Equity capital for small business

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BENEL D. LAGUA

BENEL D. LAGUA

According to a World Bank report, the growth potential of the micro, small, and medium enterprises in the Philippines has not been fully leveraged. Among the indicators cited in support of that view are, low rate of business entry (the Philippines is among the bottom 15 percent of countries with the lowest rate of newly registered firms), low productivity (labor productivity of MSMEs is about one-third of that in Malaysia and one-twentieth of the MSME sector in high–income countries), and failure of most MSMEs to grow (the 2009 World Bank Enterprise survey showed that after three years only one percent of micro-sized firms moved to the medium-sized category.

This was the premise of a recently WB-sponsored workshop called “Increasing Philippines’ SMEs participation in the global value chain.” This column will however cover only one issue – Is there a role for equity or venture capital financing for improving the plight of MSMEs?

Access to finance is a clear concern of small businesses, ranking among the top three of most surveys, and to complete the menu, it would be ideal to make available all types of funds sources. Beyond loans, the risk or equity capital alternative must be offered. Equity funding means long term risk capital, oftentimes coming with management and technical expertise, thus enabling SMEs to undertake progressive and innovative ventures for making value-added products and to create new jobs. As this writer has written previously, firms with access to finance achieve larger employment growth than firms with no access to finance. In job creation, the gap between MSMEs with access to finance and MSMEs without such access is at least three times larger than the difference between large firms with and those without access to finance.

The reality, however, is that the overall market for risk and growth capital available to MSMEs remains limited and fragmented. Thus, there is the so-called “equity-financing gap” which may be difficult to estimate. The World Economic Forum has cited persistent need for equity capital for businesses that require between $50, 000 and $2 million in external funding, especially in emerging economies.

There are some local institutional investors that can commit large amounts of capital to MSMEs. However, even those who show an interest in supporting MSMEs are often restrained by their aim for market-based returns. The incentive structure for fund managers directs them towards less risky deals and inhibits the development of smaller but equally deserving companies.

Equity investors and venture capitalists naturally look for opportunities to invest in companies with predictable risk profiles, and these are available mainly in large and established companies than in MSMEs. The usual barriers are identified – higher transaction costs, elevated risk perceptions and greater information barriers. In the Philippines especially, few venture capitalists are willing to gamble in the smaller business segments. Those that actually do, engage MSMEs only as part of a social responsibility outreach.

It must be understood that the situation is structural and unsurprising. After all, equity deals require investment of time, energy and resources in conducting due diligence, negotiating deal terms, actual execution and management.

A developing country like the Philippines must, therefore, confront this structural issue to promote the development and expansion of venture capital for MSMEs. Structural reforms in the regulatory and legal systems must make the market attractive to investors. In most emerging economies, the route taken is by encouraging development finance institutions to take the initiative. These development finance institutions in turn collaborate with private fund sources to establish a public-private sector collaboration that mitigates the risk exposures on both sides. And there are incentives provided in the deal structure, and in the exit mechanisms.

The demand side of the equation also needs education and encouragement. Most MSMEs (mainly family owned businesses) are typically apprehensive and are unwilling to dilute their ownership and decision-making authority. The information barriers also make valuation difficult. Entrepreneurs are unfamiliar with equity finance and its exit mechanisms, and are unwilling to cede control and change the culture of management.

Without doubt, the presence of equity capitalists in its various forms – private equity investment, venture capital, or even angel capital – will make a substantial impact in expanding the base of MSMEs, especially in the innovative sector where productivity and new products and services can allow entry into the global value chain.

It is a mechanism that can propel the growth of promising enterprises. The challenges are many, but not totally insurmountable. We should perhaps empower development finance institutions to play a more active role in this arena. And we must break down the regulatory and legal barriers that limit the expansion of the equity market.

(Benel D. Lagua is the executive vice president at the Development Bank of the Philippines. He is an active FINEX member and a long time advocate of risk-based lending for SMEs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)

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