THE STATE OF SME EQUITY FINANCE IN SOUTH AFRICA:

A REVIEW OF THE INDUSTRY AND THE TECHNIQUES USED
           FOR SUCCESSF...
Acknowledgements
The writers would like to thank Mike Herrington, who supervised this research, for his
assistance during ...
Declaration
This report is not confidential and may be used freely by the Graduate School of
Business.


We declare that t...
Abstract
The need for SME growth in South Africa is beyond question. Access to finance is one of
the factors standing in t...
Glossary of terms
 •   Angel investors: wealthy individuals providing venture capital
     (http://www.duke.edu).
 •   Bus...
•   Lifestyle companies: Business Partners defines lifestyle businesses as low-
    growth but low-risk enterprises with t...
Contents
 Introduction.......................................................................................................
9.2.2 Empowerment Funds........................................................................................48
  9.3 Fu...
12.11.1 Selection......................................................................................................85
...
Table of Tables
Table 1 - Stages of Venture Capital..........................................................................
CHAPTER ONE:
                                Introduction

The purpose of this chapter of the report is to introduce the t...
1 Introduction
Unemployment in South Africa’s formal business sector, already high, is rising (Abedian,
2001). Statistics ...
larger investments. Overall SME equity investment is viewed by most investors as being
unprofitable.


Business Partners h...
2 Background and definitions

2.1   The Private Equity Industry
Private equity financiers provide equity capital to enterp...
2.1.2 Size of industry
In 2002, SA’s private equity industry had total funds under management of R40.6bn (up
from R33.1bn ...
2001                     2002
                                  Realised gross IRR since Realised gross IRR since
        ...
Investments in different          Required IRR
stage of company lifecycle
Overall (all stages)              30%
Seed/start...
2.2   The SMME sector in South Africa

2.2.1 Classification of SMMEs
Ntsika classifies SMMEs in the following way (The sta...
Type of SMMEs                                  Min & Max Investment
Survivalist businesses                         R15k – ...
2.2.3 Other Classifications of SMEs
Business Partners differentiates between SME business types along the lines of growth ...
IDC Definition of SMEs
The IDC defines SMEs as independent enterprises with total assets of less than R30m,
turnover less ...
White-owned corporates can improve their scores directly (through selling equity stakes
to a black consortium), through in...
these products or services (Luiz, 2000, p.8). Further to this they, together with the
internal departments of Anglo Americ...
funds, as most have made too few investments and have not exited from enough
investments.


All of these funds and organiz...
3 Purpose and scope of report

3.1       Purpose
Investors and fund managers typically avoid low-value (<R5m) equity inves...
The following topics fall outside of the scope of the investment:
   •   A demand side perspective of SME equity finance (...
4 Relevance and importance
This research presents a view of major sources of equity finance below R5m available to
SMEs. I...
5 Research Methodology
This research presents findings based on interviews with a range of SME equity
financiers. The resu...
5.2   Hypothesis Generation
This pioneering research – with its broad objective of understanding the SME equity
landscape ...
5.5     Identification of SME Equity Financiers

5.5.1    Financier Identification
Identifying SME equity financiers prove...
5.5.3   Other Omissions from Report
The list of low-value equity financiers is to our knowledge complete with a few
except...
•   “Lifestyle” funds invest in SMEs that do not promise high capital returns, but will
       provide the entrepreneur or...
Fund Name              Investors        Fund Manager        Funds          Min + Max     Inter-   Reason              Clas...
Fund Name               Investors           Fund Manager    Funds         Min + Max     Inter-   Reason               Clas...
Fund Name             Investors             Fund Manager     Funds         Min + Max     Inter-   Reason                Cl...
Fund Name               Investors             Fund Manager      Funds       Min + Max     Inter-   Reason                C...
5.5.5      The Players in SME Equity Finance2
The table mentions the funds identified as investing amounts under R5m in SM...
National Empowerment Fund
The National Empowerment Fund (NEF) is a state-owned provider of empowerment
finance. It was cre...
launched in 2003 for investment in black youth in the franchising sector. Business
Partners was started in Eighties with f...
Enablis
Enablis is a not-for-profit organization formed in partnership with Accenture (UK),
Hewlett-Packard (US) and Teley...
HBD
HBD Venture Capital is a full service venture capital organization that was founded in
2000 and is funded by private i...
partnership with management of these enterprises. Its funds are invested in a range of
business, from early to late stage....
CHAPTER TWO:
                      SME Equity Finance
This chapter establishes the need for SME finance in South Africa, a...
6 The need for SME Equity Finance

6.1   The Need for SME Finance
The South African government’s Growth, Employment, and R...
For these reasons, argues the IDC’s Malinga (2003), organizations such as the IDC
should provide assistance to SMEs in all...
Overall, these figures suggest that currently, institutional finance is less important in
financial start-ups than entrepr...
Iwisi et al (2003: 2) argue that equity finance is an attractive finance mechanism for
SMEs in SA because equity financier...
While equity finance works for the entrepreneur, it also works for the financier. Using
equity allows financiers an upside...
7 The Obstacles to SME Equity Finance
We have shown the need for SME equity finance. However, obstacles exist.


“A major ...
low skill of SMEs management, and by the simple fact that there are more deals per
dollar invested, and each deal requires...
•   The absolute profits from the low-value investments are too small for large
    players
•   The required investment pe...
8 An example: SME Equity Finance in the US
We have shown that the drive to empower black South Africans through jobs and
b...
patient capital. (Rubin, 122: 2001) Unlike CDVCs, these do not specifically target low-
income areas.


Currently, SBIC pr...
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Introduction

  1. 1. THE STATE OF SME EQUITY FINANCE IN SOUTH AFRICA: A REVIEW OF THE INDUSTRY AND THE TECHNIQUES USED FOR SUCCESSFUL INVESTMENT A Research Proposal presented to: The Graduate School of Business University of Cape Town in partial fulfilment of the requirements for the Masters of Business Administration Degree by John Hannig and Michelle Joubert November 2003 Supervisor: Dr. Mike Herrington
  2. 2. Acknowledgements The writers would like to thank Mike Herrington, who supervised this research, for his assistance during the research project. Though extremely busy with his lecturing and consulting work at the Centre for Innovation and Entrepreneurship, Mike gave time, insights and assistance whenever needed. Thanks is also due to all staff members at the CIE who assisted with the project. We would also like to thank the fund managers and company executives without whom this project couldn’t have happened. The contributors are numerous, but the writers would particularly like to thank Mike Kloppers and Logandree Gounden of Business Partners (Cape Town) who went way beyond the call of duty by generously giving hours of their time and sharing their expertise with us. The writers would like to acknowledge the policy and industry specialists at the Department of Trade and Industry, Industrial Development Corporation, Khula, the National Empowerment Fund and Umsobomvu for their time and assistance. i
  3. 3. Declaration This report is not confidential and may be used freely by the Graduate School of Business. We declare that this research report is our own unaided work. It is submitted in partial fulfillment of the requirements for the degree of Master of Business Administration at the Graduate School of Business, University of Cape Town. It has not been submitted for any degree or examination at any other university before. All references and sources of information have, to our knowledge, been accurately reported. Michelle Joubert John Hannig 28 November 2003 ii
  4. 4. Abstract The need for SME growth in South Africa is beyond question. Access to finance is one of the factors standing in the way SME growth. As a financing tool, equity has distinct advantages over debt for the development of SMEs. But equity comes with significant challenges that have made many financiers avoid this financing option. At least one financier has shown that low-value equity investments in relatively low- growth companies can be profitable. Off the base of this observation, this research investigates SME equity finance between R250k and R5m in South Africa. The investigation has identified a comprehensive list of fund managers to determine the state the SME equity industry in South Africa. The contribution of investors and fund managers to making this sector sustainable are considered. The research shows how the funds are structured and the techniques that fund managers use to make SME equity investments sustainable and profitable. The roles of banking sector, government, DFIs and other corporates in making low cost of capital equity available to SMEs have been investigated and the effects of empowerment on the industry are uncovered. The social motivation of the various players is considered, but it is shown that this sector serves as a development and a profit opportunity for investors. iii
  5. 5. Glossary of terms • Angel investors: wealthy individuals providing venture capital (http://www.duke.edu). • Business linkage: Business linkage refers to the linking of small business with the corporate sector, primarily to obtain contracts for the supply of products from the SMMEs to the corporates. • Captive funds: Funds that make use of capital from their own balance sheet or from the balance sheets of their parent companies (SACA, 2002: 8). • Carried interest: fee enhancement for the private equity fund manager for achieving a benchmark return or hurdle rate (SAVCA, 2002: 19). • Committed capital: capital committed to specific fund, but not necessarily invested yet. • CSR: Corporate Social Responsibility. • DFI: Development Finance Institutes. • Equity financiers: fund managers who make equity investments. • Fund manager: The person who oversees the allocation of the money invested in a fund (http://www.duke.edu). • High-growth companies: Companies that are not lifestyle companies, but instead provide investors with opportunities for high capital growth. • Hurdle rate: a guaranteed rate of return on investment, above which the fund manager and the investor share in the profits. • Income notes: mechanism used by some fund managers to earn a return on investment through revenue-based payments instead of profit-based payments (dividends) by the investee company. Also called royalties. • Independent funds: Independent funds raise cash commitments from third party investors (SACA, 2002: 8). • Invested capital: capital invested by specific fund as opposed to the funds committed for future investment. • IRR: Internal Rate of Return. iv
  6. 6. • Lifestyle companies: Business Partners defines lifestyle businesses as low- growth but low-risk enterprises with the capacity to provide an individual entrepreneur or a small group of partners with a comfortable and financially secure lifestyle. • Minimum IRR: the minimum total return expected by the investor on each investment (including cost back, hurdle rate and super-profits applicable of every rand thereafter). • Private equity: all sources of finance to entities that are not quoted on the stock exchange. Equity investments in the unregistered securities of private and public companies. • Quasi-equity (or near-equity): debt that is convertible to equity or debt with warrants, royalties or participation payments. Can be structured to act like equity, with deferred payments that give young firms the patient capital they need in their early years (Rubin: 122). • Royalties: also called income notes. • SAVCA: SA Venture Capital and Private Equity Association. • SMME: Small, medium and micro enterprises as defined in section 2.3. This categorization includes survivalist enterprises. • SME: Small and medium enterprises, hence excluding micro and survivalist enterprises as defined in section 2.3. • Small Business Investment Companies (SBICs): venture capital arms that specialize in first-stage financing for businesses in fragmented local markets. • Super-profits: portion of return on investment which lies above the hurdle rate. • Venture capital: money that is made available by risk capital companies or individuals in order to finance new business (Kubr et al, quoted in Iwisi et al, 2003: 3). Cilliers and Stapelberg, (2000) defines Venture capital as investments for launch, early development or expansion of a business. v
