Can hybrid finance unburden Africa’s shaky SME sector?

For SMEs in Africa the effects of the pandemic have exacerbated a woefully under-financed area of the economy, but by cultivating the right environment and encouraging SMEs to formalise their operations, hybrid financing might provide the key to recovery

Workers at an apple factory in South Africa
Workers at an apple factory in South Africa 

It is tough being a small and medium enterprise (SME) in Africa, a continent where the SMEs sector is quite fragile. Nothing has exposed the apparent quicksand foundations of the sector more than the COVID-19 pandemic. With the crisis dragging the continent into its first economic recession in 25 years, SMEs bore the brunt with a majority sinking into oblivion. For those that have survived the pangs of the pandemic, rebuilding is bound to be torturous.

“COVID-19 had a knock-on effect for SMEs, forcing many to close or curtail operations,” says Manuel Reyes-Retana, International Finance Corporation (IFC) director for Africa. He adds that although the sector has demonstrated a zeal for resilience with many SMEs finding ways to stay in business, the damage has been substantial with a majority struggling to regain momentum.

For SMEs in Africa, the one challenge that has remained constant, and one that COVID-19 has yet again blatantly exposed, is how lack of access to finance makes the sector vulnerable. In fact, it’s been obvious that SMEs with relatively weak financial muscles have faced the most risk. Experts believe that for the sector to recover and build shock absorbers for long-term survival, adequate access to stress-free financing is paramount.

Hybrid finance is emerging as the ultimate solution in offering to achieve this. In Africa, the concept of combining debt and equity features into a single financial instrument is yet to set down roots. However, on a continent where SMEs are in desperate need of recovery and growth capital, hybrid finance has the potential to accelerate recovery of the sector and offer it a strong foundation going into the future.

“Hybrid financing is a more flexible tool for SMEs,” states Conor Savoy, senior fellow, project on prosperity and development at the Centre for Strategic and International Studies. He adds that development financial institutions (DFIs) have the ability to lead the way in creating financial instruments through which SMEs can access hybrid financing, thus giving the sector a more solid backing to pursue growth. DFIs have proved they can be an important source of equity in developing countries. Some are already investing as much as half of their portfolios in equity. “In exchange for a certain degree of ownership, equity investments provide an essential source of capital for firms without burdening them with loan repayments,” he notes.

Across emerging markets, Africa included, SMEs are the engine for economic growth, job creation and poverty alleviation. Ironically, they face significant financing gaps that stifle innovation and growth. The World Bank estimates that across emerging markets and developing economies, over 21 million SMEs constitute 45 percent of employment and 33 percent of gross domestic product (GDP). Despite their importance, they are grappling with a $4.5trn credit gap.

In Africa alone, according to the African Development Bank (AfDB), SMEs account for more than 90 percent of businesses and almost 80 percent of employment. Yet, the sector is facing a $421bn financing gap. In retrospect, this means that roughly half of small businesses on the continent cannot access the financing they need. The situation is even worse for micro enterprises, which are mostly informal.

Addressing the SME finance gap
Over the years, bank financing has been the traditional source of external financing for SMEs. Though to the extent banks have tried supporting SMEs, their rigidity in providing credit means that only a few qualify. Banks still cling to the mantra of SMEs being riskier than large firms. In Rwanda, for instance, a country where SMEs face a finance gap of $1.2bn, the share of total bank lending to SMEs stands at 17 percent compared to 60 percent for corporates. What makes this statistic more startling is the fact that SMEs comprise 98 percent of businesses in the country. In other countries like South Africa, Nigeria and Kenya, banks are more comfortable lending to the government, a strategy to stay away from risks associated with SMEs.

“Financial institutions will be more reluctant to provide additional credit to SMEs under the current conditions of COVID-19 given how cumbersome it will be for them to determine the extent and adequacy of collaterals, identify which borrowers are facing longer-term financial difficulties and be able to adequately cover monitoring costs,” states an AfDB report.

In effect, this means that COVID-19 has made it even more difficult for SMEs to access bank financing. Hybrid finance, however, can fill the vacuum. In the developed world, the concept has been instrumental in offering SMEs the lifeblood that has made the sector vibrant and given it the ability to withstand shocks. Instruments like subordinated loans/bonds, silent participations, participating loans, profit participation rights, convertible bonds, bonds with warrants and mezzanine finance provides SMEs with financing packaged in the form of debt and equity.

