CAPITAL MARKETS AND SMES IN EMERGING MARKETS AND DEVELOPING ECONOMIES: CAN THEY GO THE DISTANCE? © 2020 The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This volume is a product of the staff of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non-commercial purposes. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Directors or Executive Directors of the respective institutions of the World Bank Group or the governments they represent. The World Bank Group does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. Table of Contents Acronyms and Abbreviations III Acknowledgments V Executive Summary VII SECTION 1: Introduction 1 SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap 5 SECTION 3: Indirect Mechanisms for SME Financing 15 SECTION 4: Direct Mechanisms For SME Financing 23 SECTION 5: Preconditions and Challenges 51 SECTION 6: Aligning Incentives 65 SECTION 7: Conclusions 71 ANNEX A: The SME Equity Gap 73 ANNEX B: Importance of Alternative Platforms 75 ANNEX C: Empirical Research on Alternative Finance: Impact and Key Preconditions 77 References 85 Endnotes 91 LIST OF BOXES Box. 2.2: What is impact investing and what significance might it have for SMEs? 7 Box 3.1: Corporate bond issuances by specialized SME lenders: Bayport Financial Services corporate bond issuance in Zambia 18 Box 3.2: Selected experiences with SME securitization 18 Box 3.3: A hybrid structure using structured notes and securitization: The experience of Colombia with rural microcredit 21 Box 4.1: Selected experiences with receivables platforms 25 Box 4.2: Receivables funds in Brazil 26 Box 4.3: Marketplace lending platforms in India 29 Box 4.4: Selected experiences with SME loan funds 31 Box 4.5: Selected experiences with SME bond offerings 36 Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: I Box 4.6: Mobilizing institutional investors for SME finance in Africa: The use of private equity/venture capital funds 40 Box 4.7: Selected experience with equity crowdfunding 44 Box 4.8: SME equity exchanges: New Connect 49 Box 5.1: Multi-origination platforms 52 Box 5.2: The ELITE program 53 Box 5.3: Technical assistance in the context of early financing 54 Box 5.4: The regulation of crowdfunding 55 Box 5.5: The need to monitor developments and adjust regulations: The case of marketplace lending in China 60 Box 5.6. Selected experiences with credit scores 63 Box 5.7: A well-functioning collateral registry in Australia 63 Box 5.8: The importance of out of court workouts: Out-of-court workouts in Latvia 64 Box 6.1: Tax incentives for equity 67 Box 6.2: The importance of consolidating information: The experience of Morocco 69 LIST OF FIGURES Figure B2.2.1: Target investor types by impact theme 7 Figure 2.1: Types of alternative finance as a percentage of total volumes, 2017 9 Figure 2.2: Assets under management by pension funds in selected non-OECD countries 10 Figure 2.3: Insurance in selected non-OECD countries 10 Figure 2.4: Number of alternative platforms in emerging markets and developing economies and in advanced economies, 2013–17 11 Figure 2.5. Ratio of mutual funds to gross domestic product, 2016 14 Figure B3.2.1: Annual U.S. Small Business Administration Securities Outstanding 19 Figure B.3.3.1: Financing model 21 Figure B4.2.1: FIDC assets under management, in R billion, 2002–18 27 Figure B4.3.1 India Total Alternative Finance Market, 2013–17, US$ millions 29 Figure B4.3.2 Funding Volume from Institutional Investors, by Key Countries 2017, US$ billions (Asia-Pacific countries, excluding China) 30 Figure B4.5.1: Italian minibond market, 2016–18 37 Figure B4.5.2: Italian minibond characteristics, end of September 2018 37 Figure B4.6.1: Investments in African SMEs, 2010–17 40 Figure 4.1: Total private equity/venture capital investment in emerging markets and developing economies, 2009–19, first quarter 42 Figure 4.2: Percentage of private equity/venture capital investment in SMEs in emerging markets and development economies (ticket size = $100,000–$3 million) 42 Figure B4.7.1: Equity crowfunding in Brazil, 2016-18 44 II Table of Contents Figure B4.7.2: Investors in equity crowfunding in Brazil, 2016-18 45 Figure 4.3: SME exchanges 47 Figure A.1 Ratio of SME equity finance gap to GDP, data as of 2017 (%) 74 LIST OF TABLES Table 2.1. Investments of Selective Large Pension Funds and Public Pension Reserve Funds Social, as of 2015 8 Table 2.2: Alternative Finance Volumes: Distribution Between Advanced and Emerging Market and Developing Economy Countries, 2013 and 2017 12 Table 2.3: Alternative Finance Instruments: Top 20 Countries, by % of Corresponding Global Volumes in 2017 12 Table B4.2.1 Assets under management by types of FIDC, in R billions, as of September 2018 27 Table B4.8.1: New Connect data, 2014–17 49 Table A.1: Equity current supply and gap in 2017 in emerging markets and developing economies, in US$ millions 73 Table B.1: Total alternative platforms volumes, by region, in US$ billions 75 Table B.2: Total alternative platforms volumes, by economic category, in US$ billions 75 Table B.3: Total alternative platforms, by region, in percentage of total world volumes 76 Table B.4: total alternative platforms, by economic category, in percentage of total world volumes 76 Table C.1: Country-level Proxies for Financial Constraints 78 Table C.2: Alternative finance volumes: Summary statistics, in us$, as % of total population, 2013–17 averages 80 Table C.3: Financial depth and financial constraints variables 80 Table C.4: Financial constraints proxies: correlation matrix 81 Table C.5: Alternative finance volumes: correlations with proposed explanatory variables 81 Table C.6. Correlates of alternative finance, baseline specification 82 Table C.7. Correlates of alternative finance, baseline specification, with china dummy 82 Table C.8: Correlates of alternative finance, baseline specification, with china dummy (not reported) and gdp per capita 83 Table C.9. Correlates of alternative finance, baseline specification, with china dummy (not reported) and stock market capitalization 83 Table C.10: Correlates of alternative finance: Estimated coefficients for institutional variables, additional controls (baseline specification, with China dummy) not reported 84 Table C.11: Correlates of alternative finance: Estimated coefficients for financial constraints variables, additional controls (baseline specification, with China dummy) not reported 84 Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: III IV Acronyms and Abbreviations ABS asset-backed securities AE advanced economy AUM assets under management BCBS Basel Committee on Banking Supervision CCAF Cambridge Centre for Alternative Finance CVM Comissão de Valores Mobiliários DFI development finance institution EBA European Banking Authority ECP equity crowdfunding platform EMDE emerging market and developing economy EMPEA Emerging Markets Private Equity Association ESG environmental, social, and governance EU European Union fintech financial technology FSB Financial Stability Board GDP gross domestic product GIIN Global Impact Investor Network GP general partner IOSCO International Organization of Securities Commissions LP limited partner MDB multilateral development bank MSME micro, small, and medium enterprise NAFIN Nacional Financiera (Mexico) NBFC nonbank financial company NBFI nonbank financial institution OCW out-of-court workout OECD Organisation for Economic Co-operation and Development P2P peer-to-peer PE private equity PE/VC private equity/venture capital Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: V RBI Reserve Bank of India RXIL Receivables Exchange of India SBA U.S. Small Business Administration SME small and medium enterprise SPV special purpose vehicle TA technical assistance UCO universal credit organization USAID U.S. Agency for International Development VC venture capital All dollar amounts are U.S. dollars unless otherwise indicated. VI Acronyms and Abbreviations Acknowledgments This report was produced by a team from the from the Financial Inclusion, Infrastructure and Finance, Competitiveness and Innovation (FCI) Access Unit of FCI; Jose Antonio Gragnani, Senior global practice of the World Bank Group. The Financial Sector Specialist from the Long-Term team was composed of Ana Fiorella Carvajal, Finance Unit of FCI; and Thordur Jonasson, Deputy Lead Financial Sector Specialist, main author Division Chief at the International Monetary Fund. of the report; Richard Mark Davis, Shanthi In addition, comments were received from Arnaud Divakaran, Tanya Konidaris, all Senior Financial Dornel, Lead Financial Sector Specialist, and Peter Sector Specialists; and Nomsa Lutepo Kachingwe, McConaghy, Financial Sector Specialist, both from Financial Sector Specialist. Empirical research in the Middle East and North Africa region of FCI; as regard to the estimation of the small and medium well as from Denis Medvedev, Practice Manager; enterprise (SME) equity financing and the impact Jose Ernesto Lopez Cordoba, Lead Economist; of alternative financing platforms in addressing Justin Hill, Senior Private Sector Specialist; and financial constraints was conducted by Ricardo Subika Farazi, Economist, all from the Firms, Bebczuk, Consultant. The report was produced Entrepreneurship and Innovation Unit of FCI. The under the direct oversight of Anderson Caputo team is grateful to all of them for their insights and Silva, Manager of the Long-Term Finance Unit constructive comments, which have helped enrich of the FCI Global Practice. Alfonso García Mora, this report. Global Director of FCI, spearheaded the project, and provided invaluable guidance to the team. The team wishes to express its appreciation to the Cambridge Centre for Alternative Finance, The report was peer reviewed by Loic Chiquier, which provided access to its database on electronic Senior Adviser from FCI; Xavier Jordan, Chief platforms for fundraising. Access to this information Investment Officer from the Finance Institutions has been critical to understanding the evolutions of Group of the International Finance Corporation; the platforms. Ghada Teima, Lead Financial Sector Specialist Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: VII VIII Executive Summary Small and medium enterprises (SMEs) face markets can have in SME financing in EMDEs. significant financing gaps that stifle innovation To do so, the report reviews global experiences in the and economic growth. The credit gap alone is use of capital markets solutions and, more generally, estimated at $4.5 trillion as of 2017 for emerging in market-based solutions to expand SME financing markets and developing economies (EMDEs) only. with a view to identifying key preconditions and This represents the unmet financing needs of 21 challenges for EMDEs implementing the solutions. million SMEs. The inability of these enterprises The term market-based solutions is used intentionally, to sufficiently fund growth threatens larger growth because many of the solutions that will be analyzed trends in EMDEs as formal SMEs constitute 45 do not fit neatly into a traditional definition of percent of employment and 33 percent of gross capital markets but do share the characteristic of domestic product (GDP) in EMDEs. being nonbank financing alternatives that leverage financing from capital market investors. Bank financing has been the traditional source of external financing to SMEs; however, since The report looks at both indirect and direct the global financial crisis that started in 2007, mechanisms for SME financing. Indirect there has been an active debate about the role mechanisms refer to capital markets solutions that that capital markets can play in SME financing. are used by SME lenders to improve their funding In advanced economies (AEs), several factors have structure and to compete more effectively in the triggered the emergence of new capital markets credit market, developments that in turn can result solutions, including bank deleveraging in some in an expansion of SME financing, improvements countries; the low interest rate environment that in the lending conditions that are offered to them, or has affected institutional investors’ portfolios and both. The instruments analyzed include plain vanilla the investors’ increased interest in environmental, issuances by SME lenders, SME loan securitization, social, and governance (ESG) factors to guide their and SME structured notes. Direct solutions refer investment decisions; and financial technology. to mechanisms whereby SMEs obtain financing Some of these factors are not applicable to EMDEs. directly from capital market investors. The report However, the mere size of the gap does call for looks at both debt and equity solutions. On the debt an expansion of SME financing channels. The side three sets of solutions are analyzed: solutions growth of pension funds in need of diversification, that leverage receivables (platforms and funds), internet penetration, and the increased participation solutions that leverage loans (platforms and funds), of retail investors in EMDEs’ capital markets via and solutions that leverage securities offerings mutual funds all provide a positive outlook for the (small bond offerings along with SME bond development of new financing solutions for SMEs. platforms and funds). On the equity side the report analyzes venture capital and private equity funds, This report seeks to enhance practitioners’ equity crowdfunding, and small equity offerings understanding of the potential role that capital along with SME equity exchanges. