Emerging and Growth Markets | April 9, 2024

How and why British International Investments directs capital to small businesses

Paddy Carter
Guest Author

Paddy Carter

Development finance institutions like to style themselves as the original impact investors. It was Lord Reith, the first chairman of the UK’s development finance institution, who used the phrase “doing good without losing money” over seven decades ago. But there are differences in how DFIs invest versus most private impact investors.

Impact investors are often motivated by immediate impacts: they might invest in a fintech company simply because its loans improve borrowers’ lives, for example. DFIs of course care about immediate impacts too, but they tend to put more emphasis on longer-run, economy-wide impacts, such as the importance of a diverse and inclusive financial sector for economic growth.

In a new report from BII, How and why we finance SMEs’ we cast new light on the impact story of financing the large S’s (small) and M’s (mid-sized) enterprises in the SME spectrum. It reflects on why the SME financing gap exists and why it’s so difficult to close. And it describes how our strategy at BII toward SME financing has evolved since 2012.

The needs of SMEs are varied; the solutions and impact considerations must be varied too.

Micro v. small v. medium businesses

Financial inclusion is a major theme for prominent impact investors. LeapFrog Investments, for example, sees financial services as a safety net that prevents people falling into poverty and a springboard that helps them escape it. In 2022, LeapFrog reported $47.3 billion in loans disbursed by portfolio companies.

BlueOrchard, another industry leader, has supported over 30 million micro, small and medium enterprises with a median loan size of around $2,900.

These impact metrics, drawn from the industry standard IRIS+ catalog, are closely related to the number of people reached. That’s because at the micro end of the small business spectrum, the impact pathway is likely to be pretty short: the primary impact of financial inclusion for a micro-entrepreneur is likely to be felt by that individual and their family. It’s similar for a smallholder farmer who gains access to crop insurance

The five dimensions of impactwhat, who, how much, risk and investor contribution – are reasonably clear and measurable.

With larger enterprises, the impact story becomes more complicated. “Larger” small and mid-sized businesses, or SMEs, are more important in production networks as buyers and suppliers, and therefore have wider impacts on economic value chains. Who benefits from easing credit constraints to larger SMEs is also harder to answer than for micro enterprises; impacts could be felt by firm’s owners, workers or customers.

BII’s impact framework has a sixth dimension – how – because we often need to understand longer impact pathways, which include the indirect effects of investments on other firms.

Impact nuance

Our paper examines the evidence of the impacts of SME financing. Job creation is often the motivation for impact investors. The net effect on jobs from improving access to credit for SMEs often extends beyond any impact metrics that could be reported by lenders or gleaned from listening to stakeholders, however.

Consider, for instance, that lending to SMEs creates jobs in the borrowing firms — but it can also destroy them at competing firms. Job destruction can be a good thing.

“Despite high youth unemployment, the main problem in most lower income countries is not that people lack an occupation, it is that their occupations are precarious and unrewarding,” we note in our paper. “We want to see bad jobs replaced with better ones.”

What matters most impact-wise is whether financing SMEs drives up the quality of jobs across the economy over time.

Direct empirical evidence on how interventions to increase SMEs’ access to credit affect the overall number of decent jobs across an economy is not as complete as we’d like it be. There is plenty of wider evidence that the expansion of financial services improves local livelihoods, and job creation is not the only impact pathway – SME financing also helps firms supply a wider range of better goods and services at lower prices.  

Financing the full SME spectrum

The big picture is that a stronger financial sector, which meets the varied needs of different firms, can solve the capital “misallocation” problem that many economists blame for holding back development, where the firms that ought to grow cannot (and firms that ought to close, don’t). Impact investors cannot observe the effect of their actions on economy-wide outcomes such as the efficiency of capital allocation, but they can think about what is most likely to be useful.

DFIs and impact investors should carefully consider what forms of financing are most likely to help firms grow. SME owners are often risk averse and reluctant to put their livelihoods on the line by financing ambitious investments with inflexible and short-term debt. They want flexible terms.

To meet that particular need, we often turn to specialist SME lenders with a more hands-on business model, who are willing to lend based on a careful assessment of a borrower’s prospects. Another approach: BII founded Growth Investment Partners in Ghana to provide patient and flexible risk-bearing finance to larger SMEs. It is a model we hope to replicate elsewhere.

Flexible growth capital for larger SMEs is one solution to one problem. As a DFI with the goal of positively transforming economies, we see our role as plugging gaps across the SME financing continuum for firms of different sizes, at different stages of their lifecycle, and with different needs (growth capital, working capital, supply chain finance and more). Our approach is to support continued innovation and diversity in the financial sector.

We want to keep learning. We also hope more impact investors will join us in thinking about the big picture for SME financing beyond the impact metrics.

Paddy Carter is head of development economics at British International Investment, the UK’s development finance institution.