Securities

SECURITIES AND EXCHANGE COMMISSION
NIGERIA

MAKING CAPITAL MARKETS WORK
FOR SMEs in AFRICA

2010 Kikonyogo Capital Markets Awards
Kampala, Uganda

Arunma Oteh
Director-General
6th May 2010

1. Introduction

1.1 The 21st century is being touted as Africa’s century. This is because since the
beginning of this decade, African growth rates have finally exceeded those of the
world in general- a very welcome and positive development. Since the mid 1990s,
the percentage of the population living with less than US$1 per day and less than
US$2 per day has declined1. Between 2001 and 2008, growth in gross domestic
product (GDP) on the continent averaged 5.9 percent annually. This growth was
accompanied by significant flows of FDI into the region, leading to a near doubling
of FDI stocks between 2003 and 2007 according to UNCTAD. In 2008, Africa grew
by an impressive 5.2 percent; the sub-Saharan African (SSA) region grew even
faster, at 5.5 percent. While this growth has allowed African countries to reduce
poverty in recent years, income levels remain low and there is still much to be
done in order to realize the MDGs by 2015. The African growth rates also
continue to be much lower than those of the group of developing countries from
Asia, a region that has raised the living standards of its citizens significantly over
recent decades. The financial crisis around the world also played a part by halting
and worsening a lot of the progress that has been achieved.

1.2 Nonetheless, recovery from the crisis is currently under way across the
continent. We have seen the results of prudent macroeconomic policies over the
last decade. This was one of the main reasons why the issues arising from the
financial crisis were curtailed. The next step we have to take is to focus on other
necessary reforms that will lead to economic development. One such is to create
the enabling environment that will support the real sector, such as small and
medium-sized enterprises (SMEs). Our growth story needs to continue and this
can be facilitated through the diversification of our economy. An excellent
channel is through the development of our financial systems. Our financial
systems are currently dominated by the banking system which means there is an
urgent need to develop our financial markets. Financial deepening especially
helps those industries more dependent on external finance and also helps to
reduce financing constraints, particularly for smaller firms. SMEs are the

1
Regional Economic Outlook, Sub-Saharan Africa- Back to High Growth? April 2010

1

backbone of an economy and therefore one of the key roles the financial markets
can play is in the provision of finance to SMEs.

1.3 The paper is organized as follows: Section 2 discusses the definition and
characteristics of SMEs as well as the value they bring to an economy. Section 3
mentions the constraints faced by SMEs in Africa. Section 4 analyzes the reasons
why financing SMEs is important and the constraints they face when accessing
finance. Section 5 discusses the role of capital markets in economic development.
Section 6 considers capital markets as an alternative form of finance for SMEs in
terms of equity financing and venture capital and the constraints they can face.
Section 7 highlights key intervention in promoting SME development and looks at
what various jurisdictions are doing. It also looks at the role of government and
international finance institutions in developing SMEs. Section 8 makes some
recommendations before the conclusion in section 9.

2. What are SMEs?

2.1 The definition of SMEs varies depending on the region/country and the
threshold that is used. Definitions in use today define thresholds in terms of
employment, turnover and assets2. In the United States, small businesses that
are defined by the number of employees, refers to those with fewer than 100
employees, while medium-sized business often refers to those with fewer than
500 employees. In the European Union (EU), companies with fewer than 10
employees are defined as "micro", those with fewer than 50 employees as
"small", and those with fewer than 250 as "medium". For developing countries,
small-scale enterprises would generally mean enterprises with less than 50
workers and medium-size enterprises would usually mean those that have 50-99
workers.

2.2 In Nigeria, for example, the criteria of employment and paid up capital is used.
Small enterprises are defined as those employing less than 50 people with assets
(excluding land and buildings) below N50m ($328, 947) and a ‘medium’ enterprise
in Nigeria is seen as one which employs less than 200 people with assets less than

2
Causes for SME Financing Difficulty, International Journal of Business and Management, Vol.4, No.6, June 2009

2

N500m ($3,289,473). In Uganda, a small-scale enterprise is an enterprise or a
firm employing a maximum of 50 employees, with the value of assets, excluding
land, building and working capital of less than Ug.shs 50 million (US$ 30,000), and
the annual income turnover of between Ugshs.10-50 million (US$6,000-30,000). A
medium-sized enterprise is considered a firm which employs between 50-100
workers3.

2.3 SMEs are a very heterogeneous group. As Kristine Hallberg describes it, they
include a wide variety of firms—village handicraft makers, small machine shops,
restaurants, and computer software firms—that possess a wide range of
sophistication and skills, and operate in very different markets and social
environments. Their owners may or may not be poor. Some are dynamic,
innovative, and growth-oriented; others are traditional “lifestyle” enterprises that
are satisfied to remain small4.

2.4 SMEs are the main source of employment in developed and developing
countries alike. In the US for example, the SME sector is said to provide 67%
employment and 61% manufacturing sector output. In Korea, there are over 30
million SMEs constituting about 99.9% of the enterprises and employing over
88.1% of the labour force. Similarly, in Africa, SMEs comprise over 90% of African
business operations and contribute to over 50% of African employment and GDP.
In Nigeria, SMEs account for some 95 per cent of formal manufacturing activity
and 70 per cent of industrial jobs. The real sector of the economy, comprising
manufacturing, solid minerals and agriculture sectors- is where most SMEs fall
into. They employ an average of 50 percent of the working population as well as
contributing up to 50 percent to Nigeria’s industrial output. In Morocco, 93 per
cent of all industrial firms are SMEs and account for 38 per cent of production, 33
per cent of investment, 30 per cent of exports and 46 per cent of all jobs5. These
examples confirm that SMEs are an integral part of society and that they are
critical to economic development.

