On the Frontiers of Finance: Investing in Sustainable SMEs in Emerging Markets

October 2007

Small and medium-sized enterprises (SMEs) are a critical component of vibrant economies. They play an important role in innovation, economic growth, employment creation and the provision of goods and services to underserved communities – especially in rural areas. However, in many developing countries and emerging markets, a financing gap exists, meaning that entrepreneurs are unable to access the capital they need to make their businesses successful. Too small for local banks, and too large for micro-finance, innovative approaches are needed to ensure that SMEs are able to access the right type of capital at the right time. 

Addressing this financing gap is a key concern not just for the local businesses, but also for multi-national companies looking to invest in emerging markets, as access to a stable supply chain and the existence of "clusters" are both recognized as key components of successful foreign investments. Indeed, in testament to the importance of SMEs, companies such as IBM, Cisco, Nestle, Shell, Green Mountain Coffee Roasters, and Dow Chemical all have innovative programs to support the SMEs that comprise their international supply chains and the SME sector in countries where they invest.

What is the state of sustainable SME finance?

The Center's Institute for Responsible Investment (IRI), with funding from the UN Foundation, convened two meetings in 2006 to discuss the current state of sustainable SME finance. Bringing together practitioners, companies, investors and development institutions, the IRI was able to start a dialogue around the barriers to be overcome to bring these funds to scale. The IRI then partnered with the World Resources Institute's New Ventures Program, a business accelerator for sustainable enterprise entrepreneurs in emerging markets, to build on these discussions with an in-depth survey of the approaches being taken to Sustainable SME finance, conducting a series of 20 interviews with fund managers to find out how their funds are structured, their approach to SME investment, the social and environmental impacts they are seeking, and the challenges they are facing in achieving scale.

The funds interviewed are all focused on investing in sustainable SMEs in emerging markets and developing countries. Some funds are based in the U.S., while others are internationally based with local offices and investment teams. (View a list of the funds interviewed.) The range of different business models they represent can best be captured by looking at the two ends of the spectrum that emerged:

• Locally based venture capital funds that are realizing opportunities for financial and sustainability returns by targeting growth sectors such as cleantech and renewable energy (VC Funds) 
• Internationally based funds with a primary focus on creating positive economic, social, and environmental impact by supporting sustainable SMEs and generating financial returns for investors (Capital Aggregators)

Researchers also interviewed two intermediaries that are working directly with local banks to increase their capacity to meet the financing needs of the SME sector: ShoreCap International (a subsidiary of ShoreBank Corporation) and Shared Interest (which operates an open-ended loan guarantee facility in South Africa). 

They found that the VC Funds were focused primarily on the financial opportunities presented by the sustainability sectors, making investments of between $1m and $5m – putting them at the "medium" end of the SME spectrum. Investors in these funds were international and included a growing group of local institutional investors.

In contrast, the Capital Aggregators seek out SMEs that have the potential to generate economic, social and environmental impacts. For example: job creation in underserved areas; provision of environmentally sound energy sources; sustainable agricultural practices and land management; and economically targeted investments that serve rural or disadvantaged urban communities. These funds raised what researchers describe as "blended capital," which combines investors seeking commercial returns with softer mission-focused funds from donors or foundation program related investments. The emphasis on the sustainability and financial returns varies among the Capital Aggregators and different combinations of blended capital are used in their investment structures.

With a few notable exceptions, much of the interest in Sustainable SME finance is relatively recent, with most funds established since 1998. With greater understanding of the benefits (and limitations) of microfinance institutions, the interest in Sustainable SME financing continues to grow. This interest exists not just in the development finance institutions, but also among corporations who are increasingly looking for ways to support SMEs in countries on their international value chain. 

Several of the funds surveyed received considerable support from companies in the form of technical assistance, investment capital, assistance with pipeline development and accessing international markets:

• Grofin has a close partnership with the Shell Foundation. Operating multiple SME funds throughout Africa, Grofin provides both debt and some equity capital to entrepreneurs who would otherwise be unable to access finance. As well as being investors in the funds, the involvement of Shell and other corporate investors contributes to developing the funds' investment pipelines.

 

• Root Capital provides short- and long-term loans to producers in rural, low-income communities in Latin America, Africa, and Asia with a goal of proving that these businesses are bankable. Root Capital uses a three way "factoring" model whereby loans are guaranteed with future purchase contracts that the SMEs hold with buyers, which include international coffee roasters such as Green Mountain and Starbucks. These companies are not only investors in the fund, but they also provide technical assistance to producers to enable them to access premium supply chains and are key customers of the SMEs. Further, these investments are not seen as grants, but rather investments in a secure supply chain. 

Despite this growing interest, researchers identified three key challenges that are faced by sustainable SME funds in reaching more SMEs and creating even greater development impact. These challenges are in addition to the already substantial institutional barriers that exist in the countries where the investments are being made.

• Designing a fund structure that enables a "blended capital" approach: combining profit-seeking funds with development-oriented funds and softer capital. This is a challenge not only from a legal standpoint, but also because it requires transparency around who is contributing what to the fund and effective communication of the role of each source of capital.

 

• Developing tools for monitoring and evaluation of the social, environmental and economic impact of the investments. In particular, the lack of standardization in impact measurement across funds was a concern. In an innovative partnership, Google.org and the Acumen Fund are currently developing an online platform for information collection and sharing. However, there is also a need for shared metrics in the sector to enable more donors and companies to understand the benefits of supporting sustainable SMEs.

 

• Meeting the costs and building capacity to provide technical assistance and business development services to entrepreneurs. These services are a key distinguishing feature of the Sustainable SME funds interviewed. By providing these services, lasting value is being created on the ground in the form of skilled managers or the technical know-how necessary for providing products or services. In addition, providing these services helps funds mitigate against the risk of business failure by adding insight to the due diligence process and alerting the fund manager to additional assistance during the investment phase.

Large corporations – whether locally based or multi-nationals – can also play an integral role in helping sustainable SMEs overcome the challenges they face. Identifying ways to work with financiers to advocate for a better business enabling environment, providing technical assistance and potentially capital for investments – all these contributions would foster a vibrant SME sector and simultaneously create business value by building stronger suppliers and stable, local communities. There remains room for further research to identify ways that corporations can contribute to supporting this vital sector. One of the IRI’s next projects will be to engage with corporations and foundations to help identify the resources that are available to build sustainable SMEs.

(Business Linkages: Lessons, Opportunities, and Challenges, a recent paper by Beth Jenkins of Harvard's CSR Initiative, describes ways that corporations are using "business linkages" to contribute to economic development across their value chains.)

Moving from the frontier to the mainstream

There is much work to be done to clearly define the sustainable SME finance sector as an "investable"' asset class – for both investors seeking financial returns, as well as those seeking environmental, social and economic returns. Investing in sustainable SMEs, in addition to supporting reforms of the institutional infrastructure in developing countries and promoting enabling business environments, can be a powerful intervention for achieving social and environmental benefits.

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