The SME finance gap in Kenya: how are investors missing the ‘missing middle’?

Published on 12 February 2019

Small and medium size enterprises (SMEs) are still struggling with the gap in funding between micro loans and larger commercial lending. Governments, NGOs and the private sector in Kenya are attempting to fund that gap but are still only catering for a small share of the market. To succeed they need to be more ambitious, less risk averse and must move away from targeting only high growth companies.

The well-known term ‘missing middle’ refers to the gap in available finance that SMEs fall into when looking for capital. Lack of capital is still the largest constraint to SME growth in Kenya, preventing SMEs potential to be realised with their ability to create jobs, pay taxes and provide goods and services. Kenya provides an interesting case as many actors have been attempting to serve this segment of the market, however their approach to date has not filled the gap. This blog will look at the reasons why and will offer suggestions around redesigning SME finance to target the missing middle.

Truphena Anyango, a 29-year-old mother of one, at her pharmacy in Mikindani, Mombasa, Kenya on July 31, 2009. Truphena has been using microloans from Kiva partner KADET to grow her pharmacy, buying a greater range of medicine and personal care products in order to better serve her customers.
Truphena Anyango, a 29-year-old mother of one, at her pharmacy in Mikindani, Mombasa, Kenya on July 31, 2009. ‘ by hodag, CC BY- NC -ND 2.0

What’s the issue?

There seem to be 3 reasons why current finance options are failing to serve the missing middle in Kenya:

Unworkable finance types

The first issue is that funders largely use traditional instruments for financing SMEs that have worked well in the developed world, without looking at the needs of SMEs in developing contexts. For example, equity investing works very well for angel investors and venture capital firms in Silicon Valley, but the structures required for successful equity investing; legal frameworks, high growth potential and a clear exit strategy is not viable for many SMEs in Kenya. As in the rest of the world, SMEs largely need simple growth and working capital in the form of debt, at good rates that they can easily access. For a select few, equity does work but this is a clear minority in the market.

Disconnect between supply and demand

Market expectation is another issue. Most funders, including impact investors, are looking for SMEs with somewhere between 10-30% annual growth to manage the risk of investing in frontier markets as well as satisfying their return expectations. Looking at the Kenya SME market, a mere 13% of SMEs would therefore qualify for funding, those being high growth tech start-ups or successful scalable businesses known as gazelles. However, the majority, 45%, are categorised as ‘low growth’, often small businesses (5-19 employees) that generate modest growth and return but make a living for employees. With such a mismatch between expected returns and the reality of the market, it is clear how the missing middle persists.

Risk Aversion

This all boils down to general risk aversion. Funders are only willing to use tried and tested finance models and only fund SMEs with the highest growth potential to mitigate risk in a tumultuous market. The funding gap persists because the options offered do not to serve the majority: the slow growth, higher risk, moderate return businesses. While these may be less attractive investments, these businesses must be targeted to realise the broad-reaching economic benefits of SME growth. Blending finance between private and public sources spreads risk and is one way to tackle this, and several enterprises are using this to take on more risk, but funders need to be more ambitious with reach and less with return if they are going to serve the missing middle successfully.

A model to fill the gap

The reality is, as in most countries around the world, the vast majority of SMEs are small, low growth, unglamorous businesses. However, despite the odds they are turning over a profit, paying taxes and hiring staff. Funding options need to be redesigned to cater for the needs of SMEs in markets such as Kenya instead of simply rolling out existing funding models. Research suggests some criteria that could lead to success:

  1. Debt finance – with such low growth, there is little opportunity for successful equity investing with exit plans for most SMEs, so debt finance for growth and easily accessible working capital is needed
  2. targeting small, modest growth businesses – The real missing middle SMEs have small capital requirements, between $5000-$100,000, and have modest growth. Any SME outside this remit is already served by existing channels
  3. with low interest rates – in order to avoid crippling SME’s returns, interest rates would have to be kept at only a few percentage points above inflation, often below national bank lending rates
  4. and low security requirements – many businesses cannot access existing finance due to lack of securities, so unsecured lending would have to be offered
  5. and very low operating costs – due to all of the above, the returns would be modest at best and so digital platforms for management and due diligence would have to play a key role in keeping costs down, or even use a blended approach to cover operating costs

Can this work in practice?

‘Debt finance targeting small, modest growth businesses with low interest rates and low security requirements and very low operating costs’ may sound unworkable. However, on a recent trip to Kenya, I managed to find some enterprises that were attempting some of these challenging requirements to serve SMEs:

  • Cutting risk of failure
    The Somo Project in Nairobi provides small initial grants to entrepreneurs in Nairobi’s Kibera slum and helps them build strong businesses with the support of training and mentorship. Once profitable, it then plans to open them up to more market-oriented private investment to help them grow, feeding the market with strong businesses prepared for investment
  • Cutting management costs
    Business Partners International has cut due diligence costs by categorising business plans it receives by risk, thus being able to ‘pre-approve’ certain SMEs that they know could be successful.
  • Cutting security requirements
    Tala, a fintech start-up has found a way of providing unsecured lending based on customers’ phone and social behaviour, for example, having many contacts suggests a large network which therefore lowers the risk of default.

While the above enterprises are a welcome change to traditional approaches, there is still a lack of funders attempting to genuinely disrupt the market and target low growth SMEs. To make progress at scale, funders need to be more ambitious, less risk averse and reach far more SMEs that need finance. There are many good businesses that turn over a profit that are being side-lined for the glamorous, high growth ventures that make good headlines. Focus needs to be on impact over profit and reach over growth potential. Without this ambition, the missing middle will persist, and Kenya’s entrepreneurial potential will not be fully realised.

Alistair Cowan is a MA Globalisation, Business and Development student at IDS (2017-2018), and is currently based in the East Africa region focusing on private sector and market systems development.

The views expressed in this opinion piece are those of the author/s and do not necessarily reflect the views or policies of IDS.


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