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: IX The experiences analyzed in this report support of development of the capital markets, they all the thesis that capital markets have the potential require that some of the basic preconditions to play a larger role in SME financing, albeit for capital markets development are in place. complementary to banking. Data gaps and Research conducted by the World Bank suggests the novelty of many of these solutions prevent that the development of alternative platforms is not definitive conclusions from being made. That dependent on the wealth of countries, which can be said, the World Bank Group’s experience in the considered a positive finding regarding EMDEs. It field and the data available suggest that such also suggests that the development of lending and potential is larger in the facilitation of credit and receivable platforms is independent from the level working capital to SMEs. For example, concerning of development of the capital markets, or at least that electronic platforms, of the $418 billion that had no correlation was found. But the empirical research been raised as of 2017, 83 percent corresponded to did find a correlation between equity crowdfunding lending platforms. The expansion of the avenues platforms and stock market capitalization. Further, for equity financing is likely to have a more limited it also found a strong correlation of all the platforms impact. The experiences analyzed also suggest that with the level of credit intermediation and the level to achieve such potential, other solutions beyond of respect for the rule of law. Finally, experience traditional public offerings of securities need to indicates that a sizable investor base is needed for be included in the toolkit for SME financing, these solutions to have an impact. because only the larger SMEs are able to comply with the requirements that those offerings entail. It is important to acknowledge that the health of Thus, solutions should also include both indirect the SME sector, and more generally of the more mechanisms for SME financing, such as issuances traditional SME finance market altogether, can by SME lenders, and direct nontraditional affect the viability of the solutions described mechanisms, such as the platform and fund-based in this report. Indeed, at the basis of all these solutions mentioned earlier. Table ES.1 provides a solutions must lie a healthy SME sector, which summary of the key characteristics and conditions in turn is affected by many conditions, including necessary for each instrument to develop. the macroeconomic environment and the ease of doing business. Furthermore, as the experience of However, the majority of the solutions described AEs during the global financial crisis indicates, in this report are at an early stage in most the situation of banks can affect—either positively EMDEs, a condition which is largely a reflection or negatively—the development of some of the of the level of development of their capital solutions analyzed. markets. This is the case for indirect solutions, because they rely on the existence of corporate Beyond these conditions, there are specific bond markets. It seems also to be the case for challenges that affect the development of the direct solutions that rely on funds because some capital markets solutions analyzed in this report. development of the mutual fund industry is needed These challenges relate to the supply, the demand, to anchor such SME solutions. The same applies and the market infrastructure. to securities offerings solutions—particularly those that rely on the existence of secondary markets to To start, many challenges relate to the anchor them. Finally, as experience in AEs shows, availability of the underlying assets themselves. to truly thrive, venture capital requires robust At the operational level, each solution requires the capital markets that can provide an exit mechanism existence of a particular type of asset. For example, for such investments. solutions that rely on loans require that a pipeline of quality loans to SMEs exists, which is not always While some of the financial technology the case. However, the experience of lending solutions do not seem to require a similar level platforms does show that in some cases the key X Executive Summary challenge is not the creditworthiness of the SMEs, Other challenges refer to the lack of important but rather the lack of information to assess it. That components of market infrastructure. As problem is being dealt with by platforms via scoring explained in this report, many of the solutions systems that use nontraditional information— require the existence of a wide range of securities in this case, big data. The challenge of finding a market participants (brokers, auditors, credit rating pipeline of quality SMEs to invest in is more acute agencies) that are not always present, or whose for solutions that are based on securities offerings capacity is still limited. Although traditional (equity and bonds), not just because in many cases intermediaries are not needed in the case of platform SMEs do not know the options available to them solutions, the platform operators would need to but also because some of those options require that comply with certain minimum requirements. In the SMEs undertake organizational improvements, addition, some countries still face challenges including in their corporate governance. in providing the basic enabling environment, including the tax system, collateral registries, the There are challenges also on the demand side, insolvency regime, or even the judiciary. regarding whether investors are willing and able to invest in these solutions. Many of the solutions Finally, it is critical that EMDEs work to ensure analyzed in this report have a higher risk profile that appropriate regulation and supervision than traditional equity or bond offerings placed on are in place. As previously indicated, many of the main markets. Thus, they might not be suited the solutions analyzed have characteristics that for retail investors. In addition, they might not fit make them “riskier” than traditional equity or bond neatly into the portfolio of institutional investors. As offerings. Thus, at a basic level it is necessary that will be further explained, changes to the investment investors understand such characteristics and are in regulations of these investors might be needed, as a position to evaluate them. The starting point is well as capacity building. The way the solutions having regulations for the products that strike the are structured will be key, including the potential right balance between the need to protect investors need for de-risking and other types of interventions and ensure financial stability and the goal of to align them with the risk-return appetite of expanding mechanisms for SME financing. Robust investors. In some countries such interventions conduct obligations also must be in place for the have included (a) credit guarantees for some of the intermediaries involved in the distribution of the debt instruments, (b) co-investments for venture instruments designed. Moreover, the regulations capital as well as for newer solutions, such as for institutional investors need to allow them lending platforms and loan originating funds, certain flexibility while also requiring managers and (c) tax incentives, mainly in relation to early to improve their risk management capabilities. equity investment. Because these interventions Unfortunately, some of these regulations are have a fiscal impact, before any interventions still missing or are deficient in many EMDEs. In are implemented government authorities must addition, robust supervisory programs need to be in determine that the specific intervention to be place to ensure that the supervisory authorities are used is the best tool to address the market failure in a position to understand how the solutions are identified. In addition, the interventions should evolving and whether they pose material risks to be set in a way that allows for the assessment of investor protection and financial stability, so that the their impact. Because of their fiscal situation, many authorities can take measures to address buildups of EMDEs might have limited space to implement vulnerabilities in a timely manner. In some EMDEs these types of interventions, even if needed. In that deficiencies in the regulatory framework prevent context, multilateral development banks (MDBs), supervisors from having key information to make which can provide guarantees or co-investing this assessment and, in many, supervisory capacity in transactions that could have a catalytic effect, is still a challenge. become even more critical. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: XI Because the stated challenges are many, it is key • Make the strategies and action plans publicly that authorities in EMDEs take an active role in available and require periodic reporting on the developing comprehensive strategies to mobilize progress made. capital markets solutions for SME financing and in setting clear priorities for action. The development of sound strategies depends on These strategies should be well articulated into the existence of robust information on the number comprehensive strategies for SME access to finance of SMEs, their characteristics, and the channels on one hand and capital markets development they have to access finance—data that are not easily strategies on the other. For the former, many of available in many EMDEs. Thus, a complementary the solutions analyzed in this report leverage exercise for many EMDEs is to identify a set of key traditional funding sources and require that the data that should be compiled and kept up to date. enabling environment for credit intermediation be in place. Therefore, it is critical that the strategies Development institutions should continue to are well articulated into SME finance strategies support the governments of EMDEs as they but also more generally into comprehensive seek to mobilize private sector funding to SME SME development strategies that rely on a clear financing via capital markets solutions. This understanding of the interplay between addressing support can encompass assistance in preparing financing limitations and other obstacles to firms’ and implementing the strategies mentioned here, performance. For the latter, many of the solutions along with capacity building. This support should require that a capital market with a certain level of be anchored by a comprehensive analysis of the development is already in place; thus authorities SME financing gap in the country, with a view need to be careful in assessing which solutions could to ensuring that market-based solutions enhance work in their jurisdictions. It is likely that in less competition and complement bank funding, as developed EMDEs, only solutions that require very appropriate. To the extent possible, policy advice basic preconditions such as lending and receivable should be complemented with transactions support, platforms might be feasible initially. Accordingly, so that one reinforces the other. Furthermore, governments would need to continue working to transactions should be structured in a way that improve the preconditions necessary for capital brings additional private sector funding to SME markets to develop, from the macroeconomic financing. MDBs should periodically assess the environment and the financial sector to the rule of impact and replicability of different transactions law, to be able to use the capital markets solutions solutions being tested and share information described in this report more broadly. accordingly. Likewise, MDBs could assist EMDEs in periodically evaluating