In the Media

The innovation—microfinance—involves making small loans to poor entrepreneurs, usually in developing countries. It has been around since the nineteen-seventies, but in the past few years it has seized the imaginations of economists, activists, and bankers alike. The U.N. declared 2005 the International Year of Microcredit, and the microfinance pioneer Muhammad Yunus won the Nobel Peace Prize in 2006, while celebrities like Natalie Portman and companies like Benetton have become fervent microloan advocates. Even ordinary Americans can now get in on the act, at sites like Kiva.org, where you can make a microloan yourself. (Right now, a clothing vender in Cambodia needs seven hundred dollars to “ purchase more clothes
to sell.” )

This vogue has translated into a flood of real dollars: institutional and individual investments in microfinance more than doubled between 2004 and 2006, to $4.4 billion, and the total volume of loans made has risen to $25 billion, according to Deutsche Bank. Unfortunately, it has also translated into a flood of hype. There’s no doubt that microfinance does a tremendous amount of good, yet there are also real limits to what it can accomplish. Microloans make poor borrowers better off. But, on their own, they often don’t do much to make poor countries richer.

This isn’t because microloans don’t work; it’s because of how they work. The idealized view of microfinance is that budding entrepreneurs use the loans to start and grow businesses—expanding operations, boosting inventory, and so on. The reality is more complicated. Microloans are often used to “smooth consumption”—tiding a borrower over in times of crisis. They’re also, as Karol Boudreaux and Tyler Cowen point out in a recent paper, often used for non-business expenses, such as a child’s education. It’s less common to find them used to fund major business expansions or to hire new employees. In part, this is because the loans can be very small—frequently as little as fifty or a hundred dollars—and generally come with very high interest rates, often above thirty or forty per cent. But it’s also because most microbusinesses aren’t looking to take on more workers. The vast majority have only one paid employee: the owner. As the economist Jonathan Morduch has put it, microfinance “rarely generates new jobs for others.”

This matters, because businesses that can generate jobs for others are the best hope of any country trying to put a serious dent in its poverty rate. Sustained economic growth requires companies that can make big investments—building a factory, say—and that can exploit the economies of scale that make workers more productive and, ultimately, richer. Microfinance evangelists sometimes make it sound as if, in an ideal world, everyone would own his own business. “All people are entrepreneurs,” Muhammad Yunus has said. But in any successful economy most people aren’t entrepreneurs—they make a living by working for someone else. Just fourteen per cent of Americans, for instance, are running (or trying to run) their own business. That percentage is much higher in developing countries—in Peru, it’s almost forty per cent. That’s not because Peruvians are more entrepreneurial. It’s because they don’t have other options.

What poor countries need most, then, is not more microbusinesses. They need more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation. In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need. It’s easy for really big companies in poor countries to tap the markets for funding, and now, because of microfinance, it’s possible for really small enterprises to get money, too. But the companies in between find it hard. It’s a phenomenon that has been dubbed the “missing middle.”

The problem is a dearth not just of lenders but also of people willing to buy an ownership stake in companies, like the angel investors and venture capitalists that American entrepreneurs often rely on. Microfinance has led us to focus on lending, but it can be hard for young companies to get big purely on bank loans, which consume cash flow that could be reinvested in the business. Supplying the missing middle will require backers who want to invest in companies rather than just lend to them. There’s been some progress on this front of late; three weeks ago, Google.org, the Soros Economic Development Fund, and the Omidyar Network announced that they are setting up a firm in India that will invest only in small-to-medium businesses. But there have yet to be celebrities speaking up for the missing middle.

Both socially and economically, microloans do a lot of good, working what Boudreaux and Cowen call “Micromagic.” But the overselling of their promise has made us neglect the enterprises that could be real engines of macromagic. The cult of the entrepreneur that the microfinance boom has helped foster is understandably appealing. But thinking that everyone is, and should be, an entrepreneur leads us to underrate the virtues of larger businesses and of the income that a steady job can provide. To be sure, for some people the best route out of poverty will be a bank loan. But for most it’s going to be something much simpler: a regular paycheck.