  7. 7. Contents Introduction.......................................................................................................................10 1 Introduction.....................................................................................................................11 2 Background and definitions ...........................................................................................13 2.1 The Private Equity Industry.....................................................................................13 2.1.1 Classification of private equity.........................................................................13 2.1.2 Size of industry.................................................................................................14 2.1.3 Size of investments made by private equity firms............................................14 2.1.4 Returns on investment in the private equity industry.......................................14 2.1.5 The impact of business life stage on expected IRRs ........................................15 2.2 The SMME sector in South Africa .........................................................................17 2.2.1 Classification of SMMEs..................................................................................17 2.2.2 The financing needs of SMMEs.......................................................................17 2.2.3 Other Classifications of SMEs..........................................................................19 2.3 Empowerment as a Driver of SME Equity Finance.................................................20 2.3.1 Industry Charters and the Empowerment Scorecard........................................20 2.3.2 The Supply of SME Finance Stimulated by Empowerment ............................22 3 Purpose and scope of report............................................................................................24 3.1 Purpose.....................................................................................................................24 3.2 Scope........................................................................................................................24 4 Relevance and importance..............................................................................................26 5 Research Methodology...................................................................................................27 5.1 Desk Research..........................................................................................................27 5.2 Hypothesis Generation.............................................................................................28 5.3 Questionnaire Development.....................................................................................28 5.4 Data Collection........................................................................................................28 5.5 Identification of SME Equity Financiers.................................................................29 5.5.1 Financier Identification.....................................................................................29 5.5.2 Financiers Excluded from Report ....................................................................29 5.5.3 Other Omissions from Report...........................................................................30 5.5.4 Financiers selected for this report.....................................................................30 5.5.5 The Players in SME Equity Finance.................................................................36 6 The need for SME Equity Finance..................................................................................32 6.1 The Need for SME Finance ....................................................................................32 6.2 Types and Sources of SME Finance........................................................................33 6.3 The Need for Equity Finance...................................................................................34 7 The Obstacles to SME Equity Finance...........................................................................37 8 An example: SME Equity Finance in the US ................................................................40 8.1 Small Business Investment Companies...................................................................40 8.2 Community Development Venture Capital.............................................................41 9 Industry Overview..........................................................................................................44 9.1 Funds Available ......................................................................................................44 9.2 Classification of Funds............................................................................................44 9.2.1 Lifestyle vs High-Growth.................................................................................45 vi
  8. 8. 9.2.2 Empowerment Funds........................................................................................48 9.3 Funds Invested.........................................................................................................49 9.4 New Funds Driven by Empowerment......................................................................50 9.5 Sources of Funds......................................................................................................51 9.6 Development Objectives..........................................................................................53 9.6.1 Capital Retention vs Profit................................................................................53 9.6.2 Lifestyle vs high growth...................................................................................53 9.6.3 Empowerment...................................................................................................54 9.6.4 Job Creation......................................................................................................54 10 The Financial Structures of SME Equity Funds...........................................................55 10.1 Cost of capital and the Structure of Funds.............................................................55 10.1.1 Background.....................................................................................................55 10.1.2 Findings...........................................................................................................57 10.2 Sources of Income..................................................................................................61 11 Techniques Used by Fund Managers............................................................................63 11.1 Selection.................................................................................................................64 11.1.1 Lifestyle vs High Growth Businesses.............................................................64 11.1.2 Franchise Funds..............................................................................................65 11.1.3 Business Linkage Funds.................................................................................65 11.1.4 Specialisation, Expertise and Information......................................................66 11.2 Involvement...........................................................................................................67 11.2.1 Type of Support (operational, strategic and board seats)...............................68 11.2.2 Mentorship......................................................................................................70 11.2.3 Sources of Support..........................................................................................70 11.2.4 Incubation.......................................................................................................71 11.3 Exit.........................................................................................................................72 11.4 Deal Structuring.....................................................................................................73 11.4.1 The use of pure equity.....................................................................................73 11.4.2 Revenue based recovery.................................................................................74 11.4.3 Secured Debt ..................................................................................................75 11.4.4 Equity as a “Sweetener”..................................................................................75 11.4.5 Interest Charges..............................................................................................76 11.4.6 Diversification.................................................................................................76 11.5 Fund Maturity........................................................................................................77 12 Conclusion ...................................................................................................................79 12.1 The Size of the SME Equity Industry....................................................................79 12.2 Growth of SME Equity Finance ...........................................................................79 12.3 Government’s Contribution to SME Equity Finance.............................................79 12.4 The Impact of Empowerment ...............................................................................80 12.5 Lifestyle Business Equity Finance.........................................................................81 12.6 The Cost of Capital for Fund Managers and SMEs..............................................82 12.7 The Structuring of Finance Between Investors and Fund Managers.....................82 12.8 Evidence of Social Motivation...............................................................................83 12.9 The Motives of Fund Managers.............................................................................84 12.10 Operating Costs of SME Financiers....................................................................84 12.11 Techniques Used by Fund Managers..................................................................85 vii
  9. 9. 12.11.1 Selection......................................................................................................85 12.11.2 Involvement................................................................................................86 12.11.3 Exit..............................................................................................................87 12.11.4 Deal Structuring..........................................................................................87 12.12 Fund Maturity....................................................................................................88 12.13 Conclusion.........................................................................................................88 13 Areas for Future Study..................................................................................................90 14 References.....................................................................................................................91 15 Appendix.......................................................................................................................96 15.1 Questionnaire.........................................................................................................96 viii
  10. 10. Table of Tables Table 1 - Stages of Venture Capital...................................................................................13 Table 2 - IRRs achieved by private equity funds since fund inception.............................15 Table 3 - South Africa average required IRRs...................................................................16 Table 4 - Alternative South African IRRs.........................................................................16 Table 5 – Classification of SMMEs...................................................................................17 Table 6 - Lifestyle vs High Growth Funds........................................................................46 Table 7 - Empowerment vs non-empowerment Funds......................................................48 Table 8 - Funds started since 2001....................................................................................50 Table 9 - Major Investors in SMEs in South Africa..........................................................51 Table 10 - Minimum Expected IRR for SME equity investors.........................................58 Table 11 - Hurdle rates for SME equity investments........................................................58 Table 12 - Funds per deal executive..................................................................................69 ix
  11. 11. CHAPTER ONE: Introduction The purpose of this chapter of the report is to introduce the topic being researched and to provide some background on SMMEs and the private equity industry. 1. Introduction: This section introduces the topic of research. 2. Background and Definitions in Private Equity: The private equity industry has existed for a long time in South Africa. In 2002, the value of funds under management was over R40bn. But these funds aren’t accessible to SMMEs. This section discusses the private equity industry and defines the equity gap for SMMEs. 3. Purpose and Scope of Report: This section discusses the aims and objectives of the research. 4. Relevance and Importance: This section discusses who will be interested in the research, and why. 5. Research Methodology: This section discusses the methodology used to carry out the research. In particular it provides a list of the equity financiers included in the investigation along with brief descriptions of these financiers.
