Role of capital markets in SME financing needs
Small and medium-sized enterprises (SMEs) comprise the backbone of our economy, according to some estimates, SMEs account for 90 percent of all companies (and businesses), providing over 80 percent of employment.
SMEs continue to be fundamental to the future economic success of our country, with the potential to facilitate establish a new middle class and boost the demand for goods and services. SMEs role in driving innovation, creating employment opportunities and therefore contributing to domestic wealth creation routes is critical for sustained economic development.
Despite their crucial role in driving the country’s economic development, evidence suggests that SMEs experience a severe shortfall in financing which hinders their growth. With all fairness, the challenge of SMEs financing is wide and large, a study conducted by Investisseurs & Partenaires found that 40 percent of SMEs in Africa identified the primary factor constraining their growth as accessing finance, and according to a recent report by the London Stock Exchange Group (LSEG) Africa Advisory Group, the current funding gap for SMEs in Africa is estimated to be about $140 billion.
Ultimately, the lack of funding results in thousands of SMEs being forced out of business within a few months of beginning operations and significantly inhibits their ability to reach their full growth potential and become the future ‘blue chips’.
The lack of funding for SMEs calls into question how well our domestic capital market is serving the needs of these companies, who form the bulk of our business universe. In general, the purpose of capital markets is to promote growth in the economy by providing capital for enterprises to innovate, expand and create jobs -- for an economy to efficiently work, capital must flow from investors to businesses, ranging from the largest companies to SMEs and entrepreneurs, instead of being concentrated on the large and well-established firms.
According to the research conducted by the LSEG Africa Advisory Group to the continent, there is a significant lack awareness by potential as well as entrepreneurs of the variety of financing options available to SMEs to support their growth trajectory. These options range from microfinance and angel investing to venture capital, banks, private equity and potentially listing on local exchanges. This unfamiliarity has resulted in low levels of domestic participation in the capital markets, leaving local equity markets underdeveloped. This contributes to the lack of depth and liquidity within domestic capital markets, which eventually results in a smaller initial public offering (IPO) pipeline for local exchanges.
As a result, SMEs seeking to raise capital have traditionally relied on bank loans. The result is excessive dependence on the banking sector – specifically, on bank loans. As such, the financial sector has continued to grow around this common notion, with banks and other stakeholders focusing their operations on bank loans and debt financing.
As it were, the type of financing (equity or debt) that would best suit a company’s needs is heavily dependent on a company’s stage of development. For instance, debt is form of capital raising that would suit a well-established company. That said, the same would not apply to a high-growth SME where funding is required in order to finance expansion. As such bank loan financing leave a small company prioritizing loan repayments or face risking default.
In our context, the business environment poses some obstacles to debt-financed SMEs. My experience, based on personal observation, experience and engagements with various stakeholders, and supported by other studies; the following issues, as far as the matter of SMEs financing (by banks) is concern, concerns SMEs: (i) some banks constrain SMEs participation in their line of business due to the use of sophisticated scoring models when assessing creditworthiness for SMEs, it is well known that SMEs often lack the track record and meaningful data inputs required by banks; (ii) some banks do not use credit scoring for SMEs and prefer to focus on relationship-based lending -- a consequence of this is that some of our banks experience higher rates of non-performing loans; (iii) credit bureaus, as good the concept as is, but have predominantly served as a negative reinforcement tool as a result of the harsh measures that some banks ends up taking in the case of delayed payments by SMEs – SMEs run the risk of being ‘blacklisted’ if a single loan repayment is delayed (caveat: this matter is somehow complicated because of regulatory and compliance); and (iv) some lenders seek prohibitive high collaterals to mitigate the high, and often unquantifiable, credit risk associated with lending to SMEs, again – this is a regulatory requirement.
As such, it is crucial for us to unleash the potential of equity capital to support SMEs that are so vital to the future of our economy. With the right combination of advice and support, SMEs can navigate the challenges, identify the right forms of equity capital raising and drive growth to support the economic development as envisaged.
While the launch of EGM segment within the DSE was supposed to be far beneficial, but without the right training and a supporting advisory community, as has been the case thus far, the EGM segment is likely to be left untapped. In the these past 5-years since introduction of EGM only five companies have accessed the segment raising just over Sh50 billion.
– definitely a relatively small amount, given the potential.
