Financing the Missing Middle: Small Business Finance in Africa

which has established a specialised small business leasing institution in Tanzania. Madeleine was one of the winners of the G20 SME Finance Challenge. She previously worked in the UK venture capital industry, and is a former McKinsey consultant. She spoke at the recent Business Action for Africa, DFID, IDS event in London.

The missing middle has two related meanings. Firstly, it refers to a small and medium enterprise (SME) gap: the much smaller contribution of SMEs to the economies of low income countries (17% of GDP) compared to their counterparts in the rich world (50% of GDP). And secondly, it refers to a financing gap: the lack of financing solutions available for entrepreneurs who have grown out of microfinance but are not yet able to access mainstream finance [1]. Both are discussed here.

After much debate, and with significant sums of investment raised to address this problem over the past few years, we might hope that the middle is no longer quite so missing. But on the ground at EFA, we feel much of the work required has hardly begun – because an over-simplified debate has encouraged an over-simplistic approach to the problem.

This is because the term “SME” covers too many different kinds of enterprises, which present different challenges and lend themselves to different solutions. There has been exciting progress in private equity, which focuses on the higher potential, larger version of “SME”. This supports a low-volume bespoke investment model, investing from $100,000-$2,000,000 at a time. However, a lack of disaggregation has allowed the rest of the SME market to go un-noticed. Important innovations such as forward financing, invoice discounting and leasing have not been driven forward, and we have not seen as many new innovations as we might hope.

Last week I started a very basic disaggregation of the SME market, for a presentation on inclusive businesses for a Business Action for Africa event. This has got me thinking that what the sector really needs is a good old-fashioned, solutions-orientated segmentation – to identify gaps, drive innovation and prioritise resources. It may be more revealing to move away from descriptions of size and sector, to look at distinctions based on needs or business models: level of formality, value chain linkages, or the equipment needs which are the basis for Equity for Africa’s finance. Highlighting these differences between businesses allows us to carve out market segments where we can innovate around better-targeted ways of mitigating risk. Here are a few examples, together with some examples of the innovations associated with these segments.

Taking formality, which seems to be at the heart of the missing middle. The main benefit of this distinction is to remind us that except in the special case of venture capital, the focus should not be on these SMEs. Tackling the missing middle means identifying ways to lend in spite of semi-formal or informal practices. Formal SMEs, with audited accounts, board meetings, legal contracts, etc., are a distinct and very small segment of the market which tends to have good access through financial institutions already.

Next, to take growth potential: there are two relevant distinctions which bring two innovations into focus. Some SMEs are high-growth opportunities because of their sector – contrasting SMEs in relatively stable markets and start-ups based on new technology, which are much more dynamic but also riskier [2]. Other SMEs are high-growth because of the motivation of the entrepreneur: genuine “opportunity entrepreneurs” committed to innovating, as opposed to “necessity entrepreneurs” focused on generating immediate income [3].

For both these types of high-growth SME the key challenge is still risk: the risk of a new market or the risk of fast growth. This calls for different bespoke investment models – a Silicon Valley venture capital model for the tech ventures, a private equity model for the entrepreneur-led SMEs. The important lesson that segmentation teaches here is that these two models require different skills, different amounts of capital and timelines, and probably different investor bases. To date, much SME finance innovation has been on private equity for the “opportunity entrepreneurs”; this has diverted our attention from the need for genuine venture funding.

However, both the formal segment and the high growth segment represent only tiny parts of the overall SME market. The main engine of growth in Africa are the semi-formal SMEs with moderate growth potential; small businesses which in Tanzania for example make up over 90% of a country’s registered enterprises. For these, traditional banks and private equity are inappropriate. Equity for Africa has some general principles to reach them – relationship-based lending, flexible terms – but these alone are not enough to mitigate risk and enable lending the sophisticated investor needs to take the segmentation deeper.

In Equity for Africa’s case, our model is based on carving out the segment of these small enterprises that require fixed assets to grow, such as maize mills or printing presses. For such businesses, equipment makes up 70% or more of their financing needs. This is not a small niche. The machinery (to which Equity for Africa retains legal title until the loan is cleared) provides a collateral substitute, making it possible to mitigate risk sufficiently to support a commercial institution.

In value chain finance, SMEs are segmented based on the presence of the larger, more formal company that the SME either supplies or distributes for. As well as providing a more stable and productive market for the SME, for large company suppliers this allows the lender to recover the investment directly from the large company before the SME is paid (forward financing), and for large company distributors this allows the large company to provide goods to the SME on credit but re-finance this with the banks so that it doesn’t tie up the large company’s capital (invoice discounting).

As we identify more needs-based distinctions to carve out distinct segments of the market, perhaps we will be able to identify more innovations like these?