Alternative Finance: An Avenue for MSME Growth in Africa

Research Aim:

  • To explore the importance of alternative finance as an avenue for MSME finance outside traditional banking systems and capital markets in Africa

Research Scope:

  • The research focused on sub-Saharan Africa

Research Objectives:

  • To describe alternative finance
  • To highlight recent trends in financial flows to Africa
  • To determine the potential benefits of alternative financing for MSMEs

Research Questions:

  • What is alternative finance?
  • What are the different types of alternative finance?
  • What are the benefits of alternative finance?
  • How is Africa exploiting alternative financing opportunities?
  • What does the future hold for alternative finance in Africa?

Methodology:

  • Literature Review
  • Statistical Data Analysis

1. MSMEs and their Role in Economic Development

The growth of many economies is tied to the performance of micro, small, and medium enterprises (MSMEs). Sub-Saharan Africa alone has an estimated 44.7 million MSMEs. To provide more context, about 90 percent of all enterprises in Africa are MSMEs. They contribute about 40 percent of Africa’s total gross domestic product (GDP) and create over 60 percent of all jobs (LSEG Africa Advisory Group 2018).

The importance of establishing a strong economic base for MSMEs cannot be overemphasized. There are positive consequences that result from adopting MSME growth policies, such as higher GDP growth, lower unemployment and tax returns. Nevertheless, MSMEs face several challenges that hinder their growth and development. Some of the challenges MSMEs are facing include insufficient financing, a lack of necessary equipment and technology, poor accessibility to capital markets, a lack of managerial and technical skills, a high cost of capital, and so on (Gockel and Akoena 2002; Peter, Ebo and Joshua 2017).

According to the World Bank’s (2021) Enterprise Surveydata, about 38 percent of enterprises in sub-Saharan Africa highlight access to finance as the number one constraint to their growth and development. This is especially so with traditional forms of MSME financing (Beck and Cull 2014).

Global crises have not helped the cause of MSMEs. Drops in consumer demand coupled with a decline in productivity have shrunk the liquidity pool for MSME finance, making it even more challenging to access financing (Beck et al., 2011). The Financial Access Survey showed that there was a decline in loans to SMEs by commercial banks in 2021 compared to 2020 (International Monetary Fund 2022).

To curtail the rise in the cost of doing business on the continent and chart a path toward economic recovery, the evolution of MSME financing remains crucial now more than ever. A window of opportunity has opened for non-traditional forms of MSME finance to step in. In particular, alternative finance has taken a lead role in providing support and decentralized MSME financing in recent years and warrants further exploration.

2. What is Alternative Finance?

Alternative finance can be defined as financing obtained from external sources other than banks or stock and bond markets. Alternative financing has become an important source of finance for MSMEs, as it provides them with the opportunity to access financial markets through private funding and/or non-traditional forms of finance (Kovács et al. 2020). Table 1 below presents a list of the main types of alternative financing mechanisms.

Table 1: Types of Alternative Finance
 TypeDescription 
 Private EquityPrivate equity refers to firms that provide debt and equity to enterprises. 
 Venture CapitalVenture capital is a type of investment that provides capital to small enterprises that have high growth potential. 
 Angel InvestingAngel investing matches high-net-worth individuals with MSMEs.  
 Peer-2-Peer (P2P)P2P lending is a process where enterprises borrow funds from an assortment of lenders, which have to be repaid to the lenders with added interest. 
 CrowdfundingCrowdfunding involves obtaining funds through equity or rewards from a series of investors to fund a particular campaign. 
 Blended FinanceBlended finance is the use of catalytic capital from public or philanthropic sources to increase private sector investment. 
 MicrofinanceMicrofinance is a credit service provided to unemployed or low-income groups that otherwise would have no other access to financial services. 
 Sources: (Convergence 2021; EIB 2021; Investopedia 2022) 

There are several lenders in the alternative financing market space, each with specialized products and services that cater to different enterprises that previously wouldn’t have been able to access MSME financing due to their type of business, industry, strict lending guidelines, or risk profile.

3. Key Enablers of Alternative Finance

The following factors have been identified as the dominant key enablers for the creation of alternative financing in leading countries globally (Kovács et al. 2020; Runde et al. 2021).

Investor Risk Tolerance: Investors looking to provide alternative finance will have to have a high level of trust in their investments and a high level of risk-taking ability.

Policy & Regulation: Governments have a huge role to play in enabling alternative finance. Through building trust, policy development, minor regulations, e-government services, and others, they indirectly lower market entry barriers and ease the absorption of alternative finance.

