Can Small and Growing Businesses in emerging markets not only survive—but also adapt and thrive post-Covid19? Dalberg’s Kusi Hornberger and Triple Jump’s Julia Kho share approaches that can help finance Missing Middle enterprises and provide a clear pathway for supporting inclusive economic recovery in emerging markets.
This article was originally published in Next Billion.
Covid-19 has made access to capital for small and growing businesses (SGBs) in emerging markets more essential than ever. Drivers of job creation and inclusive economic growth, these “missing middle” businesses—too big for microfinance, too small or risky for banks or private equity firms—face existential threats from stay-at-home orders, disrupted supply chains and other pandemic fallout. And as Small and Growing Business (SGB) finance providers across the board tighten credit requirements, especially for new clients, the SGB finance gap – which was estimated at US $930 billion annually before the Covid-19 pandemic—widens, further complicating economic recovery and rebuilding.
Yet the pandemic also provides opportunities to channel finance to SGBs with high potential to not only survive but to adapt and thrive post-Covid-19. SGBs’ diverse business models and growth trajectories create different unmet general and crisis-related financing needs. A 2018 research study from the Dutch Good Growth Fund (DGGF), Omidyar Network and Dalberg Advisors brings this diversity into sharp focus, identifying four segments with distinct growth potential and approaches to innovation and risk: High-growth Ventures, Niche Ventures, Dynamic Enterprises, and Livelihood-Sustaining Enterprises. The pressure of Covid-19 allows high-potential SGBs in each segment to demonstrate to finance providers the ability to adapt and, when necessary, reinvent their business models to maintain growth.
SGB finance providers that understand each segment’s financing needs can determine how those needs can align with their investment strategies. For example:
- High-Growth Ventures, as early-stage businesses using initial funding to validate unproven business models, often have limited financial runway. They also lack robust systems (including IT) that could allow them to withstand unexpected shocks by centralizing knowledge and reducing administration costs. Due to Covid-19, fundraising for these enterprises (especially from new investors unable to conduct in-person due diligence) has become more difficult and unpredictable. Given that most do not break even, these ventures need more equity capital to survive.
- Niche Ventures face the same challenges as High-Growth Ventures but are even more impacted by the crisis, given their dependence on specific market segments or customers that may change their behavior due to Covid-19. Fundraising for their highly innovative products and services has become more complex because their target customer segments/markets are not easily scalable.
- Dynamic Enterprises have seen severe but uneven effects from Covid-19. Their main challenges are changes in consumer behavior due to store closures/social distancing, supply chain disruptions, and staff retention given reduced revenues and workplace health risks. Challenged by lack of collateral, track records, sufficient cash flow and/or net profit, their ongoing needs for working and growth capital are more acute under the pandemic.
- Livelihood-Sustaining Enterprises provide critical goods and services to local communities, but their resilience is challenged by Covid-19’s disproportionate financial impact on their customers, their reduced ability to pivot their business models, and their reliance on a few core employees and informal systems to drive decisions. Reduced revenues in this segment have created large working capital finance and asset financing gaps.
Finance providers that understand these differing financial needs can identify approaches to best fill them. The SGB finance gap has many sources, but one big driver is misalignment between the products, strategies and expectations of finance providers (and their investors), and the impact and financial return provided by different types of SGBs. Building on their segmentation research, DGGF and Dalberg Advisors – along with other partners – authored a follow-up study in 2019 that identified five pathways for serving SGBs’ unmet finance needs. Characterized by how they primarily create value, these pathways align the interests of SGBs and their finance providers, and can help mobilize and channel finance to Covid-19-affected SGBs. The pathways include the following approaches:
- Enhance: This approach uses sector expertise and nonfinancial support to enhance the value of equity investments. This pathway supports promising High-growth Ventures and Niche Ventures experiencing crisis-generated temporary cash shortfalls. It also uses technical assistance and networks to help them pivot their business models to respond to new opportunities. This approach can also help identify new high-growth investment opportunities emerging from the pandemic.
- Catalyze: This approach blends finance to help hard-to-serve businesses or markets catalyze impact and follow-on investment. This pathway is especially important today, since many businesses supported by catalyzing investors lack financial resilience. Investors use catalytic capital and technical assistance to reduce the cost of serving Livelihood-sustaining Enterprises and Dynamic Ventures and to directly fund early-stage Niche Ventures and High-growth Ventures with clear social missions. This approach blends traditional investment sources with Covid-19-related grant funding and technical support designed for vulnerable high-impact SGBs.
- Adapt: This approach adapts products and partners to SGBs’ specific needs and local market contexts. Investors can work hand-in-hand with Dynamic Enterprises, Niche Ventures and High-Growth Ventures to adapt financial products and technical assistance to help them survive the pandemic. Highly customized financial products are especially useful where straight equity or debt investments are difficult.
- Systematize: This approach uses internal knowledge and processes to lower due diligence and investment costs. These SGB finance providers have deep experience in specific sectors, providing leverage to accelerate promising business model pivots in response to Covid-19. Systematizing finance providers see firsthand how Dynamic Enterprises and Livelihood-sustaining Enterprises can adapt to the crisis and consequently where new capital will—and won’t—have significant impact.
- Digitize: This approach automates decision making and achieves radically lower costs. This enables funders to make highly data-driven decisions about which Dynamic Enterprises and Livelihood-sustaining Enterprises to support by, for example, detecting correlations between effectively adapting businesses and key business characteristics. Because these finance providers’ technology infrastructure limits in-person interaction and can reach many small businesses with urgent needs but limited access to traditional finance, they can help these SGBs emerge from the Covid-19 crisis stronger.
Leading nontraditional finance providers are putting these approaches into practice. For instance, iungo capital uses the “Adapt” approach to make palatable, value-adding investments in Dynamic Enterprises using revenue sharing (rather than ownership stakes) to provide working capital and risk-sharing, and bringing on local angel investors with on-the-ground skills in navigating market disruptions. Omnivore Venture Capital in India uses the “Enhance” approach, combining equity capital with expertise and networks to help innovative High-growth and Niche Venture agribusinesses identify new revenue sources and enhance operational resilience. Upaya Social Ventures, also in India, uses the “Catalyze” approach to combine patient capital, recoverable grants and technical assistance to help Livelihood-sustaining and Dynamic Enterprises create jobs and attract follow-on investment.
These five approaches can help international development and investment communities ramp up their support for the SGB sector. Providing SGBs with access to finance has been challenging historically, primarily because of limited knowledge about how to connect the large, complex ecosystem of SGB finance providers with SGB finance seekers. These five approaches provide clear pathways for navigating this complexity, and for supporting inclusive economic recovery in emerging markets.
Please find the full research here: “Closing the Gaps: Financing Pathways for Serving the Missing Middles”
Julia Kho is a Knowledge Manager at Triple Jump, and Kusi Hornberger is an Associate Partner and co-leads the Finance & Investment Practice for Dalberg Advisors.