Authors: Daniel F. Runde, Janina Staguhn
Site of publication: Center for Strategic and International Strategies (CSIS)
Type of publication: Article
Date of publication: July 2021
African SMEs face two significant financing challenges: accessibility and affordability. Accessibility refers to the ability of SMEs to access finance. SMEs in Africa are frequently informal—meaning they are not formally registered as businesses—and this makes it difficult for them to access financing. Moreover, even those that are formally registered still frequently suffer from a lack of accessibility. This is a significant issue because without sufficient working capital, firms are unable to invest and grow. Only between a third and a fifth of SMEs in sub-Saharan Africa have a bank loan or line of credit. An estimated 28.3 percent of firms in the region are fully credit constrained.
Affordability refers to the cost of capital, or how much it costs for a firm to take out a loan or receive an investment. The total loan cost comprises not just the cost of the original loan but also the interest charged and transaction costs, like fees for lawyers to perfect collateral. This is a serious challenge in Africa because local interest rates from banks are often in the double digits, sometimes higher than 20–25 percent. Alternative finance providers, such as microfinance institutions or digital lenders (e.g., m-Shwari, Branch), can charge even higher rates, as much as 40–50 percent. High interest rates often deter SMEs from even trying to apply for financing. This lack of affordable financing seriously hinders SMEs in Africa.
The World Economic Forum defines blended finance as “the strategic use of development finance and philanthropic funds to mobilize private capital flows to emerging and frontier markets”
Blended finance is one approach to providing SMEs with access to the capital needed to grow. Historically, development finance institutions (DFIs) and bilateral donors have focused on direct funding for projects. But with official development assistance (ODA) representing a mere 6 percent of the $2.5 trillion Sustainable Development Goal (SDG) investment gap, their resources are insufficient. The World Economic Forum defines blended finance as “the strategic use of development finance and philanthropic funds to mobilize private capital flows to emerging and frontier markets.” Blended finance seeks to “de-risk” potential investments in such a way that private sector actors will feel comfortable investing alongside or on top. Blended finance is one of the primary ways that official finance can “crowd in” or catalyze private investment from institutions that have a lower risk tolerance or seek a higher rate of return.
Blended Finance Ecosystem
Successful blended finance programs do not operate in a vacuum; rather, they require a robust ecosystem. The end goal of blended finance is to increase SMEs’ ability to access private capital independently, without having to rely on grants or concessional terms. Local capital providers are essential partners because they have a deep understanding of the social investors and local knowledge of the market, helping ensure that funds go where they are needed. This familiarity can also address concerns about moral hazard and adverse selection problems confronting larger financial institutions. However, local capital providers experience their own challenges and also need support. There are gaps in knowledge and capabilities, and these local investors are often unfamiliar with innovative forms of finance. The University of Cape Town, for example, is the only institution in Africa with an innovative financing program. There certainly is room to increase the number of programs and institutions on the continent.
Blended Finance Tools
Loans, equity, guarantees, grants, and technical assistance are five tools available to DFIs and development agencies to support SME growth. Whether using loans, equity, or some type of guarantee, the point with blended finance is that the provider is taking the riskiest parts of a capital stake and thereby de-risking the investment for others who want either lower risk or higher return. Blended finance is not just a set of tools; it is a strategy. When DFIs use loans, equity, grants, or guarantees, they do so in such a way as to adjust SMEs’ risk profiles to make them more palatable for private investors.
Financing tends to be inaccessible and unaffordable for African SMEs because they carry a high degree of perceived risk and because governments borrow a lot, which crowds capital out of the private sector. Development actors are much more comfortable with risk than institutions who have fiduciary duties. The de-risking instruments of blended finance adjust the risk-return calculus to attract private capital flows. First-loss coverage guarantees are one of the most popular de-risking mechanisms. They also make private investments as attractive as government debt offerings. Partnering with financial institutions, funds, and companies to provide first-loss guarantees lets partners take risks they might not be comfortable with otherwise. The partnerships allow development actors to assume responsibility for the riskiness of lending to SMEs. These guarantees are especially useful during the Covid-19 pandemic because they ensure that SMEs with existing loans can keep them. For foreign investors, de-risking currency fluctuations is also important, particularly in countries with macroeconomic instability.
