Non-traditional private equity financing can be a win-win solution for SMEs

(Credit: Elis Alves, Flickr Creative Commons)

The difficulties faced by Small and Medium-sized Enterprises (SMEs) in getting finance, especially in the developing world, have been well documented. The causes are equally well known. First, traditional bank financing (secured or cash-flow based) is often not available due to the lack of adequate collateral or the opaque modus operandi of many SMEs. Also, financial markets may not be sufficiently well developed to facilitate traditional private equity (PE) financing of SMEs. A typical private equity (PE) firm or fund requires controlling positions in a company it invests. But in Sub-Sahara Africa, most small businesspeople are both owner and operator of lifestyle businesses and have little interest in letting go of control of their company. Another constraint to the traditional PE financing model is the lack of exit channels such as a well-functioning initial public offering (IPO) or merger and acquisition (M&A) market.  In this regard, Kenya is no exception although the country is considered as having a relatively dynamic SME sector when compared to other East African countries. Surveys and studies point to a polarized financial market. At one end, dozens of commercial banks and licensed non-bank financial institutions service a narrow spectrum of the formal economy with limited financial products. At the other end, over 5,000 microfinance institutions and credit cooperatives provide microloans to individuals or households. In the middle, SME financing has been improving but is a long way from meeting SME financing needs.

Supported by the Kenya Ministry of Industrialization, the World Bank financed Kenya Micro, Small and Medium Enterprise Competitiveness Project piloted a new SME risk capital financing model. The US$14.1 million Kenya SME Risk Capital Fund (the Fund) was funded by five investors led by the IFC and managed by BPI (a subsidiary of the South Africa based Business Partners ltd). The Bank provided US$2.5 million IDA funding for a parallel Technical Assistance (TA) Facility. The Fund went into operation in 2007, and by the closure of the MSME Project had invested in 98 SMEs and extended 178 interest-free TA loans.

Those investments were tailored to the financing and cash flow needs of the investees on a case-by-case basis. The financing often combined different investment instruments (e.g. secured loans, unsecured cash flow financing and minority equity financing), and most were self-liquidating. The typical investors’ concern of a lack of exit options was addressed and the investees did not have to give up control of their company. These nontraditional PE instruments provided the investees with much needed financing that they might not otherwise have been able to access under the prevailing market conditions (see the table below for details).

Source:  World Bank sector reviews and BPI Kenya, August 2012

The support to the investees did not stop at providing finance. The TA Facility addressed the SMEs’ needs for business development services and supported management strengthening, market development and debt restructuring.

Evidence collected at the end of the MSME Project shows that the Fund brought about significant benefits to the investees which saw their profitability grew by 79% and jobs by 25%.  For the investors, the Fund obtained equity-like returns with average Internal Rate of Returns (IRRs) of 25% - 27% at a lower than expected loss rate (7.5% vs. 10%). To compare, the IRRs realized by three small business PE funds supported by AfDB were 3.4% - 5.7%, and the highest IRR of the SBIC Debenture Funds (supported by the U.S. Small Business Administration) was about 16%.

Several main factors contributed to the success of the Fund. First is Business Partner South Africa’s business model and well-tested financing instruments (Business Partners Ltd). The IDA financed TA Facility is another important factor which provided value-added services to the investees. IFC’s SME Solutions Center hosted the Fund. Through that networking forum, the Fund manager got to know customers better and hence enhanced portfolio quality. When analyzing the performance and development benefits of the Fund, we found that the secret of its success is perhaps in the Fund’s access to broad and deep local knowledge on thousands of SME investees and the dynamics of the economic sectors those enterprises operate. The knowledge has been built up and is maintained by Business Partners South Africa through the firm’s 30 years in nontraditional SME financing and more recently by PBI in a number of Southern and Eastern African countries. Insights learnt from this store of knowledge enabled the Fund manager to efficiently carry out due diligence and make well-informed investment decisions.

Our biggest takeaway from this experience?  Nontraditional PE financing as tested in Kenya can be a win-win solution for both PE investors and SME investees, provided extensive local knowledge is brought in and the advisory services and expertise we offer add value at a reasonable cost.