Access to finance is a key determinant of a firm’s growth and performance at various stages of its life. But firms in developing countries that want to expand often find it difficult to obtain external finance in the form of equity, loans, or longer-term debt. This column explores the constraints on smaller firms in Africa getting such access, as well as the effects on their growth and investment decisions. Lack of finance disproportionately hurts young firms as they lack internal funds.
Access to financial services is vital for growth and development as it enhances the resource mobilization needed for productive investments. Access to finance helps firms to expand their operations, to innovate, and to invest in production facilities and new staff.
The main sources of external finance for firms include bank loans, other forms of debt financing, private equity, and venture capital funds. Venture capital funds are important for financing projects in the early stages that are highly risky but also offer potentially high returns. Private equity capital is important for small and medium-sized enterprises (SMEs) that are past the seed funding or start-up stages.
Access to finance is one of the primary bottlenecks for SMEs’ growth. For example, a study of over 10,000 firms across 30 African countries highlights that the percentage of firms citing access to finance as a major constraint is significantly higher than for any other constraint, including electricity, corruption, economic instability, and labor regulations.
Gaps in external finance for SMEs in developing countries
In advanced economies, the stock market is one of the sources of external capital. But in many sub-Saharan African countries, the capital market is either non-existent or at an early stage of development. For young and small firms, obtaining bank loans is difficult due to collateral requirements and high interest rates. Consequently, many SMEs consider other external sources of finance (including semi-formal and informal sources) to start businesses and/or to expand operations.
Private equity and venture capital provide equity finance. Private equity firms purchase securities of operating companies to take ownership stakes that range from a minority to majority ownership of the company. Private equity investors hold ownership of the company with the expectation of generating attractive risk-adjusted financial returns on exiting the investment. Their primary benefit is generated in the form of capital gain.
Private equity investors have a secondary effect beyond relaxing the financial constraints on SMEs: they can bring new management skills, better financial control systems, and network associations with their portfolio of companies, all of which can improve capacity and performance. Yet despite the wide range of benefits of private equity and venture capital, their investments in Africa remain small in comparison with the rest of the world.
There is a difference between loans from banks (which are relatively short-term), and equity or longer-term debt (quasi-equity). Debt financing is repaid with interest on an agreed schedule, whereas equity is raised through selling shares. In practice, firms might substitute the two types of finance to a certain degree.
For different purposes, different types of firms might want debt or equity. For example, a company may not finance working capital with equity, but equity might be used to expand its operations, especially if the financial rewards of that expansion are going to take some time to emerge, which could make it hard to meet debt repayments.
Access to finance and firm growth
A recent study in Ethiopia shows that over 50% of sampled companies did not make any growth-oriented investments between 2017 and 2019. One of the main reasons is that companies did not have sufficient revenues or assets, and they believed that they could not raise the required funds through external financing to support new growth investments.
Furthermore, only two of the firms surveyed had received private equity or venture funding. The rest of all the equity capital in the firms is either from the owners’ own savings or friends and families in the form of shares. Thus, about 44% of the surveyed firms reported that the inability to borrow sufficient funds prevents them from making all or part of their desired growth investments.
A large proportion of the SMEs did not apply for a loan, as they knew in advance that they could not satisfy the banks’ loan requirements such as collateral. But companies that obtained bank loans show a positive and higher growth rate than companies that obtained equity financing or other debt sources of financing for their growth-oriented investments.
The study also finds that small firms obtained more than 40% of their loans from informal sources. This suggests that small firms face bigger challenges in obtaining finance compared with larger firms.
Improving access to finance for SMEs in East Africa
Given the size of its population and the high economic growth rates of the last two decades, Africa has the potential to be an attractive market for private and venture capital investments. The recent trade agreement – the African continental free trade area (AfCFTA) – will also be a driving force to strengthen trade and investment within the continent and to make it a preferred destination of foreign capital.
Much of the private and venture capital investment in East Africa, in terms of both value and volumes, is made in Kenya. According to the 2018 Annual African Private Equity Data Tracker published by the Africa Private Equity and Venture Capital Association (AVCA), between 2013 and 2018, 110 of the region’s 194 private equity and venture capital deals were conducted in Kenya. The value of these transactions is estimated at $1.3 billion from an East African total of $2.4 billion; and this accounted for 59% of deals by value in East Africa.
Kenya’s performance is attributed to a liberalized, diversified, and advanced economy with a growing middle class and demand for high-value goods and services, all of which make it an attractive investment destination for global investors.
Globally, equity and venture capital investors play an important role in contributing to higher growth and job creation. Surprisingly little is known about these investors in Ethiopia. For example, the first private equity firm in the country – the Schulze Global Ethiopia Growth (SGI) – was introduced in 2012. Currently, a few private equity companies operate, but some do not have active investments. Either the equity companies are in the fundraising stage or deals have not been reached with companies.
Ethiopia’s recent initiative to improve investment administration and bureaucracy to attract international investments illustrates that the government is willing to strengthen the private sector by making it easier to do business and improving the country’s profile among the investing community.
The Ethiopian government should be more committed to putting in place the right policy and legal frameworks to make the country a preferred investment destination for investors seeking attractive and long-term returns.
Kenya’s experience shows that opening up the financial sector plays a key role in attracting international investors. Furthermore, stabilizing the macroeconomy (for example, containing growing inflation), bringing peace and security, reducing corruption, adopting a strong regulatory framework, and removing all obstacles that impede the free flow of trade and private investments will generally put the country in a more competitive position in the region.