In today’s Africa, perhaps the single most important responsibility that an institutional balance sheet brings with it may be the obligation to fund grassroots business growth.
However, those few financial institutions, including banks and large insurers and pension funds, that understand this are still not investing in small and medium enterprises (SMEs) because, theoretically, they can’t find the right mechanism.
The irony is that the mechanism – private equity – has been around and successfully active for decades.
The intention gap
One of the traditional problems with financing SMEs has been their high rate of failure. Almost 80% of start-up small businesses fail in their first year.
Inherently and properly risk averse, large financial institutions have, therefore, not wanted to expose their stakeholders to investment in a high probability of failure.
So, in spite of consensus in every part of the world that SMEs should be the engines driving national economies, in Africa, they remain unsupported financially and in terms of business expertise and market access by those organisations with the deepest pockets, largest operational footprints, and most extensive business networks.
It really is quite extraordinary, given the trend towards triple balance sheets that include social and environmental custodianship, that the power for good contained in the billions of dollars over which large national financial institutions exercise control is not applied where it can do the most amount of good in terms of the ripple effect it can directly trigger for communities whose need is the greatest.
By the same token, it would be reckless for large financial institutions to take the risk of investing in organisations with no track record, where balance sheets often don’t exist or are inadequately drawn up, where management and technology systems are absent, and where there are not enough assets to secure the kind of loan that would actually prompt an organisation’s growth. Particularly so on a continent where dire poverty has been the norm and, therefore, business education comes a poor second to academic education which, too often takes place under trees and without text books or qualified teachers.
That said, in exactly the same scenario, private equity in Africa has flourished.
Formula for success
Certainly, private equity’s stakeholder burden is not as unwieldy as that of financial institutions. And, by nature, private equity is entrepreneurial. So its risk appetite is greater. But private equity survives and prospers only because it gets higher returns on investment than institutions can offer – by investing in the very organisations that traditional financial institutions feel they can’t support.
Large financial institutions should, therefore, be able to use private equity firms to de-risk investing in SMEs.
Private equity thrives because it pro-actively seeks out the entrepreneurs with the best business propositions and then goes hands-on in the business to ensure that it prospers and is able to deliver the returns investors expect.
Private equity can, therefore, function not only as a financial institution’s eyes and ears in the SME sector in general, identifying opportunities, but also as its hands and feet inside a given business. By contrast, a financial institution’s input to a customer business is usually limited to general advice and the making of loans.
Also, while private equity firms flourish among entrepreneurs, they generally bring to the investee business the financial sophistication that is normally found only within large institutions. They also impose governance and financial best practice on investees in order to ensure effective returns to their own investors.
This provides comfort for institutions, because there is a shared language and governance platform on which to operate and, therefore, reduce risk.
In addition, private equity firms that have been operational on the continent for several years will have developed extensive government and commercial networks through which they both source business opportunities for themselves and build up- and down-stream relationships across multiple industries that represent market access for their investee companies. This also enables private equity firms to create synergies amongst their investees.
Entrepreneurs building entrepreneurs
Private equity’s greatest value to financial institutions, however, is probably the fact that private equity firms are the ultimate entrepreneurs, risking their own money on other people’s ideas. So, they are ideally placed to mentor the entrepreneurs in whom they invest.
Overall, private equity represents a total business package into which large institutions can tap to fulfil their modern obligation to grow the economy by growing SMEs.
Private equity is the ideal translation point between the SME sector and institutional finance, able to convert institutional requirements into on the ground operational outcomes for SMEs and render SME opportunities into real investment value for institutional stakeholders. It is, therefore, institutional finance’s most effective tool for meeting its responsibilities in leading investment in grassroots economic activity.