How does your proposed innovation leverage public intervention in catalyzing private SME finance?
This is an opportunity to firmly establish an innovative equipment-based finance product in East Africa that can unlock private finance at scale for small uncollateralized borrowers on the margins of the SME sector.
We have conducted a thorough pilot over the last five years in Tanzania which has shown that it is possible to reach this segment profitably using a machinery-based leasing model. However, this has not been on a scale to catch the attention of mainstream private investors required to roll this model out across East Africa. We believe they will need to see a more established organisation succeeding on a larger scale before this can become genuinely mainstream.
There are two time horizons for attracting private finance to this sector. In the first horizon, public finance can leverage the available sources of private investment to support EFA's scale up. In the current market, early stage investors typically require higher returns than we can offer, even though they can tolerate higher risks than we represent. As well as leading the way for these investors, public finance can take lower-risk debt exposure to engineer the risk-return profile they require. We expect this to leverage private finance on a one to two basis. This will build a sustainable platform for growth within our organization, creating a robust institution that can provide a credible investment option to kick-start mainstream investment in the next phase.
In the second time horizon, this scale-up phase will have created a strong demonstration effect. This will increase the comfort of a broader range of private investors to enter the sector on a much larger scale, both through EFA and through new market entrants. Demonstrating a viable new model in this way is one of the most effective ways of leveraging scarce public resources. This is akin to the role played by public finance in the development of the microfinance industry, where early pioneers took on higher perceived risk to prove a poorly understood model for the private sector, paving the way for previously unimaginable private sector investment levels targeted directly at the very poorest segments of society. This is also similar to the role played by the Shell Foundation in seeding SME fund manager Grofin, taking on the previously unknown risk of SME investments in Africa, which has led to an influx of SME funds for the larger individual SME investments. This time, public investors have the chance to catalyse the development of a sector with exceptional job creation rates which can lift people permanently out of poverty.
What barriers does your proposed solution address?
Asymmetry of information, Lack of collateral, Lack of financial capacity, Lack of SME access to skills / knowledge / markets, Unavailability of financial products tailored to SME needs, High transaction costs for financial intermediaries to serve SMEs.
If you checked any of these barriers, describe how your solution addresses them
f), c): EFA is demonstrating a product tailored to the needs of uncollateralized entrepreneurs on the margins of the SME range. The lower end of the SME spectrum is particularly poorly served by traditional institutions and cannot access existing products. World Bank research from 2006 showed that only 3% of small formal manufacturing enterprises (5-19 employees) in Tanzania use bank finance to fund investment compared to 10% of medium-sized ones (20-99 employees) and 36% of large ones. Microsave field research from 2001 identified particularly high demand for leasing between $1,500 and $100,000.
In order to meet the needs of these customers and provide effective access to finance, our product contains a collateral substitute. This overcomes the issue of lack of collateral, which is one of the major barriers for entrepreneurs accessing bank debt. We invest $2,000-$50,000 in machinery, paying the equipment supplier directly and using the machines as security.
Customers repay 150% of the capital invested (in local currency) in 36 equal monthly repayments, with a formal rescheduling procedure for good customers who face temporary disruptions out of their control. This provides a long-term repayment period essential for entrepreneurs growing beyond the micro level. Our rescheduling facility provides the equity-like flexibility necessary to accommodate the unpredictable shocks that SMEs can face in these environments, without the prohibitive resource requirements and exit difficulties associated with equity. The machinery focus also better meets small business needs by protecting the entrepreneur from community pressure to divert the investment away from revenue-generating activities, since the equipment supplier is paid directly for the machine.
d), e): To overcome the barrier of low levels of financial literacy, our investment process starts with a half-day training seminar where customers are given an essential introduction to our product structure. Our product structure uses a fixed premium rather than compound interest, with 150% of capital repaid in 36 equal monthly repayments, which increases transparency for entrepreneurs who rarely understand compound interest. Customers are also given training to complete a basic business plan template which acts as our application form, guiding them step by step through a product by product analysis. After investment, our investment officers are in regular contact with customers, and visit them at their site at least once every three months to see how business is going and provide informal advice.
h), a): This is provided using a focused, standardized model which allows us to reach scale and minimize transaction costs. This depends on nitty-gritty operational focus, for example keeping investments within a manageable range of our physical office and using competent locally trained staff rather than internationally trained executives, local or otherwise. This commoditized approach makes it possible to realize the full potential of this important market to create system-changing impact. In addition it reduces the challenge of information asymmetry, by building institutional knowledge of specific sectors which are popular among small entrepreneurs, making it possible to reduce costs further by simplifying the appraisal process.