  12. 12. 1 Introduction Unemployment in South Africa’s formal business sector, already high, is rising (Abedian, 2001). Statistics South Africa estimates that unemployment rose from 36.3 percent in 1999 to 41,8% in 20021 (Statistics South Africa). SMMEs, which drive much of today’s global job creation (Karungu et al 2000), will need to do so in South Africa too. Alec Erwin, the Minister of Trade and Industry believes that small businesses need to double their contribution to the economy in the future. However, SMEs face significant challenges, which include access to finance (Iwisi et al, 2003: 2) and financial management skills and support (Gem Report, 2003: 32). This contributes to slow development and high mortality rates of small businesses in SA (Iwisi et al, 2: 2003). Access to finance is particularly relevant for previously disadvantaged entrepreneurs who do not have access to collateral and the networks of wealthy individuals who could provide angel financing. Therefore it is clear that the need for SME finance exists in SA, in order to boost the growth of the sector. Moreover, the method of finance used should facilitate the creation of sustainable SMEs. Debt finance is associated with prohibitively high interest payments that can cripple a young company. Business Partners CEO Joe Schwenke believes that equity finance fills this gap by providing growth capital for businesses while delaying repayment until the business can afford it. However, there are obstacles to equity finance. These include the perception by many financial institutions that funding SMEs involves higher risk, and inexperienced SME management require more involvement and therefore higher transaction costs. Furthermore low value equity transactions do not enjoy the economies of scale of the 1 The figure is the expanded rate, defined by Statistics SA as including discouraged job seekers (those who said they were unemployed but had not taken active steps to find work in the four weeks prior to the interview). 11
  13. 13. larger investments. Overall SME equity investment is viewed by most investors as being unprofitable. Business Partners has succeeded in developing a model for equity finance that has proved beneficial to SMEs and profitable for the investor. The group’s method is similar to that promoted by Small Enterprise Assistance Funds (SEAF), a US- and Dutch-based DFI which manages commercially driven investment funds worldwide. Like Business Partners, SEAF uses an “equity plus assistance” method of SME investing (Van der Vaart: 2001). A number of other SME equity financiers, similar to Business Partners, have also been created in the past few years, and banks are looking to increase their focus on this sector in the near future. The purpose of this research is to describe the state of SME equity finance (ie. finance between R250k and R5m) in South Africa, and to understand how investors and fund managers team up to provide sustainable and profitable funds to a broad base of SMEs. In particular, the research is aimed at identifying the players in the industry and establishing the techniques used by SME equity fund managers to survive or prosper in this environment. The report is laid out in three chapters: • Introduction, in which the private equity industry is discussed, the purpose and relevance of the report are identified and the research methodology is discussed; • Background, in which the need for SME equity finance is established, the obstacles are described and the US SME industry is discussed for purposes of comparison; and • Findings, in which the industry is analysed, the financial structure of SME equity funds is described and the techniques used by SME equity fund managers are identified. 12
  14. 14. 2 Background and definitions 2.1 The Private Equity Industry Private equity financiers provide equity capital to enterprises not quoted on a stock market (SAVCA, 2002: ii). 2.1.1 Classification of private equity For the sake of clarity, private equity is generally classified into the following stages (KPMG Private Equity Survey 2002: http://www.kpmg.co.za). Venture Capital Seed Capital Funding for research, evaluation and development of a concept or business before the business starts trading Start-up and Early Funding for new companies being set up or for Stage the development of those which have been in business for a short time Development Expansion and Funding for the growth and expansion of a Capital Development company which is breaking even or trading profitably Buyout Management buy- Funding to enable a management team and out (MBO) or buy- their backers to acquire a business from in (MBI) existing owners. Buy-outs are often leveraged. Replacement Funding for the purchase of existing shares in a Capital company from other shareholders. Buy-outs are often leveraged. Table 1 - Stages of Venture Capital As shown in the table, venture capital is a subset of private equity including seed and start-up investments. Venture capital focuses on high-growth businesses in early stages of development that promise significant capital growth. 13
  15. 15. 2.1.2 Size of industry In 2002, SA’s private equity industry had total funds under management of R40.6bn (up from R33.1bn in 2000). The industry is dominated by substantial private equity players who were responsible for the large buyout transactions during financial 2002 (SAVCA, 2002: 21). The majority of investments, 77% in 2002, are made in later stage deals – i.e. development and buy-out stages. 2.1.3 Size of investments made by private equity firms Due to the dominance of the larger players in the industry, the average new investment size has increased from R9.7m in 1999 to R14.5m and R15m in 2000 and 2001 (SAVCA, 2002: 21). Most equity investors offer minimum investments of above R2m (SAVCA: 2002). The large firms taking equity stakes in companies, such as Brait, Ethos and Venfin, will invest a minimum of R10m in a transaction (SAVCA: 2002). This means that funds from these players are not accessible to SMMEs, who require smaller sums of money. 2.1.4 Returns on investment in the private equity industry Funds in the private equity industry judge their performances on the Internal Rate of Return (IRR) achieved by the fund. In the 2002 KPMG survey, 12 funds reported IRR performances for the year. Of these, 4 funds reported achieving an IRR below 15%. This is lower than the IRR expected by development funds investigated during this research, despite the fact that the development funds focus on job growth and empowerment rather than profit. (These development funds are outside of the radar of the KPMG report.) Seven funds achieved an IRR between 15% and 40% in 2002, a better record than the previous year. Only 1 fund achieved an IRR above 40%. 14
  16. 16. 2001 2002 Realised gross IRR since Realised gross IRR since fund inception fund inception Number of funds reporting 9 10 IRR below 15% 3 4 IRR between 15% and 40% 2 2 IRR above 40% 4 4 Table 2 - IRRs achieved by private equity funds since fund inception These statistics serve to contextualize the performances of the funds discussed in this research. It should be noted, however, that there is a major difference between achieving a certain IRR and expecting to achieve it. Most funds included in the research are too young to have recorded meaningful IRR figures. 2.1.5 The impact of business life stage on expected IRRs The minimum expected IRR is the internal rate of return that investors in a private equity fund want in order to invest in the fund. A fund will not invest in a company if the potential investment does not meet this IRR. The minimum IRR is highly dependent on the risk of the investment (Stapelberg and Roberts-Baxter, 2000). The risk is often associated with life the stage of investment, but risk is also dependent on the industry (ibid) and the company itself. Taylor (2001: 27) identified the minimum expected IRRs for different stages of equity investments in South Africa. The table shows that investments in seed companies require a higher return (IRR of at least 56%) than investments in management buyouts (IRR of at least 31%), for example. A fund manager recording an IRR lower than the required IRRs given in the table – for example, 56%, if the fund invests in seed companies – should not expect to receive further capital from investors into the fund. Only fund managers achieving the required IRR or above are generating returns which, according to investors, match the risk inherent in the investment. By implication, the table demonstrates the perceived risk of an investment in a particular stage of the company’s lifecycle (Stapelberg and Roberts-Baxter, 2000) – for example, investments in seed stage companies (56% - 70%) are higher risk than investments in MBOs (31% - 35%). 15
  17. 17. Investments in different Required IRR stage of company lifecycle Overall (all stages) 30% Seed/start-up/early 56 – 70% Expansion development 36-45% MBO 31-35% MBI 31-35% Secondary replacement 31-35% Table 3 - South Africa average required IRRs The returns for later stage investments (of 30% to 35%) were confirmed by interviews with 4 of the large private equity houses that specialize in later stage investments. Taylor (2001: 59) identified that smaller investments had an additional 3.9% premium on top of the 30% average for all stages, and deals that required additional post deal reorganization had a premium of 7.6%. Taylor compared these to findings by Mullet (1998), which appear to be slightly higher. Stage of investment Required Return Seed/start-up 50 – 100% Early stage 40-70% Later stage 25-50% Finance 20-30% Secondary replacement 31-35% Table 4 - Alternative South African IRRs 16
