Frontier and Growth Markets | April 27, 2023

Small and growing businesses are the key to inclusive development. Let’s get them the capital they need to thrive.

Drew von Glahn
Guest Author

Drew von Glahn

Development finance institutions and impact investors recognize that Africa’s small businesses are key to the continent’s sustainable and prosperous economic development. Yet most are unable to meet small businesses where they are, with the financial tools they need, because they are stuck in obsolete funding models.

In turn, Africa’s small and growing businesses remain stubbornly underfunded and unable to reach their full potential.

There needs to be a complete rethink among DFIs and impact investors about how and through whom they’re channeling capital to such enterprises. This opportunity does exist: though local capital providers. Let’s give them a chance.

We call local capital providers an emerging asset class because, despite operating in different markets with varying investment vehicles, they share many common features.

  • They purposely target financing for the “missing middle,” cutting checks of $20,000 to $2 million (though the majority are below $500,000) to small and growing businesses that are too large for microfinance institutions and too small for commercial lenders. With this segment and transaction of this size, most of local capital providers are raising and managing funds of $10 million to $25 million.
  • They provide the types of funding needed by small businesses, such as working capital and growth capital. Their lending and investing is cashflow-oriented, with minimal collateral-based protections.
  • They finance more intangible needs, including staff build-out, expansion of sales and marketing capabilities, new market entry, product and services development, technology applications and internal management systems. While not tech investors, many of their portfolio companies’ business models are underpinned by technology.
  • The fund managers principally consist of business executives with extensive experience and deep knowledge of their local markets, customer needs, supply chains and overall operating environment.
  • Their investment thesis and the capabilities of the management team look to address the post-investment needs of their portfolio companies. 
  • They’re impact-oriented, focusing on job creation and the SDGs.
  • The managers and their teams, while small in number, purposely focus on diversity and inclusivity among the team and their portfolio businesses, with a strong focus on gender opportunities.

Essential small businesses

The development field has been a key enabler of inclusive access to finance for subsistence and micro-enterprises, helping to build a microfinance sector that now has more than $30 billion in assets under management.

Yet, at the next phase of enterprise development from micro to small, and small to medium sized businesses has persistently struggled. There are several well-documented factors – a critical one is the lack of access to appropriate capital. 

Small and growing businesses—those with anywhere between five and 250 employees—play a critical role in creating sustainable jobs while achieving the Sustainable Development Goals in emerging and frontier economies.

As the foundation of their economies, small businesses serve as a launchpad for initiating national agendas on inclusive and sustainable economic growth. The World Bank estimates that small and growing businesses create seven out of 10 jobs in the formal economy. They are where climate adaptation, gender inclusion, youth employment and living-wage jobs begin. 

Their financing needs largely range from $20,000 to $500,000 (and in some markets, up to $2 million in growth capital). Systemic barriers, however, severely limit the available capital to sustain and grow these businesses: Africa’s banking community is not well-positioned to serve small businesses given their strong reliance on collateral to extend credit. The global north’s focus on venture capital, meanwhile, does not align with most small businesses, which will never become “unicorns” with businesses that meet the everyday needs of their communities.

Those that are able to access growth capital typically rely on local money lenders and other informal capital sources.  

Local funder effect

Local capital providers are often the first formal financiers for small and growing businesses in emerging markets. The Collaborative for Frontier Finance estimates there are approximately 100 local capital managers already operating in Africa. We identify them as having three key components to their DNA:

  • They are market- and solutions-oriented. Their principal focus is on the businesses they target, those businesses’ capital needs, and extending the most appropriate types of financing.   
  • They have deep knowledge of the local business environments in which they operate.
  • They are highly capable at adapting and integrating new knowledge and financing approaches.

These non-bank local capital providers take a dynamic, entrepreneurial and learning-based approach to providing local and regional businesses with capital.

Local capital providers haven’t shown up on investors’ radar because the “science” of finance has traditionally steered capital to large institutions that operate highly-centralized but efficient decision-making and underwriting processes. But in small business finance, local context matters.

A report last year from the Impact Task Force on mobilizing institutional capital called for capital to be “grounded in local considerations of needs, capacity and priorities.” Investment and risk managers need to be close to their clients and the local business environment. That proximity in turn, yields an understanding of market needs, and which businesses in the local ecosystem are truly investable, viable and scalable.  