Loans and equity
Loans are offered on concessional terms or in local currency (which should become the primary form), to make them more accessible to SMEs. Doing so facilitates the goal of transitioning to commercial lending. The loans are good examples of blended finance if they are paired with other types of capital. Working capital is frequently provided as a loan because there is more flexibility in terms of how a firm can use it and tap a line of credit for additional capital if needed. For some new firms, concessional loans exceed the capacity of their balance sheets. That is why equity investments are critical instruments for development finance.
To create a greater pool of capital, additional instruments are often required to address SMEs’ high degree of perceived risk. This is where guarantees come in. Rather than providing capital to SMEs directly, guarantees are contracts whereby development actors take responsibility for potential future liabilities that otherwise would have been suffered by commercial lenders. By adjusting the risk-return calculus, these guarantees help catalyze private capital flows. Guarantees were the blended finance tool responsible for mobilizing the most private finance in developing countries between 2012 and 2018. First-loss coverage is one of the most common forms of guarantees whereby development finance institutions promise to compensate private lenders if an SME defaults on their loans. These guarantees are especially important during the Covid-19 pandemic given the increased systemic risk. For external private investors, de-risking exchange rate fluctuations is also important, particularly in developing countries with macroeconomic instability.
Areas of Opportunity
Addressing climate change in Africa presents a $3 trillion economic investment opportunity in the continent by 2030. The private sector in Africa is critical to adapting to, as well as mitigating, climate change. This is especially true of SMEs, given that they make up a significant part of the continent’s private sector. It is critical that incentivization exists for SMEs to function in a sustainable manner and achieve green growth.
African SMEs’ lack of access to financing unfortunately often forces them to behave in ways that are not sustainable. It is harder for SMEs focused on sustainability and green business to gain financial support because there are typically higher up-front costs and the markets are underdeveloped. Green technology is expensive because it is newer and comes with many up-front costs associated with installment. Green SMEs may also suffer from high interest rates as they begin to use and implement new technologies since they lack collateral and have a perceived higher risk as a business.
Agriculture represents a significant source of employment and economic growth across sub-Saharan Africa. Currently over half of all sub-Saharan African employment is in the agricultural sector, with 70–80 percent of people in rural areas working on their personal farms. Agricultural SMEs are unfortunately also particularly troubled, especially with the Covid-19 pandemic severely impacting Africa’s agricultural sector. These SMEs bring food from farms to households and seek to bring efficiency and effectiveness to a sector with greater potential.
Addressing climate change in Africa presents a $3 trillion economic investment opportunity in the continent by 2030. The private sector in Africa is critical to adapting to, as well as mitigating, climate change
According to a 2018–2019 study, lending to agricultural SMEs is twice as risky as lending to other sectors, but yields lower returns. Additionally, individual farmers often operate at a scale that is too small to be commercially investable. This highlights one of the greatest challenges for agricultural SMEs, known as the missing middle. The missing middle is the idea that many SMEs are too large to be assisted by microfinance, but do not have the ability to receive loans from commercial banks. As a result, agricultural SMEs receive less than 10 percent of commercial bank lending in most countries.
Female business owners in Africa continue to face gender-based discrimination and obstacles that affect their profits, community engagement, and ability to successfully maintain businesses. These include legal discrimination, social norms, risk of gender-based violence, education and skills gaps, confidence and risk preferences, access to networks and information, household allocation of productive resources, and time constraints and care. Because of these obstacles, women-owned businesses in Africa on average earn 34 percent less per month than those owned by men. A mere 10 percent of women-owned SMEs have access to the financing they need. With less access to land for collateral and a lack of credit histories, women are perceived as even more risky by private lenders. During the Covid-19 pandemic, women-owned SMEs have faced additional strains, as women are often asked to simultaneously maintain their traditional caregiver roles and run their businesses. These disadvantages have increased their risk of closure during the pandemic. Blended finance programs that specifically target women would yield significant development gains.