  18. 18. 2.2 The SMME sector in South Africa 2.2.1 Classification of SMMEs Ntsika classifies SMMEs in the following way (The state of small business in South Africa, 2001: 40): Sector Description Employment Survivalist •Income generated is below poverty line •3 % of total employment Micro (0) •Owner manager (no employees) •6 % of all employment •Turnover is less than VAT registration limit •Not usually formally registered for tax or accounting purposes Micro (1-4) •Same descriptors as Micro (0) except •5% of all employment the number of employees are more than •Less than 5 employees one Very Small •Operate in formal market •Less than ten employees •13% of total employment Small •Distinguished by some form of •Less than 50 employees Enterprises managerial coordination •20% of total employment Medium •Further decentralisation of decision •Less than 100 employees (200 Enterprises making in mining) •More complex decision making •14% of total employment •Increased division of labour Table 5 – Classification of SMMEs 2.2.2 The financing needs of SMMEs Ebony Consulting (2001: 17) calculated the average equity investment made by financiers in different SMME’s by looking at their average asset values. Applying a 15% to 40% range to these asset values, in line with the average investment range of equity investors, Ebony Consulting calculated the minimum and maximum investments made in the different types of SMMEs: 17
  19. 19. Type of SMMEs Min & Max Investment Survivalist businesses R15k – R404k Micro-enterprises R84k – R223k Small businesses R315k – R840k Medium-sized businesses R836k-R2.2m Source: Ebony Consulting,2001: 17 Table 6 – Financing needs of SMMEs The values would suggest that true equity investments in SMMEs would lie below R2.2m. However, most financiers offering below R2m focus on loan finance. One limitation of these estimates by Ebony Consulting is that the asset value of the SMMEs is not necessarily a good basis for valuation of the SMMEs, and is really the minimum value of these SMMEs (if we exclude any debt). A more accurate basis for valuation would be on the discounted future cash flows expected by the SMMEs. High- growth SMMEs could therefore have significantly larger equity values. The focus of this study is however on the availability of SMME finance to a broad base of SMMEs. A maximum limit of R5m was chosen as the highest minimum limit specified by a fund manager for SMME investment that would be considered for this research. This limit was also chosen because interviews suggested that investments below R5m started to experience some of the obstacles associated with SMME and low value equity investments that are discussed in section 7. The focus of this research is on formal sector small and medium sized businesses. The finance requirements of survivalist and micro business generally fall below the minimum investments that most equity financiers are prepared to invest. This implies a minimum limit of approximately R250k on the financiers that will be considered for this research. In line with this, the term SME will be used instead of SMME. 18
  20. 20. 2.2.3 Other Classifications of SMEs Business Partners differentiates between SME business types along the lines of growth of the businesses. They differentiate between lifestyle and high-growth businesses. Lifestyle Businesses Business Partners defines lifestyle businesses as low-growth but low-risk enterprises with the capacity to provide an individual entrepreneur or a small group of partners with a comfortable and financially secure lifestyle. “Lifestyle businesses are represented across all sectors and include, amongst others, private and professional practices, small manufacturing and engineering concerns, service stations, guesthouses, caravan parks, bed and breakfasts, restaurants, fast food outlets, travel agencies, private fishing boats and processing facilities, supermarkets, camping stores and even pet grooming parlours. (Business Partners pamphlet, 2003). Businesses of this nature are the backbone of the small and medium enterprise sector and make up a significant component of the Business Partners client base” (Interview with Mike Klopper (September), 2003). Franchises form a subset of these lifestyle investments. Business linkage companies also fall into this category. Business linkages are set up between small businesses and corporates to create demand for the small business and to provide them with a stable source of income through contracts. These linkages create opportunities for investors to provide lower risk finance to these SMEs. High-growth High-growth businesses are those businesses that are likely to experience high-growth. Equity investors, specifically venture capital companies target these investments for the growth in capital that they promise. These businesses are more suitable to pure equity investments where the returns are heavily based on capital growth, in contrast to lifestyle investments where equity growth does not contribute heavily to the calculated returns. 19
  21. 21. IDC Definition of SMEs The IDC defines SMEs as independent enterprises with total assets of less than R30m, turnover less than R50m and less than 100 employees. SMEs were the main recipients of the IDC’s financing approvals during financial 2002 and accounted for 80% of the number of approvals compared to 75% during the previous year (IDC Annual Report 2002, 25). This definition of SMEs is broader than the focus of this research, as it would include investments of up to R15m (assuming equity investments of close to 50% of asset value). 2.3 Empowerment as a Driver of SME Equity Finance Empowerment is a major driving force behind SME equity investment in South Africa. It influences development equity investments by: • Increasing the supply of funds to empowered businesses • Creating demand for the products and services of empowered businesses. This increases their competitiveness in the market and improves the likelihood of success for equity financiers. 2.3.1 Industry Charters and the Empowerment Scorecard The scorecard and the charters were instituted by government to drive corporate participation in empowerment. These instruments were designed to stimulate demand for small black businesses and also encourage corporates to support enterprise development. The empowerment scorecard is a measurement instrument through which government and corporates are able to measure the degree to which companies are empowered. These scores are used by government to evaluate white-owned companies in their procurement process. The scorecard provides general scores and targets applicable to all white-owned companies, except for those companies falling into industries for which an industry charter exists. At time of writing, government had published charters for the Mining, Fishing, Liquid Fuels and Financial Services industries. 20
  22. 22. White-owned corporates can improve their scores directly (through selling equity stakes to a black consortium), through increasing the number of black or female employees or indirectly (through increasing diverting procurement spend to empowered companies or developing enterprises). Each category of the scorecard has a specific weighting, contributing to a total company score, as shown in the general empowerment scorecard below. Specific industry scorecards have been developed for those industries with Empowerment Charters. Criteria Weighting Target Ownership 20% 25.1% Management 10% 40% Employment Equity 10% 40% Skills Development 20% 30% Preferential Procurement 20% 30% Enterprise Development 10% 10% Variable Criteria 10% 50% Table 7 – General Empowerment Scorecard Of particular importance to the stimulation of SME development and equity finance, the generic scorecard allocates a weighting of 20% to procurement from black owned companies and 10% for development of black owned enterprises. The procurement weighting encourages corporates to purchase from empowered businesses. This gives these empowered businesses, many of which are SMEs, a competitive advantage in the market. The role of affirmative public procurement programmes in creating opportunities for SMEs has already been recognised (GEM, 2001: 47). These opportunities have resulted in the creation of the Enterprise Equity’s Progress Fund that specifically targets investments in black businesses in the supply chains of corporates and government. The Progress Fund searches government and corporate procurement records to identify opportunities for investments in BEE SMEs. Zimele, Anglo American’s SME equity investment business, takes this a step further to include enterprise development. Zimele looks for opportunities to outsource functions currently performed internally, and then sets about developing BEE SMEs to supply 21
  23. 23. these products or services (Luiz, 2000, p.8). Further to this they, together with the internal departments of Anglo American provide support to the SMEs. A representative from USAID indicated that, in recent months, the banks in South Africa had been increasingly looking at opportunities to invest in small businesses, which he suspected was linked to the financial services charter. Enterprise Equity Partners, a division of FNB, and an equity investor in SMEs, confirmed that the banks were preparing strategies on how to make finance available to SMEs. This preparation is in response to charter pressure. 2.3.2 The Supply of SME Finance Stimulated by Empowerment Government’s focus on empowerment has resulted in the creation of a number of funds to provide equity finance to SMEs. Government currently provides funding through a number of organisations: • The Industrial Development Corporation, which, since 2001, has been mandated to aid empowerment and to provide development finance to SMEs in order that entrepreneurship is encouraged in black communities; • The National Empowerment Fund (NEF), which was formed to finance and support black-managed and black-owned businesses; • Khula Enterprise Finance, which was formed to facilitate access to credit for SMEs, but has also moved into equity financing; and • Umsobomvu Youth Fund, which was formed to finance development opportunities for black youths (aged between 18 and 35 years), including equity financing on SME development. Since 2000 these organisation have created a number of equity funds targeting empowerment, including NEF Ventures, the Women’s Private Equity Fund, the Umsobomvu General Fund, the Franchise Fund, the Progress Fund, Khula’s Equity Fund and the Anglo-Khula Mining Fund. It is too early to comment on the success of these 22
  24. 24. funds, as most have made too few investments and have not exited from enough investments. All of these funds and organizations will be discussed in more detail during this report. 23
