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Five steps that create inclusive growth through SMEs

This article also appear on The Broker

Despite being the world’s second fastest-growing region, Africa’s challenge is translating this growth into broad-based improvements in well-being.

How can a 5% GDP growth fail to translate into a commensurate reduction in poverty, over years and years? Perversely, how can Africa have managed to increase the number of people living in extreme poverty over the past decade?

It all boils down to economic expansion with insufficient job creation. In some countries, this is because GDP growth is mostly stemming from resource extraction and foreign investment, with relatively little upscaling of the local services or manufacturing sectors. For example, according to Standard Bank, the discovery of the world’s 4th biggest gas reserves in Mozambique is predicted to more than quadruple GDP over the next 20 years, but create less than 1 million jobs in a country of over 20 million (mostly young) people. In some cases, there is a misalignment in the types of jobs created and the educational backgrounds of and resources available to citizens. Insufficient local job creation is compounded by increasing urbanization of former agricultural producers, inadequate infrastructure, paltry public services, sub-par intra-regional trade and other limitations. All of this gives rise to the current situation, in which “lived poverty” pervades and remains virtually unchanged across Africa.

Promoting local small and medium enterprise is the most effective and sustainable solution for creating more inclusive growth. SMEs, in general, comprise the majority of firms and the largest employer in much of the world. As opposed to foreign investment, which may be concentrated in a particular sector or region, local SMEs create opportunities across geographic areas and sectors and employ much broader and more diverse segments of the labor force. In addition, preliminary evidence suggests that formal small enterprises provide better stability, higher pay and better benefits to their employees than micro enterprises and informal firms. In comprising the majority of firms and reaching much deeper and earlier market penetration than foreign firms, local SMEs are often the principal provider of goods and services in lower and middle income communities.  They also are more tapped into local networks and are instrumental in creating offtake for other local suppliers, thus strengthening local value chains.The expansion and fortification of these local value chains means higher local job creation and increased revenues to both private and public sectors.

Tackling five key areas for sustainable SME development (infrastructure, regulation, capacity, finance and business linkages) together with targeted investment in high-growth sectors will put Africa on the trajectory toward booming, yet inclusive economic development.

Yet across Africa, more than 70% of SMEs cease within 5 years and in some countries, the failure rate is as high as 90%. While some of this dissolution may be inherent to creative destruction, there are also internal and external factors that combat SME growth potential. Having identified these factors, we can maximize the likelihood of success. Above all, we must create strong SME ecosystems. An enabling environment for a successful SME segment would have the following characteristics:

1) Infrastructure: Comprehensive and navigable transport networks (from roads to trains and aviation), consistent electricity, decent telecommunications systems and fiber-optic networks ensure SMEs can produce and sell. In many African countries, SMEs have cited regular electricity and infrastructure as their biggest growth challenge.

2) Regulation: Regulatory factors can make it too costly or too cumbersome for SMEs to grow their businesses. These factors can include cost and time of formalization, legal structures to protect investors, the bureaucracy of labor policy and tax payments. African countries have historically demonstrated higher relative monetary and time requirements for regulatory compliance.

3) Capacity: Improving human capital is correlated with improved growth, at the firm level. At the most basic level, setting standards and providing instruction on basic principles of accounting, strategy and marketing can be instrumental for SMEs. For example, GroFin’s surveys of over 5,000 SME entrepreneurs across Africa indicate that most of them lack basic accounting systems as well as formal ESG standards. As SMEs grow, more rigorous technical assistance becomes vital, especially to comply with procurement protocols of government or large corporates.

4) Finance: Over 70% of SMEs in Africa cannot access adequate capital to grow their businesses. Whether it’s fulfilling their first large contract or expanding facilities to fit more customers, SME capacity to meet demand is often capped by capital constraints.

5) Linkages: Networks can play a pivotal role in enabling SME growth. This is particularly true when revenues are derived from business-to-business sales, but networks can also play a role accessing capital, inputs and other business opportunities. At GroFin, we have now added business linkages to our social performance metrics so that we can leverage our networks to find investees new suppliers and clients. Additionally, local and international networks (ranging from chambers of commerce to investment facilitation organizations such as VC4Africa) are helping to connect entrepreneurs and make business opportunities more widely available.

Assuming the aforementioned factors are addressed in the business enabling environment, SMEs are in an optimal position to advance inclusive growth in Africa.  This can be accomplished most rapidly by high-growth SMEs, specifically. In other words, increasing the number of new firms is not as important as supporting firms with high job creation potential. Contrary to popular belief, it is high-growth SMEs, and not start-ups, that significantly expand employment. While short-term growth is expected from any company that fills a gap in an emerging market, the goal is to find more long-term high growth companies. Research on the high-growth SME segment is still nascent in Africa, but the global literature, as well as applied experience in SME development and impact investing, leads to a few insights on defining characteristics:

  • Established cash-positive firms and seasoned entrepreneurs: Cash-positive firms with even 2 years of activity have a greater probability of overcoming the segment’s 70% failure rate. Likewise, seasoned entrepreneurs with a track record in the target sector or industry are more likely to be able to navigate launching a new business or product.
  • Corporate supply chains: Insertion within large corporate supply chains can help SMEs improve operational standards and reach scale through consistent cash flows.
  • Consumer products for a growing middle class: Africa’s growing middle class is expected to reach 1 billion by 2060. Businesses that tackle gaps in their consumer demands, especially those with solid product and marketing distribution systems can ride a huge wave of growth.
  • Localized Technology: Globally, tech businesses are recognized for delivering tremendous returns to investors. But to be classified as high-growth in Africa, these businesses should be responding to gaps in the local market. There is a huge difference between replicating Western apps for a relatively small upscale market versus scaling mobile payment services in a region which is over 80% unbanked. The latter would be classified as high-growth, as evidenced by the successes of M-Pesa, MTN Mobile Money and Zoona.