New entrants eye small investments as big funds keep away

The growth of funds targeting small-ticket investments is linked to the kind of corpus they manage.

A Delhi-based private equity, or PE, fund manager recently met the owner of an office automation firm. With an annual revenue of Rs40 crore, the firm was plotting a high-growth graph. The story was exciting enough for the PE executive, but the deal fell through when the company said it needed only Rs5 crore.

The executive from the PE fund that managed $200 million (Rs976 crore) says he was not interested in funding such a small amount. His investment sweet spot was $10-25 million. The executive had niether the appetite nor the time to nurture a $1 million investment. His rationale was that one cannot earn much on $1 million even with a five-fold return.


The PE fund manager didn’t want his firm or himself to be named. He also didn’t want the office automation firm to be identified.

The disinterest of big funds in small-ticket investments (primarily in non-technology companies) is presenting an opportunity for newbie funds such as Song Investment Advisors and Epiphany Ventures that are eyeing this space. Song is a $17 million fund backed by search giant Google Inc., Soros Economic Development Fund and Omidyar Network, while the $25 million Epiphany is backed by steel magnate L.N. Mittal and other non-resident Indians.

“Firms like ours can be a feeder to the funds which want to put $10-15 million to work,” said Vishal Vasishth, founder and managing director of Song Investment Advisors. Vasishth was most recently the founder and chief executive officer of Clean Partners, a business advisory and investment firm in the US.

Song, for instance, plans to invest $0.5-3 million each in small and medium enterprises, or SMEs, operating in sectors such as healthcare, education, waste water management, low cost housing, basic utilities, micro finance, rural energy, rural telecom and business services. The fund is housed in Hyderabad’s Indian School of Business (ISB) campus. ISB’s Centre for Emerging Markets Solutions (CEMS) is the fund’s local strategic partner.

Epiphany, too, is targeting investing $0.5-3 million in early stage businesses in education, clean technology and those focusing on inclusive growth and not necessarily pure technology plays. “Only a handful of funds are fulfilling this need,” said Gaurav Saraf, director, Epiphany Ventures.

Traditional SME-focused PE firms such as Broadgate Technical Services India Ltd, SIDBI Venture Capital Ltd, Aureos India and Zephyr Peacock India Fund invest $5-20 million. There are also firms such as Seed Fund, Ojas Venture Partners, and Accel India (formerly Erasmic Venture Fund) which provide $0.5-2 million of funding, but they are mainly focused on consumer Internet, mobile and technology space.

So that leaves a widening funding gap for emerging non-tech companies that need equity capital in smaller doses.

Song’s strategy of looking at sectors beyond technology may be ideal in the Indian context. “For India to grow at 6%-7%, sectors focusing on inclusive growth are critical. We are going to focus our energies on them,” said Vasishth.
Song is not chasing business plans, but firms clocking revenues of Rs5-10 crore and in the non-tech space. These companies “have a very hard time” raising equity capital, he reckons. Song is already at a term sheet (a basic document that lists terms and conditions of an agreement) stage with one firm. “We are seeing interesting companies in the education training space,” he adds.
The growth of funds targeting small-ticket investments is linked to the kind of corpus they manage. As the corpus grows, the investment range tends to expand.

This is because funds with a larger corpus lack the bandwidth to manage too many small investments. They instead prefer to enlarge their investment range across fewer deals.

For instance, Delhi-based Avigo Capital Partners invested $1 million in a company when it was managing its first fund of $5 million. When it raised its second fund of $125 million in 2006, the investment range went up to $5-7 million. Avigo, which has now closed its third fund of $250 million at $150 million, invests $7-10 million or more.

 

For funds such as Song and Epiphany, the challenge would be to remain in the small-ticket investment space even if their corpus expands.

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