  25. 25. 3 Purpose and scope of report 3.1 Purpose Investors and fund managers typically avoid low-value (<R5m) equity investments in SMEs, particularly in low-growth lifestyle companies. SME investments, as well as low value equity investments, have obstacles associated with low profitability, high risk and high transaction costs (discussed in more detail in section 7). But a number of funds exist in South Africa that target these sorts of investments, and at least one, Business Partners, has managed to do so profitably. The purpose of this research is to describe the state of SME equity finance (ie. finance between R250k and R5m) in South Africa, and to understand how investors and fund managers team up to provide sustainable and profitable low-value equity funds to a broad base of SMEs. More specifically the study has three main objectives: • To describe the SME equity finance landscape in South Africa in terms of the funds available, the source of funds and the objectives of these funds • To describe how investors and fund managers structure the SME equity funds to provide low cost of capital funds to a broad base of SMEs • To identify the techniques used by SME equity fund managers to survive or prosper in this environment 3.2 Scope The scope of this research is limited to low-value (between R250k and R5m) equity investments in SMEs that do not have access to conventional private equity financing. The research specifically targets the supply side view of equity financing – i.e. fund managers. These fund managers, whether profit motivated or only aiming to maintain their capital, all invest in commercial, profit seeking small businesses. 24
  26. 26. The following topics fall outside of the scope of the investment: • A demand side perspective of SME equity finance (i.e. the views of SMEs) • Angel investors • Policy in place to stimulate SME investment (such as tax incentives) 25
  27. 27. 4 Relevance and importance This research presents a view of major sources of equity finance below R5m available to SMEs. It is aimed at understanding the how fund managers and investors team up to create sustainable SME equity investment funds. More specifically the information presented in this research is applicable to: • SME equity fund managers and investors interested in understanding the SME equity industry • Existing and new SME equity fund managers interested in understanding the techniques currently being used to reduce risk and transaction costs in their investments • Policy makers, NGOs, Development Finance Institutes (DFIs), government departments and corporate social responsibility programmes seeking to stimulate SME growth through equity investment • Entrepreneurs looking for sources of equity finance 26
  28. 28. 5 Research Methodology This research presents findings based on interviews with a range of SME equity financiers. The results are primarily qualitative and are designed to demonstrate the different techniques and views in the industry. Though the researchers would like to have determined how effective the investment techniques used by the funds are, this was not possible. Most funds are young and have not exited from sufficient investments to make investigation into the effectiveness of their techniques possible. Business Partners is the only fund manager that made financials available on their investments, and these demonstrate the success of their techniques. Furthermore the success of the techniques is dependent on the mix of techniques and the success of individual techniques cannot be determined. The research methodology included 6 stages: 1. Desk research and primary interviews 2. Hypothesis Generation 3. Questionnaire development 4. Identification of SME equity financiers 5. Data collection 6. Analysis 5.1 Desk Research Desk research was used to understand the private equity industry in South Africa and to identify the key funds available for SME investment. Searches were also conducted to identify similar case studies in other countries, particularly in emerging markets. Primary interviews were held with Khula and Business Partners as these organisations were believed to be the primary development focused equity financiers in the industry. Interviews were conducted with some of the larger private equity financiers and DFIs to get their perspectives of development-focused and SME private equity. 27
  29. 29. 5.2 Hypothesis Generation This pioneering research – with its broad objective of understanding the SME equity landscape and the techniques used for sustainable investment – was not suited to a hypothesis-driven approach. Desk research and high-level interviews were however used to focus the research in a few key areas. 5.3 Questionnaire Development A semi-structured questionnaire was designed as a framework for telephonic and face-to- face interviews. Not all questions were applicable to all the companies interviewed. The questions were designed to stimulate discussion and to uncover unique approaches used by the different organisations. The framework used for the interviews is provided in the appendices. 5.4 Data Collection Data was collected primarily by conducting telephonic interviews, since most of the organisations interviewed were in Johannesburg. Data collection could not be collected through email surveys. For this reason, interviews were used instead that allowed a more reactive style of data collection depending on the information uncovered during the interview. The interviews ranged between 30 minutes and one hour depending on the relevant information that the interviewee could provide. In excess of 30 people were interviewed, and brief telephonic discussions were held with a number of other people in the industry. 28
  30. 30. 5.5 Identification of SME Equity Financiers 5.5.1 Financier Identification Identifying SME equity financiers proved to be difficult. The objective was to identify all reasonably sized equity funds with minimum investment criteria below R5m, which is the maximum amount that could normally be considered to be an investment in an SME (as has been shown in the previous section). The 2002 SAVCA directory was the first source, but this directory did not include many of the funds. The reason for this is because some of the funds are new and others are not listed in the directory. A total of 14 additional funds were identified through internet searches and referrals by other funds. 5.5.2 Financiers Excluded from Report Some of the funds listed in the SAVCA directory were fully invested, had closed, or were not contactable on the telephone numbers provided and could not be found on internet searches. These funds have not been included in the list provided below. Three funds that were listed in the SAVCA (Venfin, Global Capital and Aquila Growth) admitted that their stated minimum investments were only applicable to exceptional cases and had average investments far in excess of the R5m limit. These three funds have been excluded from all statistics drawn. Having identified 29 equity financiers that provide finance below R5m excluding the three mentioned above, 17 were telephonically interviewed and a further 5 were indirectly interviewed through the investors in these funds (IDC and Khula). Three lifestyle financiers were not interviewed because they declined to be interviewed or were not available for the scheduled telephonic interviews. Where information was available on the internet about the companies that were not interviewed, it was included in the analysis. 29
  31. 31. 5.5.3 Other Omissions from Report The list of low-value equity financiers is to our knowledge complete with a few exceptions: • At least one other biotechnology fund that makes low value investments was mentioned by one of the fund managers, but biotechnology funding is targeted at high growth with the possibility of additional future investment. These funds are therefore not the focus of the study. Also, some of this money, although low in value, is targeted at large institutions and is therefore not within the scope of this research. • No additional corporate funds for equity finance could be found or were identified through referrals. It was hoped that Zimele could refer us to some of these corporate funds, but Zimele declined to be interviewed in November. It is suspected that such funding exists. • There are many small businesses that focus on providing loan finance to other small businesses. It is suspected that some of these also take equity stakes in the companies they invest in (one example of this is NewBusiness Finance). These funds are also likely to be small, not equity focused. • Angel funders (rich individuals) provide support to many small businesses. These financiers are not easily identified and also are not generally available to small businesses outside of their networks. 5.5.4 Financiers selected for this report The listed equity financiers below were classified into two groups: Lifestyle, high-growth and private equity. The reasons for these classifications are part of this research and will be discussed in more detail later, but brief definitions are as follows. • “Private Equity” funds were interviewed for comparison purposes only, and all invest amounts larger than R10m, and are not primarily aimed at SMEs • “High-growth” funds exclusively targeted SMEs with high growth potential 30
  32. 32. • “Lifestyle” funds invest in SMEs that do not promise high capital returns, but will provide the entrepreneur or small business with comfortable and financially secure returns Not all the funds included in the list are necessarily the focus of the research. Some of the funds have minimum investments that fall below the R5m mark, but their maximum investment are higher than this. The IDC-backed funds, including the 9 wholesale funds and the direct SBU funds, have averages that are higher than R5m. Where possible these funds prefer larger investments, but they do make funds available to SMEs. These funds have therefore been included in the totals applicable to SMEs, but the research has focused more heavily on the funds that actually target investments of less than R5m. The table overleaf indicates which financiers have been included, excluded and why. 31
