BY MARK & ASSOCIATE
Exploring the missing-middle
THE term small and medium-sized enterprise (SME) covers widely different types of firms. Everything is included, from fragile zero growth micro-firms (normally employing up to a couple of workers generating subsistence level revenues) to fast growing medium-sized firms with up to 250 employees.
The role these firms play for the developing economy and the hurdles they face are often completely different. Micro-firms often struggle with fluctuating revenues, red tape complexity, and lack of knowledge and relevant competencies. For medium-sized firms, access to enough risk capital, access to technology and access to stable electricity supply may be more of a challenge.
Mark & Associates Consulting Group notes that most enterprises worldwide can be categorised as small- and medium-sized enterprises (SMEs). They play a crucial role in providing a livelihood and income for diverse segments of the labour force, in creating new jobs, fostering value added and economic growth.
According to Small Enterprise Impact Investing, Exploring the “Missing Middle” beyond Microfinance by Symbiotics (Roland Dominicé and Julia Minici), more than 95% of registered businesses in the world are small. Together, they constitute the largest employer in any given private-sector economy, whether of high-, middle- or low-income levels.
Generally, lower income countries tend to have a much higher concentration of micro-enterprises than SMEs, contrary to higher income countries, which have many more SMEs than micro-enterprises — a gap referred to as the “missing middle” in the low-income SME markets.
The current growth they face will gradually bridge this gap. But ultimately, the pace at which they will grow will depend on the sources of financing they can access, and the quality of their growth will depend on regulation and behavioural standards that guide their expansion.
The missing middle can largely be attributed primarily to:
- a lack of economic opportunity to sustain the needs of SMEs;
- a lack of regulatory, policy and infrastructure support to promote the development of SMEs; and
- a lack of access to finance in the “missing middle”.
In the past decades, each of these elements in many low-income countries have started gradually evolving and improving, feeding each other into setting the stage to progressively bridge this gap. It is a fact that access to finance is still by far the largest obstacle to growth for micro, small and medium enterprises alike, particularly in low- and middle-income markets.
They largely depend on self-financing or informal financing solutions, as mainstream commercial banks and financial institutions continue to under serve their needs. That said, a new market segment of up-scaling microfinance institutions (MFIs) and SME banks is emerging as a consequence.
unmet demand for banking services
Despite the recognised importance of the SME sector, evidence indicates that SMEs continue to be undersupplied with the financial products and services that are critical to their growth. In global surveys, including the World Bank’s Enterprise Surveys and Investment Climate Assessments, SMEs report that the cost of finance is their greatest obstacle to growth and rank access to finance as another key obstacle.
SMEs are particularly in need of bank services because they lack the cash flow to make large investments, they cannot access capital markets as large firms can, and they often lack qualified staff to perform financial functions.
This key constraint is directly linked to banks’ conduct with respect to financing activities. Banks — by far are the largest providers of financial services — very often lack an interest in SMEs, particularly in providing loans, especially long-term finance.
This is primarily due to a few reasons such as:
- Problems of information asymmetry. Known as the principal-agent problem, it presents an initial risk that the bank would adversely select and lend to a high-risk SME that is willing to borrow even at high interest rates, while a low-risk SME would not be incentivised to borrow at all at high interest rates. The second risk, typically following adverse selection, is a “moral hazard”, which means the borrowed money would not be utilised for purposes other than those presented to the bank to secure a loan. The problems are worsened because SMEs do not produce sufficient information such as verifiable accounting records, and the banking sector does not yet have adequate information infrastructure and contract enforcement in place;
- High incidence of non-performing loans. SMEs in developing countries have accounted for a lion share of banking sector non-performing loans (NPLs), owing to relatively unreliable cash flows. SMEs are often constrained by delayed payments from either larger corporate clients or government, resulting in mistiming of cash receipts to meet loan repayment obligations. In addition, failing SMEs do not always prioritise repayment to creditors ahead of failure, as business owners attempt to conceal or dispose operating assets for cash to finance personal consumption; and
- Lack of collateral to secure loans. There are two hurdles related to collateral. The first is simply that SMEs do not have enough (if any) of freehold land, buildings and equipment to back their loans and minimise risk to the banks. The second is that there is a lack of robust secondary markets for which banks can foreclose and auction collateral, if any; or to mark-to-market the value of the pledged.
Overall, the more obvious structural impediments that explain banks’ subdued interest in financing the SME sub-sector include:
- Problems of information asymmetry;
- High NPLs;
- a lack of collateral;
- High administrative costs; and
- high risk perception.
There are other important factors, such as: Lack of internal capacity within banks structures, inadequate government intervention, the prevalence of sole proprietorship and associated key-man risk, poor capital structure of SMEs, and a low level of financial literacy among SME owners.
Internal capacity constraints
Most established banks exhibit a strong focus on large commercial customers and high net worth individuals, where information production is considerably higher and attendant risk lower. This leaves the SME segment relatively under-banked, as some banks categorically highlight that their growth strategies currently exclude an increase in exposure SMEs. Likewise, few banks have adequately invested in increasing their capacity to finance SMEs, via: directing credit, tailoring product development, adopting unconventional methods in risk management and importantly employing sufficiently skilled employees to manage SME relationships. Second tier banks, notwithstanding, face structural limitations in competing for a share of large corporates, and some appear to have made in-roads in the SME segment.
Lack of government support
Several state-led intervention mechanisms in support of SMEs have been well-documented. The purpose of these intervention schemes, of course, is to direct credit to SMEs under a developmental policy framework. However, much less has been documented, in so far as the State providing direct support to banks. Because they generally assume all risk when lending to SMEs, much more is required to support bank profitability, beyond the ambit of lending. Such direct support could be in the form of tax incentives for banks that surpass stipulated thresholds for loans granted to SMEs.
Sole proprietorship, key-man risk
Informal SMEs are least organised and produce little or no information about their business activities. They are also generally managed as sole proprietorships, and though this is largely an acceptable form of incorporation, increases key-man risk and presents difficulties in separating the business from the owner.
Poor capital structure of SMEs
Most SMEs operating in the informal to semi-formal segments have critically low levels of capital. Moreover, distinguishing between personal wealth and capitalisation of the business is difficult, thus limiting the ability of banks to assign risk levels accurately. Further, banks are averse to lending to SMEs that exceed prescribed debt-to-equity levels, to ring-fence risk levels.
Financial illiteracy impacts decisions
This is an increasingly important consideration, as low levels of financial illiteracy negatively impact SME owners’ ability to complete application forms, understand and manage financial products and loan contracts entered, ensure effective financial control and conduct effective financial projections. There is a strong opportunity for banks, however, to provide SME financial skills training and advisory services to business owners, before committing to financial contracts. This would be a useful measure in reducing the high-risk profile of SMEs in the long term.
This is an excerpt from a research report on the Microfinance sector compiled by Mark & Associate Consulting Group, in partnership with Zimbabwe Independent.