Aa Article - Capitala Nov 2009 - Gaining Access

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A Finance Framework for MSMEs in the Middle East

By Ahsan Ali

Micro, small and medium enterprises (MSMEs) are the backbone of any economy. MSMEs form the majority of enterprises in any country and contribute to value addition, employment generation and innovation. Many of the largest and most successful enterprises in the last two decades have started as MSME ventures.

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Country

Saudi Arabia UAE Egypt

MSMEs’ estimated contribution to GDP NA 30% 80%

Jordan

50%

MSMEs’ estimated contribution to employment 25% 86% 75% of private sector 60%

Lebanon

Percentage of total business entities 90% 90% 99% (non-agriculture) 98% (registered companies) NA

99% of 82% economic activity Source: Government agencies, SCB Research “Middle East – The Rising Importance of SMEs”

Recently, there has been a shift of focus onto MSMEs for:

tant from a human-development as well as an enterprise-creation perspective.

Employment Creation: It is estimated that by 2030, there will be in excess of 100 million youths (age 18 to 30) within the wider Arab-speaking world. Unless new enterprises mushroom dramatically, countries will not have the capacity to absorb this population in productive employment. Diversification of GDP: With the advent of global trends in energy security, renewable energy and depletion of oil reserves, Middle Eastern governments are focused on diversifying their reliance on oil-based products. Other major concerns are cluster developments around key industries, value-chain linkages and development of a wide manufacturing base. MSMEs are crucial for the successful execution of these strategies. Innovation: The key differentiator for enterprises of the future is going to be an innovative product offering. The region is focused on the development of a knowledge-based economy, able to compete globally with ideas that can be commercialised. Skill set development: With the majority of the educational sector geared towards producing “graduates” versus developing skill sets (vocational or knowledge-based), most of the learning and development of practical skills is learnt as an entrepreneur. Vocational training initiatives are going to be impor-

Despite the focus on MSMEs, the failure rate for new enterprises in the Middle East remains close to the global average (67% fail within the first three years). Amongst the main reasons for failure is access to finance for MSMEs (new startups as well as growing enterprises). A recent Dun & Bradstreet study of SMEs in the UAE showed that 55% of the respondents were unable to get financing. Study on SME Lending in the UAE Able to get credit

With the advent of global trends in energy security, renewable energy and depletion of oil reserves, Middle Eastern governments are focused on diversifying their reliance on oilbased products.

Economic Importance of MSMEs to the Middle East

Satisfied with interest rate

W

ith the advent of the free flow of “knowledge streams”, the barriers to entry in any MSME business discipline are eroding dramatically, as most business acumen or know-how is freely available in digital form. The global recession is also spawning the “necessity entrepreneur” as job security plummets and job losses increase. This is expected to lead to a dramatic increase in the number of startups within the MSME arena. In the Middle East, there is growing awareness of the importance of MSME enterprises.

Satisfied overall

Gaining Access

45%

55%

50%

50%

58%

42%

yes

no

Source: SME Lending in the UAE – 2008, Dunn & Bradstreet capital business magazine 45

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Access to Finance Framework

This impacts enterprise creation as well as constrains growth. The effects of financing constraints have been documented in various studies and have conclusively demonstrated that MSME firms’ growth suffers far more than that of large firms.

Micro

Small

Medium

Effect of Financing Constraints on Growth

Definition of MSME’s Financing obstacle Collateral requirements Bank paperwork or bureacracy High interest rates Need special connections with banks Banks lack money to lend Access to foreign banks

G O V E R N M E N T

Microlending

Loan Guarantee Based Schemes

Priority Sector Lending Policy

Incubators

Access to financing for leasing equipment

Cluster Based Development Policy

Innovation Strategy

Access to long-term loans -12

-8

-4

0

4

% change in firm growth Small firms

Large firms

PRIVATE SECTOR

Improving access to finance and investment is crucial for newenterprise generation as well as sustainable growth for existing entities. 46 capital business magazine

right industry segments, devise policies and focus on cluster development. • Private initiatives are rarely altruistic and the profitseeking motive might deter private entities from long-term developmental commitments.