3
Louis Kasekende and Henry Opondo (2003) Financing Small and Medium-Scale Enterprises (SMEs): Uganda’s
Experience, Bank of Uganda Working Paper
4
Kristen Hallberg, A Market-Oriented Strategy for Small and Medium-sized Enterprises, IFC Discussion Paper No.40
5
Source: African Development Bank and OECD Development Centre, African Economic Outlook (2004-2005)

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The Value of SMEs in an Economy

2.5 Entrepreneurial activity is crucial to fostering economic and social progress on
the continent. The Global Entrepreneurship Monitor, a research program aimed
at assessing the national level of entrepreneurial activity in selected countries,
conducted an entrepreneurship and economic growth study on 37 countries in
2002. According to the study, the economic growth of a country is directly
correlated to its level of entrepreneurial activity. In particular, there is a high
correlation between economic growth and entrepreneurial activity in
industrialized countries. For instance, the American economy is well known for its
flexibility, adaptability, and grasping of opportunity partly because of a
prevalence of entrepreneurial culture in the United States. According to the
report, countries that are able to replenish the stock of businesses and jobs and
have the capacity to accommodate volatility and turbulence in the
entrepreneurial sector are best placed to compete effectively.

2.6 Looking at a specific country, in 2003, Uganda was ranked the most
entrepreneurial country in the world amongst the Global Entrepreneurship
Monitor countries with a Total Entrepreneurial Activity [TEA index] of (29.2)
signifying that 29 out of 100 Ugandans – almost every third Ugandan is engaged in
some kind of entrepreneurial activity6. This index was extraordinarily high in both
men and women. Entrepreneurship in Uganda is inspired by both “necessity” and
“opportunity”. Of the 41 countries in the study, Uganda came first followed by
Venezuela, Thailand and Mexico. Countries such as Croatia, Hong Kong, Japan
and Belgium were ranked at the bottom. This was a remarkable achievement
because Uganda outperformed many countries that are more developed and
known for their entrepreneurship, including the United States which came 12th.
Entrepreneurs and SME development can play a key role through their
contributions to economic advancement and social empowerment. They also
play a part in poverty reduction, thereby contributing to the realization of the
MDGs.

6
Global Entrepreneurship Monitor, 2009

4

2.7 SMEs add value because they are the emerging private sector in developing
countries and thus form the base for private sector-led growth. Economically, the
presence of SMEs stimulates markets. Entrepreneurs create new enterprises,
new commercial activities and new economic sectors which have a positive
multiplier effect on the economy. They generate jobs for others; increase
research and development; produce goods and services for society; introduce
new technologies and improve or lower cost outputs; and they earn foreign
exchange through export expansion or the substitution of imports. Their
presence is crucial not only for improving the number of employment
opportunities for the poor but also the variety and quality. SMEs are the brains of
an economy and providing them with an environment to flourish helps foster a
knowledge economy. SMEs are also said to be more innovative than larger firms.
In developed countries, SMEs often follow “niche strategies,” using high product
quality, flexibility, and responsiveness to customer needs as means of competing
with large-scale mass producers.

2.8 For many developing countries, the promotion of SMEs has also been a
powerful engine of wealth creation. It helps create wealth for individuals seeking
business opportunities and provides them with the chance to pursue
entrepreneurial aspirations. Both a new business and the wealth the owner can
obtain will help boost the economy by providing new products as well as the
spending power created for the entrepreneur. It is also often said that SMEs
contribute to a more equal distribution of income or wealth. To the extent that
SME owners and workers are in the lower half of the income distribution,
promoting the growth of SMEs may lead to a more equitable distribution of
income. Socially, self employment serves to empower people and generates
innovation and changes mindsets. Therefore the promotion of SMEs is a
necessary component in trying to achieve economic and social advancement in
Africa.

2.9 Supporting SMEs will also encourage and enhance the participation of women
in the economy since most SMEs are owned by women, especially in the
agricultural and informal sectors. Available data shows that they grow up to 70%
of the food produced on the continent. We are seeing a growing class of
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determined women who own their small businesses and they are increasingly
being engaged in formal employment and entrepreneurship. They also play
substantial roles in micro and small scale businesses and trade and they make up
about 60% of the informal sector. Table 1 shows the share of micro, small and
medium scale enterprises (MSMEs) owned by women in six Sub-Saharan African
countries7. The table clearly shows that most of the countries have a majority
female ownership of MSMEs which has in turn led to a majority of female workers
in the enterprises.

Table 1: Share of MSMEs Owned by Women in Selected African Countries

Botswana Kenya Lesotho Malawi Swaziland Zimbabwe
% of MSMEs owned by women 75 46 73 46 84 66
% of women workers 67 40 76 40 78 57

Female entrepreneurship can be a driving economic force to spearhead job
creation, increase production, boost market innovation as well as augment
human resources and skills development. World Bank research has established
that women are more likely than men to contribute additional income to
household poverty reduction, meaning that giving more women access to credit
and increasing their economic power is likely to translate into improved
livelihoods for a higher proportion of society8.

2.10 Entrepreneurship and business creation are also a growing alternative for
young people whose age group often faces a labour market with high
unemployment rates. Traditional career paths and opportunities are gradually
disappearing and many young people are taking up the challenge of starting their
own businesses as an alternative form of employment. Many countries and
several international donors and institutions have identified entrepreneurship as
a key priority in the promotion of youth livelihoods and employment9. Indeed,

7
AfDB-UNIDO report on Promoting SMEs in Africa (2002)
8
African Development Bank (2009). African Women in Business Report, Private Sector Department.
9
OECD 2001; Africa Commission 2008; ILO 2009

6

according to the International Labour Office (ILO) in the last decade or so, most
new formal employment has been created in small enterprises or as self
employment. Youth entrepreneurship is also on the rise not just out of necessity
but also because of identified opportunities as well as young people’s desire for
independence and flexibility in their working lives. In other words,
entrepreneurship and self-employment can be a source of new jobs and
economic dynamism in developed countries, and can improve youth livelihoods
and economic independence in developing countries.

3. Constraints Faced by SMEs in Africa

3.1 Notwithstanding the widely acknowledged role of SMEs in fostering economic
growth and development, they have continued to face a variety of constraints.
Some of the challenges they face are inadequate infrastructural facilities,
shortage of skilled manpower, high rate of enterprise mortality, low level of
entrepreneurial skills, lack of a conducive operating environment, restricted
market access and cumbersome regulatory requirements. One of the major
difficulties SMEs come across, however, is the issue of access to finance. SMEs,
especially in developing countries, suffer from lack of access to appropriate (term
and cost) funds from both the money and capital markets. This is due in part to
the perception of higher risks resulting in high mortality rate of the business,
information asymmetry, poorly prepared project proposals, inadequate collateral,
absence of, or unverifiable history of past credit(s) obtained and lack of adequate
historical records of the company’s transaction.