  33. 33. Fund Name Investors Fund Manager Funds Min + Max Inter- Reason Classification Available investment viewed IDC SBUs • IDC IDC R1.4bn R1m Y • Both • Agro-Industries (invested in minimum • Chemicals IDC’s Ave = R6.5m • Entrepreneurial definition Mining of SMEs) • Metal, Transport & Machinery • Textiles, Clothing, Footwear • Wood, Paper & Other Khula Equity Fund • Khula Firm Capital R40m R250k to Y • Lifestyle R5m Anglo-Khula Mining • Khula Zimele R40m R1m to R5 N Interviewed Khula • High-growth Fund • Anglo instead American Umsobomvu Youth • Umsobomvu Umsobomvu R90m R500k to Y • Lifestyle Fund (General Fund) Youth Fund Youth Fund R5m Franchise Fund • Umsobomvu Business Partners R125m R250k to Y • Lifestyle Youth Fund R15m • Business Partners Progress Fund • Umsobomvu Enterprise Equity R100m R100k to Y • Lifestyle Youth Fund Partners R5m • First Rand Group Business Partners • Business Business Partners R1.2bn R250k to Y • Lifestyle Partners R15m Business Partners • Business Business Partners R100m R250k to Y • High-growth Venture Capital Partners R15m 32
  34. 34. Fund Name Investors Fund Manager Funds Min + Max Inter- Reason Classification Available investment viewed Equity Africa • ABSA Equity Africa R200m N Declined interview • Lifestyle • Shanti Industries Holdings Zimele • Anglo Zimele R15m Unknown N Declined interview • Lifestyle American Enablis • Hewlett- Enablis R55m Not Y • Lifestyle Packard determined • Accenture yet • Telesystems • Government of Canada REDI • Old Mutual REDI R2m R350k to Y • Lifestyle R1m Kagiso Rural Fund • Kellog Kagiso R15m R1m to R5m Y • Lifestyle NewFarmers • Capespan NewFarmers R51m R1m to R5m N Declined interview • Lifestyle • Old Mutual Current Ave • Sanlam = R5m • ABSA • Other DFI’s • Other NEF Ventures • IDC NEF R200m R3m to R10m Y • High-growth • NEF Womens Private Equity • IDC Glenhove Fund R130m R2m to R25m Y • High-growth Fund • Eskom Managers • DBSA HBD • HBD HBD R70m R250k to Y • High-growth R7m HBD Development • HBD HBD R1m R100k Y • Lifestyle Fund HBD Incubator • HBD HBD R1m R50k Y • High-growth Catalyst Innovations • Catalyst Catalyst Unspecified R2m to R5m Y • High-growth 33
  35. 35. Fund Name Investors Fund Manager Funds Min + Max Inter- Reason Classification Available investment viewed Innovations Innovations Point Break • Point Break Point Break Unspecified Was R0 to N Did not return call • High-growth R5m but Focused on MBOs focus has and LBOs changed to larger businesses NewBusiness Finance • NewBusiness NewBusiness R10m Ave = R250k Y • Lifestyle Finance Finance Global Capital VC • N/A Global Capital R90m R500k + N They confirmed that • High-growth Fund they only made low (EXCLUDED FROM investments in very STUDY) exceptional cases Venfin • N/A Global Capital R400m No minimum N They confirmed that • High-growth (EXCLUDED FROM they would not STUDY) generally invest under R10m Aquila Growth • Private sector Aquila Growth R300m + No min or N Primarily large • High-growth (EXCLUDED FROM and individuals max investments (Ave = STUDY) Ave = R28m R28m) Growth Fund • Private sector i Capital Fund R50m R4m to R15m N Minimum is too • High-growth Managers Avg = R5m high, and did not return call 34
  36. 36. Fund Name Investors Fund Manager Funds Min + Max Inter- Reason Classification Available investment viewed Archway Venture • IDC Gensec R160m R500k to N Spoke to IDC • High-growth Partners Trust • Gensec, Didata, R15m department • High-growth SCMB, Ave = R8m responsible for • High-growth Metropolitan, funds – Average • High-growth Libam investments were • High-growth IDC Venture Capital • IDC Argil Venture R100m R3m to R15m N between R5m to R10m and the • High-growth Fund • E&YLwail Capital Ave = R8m Bioventure Fund • IDC Gensec Bank’s R80m R1m to R12m N objective is high growth. These make • Gensec, it beyond the scope Horizon Techventures • IDC Horizon Equity R143m R2m to R20m N and focus of this • CDC, Norfund, Partners research Horizon Technology Vantage Capital Fund • IDC Vantage Capital R223m R2m to R23m N • FMO, Transnet, Esom New Africa Mining • IDC Decorum R564m Unknown N Fund • ABSA, SIM, DBSA, Harmony, Goldfields Brait • N/A Brait N/A >R10m Y • Private Equity Ethos • N/A Ethos N/A >R10m Y • Private Equity Gensec Private Equity • N/A Gensec N/A >R10m Y • Private Equity Table 8 - Funds and fund managers considered in the research report 35
  37. 37. 5.5.5 The Players in SME Equity Finance2 The table mentions the funds identified as investing amounts under R5m in SMEs. This section briefly describes the organizations and companies included in the research, including their objectives and their criteria for selecting investments. Industrial Development Corporation The Industrial Development Corporation (IDC) is a self-financing national development finance institution (DFI). The IDC’s original objective was to contribute to economic growth and industrial development but it now (since 2001) also has an empowerment objective in its financing activities. The IDC funds SMEs in two ways: directly, through Strategic Business Units focusing on specific sectors, and indirectly, through its Wholesale division which makes funds available to external fund managers and providing an SME-oriented mandate. Depending on the type of fund, the IDC’s funds have different selection criteria ranging from growth objectives to sectoral development, job creation, empowerment and poverty alleviation (IDC Annual Report, 2002: 26). Most SME investments are targeted at job creation, empowerment and poverty alleviation though some (specifically the Wholesale business unit’s funds) are also aimed at high growth. Khula Khula Enterprise Finance Limited is an agency of the Department of Trade and Industry established in 1996 to facilitate access to credit for SMEs through delivery mechanisms including commercial banks, retail financial intermediaries (RFIs) and micro credit outlets. Khula also provides mentorship services to guide and counsel entrepreneurs. Khula has one equity fund in which it uses its own funds, and another fund in which Anglo American is a co-investor. Though it has a commercially-based mandate for its equity funds, investments are also selected on job creation criteria (http://www.khula.org.za/index2.html). 2 Excluding those funds and companies that were considered outside of scope of the research (see table 6) 36
  38. 38. National Empowerment Fund The National Empowerment Fund (NEF) is a state-owned provider of empowerment finance. It was created in 1998 as part of the Department of Trade and Industry’s group of development finance agencies. NEF currently has one fund, namely NEF Ventures, which has committed capital of R200m. This fund is managed by the NEF and is jointly financed by the NEF and the IDC’s Wholesale Finance Unit. NEF Ventures’ mandate is to facilitate successful and sustainable black economic empowerment through finance and investment activities (http://www.nefcorp.co.za). Umsobomvu Umsobomvu is a government agency aimed at empowerment of youths (aged between 18 and 35). The organisation aims to provide opportunities for youths to become entrepreneurs and to improve their entrepreneurial skills. Umsobomvu has invested in the Progress fund managed by Enterprise Equity Partners, an equity fund which is managed in-house, and a youth franchise fund which is managed by Business Partners. The latter creates low-risk business opportunities by investing in franchise outlets to be owned and managed by the new entrepreneurs (http://www.uyf.org.za/progs/index.asp?page=01). Business Partners Business Partners is an unlisted specialist investment group, which provides debt and equity investment, mentorship and property management services for SMEs in South Africa. Business Partners Investments focuses on investing in enterprises requiring up to R15m for start-up, growth, franchise, management buy-out or a management buy-in purposes. Though it runs on commercial criteria, deal executives are incentivised on the empowerment deals that they finance and records are kept of jobs created as a result of investments. Business Partners has 22 offices servicing the SME sector nation-wide. The company also manages the R125m Business Partners Umsobomvu Franchise Fund 37
  39. 39. launched in 2003 for investment in black youth in the franchising sector. Business Partners was started in Eighties with funding from DTI (www.businesspartners.co.za). Enterprise Equity Partners Launched in 2002, Enterprise Equity Partners is an initiative which aims to find ways to provide equity and/or quasi equity financing to enterprises. It manages the Progress Fund, which is part-funded by the First Rand Group, but the majority of the funds come from the Umsobomvu Youth Fund. Enterprise Equity Partners is a subsidiary of First National Bank. The central thrust of the fund’s investment strategy is to propel the growth of small to medium sized financially viable ‘going concerns’ that have (or are in a position to secure) a contract with a corporate, a parastatal enterprise, or an arm of government (http://www.sbp.org.za/sme.htm). Equity Africa Established and funded by ABSA and Shanti Industrial, Equity Africa is both a fund and a fund management company. It invests in broad based black economic empowerment in the SME sector. (http://www.equityafrica.com/index.html) Zimele Zimele, Anglo American's SME development arm, is a CSR initiative that aims to facilitate black economic empowerment, provide finance to black-owned emerging companies, assist in the development of entrepreneurship by providing business skills, management and expertise. Anglo also aims to divert procurement spend to the companies in which Zimele invests, in order to improve the mining company’s empowerment scorecard (http://www.zimele.co.za/about_zimele_o.asp). 38
