Towards A Scalable Way To Invest In Small And Medium Sized Enterprises (SMEs)
The importance of small and medium-sized enterprises (SMEs1) to the welfare of any economy is universally accepted. At SEAF2, we have seen that not only do SMEs generate employment at a high rate, but they tend to hire unskilled or semi-skilled workers and provide valuable training—making employment not only sustainable but resulting in significant annual wage increases3. Such stable employment provides hope and opportunity for many, while also—given that SMEs are the first formal step on the ladder of economic activity—generating highly needed tax revenues for governments facing the important tasks of providing infrastructure, education, and health for their citizens.
Yet despite the importance of SMEs, supplying the risk capital—particularly equity capital—that allows SMEs to grow continues to be extremely difficult. There is a “lack-of-scale” issue from the investor’s side, as well as distrust from the point of view of the entrepreneur who, in all likelihood, has never before shared the ownership of his or her enterprise with a third party outside the family. Yet the model that has heretofore been accepted by the development financial institutions (DFIs) to finance such growth is the 10-year limited life investment vehicle earlier developed by the US and UK venture capital and buy-out industry. Furthermore, the sums these institutions can make available to SME funds are relatively small—far less than what has been mobilized for microfinance institutions. While SEAF has been able to find visionary private sector investors (including pension funds and life insurance corporations in Peru, Germany, Colombia and India, to name a few), not enough capital is being invested in growing SMEs.
A major reason for this shortage is that the limited-life, investment vehicles thus far accepted by the DFIs for investment in SMEs implicitly require the capital to be invested within 4 to 5 years and to hold those investments for a maximum 3 to 5 years, after which the fund’s investment must be repaid. Yet this time period—appropriate for investment in much larger companies with developed capital markets like the USA or UK—is generally far too short to enable the SME to grow and thrive. SMEs simply need more time to build their systems and achieve the growth that makes exits interesting in absolute terms to attract most investors and that has the most sustainable and measurable impact on local communities.
SEAF nonetheless has been able to achieve consistent cash returns on its SME equity risk capital investments, achieving a gross IRR of 18% across its active funds (December 2009). Over the past 20 years, what has become clear to us however is that establishing small private equity funds, investing and harvesting the investments is an inefficient and hard-to-scale way to invest in SMEs.
Specifically, we have identified the following problems.
1. Raising a fund is time consuming. Even with SEAF’s track record, it generally takes us 18 months to raise SME funds, and often by the time we have raised the money, the interest of some of the DFIs may have shifted to a different set of countries or the conditions for investing may have changed;
2. There is a limited investor base. Country-based funds are often too small for private institutional investors and require a complex coalition of DFIs given their desire to cap participation at a modest percentage of the overall fund and given the limited focus areas (geographically or by sector), especially among the smaller DFIs.
3. The fund expenses are large relative to the capital of the fund: Auditors and lawyers will generally charge comparable amounts for their services, regardless of how large the fund is, even with SEAF's abilities to perform the majority of the legal work in-house.
4. Especially in first-time funds in difficult countries or countries which never before had private equity funds targeting SMEs, it often takes a substantial amount of time to make the first investment. The novelty of third party equity has often resulted in delays in educating entrepreneurs and in obtaining the necessary governmental registrations or licenses. While SEAF has virtually always invested at least 75% of committed capital, delays in investing capital mean delays in the compounding of growth and such delays amplify the management fees spent versus capital invested over time.
5. The limited life structure requires the fund manager to exit arbitrarily within the 10-year fund period, instead of staying with the most successful SMEs to a more natural point of exit.
Based on my experience, I believe that in order to scale investment in SMEs the following steps should need to be taken:
1. There should be more funds or financing companies established that are able to make mezzanine investments (cash flow-based lending with some participation interest)—and with the ability to follow on with equity when trust (on both the entrepreneur and the fund manager) has been built.
2. There should be a greater opportunity for investors to invest in or exit from a larger (more diversified) SME fund, such as a permanent capital vehicle (PCV). The US Business Development Corporation structure (BDC) is one potentially suitable structure, as is the UK’s 3i—which originated as a government-funded entity making mezzanine investments in British SMEs. Such a PCV could target a global emerging markets portfolio of SME investments. Here, investors could sell their shares in the portfolio rather than require the individual portfolio companies to be sold or to buy back risk capital participations before the SMEs were ready.
3. There should be a public/private partnership to explore providing a range of investors the ability to sell their shares in the PCV. With the help of the Rockefeller Foundation, SEAF is currently exploring partnerships with foundations interested in promoting development to make a market for such investors, which include European family offices and private bank customers. In this context, it is worth noting that SEAF has consistently achieved current returns in excess of US ten-year Treasuries, as well as substantially higher NAV increases. The increasing shift to mezzanine should make this characteristic even easier to achieve in the future.
4. Franchised mezzanine plus revenue participation, or so-called “Fourth Door” funds could be established which would link up with the local PCV as SMEs in such funds became ready for larger risk capital investments. The world is ready for new impulses for economic growth. SEAF believes that SMEs can provide a major part of that growth and all the positive impact that results from it, but that new structures need to be established which will be able to deliver SMEs the necessary risk capital efficiently.
1 For a definition of what is an SME, please see “Defining SMEs: A Less Imperfect Way of Defining Small and Medium Enterprises in Developing Countries” by T. Gibson and H. J. van der Vaart, The Brookings Institution, September 2008: http://www.brookings.edu/papers/2008/09_development_gibson.aspx
2 Small Enterprise Assistance Funds, a New York 501-c-3 corporation established in 1989 to invest in, and promote the growth of SMEs in underserved areas of the developing world. As of December 2009, SEAF had $540 million in committed capital and had invested $334 million in 304 SMEs across 30 developing countries around the globe. For more information on SEAF and its funds, please visit www.seaf.com.
3 To download SEAF’s reports on the development impact of SME investing, please visit: http://www.seaf.com/impact.htm. SEAF’s analysis (through 2008) of a sample of companies across 13 countries recorded a 17% average annual increase in wages in USD terms, with 73% of new jobs going to unskilled and semi-skilled employees.