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3.2 In some cases, there is a virtual absence of capital market facilities and
instruments that SMEs can access. For instance, the financial systems in most
African countries are underdeveloped and provide few financial instruments.
Capital markets are still evolving while other conventional sources have no
confidence in the credit worthiness of the SMEs. Non-bank financial
intermediaries, such as micro credit institutions, could play a greater role in
lending money to the smaller SMEs but do not have the resources to monitor
their customers when they expand. The main source of capital for SMEs are their
retained earnings and informal savings and loan associations, which are
unpredictable, not very secure and have little scope for risk sharing because of
their regional or sectoral focus. The many problems SMEs face when accessing
finance will be discussed in more detail later on and the subsequent section will
highlight the key reasons why access to appropriate finance is of critical
importance to SMEs.

Figure 1
"The Missing Middle"

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4. Why is Financing SMEs so Important?

4.1 SMEs are vital for economic growth and development in both industrialised
and developing countries, by playing a key role in creating new jobs. Small and
medium-sized enterprises need adequate financing to meet needs at each stage
of their life cycle, from creation through operation, development, restructuring,
recovery and beyond. Financing is necessary to help them set up and expand
their operations, develop new products, and invest in new staff or production
facilities. Many small businesses start out as an idea from one or two people, who
invest their own money and probably turn to family and friends for financial help
in return for a share in the business. But if they are successful, there comes a time
for all developing SMEs when they need new investment to expand or innovate
further.

That is where they often run into problems, because they find it much harder
than larger businesses to obtain financing from banks, capital markets or other
suppliers of credit. Many African countries have to deal with this chasm between
the role of micro credit institutions and that of larger financial institutions. This is
the space where SMEs operate and referred to in the Africa Commission’s Report
as ‘the missing middle’ and as shown in Figure 1. This ‘missing middle’ or
‘financing gap’ is all the more important in a fast-changing knowledge-based
economy because of the speed of innovation. Innovative SMEs with high growth
potential, many of them in high-technology sectors, have played a pivotal role in
raising productivity and maintaining competitiveness in recent years.
Nonetheless, innovative products and services need investment to flourish,
however great their potential might be. If SMEs cannot find the financing they
need, brilliant ideas may fall by the wayside and this represents a loss in potential
growth for the economy. In some cases, the financing is available but only for a
particular sector or type of SME.

Financing Constraints for SMEs

4.2 As mentioned previously, SMEs face numerous difficulties during their life
cycle. One of the main challenges they have to deal with is the issue of financing
constraints. This is because the conditions for financing for SMEs are inferior to
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that of large enterprises. The lack of access to credit is a major factor in the
underdevelopment of SMEs in Africa. Figure 2 shows the most problematic
factors for doing business in Uganda in 200910.

Note: From a list of 15 factors, respondents were asked to select the five most problematic for doing
business in their country and to rank them between 1 (most problematic) and 5. The bars in the figure
show the responses weighted according to their rankings.

The table shows that access to finance was identified by the respondents (22.9%)
as the most significant constraint in doing business in the country. This is quite
common in many African countries, including Nigeria, where access to finance
was the second most important constraint to doing business (22.3 % of
respondents), after inadequate supply of infrastructure. Despite their dominant
numbers and importance in job creation, SMEs traditionally have faced difficulty
in obtaining formal credit or equity. Banks have also been quite reluctant to
service SMEs for a number of well-known reasons, which include the following:

10
Africa Competitiveness Report, 2009

10

(i) SMEs are regarded by creditors and investors as high-risk borrowers due to
insufficient assets and low capitalization, vulnerability to market fluctuations and
high mortality rates;

(ii) Information asymmetry arising from SMEs’ lack of accounting records,
inadequate financial statements or business plans makes it difficult for creditors
and investors to assess the creditworthiness of potential SME proposals. SMEs
are less structured than large scale organizations and are usually dominated in
terms of management style and other characteristics by the promoter. They are
therefore perceived as higher risk.

(iii) High administrative/transaction costs of lending or investing small amounts
do not make SME financing a profitable business. Since banking credit is a scale
economy, it is typically more expensive on a unit cost basis to lend to SMEs
compared to larger organizations.

4.3 As a result, commercial banks are generally biased toward large corporate
borrowers, who usually provide better prepared business plans, have credit
ratings, more reliable financial information, better chances of success and higher
profitability for the banks. When banks do lend to SMEs, they tend to charge
them a commission for assuming risk and apply tougher screening measures,
which drives up costs on all sides. Borrowers are typically required to
demonstrate that they have sufficient equity to contribute to their businesses,
which many small business owners usually lack. Entrepreneurs also tend to lack
traditional collateral (such as land) and the credit history needed to qualify for
loans. Banks also tend to regard SMEs as unprofitable because of the high
transaction costs involved in providing many small-sized loans as opposed to
fewer large loans. Even when SME owners are able to access bank financing, the
maturities of commercial bank loans are often too short to pay off any substantial
investment. Another problem is that entrepreneurs also tend to have less
information about financial products and services because of their higher financial
illiteracy rate. The actual cost of finance is also an issue. The lengthy and costly
procedures involved in starting and exiting a business often serve as huge
deterrents for them. High interest rate payments are also a significant barrier.

11

This means that not only do SMEs have difficulty accessing finance, they also have
to deal with the higher cost of finance relative to the charges larger firms face.
This provides a strong rationale for the exploration of alternative sources of
funding for entrepreneurs.

5. Capital Markets and Economic Development

5.1 The capital market is a crucial component of a good working financial system
and a critical vehicle for a nation’s development. The development of a strong
capital market is imperative because theoretical and empirical literature have
shown that there is a strong, positive correlation between capital market
development and economic growth. Stock markets can lower the cost of
mobilizing savings and thereby facilitate investment in the most productive
technologies. They link those who have the resources to invest with those who
could use this capital to turn new ideas into businesses, generating jobs,
improving living standards and contributing to the economy. The impact on
economic activity also occurs through the creation of liquidity. A well functioning,
liquid and broad capital market is crucial to the operation of any emerging
economy. Research has shown that countries that have relatively liquid markets
tend to grow much faster than countries with illiquid markets. Among other
things, liquid markets make it possible to obtain financing for capital intensive
projects with long financing horizons. They can therefore lead to faster rates of
capital accumulation and general productivity gains. In African countries,
improvements in the capital market are essential because they also facilitate the
diversification of their economies.