Building Blocks of an Access to Finance Framework Within the context of Middle East, there is a need to devise a simple framework which can facilitate an increase in MSMEs’ access to financing. Any framework needs to work on the concept of public-private partnership. This is essential for the following reasons:

1. Government. 2. Private sector (banks, investors, capital markets, financial institutions). 3. Enabling environment (initiatives, partnerships with global experts, etc.).

• A pure public-driven initiative reduces efficiencies, has restricted scale and ties up precious resources. • Public frameworks tend to create a protected environment, reducing competitiveness and thus reducing chances of sustainability of the supported enterprises. • A private endeavour lacks the ability to identify the

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Equity - Angel Investors

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Universal SME Credit Rating / Bureau

A basic framework for MSMEs would have the following three key pillars:

1. Government The government in this model plays a central role, with most of the activities concentrated in strategic planning.

Score Based Lending Models

Microfinance Institutions

Source:Beck, Demirgüç-Kunt, and Maksimovic (2005) as reported in World Bank (2008). The problem of access to finance does not have a universal solution. The theoretical and practical constructs of increasing access to financing are impacted by geographical peculiarities, state of the financial system in the economy, policy support infrastructure, risk tolerance of financial institutions, private investment and direct intervention by governments.

Score Based Lending Models

ENABLING ENVIRONMENT

Non Governmental Organization

Access to Markets

Skill Development and Support

Procurement Programmes

Supply Chain Linkages

Partnership with Multilateral Agencies

IP Protection Framework

Definition of MSMEs In order to create a sustainable framework, the starting point is the definition of an MSME. Without a clear-cut definition, it is impossible to align policy capital business magazine 47

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The private and the public sector can start access to a finance framework; however, unless the environment in sufficiently enabled, the framework cannot be sustainable over the long term.

initiatives, engage the private sector or undertake performance measurement of key initiatives. The definitions for MSMEs vary across geographies, but usually they are based on a combination of:

Microlending Microfinance is a captivating concept, enshrined in the community concept of self-help leading to poverty alleviation. For microfinancing to be successful, certain key characteristics need to be in place:

• Assets or investments (capital employed). • Number of employees (indication of size). • Turnover (indication of size). • Nature of entity (complexity).

• Large population base. • High incidence of population at the subsistence level. • Absence of or limited social security. • Cultural nuances supporting teamwork for survival.

The definition of MSMEs in a country is usually undertaken by the relevant ministries or central banks or recommendations are taken from multilateral agencies. In certain countries, in the absence of an “official” definition, banks’ definition of SMEs may be used. However, this is not a viable approach because bank definitions are based on profit-based segmentation versus economic classification, and in developing economies, the scarcity of credit information means that banks gravitate towards larger and organised clients. Thus the bank’s SME definition is skewed towards medium to large enterprises

From these, it is easy to ascertain that the typical microlending model will not be successful within most of the Middle Eastern nations (especially the GCC countries). In countries such as Egypt, Saudi Arabia and Morocco, traditional microfinance models are applicable. However, in most of the GCC countries (with Saudi as a notable exception), the local population is a minority. The governments have ample resources available and employment for the native skilled population outstrips the supply. Here, the microfinance approach needs to be targeted and packaged with skill development. The ob-

SME Definition by Country Country

Microenterprises

Small enterprises

Saudi Arabia

NA

UAE

N.A.

Egypt

1-9 employees; registered capital of < USD 87,864 (Microenterprises make up 71% of total SMEs)

Jordan

Up to 10 employees; registered capital of less than JOD 30,000

< 59 employees; 60-99 employees; capital of SAR 1-5mn capital of 5-20mn Turnover: < USD Turnover: USD 1010mn 25mn 10-50 employees; 50-100 employees; registered capital of registered capital of USD 87,865-USD USD 878,660-USD 878,659 (small 1.76mn (mediumenterprises make sized enterprises up 19% of total make up 10% of SMEs) total SMEs) 10-99 employees; maximum annual sales of JOD 1mn (USD 1.4mn), maximum assets of JOD 1mn (USD 1.4mn)

Lebanon

Fewer than 5 employees (88% of total businesses)

Medium-sized enterprises

If sales and total assets both exceed JOD 1mn, a company does not qualify as an SME Fewer than 200 employees (99% of total businesses)

Source: Government agencies, SCB Research “Middle East – The Rising Importance of SMEs”.

