New approaches to SME and Entrepreneurship Financing

Abstract

Bank lending is the most common source of external finance for many SMEs and entrepreneurs, which are often heavily reliant on traditional debt to fulfill their start-up, cash flow and investment needs. While it is commonly used by small businesses, however, traditional bank finance poses challenges to SMEs, in particular to newer, innovative and fast growing companies, with a higher risk-return profile.

Capital gaps also exist for companies undertaking important transitions in their activities, such as ownership and control changes, as well as for SMEs seeking to de-leverage and improve their capital structures. The long-standing need to strengthen capital structures and to decrease dependence on borrowing has become more urgent, as many firms were obliged to increase leverage in order to survive the recent economic and financial crisis. Indeed, the problem of SME over-leveraging may have been exacerbated by policy responses to the crisis, which tended to focus on mechanisms that enabled firms to increase their debt (e.g. direct lending, loan guarantees). At the same time, banks in many OECD countries have been contracting their balance sheets in order to meet more rigorous prudential rules.

While bank financing will continue to be crucial for the SME sector, there is a broad concern that credit constraints will simply become “the new normal” for SMEs and entrepreneurs. It is therefore necessary to broaden the range of financing instruments available to SMEs and entrepreneurs, in order to enable them to continue to play their role in investment, growth, innovation and employment.

Through asset-based finance, firms obtain funding based on the value of specific assets, including accounts receivables, inventory, machinery, equipment and real estate, rather than on their own credit standing. In this way, it can serve the needs of young and small firms that have difficulties in accessing traditional lending. Asset-based lending, which provides more flexible terms than collateralized traditional lending, has also been expanding in recent years, in countries with sophisticated and efficient legal systems and advanced financial expertise and services.

Policies to promote asset-based finance relate primarily to the regulatory framework, which is key to enable the use of a broad set of assets to secure loans. While asset-based finance is a widely used tool in the SME financing landscape, alternative forms of debt have had only limited usage by the SME sector, even within the larger size segment which would be suited for structured finance and could benefit from accessing capital markets, to invest and seize growth opportunities. In fact, alternative debt differs from traditional lending in that investors in the capital market, rather than banks, provide the financing for SMEs. To foster the development of a corporate bond market for SMEs, mainly mid-caps, policy makers have especially targeted transparency and protection rules for investors, to favour greater participation and liquidity. Recent programs have also encouraged the creation of SME trading venues and the participation by unlisted and smaller companies. In some countries, public entities participate with private investors to funds that target the SME bond market, with the aim of stimulating its development.

In some countries, the regulatory framework allows private placements of corporate bonds by unlisted companies, which are subject to less stringent reporting and credit rating requirements. However lack of information on issuers and of standardised documentation, illiquid secondary markets and differences in insolvency laws across industry players and jurisdictions currently limit the development of these markets.Debt securitization and covered bonds, which also rely on capital markets, had increased at high rates before the global crisis, as an instrument for refinancing of banks and for their portfolio risk management. However, in the wake of the crisis, these instruments came under increasing scrutiny and criticism, and markets plummeted. The post-crisis deleveraging in the banking sector, however, has contributed to reviving the debate about the need for an efficient – and transparent – securitization market to extend SME lending. In recent years, new measures have been introduced at supra-national and national level to re-launch the securitization markets and some countries have lifted the limitations that did not permit SME loans as an asset class in covered bonds.

In recent years, with the support of public programs, it has become increasingly possible to offer hybrid tools to SMEs with lower credit ratings and smaller funding needs than what would be the practice in private capital markets. Governments and international organizations mainly intervene through: i) participation in the commercial market with investment funds that award mandates to private investments specialists; ii) direct public financing to SMEs under programs managed by public financial institutions; iii) guarantees to private institutions that offer SMEs the financial facility and; iv) funding of private investment companies at highly attractive terms.

Equity finance is key for companies that seek long-term corporate investment, to sustain innovation, value creation and growth. Equity financing is especially relevant for companies that have a high risk-return profile, such as new, innovative and high growth firms. Seed and early stage equity finance can boost firm creation and development, whereas other equity instruments, such as specialised platforms for SME public listing, can provide financial resources for growth-oriented and innovative SMEs.

In some countries, to address the lack of liquidity, government policies favour retail investment or reduced taxation on security transactions. Recent regulatory approaches recognize that these platforms may require specific regulation and infrastructure. SME listings benefit in most cases from looser listing and disclosure requirements and lower fees than in the main market. However, a key challenge is to achieve a right balance between greater flexibility and lower costs for SMEs and due diligence, to preserve market integrity, transparency and good corporate governance.

Venture capital funds and business angels are characterised by different motivations, targets, scale and operating models, but are highly complementary in the financing continuum for early stage firms. Business angels need a well-functioning VC market to provide the follow-on finance that some of the businesses they support will require. At the same time, a well- developed angel market can create more investment opportunities and increase the deal flows for VCs.

Policy makers have placed increasing attention on these equity markets, as a way to mobilise financial resources and entrepreneurial expertise towards innovative ventures. The policy mix has been largely composed of supply-side measures, such as tax incentives, direct investment and co-investment, support to industry networks and associations, to increase visibility and scale and favour match-making with entrepreneurs. To a lesser degree, policies also target training, mentoring and coaching for investors. As in the case of other instruments, the demand side has received less policy attention and resources, although countries are increasingly implementing measures that target the skills of existing or would-be entrepreneurs.