the impact that Mechanisms should be established to engage government interventions are having in expanding relevant stakeholders in the definition of such SME financing via market-based solutions. strategies and priorities for action. In this context, it is recommended that the authorities More time and analysis are needed to assess the role that these new solutions can have • Appoint a responsible champion that can lead and in financial inclusion. Overall, on the capital shepherd the process forward; markets side, the research available has focused on electronic platforms given the hypothesis that due • Establish committees or consultation groups to to the characteristics of such platforms they might support the development and implementation of the play a more significant role in financial inclusion. strategy, in a manner that allows broad engagement At the global level, the research conducted by with private sector stakeholders given that, in the the World Bank did not find that those platforms end, these plans should foster mobilization of are developing in the countries where they are private sector funding to SMEs; and needed most, in terms of the size of their credit XII Executive Summary and equity gaps. Nevertheless, it is still too early The World Bank Group plans to continue to assess whether this trend will remain. Third- enhancing its capacity to assist countries in party research conducted in specific countries, at mobilizing capital markets solutions for SME the level of individual platforms, has concluded financing (table ES.1). In this context, the World that some percentage of the platforms’ clients Bank plans to (a) develop a policy note on the topic, are unbanked clients. However, those findings (b) produce a toolkit that practitioners can use as cannot be extrapolated. Further, data from the a starting point to assess the potential of different Cambridge Centre for Alternative Finance suggest capital markets solutions to be implemented in a that the patterns on the use of the platforms by particular jurisdiction, and (c) delve deeper into the banked, underbanked, and unbanked clients differ financial aspects of these solutions compared with significantly from country to country. banking solutions. Table ES.1: Capital markets solutions for small and medium enterprise financing: Summary of key characteristics Indirect Mechanisms for SME Financing Topic Plain vanilla issuances by SME loan securitization SME structured notes SME lenders SMEs that benefit All types of SMEs and potentially All types of SMEs and potentially All types of SMEs and potentially also microenterprises also microenterprises also microenterprises Level of market development Some basic level of development Higher level of development of Higher level of development of needed of the corporate bond market the corporate bond market the corporate bond market Issuer Specialized lenders and other Banks, specialized lenders and Banks, specialized lenders and nonbank financial institutions other nonbank financial institu- other non bank financial institu- (NBFIS) tions tions Initially likely only for larger NBFIs Smaller NBFIS might require credit enhancements for first-time bond issuances Investors All types of domestic investors Potentially all types of domestic Potentially all types of domestic investors, but in practice mainly investors, but in practice mainly for institutional for institutional Capital markets regulations No specialized regulations need- Specific regulations for securiti- Specific regulation for SME struc- needed ed; securities will be issued on zation (post-crisis emphasis on tured notes with provisions on the the basis of the general regime standardization, disclosure, and quality of the loans and poten- for equity and corporate bonds retention requirements) tially a differentiated risk weight treatment for these notes com- pared with unsecured notes Changes to investment No changes will likely be needed No changes will likely be needed No changes will likely be needed regulations of institutional (if placed under public offering) (if placed under public offering) (if placed under public offering) investors Key market infrastructure Securities intermediaries to struc- Securities intermediaries to struc- Securities intermediaries to struc- ture the issuances ture the issuances ture the issuances A bond platform A bond platform A bond platform Credit rating agencies Credit rating agencies Credit rating agencies Additional government Credit guarantees potentially Credit guarantees likely needed interventions needed needed for first-time bond issu- ances Key enabling environment Insolvency regime Existence of SPV that is bank- Insolvency regime ruptcy remote Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: XIII Direct Mechanisms for SME Financing via Debt Topic Receivable-based solutions Loan-based solutions Securities offering solutions SMEs that benefit All types of SMEs, but particularly All types of SMEs Larger SMEs for private offerings useful for smaller SMEs and mi- Potentially smaller SMEs for mini- croenterprises bonds Level of capital market For platforms: no need for devel- For platforms: no need for devel- Some level of development of the development needed oped capital markets, but certain oped capital markets, but certain corporate bond markets basic preconditions needed basic preconditions needed For funds: some level of develop- For funds: some level of develop- ment of the mutual fund industry ment of the mutual fund industry Issuer For platforms: technically, there For platforms: technically, there is SMEs themselves are the issuers is no issuer; the receivables are no issuer; the SMEs ask for loans of securities posted by SMEs For funds: the fund issues partici- For funds: the fund issues partici- pations pations Investors Potentially all types of domestic Lending platforms cater to all Private offerings by SMEs are investors types of domestic investors targeted mainly to sophisticated Loan funds are more suitable for investors. sophisticated investors Minibonds could potentially tar- get both sophisticated and retail investors, but for the latter disclo- sure requirements might need to be more stringent Capital markets regulations In general, platform solutions Both platform and fund solutions Require a regime for private offer- needed might not require capital markets require a specialized framework ings, and potentially a specialized regulations regime for minibonds Fund solutions require a special- ized framework for receivable funds Changes to investment Changes are likely needed to Changes are likely needed to Changes might be needed to regulations of institutional expand the alternative assets expand the alternative assets expand the investors’ ability to in- investors category category vest a percentage of their portfo- lio in securities of private offering Key market infrastructure For platform solutions: intermedi- For platform solutions: intermedi- Securities intermediaries to struc- aries that act as platform provid- aries that act as platform provid- ture the offerings ers with proprietary systems to ers with proprietary systems to SME bond platforms to provide assess the credit risk of receiv- assess the credit risk of the loans liquidity – the listing requirements ables For fund solutions: specialized should be proportionate and For funds solutions, specialized fund managers might enter into would differ depending on wheth- fund managers might enter into contracts with third parties that er the bonds can only be traded contracts with third parties that operate as “credit officers” (find- among institutional investors perform the “factoring” functions ing the SMEs and assessing their Credit rating agencies (finding the receivables and as- creditworthiness) sessing the creditworthiness of the debtors) Additional government Potentially co-investments Potentially co-investments Potentially co-investments interventions XIV Executive Summary Key enabling environment Efficient rules for the transfer of Tax-transparent SPV for fund- Credit information registries receivables based solutions Insolvency regime Ideally, implementation of elec- Credit information registries tronic receipts Insolvency regime Tax-transparent SPV for fund- based solutions Credit information registries Insolvency regime Direct Mechanisms for SME Financing via Equity Topic Private equity/Venture capital Equity crowdfunding SME offerings SMEs that benefit Start-ups/early stage companies In practice, start-up companies Larger, more established SMEs Level of capital markets Need for equity markets as an Seem to develop where equity Need for equity markets development needed exit mechanism markets already exist Issuer Start-ups/early stage companies Start-up companies SMEs Investors Domestic sophisticated investors Retail investors along with other Potentially all types of domestic In some cases, also foreign in- investors investors but, in practice, mainly high-net-worth individuals vestors (but mainly in off-shore vehicles) Capital markets regulations General securities markets regu- Likely that a bespoke regime Proportionate regulations for needed lations that provide a space for for equity crowdfunding will be SME equity offerings; the specific funds to be placed under a pri- needed requirements would vary depend- vate offering regime ing on whether the offerings can be sold to all investors or only to sophisticated investors Changes to investment Changes likely needed to allow Changes not needed. But, in gen- Changes not needed. But, in gen- regulations of institutional investment in alternative assets eral, not a product for institutional eral, not a product for institutional investors and/or securities of private offer- investors investors, unless pooled ing Key market infrastructure Specialized fund managers Intermediaries that act as plat- Likely to require specialized inter- form providers that are able to mediaries that act as sponsors conduct a due diligence on the SME equity exchange to provide companies seeking funding liquidity, but that likely will not be enough, and additional measures should be considered (for exam- ple, market makers) Additional government Tax incentives likely needed Consider tax incentives Consider tax incentives interventions needed Consider co-investments Key enabling environment Tax transparent SPV for the funds Insolvency regime Insolvency regime Insolvency regime Note: The term sophisticated investors includes both institutional investors and high-net-worth individuals. NBFI = nonbank financial institu- tion; PE = private equity; SME = small and medium enterprise; SPV = special purpose vehicle; VC = venture capital. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: XV XVI SECTION 1 Introduction This report seeks to enhance practitioners’ that capital markets can play in SME financing. understanding of the potential role that capital In advanced economies (AEs), new solutions for markets can have in financing of small and SME financing have been triggered by several medium enterprises (SMEs) in emerging factors, including bank deleveraging in some markets and developing economies (EMDEs). countries, the low interest rate environment that To do so, the report reviews global experiences has affected institutional investors’ portfolios, with the use of capital markets solutions, and the institutional investors’ increased interest in more generally of market-based solutions to environmental, social, and governance (ESG) expand SME financing with a view to identifying factors to guide their investment decisions, and key preconditions and challenges1 for their financial technology (fintech). Some of these implementation by EMDEs.2 The term market- factors are not applicable to EMDEs. However, the based solutions is used intentionally, because many size of the SME financing gap calls for additional of the solutions that will be analyzed do not fit solutions to expand SME financing, especially now neatly into a traditional definition of capital markets when many EMDEs are seeing their pension funds but do share the characteristic of being nonbank grow, financial technology is opening the doors to financing alternatives that leverage financing from new mechanisms for market-based financing, and capital markets investors. a growing middle class is increasingly investing in capital markets through mutual funds. The need for additional solutions for SME financing The instruments analyzed SMEs in EMDEs face significant financing This report focuses on a set of key capital markets gaps that could stifle innovation and economic instruments and market-based solutions that growth. The credit gap alone has been estimated could facilitate mobilization of investors to at $4.5 trillion as of 2017 for EMDEs. This SME financing in EMDEs.3 This report leverages represents the unmet credit need of 21 million previous research conducted by the International SMEs. The inability of those enterprises to fund Financial Institutions and expands it by looking sufficient growth threatens larger growth trends at both debt and equity solutions including those in EMDEs because formal SMEs constitute 45 that have been brought by financial technology.4 percent of employment and 33 percent of the GDP The working hypothesis has been that the role of of those economies. capital markets in SME financing is very limited if only the traditional public markets are considered. Bank financing has been the traditional source However, if indirect and nontraditional solutions of external financing for SMEs; however, since are considered, then capital markets can have the global financial crisis that started in 2007 a more expanded role in SME financing, albeit there has been an active debate about the role complementary to that of banking. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 1 In this context, the report looks at both indirect • Venture capital and private equity funds, and direct market-based mechanisms for SME financing.5 Indirect mechanisms refer to capital • Equity crowdfunding, and markets solutions that are used by SME lenders to • Small securities offerings along with SME improve their funding structure so the lenders can equity exchanges. compete more effectively in the credit markets, which in turn could result in an expansion of SME Certain exclusions must be explicitly financing, the provision of credit to SMEs on acknowledged. The report does not cover angel better economic terms, or both. Direct solutions investors, leasing funds, and mezzanine financing. refer to mechanisms whereby SMEs obtain In all three cases, the recommendations given in financing directly from capital market investors. the context of other solutions—venture capital, Nontraditional solutions refer to any mechanism receivables and loan funds, and private offerings, different from direct public offerings by SMEs. respectively—can guide authorities as to potential actions to ignite those other solutions. It must be The selection of the specific solutions analyzed acknowledged, however, that each of the solutions in the report has been made based on the World excluded meets a specific need that might not be Bank Group’s judgment about the potential fully addressed by the solutions covered in the importance of different solutions that are being used report.8 Recent reports discuss the potential role of or explored at a global level,6 and their replicability initial coin offerings in allowing retail investors to in a wide range of EMDEs, along with practical participate in the financing of small businesses and considerations related to data availability—or the start-ups. However, in its current form, initial coin lack thereof—particularly in EMDEs.7 offerings carry significant risks to investors that have triggered warnings from securities regulators Regarding indirect mechanisms, the report around the globe. That is why they have not been explores covered in this report. That said, such assessment might change over time if the challenges identified • Plain vanilla issuances by specialized SME by regulators were successfully mitigated.9 lenders, SMEs constitute a very heterogeneous universe, • SME loan securitization, and thus not all instruments discussed in the report • SME structured notes. would be useful for all. In the analysis, the report seeks to identify at a general level the type of SMEs Regarding direct mechanisms, the report that could potentially benefit from each type of explores the following solutions: instrument. This effort could be the starting point for a sectoral analysis. • On the debt side, the report analyzes • Receivable-based solutions (platforms and The structure of this report funds), This report is structured as follows: • Loan-based solutions (platforms and funds), and • This section explains the objective of the report • Small securities offerings solutions (minibonds and the scope of the work undertaken. along with SME bond platforms and SME bond funds). • Section 2 provides an overview of the reasons driving the quest for capital markets solutions to • On the equity side, the report looks into expand SME financing. 2 SECTION 1: Introduction • Sections 3 and 4 analyze key capital markets • Section 7 provides summary conclusions. solutions that might help mobilize investors in EMDEs to provide SME financing, and the • Annex A provides an estimate of the SME equity current use of such solutions in AEs and EMDEs. gap. • Section 5 explains the preconditions and • Annex B provides additional information on challenges affecting the development of capital the importance of alternative platforms in AEs markets solutions in EMDEs. versus EMDEs, and on a regional basis. • Section 6 analyzes mechanisms used to align • Annex C provides the results of empirical market participants with the goal of expanding research conducted by the World Bank to assess the role of capital markets solutions in SME the extent to which the same preconditions that financing, beyond having in place a robust apply to capital markets development apply to enabling environment. electronic platforms, as well as whether these platforms are developing in the countries that exhibit the most financial constraints. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 3 4 SECTION 2 Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap The SME finance gap of employment and 33 percent of gross domestic product (GDP) in EMDEs. SMEs are the backbone of EMDEs. There is no universal definition of SMEs. In general, many Yet, the survival and growth of MSMEs are countries use the number of employees, assets, threatened by many factors, including access and revenues, either separately or concurrently, to financing. Although many constraints relate to as key defining criteria. The specific threshold their ability to tap into critical infrastructure, such to define a SME varies in each country, as per the as electricity, SMEs also consider access to finance size of the economy. For purposes of this report, among their key constraints. As of 2018, the MSME microenterprises are defined as businesses with credit gap in emdes was estimated at $5.2 Trillion, of fewer than 10 employees and SMEs as those with which the SME gap amounted to $4.5 Trillion (see fewer than 250 employees.10 According to this box 2.1). This does not take into consideration the definition, there are about 141 million micro, small, equity gap, which is much more difficult to estimate and medium enterprises (MSMEs) in EMDEs, of and which affects SMEs altogether but especially which 121 are microenterprises and the remaining innovative firms. A very preliminary estimate of this are SMEs. SMEs alone constitute about 45 percent gap can be found in annex A. Box 2.1: The SME credit financing gap There are close to 162 million formal micro, small and medium enterprises (MSMEs) in developing countries, of which 141 million are microenterprises and 21 million are SMEs. Three countries—Brazil, China, and Nigeria—contribute 67 percent of the total number of MSMEs, which is equivalent to 109 million enterprises. Close to 12 million SMEs are in China alone and represent 56 percent of all SMEs in developing countries. China also has 44 million microenterprises, which represent 31 percent of all microenterprises in developing countries. Of $8.9 trillion in potential demand for MSME finance, only $3.7 trillion is currently being supplied. Thus the unmet demand for financing in the MSME segment in developing countries is valued at $5.2 trillion, of which the microenterprise finance gap is estimated at $718.8 billion and the SME finance gap at $4.5 trillion. Altogether this gap represents 19 percent of developing countries’ cumulative gross domestic product. In lower-middle-income and high-income countries, this indicator is 20–21 percent. In upper-middle-income countries it is 18 percent, and in low- income countries it is 15 percent. The total MSME finance gap volume is dispersed widely among regions. The highest proportion of the finance gap compared with potential demand can be found in two regions: Latin America and the Caribbean and the Middle East and North Africa—with 87 percent and 88 percent, respectively. The smallest proportion can be found in East Asia and Pacific, with 46 percent. Comparing the level of development of the countries, the finance gap as a proportion of potential demand is the highest in the low-income and lower-middle-income countries, with 80 percent in comparison with a total of 59 percent for all developing countries included in this study. The microenterprise finance gap as a proportion of the microenterprise potential demand is the highest in the lower-middle-income countries (94 percent), and lowest in the high-income countries (63 percent). The SME finance gap as a proportion of potential SME demand is highest in low- income countries (78 percent), as compared with 56 percent in all developing countries. The higher the proportion, the smaller the current lending volume. Source: IFC 2017. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 5 The potential of capital markets has been limited and has taken place mostly via the solutions to supplement traditional private markets. First, the markets have provided risk capital for innovative companies, mainly via venture funding sources capital (VC) funds—although the role of angel SMEs require different types of funding at different investors should be acknowledged. Pension funds, stages of their life cycle. Some of this funding can insurance companies, foundations, endowments, come from internal sources—in particular, founders’ high-net-worth individuals, sovereign wealth funds, capital and retained dividends; however as SMEs and development finance institutions (DFIs) have grow, they need access to additional financing. been typical investors in these funds. Second, they have provided medium-term financing to medium- Banks have been the main providers of external size companies, mainly in the form of private credit to SMEs, complemented in some countries placements of bonds. In this case the main investors by other specialized lenders. It is estimated that have been institutional investors. financing from banks accounts for 50 to 70 percent of the external financing used to fund SMEs’ However, particularly since the global financial investments in growth (Stein, Goland, and Schiff crisis there has been a push in AEs to expand 2010). This prevalence has stemmed mainly from mechanisms for SME financing, including via the characteristics of SMEs—small in size, informal capital markets, and for institutional investors in nature, and with limited information—which have to play a larger role in SME financing. This push made them better suited to bank lending because has been triggered by several factors, including the banks establish relationships that enable them bank deleveraging; a hunt for yield by institutional to gather soft information about the SME business investors, which has been driven by the low interest that is not visible to outside investors. Thus the rate environment; investors’ increased interest banks are in a better position to assess the credit risk in recognizing ESG criteria in their investment of such businesses.11 In addition, in many countries, decisions; and financial technology. Each of these including EMDEs, other specialized lenders such as trends has had implications for the emergence of microfinance institutions and cooperatives are also capital markets solutions for SME financing. It is serving the micro and SME sectors. Finally, asset- important to mention that there has been concern based financing has been an important source of about the impact that Basel III requirements could working capital to SMEs because it can more easily have on banks’ lending to SMEs.12 Nevertheless, mitigate the information problems of SMEs, given based on a global survey, a recent Financial Stability the existence of assets that serve as collateral. Board (FSB) report released for consultation in June 2019 “did not identify material and persistent negative The contribution of capital markets to SME effects on SME financing in general, although there financing has been very limited. Overall the is some differentiation across jurisdictions.”13 characteristics of SMEs make them unsuitable