Bringing Capital to Small Enterprise

The predicament lies in balancing the risk and reward in an environment where the perceived risk of lending demands a premium the borrower cannot afford. Solutions therefore must see risk reduced to a level where the credit seeker can afford the interest charges while the credit grantor is adequately compensated.

In 1980, the US Congress and the Federal Home Loan Bank, under vastly differing circumstances and acting in a different environment, increased guarantees to lenders. This intervention was ill-considered, led to unprecedented credit extension and soon led to period described as "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time". The lesson – non-intervention purists aside – is that financial guarantees must only facilitate and no more; the bulk of the credit risk must remain with the lender and the borrower, in aggregate, must remain obliged.

And here we can borrow, intellectually, from capital markets: specifically, from financial structures in the collateralised debt obligations (CDO) market.

Imagine we create a loan fund of R100m, administered by a special purpose vehicle (SPV), that has as its purpose the granting of loans to prospective entrepreneurs. The fund would have as its contributors a commercial bank (R60m), private investors (R20m) and national government (R20m). For their contributions each would  receive from the SPV a credit linked note (CLN) that pays the holder interest amounts and, on maturity, repays the capital – all of which is based on the overall performance of the loans the SPV has made to the SMMEs. However, each note would carry different terms and offer different payouts.

The government, net contributor (or investor deriving returns from a growing SMME sector) would own the equity tranche; so called because this CLN would carry the initial default risk – up to its initial investment of R20m. That is to say, government's CLN would (in this simple form) carry zero interest return and, if all the borrowers repay all of the borrowed capital, will receive 100% of its capital back. If, however, any one of the borrowers defaults, government's capital repayment would be adjusted downward accordingly (limited to R0m).

This CLN offers limited, but adequate, protection to the holders of the tranche 1 and tranche 2 CLNs from default. Now consider the R20m investment by private investors (tranche 2). They would stand next in line in absorbing default (again limited to R20m) and, as private investors, would demand a return on their investment that reflects this risk. Tranche 1, the R60m invested by the commercial bank, being the least risky and protected by R40m of default, would offer a low return. As a combination, the SPV - not having to pay interest on R20m, paying a low interest rate on R60m and paying a high interest rate on R20m – only needs a moderate interest return on the loans made to the SMMEs to service its CLN obligations.

The result; SMMEs gain access to cheaper (subsidized) financing, government has limited exposure while leveraging up the total funds advanced to SMMEs, commercial banks on an investment that better suits their lending and risk appetite profiles, and, because its easier for everyone, we bring responsiveness to an environment plagued by red tape and policy.

Key to this proposal – default rates and rates of return aside – is encouraging normal capital markets behaviour.

While government's provision of collateral to a sector typically unable to do so on a substantial basis makes such a transaction economically feasible, we must remain cognizant of the need for accountability and cautious of moral hazard.

Diversification, combined with a bottom up approach to default risk can tempt the SPV into the lacks allocation of funding. To address this concern a second SPV (SPV2), tasked with the long-term management of the loans to SMMEs and also owned by the commercial bank, stands between the first SPV (SPV1) and the holder of the tranche 1 CLN.

The purpose of this SPV is two-fold. In the first instance it isolates the long-term responsibility for the management of the loan portfolio, thereby creating a specialized entity with the requisite resources required for the administration and a vehicle that can be paid by SPV1 for this function. In the second instance, by paying the SPV a percentage of the interest collected from the SMME portfolio (starting with the initial R100m), the commercial bank stands to gain from effective administration – a carrot well understood by these entities. This way too, since the fee is paid by SPV1, all role-players contribute and benefit.

Regards the long-term administration, the intention is for SPV2 to take part of the fees received from SPV1 to pay enterprise development consultants for mentoring the SMMEs – such consultants having been rated by Whythawk Ratings. Again, all CLN holders pay and all SMMEs and CLN holders stand to gain. The approach encourages accountability and obviates moral hazard.

This leaves us with the purpose of SPV1 and the responsibility for the initial loan allocations. Surely there's an unnecessary duplication an certainly SPV2 would complain that it suffers the decisions of SPV1 in the allocation process. This could well be argued, and this proposal is not set in stone, but what this duplication allows is the rapid allocation of funding.

SPV1 would specialize in the assessment of business plans and loan approvals and own the loan obligations. Owned by the commercial bank, it would have the expertise to deliver on its mandate but its board would allow for representation by all CLN holders (while limiting their administrative input).

The final consideration of this piece is the extent of the collateral or equity tranche and the likelihood of enticing private investors. Here we can turn to the corporate social investment funds. With many corporates keen to support SMME development, the equity tranche could be enlarged, with the proviso that the repaid loans remain in the fund for recycling to new SMMEs.