Many developing country economies are vexed by the so-called ‘Missing Middle’ – these countries have large numbers of micro-enterprises and some large firms, but very few small and medium enterprises (SMEs). This dearth of SMEs inhibits growth because in most high-income countries, it is SMEs that comprise upwards of 60% of private sector employment and account for the bulk of new job creation. Thus, the ‘Missing Middle’ makes it difficult for frontier economies to drive private sector growth and create jobs to meet the needs of growing populations.
Why do these economies struggle to create and sustain large numbers of SMEs? Most research points to the lack of access to finance as a key constraint to SME creation and growth. While there is capital available in many countries, few SMEs have the know-how to access debt and equity financing.
This is where project preparation facilities (PPFs) can play a vital role in filling in the ‘Missing Middle.’ By working directly with promising entrepreneurs to strengthen business plans, conduct market analyses and environmental impact assessments and structure their finances, these facilities are able to ‘buy down’ risk for banks and equity investors and, therefore, unlocking investment for promising investment projects. Effective project preparation can drive investment into SMEs, drive their growth and thereby enable frontier economies to address the ‘Missing Middle.’
Over last year, the Resonance team has been developing and strengthening two project preparation facilities designed to use a small amount of donor funds to unlock large amounts of debt and equity from the private sector. In Africa, Resonance has been working with USAID and the African Development Bank to establish and launch the Agricultural Fast Track Fund (www.aftfund.org), which is meant to drive investment into agricultural infrastructure (feeder roads, processing plants, storage facilities, etc). In Southeast Asia, Resonance recently began working with USAID and Deloitte on the Private Financing Advisory Network-Asia (PFAN-Asia), which works to prepare smaller scale ($1-50 million) clean technology projects for investment. While the two efforts work in different regions and in different sectors, there are some shared insights:
- Small donor investments can unlock large amounts of private capital. Through less than $3 million dollars in donor funds, we project that AFT will unlock $84 million dollars in debt and equity investment in its first round of pilots and grants in 2013 alone. Similarly, PFAN-Asia states that it has leveraged more than $200 million in investment in clean energy projects using roughly $3 million in donor funds. Clearly, these PPFs have the ability to unlock substantial private capital.
- Effective deal sourcing is essential. For PPFs to be effective, they must develop and maintain a substantial pipeline of prospective projects. For example, in the case of AFT, Resonance reviewed nearly 300 potential investments in 6 African countries, which ultimately yielded less than two-dozen investments selected for AFT grant funds. Here, relationships with investment funds and commercial banks are essential as sources of deal flow. Investors have a strong incentive to send promising projects to PPFs, which in turn increases the likelihood those projects will be ‘banked’ following the support of the PPF. Put simply, the more effective the PPF is at sourcing promising projects, the greater its impact will be.
- Focus on ‘additionality.’ A key challenge for these PPFs is finding worthy investment projects where donor support can make a meaningful difference in terms of whether an investment takes place. This ‘additionality’ justifies the use of public funds to facilitate the investment. It is, therefore, essential that donors ensure that these facilities are focused on projects that fall within the ‘sweet spot’ of having good potential to yield the development outcomes and also business results, but are in such good condition that they obviate the need for assistance. In the case of AFT, Resonance developed a rigorous series of metrics that evaluated applicant firms in terms of their business potential, development impacts (in this case small hold farmers) as well as the likelihood that AFT support would make the difference in whether or not the project was ultimately financed. By carefully analyzing this additionality, donors can be certain that they are truly unlocking private capital as opposed to subsidizing deals that would likely happen anyway.
While addressing the problem of the ‘Missing Middle’ will require more than investment, properly structured PPFs have enormous potential to strengthen the ability of promising SMEs to attract capital and grow.