Small and medium-sized enterprises (SME’s) in both the Developed and the underdeveloped world create vast and more opportunities than any other sectors in the economy for the populace and contribute more to the economy, but their thriving has not been automatic in the developed world, SME’s in the developed world recognised their importance and put in place, policies that favoured the growth, financing and finally the protection of SME’s which in turn led to a gross contribution to GDP which translated into the big economies we hear of or admire.
Despite the existence of both public and private capital markets in Uganda SMEs are yet to actively participate in these markets. Is it because there are better financing options than the capital markets in Uganda such as retained earnings and banking finance as clearly depicted in the statistics or the capital markets are a viable option but they are still underdeveloped and the SMEs are not attractive to would be investors? Certainly bank financing and Internal financing are not sustainable especially if SMEs are aiming at growing and expanding their markets according to a study by Gibson in 2008.
Bank financing unlike equity financing exerts a substantial financial cost on SMEs in terms of interest payments which can greatly affect the cash flows of the business.
The continuous drain of the business cash flows by interest payments can have a substantial negative impact on the working capital position of the company thereby hindering its ability to grow and expand.
In some cases, excessive debt obligations have been the cause of the SME business failures. It is also sufficing to say that corporate bonds a major component of capital markets financing like bank loans also exert a substantial cost on SMEs in terms of interest payment obligations.
Bank financing does also require collateral in addition to the interest payment obligations. On average 86% and 97% of loans taken out by Small and Medium sized companies respectively require collateral, according to the World Bank document 2006.
Collateral requirements are exorbitant and are indeed one of the major bottlenecks of access to business finance among SMEs because usually SMEs do not have any substantial tangible or intangible assets.
On average the value of collateral needed for a loan is 173% of the loan amount. In small companies the average value of 121% of the loan amount and in medium sized companies it is 173 % accordingly.
Private equity (PE) financing on the other hand does not require collateral and there are no interest payment obligations for the SME thus making it the most suitable form of long-term financing for SMEs.
It also comes along with business development services for the SMEs which are provided by the private equity investor as part of their equity investment.
The business development services offered by the PE investor entail institutions of good corporate governance, management and operational structures and systems. This may also at times mean replacement of the current management in the investee company with a high caliber and experienced management team to drive the growth and expansion of the company.
Private equity investors also usually aim at owning a substantial equity stake in the invest company so as to guarantee them a majority or veto power on the company board.
This gives the PE investors the leeway in determining the way the investee company will be run so that they get the maximum return out of their equity investment.
Much as this approach may impinge on the independence of founding entrepreneur it will most likely yield the required business growth and rate of returns for the PE investor which is estimated at 45% for SMEs in developing countries.
Private equity financing has been the drive towards SME development in the developed world especially in the United States of America, Europe and Asia but is yet to have a mark in SSA and especially in Uganda.
The limited success of the private equity financing can be attributed to a number of factors including but not limited to, the small size of SMEs, the high transaction cost relative to investment size, the inactivity or illiquidity of local stock exchanges at the small business level, and the rarity of opportunities for favourable sales of shares through mergers and acquisitions according to Gibson 2008.
These bottlenecks have generally resulted in Private Equity SME funds, being largely underinvested, raising their investment size to above the SME level, or performing unsustainably by failing to exit equity positions.
The size of a private equity investee company is critical for a successful private equity investment because investing in a small company takes many, if not more resources compared to a larger transaction. Equity investments in SMEs through the nascent private equity and private equity industry have generated mostly poor returns and many business failures according to Patricof and Sunderland study of 2005.
In analysing the portfolios of leading global SME funds they find that, without even taking into account transaction costs, the gross realizations and valuations on these investments barely return capital to the funds, compared to healthier multiples on larger investments. When even small transaction costs are incorporated into the returns calculations, the base capital on the small investments is quickly eroded.
In looking at Illiquid and Inefficient Stock Markets, the rapid growth in the private equity portfolios hinges on returns at divestment according to Adong and Stock study of 2006.
It is widely recognized that the highest return from private equity investments result from IPO exits. Besides deal flow, which determines the number of firms taken to the market by the private equity investor, a strong financial market is a key factor that determines the returns made on divestment.
Unfortunately, financial markets in Africa are relatively small, illiquid and have low trading volumes compared to other emerging markets. In a survey of selected limited private equity partners, insufficient exit options were cited as one of the major reasons for not for not actively investing in emerging markets (EMPEA 2007)11.
Growth/Alternative markets which target younger and small companies with a high growth potential have performed extremely well in Asia which also has been the bastion of private equity investments in the last three years. the number of companies listed on and the level of liquidity of selected growth/alternative markets in the world according to the Global Markets Chart.
In Uganda the AIMS market which would have been the ideal exit route for Private Equity Investee companies has not had any listing since its inception in 2003. It is argued that many companies including SMEs consider the AIMS market a second class market and thus aim at listing on the MIMS market. USE in a bid to dispel the myth of a second class status has decided to rebrand the AIMS market the Small and Medium Enterprise Exchange (SMEX) and beginning this year it is going to aggressively market among SMEs.
Only if policy is pursued, implemented and the capital markets developed. SME’s could then be expected to provide a favourable environment for private equity financing among SMEs in Uganda as is the case in Europe, Asia and America. Yes, SME’s in Uganda can replicate.