for the public markets, as they are not in a position to Bank deleveraging, which was more pronounced provide the financial disclosure required by these in Europe than elsewhere, has led to policies markets, either because they cannot produce it or that foster alternative mechanisms for SME because the costs would be prohibitive compared financing and has led pension funds and insurance to their financing needs. Further, on the equity side, companies to take up these instruments in their the public markets impose corporate governance portfolios. For example, in Italy reforms approved requirements that do not fit well with the family- in 2012 allowed nonlisted SMEs to issue minibonds, owned nature of SMEs. Thus, very few countries and banks, pension funds, and insurance companies have been able to successfully provide SMEs direct to invest in these instruments (see box 4.5). Many access to the public markets. In this scenario, the other countries in Europe have fostered the issuance contribution of capital markets to SME financing of minibonds by SMEs, and SME bond platforms 6 SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap have been developed in countries such as Germany, SME financing market has been driven by a complex Spain, and the United Kingdom. In addition, other set of factors, including the small size of some of the alternative mechanisms to provide credit to SMEs, investments, the lack of transparency and liquidity of such as loan funds, have been developed. In some many of the investment vehicles, and, in some cases, cases, their development required changes to laws regulatory restrictions. However, the low interest rate and regulations not just to enable the issuance of the environment triggered by the monetary policies of instruments themselves, but also to enable pension central banks has driven a search for alternatives to funds and insurance companies to invest in them. replace some portion of the fixed income part of the That occurred in France, where legal reforms were portfolio. Two examples of products that have helped needed to allow the creation of loan originating funds to deliver more yield for institutional investors are as well as to allow insurance companies to invest in minibonds and SME loan funds. It is important to note, them (see box 4.4). however, that the increased holding by institutional investors of these type of assets (which are more The low interest rate environment of recent years illiquid and, in some cases, contain leverage) might be has resulted in much lower returns for the large contributing to a buildup of vulnerabilities that needs fixed-income holdings of institutional investors; as to be addressed.16 a result, their search for alternative investments, including SME solutions, has grown. Pension funds The increased interest of institutional investors in and insurance companies hold roughly $54 trillion in ESG investment might also have a positive effect assets in Organisation for Economic Co-operation and on SME financing. Both pension and insurance Development (OECD) countries.14 Overall, a large companies are being affected by the growing majority of their investments are in fixed-income15 movement toward stronger consideration of ESG or public equity instruments, although investments factors in the investment decision-making process. in alternative assets have grown over time (OECD This trend has particular importance for SME 2018a). Historically, their investment in SME financing growth in that some of the funds launched to address has been limited and mostly focused on private equity/ the social aspect of this area are “impact” funds that, venture capital (PE/VC), as part of the alternative assets in some cases, have a specific mandate to further the category. This lack of meaningful involvement in the growth of small and medium enterprises (box 2.2). Box. 2.2: What is impact investing and what significance might it have for SMEs? The “S” in ESG stands for social, and a key strand of Figure B2.2.1: Target investor types social investment is known as impact investment. Impact investments are made in companies, by impact theme organizations, and funds with the intention DFIs to generate social and environmental impact alongside a financial return (GIIN 2018). SME- Endowments dedicated impact investment funds are one of the Family offices prevalent versions of impact investments. Inclusion Foundations in this trend carries no special requirements for the “investee” SME firms, in most cases. The SMEs are Pension funds not required to adhere to ESG principles themselves Retail investors but rather are targeted for their size, geographical 0 100 200 300 location, and perhaps their specific industry. Figure Number of funds B2.2.1 shows the target investor types by each high-level impact theme. (SME investment fits Triple bottom line (n=130) Social focus (n=200) largely within “social focus.”) Environmental focus (n=86) Source: OECD 2018c. Note: SME = small and medium enterprise; VC = venture capital. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 7 Impact investing is still a small portion but has the to connect more directly with investors. Financing potential to become a more significant element of raised through electronic platforms has been growing SME access to finance in the mid to longer term, at a fast pace over the past few years. Data compiled in AEs. The 2018 Investor Survey of the Global by the Cambridge Center for Alternative Finance Impact Investor Network (GIIN) indicated that (CCAF) show that global volumes multiplied by $228 billion in aggregate impact assets were under 43 times from 2013 to 2017, from $10 billion to management among over 200 survey respondents $418 billion (figure 2.1). Although impressive, this (GIIN 2018). This amount was up from $114 rate of growth is related to the nascent state of these billion in 2017. As illustrated in table 2.1, taken markets, still representing a median 0.015 percent of from the OECD Large Pension Fund Survey (2016 GDP around the world in 2017, with China (3.000 data, published in 2018), there are already a number percent of GDP) and Georgia (1.300 percent of GDP) of pension funds that are starting to make real as the only outliers. In absolute terms, the bulk of the investments in this area of social investment. The financing is concentrated in China, the United States, data include some other elements, but SME finance and the United Kingdom. In terms of instruments, is a key component included in this category. lending platforms largely prevail over the rest, accounting for almost 83 percent of total flows, in Finally, financial technology has triggered the turn divided between 58 percent for consumers and emergence of new capital markets solutions 25 percent for businesses. that allow start-ups and SMEs in need of funding Table 2.1. Investments of Selective Large Pension Funds and Public Pension Reserve Funds Social, as of 2015 Social investments (as a % of total investments) Total Social/ investments Social development Country head in 2015 in impact VC and SME Other social Total social officce Name of the fund or institution US& millions investments finance investments investments Argentina Sustainability Guarantee Fund (1) 50.689 6.1 - - 6.1 Australia Health Employees Superannuation 24,683 - - 0.1 0.1 Trust Australia Australia Sunsuper (2) 16,732 0.3 - - 0.3 Australia Hostplus Superannuation fund 13,947 - - 0.6 0.6 Denmark PFA Pension 56,574 - 0.2 - 0.2 France ERAFP 25,572 0.1 1.0 - 1.1 Netherlands Stichting Pensioenfonds ABP 429,916 - 0.6 - 0.6 New Zealand New Zealand Superannuation Fund 19,974 - - 0.4 0.4 South Africa GEPF 109,203 - 0.1 - 0.1 Spain Fonditel (3) 3,731 - - 0.9 0.9 Spain Santander 238 - 0.7 - 0.7 Sweden AP2 35,387 - 0.1 - 0.1 Switzerland Pensionskasse Post 15,788 - - 1.3 1.3 United Kingdom USS 70,602 - 0.0 - 0.0 United States Massachusetts PRIM Board (4) 60,965 0.0 0.0 0.0 0.0 Source: OECD 2018c. Note: SME = small and medium enterprise; VC = venture capital. 8 SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap Figure 2.1: Types of alternative finance as a percentage of total volumes, 2017 70 60 58.6 50 Percentage 40 30 24.6 20 14.7 10 0.3 1.8 0 Equity crowfunding Invoice trading P2P business P2P consumer Other Source: World Bank elaboration based on data from the CCAF database on alternative finance. Note: P2P = peer to peer lending. Some, but not all, of the factors that have pushed with demographics. As shown in figure 2.2, pension AEs to develop alternative mechanisms for SME fund assets in selected non-OECD countries almost financing are applicable to EMDEs. The key issue doubled over the previous five-year period, with is whether the capital markets in EMDEs, which pension assets making up over 95 percent of GDP are at earlier stages of development, could support in countries such as Namibia and South Africa. the development of solutions and products that are In contrast, as can be seen in figure 2.3, insurance similar to those present in AEs. In this regard, in the penetration has remained low, although there has bulk of EMDEs both the equity and corporate bond been some growth of the life insurance portion, markets are at a limited level of development. Only which requires long-term assets. “emerging markets,” as per the Morgan Stanley Capital International (MSCI) definition, have more So far, the investment of pension funds and developed capital markets, although in many of them insurance companies in SME-related assets liquidity is still a challenge. However, there are three in EMDEs has been limited. In many EMDEs, positive factors to consider. One is the emergence in institutional investors have restricted their many EMDEs of an institutional investor base with investments in SME-related assets to holdings of sizable assets under management. A second factor is issuances by banks (with large SME portfolios) financial technology, which is taking hold in many and specialized SME lenders. In addition, in some EMDEs as a result of demographics and internet countries institutional investors also participate in penetration. The third factor is the growth of mutual venture capital and private equity, although their funds, which are the vehicle through which retail investments in this asset class are still very limited, investors are starting to participate in capital markets as will be further discussed in this report. in most EMDEs. Further, the portfolios of institutional investors In many EMDEs institutional investors, in EMDEs are still highly concentrated. Pension in particular pension funds, have grown fund assets in selected non-OECD countries are considerably during the past decade. For many concentrated in fixed-income investments (bills and EMDEs this growth is the result of reforms that have bonds) and in public equity, a reflection of the funds’ instituted mandatory retirement systems, combined continued preference for government securities Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 9 10 Ho Percentage of GDP ng Ho So Ko 20 40 60 80 100 120 uth 0 ng Percentage of GDP ng SA Ko Af ng 2 4 10 12 14 0 16 18 20 6 8 R, Na rica C SA m Si hin ng a a W eig hte R, ibia Ch in countries Ma pore dA M a lay si v El er a alt Br a Sa age Co az lva lo il Ja dor Ur mbia m u Ur aica 2012 Ar gua ug ge y u Co nti Cr ay sta na oa Ind Ric Ko tia on a Co sov es lom o ia b Ni Pe Si Br ia 2017 ca ru mp az r le P il Pa agu ra a A e Source: Own elaboration based on data from OECD 2019b. Source: Own elaboration based on data from OECD 2018a. Insurance premiums as a % of GDP gu Co vera ru ay 2012 sta ge B Gu oli R ate via Do Ke ica ma mi nic Bu nya la an lg Re aria Note: OECD = Organisation for Economic Co-operation and Development. Percentage of GDP Ma p ce Le ubli 0 10 20 30 40 50 60 70 80 90 100 Ar do so c ge 2017 nia th nt , o Bo ina Ma FYR liv ia l Ru Th dive Ho Co Braz ss ail s C lo il Figure 2.3: Insurance in selected non-OECD countries ng ian N and Ko osta mbia Fe iger ng Gu R de ia SA ate ica R, ma Ro ratio Ch la m n in Ma ani Life Note: GDP = gross domestic product; OECD = Organisation for Economic Co-operation and Development. Ind Ind a Ind urit a on ia on ius Ma es Gi esia la ia bra Ru Par ysia a lt ss gu Ch ar ia in Fe P ay d e I a Si era ru Pa ndia ng tio na Non-Life Sr apo n m i L re Se a a Al biar Tu nka b Share of life and non-life premiums, 2017 Ur nisi Pa ania Figure 2.2: Assets under management by pension funds in selected non-OECD ug a kis ua tan y SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap and large corporate debt and equity instruments. of institutional investors in other asset classes given Similarly, insurance assets