Funding small business is risky – a hybrid solution

Small business has been earmarked as one of the key facilitators of driving down unemployment. The latest unemployment rate, according to Statistics South Africa, was 26.4% in the first quarter of 2015. This saw an increase from the last quarter of 2014, which showed 24.3%. The figure is also above the average 25.27% recorded from 2000 until 2015. In this piece Democratic Alliance’s Toby Chance searches for a solution to the small business financing conundrum – access to finance and quality businesses concepts worth funding. He also looks at the need for small business to receive support beyond just finance. – Stuart Lowman

By *Toby Chance

Most surveys of small business cite difficulties in accessing finance as one of the top three challenges they face. But talk to providers of finance and they say the opposite: there is a scarcity of fundable small businesses out there.

Solving this conundrum is at the heart of South Africa’s biggest challenge: how to create the 11 million new jobs we need by 2030 to reduce unemployment to 6% from its current 36%.

South Africa’s small business finance ecosystem is fragmented and inaccessible to those most in need. And there is a paucity of published material on why some small business support programmes, both financial and non-financial, deliver returns while others do not.

It’s a classic case of the market failing to match supply and demand, and government failing to fill the gap.

In the case of debt finance or loans, the private sector is risk-averse, especially retail banks which stay clear of this market to protect depositors. Start-ups and early-growth stage businesses find it hardest to get bank loans, as do survivalist informal businesses, but for very different reasons. The former require collateral which many do not have. In the latter case, it’s because they are below the radar of most commercial funders and are too numerous for government to cope.

The Small Enterprise Finance Agency, Sefa, an agency of the Department of Small Business Development, is government’s main play in this category and has focused on survivalist at the expense of high-growth businesses or “gazelles”.

This has come at a high cost to the tax payer, and the creation on average of only one and a half jobs per business financed. Sefa’s cost-to-income ratio is 160% compared to commercial banks’ 50-60%, mainly due to its high impairment rate. The Khula Guarantee Fund, which was run by Sefa and offered loan guarantees via retail bank intermediaries, was discontinued after losses mounted in the late-2000s.

The Small Enterprise Foundation, which replicates the Bangladeshi Grameen Bank’s model of micro finance from its base in Tzaneen, boasts a 98% repayment rate on loans made to its mostly women-owned micro enterprises. It is hard to find any equivalents elsewhere in South Africa.

When it comes to equity finance, the private sector is showing some interest in Treasury’s Section 12 J income tax incentives for the formation of venture capital funds. But these incentives have not been attractive enough to lure institutional or sufficient angel investors to provide scale. Grovest, Alpha Wealth and Acorn Private Equity are three private equity funds showing promising returns in the private equity segment focused on small business.

Several private sector business incubators have stepped in, including pioneer Raizcorp, MEDO and Aurik, which take stakes in businesses with potential to grow or offer other support services. They and others have tapped into corporate BBBEE spend on enterprise and supplier development. More recently Awethu Project has partnered with Sefa in a R64m equity investment fund but only after an expensive three years refining its model.

From government, the National Empowerment Fund only targets majority black-owned businesses, while the Industrial Development Corporation looks for large scale investments. At municipal and provincial levels funds are there but to date their reach has been limited and their offices tend to be staffed by bureaucrats not investment professionals.

Grant finance comes in various forms. The DTI offers grants for machinery and a number of sector-specific incentives. Its Incubation Support Programme, which aims to establish 250 incubators eventually, is bedevilled by bureaucracy and is missing its targets.

The Jobs Fund is government’s biggest play in this category but has focused on job creation projects rather than the formation and growth of new businesses. An exception is the Riversands Incubation Hub near Diepsloot but this is just getting off the ground.

Choosing which of the three main sources of finance to go for – debt, equity or grants – is bewildering for most small businesses. Each carries different risks and rewards for the business and funder. Too much debt can cripple cash-flow, giving up equity is easy at first but expensive in the long run while grants can lead to a dependency mind set and prop up businesses which have no economic right to exist.

The most successful funding models combine two or more of the financing categories backed up with training, support and mentorship.

Anglo American’s Anglo Zimele and SAB’s Kickstart programmes are perhaps the best examples of corporate BBBEE enterprise development at scale. The Cadiz Enterprise Development Investment Fund and Old Mutual’s Masisizane Fund appear to be achieving social impact as well as decent returns.

First National Bank’s Edge Growth business incubator sets the benchmark for the big retail banks’ entry into high-growth business financing. Endeavour SA, supported by the First Rand Group and other corporates, claims its active portfolio of 22 businesses created 5 000 jobs in 2014. But government plays very little part in either.

LifeCo’s recently-announced R30 million fund backed by Standard Bank and the IDC is the closest we have to a government-private sector model for small business funding and support. Its focus on developing a pipeline addresses the problem of scarcity of fundable businesses.

Can we learn from these successful models and deliver social impact and market-friendly returns at scale, using both public and private sector money to find and support viable small businesses?

The answer, I believe, is to create a hybrid fund manager which blends all available funding sources into a wholesale vehicle backed by training, mentorship and support at the point of loan. The UK Department of Business, Innovation and Skills has succeeded with its British Business Bank and subsidiary, the Start-Up Loans Company. We can learn from this model.

Minister of Small Business Development Lindiwe Zulu is warming to my idea to merge Sefa with the Small Enterprise Development Agency, Seda. Evidence shows the survival and growth rates of small businesses are higher when finance is combined with high-touch support.

But she needs to go further and place the combined entity in a new public-private partnership vehicle, run by investment and development professionals, along the lines of the now-defunct Small Business Development Corporation.

Founded by the DTI and the Rembrandt Group in 1981, it channelled public and private sector funding into small businesses and enjoyed a high degree of success. Political pressure and the ANC’s instinct for state-led development saw the partnership being dissolved in 1995, leaving the public sector parts (today’s Sefa and Seda) struggling while the private sector part (now Business Partners) continues to deliver good investor returns and beneficiary growth, but on a relatively small scale.

In South Africa, social and economic impact are often indivisible. New enterprises create jobs, generate tax revenues, reduce dependency on the state and build communities. This is why such a vehicle should attract BBBEE and CSI funding which chase both social and economic impact.

The new fund should have separate arms targeting the micro/survivalist, high-growth and lifestyle small business segments. To maximise penetration and capacity they should offer equity, loans and support through existing channels such as banks, micro-financers and business incubators, with government grants providing a first-loss guarantee.

If successful, this approach could achieve what the likes of Clem Sunter, Peter Bruce and Mark Barnes call for – a viable way of bringing big business and government to the small business funding party.

* Toby Chance is the DA’s Shadow Minister of Small Business Development

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