Tackling the Missing Majority and Why We Must Look Beyond Agricultural Productivity

The “missing middle:” most investors have heard of it, most social entrepreneurs don’t want to be stuck in it. If you want to start an informal micro-enterprise, then it is usually possible to secure micro-credit, while banks will back well-established medium-to-large companies. But in between lies an entire segment of entrepreneurs who are faced with a terrible problem: virtually no financial services serve their segment. Madeleine Anderson, CEO of Equity for Africa, explores this problem and suggests innovative solutions.

Most investors looking to go “beyond profit” have heard of the missing middle. The term was originally used to describe a gap between very large and very small companies in low income countries, with small and medium enterprises (SMEs) contributing a much lower proportion of GDP and employment than in high-income countries.

Over time, the term has shifted to mean the financing gap between microfinance and very large commercial investments. There is very poor access to finance for the companies in between, constraining SME growth and possibly causing this SME gap.

In response, a new industry of SME fund managers has begun to emerge in Sub-Saharan Africa. Grofin is the undisputed leader, but there are a number of new entrants to the market as the concept has become increasingly mainstream. These organizations use a private equity (PE) model to invest in small numbers of SMEs with the potential to become internationally competitive, with the best of them also providing extensive capacity building from separate grant funds. They attract the very best of African talent, bringing highly skilled workers back from the diaspora to manage the investments.

Data from a 2007 SEAF report1 has shown the huge impact SME investments can have, not just for the people who are employed by the growing businesses, but also everyone in the value chain, right down to the smallest farmer. This presents an exciting opportunity for social investors, or Impact Investors, as they are now often called. There is a clear market failure, and investors may be able to have it all: making a reasonable return, while achieving development goals.

Digging Deeper

But, there is a flaw. These funds are only addressing the section of the financing gap that fits with existing supply models, with minimum investments usually starting at US$ 100,000 or above. Why? Because if you use a conventional PE model, even one adapted for African SMEs, based on highly-skilled investment staff, it is necessary to invest at larger sizes because the unit cost of doing a deal is high. And the cost is getting higher: because of the increasing demand from banks and PE investors, demand for skilled people is rising, so the minimum investment size may also rise.

This supply-driven approach misses a market with potential for major development impact. The job creation rate per dollar invested is much higher at the smaller end of the gap, the “transition investments” below US$ 100,000. These investments are needed to help very small businesses make the transition to the next level. And there is high demand here. Equity for Africa (EFA) invests in this segment; our portfolio includes a number of agricultural processing businesses, in sectors as diverse as fish filleting and ice-cream, and also many service industries such as printing presses and dry cleaning. They all keep basic accounts, and 70% provide formal training to their employees.

The combination of strong demand and the high job creation rate means investing successfully in this segment really puts the Impact in Impact Investing. Without tackling this segment, it is hard to see what the foundation of broad-based growth will be. So the key issue is how it can be done successfully.

Tackling the Missing Majority

Microfinance cannot serve this need effectively. The group-lending model in microfinance is just as unsuited to these “transition” investments as the larger SME funds, albeit for different reasons. Micro-loans are very small and short-term, and are more likely to be used to improve livelihoods of self-employed sole-traders or smooth out income than to grow genuine businesses. In Tanzania, less than 40% of microloans are used to set up or expand a business at all.2

Growing businesses need flexible finance, but equity finance as a concept is not recognized by the smaller entrepreneurs in Africa. Neither is equity practical, because it is too difficult to monitor and it is virtually impossible to get your money out of the business. Flexibility is nevertheless key, as the recent droughts in Tanzania have shown. Small businesses, which need electricity to operate their machinery, were hit hard because much of Tanzania’s electricity is generated by hydro power.

Investors who know this area well often claim it can’t be done. However, we believe it is possible to provide flexible finance at affordable rates while generating attractive returns for impact investors. The key is not to start from the Western model, but to make it local and reduce the need for specialized skills. We see four core success factors:

• Appropriate Product: A single, simple product means we stay focused and our employees do not need to conduct complex negotiations. A “patient debt” product with a 3-year term is self-liquidating, and also allows for growth and flexibility in an uncertain environment. We only fund equipment, so the product is naturally collateralized.
• Standardization: The application and appraisal process is highly standardized, keeping the process efficient and manageable. The application form functions as a simple but thorough business plan template, and half-day seminars demonstrate how to complete this.
• Good Technology: Well-designed software also improves efficiency, and appropriate SMS technology can enhance this further. It is important to emphasize that this is not a question of the more innovative the better: this is about consistent, single-minded delivery.
• Low-Cost Culture: Transaction costs are reduced by sourcing local, reliable staff, and using a few skilled people to design, develop and oversee the process at charity salaries rather than MBA salaries. No frills: no business class flights, no US$ 10,000 memberships of development networks, no international networking conferences, no Western-style hotels.

For us, it works: we have been investing for three years and have made 79 investments totalling over US$ 450,000, with several of these already completed and a minimal amount of capital written off. Because of the design features above, we need great people in order to scale, but not top bankers who are so hard to find. Based on historic performance and current scale, we can target 10-15% returns. Having proven the model, we are now looking to scale up substantially to increase our impact.

Impact on Agriculture

We cannot talk about SME investing in the current environment without talking about the relation to agricultural development. Two forces have come together to make this a hot topic. Firstly, food security is deteriorating as a result of global climate change and demographic shifts. Given the reality that much of Africa’s agricultural land is owned by impoverished smallholders, this has led to a renewed focus on smallholder productivity. And secondly, many development organizations now view smallholder productivity improvements as a key way to reduce poverty on a large scale.

SME investments complement smallholder productivity initiatives directly by developing agricultural value chains. SMEs that purchase agricultural outputs are essential to strengthen local demand, ensuring increased productivity does not result in local price depressions and providing smallholders with accessible markets for new crops. SMEs that supply agricultural inputs also put productivity gains on a more sustainable footing.

In addition, SME investments create jobs, which provide an important source of additional income for farming families. World Bank research shows employment growth in the secondary sector has almost as much impact on poverty as agricultural productivity growth – potentially at a lower cost. In the long run, there will be little incentive for mechanization while there is high under-employment in farming communities.

In summary, we cannot afford to overlook the huge “transition investing” market at the bottom of the missing middle. Equity for Africa’s experience shows it is possible to build a powerful tool for cost-effective and sustainable investment in this market. This is not about indiscriminate growth; it is about targeting investment at an under-served market shown to deliver high job creation and smallholder impact. By taking hold of this opportunity, we believe impact investors really can have it all.

Madeleine Anderson is the CEO of Equity for Africa, which invests in small businesses at the bottom of the pyramid. She was previously a consultant at McKinsey and a venture capital investor, and she has also worked with development NGO Technoserve.