in selected non-OECDs that by investing in government issues the investors are particularly concentrated in fixed-income and can earn a good return at “lower” risk. cash instruments, which might largely be a reflection of the low penetration of life insurance in some The second development that could ignite further EMDEs, with insurers having to maintain enough use of capital markets for SME financing is the liquidity to service non-life insurance claims. increased role of financial technology in EMDEs. While lower than in AEs, internet penetration In this context, the need for further diversification in EMDEs is growing at a fast pace, fueled by an could trigger investors’ interest in new SME increased availability of information technology capital markets solutions. Particularly in infrastructure and a young population. That progress connection to pension funds, some shifts toward is paving the way for an enhanced application of alternative or “other” assets17 have been observed in technology to financial services. The first example a few EMDEs, most notably in Brazil, Kenya, South has been in payments. However, as technology takes Africa, Tanzania, and Zambia, where over 40 percent hold other applications will start to become available. of pension assets are in alternative investments. As In the capital markets area, one key application will be further explained in this report, the “other” affecting SME financing has been the development assets category is one in which many SME-related of platforms for fundraising, as has been the case solutions would fall. However, in some EMDEs, in AEs. Figure 2.4 shows the rapid expansion of governments have had a crowd-out effect, because alternative finance throughout EMDEs: while data to finance their large fiscal deficits they have were available for just 12 EMDEs in 2013, that continuously issued securities in the domestic market number jumped to 80 in 2017. at very high rates. That action dampens the interest Figure 2.4: Number of alternative platforms in emerging markets and developing economies and in advanced economies, 2013–17 90 80 80 70 60 50 40 37 30 33 29 30 25 18 22 20 15 12 10 0 2013 2014 2015 2016 2017 EMDE Advanced Source: World Bank elaboration based on CCAF database on alternative finance. Note: EMDE = emerging market and developing economy. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 11 But the presence of EMDEs goes beyond the the leading position, surpassed by both the United number of countries. As table 2.2 indicates, Kingdom and the United States. EMDEs agglutinated 86 percent of global volumes in 2017 (44 percent in 2013). EMDEs concentrated But many other EMDEs make the top 20. In between 84 percent and 95 percent of total volumes 2017, a heavy concentration still existed in the top in each instrument except for equity crowdfunding 10 countries (99 percent of total volumes and no less (19 percent). than 91 percent at the level of individual instruments). However, as table 2.3 shows, the Republic of Korea, Part of the explanation for the EMDEs’ high India, and Brazil joined China in the top 20 overall share of the alternative finance market stems ranking. Also, Georgia, Korea, Poland, India, Latvia, from the dominant position of China, with about and Brazil made the top 20 for peer-to-peer lending; 86 percent of total volumes, as seen in table 2.3. In a Chile, Czech Republic, Mexico, Slovenia, Estonia, distant second and third place come the United States United Arab Emirates, and Poland ranked in the top (10 percent) and the United Kingdom (2 percent), 20 for invoice trading; and India, Korea, Malaysia, respectively. China contributes 93 percent of P2P Brazil, United Arab Emirates, and Indonesia were flows and 73 percent of invoice trading. Only in the included in the top 20 for equity crowdfunding. equity crowdfunding segment does China not hold Table 2.2: Alternative Finance Volumes: Distribution Between Advanced and Emerging Market and Developing Economy Countries, 2013 and 2017 Instrument Total Total AEs EMDEs AEs EMDEs 2013 2017 2013 2013 2017 2017 In US$ billion In % of total In % of total Equity crowdfunding 0.2 1.3 100 0 81 19 Invoice trading 0.2 6.7 86 14 16 84 Business P2P 2.2 102.2 35 65 5 95 Consumer P2P 6.6 242.9 53 47 7 93 Total P2P 8.8 345.3 48 52 7 93 Total volume 11.0 418.0 56 44 14 86 Source: World Bank elaboration based on CCAF database on alternative finance. Note: AE = advanced economy; EMDE = emerging market and developing economy. Table 2.3: Alternative Finance Instruments: Top 20 Countries, by % of Corresponding Global Volumes in 2017 Ranking Country Total Country Equity Country Invoice Country P2P volume crowdfundimg trading total 1 China 85.62 United Kingdom 31.07 China 72.99 China 92.91 2 United States 10.22 United States 17.09 United Kingdom 13.20 United States 4.65 3 United Kingdom 1.91 China 16.29 Italy 2.04 United Kingdom 1.26 4 Australia 0.27 Israel 8.62 Australia 1.86 Germany 0.13 5 Korea, Rep. 0.27 Finland 4.15 Chile 1.54 France 0.12 6 Canada 0.21 France 3.96 Ireland 1.47 Korea, Rep. 0.09 7 France 0.18 Singapore 3.58 United States 1.46 Australia 0.08 12 SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap 8 Germany 0.16 Sweden 2.78 Belgium 1.07 New Zealand 0.07 9 Japan 0.08 Spain 1.73 Sweden 0.46 Georgia 0.06 10 Netherlands 0.08 Germany 1.61 Spain 0.45 Japan 0.05 11 Israel 0.07 Netherlands 1.46 France 0.44 Finland 0.04 12 Italy 0.06 India 1.28 Netherlands 0.44 Poland 0.04 13 India 0.06 Canada 1.00 Denmark 0.40 India 0.03 14 New Zealand 0.06 Korea, Rep. 1.00 Singapore 0.35 Israel 0.03 15 Finland 0.05 Austria 0.71 Czech Rep. 0.32 Netherlands 0.03 16 Sweden 0.05 Malaysia 0.58 Mexico 0.27 Canada 0.03 17 Brazil 0.05 Brazil 0.42 Slovenia 0.20 Latvia 0.03 18 Georgia 0.05 Italy 0.39 Estonia 0.16 Brazil 0.03 19 Singapore 0.05 United Arab 0.35 United Arab 0.16 Italy 0.03 Emirates Emirates 20 Spain 0.04 Indonesia 0.27 Poland 0.16 Spain 0.02 % Top 99.00 90.88 96.55 99.42 10 % Top 99.56 98.35 99.44 99.74 20 Source: World Bank elaboration based on CCAF database on alternative finance. Note: P2P = peer to peer. Finally, as mentioned earlier, in many EMDEs and securities offerings solutions. These solutions retail investors are starting to participate in will be discussed in sections 3 and 4, respectively. capital markets via mutual funds. Although assets under management by mutual funds in EMDEs are That said, at a country level several challenges much smaller than those of pension funds, they affect the development of capital markets solutions are growing at a reasonable pace on the back of an for SME financing. Overall, the development of the emerging middle class with savings to invest (figure solutions is affected by the level of development of the 2.5). As will be explained later in this report, mutual capital markets, the health of the SME sector, and the funds are a key vehicle for SME financing, because condition of the SME finance markets. But at a more they allow investors to “liquify” several SME- granular level, EMDEs face challenges related to the related assets that traditionally could not be traded in supply side (availability and quality of the underlying the capital markets. assets), the demand side (existence of a broad investor base willing and able to invest in SME-related The evidence in this section provides a favorable assets), and the market infrastructure (availability picture for an expansion of the role of capital of a wide range of securities intermediaries and markets in SME financing in EMDEs. However, information providers) that affect the development of for such a role to materialize, different types of capital particular types of solutions. In addition, appropriate markets solutions need to be available to cater to regulation and supervision need to be in place to different needs. As indicated in the introduction to this ensure that the expansion of nonbanking solutions report, the solutions have been divided into two main does not create material risks to investor protection groups: indirect mechanisms for SME financing— or to financial stability. This in turn requires that the which cover mechanisms to refinance SME lenders regulators as well as the market participants possess via capital markets (issuances by SME lenders, SME a deep understanding of the characteristics and risks loan securitization, and SME structured bonds)—and imbedded in each of the market-based solutions. That direct mechanisms for SME financing—which cover is not always the case in EMDEs. All these challenges loan-based solutions, receivables-based solutions, are discussed in section 5. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 13 Figure 2.5. Ratio of mutual funds to gross domestic product, 2016 Netherlands United States Canada France Switzerland South Africa Germany United Kingdom Sweden Brazil Austria Denmark Finland Belgium Norway Namibia Japan Malaysia Barbados Trinidad and Tobago New Zealand Korea Republic Tailand Spain Iceland Chile Israel Hungary Australia Italy China India Mexico Slovak Republic Czech Republic Poland Croatia Slovenia Portugal Albania Mauritius Costa Rica Bolivia Peru Argentina Kazakhstan Bosnia and Herzegovina Lithuania Greece Philippines Estonia Jamaica Turkey Bulgaria Sri Lanka Latvia Armenia 0 20 40 60 80 100 120 Source: World Bank elaboration based on the World Bank’s Global Financial Development database. 14 SECTION 2: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap SECTION 3 Indirect Mechanisms for SME Financing The first role that capital markets can play in of instruments that institutional investors are SME financing is to be a refinancing facility for accustomed to. In addition, unlike other instruments SME lenders. Capital markets can provide SME that will be analyzed in this report, the investment lenders with mechanisms to refinance themselves, regimes of institutional investors across EMDEs which can help them lower their own funding generally allow their investment in these types of costs. This in turn could help them compete more securities.19 That said, other factors could still play effectively in the credit markets, which can lead to a role in investors’ appetite for these issuances, an expansion of the universe of SMEs served, to including the issuances’ size and, in the case of bond better lending conditions for the SMEs, or to both. issuances, their rating—as will be further discussed in section 5. In addition, particularly if placed via a public offering, the issuances would also constitute Plain vanilla issuances by a natural investment for retail investors. specialized SME lenders For this report, plain vanilla issuances by Plain vanilla issuances by specialized SME specialized SME lenders are defined as lenders are a viable solution for many EMDEs, equity and debt issuances issued by entities and in fact they can already be found across a different from banks that provide financing wide range of EMDEs. Overall, banks have been to microenterprises and SMEs.18 In many the first issuers in many EMDEs. That is the case countries financial institutions other than banks because as regulated entities banks are already that have come to serve the micro and SME sectors required to provide audited financial statements on include entities such as microfinance institutions, an ongoing basis as well as to have a basic corporate cooperatives, factoring and leasing companies, and, governance, and thus they are better able to comply more recently, fintech companies that specialize in with the requirements that accessing the traditional providing financing online. Some of these entities public markets imply. But other specialized cater to SMEs that are not served by banks. In lenders, including microfinance institutions and addition, some of them require less collateral than leasing and factoring companies, have been able to that required by banks. The latter is of particular come to market, which in turn has enabled them to importance to SMEs because many of them lack the diversify their funding sources and, in some cases, type of collateral (real estate) that banks prefer. to also obtain longer-term and cheaper financing. Such issuances have been attractive to institutional Equity and debt issuances by specialized SME investors in EMDEs (Reille and Forster 2008). lenders constitute a first mechanism through Recent examples in Africa include issuances in which capital markets can assist in expanding Zambia (Bayport), Kenya (Faulu), and Tanzania SME financing. These issuances constitute a (Pride), which attracted interest from both global natural instrument for the portfolio of institutional and local institutional investors, in addition to DFIs investors, and their analysis falls within the type (Carvajal and others 2017). See box 3.1. