Stimulating Investment in Emerging-Market SMEs

Oct 01, 2009

Small and medium-sized enterprises are considered critical engines for job creation and economic growth, but risk capital is largely unavailable to these businesses in developing countries.

In developed countries, small and medium-sized enterprises (SME) account for 57 percent of total employment and just over half of gross domestic product. Among low-income countries, SMEs contribute just 18 percent of employment and 16 percent of GDP. If barriers to their growth were removed, SMEs would impact economic development by providing jobs and income, expanding the middle class, broadening the tax base and ultimately decreasing poverty levels.

To identify the obstacles and devise potential solutions, a diverse group of fund managers, investors, entrepreneurs, researchers and representatives from development finance institutions met for a Financial Innovations Lab in February 2009 in New York City.

The biggest barrier they found to attracting foreign capital for SMEs is that exiting investments in developing nations is difficult and discourages investors. Among the potential solutions to this illiquidity:

  • Create an exit finance facility. The facility would provide peer-group lending leveraged by an organization such as the Overseas Private Investment Corp. to help investors sell their stake.

  • Create a permanent capital vehicle. Two types of PCV structures were proposed. One was structured much like a business development company in the United States, and the second was structured as a mezzanine buyout fund.

  • Use the royalty model. Royalties, a percentage of a company's revenue or sales, give the investor a stream of capital over the life of the investment and allow the typically cash-strapped investee to make a smaller payment when the investor exits.

    The group also found that investment returns are not fully risk-adjusted, and sources of capital have little access to credit information about these enterprises. Solutions to these obstacles included creating regional investment funds and grant-based pools for technical assistance and matching investors to entrepreneurs through Internet platforms.