5.2 Looking at how stock markets have evolved, the number of stock markets in
sub-Saharan African countries has risen from 5 in 1989 to 16 today. Between
2002 and 2007 their value (market capitalization) nearly doubled to 153 percent
of GDP before dropping to 83 percent of GDP in 2008 as a result of the global
financial crisis11. Table 2 shows some stock market development indicators for
some selected SSA countries. The table shows that except for South Africa and
Nigeria, the markets are generally small. Most of the countries have only a small
11
Regional Economic Outlook, SSA- Back to High Growth? April, 2010

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number of listed companies and the average ratio of market capitalization to GDP
(about 20%) is lower than in most emerging markets. Market liquidity is less than
10 percent of the value of shares actually traded each year which is considerably
low. Low business volumes and small market size present difficulties when
attempting to create a world class market and also serves to discourage foreign
investors. One potential solution to this is to encourage small markets to move
towards integration and create a regional market or cross-border alliances. While
there are constraints to this such as the difficulties in creating uniform regulatory
standards, a significant advantage would be that larger markets are better able to
provide the needed liquidity. It would also increase efficiency and lower
transaction costs if implemented successfully.
Table 2:Stock Market Development Indicators for Select Markets (2007)

Number of Stock Stock Value Turnover
Listed Market Market Traded
Companies Capitalization Capitalization

(% (billions (%
Of GDP) of US$) of GDP)
Botswana 18 41.9 5.9 0.9 2.2
WAEMU* 40 32.0 8.4 0.8 2.5
Ghana 32 18.6 2.4 0.7 4.5
Kenya 51 42.2 13.4 4.5 9.8
Malawi n.a. 12.9 1.8 2.4 0.5
Mauritius 41 73.1 5.7 5.8 7.9
Namibia 9 9.3 0.7 0.3 3.3
Nigeria 202 35.9 86.3 10.1 19.4
South Africa 401 280.8 833.5 153.4 51.1
Tanzania n.a. 4.0 1.3 0.1 2.1
Uganda n.a. 1.2 0.1 0.1 5.0
Zambia n.a. 15.6 2.3 0.6 3.1
Emerging Markets
Argentina 103 31.9 52.3 4.1 9.5
Brazil 392 79.3 589.3 44.5 42.6
Chile 244 118.9 132.4 27.1 22.8
Mexico 131 42.0 232.6 12.9 30.8
Malaysia 1027 156.0 187.1 83.0 53.2
Thailand 476 68.9 102.6 45.1 55.1
*WAEMU- West African Economic and Monetary Union

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Source: Financial Structure Database; and World Bank, World Development Indicators.

5.3 This means we do have some more to do with respect to our capital markets
before they will pave the way for our economic development. Most capital
markets in Africa are not sophisticated enough to play the developmental role
they need to play. Our rapidly developing economies require a modern financial
system that increases the efficiency of investment and contributes to sustainable
economic growth. One of the key ingredients to a good working capital market
system is an effective regulatory framework governing the markets. This is where
the input of a Capital Market Authority comes in. We must strive hard to provide
the enabling environment to allow capital markets to grow and become a viable
source of finance for all types of businesses.

6. Capital Markets as an Alternative Form of Finance

6.1 The use of the capital market is one such alternative. Capital markets foster
entrepreneurship and innovation which in turn, creates job opportunities. This
means like SMEs, they have a major role to play in the economic development of
a nation. Capital markets are a viable way of increasing financing options to SMEs
and would ultimately serve to develop the SMEs. The ability of companies in their
early stages of development to raise funds in the capital markets is beneficial
because it allows these companies to grow very quickly. This growth in turn
speeds up the dissemination of new technologies throughout the economy.
Furthermore, by raising the returns available from pursuing new ideas,
technologies, or ways of doing business, the capital markets facilitate
entrepreneurial activities. However, most African capital markets currently do not
have the depth and liquidity to support financing of SMEs. Nonetheless, efforts
are being made to increase the sophistication of securities markets all over the
continent.

What is the Role of Capital Markets in SME Development?

6.2 For entrepreneurship and innovation to thrive, not only does credit need to
be accessible, but there needs to be different types of financing. Capital markets
are an important source of long term finance, especially since SMEs have been
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primarily dependent on banks for financing. A financial system that is built on the
two pillars of banking and securities markets is stronger than a system that is built
solely on banking credit since a well -functioning system would be comprised of
various sources of finance. The choice of banks or the market would then depend
on the needs of the SME. They are both crucial components of an economy, and
it is impossible to say unequivocally which of the two systems is better for
economic growth12. The capital market can and should compete head on with
banks in the supply of debt finance to businesses including those to SMEs. From a
regulatory viewpoint, it is necessary for the competition between the banks and
capital markets to take place on a level playing field13. Therefore, capital markets
should be actively promoted as an important alternative source of finance for
SMEs, particularly long term finance through equity financing. Equity and debt
financing can be made available as well as venture capital funds.

Equity Financing

6.3 Equity investors primarily seek growth opportunities, so they are often willing
to take a chance on a good idea and provide the needed capital. Equity financing
is a strategy for obtaining capital that involves selling a partial interest in the
company to investors. The equity, or ownership position, that investors receive in
exchange for their funds usually takes the form of stock in the company. This
provides small business owners with a broader scope in terms of financing as they
gain access to multiple funding sources. In contrast to debt financing, which
includes loans and other forms of credit, equity financing does not involve a direct
obligation to repay the funds. Instead, equity investors become part-owners and
partners in the business, and thus are able to exercise some degree of control
over how it is run. As the only way for equity investors to recover their
investment is to sell the stock at a higher value later, they are generally
committed to furthering the long-term success and profitability of the company.
Many equity investors in startup ventures and very young companies also provide

12
Levine and Zervos (1998) The American Economic Review
13
The Economist, “A survey of global equity markets”, May 2001

15

managerial assistance to the entrepreneurs and are often good sources of advice
and contacts.

