Tier 3. Mom-and-pop shops and small premises in the informal sector generating
D. Inclusive Business Financing Modalities
2. Idiosyncrasies of Inclusive Business Financing
Effective IB financing requires a combination of carefully selected financial instruments and, in many cases, nonfinancial support. IBs have much in common with MSME lending/
investing in this regard. However, it is helpful to think of IB as a subset of generic MSME financing with particular needs, reflecting the challenges associated with the inclusion thesis embedded in the IB model and demographic and socioeconomic context in which the IB operates.11 IB financing is most effective when the instruments used and nonfinancial value added address and accommodate these factors. In this way, both the lender and borrower, in cases of debt, and investor and investee, in cases of private equity, follow a common vector.
The key, therefore, is for the lender/investor and borrower to share a clear understanding of what the IB requires to achieve sustainable growth. It is a familiar maxim that many MSMEs do not know what they do not know, do not necessarily know what their needs are (financial and nonfinancial), and do not necessarily need what they believe that they need. The key to effective IB financing is anticipating blind spots at every stage of the loan or investment cycle, especially in product design, borrower/investee engagement, capital deployment, and portfolio management.
Financial needs. All businesses need financing to grow. The key question is what kind of finance do they need: debt or equity. In the end, however, businesses may not have a choice after all. Equity may not be available due to company size, its current stage of development, risk profile, quality of financials, or degree of informality. It may also be that equity investors are not active in a particular geography or sector, or that it is prohibited by local legislation.
In the case of debt, the loan size, terms, and tenor must suit both the IB and the borrower.
11 Some key factors include the enabling and policy environments and the macro and political conditions.
The distinction made here between the business and individual liable for repayments is important. The loan size and repayment conditions must do two things: suit and support the productive capacity of the business and thus the cash flow it generates, and accommodate the relationship between these and the borrower’s own needs (i.e., between the commercial and personal). This is especially significant in developing economies, where the smaller the business, the more unclear the lines are between the commercial and personal. There may be no perceived or actual distinction at all. Therefore, a lending institution cannot consider commercial and personal cash-flow sensitivities independently from the other.
Nonfinancial needs. Emerging market IB invariably needs nonfinancial support, regardless of size. Medium-sized enterprises seeking debt or equity of $2 million–$10 million may also require intense engagement, although not as intense as micro and small enterprises. The focus areas tend to be similar, and include some or all of the following: management capacity, corporate governance, strategic decision making, working capital and asset allocation, financial systems and controls, inventory management, and marketing.12 Further, it is possible to identify areas of engagement required for particular IB models:
(i) Consumer-focused. Customer and market segmentation, data collection and management, client outreach and engagement, pricing, product marketing and positioning, and inventory management.
(ii) Producer/supplier-focused. Training and upskilling, access to financing, access to and training in application of key inputs (e.g., seeds and fertilizer for farmers), use of technology, logistics and distribution, packaging, certification, and compliance.
(iii) Distributor-focused. Product understanding and sales training, cash management, use of technology, and client outreach and capture.
Value addition in nonfinancial areas raises the question of who bears the cost. In the private equity model, the fund manager uses the management fee paid by investors to create value by engaging deeply with portfolio companies. Alignment of interests between investors and the fund manager incentivizes such engagement. In the case of many IB funds, a discrete pool of TA funding is also made available for this purpose.
Cost-bearing is not as clear with debt. Financial products generally need volume and economies of scale to break even and become profitable. Loan officers have neither the time, skills, nor resources to mentor the hundreds or even thousands of borrowers in their portfolios. Yet one could venture that these more precarious entrepreneurs, micro and small enterprises, have most to gain from such value addition. This issue is explored in detail in Section IV, but note here that the financing–advisory gap can be bridged by modifying traditional and proprietary financial inclusion techniques and introducing new technology.
Indeed, some financial institutions are finding innovative ways to cover the costs of client engagement. To the extent that growing IBs deliver direct and externalized benefits to society, alternative or supplementary cost-bearing arrangements should be explored in support of accelerated IB growth.
12 Note that not all of these areas apply to individual entrepreneurs and microenterprises. Corporate governance training is unlikely to benefit the street vendor or mom-and-pop shop owner, and a shoe polisher will probably not increase revenues by appointing a board of directors. This said, the marginal benefit to the street vendor of financial literacy training is just as great, if not greater, than bookkeeping training is to a small enterprise.
E. Conclusion
The needs of inclusive businesses are many and complex; even the identification of active or potential IB models can be challenging. Tailored lending and investment approaches are required to meet IB needs effectively, yet this is only possible if the practitioner is engaging from a solid institutional platform (i.e., bank or fund) that establishes a constructive balance between experimentation and risk taking on one hand and commercial rigor on the other.
Especially in the fund context, relationships between purveyors of financing and recipients of financial products depend on the robustness and perspective on entrepreneurs or MSMEs of the establishments providing them. The perspective needed is of the entrepreneurs or MSMEs as an opportunity and change agent best served by flexible, context-specific solutions. In this way, the discipline of the relationship with the lender or investor cements the foundations for commercial success and profitability.