaches investing in developing countries differently,” the researchers note.

Start-up investors range from business angels who tend not to focus solely on making money to venture capitalists, who want rapid results, a sizeable market and a product considerably better than the competition. “The dearth of venture capital in developing countries hinders the development of exciting entrepreneurial ideas,” they observe.

FDI and specialized funds

Foreign direct investment (FDI) into developing countries totals $600 billion. The promise is that these investments can mean technology and knowledge transfer, support for certification to international standards, and access to substantial finance.

The appeal of specialized investment funds is that “local financial institutions can bundle thousands of small loans into larger sums, to build a portfolio big enough to entice investors”.

The drawback is that the funds will want accurate performance assessments of these SMEs, and this is often a barrier: “A lack of information leads to higher perceived risk”, particularly when a developing country’s financial sector is weak. The high costs of searching for and serving thousands of small firms puts investment managers off in the early stages.

Public registries, SME stock exchanges and blockchains

ITC suggests that public registries, SME stock exchanges and immutable records held by new blockchain technologies can make it easier for investors to make a deal with SMEs.

Is it worth it? “Traditionally, financial institutions serving SMEs in developing countries have struggled to earn returns above their cost of raising capital,” the ITC report notes. “The main reasons are smaller volumes per client, higher transaction costs and higher default risks. There are also important constraints, such as interest rate caps, low-quality credit bureau information, lack of suitable collateral, inappropriate insolvency regulations and insufficient access to appropriate SME insurance.”

Returns of 15-30%

But the International Finance Corporation (IFC), the World Bank’s private investment arm, says some financial institutions lending to SMEs can achieve returns of 15-30%. Another study found that financial institutions specialized in serving SMEs can generate earnings on assets of 3-6%, compared to 1-3% for non-specialists.

Nevertheless, IFC estimates the “finance gap” for SMEs at $5.3 trillion. “In 2018 global funds held $1 trillion of cash-in-hand private equity capital that was seeking investment opportunities.”

Feasible and important for SDGs

That happens to be the amount ITC estimates would “unleash the potential of SMEs to deliver on the Sustainable Development Goals (SDGs)”. Delivering this to developing countries’ SMEs would be “challenging”, ITC admits. “But it is feasible,” because of the amount of investment cash looking for returns and its small size compared to the finance gap.

In return, the investment would contribute to achieving 60% of the 169 SDGs, through its impact on employment, business practices, sectoral services and the national economy. “Increasing annual investments in small and medium-sized enterprises by $1 trillion would yield disproportionate dividends in terms of progress towards the Sustainable Development Goals. These investments also have the potential to deliver healthy returns for investors,” ITC concludes.

How to get stellar returns

The lenders who earned stellar returns from investing in SMEs did so by reducing operating costs, through innovative distribution models, understanding SMEs better through innovative credit risk scoring mechanisms and offering business/financial literacy training to the businesses.

“Many investment promotion agencies in developing countries suffer from budgetary constraints, unfocused mandates and operational weaknesses,” the report states. Benchmarket agency performance and coordination with organizations such as credit bureaux, chambers of commerce and sectoral associations can be essential.

Local financial institutions need help in bundling SME investment through technical assistance to automate activities, improve decision-making and create credit registries. Apart from the three main sources of funds, ITC suggests crowdfunding can help innovators or SMEs in remote locations.

The ITC report is available in English on its website, along with an English and Spanish summary. It offers 85 country profiles, seven case studies and five specialist essays as well as its analysis.