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 15 Box 3.1: Corporate bond issuances by specialized SME lenders: Bayport Financial Services corporate bond issuance in Zambia Bayport Financial Services (Bayport) is Zambia’s largest microfinance lender, serving more than 100,000 customers across 30 branches, with a net loan book of US$216 million. As a market leader in payroll-based lending, Bayport wanted to expand its services to small businesses and low- and middle-income borrowers. With support from the International Finance Corporation (IFC), Bayport established a medium-term note program that would enable it to regularly raise funds in the domestic capital markets to fund the expansion of services. In 2014, Bayport became the first nonbank financial institution in Zambia to tap local capital markets, with the issuance of a four-year medium-term note of ZMW172 million (US$26.5 million at the exchange rate at the time). The initial ZMW150 million offered was increased by ZMW21 million in response to strong investor demand. The IFC provided an anchor investment of ZMW60 million (US$9.3 million at the exchange rate at the time) and the African Local Currency Bond Fund, a unit of Germany’s KfW, committed to invest 13 percent of the issuance. These anchor investments enhanced Bayport’s profile and attracted other investors, including pension funds and insurance companies, to the transaction. Bayport has since issued a second five-year corporate bond worth ZMW300 million in the local capital markets. The issuance was approved by the Securities and Exchange Commission of Zambia in 2017. Source: Shi 2016. Nevertheless, in some countries access has backed by the loan portfolio (asset-backed securities, remained relatively restricted to larger, well- or ABS). The ABS, classified by risk categories, established nonbank financial institutions represent tranches of the underlying portfolio. (NBFIs). Smaller NBFIs have struggled to tap the local markets for various reasons—including SME loan securitization has the potential to the cost of listing requirements relative to the size expand SME financing. Securitization can provide and sophistication of the NBFI, weak governance SME lenders with an alternative source of funding structures, and the inability to meet minimum credit in cases in which other mechanisms of refinancing ratings (in the case of bond issuances), among other (such as plain vanilla bonds) can be sold only at constraints. That is why, for example, initial bond high cost. In addition, it potentially enables banks to issuances by less-established NBFIs have typically achieve economic and regulatory capital relief. Also, required credit enhancements or anchor investments this solution could reduce the cost of financing for from reputable banks or DFIs. As will be discussed SMEs. Further, SME securitization can potentially further, in other markets structured transactions— have a multiplier effect in the funding available to such as microfinance loan securitization funds— SMEs if the lender uses the capital “freed” through have enabled smaller NBFIs to indirectly tap local the transaction to lend again to SMEs. bond markets. From an investor’s perspective, SME loan securitization could have many benefits. First, it SME loan securitization enables investors to gain access to an asset class SME loan securitization is a financing technique whose performance is tied to the whole economy. that allows the transformation of SME loans, While other asset classes can do that, the attractive which are illiquid in nature, into tradable feature of SME securitization is that it has the securities. To this end a bank or SME lender (the potential to include a portfolio of more diverse and “originator”) bundles a package of SME loans into granular (smaller individual) assets, thus allowing a pool (“portfolio”) and sells the portfolio to capital investors to better diversify their risk. In addition, market investors through the issuance of securities by investors can choose the degree of risk they are a special purpose vehicle (SPV). The securities are exposed to by selecting the tranche to hold. Finally, 16 SECTION 3: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap the securities can be traded at lower transaction But it has also been affected by more costs than individual loans are. “transitory” issues. In Europe in particular, the financial condition of banks has resulted in the SME loan securitization constitutes a very small retention of securitization transactions so that they part of the overall securitization market in AEs. can be used for repo (repurchase) funding through As of 2018 it accounted for just 2.3 percent ($36.5 the European Central Bank. More generally, there billion) of U.S. asset-backed securities outstanding is still a reputational issue associated with this ($1,561.8 billion), and 6.4 percent ($94.7 billion) of asset class, given its role in the global financial total European securitization outstanding ($1,489.2 crisis. However, because of the importance of the billion). Furthermore, partly on account of the securitization market in general and for SMEs in contraction in European loan growth, new issuance particular, a number of initiatives have sought to (that is, capturing flows) has reduced substantially revitalize it and to deepen SME securitization.23 any in Europe since the peak of $107 billion in 2007. of these efforts emphasize the need for high-quality The United States has the largest SME securitization securitizations.24 market in the world, with a significant proportion anchored in the Small Business Administration In EMDEs the SME securitization markets are at (SBA) securitization program (see box 3.2). Before a nascent stage. The characteristics of SME loans the global economic crisis, Germany and Spain were previously discussed and the complexity and costs the largest SME securitization markets in Europe. of the transactions are challenges that apply equally However, the program in Germany has disappeared to EMDEs. In addition, in many EMDEs banks since the crisis.20 The Spanish program, which is have not found the need to securitize assets because anchored on a government guaranteed scheme, they enjoy ample liquidity. However, their interest is still use, but the volumes are low. Post-crisis in securitization as a risk optimization tool might Italy,21 and peripheral countries such as Greece increase with the implementation of Basel III.25 and Portugal, became more active, but the volumes correspond to a very small number of underlying In many of the cases found in EMDEs, SME deals. More recently, marketplace lenders have securitization has been used by specialized SME started to make use of the securitizations markets. lenders. India is one of the few countries where SME loan securitization is used consistently. To a The limited use of SME securitization in AEs is large extent its use has been driven by regulatory mainly a result of structural challenges. Challenges requirements imposed on banks, which are required include the limited availability of quality SME loans at to meet certain targets for SME financing either a sufficient volume to allow for “individual” issuances via their own lending or via holdings of ABS in by different lenders; the heterogeneity of the loans, which the underlying assets are SME loans. This which makes it difficult to make assumptions about requirement has prompted securitizations by the underlying portfolio and its risks; and the short- microfinance institutions. Yet interesting examples term nature of the loans, which is not compatible not driven by regulatory requirements are starting to with the long-term liabilities of institutional investors. appear also; in these cases, specialized lenders are In addition, there are also challenges associated using the securitization markets as their first step to with information availability because it is difficult access the capital markets. For example, in China to obtain loan-level data in a standardized format. since Ant Financial Group, a subsidiary of Alibaba, These transactions also have an elevated initial cost securitized its consumer loans portfolio in 2013, due to many of the issues that have been described. many microfinance institutions have followed suit. In addition, post crisis the regulatory charges 26 In addition, some securitizations by marketplace associated with the loans have increased, although lenders are also taking place in EMDEs. For the international setting bodies have made some example, in 2018 an online lender made the first calibrations for high-quality securitizations.22 securitization of digital loans in Argentina. Finally, Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 17 recent examples have been found of the use of SME be tackled, including enhancements to the regulatory securitization by banks. In particular, in Russia a framework for securitization, as explained in section 5. multi-origination platform was recently developed to securitize SME loans from banks. This platform holds promise as a mechanism that such entities SME structured notes could use on a recurrent basis. Covered bonds are debt securities issued by a credit institution that are backed by a dynamic Overall, consistent use of SME securitization cover pool of loans. Investors have double seems more viable for larger EMDEs, and as a recourse to the issuer and to the cover pool and, as medium-term proposition. Its development requires a result, the covered bond remains an on-balance- a corporate bond market to already be in place. sheet instrument. Issuers can be traditional deposit- Further, given the risk imbedded in SME loans, the taking institutions or in some cases specialized existence of a public guarantee program might be a mortgage lending institutions primarily reliant on critical element to align the risk appetite of investors covered bonds for their funding. A key feature, with SME securitization, as the experiences of Spain though, is that the issuer must be a regulated and the United States show (box 3.2). The other institution meeting minimum governance standards critical challenge affecting the viability of the product and capital adequacy requirements. is the need for a sufficient volume of quality SMEs. Recent examples both in AEs and EMDEs confirmed In general, covered bonds are issued under a the role that multi-origination platforms can play in dedicated legal framework. In countries that addressing this challenge. Multi-origination platforms have covered bond legislation, only a restricted have allowed lenders with low volumes of SME loans type of assets may be included in the cover pool, to access capital markets funded by securitization, mainly mortgages and public loans with certain because the fixed cost of setting up the vehicle could characteristics that make them of high quality. be shared in proportion to the loans contributed to the Further, the legislation also requires the exchange deal. Thus, barriers to entering the SME securitization of the original loans for performing assets should market and SME lending are potentially reduced. they become impaired.27 The existence of such It must be acknowledged, however, that multi- requirements provides investors with confidence origination platforms add another layer of complexity that the bonds are issued in a uniform way and adhere to these transactions. Other issues would likely need to to strict standards. This in turn creates a pool of Box 3.2: Selected experience with SME securitization United States The U.S. Small Business Administration (SBA) was created in 1953 to further the interests of the small business community and to promote competition in the marketplace. As part of its mission, the SBA, under section 7(a) of the Small Business Act, provides loans and loan guarantees to small businesses. On the basis of such authority, the SBA implemented a scheme that provides a partial guarantee on almost $20 billion annually in loans to small businesses. Businesses must be for-profit and meet the SBA’s definition of small. The maximum loan size is $5 million and the guarantee percentage ranges from 50 to 85 percent, averaging about 72 percent. Loans may be used for machinery, equipment, working capital, and real estate and typically have floating interest rates based on the prime rate or Libor. Tenors up to 25 years are available for real estate loans. In 1985 the SBA started securitizing the guaranteed portion of the loans, whereby the SBA issues securities that are backed by multiple guaranteed portions of