The Role of capital markets in empowering SMEs

Small and medium-sized enterprises (SMEs) comprise the backbone of our economy, according to some estimates, SMEs account for 90 percent of all companies (and businesses), providing over 80 percent of employment.
SMEs continues to be fundamental to the future economic success of our country, with the potential to facilitate establish a new middle class and boost the demand for goods and services. SMEs role in driving innovation, creating employment opportunities and therefore contributing to domestic wealth creation routes is critical for sustained economic development.
Despite their crucial role in driving the country’s economic development, evidences suggest that SMEs experience a severe shortfall in financing which hinders their growth. With all fairness, the challenge of SMEs financing is wide and large, a study conducted by Investisseurs & Partenaires found that 40 percent of SMEs in Africa identified the primary factor constraining their growth as accessing finance, and according to a recent report by the London Stock Exchange Group (LSEG) Africa Advisory Group, the current funding gap for SMEs in Africa is estimated to be about US$140 billion.
Ultimately, the lack of funding results in thousands of SMEs being forced out of business within a few months of beginning operations and significantly inhibits their ability to reach their full growth potential and become the future ‘blue chips’.
The lack of funding for SMEs calls into question how well our domestic capital market is serving the needs of these companies, who form the bulk of our business universe. In general, the purpose of capital markets is to promote growth in the economy by providing capital for enterprises to innovate, expand and create jobs — for an economy to efficiently work, capital must flow from investors to businesses, ranging from the largest companies to SMEs and entrepreneurs, instead of being concentrated on the large and well-established firms.
According to the research conducted by the LSEG Africa Advisory Group to the continent, there is a significant lack awareness by potential as well as entrepreneurs of the variety of financing options available to SMEs to support their growth trajectory. These options range from microfinance and angel investing to venture capital, banks, private equity and potentially listing on local exchanges. This unfamiliarity has resulted in low levels of domestic participation in the capital markets, leaving local equity markets underdeveloped. This contributes to the lack of depth and liquidity within domestic capital markets, which eventually results in a smaller Initial Public Offering (IPO) pipeline for local exchanges.
As a result, SMEs seeking to raise capital have traditionally relied on bank loans. The result is excessive dependence on the banking sector – specifically, on bank loans. As such, the financial sector has continued to grow around this common notion, with banks and other stakeholders focusing their operations on bank loans and debt financing.
As it were, the type of financing (equity or debt) that would best suit a company’s needs is heavily dependent on a company’s stage of development. For instance, debt is form of capital raising that would suit a well-established company. That said, the same would not apply to a high-growth SME where funding is required in order to finance expansion. As such bank loan financing leave a small company prioritizing loan repayments or face risking default.
In our context, the business environment poses some obstacles to debt-financed SMEs. My experience, based on personal observation, experience and engagements with various stakeholders, and supported by other studies; the following issues, as far as the matter of SMEs financing (by banks) is concern, concerns SMEs: (i) some banks constrain SMEs participation in their line of business due to the use of sophisticated scoring models when assessing creditworthiness for SMEs, it is well known that SMEs often lack the track record and meaningful data inputs required by banks; (ii) some banks do not use credit scoring for SMEs and prefer to focus on relationship-based lending — a consequence of this is that some of our banks experience higher rates of non-performing loans; (iii) credit bureaus, as good the concept as is, but have predominantly served as a negative reinforcement tool as a result of the harsh measures that some banks ends up taking in the case of delayed payments by SMEs – SMEs run the risk of being ‘blacklisted’ if a single loan repayment is delayed (caveat: this matter is somehow complicated because of regulatory and compliance); and (iv) some lenders seek prohibitive high collaterals to mitigate the high, and often unquantifiable, credit risk associated with lending to SMEs, again – this is a regulatory requirement.
As such, it is crucial for us to unleash the potential of equity capital to support SMEs that are so vital to the future of our economy. With the right combination of advice and support, SMEs can navigate the challenges, identify the right forms of equity capital raising and drive growth to support the economic development as envisaged. While the launch of EGM segment within the DSE was supposed to be far beneficial, but without the right training and a supporting advisory community, as has been the case thus far, the EGM segment is likely to be left untapped. In the these past 5-years since introduction of EGM only five companies have accessed the segment raising just over Tsh. 50 billion – definitely a relatively small amount, given the potential.