6.4 While there are many benefits that can be derived from equity financing,
there are also a few reasons why there has traditionally been a lack of equity
investment in SMEs. The primary reason is that equity investors seek highest
return consistent with the risk of investment; SME investments are difficult to
evaluate; SME investments take time to mature; and they are often difficult to
liquidate. One of the major disadvantages of equity financing is that the founders
must cede some control of the business. If investors have different ideas about
the company's strategic direction or day-to-day operations, they can pose
problems for the entrepreneur. In addition, initial public offerings can be very
complex and expensive to administer because of onerous listing rules and other
disclosure requirements. Such equity financing may require complicated legal
filings and a great deal of paperwork to comply with various regulations put in
place to provide credible information to investors. For many small businesses,
therefore, equity financing may necessitate enlisting the help of attorneys and
accountants. Nevertheless, the benefits tend to outweigh the disadvantages.
This is primarily because equity finance raised by an SME provides additional
equity cushion for more credit that can further fund growth and expansion.

Venture Capital

6.5 Venture capital, on the other hand, refers to the next round of finance in
companies that have achieved stability and have strong growth potential. A
venture capital fund would typically invest in an SME in a high-growth sector
looking to expand its operations. Venture capital can also play a role in buy–outs
of more established companies. The involvement of a venture capitalist is usually
from two to four years, after which the venture capitalist will typically either sell
the shares of the company on a stock exchange, e.g. an initial public offering
(IPO), or sell the whole stake in the company, for example, to a more established
competitor. Venture capital firms can be key financing vehicles for SMEs and
venture capital funds value the possibility of monitoring the performance of the
16

invested business, giving advice when needed and following-up on such advice.
Capital markets provide important exit opportunities for venture capital firms
enabling them to put their capital at risk to finance other SME opportunities.
Specifically, the capital markets provide initial public offerings and other
opportunities for venture capital firms to exit an investment in an SME.

6.6 Venture capital has the potential of offering a valuable source of finance
complementing the more traditional credit finance provided by commercial
banks. Some of the fundamental reasons hindering SMEs from obtaining credit
from commercial banks and other credit institutions are less important in
attracting venture capital. The advantages of venture capital are therefore:
(i) Venture capitalists are willing to accept higher risks than traditional banks in
exchange for potentially large gains from the sale of shares in the company.
(ii) Venture capitalists do not require collateral from borrowers.
(iii) Operating costs are lower due to the absence of high interest rate payments
(iv) Venture capital, by nature, is long-term or at least medium-term capital, in
contrast to short-term loans from banks.
(v) The managerial know-how provided by venture capitalists can in some cases
be more valuable to the start-ups of SMEs than the actual financing received.

However, there are also a number of drawbacks:
(i) As in traditional bank lending, operating costs associated with lending a small
amount may discourage investors.
(ii) The need for highly liquid markets is not as pressing compared to open-end
funds or mutual funds, since venture capital funds have a long-term involvement
in the companies they invest in. Nevertheless, an exit mechanism is necessary for
venture capitalists to attain capital gains.

Constraints SMEs Face When Accessing Capital Markets

6.7 While SMEs have the opportunity to leverage the capital markets in terms of
financing, they unfortunately face relatively high entry barriers to the capital
market. In attempting to improve SME access to capital markets, there are

17

several issues that need to be understood and addressed. The first hurdle to
overcome is having an adequately developed capital market in terms of depth and
liquidity. Second, SMEs, in essence, have relatively high credit risk. While SMEs
have high growth potential, they are also more vulnerable to sudden changes in
the economic and competitive environment. Third, there exists severe
information asymmetry in this segment of enterprises. SMEs’ corporate
information is often nonexistent, or comes with very high access costs in many
economies in the region. Fourth, SME financing is inherently associated with a
higher unit cost when compared with that of large corporations. The relatively
smaller size of funding, as well as higher information and monitoring costs, leads
to higher implementation costs per deal when processing finance in capital
markets. Moreover, financial instruments related to SMEs in the capital market
are often illiquid, partly because the total amount of the instrument itself is
relatively small and because the investor base with matching risk profiles in the
market is shallow.

6.8 There are also several practical barriers they face when accessing capital
markets. The common problems faced by SMEs in raising resources are well
known and begin with the initial public offer itself. As a share offering by a
medium enterprise cannot obviously be large, the high issue expenses become
particularly burdensome. Certain pre and post issue expenses are fixed in nature
and do not vary with the issue size. Furthermore, merchant bankers who
generally get their fees as a percentage of the issue size, are naturally less
enamoured of the SME business. Even after listing a smaller company’s stock will
more likely be illiquid. In fact a smaller company may have to spend
proportionately more on advertising and publicity to gain ‘visibility’.

6.9 Nonetheless, even with all these hurdles, capital markets can still be an
excellent source of funding for some SMEs. Listing on a stock exchange is a
transparent and beneficial strategy which provides an exit mechanism for
investors, including venture capital firms and the providers. A listing also brings
visibility and credibility to the firm further supporting its brand. A stock market
quotation, in any case, is an invaluable benchmark.

18

7. Interventions in Promoting SME Development

7.1 SME’s have played a vital role in raising productivity and maintaining
competitiveness in recent years. SME’s provide brilliant ideas but in some cases,
these ideas are never developed due to lack of funding. Due to the
developmental advantages SMEs bring to an economy, many governments,
international financial institutions (IFIs), NGOs and the private sector are
supporting African countries in their efforts to promote the development of SMEs
and overcome the financing hurdles they have to deal with.

7.2 In Uganda, for example, the government supports the ILO’s SME initiative, the
Expand Your Business Programme (EYB). It is an integrated business training and
support package for small to medium scale enterprises that have growth
objectives in mind. The EYB programme in Uganda is coordinated by Enterprise
Uganda. Enterprise Uganda is an institution designed to support the government
in realizing its objective of promoting the development of SMEs to become the
main vehicle for expanding production, providing sustainable jobs and enhancing
economic growth. It was established under a framework of the UNDP Enterprise
Africa regional initiative. A consortium of local and international donors including
UNDP Uganda, Enterprise Africa, UNCTAD and the Government of Uganda is
promoting it. Its concept is based on the Empretec Programme model currently
operating in 25 countries in Africa, Eastern Europe and Latin America. The
Empretec model is designed as one-stop programme, which provides an
integrated and comprehensive range of business support services for SMEs using
a hands-on approach. Box 1 provides some more detail on the objectives of the
EYB programme.