First, incorporating flexibility into public-sector lending strategies will allow DFIs and other development agencies to fill the initial SME financing gap left by risk-averse commercial lenders. In taking a nuanced and flexible approach to early SME engagement, development actors can improve the organizational and administrative capacities of seed enterprises, ensuring preparedness for future private capital integration. Organizations like USADF and DFIs have an important gap to fill in financing SMEs in sub-Saharan Africa. Of the various types of capital, the private sector is the most risk-averse and inflexible.
Second, the long-term success of blended finance programs will require an expanded focus on localized and in-depth knowledge of investment ecosystems. Using flexibility to adapt to certain investment ecosystems requires an understanding of what blended finance looks like in different places. Through case studies and exploratory missions, development actors will be better able to tailor their lending strategies with consideration for operational and market limitations. Analyses could also be conducted on an industry-specific basis.
Third, a new methodology for lending and investment selection must be developed. Any effective strategy for blended finance implementation requires a firm determination of when and where it should be pursued. Going forward, DFIs and other development actors should establish a common framework that reflects their foremost role as development institutions—prioritizing early, higher-risk lending opportunities that can shape emerging markets and expand future access to private capital. They should establish a framework for understanding de-risking opportunities, weighing the financial and administrative capacities of a given SME with the potential for sustainable returns and greater market development.
Fourth, development actors should incorporate local market development in conjunction with blended finance activities. To ensure the sustainability of blended finance programs beyond the immediate term, the expansion of investment opportunities for SMEs will require adjacent development initiatives to address other local barriers to economic growth and prosperity. Using blended finance to grow investment opportunities for SMEs will only have long-term successful impacts if the local markets are being developed simultaneously. Organizations like USADF should look to partner with existing local markets to tap into their local knowledge, include some of their financing, and more importantly, develop existing market capabilities.
Finally, like local market development, ODA and grant allocations should be targeted toward investment facilitation and the strengthening of local advisory firms and intermediaries. It is important to combine technical assistance with other financing tools. In the longer term, an effective investment facilitation infrastructure will be critical to the development of a self-sustaining investment ecosystem and allow for continued engagement between African SMEs and commercial lenders at large. In fragile markets, there tends to be an absence of investment intermediaries capable of assisting in deal-sourcing and the long-term facilitation of private investment. Targeting local advisory firms and other intermediaries through grants and ODA allocations will be an essential step in overcoming this challenge. Expanding attention toward investment facilitation will also be critical for the sustainable success and impact of blended finance initiatives, helping drive SME markets toward a self-sustaining investment ecosystem.
Les Wathinotes sont soit des résumés de publications sélectionnées par WATHI, conformes aux résumés originaux, soit des versions modifiées des résumés originaux, soit des extraits choisis par WATHI compte tenu de leur pertinence par rapport au thème du Débat. Lorsque les publications et leurs résumés ne sont disponibles qu’en français ou en anglais, WATHI se charge de la traduction des extraits choisis dans l’autre langue. Toutes les Wathinotes renvoient aux publications originales et intégrales qui ne sont pas hébergées par le site de WATHI, et sont destinées à promouvoir la lecture de ces documents, fruit du travail de recherche d’universitaires et d’experts.
The Wathinotes are either original abstracts of publications selected by WATHI, modified original summaries or publication quotes selected for their relevance for the theme of the Debate. When publications and abstracts are only available either in French or in English, the translation is done by WATHI. All the Wathinotes link to the original and integral publications that are not hosted on the WATHI website. WATHI participates to the promotion of these documents that have been written by university professors and experts.