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Defined by

Government Commercial banks Government

USAID recommended definition

Ministry of Economy and Trade

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Intellectual property rights are crucial for maintaining a competitive edge and restricting unique products from turning into commodities.

jective is not poverty alleviation, but absorption into gainful employment, reducing the burden on the national exchequer (social security, state subsidies, etc). In other words the outcome of microlending is tilted more towards human capital development rather than poverty alleviation. Some countries are also coupling this with cultural preservation programs (handicrafts, textiles, etc.) specific to the region. Others are engaging the native population through microfinancing, upgrading their skill sets and either placing them in value-added employment or upscaling them to sustainable small concerns. Governments need to take the lead in microfinancing to identify needs, decide objectives and develop skill bases. The size of the native population and its relative wealth does not make the Middle East an attractive sector for a private microfinance institution. Loan Guarantee Schemes MSMEs are viewed as high-risk entities by financial institutions. The banking system does not encourage startup financing. The asymmetry of information caused by limited tax regimes (GCC), lax regulatory oversight, basic credit models and small loan sizes makes evaluation a costly exercise for banks. Government intervention in the form of institutions or entities that evaluate project financing for SMEs − with a view towards providing risk participation to the banks in their lending to MSMEs − increases the flow of finance with the following advantages: • Banks provide financing to feasible projects, reducing paperwork and bureaucracy. • Interest rates charged are substantially lower because of the risk participation of the government. • Tangible collateral is not required from MSMEs. • Risk participation encourages selection of viable startup projects and once cash-flow generation starts, the bank transfers these clients to a “regular” relationship. • Banks can develop score-based lending programs; these need a decent portfolio size and loss data over three years. The government guarantee program can effectively fund the “development” cost of these programs by underwriting the risk which the bank would not have taken alone. Cluster Development and Priority Sector Lending Government entities need to formulate economic development strategy with a focus on industry segments that have a competitive advantage or want to develop a competitive advantage. For example, shipping and logistics can be a focus industry; this would require developing infrastructure, manpower development, engineering workshops, etc., to support this industry.

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The government can prescribe a minimum percentage of credit extension (as a total lending base) to MSME entities within a particular cluster or MSME entities across sectors. This approach has been successfully implemented in Pakistan, India (sector focus on agriculture and cottage industries) and the Philippines (entity focus) within emerging markets. Incubators and Innovation Experience across the world has shown that innovation prospers with the right incubation facilities. Physical proximity to universities, industry focus, information and communication technology infrastructure, and subsidised research facilities are the key characteristics for a viable incubator setup. Apart from incubators for innovation to thrive, the basic pillars of education, technological capabilities, government incentives and development of intellectual property protection are essential. Innovation and incubation supports ensure that the quality projects coming up for funding generate the requisite interest within the financial community. Apart from funding, this spawns equity investment and venture capital industries. The best example of this is the US, where the venture capital industry is credited with major breakthroughs in health care, technology, communications and internet-based services. Once the private sector establishes the financial viability of incubation and innovation, the transition from a government-sponsored initiative to a public/private partnership or private-only setups becomes relatively easier. 2. Private Sector The role of the private sector in any economy is to efficiently allocate resources and factors of production to derive the maximum possible gain. Provision of Loans and Financial Products The private sector should be encouraged to develop a suite of financial products covering the needs spectrum for MSMEs. The challenges arise within microfinancing, where the private sector must identify niche opportunities with sufficient scale for the model to be commercially viable. Usually this can be aided by government intervention in the form of public-run microfinance institutions, subsidising the cost of funds to microfinance institutions and incentives on the tax or regulatory front. Once suitable scale is achieved, these can be eased out and microfinance institutions can function independently. The two models for regular loan provision for SMEs can be scorecard-based lending and relationship lending.

