Spring | Summer 2009

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Investment, or capital injection in portfolio companies created by entrepreneursto solve market problems and seed innovation, is of fundamental importance tonew business creation in Africa and sustained economic growth across the vastcontinent. Capital injections can come in all shapes and sizes. Since the 1970s,

Grameen Bank in Bangladesh has popularized the advent of “micronance,” or

small loans –debt capital– offered to help impoverished women gain economic

autonomy. Micronance, however popular and imperative for poverty alle

-viation, is but one piece of a comprehensive investment palliative in Africa, an

impoverished continent with extremely high potential. Micronance provides

small injections of capital to small entrepreneurs. For those with greater capitalneeds, such as Small and Medium Enterprises (SMEs), however, the means of

obtaining nance become substantially more difcult.

SME Investment Overview

While global denitions of SMEs vary, according to the World Bank employ

ment-based denition, Small Enterprises are those with between 5-20 employ

-ees, and Medium Enterprises are those between 20-50. Thus the World Bank

broadly denes SMEs as organizations with between 5-50 employees.

In Africa,

the SME economic sector accounts for signicant percentages of employment,

GDP, and total exports.According to a study by the Small Enterprise Assistance Fund (SEAF), for eachdollar invested in an SME, an additional US$10 was generated in the localeconomy. Additionally, such investment created jobs, introduced new businessmethods, and plugged otherwise isolated regions into the global supply chain.

Yale Journal of International Affairs

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scott e. hartley

SME production can promote growth and industry agglomeration, and can trans-fer technology, provide windfalls for local industry, educational opportunities,

and empower inspirational heroes t for future leadership. Capital injectionsthat address SME nancing needs come in two forms: debt and equity.

Debt Financing

Debt nancing is traditionally made in the form of a loan with a given maturity.

Loans often require collateral, or proof of entrepreneurial competency so that

the lending institution – typically a bank – can lend with condence that the

borrower will not default. Accordingly, banks must assess the risk associatedwith lending to a particular entrepreneur. This process takes time and energy,

and lending institutions incur a “Transaction Cost” in determining risk. In

Africa, the transaction costs associated with risk assessment are high because

un-standardized and disparate information make the process difcult and pro

-tracted, and therefore more expensive. Consequently, high transaction costsmake up-market, or higher-value loans the standard rather than the exception;if banks are to spend wisely on assessing risk, they will pragmatically assess risk

for higher-value proposition loans rst, leaving out smaller business owners,

or the entrepreneurs of SMEs. The opportunity cost associated with SME risk assessment is too high to warrant reallocation of lending resources, and this isdue to technology and transaction cost constraints.

Equity Financing

Equity nancing is traditionally made in the form of “Venture Capital.” Venturecapital (VC) is capital provided to entrepreneurs – typically slightly larger thandebt nance in scope and capital demand – in return for partial ownership orintellectual property rights to what is developed. Also known as “risk capital,”VC is capital with returns that are not contractually guaranteed, and is contingent

on counterparty post-investment success.

Unlike “risky” debt capital, neither

principal nor upside returns are binding matters of contract. Ownership comesin many forms, though traditionally in preferred shares convertible to common

stock issued on an exchange when a company is “taken public” or makes its“exit” from private ownership. VC deal composition can also provide incen

tive for engagement over the longer term by providing “coupons” stipulatinginterest returns, and “equity kickers” that provide additional ownership beyondspecied time horizons.

In Africa, as in other emerging markets, the opportunities to have an Initial PublicOffering (IPO), or public issuing of stock, are limited due to shallower capital

markets and greater nancial disclosure requirements that preclude companies

with less established means of corporate governance to prove their mettle beforeissuing common stock. In other words, there are few opportunities to success-fully debut SMEs on markets, as limited demand from open-market buyers tocapitalize the company through an IPO limits the extent to which equity inves-

Spring | Summer 2009

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bringing africa online

tors can realize upside returns on their early-stage capital injections. Smallercapital markets, fewer exchanges available for public listing, weak accountingsystems, and lack of transparency all perpetuate the problem.

Addressing “The Missing Middle”

Such systemic challenges – high transactioncosts associated with risk assessment, largertransaction sizes, higher risks associated forearlier-stage ventures, and lack of exit options

for trading smaller rms on secondary markets

– have created a funding gap known as “The

Missing Middle.” This missing middle is a gap

between those small businesses with access to

debt nance, and those established rms withaccess to both debt and equity nance. For en

-trepreneurs with capital demands greater than

micronance though less than the thresholdprotability for a bank to perform sufcientcounterparty risk assessment, nance availability will necessarily be limited,

and the inability to obtain seed and expansion capital limits business creation,and reduces innovation. The opportunity cost of SME policy oversight is tre-mendous in burgeoning economies such as those in East Africa.What follows is an illustrative, though not exhaustive, attempt to outline those

salient deciencies in current risk assessment processes, and those transaction

costs that could be mitigated by better leveraging private sector technologicalresources for gains on the African continent. This paper will seek to highlightsome of the more innovative tactics used by private philanthropists to addressthe missing middle, and provide prescriptive recommendations for technolo-gists to address systemic challenges that deter more widespread use of debt

and equity nance in Africa. The hope is that such normative guidance might

impel improved private and public partnerships that will leverage technologyto mitigate transaction costs associated with counterparty risk assessment, and

facilitate capital allocation. By addressing the “missing middle,” SME develop

-ment can be a means to poverty alleviation, job creation, and sustained economicgrowth in Africa.

Addressing Systemic Limitations

Although the above paragraphs detail some of the systemic limitations associ-

ated with debt and equity nancing in emerging markets, and specically in

Africa, there are means of addressing and mitigating such challenges throughcreative innovation. Solutions to the world’s biggest problems will require the

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