19

Box 1: EYB programme and Enterprise Uganda

The mission of Enterprise Uganda is to develop a new generation of dynamic Ugandan entrepreneurs by
actively providing support to the SMEs to enhance their productivity, growth and competitiveness.

The objectives of Enterprise Uganda are to:
-create general entrepreneurial awareness, enhance indigenous entrepreneurship skills and develop an
effective entrepreneurial and management training capacity in Uganda;
-develop bankable proposals for business expansion, new ventures and to assist sponsors negotiate for
financing;
-enhance the operational efficiency and competitiveness of SMEs to assist companies to diversify into
new products;
-develop subcontracting linkages between SMEs and large local private companies as well as
government procurement agencies; and
-promote and develop productive, stable and equitable linkages between SMEs in Uganda and foreign
companies.

7.3 The Bank of Uganda also operates a number of credit schemes and support
programmes on behalf of itself, the government and the donors. The credit
schemes provide loans to small and medium size enterprises in the private sector
through licensed banks while the support programmes are for building the
capacity of financial institutions, including MFIs. The credit schemes include:
Apex Private Sector Loan Scheme (Apex), which was designed to support small and
medium scale private sector enterprises in manufacturing, agro-processing, and
services, including tourism and the Export Refinance Fund (ERF), which was
designed to provide working capital in support of export of non- traditional
exports.

Alternative Stock Exchanges

7.4 One answer to the problems SMEs face when attempting to tap into the
capital markets is the creation of exclusive stock exchanges for SMEs. There are
many SMEs which are excluded from the listed category in spite of having a good
track record of growth because they do not meet the listing criteria. A SME-
focused stock exchange is likely to boost the confidence of SMEs planning to tap
the capital market to raise low cost capital.

20

Table 3: Differences between AltX and Main Board (Johannesburg)
Listing Requirements Main Board AltX
Minimum Share Capital R25 million R2 million
Profit History 3 Years None
Pre-tax Profit R8 million N/A
Shareholder Spread 20% 10%
Number of Shareholders 300 100
Sponsor/DA Sponsor Designated Adviser
Publication In The Press Compulsory Voluntary
Number Of Transaction 2 2
Categories
Special Requirements N/A Appoint Financial Directors
Annual Listing Fee 0.04% of average market R22,000 (including VAT)
capitalisation with a minimum of
R26,334 and a maximum of
R121,700 (including VAT)
Education Requirements N/A All directors to attend Director’s
Induction Programme
Source: Johannesburg Stock Exchange

Some examples of SME dedicated stock exchanges include AltX, Africa’s first
alternative exchange for SMEs, a partnership between the Johannesburg Stock
Exchange Ltd. and the Department of Trade and Industry. AltX allows smaller
companies to float shares with a more flexible regulatory system as compared to
the main market. Table 3 shows some of the major differences between the
listing requirements for the AltX market and the Main board. It shows how the
requirements for the AltX market have been relaxed to cater to SMEs. The
creation of an SME stock exchange will also help in bridging the gap between
private equity players, venture capitalists and the SMEs whilst providing them
with a platform to raise funds in the capital markets.

7.5 Another successful SME dedicated market is the Alternative Investment
Market (AIM), a self-regulated, sub-market of the London Stock Exchange (LSE).
Although most AIM-listed companies are not start-ups, most are small and highly
risky. AIM combines the benefits of a public quotation with a flexible regulatory
approach and allows smaller companies to float shares with a more flexible
regulatory system than that which is applicable to the main market. Launched
only in 1995, AIM has raised well over £25 billion for more than 3000 companies

21

to date. Flexibility is provided by less regulation and no requirements for
capitalization or number of shares issued. Some of the other characteristics of
the market include: no minimum shares to be in public hands; no trading record
requirement; no prior shareholder approval for transactions (except to reverse
takeovers); currency for and easier rules on acquisition; nominated adviser
required at all times; no minimum market capitalization; eligibility for a range of
tax benefits.

7.6 TechMark is another alternative exchange and like the AIM, is a division of
LSE. They have the same rules but TechMark is for technology-based companies.
There are actually no rules on trading period, public ownership, or capitalization
but two sets of lawyers and a corporate broker are required in the process. AIM
and Techmark suit companies with a clear intention and prospect of progressing
onto the main London Stock Exchange market. Both processes also engage a
financial PR firm to ensure the issue is well publicized and achieves its minimum
subscription. Each company applying to join AIM must appoint a nominated
adviser, popularly known as a ‘nomad’. Nomads are responsible, amongst other
duties, for warranting that a company is appropriate for AIM. Once admitted to
AIM, a company has ongoing disclosure requirements and must retain a
nominated adviser.

7.7 Ofex is another independent market catering for smaller issues in the UK. The
process is quite similar to the AIM and TechMark but slightly less involved. The
market is less liquid (sales of shares are infrequent and made amongst a relatively
small number of buyers) compared to AIM. There are no minimum trading,
capitalization, public ownership, or other requirements other than the basic
public limited company requirements. There is a 'sponsor' company and a firm of
external auditors and lawyers whom together will undertake an independent
audit of the accounts and produce a report and prospectus on the company.

The following are examples from India and Korea which further illustrates what
other jurisdictions are doing to encourage SME development through the use of
capital markets.
22

The Indian Experience14

7.8 In India, policy makers, alive to the special needs of SMEs, created a niche
market/ separate exchange for them and also simplified the procedural
requirements, thereby reducing certain costs. The OTC Exchange of India (OTCEI)
set up in 1990 was the first exchange to deal exclusively with smaller sized
companies. It had as its twin objectives helping smaller companies raise capital in
a cost effective manner and providing the investors with an efficient and
transparent method of trade. The OTCEI has been a pioneer in introducing screen-
based trading and market making. Yet it failed to take off, probably because it
was ahead of its time.