  40. 40. Enablis Enablis is a not-for-profit organization formed in partnership with Accenture (UK), Hewlett-Packard (US) and Teleystem Ltd. (Canada) in 2003. It aims to drive economic development in Africa and to build self-sustaining businesses by supporting SMEs. Enablis will focus its efforts on enterprises that cross the digital divide and that drive economic growth in their communities (http://www.acdi-cida.gc.ca/cida). REDI The Rural Economic Development Initiative (REDI) is supported by the Old Mutual Foundation, DfID and the Ford Foundation. REDI aims to improve skills in financial management and to provide seed capital for the establishment and expansion of new, viable businesses within 18 rural communities. It focuses on establishing new businesses and jobs that help the rural villages to become more self-sufficient (http://www.oldmutual.co.za/corporatecitizen/SocialInvest/Redi.asp?npage=2). Kagiso Trust Investment Company Kagiso Trust Investment Company owns Kagiso Rural Fund, a developmental investment company funded by the Kellogg Foundation. The fund was started in late 2002, and hasn’t made an investment yet. The fund aims at empowerment, rural development and job creation. Glenhove Fund Managers Glenhove Fund Managers manage the Women’s Private Equity Fund. Women Private Equity Fund is funded by Development Bank of Southern Africa, the IDC and Eskom Pension Fund. It will invest in companies managed by women entrepreneurs, or that have a “female-only focus.” (Rose: 2003). 39
  41. 41. HBD HBD Venture Capital is a full service venture capital organization that was founded in 2000 and is funded by private investor Mark Shuttleworth. It aims to invest in innovative technology projects, support entrepreneurs, promote “breakthrough” technology and develop global potential. The company invests in seed or start-up companies that are initiated from South Africa but have global markets and are not limited to one country or region. HBD Venture Capital has invested in seven projects since early 2001 (http://www.hbd.co.za/venture_capital/investments.php). Catalyst Innovations Catalyst Innovation invests in the health care, electronics and medical sectors providing finance and strategic, marketing, and project and operational management. On occasion Catalyst will invest in other sectors. This company targets high-growth investments. It provides seed capital and also finance for start-ups, management buy-ins and turnarounds (www.catalystinnovations.com). New Business Finance Started in 1998, New Business Finance finances companies ranging from start-up to established businesses, in all sectors of the market. The company’s products include working capital, bridging finance, micro business and transaction finance. It also offers consultancy and monitoring services. New Business Finance is commercially oriented, but considers its mandate partly developmental due to the businesses it funds (which are generally owned by black entrepreneurs.) The company began to offer equity finance in 2002. Brait Brait Private Equity is a subsidiary of listed Brait SA, an international financial services group listed on the JSE Securities Exchange, and the Luxembourg and London stock exchanges. Brait's Private Equity invests in high growth potential enterprises, through a 40
  42. 42. partnership with management of these enterprises. Its funds are invested in a range of business, from early to late stage. Ethos Ethos is a private equity company that was founded in 1998 to assume the business of FirstCorp Capital Investors. Using the funds it manages, Ethos specializes in acquisitions that involve management participation. Ethos is a pure play private equity firm with controlling ownership by its executive management. Its operations cover management buy-outs and buy-ins of large companies, expansion capital to high growth entities and replacement capital. Gensec Private Equity Gensec Bank is an investment bank that provides derivative-based risk management products to the savings industry, arranges debt and equity finance for corporates and is a manager of private equity funds. Its private equity funds provide expansion capital to viable businesses and contribute strategic advice. Among Gensec’s funds are development funds Achway II and BioVentures, which are part-funded by the IDC. 41
  43. 43. CHAPTER TWO: SME Equity Finance This chapter establishes the need for SME finance in South Africa, and acknowledges the challenges that inhibit this sort of investment. SME Equity finance in the US is then presented as a case study for comparison with the South African industry. 6. The need for SME Equity Finance: This section proves that there is a need for SME finance, in particular, for equity finance 7. The Obstacles to SME Equity Finance: Many financiers avoid SME equity finance. This sections investigates why this is the case and acknowledges the challenges faced by these financiers 8. An example: SME Equity Finance in the US: A US case study is provided as an example of how other countries manage their SME equity finance needs.
  44. 44. 6 The need for SME Equity Finance 6.1 The Need for SME Finance The South African government’s Growth, Employment, and Redistribution Strategy (GEAR) has achieved significant success in stabilising the economy. However, the tight fiscal discipline that is part of GEAR has not relieved the economic hardship of most South Africans. For this reason, government introduced a growth-focused microeconomic reform strategy, called Vision 2014. The strategy targets SME development (DTI medium-term strategic plan: 2002-2004: 13-15; DTI, 2003). SMEs now form the growth driver of the world's largest economies and are driving much of today's global job creation. In SA, eight out of 10 jobs that are created occur in the SME sector (Karungu et al, 2000). In the US, Japan and Germany for instance, small business contributes more than half of the gross domestic product (GDP) in each of those economies. Alec Erwin, Minister of Trade & Industry, believes that small and medium- sized businesses, currently accounting for 35% of GDP, should contribute 60% to 80% of South Africa’s GDP within the next 10 to 15 years (Business Day, 12 November 2002). Lack of finance has been regarded as one of the major problems contributing to slow development and high mortality rates of small businesses in SA (Iwisi et al, 2003: 2). The Gem report (2003:32) states that SMEs do not experience greater difficulty that other emerging countries (surveyed by Gem) in obtaining finance and argues instead that in South Africa, lack of adequate financial management support is the second biggest weakness in the national environment for entrepreneurial activity (ibid). The precarious nature of many SMEs is born out by a statistic quoted by Karungu et al (2002): of all the jobs created in the SME sector, up to 75% are lost within a year. Access to finance is particularly relevant for black entrepreneurs who do not have access to collateral and the networks of wealthy individuals who could provide angel financing. 32
  45. 45. For these reasons, argues the IDC’s Malinga (2003), organizations such as the IDC should provide assistance to SMEs in all sectors. The target market should be black entrepreneurs. Assistance should include financial skills and “capacity in business skills” (including financial, marketing and customer relations skills) as these are challenges facing black entrepreneurs (Malinga: 2003). Therefore it is clear that the need for SME finance exists in SA, in order to boost the growth of the sector. This will also stimulate job growth. However, support to management of SMEs is needed to maximize the benefits of SME finance. 6.2 Types and Sources of SME Finance Currently, sources of finance exist for SMEs. These include • Equity financiers • Angel financiers • Government programmes; • Financial institutions; • Family and friends; and • Own funds. The most important source of funding in all countries included in Gem is the entrepreneurs themselves (Gem Report, 2003: 34). Fifty-four percent of South African entrepreneurs report that they have used or expected to use their savings and income to fund their business (ibid). For all developing countries, savings and personal income were the most frequently mentioned expected sources of funds (ibid). The second most important source of funds is the entrepreneur’s personal network (Gem Report, 2003: 35). Thirty-seven percent of South African start-up entrepreneurs expected to receive funds from their personal network (ibid). In SA, 27% expected to or had received institutional finance (ibid). 33
  46. 46. Overall, these figures suggest that currently, institutional finance is less important in financial start-ups than entrepreneur’s own savings and their ability to mobilize finance from their personal network of family, friends and colleagues (ibid). The major reason appears to be a lack of collateral acceptable to the banks. The evidence from Gem suggests that many township entrepreneurs are unable to raise finance as many key personal assets in South African townships, are either heavily of entirely disregarded by banks in calculating an individual’s net asset position. This includes property. The reasons include the high probability of criminal damage to property, uncertainty over property rights, and potential difficulties in selling properties in townships, former homelands and inner cities (Gem Report, 2003: 36). 6.3 The Need for Equity Finance In SA, most SMEs are under-capitalised and over-leveraged (Ebony Consulting International, 2: 2001). Moreover, as has been shown above, many township entrepreneurs have a lack of collateral acceptable to the banks. This is due to the fact that before 1994, black entrepreneurs were legally hindered from building up assets and do not have access to collateral (Falkena et al, 226: 2001). This means that equity finance would be more suitable than debt finance and is one of the only options for entrepreneurs without collateral (Falkena et al, 226: 2001; Ebony Consulting International, 2: 2001). However, currently the low-value equity market is under-serviced and the need for financing under R5m exists globally (Falkena et al, 2001:226). Falkena (226: 2001) and Ebony Consulting International (2:2001) refer to this need as the “equity gap”. Moreover, Business Partners CEO Joe Schwenke believes that equity finance makes it possible to provide growth capital for businesses and to delay taking profits until the business can afford it. Equity finance avoids the prohibitively high interest payments associated with debt. This facilitates the creation of sustainable investments. 34