Technology: The rise of fintech innovations has been successful in unlocking financing for non-banked MSMEs. Smart data and mobile money technology have removed the need for intermediaries to facilitate the exchange of capital. The use of smart data has massively improved the identification of high-potential MSME businesses.

Adoption: The COVID-19 pandemic accelerated the disruption in access to financial services on the African continent. Most countries saw a rise in the digitalization of finance (World Bank, 2022). This trend has affected both traditional and alternative financing solutions, as most financial services, including MSME finance, are shifting to mobile and online platforms.  

Financial Literacy: The financial literacy of managers and technical staff in MSMEs increases the level of financial inclusion as enterprises can access available opportunities given a basic understanding of alternative financial services and opportunities.

4. The Future of MSME Financing

The future of MSME financing in sub-Saharan Africa looks bright based on the potential of the continent. Recent years have seen high adoption of disruptive technology in finance and a steady increase in financial literacy levels for small and medium enterprises (MSMEs) (World Bank, 2019). Nonentheless, sub-Saharan Africa has some of the highest risk profiles and most highly regulated markets in the world.

According to the SME Finance Forum (2018), MSMEs in Africa are only receiving around USD 70 billion in financing. This has left a deficit of over USD 300 billion from the total MSME financing need. There is a significant shortfall in financial flows to and within the African continent to meet the required deficit, as depicted in Figure 1.

Figure 1: Financial Flows to Africa, 2021

Sources: (SME Finance Forum 2018; AVCA 2022; Convergence 2022; OECD 2022; UNCTAD 2022)

Alternative financing has the potential to galvanize local resources towards MSMEs efficiently and innovatively and to contribute to meeting the financing gap. Alternative financing could be argued to be the missing key to solving the ‘missing middle’ problem in Africa by ensuring MSMEs are financially included and have holistic access to financial services.

African countries will need to develop a robust finance ecosystem that responds to the needs of MSMEs. Financial hubs will need to refrain from existing in silos with little to no interaction within and between countries (Alliance for Financial Inclusion 2021).

Furthermore, both private and public sector actors will have to invest in data-driven solutions. This will entail the development of a comprehensive regional database linking MSMEs and alternative finance providers. In the same vein, there must be deliberate action to harmonize financial policies and cross-border transactions to allow for the smooth flow of alternative finances between countries (Alliance for Financial Inclusion 2021).

Alternative finance provides patient, risk-absorbing finance, the kind of finance MSMEs are in desperate need of (EIB 2021). Deliberate policy action to support alternative finance growth in the financial sector will go a long way in addressing the major concern raised by MSMEs in sub-Saharan Africa.

References
African Private Equity and Venture Capital Association. 2022 H1 African Private Capital Activity Report. London: African Private Equity and Venture Capital Association, 2022.
Alliance for Financial Inclusion. Policy Catalogue on MSME Financing in Africa: Enabling Access to Finance for MSMEs in Africa. Kuala Lumpur: Alliance for Financial Inclusion, 2021.
Beck, Thorsten and Robert Cull. “Banking in Africa.” Berger, Allen, Molyneux Phil and Wilson John. Oxford Handbook of Banking. London: Oxford Publishing, 2014.
Beck, Thorsten, et al. Financing Africa: Through the Crisis and Beyond. Tunis: Making Finance Work for Africa, 2011.
Convergence. State of Blended Finance 2022: Climate Edition. Toronto: Convergence – Blending Global FInance, 2022.
—. The State of Blended Finance 2021. Toronto: Convergence – Blending Global Finance, 2021.
European Investment Bank. Finance in Africa: for green, smart and inclusive private sector development. Luxembourg: European Investment Bank, 2021.
Gockel, A.G. and S. K. Akoena. “ Financial Intermediation for the Poor: Credit Demand by Micro, Small and Medium Scale Enterprises in Ghana. A Further Assignment for Financial Sector Policy?” IFLIP Research Paper 02-6, International Labour Organization (2002).
International Monetary Fund. Financial Access Survey: 2022 Trends and Developments. Washington D.C.: International Monetary Fund Statistics Department, 2022.
Investopedia. Investopedia Dictionary. 2022. <https://www.investopedia.com/financial-term-dictionary-4769738>.
Kovács, Katalin, et al. “White Paper on Alternative Finance.” 2020.
LSEG Africa Advisory Group. The challenges and opportunities of SME financing in Africa. London: London Stock Exchange Group, 2018.
Quarty, Peter, et al. “Financing the growth of SMEs in Africa: What are the constraints to SME financing within ECOWAS?” Review of Development Finance 7 (2017): 18-28.
Proparco. “Private Sector and Development.” SME Finance in Africa: What’s New. Paris: Proparco, 2019.

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