7.9 Securities Exchange Board of India (SEBI) is now addressing the issue by
exempting companies listed on the SME exchanges from eligibility norms
applicable for IPOs. SME companies for the purpose of these new regulations will
have a paid-up capital of not more than Rs. 25 crore (US $5,617,975). They can
list on the main boards of National Stock Exchange of India/Bombay Stock
Exchange with a minimum paid-up capital of Rs. 10 crore (approx. $US 2,247,190).
In what is by far the most noteworthy of the current measures, the minimum IPO
application size will be Rs. 1 lakh (approx. US$2250). This way the regulator hopes
to have informed financially sound and well-researched investors with some risk
taking ability. However, the high minimum requirement will shut out many small
investors and will also reduce the number of shareholders. How far that will
impact on liquidity of the company’s stock remains to be seen. Merchant bankers
have been given special responsibility in market making (for a minimum period of
three years) and underwriting the issue. Guidelines have been laid down for
procedures to be followed when the paid-up capital of the listed company
exceeds Rs. 25 crore (US $5,617,975) and when an investor’s holding falls below
Rs. 1 lakh ($ 2250).

14
Ayan Banerjee, Capital Market Access to SMEs in India, Available at: http://ssrn.com/abstract=962033

23

The Korean Experience15

7.10 Capital markets provide an opportunity for loans of banks to SMEs to be
securitized. The Korean government introduced the primary collateralized bond
obligation (P-CBO) program in order to smooth out liquidity constraints and
support SMEs. Started in 1999, the P-CBO program was expanded to include
venture firms in 2001. A P-CBO is a type of asset-backed security (ABS) with
newly-issued corporate bonds as the underlying asset. SMEs issue new corporate
bonds and sell them to a special purpose vehicle (SPV) as an underlying asset. The
SPV then issues the CBO based on the pool of SMEs’ newly-issued corporate
bonds, and sells the CBO to investors in the market. Credit enhancement is
provided through various channels, including banks and credit guarantee funds.
The SPV issues both senior and junior tranche bonds, with senior tranche usually
at AAA grade. From 2000 to 2006, about 17,334 billion won (US $ 15,493,385)
was raised for financing SMEs through P-CBO.

7.11 P-CBOs offer more fundraising opportunities to SMEs that have low credit
ratings. In fact, the distinguishing feature of the P-CBO program lies in facilitating
the issuance of corporate bonds to help finance SMEs. Because P-CBOs pool
bonds with different levels of risk, the overall risk of default decreases. Also,
because the P-CBOs are issued through strict surveillance by credit rating
agencies, they are a relatively safe and fairly attractive investment. Furthermore,
P-CBOs can offer higher yields than general corporate bonds. In short, P-CBOs can
be a useful instrument that can resolve the credit mismatch problem that exists
between investors and SMEs, thus filling the financing gap of SMEs.

Government Actions

7.12 In order to facilitate active SME financing through capital markets, our
governments must pay attention to the development and growth of the capital
market and come up with ideas to tackle obstacles inherent in SME’s, such as
sources of funding. The government can play an essential role in alleviating SME’s

15
Jae-Ha Park, Byung-Chul Lim, Jung-Han Koo (2008) Developing the Capital Market to Widen and Diversify SME
Financing: The Korean Experience, Korea Institute of Finance.

24

financing gaps in the capital market. In Nigeria, for example, the government
introduced the Small and Medium Industries Equity Investments Scheme (SMIEIS),
which requires banks to set aside 10% of their profits before tax to improve
availability of funds to SMEs. They believe that supporting groups in
entrepreneurship is crucial for opening up economic resources and
entrepreneurial potential critical to long-term economic prosperity. Nigeria has
also taken steps to address the other challenges faced by SMEs as the UN ECA
study notes that the Nigerian government has formulated special policy measures
and programs to encourage the development of SMEs including the enactment of
favorable laws and regulations on contracts, leasing, and corporate tax, as well as
fiscal and export incentives for SMEs.

7.13 Government support programmes can complement and support policies
directed towards SME development. Government support schemes for business
development should be targeted to SMEs and existing programs should be
constantly evaluated and revised based on experience, research and best
practices around the world. Additionally, governments can promote
entrepreneurship through information programmes, which can build awareness
of the opportunities afforded through entrepreneurship. Furthermore, they can
introduce people to existing economic incentives for entrepreneurial activities
and motivate people to take advantage of these. Also, since small businesses
often do not meet the conditions for bank loans, governments can endeavour to
create an environment that is conducive to entrepreneurial activities, through
supportive legislature for example.

International Financial Institutions (IFIs)

7.14 One IFI that is greatly involved in the development of SMEs on the continent
is the International Finance Corporation (IFC). The IFC has SME Solutions
Centers, which are a key component of IFC’s support for small and medium sized
enterprises in Africa. The centers promote access to finance for small and medium
sized enterprises in the region complemented by specific capacity building
services. They support small and medium sized enterprises at different stages of

25

business development to enable them to improve their business processes,
human resources, structures, and products and services.

7.15 The IFC has recognized that smaller businesses generally struggle to attract
finances, whether in the form of debt or equity. Traditional long-term bank
finance is generally inaccessible to small and medium sized enterprises because
they lack the required collateral. To address these challenges, IFC has engaged
Business Partners, a fund manager to set up the Business Partners International
risk capital fund as the access to finance component of the SME Solutions
Centers. Business Partners International (BPI) is a wholly owned subsidiary of
Business Partners, a leading South African provider of risk capital to small and
medium enterprises. So far, BPI has raised $14.1 million in Kenya and $10 million
in Madagascar. IFC contributed 32 and 35 percent of the capital of the BPI risk
capital funds for Madagascacar and Kenya, respectively. Other international
investors include the European Investment Bank, Commonwealth Development
Corporation, Norfund, and Doen Foundation. A number of regional and local
institutions have invested in the funds as well, including the Assurance
Reassurance Omnibranche in Madagascar, and Trans Century Ltd and the East
African Development Bank in Kenya. Using the funds raised, support is extended
to qualifying small and medium sized enterprises in the form of equity, quasi
equity, and debt financing. Repayment and exit (where equity is provided) is
generally achieved from the cash flow of the investee companies.

7.16 The SME Solutions Centers commenced operations in 2005, initially
concentrating on providing business information and capacity building support to
small and medium sized businesses. The BPI risk capital funds for Madagascar
and Kenya were launched on September 2006 and January 2007, respectively.
More than 450 small and medium sized businesses have received enterprise level
support to improve their processes. Over 3,000 employees from these businesses
have participated in training provided by the centers. Currently, 16 companies
are part of the in-house incubation facilities. More than 170 business plans have
been received, out of which a good number are being considered for possible
investment.

