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New Banking Solutions
The funding of entrepreneurs and small and medium-sized enterprises (SME) is likely to become the next growth sector for bank lending globally, according to the ‘futurebankinglab’ conference, an international conference hosted in Madrid, Spainon the future direction of funding SMEs.
The conference was attended by 20 of the leading SME financiers in the world, with Standard Bank and Business Partners representing South Africa. Several differentiated models of funding were reviewed as to their applicability in other jurisdictions and by traditional banks.
One thing evident from this conference was that South Africa does not lag the rest of the world, and is ahead of many of the global banks. We have an increasingly strong entrepreneurial mindset when it comes to finding funding solutions in this country, and I came away highly encouraged.
Availability of finance
Under discussion was the poor availability of finance in the R400 000 to R20 million turnover space: called the ‘missing middle’ and which is the level of finance typically required by SMEs. This is a global phenomenon and by no means restricted to South Africa. Below and above that missing middle, finance is relatively freely available from various sources, including micro-lenders, banks and private equity investors respectively.
The funding gap is due primarily to the traditional way in which banks look at finance: typically requiring owner’s equity of anything up to 60 percent in the business, as well as collateral to cover the balance.
Given the high failure rate of SMEs, this traditional – and sensible approach if you’re a banker – does not cut it with the entrepreneur, a fact which is likely to become ever more the case as banks’ compliance with Basel3 kicks in. What entrepreneurs require is risk capital and capital to help manage their growth – not secured capital.
Risk capital is most commonly seen among development finance institutions (DFIs) when they offer what is often termed ‘patient capital’. This means structuring loans so as to preserve the cash flow of the fledgling business – with repayments ‘light’ at the beginning and increasing later on as the business stabilises.
The conference also emphasised the need to provide non-financial support such as: mentorship; business and financial skills development; and possibly even with the financier obtaining an equity stake in the business.
Essentially, what is needed for an entrepreneur is a tailor-made solution, one that especially offers a partnership approach and linkages to other institutions, like Raizcorp or Khula. However, such mentoring solutions are not at a mature stage in South Africa. Incubator models such as that done by Raizcorp, while very effective for individual businesses, do not scale up to the thousands, which is what is needed.
Those models that do scale up to the necessary volume are often inadequate for individual businesses. A voucher for two days of mentoring or writing a business plan is not going to fundamentally change a business.
There was a growing consensus reflected at the conference that SME lending is an asset class of its own requiring a different set of rules. Only once these are defined and entrenched in lending practices that SME financing will become the next growth phase for banks.
Lending to this category (R400 000 – R20 million turnover) demands a dedicated focus. It cannot simply be relegated to a Business Banking division. For one, the approach requires a much lower cost solution as the loans are of smaller value and the business cash flows are less predictable.
Finding new tools
To succeed in entrepreneur lending requires a new set of tools, and this is what the conference was investigating. Furthermore, while the lending has to be at a rate affordable to the SME it still has to be profitable for the lender.
There are typically two issues around repayment: ability to repay and willingness to repay. To assess the willingness to repay – at the approaches include assessments of the entrepreneur, particularly his character, capabilities, traits and past banking history, in the credit assessment process.
Standard Bank has recently undertaken a pilot using a detailed assessment of the entrepreneur and is currently already looking at the financial behavior of entrepreneurs prior to starting their business, as this allows us to draw up a set of assumptions regarding their likely subsequent behavior.
This reflects the need to develop the right lending products for this market, including unsecured loans for SMEs. Typically these include cash flow based lending solutions, supply chain finance and graduated loans.
The conference looked at several successful models from around the world, for their applicability in other markets. One model from Tanzania involved shifting the focus of financiers from inbound to outbound – in other words, getting out of the office and walking the streets of the local business community to finding viable businesses worthy of funding.
Another was initiatives in the business-to-business space, particularly in the US where peer-to-peer funding is being experimented with. I must emphasise that this model is in the very early stages.
Another theme was improving linkages between seed or risk capital partners and banks to provide more early-stage risk financing.
Niching is also going to be another part of the toolbox. This involves looking at a small geography, sector or community, and is currently most developed in the franchising market. By addressing the risks of a common activity or market, financing becomes more predictable.