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The first variant is applicable for smaller size loans. In a score-based model, based on actual statistical data, a scorecard is developed for an applicant for a particular industry. The scorecard has predictive ability on the likelihood of default for any applicant based on demographics, industry variables, repayment history and other factors. This approach is cost-effective, as the disbursement, monitoring and collection is done on a portfolio basis with economies of scale. However, the downside is that there is no “tangible” relationship with the MSME enterprise. An example of scorecard-based lending would be the credit-card lending model. Relationship-centric lending models usually have a one-on-one relationship with the SME concern through either a relationship manager or branch manager. This entails a better understanding of the business and development of customised solutions for the MSME’s financial needs. Though generally preferred by MSMEs all over the world, the model entails substantial investment in the operating framework from the bank’s side. Unless a bank has sizeable scale of profitable SME customers, it does not prefer this approach. Raising Equity Investment In the developed markets, the private sector is credited with raising a substantial chunk of equity investment through angel investors, venture capital firms and stock exchanges. Within the GCC, the angel investment network is credited with raising only $7 million in 2008, compared with more than $26.5 billion in the US alone. Investors (both private and institutional) are wary of equity investments in the Middle East because of a lack of transparency stemming from the regulatory framework, absence of data to make comparative valuations, missing bankruptcy laws and limited opportunities for exit. Even though stock exchanges exist within the Middle East, the small cap exchange model (along the likes of AIM in the UK) has not been implemented yet. Thus the market-making and exit possibilities for equity investors are quite limited in scope and most of the transactions occur as private placements. This is one of the most lucrative regions in the world to raise equity, but the sad part is that an overwhelming majority of equity investments are routed to developed markets. The three pillars of equity investment (angel, venture capital and stock exchanges) need to be revamped within the Middle Eastern markets for equity investments to start flowing. 3. Enabling Environment The private and the public sector can start access to 52 capital business magazine

a finance framework; however, unless the environment in sufficiently enabled, the framework cannot be sustainable over the long term. The key enablers in such an environment ensure the success of MSMEs, promote transparency and develop the skill base of entrepreneurs, thus raising confidence in MSME enterprises. Credit Ratings and Bureaus The role of independent credit ratings for MSMEs is essential for the flow of financing and equity investment to take root. Independent credit ratings usually are the domain of larger corporate concerns. They communicate an assessment of the entity’s expected business performance, financial performance, management effectiveness and, consequently, creditworthiness from a going concern perspective.

The rating process is dependent on accounting regulations, disclosure laws, industrial data, credit loss, migration data and peer group analysis. This is a costly and time-consuming process to put in place for MSMEs. What actually makes sense is to develop an MSME rating bureau along the lines of a retail private credit-reporting agency. This would provide an assessment on the basis of statistical scorecards tailored by industry segments, hence lowering the cost and the turnaround time substantially. However, this requires a concerted effort to invest in collating data at the national level, which in itself is a complicated exercise. The global existence of private credit reporting is mostly limited to the developed markets, with some coverage recently in Asia.

In most of the Middle East, import-based economies with limited protection pit a nascent MSME enterprise against large players from across the globe.

Private Credit Reporting

Rating Parameters Criteria Parameters Business

Financial

• Overall understanding of business process and practices • Estimate of the sustainability of the business • Key driving factors of the business • Important customers and suppliers • Sales and purchases fragmentation • Order book position • Strategic strengths and weaknesses • Diversification plans • Projections and synergies • Independent confirmations from suppliers and customers about the performance and market standing of the subject • Inherent risk involved in a similar type of business

• Gross profit and net profit margins • Trend analysis • Gearing • Return on net worth and return on capital employed • Contingent liabilities • Debt service coverage ratios • Inter-company loans with specific attention to the companies belonging to same owner but not consolidated with other companies • Monthly cash flows • Other financial factors peculiar to the business of the company

Promoter & Management • Constitution and shareholding pattern of the group companies • History of the group and its promoter • Review of other companies and investments held by the promoter • Financing and operational ring fencing measures taken by the management • Professionalism in management • Succession plans of management including second line of management • Management philosophy • Gearing philosophy of management • Local shareholders interference in the management of the companies • Other factors peculiar to the business and management

Private Credit Registry Existing In Process of Developing Does Not Exist No Information

