We don’t expect to make money on the smaller investments in our portfolio, but we do them anyway. The reason we don’t expect to make money is fairly simple: transaction costs are high relative to the size of the deal. The reason we do them anyway is because small businesses are fundamental to building a profitable agricultural sector and, for those that do manage to get to scale, the social impact can be very large.
Why are transaction costs so high? Agriculture is not a sector that lends itself to a “cookie-cutter” approach to deal-making. Every opportunity is different – crops, technology, markets, revenue models, weather risks, management quality. In environments where reliable information is often scarce, an investor needs to understand and develop risk mitigation strategies for all of these areas. That involves time and money, not least travel costs in visiting remote areas.
Then there are legal costs associated with structuring and documenting the deal, often in a legal and policy context which is rather opaque; and with project sponsors and regulators who are not familiar with standard venture capital type structures (e.g. convertible debt instruments). These due diligence and legal costs can easily exceed $30,000, even for the smallest transactions.
Once the investment is made a fund manager often has to spend significant time working with sponsors to help build financial management systems, formalise business processes and develop marketing strategies. From the 20 or so investments AgDevCo has made to date, we have found that the first year costs of this type of activity can easily be $25,000 or more. More significantly, supporting small businesses can take up a disproportionate amount of management time.
If total first year cost for a typical small deal exceed $55,000 then – assuming an interest rate payable by borrowers of 7.5% and a seven year loan term – an investment of anything less than $500,000 delivers a negative net present value for the fund, after taking into account on-going monitoring & evaluation costs. That is without making any provision for non-performing loans in the portfolio. Taking some equity can provide upside but doing so pushes transaction costs higher, and exit opportunities for small deals are likely to be limited.
The case for doing small deals rests on the fact that small and medium sized enterprises (SMEs) are the backbone of any economy – and typically the largest overall employer. That is especially true in the agriculture sector. Agricultural development requires multiple small, profitable businesses operating along the supply chain from input supply to production, processing, logistics and marketing. By investing in “clusters” of small businesses a social impact investor can attempt to build supply chains which benefit the sector as a whole.
Over time we expect the cost of doing smaller deals to fall. The first mezzanine debt investment in a Mozambican soya processing facility will be expensive; the second should be easier. Over time we would expect to see better data availability, streamlined regulatory and approvals processes, and the emergence of local service providers. In other words, there will be fewer market failures acting to increase transaction costs and risks.
Until then social impact investors who are prepared to operate at the smaller end of the deal spectrum will need to find ways of balancing the books. That can be done through a combination of building portfolios which include a mix of small and large investments, and by making the case to donors that the first year or two of costs of small investments should be partly grant funded. There are also innovative models for lease financing of small farming businesses, such as Equity for Africa.
Until then social impact investors who are prepared to operate at the smaller end of the deal spectrum will need to find ways of balancing the books. That can be done through a combination of building portfolios which include a mix of small and large investments, and by making the case to donors that the first year or two of costs of small investments should be partly grant funded. There are also innovative models for lease financing of small farming businesses, such as Equity for Africa.
The wrong conclusion would be for social impact investors to withdraw from smaller deals, or to cut corners on due diligence. Social impact investors bring a much needed dose of commercial discipline to small businesses which can help them reach the next level. The reality is that small businesses in the African agricultural sector face costs and uncertainties that early-stage businesses in more developed parts of the world do not. It makes sense to mix in grant funding to help get them across the first few humps in the road.
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A recent survey on entrepreneurship in Africa by the Omidyar Network, Accelerating Entrepreneurship in Africa, highlights some of the challenges faced by early-stage businesses:
- 84% of SMEs in Africa are either un-served or underserved in terms of access to capital, representing a value gap in credit financing of $140-170 billion
- Over two-thirds of respondents believe there is an insufficient supply of venture or private equity capital for small and growing firms.
- Debt financing from banks is viewed as unsuitable funding source for entrepreneurs given the structure and cost.
- Government funding is viewed as difficult to access due to bureaucracy and nepotism; and there is a shortage of alternative sources of "patient capital"
- Only a quarter of respondents believe that business support services - such as lawyers, accountants and consultants – are sufficient to meet the needs of new firms. Availability of these services is especially limited in more rural areas away from large urban centres.
- Many new businesses operate “below the radar” in the informal sector because of the high costs and uncertainties of operating in a more regulated environment, where penalties for non-compliance can be high.
- From investors’ point of view, the key determinants of success for a business are the entrepreneur’s ability to adapt to market changes and cope with uncertainty, as well as his or her level of tenacity.
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