26

7.17 The European Investment Bank (EIB) is also involved in helping SMEs with
their financing problems and has established venture capital funds in Africa. The
funds have been used to acquire an equity share in small enterprises and to
provide business guidance to these enterprises. The objective was to realize
commercial returns by participating in profits and capital gains. All in all, in 2000
the EIB made available 215 million Euros in risk capital to African and some other
developing countries.

7.18 Another major initiative is the US$ 500 million African Guarantee Facility
launched by the Africa Commission in conjunction with the African Development
Bank in May 2009. This facility is intended to provide guarantees and capacity
building support for financial institutions and SMEs. The US$ 500 million which
will be leveraged three times and will provide risk sharing coverage of 50%, is
expected to mobilize US$ 3 billion of loans and US$ 20 billion of SME investments,
representing 1.5 per cent of Africa’s GDP.

8. Recommendations

8.1 After reviewing the importance of SMEs to the economy, the challenges they
face, the various initiatives of governments and stakeholders to foster the SMEs
and the outcomes of those initiatives, it is important that a comprehensive
approach in resolving the problems of the SMEs sub-sector be adopted. It is clear
that SMEs, especially in the developing economies, face numerous challenges,
with finance being a major constraint. The following are some recommendations
that countries, policy makers and SMEs can consider:

 Improve on the management expertise and financial reporting of SMEs:
Promoters of SMEs should endeavour to improve the management
capabilities required for preparing profitable business plans and effectively
managing their businesses. They must also prepare timely, transparent and
acceptable financial reports of their companies which would be acceptable
to regulators, investors and other stakeholders. Financial reporting is one
of the burdens that SMEs face and to address this, the International
Accounting Standards Board (IASB) created a simplified version of
International Financial Reporting Standards (IFRS) for SMEs. It is shorter
27

than the full IFRS, less complex, easier to comply with and contains greatly
reduced disclosure provisions. However, SMEs that are listed are unable to
use the IFRS for SMEs and are subject to the full IFRS. Such financial reports
will be important in attracting debt and/or equity finance from lenders and
investors. Developing an adequate information disclosure regime by
adopting clear accounting standards and establishing credit bureaus would
also go a long way to encouraging lending to SMEs.

 Governments in developing economies should consider harmonizing
initiatives for supporting the SME sub-sector. This is very important
because there are instances where for instance, a number of government
agencies are found to be duplicating efforts in this direction. This was the
case in Nigeria until the Federal Government merged three different
agencies (NBC, NIDB and NERFUND) into the Bank of Industry (BOI).
Harmonizing efforts could lead to greater efficiency and perhaps lead to an
improvement in their supportive capacity.

 Adequate infrastructure: The governments of developing countries need
to ensure the provision of necessary infrastructure such as power,
education, water, roads, transportation etc. These are absolute minimum
requirements for the SMEs to flourish. Capital markets provide a financing
gateway by enabling governments and private firms to raise the funds for
infrastructure through the issuance of government and corporate bonds,
for example.

 Fostering the development of innovative instruments and risk sharing
arrangements: Some African countries are already experimenting with
innovative financial instruments. For instance, warehouse-receipt financing
is helping to guarantee loans with agricultural stocks in South Africa, Kenya
and Zambia. Other financial instruments, such as leasing can reduce risk
effectively for credit institutions. In addition to innovative financing
mechanisms, innovative measures can also be put in place to share risk.
Credit associations that reduce risk by sharing it are more common. They

28

help financial institutions choose whom to lend to, by guaranteeing the
technical viability of projects and sometimes providing guarantees.

 Promotion of Venture Capital Companies through Competitive incentives:
Venture Capital funds nurtured the Silicon Valley in the United States. In
2000 alone in Korea, venture capital invested was about 2 trillion won (US $
1,787,629,603). Venture capitalists can be encouraged through
comprehensive and competitive incentives such as tax breaks/holidays.
Viable and diverse exit strategies must also be put in place for the venture
capitalists. Above all, a key success factor for venture capital is the
provision of a conducive operating environment throughout the entire life
cycle.

 Funding through the Capital Market: It is important to find ways of easing
the processes and costs of SMEs sourcing of funds from the capital market
as well as getting listed. The following options could be considered:

a. Creation of platforms on the Stock Exchanges for SMEs: The
example of the Alternative Investment Market ((AIM) in London is
instructive, considering the amount of money so far raised on the
AIM (about 25 billion pounds for about 3000 companies across
the globe). Our SMEs can benefit greatly from these types of
initiatives. It should be noted however, that a number of
countries already have such platforms. For instance, Nigeria has
the second-tier securities market which is meant for companies in
this category, though it is still yet to be operational. What needs
to be done is a thorough review of the listing requirements of this
market as well as vigorous public enlightenments and support
policies to get the companies to move to the market.

b. Develop Asset Backed Securities (ABS): - This could take the form
of the P-CBO of Korea. The SMEs could sell corporate bonds
which will be the underlying assets to some special purpose
vehicle (SPV) This SPVs will pool the different corporate bonds
sold to them by the SMEs and in turn, sell to investors. In this
29

way, even SMEs with low credit ratings will be able to raise money
while the weighted risk of the bonds in the pool will minimize the
risk exposure of the investors.

9. Conclusion

9.1 SMEs in Africa are the catalysts of economic growth and development, as well
as the backbone of the nation. They are a very important component of an
economy, especially in Africa where they make up the majority of enterprises.
SMEs are increasingly taking the role of the primary vehicles for the creation of
employment and income generation through self-employment, and therefore,
have been tools for poverty alleviation. SMEs also provide the economy with a
continuous supply of ideas, skills and innovation necessary to promote
competition and the efficient allocation of scarce resources.

9.2 Access to finance for SMEs is a key challenge to supporting sustainable growth
in Africa. Many policymakers agree that in order to increase SME access to
finance, alternative sources of funding must be explored. Capital markets are a
viable way of increasing financing options for SMEs and would ultimately serve to
develop both the SMEs as well as the capital markets. The financial support that
capital markets could provide them will increase economic development in the
continent.

30

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