The proposed guidelines to allow retirement benefit schemes to invest up to 10 per cent of their assets in private equity and venture capital funds opens a new avenue for the growth of medium enterprises, SMEs that need to scale up operations. It also marks what could be a turning point for venture capital and private equity as an emerging industry in the country.
Access to affordable credit remains one of the main barriers towards the growth and vibrancy of entrepreneurship. In fact, the medium enterprises are perhaps the most severely starved of finances. On the lower end of the spectrum, small and micro-enterprises can thrive with unsecured funds from personal savings, friends, family and the microfinance institutions. On the upper end, established companies are better placed to negotiate with mainstream financial institutions for favourable interest rates. In the middle we have the medium enterprises whose requirements are above those of the micro-enterprises, but they do not have the bargaining power of established companies.
They are the missing middle, neither targeted by the social schemes of government and non-governmental organisation nor fitting into the capitalist world of the bigger brothers. Yet these are the precise kind of enterprises that are needed to create jobs and grow the economy, especially in our developing economy. Instead, what we have are a large number of micro-enterprises and some large companies, but far fewer medium enterprises. In the more developed economy, medium enterprises are credited with over 50 per cent of wealth of the economies as measured by Gross Domestic Product and over 60 per cent of employment creation. However, in developing countries, they contribute less than half of that; creating about 30 per cent of employment and 20 per cent of GDP.
Why the medium enterprises are missing in action in the developing countries, where they are needed most is worthy of policy intervention.
In attempting to explain the plight of the missing middle, some researchers point to hostile business environments that do not promote growth. In particular, high taxes and restrictive regulations mean that only large firms can survive while others have to fly under the radar by staying small and informal.
Yet to grow the economy and create jobs, small and informal micro-enterprises should graduate to medium enterprises. Besides, a medium enterprise is likely to have a high growth rate and return on investment because it often represents entrepreneurship that has succeeded in the start up phase and is now ready to scale up. Furthermore, research has shown that SMEs tend to hire and train low-skilled workers and promote from within, demonstrating that SMEs are more effective in generating jobs for the low-skilled workers that dominate the labour market in our country. Each Sh100 invested in an SME generates on average an additional Sh1,000 in the local economy.
The multiplier effect both quantitatively and qualitatively is experienced by multiple stakeholders including employees, suppliers, the government, the local community as well as the broader local economy.
Even though the impact of a hostile business environment cannot be underrated, most medium enterprises point out access to finance as the most significant barrier to growth. Most medium enterprises are often in the growth phase of the business cycle where large funds may be needed for capital investment and working capital purposes. Besides, at this stage, return on investment is significantly higher than for most established large companies and they have already weaned off the start up risk.
The opportunity to tap into the massive funds held by retirement benefits schemes may be the new growth driver for SMEs. The retirement benefits industry holds more than Sh600 billion in assets, and investing 10 per cent into private equity and venture capital funds will means up-to Sh60 billion can be available for investment. Traditionally, almost 35 per cent of the retirement benefits schemes investment has been held in government securities, more than 25 per cent in quoted equities, about 20 per cent in real estate, about 10 per cent in guaranteed funds, five per cent in fixed income and the remaining five per cent in offshore, cash and unquoted equities.
More specifically, only about one per cent of the investment is held in unquoted equities, the class of assets that comprises of private equity and venture capital. Scaling this to 10 per cent will therefore provide an opportunity for schemes to diversity their investments as a risk management strategy and also as a means to increase their return on investment.
Medium enterprises will also benefit greatly by tapping into the private equity and venture capital funds. The advantage of venture capital funds is the flexibility to start with people and their ideas and work towards figuring out the numbers, a risk tolerance that would greatly benefit entrepreneurship. Some of today’s giants such as Apple were moulded by venture capital that provided not only the funding but also some experienced executive to work alongside the entrepreneurs and innovators.
On the other hand, private equity funds will often target existing, but under optimised companies, most of which are in the missing middle segment. The aim is to restructure the company and optimise its financial performance. When it works right, it can save a poorly performing company from bankruptcy and turn it into a thriving profitable enterprise.
Besides the financial benefits, investment by third parties into SMEs will also tend to help companies to formalise their business practices and improve governance. In return, the SMEs have the opportunity to achieve higher growth rates and become successful and sustainable enterprises. Successful SMEs are a large source of employment as well as economic stability and growth for the country.
Karen Kandie is a financial and risk consultant with First Trident Capital and a PhD candidate in finance at Catholic University of Eastern Africa.