For SMEs, the packaging of products that are essentially debt with equity-like features comes with many benefits. First, the products are ideal because they allow SMEs to borrow long term and with limited or no collateral. This is because they align the profile of the debt repayments to the profit of the borrower.

Across emerging markets, Africa included, SMEs are the engine for economic growth, job creation and poverty alleviation

Second, the products include clear mentoring that is crucial in helping SMEs successfully run their businesses. For SMEs in Africa, lack of technical capacity is a key factor in the high rate of mortality. Third, and equally important, is the fact that they provide SMEs with stability. This is because the products are better suited for SMEs that have reached a high growth phase.

“We want to make this model replicable and expand it across Africa because of the products’ many benefits, which include diversified sources of funding, lower financing costs, greater flexibility compared to traditional bank loans and improved loan terms and conditions,” notes Reyes-Retana. The need to drive growth of hybrid finance aligns well to IFC’s commitment to being at the forefront of helping SMEs access financing. As of June 30, the financial institution’s committed SME finance portfolio was over $12.3bn worldwide, which represented a growth of 42 percent from financial year 2010. Of this amount, Africa’s portfolio stood at $2.6bn.

The right environment to thrive
Unlike other parts of the world, Africa is facing a herculean task in creating an enabling environment in order to attract hybrid finance. Top on the list is the need for SMEs to formalise their operations. It is near impossible for hybrid finance to flourish in an environment where businesses lack sophisticated financial records and proper governance structures. The fact that a majority of SMEs on the continent are family-owned means that the majority continue to pay lip service to accountability, transparency and governance.

“Making SMEs in Africa more formal is key in helping the sector become more sustainable,” avers Savoy. He adds that formalising the sector is critical in building a wider pool of businesses with the right capabilities to attract hybrid financing. Under the current setup, the available financing is competing for a limited number of companies. The companies become even more unattractive because other credit providers like banks, private equity and microfinance institutions among others are also courting them.

The continent must also resolve the challenge of lack of early stage financing. Hybrid finance is not really designed for startups. In essence, it means that governments and policy makers in Africa must provide financing to SMEs in their early stages and help them get to a point where they have the right structure to attract a blend of debt and equity. This is important considering the high rate of SMEs mortality. In South Africa, Africa’s second largest economy, research has shown that over 70 percent of SMEs fold within the first five to seven years of inception. In Uganda, about a third of new business startups do not go beyond one year of operation.

Another important factor is providing exit channels. Injecting capital in a business for an equity stake is undoubtedly a complex process. Exit opportunities are among the complex factors that investors must consider when assessing the viability of deals. In Africa, however, the tragedy is that the continent does not offer many suitable exit opportunities. Lack of well-developed and vibrant financial markets means that equity investors cannot take the option of an initial public offer (IPO) to exit from a business that has hit the maturity stage.

Work to be done
The state of the financial markets in Africa does not inspire confidence. According to the Absa Africa Financial Markets Index (AFMI) 2021, financial markets across the continent’s 23 top economies continue to score poorly across fundamental pillars like market depth, access to foreign exchange, market transparency, tax and regulatory environment, capacity of local investors, macroeconomic opportunity and enforceability of financial contracts.

“A vibrant capital market is one of the primary issues with equities,” explains Savoy. He adds that foreign investors are often reluctant to take up equity stakes in Africa’s SMEs because stock markets are relatively underdeveloped. This makes it hard to float an IPO and exit. “Deepening of the financial markets is critical because it creates opportunities for equity investors to exit,” he notes. An important aspect of making financial markets more vibrant is building the capacity of local investors, particularly retail investors, to participate in market activities. In a majority of the countries in the Absa index, foreign investors dominate about 70 percent of trading.

It is evident that it will take years before hybrid finance can take root in Africa. However, the enormous financing gap means that SMEs in the continent are in desperate need for additional financing solutions. Given the importance of the sector, it means the continent has little option but to create an environment for debt and equity instruments to thrive.