Most development experts agree that small and medium-sized enterprises (SMEs) can be effective at reducing inequality and promoting economic growth.
Yet, SMEs need equity to grow their businesses. Internal cash flows are often insufficient, and without adequate equity, banks turn their noses. There is less certainty among development experts, however, on the best way to help SMEs access that equity.
ADB looked into this issue in Sri Lanka and recently released a report on its findings. Although the country has few private equity firms, they have enjoyed some recent momentum and have provided equity to successful small businesses that want to expand. Sri Lanka also has angel investors that make small investments in startups that often have little more than a simple business plan.
The middle space—between private equity firms and angel investors—is traditionally occupied by venture capital firms, or VCs. VCs specialize in investing in firms with proven business ideas, but need more equity to expand sales growth. In Sri Lanka, this middle space is a chasm.
VCs wouldn’t have much difficulty finding promising Sri Lankan firms led by smart, hardworking entrepreneurs. But their problem would arise 4-6 years later, when the VC needs to resell its investment in order to return money to its investors.
It’s quintessential “exit” risk.
Sri Lanka is not a large market, like India. Although substantial progress has been made in the last decade, it is not a wealthy country like Taipei,China or the Republic of Korea. Sri Lanka is also not tightly integrated with its neighbors, so it can’t benefit from millions of investment dollars like Central and Eastern European countries following their accession to the EU. Given these constraints, investors may have limited appetite to invest in Sri Lankan SMEs, which means VCs will struggle to find the exit door.
There is a second problem: SMEs may not want the money. Or more accurately, SMEs may want the money but are unwilling to relinquish the control that a VCs would typically expect.
VCs are deterred by exit risk, while some SMEs are unwilling to cede control. It’s a difficult situation. One possible solution is to forego traditional “pure” equity and explore hybrid forms of capital, in particular subordinated debt and revenue-based instruments.
Subordinated debt is a well-established product. It’s similar to debt in that it has a defined repayment schedule and interest payments, but in the event of a default, its payments are second to those of senior lenders.
Revenue-based instruments are less common but have been used successfully in other emerging markets. In Sri Lanka, they could be structured as preferred shares that entitle the investor to a portion of the investee’s revenues for a defined period of time but that don’t carry voting rights. Unlike subordinated debt, whose scheduled repayments are independent of company performance, revenue-based shares do well when the company does well and poorly when business is bleak.
Both provide some of the benefits of equity without some of the features that SMEs or VCs find unpalatable.
There are, of course, risks in structuring a Sri Lankan VC fund around these instruments. They do not carry the same potential upside as equity, and without a large payoff, will qualified investment managers be interested?
If government support is needed to start the fund, could the corporate governance be structured to limit the risk of interference? Since SMEs can sometimes be quite creative in avoiding taxes, would they also be able to divert cash away from revenue-linked shares?
These risks suggest that any Sri Lankan intervention should first be piloted.
Within three years we will know if SMEs have appetite for equity in these forms and if the returns are real. A pilot, of course, raises the administrative costs, which are now being spread over a smaller base and create a further drag on returns.
Yet, this makes the case for government support even stronger, for its interests will not be in capturing every rupee of upside but rather in developing a new conduit for VCs to reach promising SMEs.