SME Financing

Small and medium-sized enterprises (SMEs) are widely recognized as the backbone of emerging economies and a major driver of job creation. These are businesses with between 10 and 250 employees and an annual turnover of up to $15 million. In developing countries, SMEs make up about 90% of the private sector and create over 50% of jobs, and in Africa SMEs account for roughly 80% of all employment. With unemployment, specifically youth unemployment raising, millions of new yobs are required and expanding SME activity is imperative for employment opportunities and reducing poverty.

One way to expand SME activity is by providing finance to unlock their growth potential, which in turn leads to more jobs. Unfortunately, lending to SMEs poses high risks for lenders and investors, and the risk increases even more if loans are extended to “unbankable” SMEs. Unbankable SMEs are businesses unable to get finance from commercial lenders for several reasons, limited credit history, lack of formal financial records, little or no collateral, and weak property laws. High transaction costs also play a major role for both the SME and the lender. The cost to evaluate, monitor, and service a small loan is high relative to larger loans, so commercial banks shy away. Even when a loan is granted, the interest rate is normally very high, and if a business misses a few repayments, then it often struggles with repayments from there on.

tions that algorithms might miss.

Financing SMEs is not only risky on paper but has also proved costly in practice. Over the past decade, many investment funds targeting SMEs have delivered poor financial performance and analyses by development finance institutions show that SME funds, even when successful, tend to deliver lower returns compared to traditional private equity or venture capital funds.

In some cases, once the “first loss” capital (those that have) is exhausted, the running cost of the fund starts to erode the investors’ capital. In my own experience being involved with several “traditional” SME finance funds in Africa and the Middle East, I observed this pattern repeatedly. These funds were typically set up with an offshore holding company (e.g. in Mauritius) and branch offices in each country of operation, plus a centralised services office handling accounting, investment decisions, and risk management. The cost to run this kind of staff heavy operation is very high and, when weighed against the low returns from the funds’ portfolios, the operating cost eventually eats into the investors’ capital. Understandably, after seeing their capital erode by a fund’s operating cost, investors often decide not to continue investing in such funds.

Many who enthusiastically backed traditional SME finance a decade ago have since moved on to other sectors. As the saying goes, “you can't keep flogging a dead horse".

However, most fintech lenders in Africa are geared toward smaller, short term loans for the MSME segment rather than the larger, job-creating segment of SMEs. Their lending models typically prioritise scale and speed, offering quick loans with interest rates well above traditional bank rates all with minimal human involvement. The financial model is to rely on the assumption that the portfolio’s good clients will cover the losses of the defaulting clients. This effectively penalises the very people and businesses that are operating responsibly who pay very high interest rates to subsidise the defaults. In my opinion this model creates a cycle where struggling businesses are burdened more than being supported. SMEs requires larger, structured, longer term finance and ongoing business support to truly grow, become sustainable and create jobs, something that most digital lenders are not set up to provide.

We are left with a catch 22 situation: Traditional SME lending models are too costly to sustain, while purely digital lending models lack the depth and structure needed for real SME growth. Neither model fully addresses the financing gap for SMEs in emerging markets and the question then becomes: How do we bridge this gap and make SME financing work in a sustainable way?

In recent years, there has been a significant rise of fintech companies in Africa offering digital finance, including loans, primarily to MSMEs and to a lesser extent, to SMEs. Fintech lenders are able to leverage technology and data to mitigate some risk factors (like lack of credit history and high transaction costs) that made traditional hands on SME lending so risky. Investors have been more inclined to invest directly in such fintech ventures, which promise lower risk and potentially better returns than traditional SME funds.

Despite the attraction of fully digital solutions, my 15 years of experience in SME finance across Africa and the Middle East has shown that certain critical risk mitigation steps cannot be effectively done without human intervention. These include:

Due Diligence: In many developing countries, basic company records are not digitalised. Verifying a business’s registration, ownership, licenses and tax compliance often requires in person checks with local authorities and scrutiny of paper records.

Business and Collateral Analysis: Every SME is unique. Assessing business viability and valuing collateral (whether property or equipment) is best done by an independent expert. Important documents like land titles or ownership certificates usually must be examined manually.

Enforceable Contracts & Collateral Registration: Loan agreements and collateral documents need to be customised to each deal. Standard templates are not suitable as legal jurisdictions and asset types vary. Creating solid contracts and physically registering collateral charges with authorities is a person intensive process.

Periodic Client Meetings & Support: Face-to-face visits allow investment managers to spot early warning signs, understand the client’s situation and challenges, and provide hands on advice. Regular interaction builds trust and helps pre-empt problems.

Debt Recovery: Recovering debts or repossessing collateral requires boots on the ground. Negotiations, legal actions, and auctions of assets are case specific and cannot be done by a digital system.

These steps highlight why a purely digital approach to SME finance can’t address all the risks involved, particularly when lending to semi formal businesses in emerging markets.

Human insight and local presence remain necessary for dealing with more complex transactions that algorithms might miss.

Disclaimer: The ideas and information shared in this article are based on my experience and research, and are intended for general information only.