SME Finance - Gap

Gap

A substantial portion of the SME sector may not have the security required for conventional collateral based bank lending, nor high enough returns to attract formal venture capitalists and other risk investors. In addition, markets may be characterized by deficient information (limiting the effectiveness of financial statement-based lending and credit scoring). This has led to claims of an "SME finance gap" – particularly in emerging economies. At a workshop hosted by The Network for Governance, Entrepreneurship & Development (GE&D) in Geneva in July 2008, SMEs that fall into this category have been defined as Small Growing Businesses (SGBs).

There have been at least two distinctive approaches to try to overcome the so-called SME finance gap.

The first has been to broaden the collateral based approach by encouraging bank lenders to finance SMEs with insufficient collateral. This might be done through an external party providing the collateral or guarantees required. Unfortunately, such schemes are counter to basic free market principles, and they tend to be unsustainable. This sector is increasingly called the Meso-finance sector.

However, there are no evidence of any significant structural barriers to the supply of bank or private equity finance to suitable SME applicants on mutually satisfactory terms and conditions in Britain. The main obstacles to funding here appear to be on the demand rather than the supply side of the business finance market. This is mainly in the form of:

• Lack of satisfactory business plans, accounting and other information;

• Inadequate assets for use as security; and,

• Insufficiently high levels of profitability, gearing, liquidity, stability, and other business-financial performance criteria on the part of funding applicants.

Thus, the second approach has been to broaden the viability based approach. Since the viability based approach is concerned with the business itself, the aim has been to provide better general business development assistance to reduce risk and increase returns. This often entails a detailed review and assistance with the business plan.

A common aim or feature of the viability based approach is the provision of appropriate finance that is tailored to the cash flows of the SME.

Although the returns generated by this approach in less developed countries may not be attractive to venture capitalists, they can be significantly better than conventional collateral based lending – whilst at the same time being less risky than the typical venture capitalist business. Thus, a new, distinct asset class, offering a new avenue for diversification, is available to investors. With higher profitability than traditional SME finance and lower risk than traditional venture capital, this sector has been named the "growth finance sector".

In the past, a significant obstacle to applying this approach in less developed countries has been getting the information required to assess viability, plus the costs of transferring and providing business development assistance. However, in the last several years, improved information and communications technology have made the process easier and cheaper. As technology and information sharing continue to improve, the approach could become significantly more cost-effective and attractive to established financiers with viability based approaches, and to consultants providing business development assistance to SMEs in other, more mainstream areas.

Some investors have promoted this approach as a means of achieving wider social benefits, while others have been interested in developing it largely in order to generate better financial-economic returns for shareholders, investors, employees, and clients.

A new organisation, Aspen Network for Development Entrepreneurs (ANDE), has been created to bring the growth finance stakeholders together, with the view to evolve into an association serving the sector, similar to what venture capital or microfinance associations do. They have declared their target audience to be Small Growing Businesses.

In 2008, a group of financial service providers and other stakeholders came together to form the Finance Alliance for Sustainable Trade (FAST). FAST is an association of financial service providers explicitly committed to improving access to finance for sustainable SMEs—defined as SMEs that are compliant with one or more of a host of growing sustainability standards (such as organics, fair trade, forest stewardship council etc.). FAST states that one of its objectives is to improve access to finance for SMEs by linking sustainable trading relationships with sustainable production practices—both of which have been observed to reduce the risk profile of SMEs in traditionally high risk sectors.