As indicated, limited capacity among SMEs in the successful and sustainable running of businesses has led to diminishing trust among stakeholders who could potentially provide much needed equity capital, leading to such stakeholders rejecting financing options for SMEs. Some of the key capacity gaps that SMEs face, which hinders their access to financing, especially equity finance, include:
Fear of control loss: one major concern that SMEs have regarding equity financing is the loss of control. Many SMEs are unwilling to accept external investment and bring in new partners, as they fear relinquishing control of their company. What we normally hear from SMEs owners, is that entrepreneurs would rather own 100 percent of one than 10 percent of a hundred. Additional observations, recent times, show that this culture is starting to change, albeit slowly, as SMEs are becoming exposed to the success stories of peer companies that have benefited from external financing, both at the regional and international level.
Good governance for growth: many SMEs are unaware of the importance of strong governance for business sustainability and growth, and hence their lack of access to expertise that could improve their management structures and practices. In many cases, company board of directors are lacking altogether, with no substitute structures in place to provide sound input, hold management accountable, oversee independent audit or remuneration decisions, or perform other traditional board functions. However, institutions such the DSE, CMSA, Institute of Directors in Tanzania Government-sponsored bodies and development financial institutions, i.e. the International Finance Corporation (IFC), sometimes help train and advise SMEs on the importance of following best governance practice.
Lack of transparency: many SMEs do not have mechanisms that safeguards operating and financing processes and preserve the integrity and transparency of their operations in order to ensure that deserving SMEs receive their fair share of financing. The preference by many enterprises to pay a lesser share of their tax obligations could be one of the reasons for lesser embrace of transparency.
Financial reporting: some SMEs do not have credible audited financial information to provide to potential investors. Entrepreneurs often lack the resources to prepare accurate records, or access to an external service provider that can produce better records on their behalf. As a result, many SMEs continue to struggle to produce accurate, useful financial information without increased access to financial education and awareness of the value of this information.
Sustaining growth: lacking a strategic vision and strategic plans for how to grow the business in a sustainable manner is also preventing many small companies from scaling up. Even when a temporary revenue boost presents itself, it is almost never sustainable. A growth strategy plan is often not present, restricting long-term success.
Retaining talent: growth SMEs often underestimate the importance of managing talent by seeking to attract, develop and retain individuals who are valuable to the company. This ultimately restricts the company’s performance.
Initial Public Offering (IPO): there is a general lack of familiarity with the IPO process, from access to finance, to listing requirements, to the benefits of being a public company in term of easy access of future financing from a broader base of existing and potential investors. Many SMEs regard IPO process as unachievable or too complicated, to the extent that many SMEs would not seriously consider accessing public money and list into the stock exchange. Becoming a public company is, however, a significant contributor not only to the development of a company, but to the further robustness of the local capital markets.
Despite the existence of capacity-building and scale-up programmes, such as incubations, but according to assessments based on publicly available information there are just few incubators in existence, and have limited capacity, i.e. most incubators can only support around 20 SMEs per year on average, which is only a small fraction of the SMEs that could benefit from such services. Moreover, that ecosystem has focused on more ICT-related sectors rather than agriculture or healthcare or energy, where more patient capital is needed. Moreover, there is a general lack of trust between SMEs and support providers, and so although business support providers are emerging, a lot of SMEs aren’t using them because of a lack of knowledge and trust between the service provider and the SMEs.
Lastly, angel investors and venture capital funds, which would normally provide equity finances to SMEs are almost not in existence, currently less than a percent of start-ups are being financed by formal angel investors and venture capital funds. There is a positive trend, however, with the number of visible angel investor groups, networks and initiatives having recently grown. For instance, the establishment of the World Business Angels Investment Forum – WBAIF Tanzania Chapter may add an impetus. However, capital remains scarce and the industry-specific knowledge and mentorship of these angels is limited.
To conclude, the existence of this profound financing gap preventing efficient deployment of private capital can be largely attributed to a lack of visibility of these companies to early-stage investment. Many investors do not feel comfortable investing in SMEs on the grounds of unestablished credibility and lack of trust, as a result entrepreneurs are forced to finance the growth of their businesses independently.

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