The future of development finance - how to fix the "missing middle"

The UK's International Development Committee has published a report on the future of aid, titled The Future of UK Development Corporation: Development Finance. The report makes the case for an increasing proportion of British aid to be delivered as "returnable capital" (i.e. loans or equity), especially where it is used to promote private sector development.

In oral evidence to the IDC enquiry, Dr Chris West of the Shell Foundation made a compelling case for a new approach to supporting social enterprises in the "missing middle". His evidence is worth quoting at length, because few people have such a good understanding of the needs of SMEs in this segment and the challenges of serving them:

"For this market segment, if I look at social enterprises growing… they need skilled support, and they need finance in the right form, which therefore means the transaction cost of servicing that market is high and the risk is high. That is why the end result is a lower yielding return out of investing in that. It is a combination of both cost and risk.

Now, there might be smarter ways of doing it, but I think fundamentally that is why you need a bridging instrument … If we do not have a higher-transactional-cost, risk-tolerant vehicle in the middle, I do not think you will get the graduation of these initiatives to the scale we all hope for.

On your second point about the range of instruments, again, there is a lot of liquidity in a lot of emerging economies…. A lot of that is locked up in banks that have hugely conservative lending rates, and of course it is often provided in short-term debt.

If you are a start-up growing business in any country in the world, you really need some form of patient, flexible finance that adjusts to your cash flow income. It is not necessarily a short-term debt instrument.

Equity is usually not very attractive to the entrepreneur, and it is also not necessarily attractive to the investor, because there is not a very clear exit route from investing in equity in small ventures like this.

You really need different finance forms. You need mezzanine finance forms related to the cash flow performance of the business that are much more patient and much more flexible in tenor."