DGGF study: SME mezzanine finance

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2 September 2016 - SMEs (Small and Medium-sized Enterprises) form a crucial part of the economies of emerging countries. Limited access to finance is commonly seen as their main barrier to growth. The lack of financing options is particularly problematic for SMEs in the so-called “missing middle”, i.e. entrepreneurs that have outgrown micro financing but do not yet have access to regular financial services. One of the most critical challenges SMEs face – as the #ClosingTheGap ecosystem study conducted last year in Kenya confirms – is to access long term growth capital and related affordable high quality business support.

Unique product

In search of instruments to address this significant gap, DGGF has identified SME mezzanine finance - which blends elements from traditional equity and debt financing into a unique product - as one of the potential solutions for providing long term finance and business support to SMEs with a regular growth potential. This instrument offers entrepreneurs an attractive alternative to obtaining capital with fewer restrictions than pure debt and less ownership dilution than pure equity. For investors it allows the benefit of upside if the enterprise is successful, but also offers “downside protection” in case the enterprise is less successful.

Learning from existing models

DGGF has invested in a number of small cap mezzanine finance providers such as GROFIN and XSML. Considering the potential of the mezzanine instrument to provide adequate finance to missing middle entrepreneurs, the Seed Capital and Business Development (SCBD) facility of DGGF has commissioned a study to learn from existing models. The objective of the study was to identify to what extent and under which conditions mezzanine finance can be used to best serve the missing middle.

New perspectives

The commissioned study New perspectives on financing small cap SMEs in emerging markets: the case for mezzanine finance provides a robust understanding of the particulars, diversity and complexities of SME mezzanine finance and concludes that:

  • Mezzanine finance is an important building block of the local SME finance ecosystem by providing long term growth capital under US$2million;
  • The SME mezzanine finance sector is still developing; there is an opportunity to improve the risk/return profile of this financial instrument and subsequently scale this emerging asset class;
  • Fund managers, DFIs (Development Finance Institution), impact investors, donors and governments should recognize the limitations but also potential of the instrument to address the missing middle.

This study is the first of its kind and represents a first step into growing SME mezzanine finance as an efficient instrument to address missing middle enterprises’ financial needs.