  47. 47. Iwisi et al (2003: 2) argue that equity finance is an attractive finance mechanism for SMEs in SA because equity financiers are motivated to give investee companies active mentorship and support. As entrepreneurs are often inexperienced and lacking in management skills, this support would promote growth of the SME sector. Iwisi et al cite an empirical study by MacMillan et al (1989), elaborated by Morris et al (2000), which suggests that venture capitalists can be involved in: • Serving as a sounding board to the management team • Obtaining alternative sources of equity financing • Interfacing with the investor group • Monitoring financial performance • Monitoring operating performance; and • Obtaining alternative sources of debt financing (Iwisi et al, 2003: 6). In a similar vein, Van der Vaart (2001) suggests that the best model for SME finance should combine early-stage equity investment and performance-enhancing technical assistance (Van der Vaart, 2001). Small Enterprise Assistance Funds (SEAF), a commercially successful US- and Dutch-based NGO of Van der Vaart is CEO, manages commercially driven investment funds worldwide with total assets of $140m which uses an “equity plus assistance” method of SME investing. Equity finance can also play a developmental role. Falkena et al (2001) conclude that for job creation and poverty alleviation reasons, equity finance has advantages over debt finance for the very large number of low-growth enterprises. Moreover, the involvement of venture capital is required when a given firm is unable to attract capital from conventional institutional sources such as public equity markets or credit-oriented financial institutions due to many restraining regulations and a dislike of risk (Iwisi et al, 2003: 4). 35
  48. 48. While equity finance works for the entrepreneur, it also works for the financier. Using equity allows financiers an upside which isn’t incorporated into a debt finance arrangement (Business Partners Annual Report, 2001). Thus there is a need for equity finance that has the advantages over debt in that it provides: • Relief from crippling upfront payments associated with debt, particularly micro- finance, • Encourages the use of mentors to provide management support, • Provides access to finance in the absence of collateral • Provides mentorship and support to SMEs • Provides the financiers with an upside. 36
  49. 49. 7 The Obstacles to SME Equity Finance We have shown the need for SME equity finance. However, obstacles exist. “A major obstacle for organizations servicing new owner-managed businesses is that assessing the risk associated with these clients is both difficult and costly. Therefore, financial institutions are selective in lending to new ventures” (Gem Report, 2003: 34). This perception exists among commercial banks and government organisations established to fund SMEs (Van der Vaart, 2001). These risks include the difficulty of assessing management, the lack of track records of entrepreneurs and lower returns in these companies, the expectation of excessively high transaction costs for financial institutions and the knowledge that investing in local SMEs often involves working with entrepreneurs unfamiliar with conventional financing relationships (ibid). South African financial institutions do not appear to have the skills to service SMEs effectively or profitably (Gem Report, 2001: 44). Interviews with Enterprise Equity Partners and USAID (USAID, Enterprise Equity Partners interviews: October 2003) suggest that the banks are addressing these issues to preempt pressure from the Financial Services Charter. Interviews indicate that large-scale commercial investors are not attracted to low value transactions as there is insufficient profit motive (Brait, Gensec interviews: October 2003). These companies prefer to make larger investments (above R2m) which are more profitable as they benefit from lower relative transaction costs. This is not only a local phenomenon (Falkena et al, 2001: 226). In emerging economies worldwide, financial institutions often avoid SMEs, discouraged by the expectation of excessively high transaction costs and the knowledge that investing in local SMEs often involves working with entrepreneurs unfamiliar with conventional financing relationships and business practises (Van der Vaart, 2001). These factors raise the transaction costs in the dealing with SME’s. The transaction costs are also driven by the inexperience and 37
  50. 50. low skill of SMEs management, and by the simple fact that there are more deals per dollar invested, and each deal requires a certain amount of time irrespective of the size of the deal. Another obstacle to SME equity finance is that a number of government agencies are not able to provide adequate mentorship services to SMEs (Karungu et al, 2000). Interviews suggest that the same applies to many privately owned financiers (Brait, Gensec, October 2003). This is an obstacle to equity finance in an environment in which many entrepreneurs are inexperienced and have poor management skills. Karunga believes that the government agencies themselves don’t always have the required experience, skills and appropriate organizational structures. Interviewees also note their discomfort about extending equity finance to entrepreneurs who are not able to contribute equal quantities of their own equity finance into the business. This is another obstacle to equity finance. Business Partners argues that in this situation, entrepreneurs are less motivated to spend time managing their businesses. Probably more important, Falkena et al (2001: 226) have shown that a major obstacle to equity finance is that entrepreneurs don’t want to give up equity. Another issue is that investments in small businesses that do not promise high growth often require longer investment periods before the entrepreneurs are able to buy themselves out. Studies in the US suggest that these businesses require investment periods of 10 years (Rubin, 2002). There are therefore several obstacles to SMEs equity finance: • SME equity investment is associated with higher risk • They require a significant amount of support which increases transaction costs • There are more deals per rand invested meaning higher transaction costs per rand invested 38
  51. 51. • The absolute profits from the low-value investments are too small for large players • The required investment periods are longer, generally close to 10 years • The entrepreneurs often don’t have the money to contribute enough of their own capital • Entrepreneurs don’t want to give away ownership of their businesses. 39
  52. 52. 8 An example: SME Equity Finance in the US We have shown that the drive to empower black South Africans through jobs and business ownership is a major reason behind the local focus on SME development. However, South Africa certainly isn’t the only country in the world to see the need to grow small business in an attempt to alleviate economic need. This section sketches the SME investment programme which has been developed in the US, for purposes of comparison with the South African environment. No similar case studies could be found for emerging market economies. The US has recognised the potential of equity finance as a source of finance and support for small businesses. The States have by far the largest and private equity industry in the world (KPMG Report 2002), with R400bn available for equity investment (ibid) but this industry is primarily targeted at specific high-growth industries in a few specific locations. In response to this – and having recognised the need for equity finance to target a broader range of SMEs across a wider geographical range – the US government created networks of two key different types of equity financiers: • SBICS – Small Business Investment Companies, and • CDVC – Community Development Venture Capital 8.1 Small Business Investment Companies The Small Business Investment Companies (SBICs) Programme was started in 1958, when Congress passed the Small Business Investment Progamme Act (US Small Business Administration: 2002). The programme was to be a public private partnership which invested many billions of long-term capital in privately owned and managed investment firms (ibid). The firms would invest across the spectrum of private equity, including venture, buyout and mezzanine funds, with the aim of bridging the gap between entrepreneurs’ needs for capital and traditional financing sources (ibid). Investments would be $1m or less, in non-technology industries, which have a difficult time attracting 40
  53. 53. patient capital. (Rubin, 122: 2001) Unlike CDVCs, these do not specifically target low- income areas. Currently, SBIC programmes are a “vital part of the venture capital industry”, providing “8% of all venture financing dollars, 64% of seed financing dollars and over 62% of all venture financings by actual numbers” (US Small Business Administration: 2002). The SBIC programme provided $7bn in SBIC financings in 2002. Companies with current SBIC financing employed 1.1m people during the period. The SBIC programme also has a broader geographic distribution across the nation than private equity as a whole (ibid). The US government matches funds in SBICs with private equity investors by contributing an additional 50% to 200% on top of the capital provided by the private investors in these funds (Small Business Administration. Accessed from website on 20 November 2003). This creates a structured network targeting SME equity investment. In comparison, the South African government sets up SME equity funds on an on an ad hoc basis. In some cases these funds are used to attract matched investment from private investors or other DFIs. In other cases, the funds are contributed solely by government. 8.2 Community Development Venture Capital In a research paper titled “Community Development Venture Capital: a Double-Bottom Line Approach to Poverty Alleviation”, Julia Sass Rubin states that the US SME investment programme has been developed for two reasons: • to develop communities in low and moderate income populations through organizations which are part of the Community Development Venture Capital (CDVC) sector (Rubin, 125: 2001); and • to fund companies seeking investments of $1m or less in non-technology industries, which have a difficult time attracting patient capital, through organizations called Small Business Investment Companies (SBICs). Unlike CDVCs, these do not target low-income areas (Rubin, 2001). 41

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