This value proposition in small business finance is not unique to emerging markets. German landesbanks and community development financial institutions in the US were founded in recognition of the importance of financiers having roots in their communities. There is a similar need for small businesses in emerging and frontier markets to have access to locally-rooted capital.

If local capital providers were able to satisfy African small businesses’ financial needs, we could see 300 such capital managers on the continent collectively managing $4.5 billion to $6 billion in assets.

To succeed and reach small businesses at scale, these funders need catalytic capital that is patient and flexible. Technical assistance and overhead support will also be critical for building up the capacity of this emerging asset class.

Problems and solutions

Why has the development sector struggled to find its footing in addressing the dearth of capital for healthy, growing small businesses in emerging economies? There are several reasons—and solutions:

“Lean in” with a sense of urgency. There is a lack of urgency among large capital holders and development agencies. It is not uncommon for a DFI to require 18 months to complete a financing commitment. There is a need to engage investment committees and change the investment underwriting processes at DFIs and institutional investors regarding the risk/benefit of investing in the missing middle via local capital managers.

This can be achieved through a dual approach. At the Investment Officer-level, a more “intrapreneurial” approach can be applied to push for engagement with local capital providers and better inform internal stakeholders of opportunities. Simultaneously, the board and senior management need to provide the vision and internal support to make these commitments happen.

Move from “transactional” to “field building”. In a recent CFF workshop with DFIs, impact investors and local capital providers, a simple question was raised: Should DFIs and other institutional capital holders look at each small and growing business investment opportunity as a “transaction” or part of a broader portfolio?

DFI investment officers are required to prioritize transactional risk concerns, and factors such as impact, additionality and ecosystem building are often not weighted against perceived-risk considerations. This highlights DFIs’ orientation towards risk management over economic development and resiliency. What is required is portfolio-level that rebalances risk versus impact.

Prioritize flexibility over governance. Local fund managers spend an inordinate amount of time – and expense – to meet highly inflexible legal requirements of DFIs. For example, the majority of managers in CFF’s most recent survey reported where they’re domiciled is determined by DFI preferences, not by what is most efficient and affordable for the managers. While DFIs shouldn’t limit their legal rights, they could improve their consideration of what is “necessary” and optimal for local fund managers.

Meet the market where it is. There is a mismatch between what local capital providers need in terms of investment size and what DFIs and institutional investors typically provide.

Local capital providers often design funds of $30 million or less in order to meet the needs of local businesses and properly manage risks. They need investors who can cut checks of $2 million to $5 million.

DFIs and institutional investors, however, have preference for larger investments because they remain convinced that fund economics begin at $30 million (one DFI and impact field-building funder each told us that they only target local funds raising $100 million). Larger investments are also preferred because the cost per transaction is high.

For DFIs in particular, efficiency with public monies should be applauded, but not at the expense of not meeting the market where it is.

Rethink risk tolerance. There is substantial room for DFIs to be more risk-tolerant in order to have a bigger impact. Let’s consider a few key numbers:

DFIs and multilateral development banks, or MLBs, have risk-adjusted capital ratios of 20% to 40%. This compares to the highest RAC global bank, HSBC, at 9.2%.

Meanwhile, the funding cost-differential for a AAA-rated issuer and a AA-rated issuer is just 30 basis points – substantial room to take on higher risk without materially impacting their own creditworthiness or cost of capital. 

No one is proposing flagrant disregard for good risk underwriting, but a more measured, risk-tolerant approach could spur new innovative risk management tools and greatly increase the potential for outsized impact.

Additionally, a stronger and bigger local business sector strengthens the local economies in which DFIs and MLBs operate, which should lead to better overall portfolio performance and credit standings in these markets over time.

Commit to data transparency. Greater transparency from DFIs and MLBs could lure investors, having that catalytic impact in private markets that DFIs and MLBs are set up for. Data on deals are often not disclosed because of stated “confidentiality” reasons, however.

Better and more transparent data on investment activities, portfolio performance and Sustainable Development Goal impact are required.

Where to go from here? To move the needle on emerging markets small business finance, and thus on sustainable economic development, DFIs and institutional investors must truly acknowledge and embrace the indispensable role that small and growing businesses play in resilient and inclusive economies. And then they must rethink and reorient the ways in which they support these businesses financially. Local capital providers are the bridge to doing that, and a potentially huge, if overlooked, investment opportunity for these investors.

Drew von Glahn is the executive director of the Collaborative for Frontier Finance.