Protected Market Environment Sustainable development of MSMEs can be ensured by providing a protected market environment. In most of the Middle East, import-based economies with limited protection pit a nascent MSME enterprise against large players from across the globe. A protected environment can be created by such initiatives as: • Creating closed marketplaces (from a competition perspective) by product category or geography. An example could be developing a handicrafts market with a high concentration of microenterprises. The fixed and marketing costs of such a marketplace can be set up under a public-private partnership. • MSMEs can be made a part of the supply chains of large corporate concerns. This can be done by mandating a certain percentage of the supply chain procurement from MSMEs, with an acceptable variation of cost and quality. • Government procurement programs targeted at MSMEs can prove to be very useful. In the Middle East, government entities control a large portion of

spending, and diverting 5% to 10% of this spending could support a large number of MSME enterprises. These types of initiatives are especially appealing to the private sector under the corporate social responsibility (CSR) philosophy. A key aspect of the protected market is “healthy turnover”. Firm criteria for both eligibility and “graduation” from the program need to be put in place. This ensures that MSMEs continue to drive for self-sufficiency and that the programme does not end up creating inefficient enterprises in the medium term. Leveraging Partnerships The concept of synergy can be applied to good effect within the framework. Supra nationals, multilateral donor agencies and nongovernmental aid institutions bring a wealth of experience and resources to the game. The important aspect is to identify and align their roles to the central MSME development policy and strategy. The role of these partnerships is crucial at the strategy and planning phase to ensure seamless execution. capital business magazine 53

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Skill Development and Support The concept of training and development has given way to skill development in recent years. Classroom sessions on theoretical aspects of running a business have given way to peer group experiential learning sessions. Instead of subject matter experts, these sessions are conducted by facilitators aiming to answer problems based on the actual experience of the peer group. This trend has forced a rethink of traditional training and delivery channels. With a knowledge focus, professional networks and context-based solutions to questions available on the internet, the traditional methodologies have to adapt and evolve. Supporting MSMEs on an ongoing basis in operational aspects, government relations, generation of business and general counseling has a tangible im-

pact on success rates. Support can come in the role of a “business counselor.” For an MSME, this combines a trusted aide, industry expert, bank financier, psychiatrist, consultant and friend. This intervention is crucial in the post-operating stage of an enterprise. If the right rapport can be established with the entrepreneur, the failure rate can be reduced. Regulatory Considerations and Intellectual Property Protection The regulatory framework, in terms of ease of doing business, bankruptcy laws, availability of the required infrastructure and logistics, commercial law and the judicial system, is important for the generation of new enterprises and sustainability of existing ones.

Ease of Doing Business Report 2009 rankings Country

Overall Ease of Doing Business ranking

Starting a business

Egypt 114 41 Jordan 101 131 Lebanon 99 98 Saudi Arabia 16 28 UAE 46 113 Source: Ease of Doing Business Report 2009, World Bank

Experience across the world has shown that innovation prospers with the right incubation facilities.

About the Author Ahsan Ali is the Director Credit for Khalifa Fund for Enterprises Development, a sovereign fund focussed on SME development, in the UAE. His previous work experience of over 12 years in banking spans across 8 countries and multiple disciplines. His areas of interest include economic development, risk management, Islamic banking and SME Development. He holds an MBA from the Institute of Business Administration, Karachi University, as well an MS in Financial Economics from the School of Oriental and African Studies, London. Ahsan is a CFA Charter Holder, an FRM certified risk manager and a member of the Securities and Investment Institute (SII), UK. 54 capital business magazine

Getting credit

Enforcing contracts

84 123 84 59 68

151 128 118 137 145

Intellectual property rights are crucial for maintaining a competitive edge and restricting unique products from turning into commodities. Establishing an intellectual protection environment requires comprehensive legal challenges as well as alignment to global standards. Tailored Solutions Improving access to finance and investment is crucial for new-enterprise generation as well as sustainable growth for existing entities. There is no clear-cut formula or model which guarantees success. Each region requires a tailored solution catering to its financial markets, human talent base, governmental resources and economic priorities. For the Middle East, keeping these factors in mind, a basic framework needs to be developed. The core of it has to be a clearly defined publicprivate partnership backed by key environment enablers to help the region’s MSMEs to prosper.