loans. In addition to the credit guarantee of the loans, the securities issued by SBA have a timely payment guarantee. Further, the securities have the full faith and credit of the U. S. government. As a result, investors did not have to worry about payments or perform due diligence on the creditworthiness of the borrowers or lenders. This reduced the investor’s purchase costs and encouraged more securities brokers to sell the 18 SECTION 3: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap product. As the loan scheme and securitization program grew, many loan officers began to specialize in SBA lending. SBA continued to improve the efficiency of the program and delegated significant authority directly to lenders. The program has continued growing, and loan volume exceeded $30 billion in 2018. The first securitization backed by the Figure B3.2.1: Annual U.S. Small Business unguaranteed portion of SBA loans took place in 1992. It was only for loans origi- Administration Securities Outstanding nated by nonbanks, or nondepository 40 (%) lenders. In 1997, banks were allowed to 35 7 securitize the unguaranteed portion of the 30 6 7(a) loans. There is no government guaran- 25 5 tee on these transactions. However, SBA 20 4 required that the lender retain some of the 15 3 risk in the deal. The amount of the reten- 10 2 tion was related to the performance of the 5 1 lenders’ portfolio. Overcollateralization 0 0 was used as a credit enhancement. This 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 process was mainly used as a financing US SBA Securities Outstanding (USD Billians) tool by nonbank lenders that did not have Share of Total US Asset-Backed Securities Outstanding a deposit base. Source: SIFMA. Spain In 1998–99, the Spanish government established the FTYMPE (Fondos de Titulizacion de Pequenas y Medianas Empresas), a program to facilitate SME securitization. The mechanics of the program are simple: the Treasury commits to guarantee certain tranches of an issuance of a securitization fund, provided that it holds in its portfolio a minimum percentage of bank loans to SMEs. In return for the liquidity gained through the sale of the SME loans, the originator commits to reinvest part of this liquidity in SME financing. The participating banks must sign an agreement with the minister of economy and finance; assuming certain commitments, in particular: (a) at least 50 percent of the assets transferred must be SME loans, with an initial maturity of not less than one year; (b) financial institutions transferring assets must reinvest at least 80 percent of the proceeds into new SME loans; and (c) the reinvestment must take place within two years, with at least 50 percent reinvested in the first year. The bonds issued by the funds with a rating of AA, Aa, equivalent or superior, can obtain a guarantee from the government, through the public Treasury of up to 80 percent of their amount. All the bonds that are guaranteed by the government must be traded in an official Spanish market. As with Spanish securitization in general, multi-originators are common. Before the global economic crisis, originating banks retained the higher risk equity tranches. Since 2008, originating banks have retained the bulk of the senior tranches (on sharply reduced new issuance) to use as collateral for refinancing from the European Central Bank. Since 2000, €50,640 million has been issued, making it possible to reinvest more than €40,512 million in new credits for SMEs, though volumes have declined since the crisis. Armenia In Armenia, monetary financial institutions—or universal credit organizations (UCOs)—are not permitted to accept deposits and therefore struggle to raise sufficient resources to meet the demand for finance from microenterprises and SMEs. To address this challenge, the U.S. Agency for International Development (USAID) Development Credit Authority worked with five UCOs—CARD AgroCredit, Garni Invest, Global Credit, Kamurj, and Nor Horizon—to establish a special purpose vehicle (SPV) to enable the UCOs to tap the local bond markets. The SPV, known as the Loan Portfolio Securitization Fund, was launched in August 2015 with the purpose of securitizing US$2 million worth of microfinance loans of the five participating UCOs. The fund issued its first bond on the NASDAQ OMX Armenia in January 2016, making it the first securitized bond issuance in Armenia. The issuance was also accompanied by a 50 percent guarantee on the bond principle from USAID’s credit authority. The securitized loans are registered with the central bank and the projected cash flows structured as bonds. The investment is expected to support up to 17,000 new loans in agriculture and other rural, small businesses. Primary bondholders include two pension funds, several banks, and other financial institutions. Source: World Bank elaboration based on information from Board of Governors of the Federal Reserve Board System 2017 and Securities Industry and Financial Markets Association for United States; Gobierno de España, Ministerio de Industria, Comercio y Turismo, Portal PYME for Spain; and USAID 2016 for Armenia. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 19 bonds that are broadly homogenous and establishes securitization funds, whereby each participating bank a deep and liquid secondary market, which helps has a separate compartment in the vehicle. Within a reduce overall funding costs. As a result of the high compartment, notes are ranked pari passu. The sponsor quality of the underlying assets, the bonds are given banks also provide overcollateralization. However, this a beneficial regulatory treatment. instrument is not included as an eligible asset under the covered bond legislation and the market does not Covered bonds have been a strategically perceive it as a “covered bond,” although it benefits important addition to the funding options from a dual recourse to the issuer and the cover pool available to financial institutions, in particular to assets (Wehinger and Nassr 2015). Only Turkey and, mortgage lenders in Europe. Covered bonds have more recently, Italy and Spain allow the inclusion of provided the market with a long-term funding tool SME loans as part of the covered bond pool. However, with cost-efficient performance on the issuer’s side at least in the case of Italy, the SME-covered bond is and a stable and safe long-term, liquid investment not explicitly covered by the Bank of Italy regulation on the investor’s side, contributing significantly for covered bonds regarding supervision, asset to the creation of an efficient housing market. monitoring, and minimum capital requirements for the They also possess other advantages for investors. issuers (Wehinger and Nassr 2015). They come in simple structures, usually as bullet bonds. In addition, adverse selection and agency In this context, the design of a separate instrument problems are lower than under securitization, since that relies on some of the characteristics of covered the collateral is still on the bank’s balance sheet. bonds (the dual recourse) might be the best option. Further, European Union (EU)–based banks like the Europe has recently proposed the creation of a separate lower capital charges and the preference the banks instrument for SME loans. In July 2018 the European receive under the Liquidity Coverage Ratio act. Banking Authority (EBA) supported the development Insurance companies like the more lenient treatment of a structured note backed by SME loans, which that covered bonds receive under Solvency II act could be structured as a dual recourse instrument (EBA compared with other private debt. 2018). However, because of the high risk profile of SME exposures, the EBA suggested a more restrictive Very few experiences with “covered bonds” backed framework, especially with respect to the coverage, by SME assets have been recorded in both AEs and the liquidity, and the disclosure requirements, and it EMDEs, mainly due to the nature of the assets, suggested strict eligibility criteria at both loan and pool which in turn has an impact on their regulatory level and a minimum level of overcollateralization of treatment. Due to the higher credit risk associated with at least 30 percent. In terms of capital requirements, SME loans, very few countries have included them in the EBA advised that no preferential treatment their covered bond laws. As a result, there are very (similar to covered bonds) be granted. Nevertheless, it few examples of covered bond transactions backed recommended that authorities consider a differentiated by SME loans. For example, some transactions have risk-weight treatment compared with unsecured notes taken place in Germany, but the “covered bonds” have subject to certain conditions. been issued under a contractual scheme (Wehinger and Nassr 2015). In France, the French Banking This type of instrument (SME structured Federation introduced a separate instrument, the Euro notes) could be particularly useful for first-time Secured Notes Issuer, which is a platform designed microfinance institutions or other NBFIs in to support SME lending in France and the rest of EMDEs. Indeed, the dual recourse characteristic of Europe. This initiative aims to overcome information this instrument might provide investors with sufficient asymmetries by making use of the Banque de France’s comfort provided that the underlying portfolio is credit assessment of nonfinancial companies as well of high quality. That is, for example, the model that as the internal ratings from banks. The scheme uses a Colombia is using as the basis for a “securitization” SPV structure, incorporated under the French rules of structure of rural microloans (see box 3.3). In the 20 SECTION 3: Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME Financing Gap Colombia case the initial structure will be issued under (high quality only) and, based on those restrictions, to a contractual arrangement. It is possible, however, provide a differentiated risk weight treatment to these that for this instrument to be scalable, a regulatory notes compared with unsecured notes, in line with the framework might be needed to establish restrictions in EBA proposal. regard to the assets that could be included in the pool Box 3.3: A hybrid structure using structured notes and securitization: The experience of Colombia with rural microcredit In Colombia, the World Bank Group is supporting relevant players in the microfinance sector to access capital markets by pioneering the country’s first securitization program for microloans. At the time of this report, four of the largest microfinance institutions in Colombia are planning to issue a multi- originator securitization bond. The initial value of the bond issue is expected to range from US$68 million to US$102 million and will underpin a three-year microcredit securitization program. The proposed model (figure B3.3.1) is anchored on a dual recourse structure. The participating entities will individually issue guaranteed debt, backed by a portfolio of assets legally separated from the originator through a special purpose vehicle. The guaranteed debt will be securitized through a “single refinancing vehicle,” which in turn will issue debt/bonds in the capital market. To reduce prepayment and refinancing risk associated with microloan operations, the bond issues will have a bullet repayment structure with periodic interest payments and principal amortization at maturity. In addition, the proposed refinancing vehicle would need to have access to a stable line of credit and a liquidity reserve fund to match the liquidity needs of the originators to the bond issuance schedule, and to prevent delays in interest payments. The sources for the line of credit are critical for the successful implementation of the proposed financing structure. Two of the three entities identified as potential providers/guarantors of funds are public institutions dedicated to guarantee and fund loans and activities that benefit the agricultural and rural sector. The third institution is the International Finance Corporation, which would be subject to the financing scheme’s operational requirements. To ensure market liquidity, the investors expect a continuous and standardized bond issuance program, with a minimum issue size. The credit line is essential to provide the participating entities with the required funds to maintain the collateral loan portfolio at a sustainable level. A continuous ongoing program should have at least one transaction a year, an outstanding balance of bonds in the market of approximately US$100 million, and overcollateralization of 150–165 percent of this amount. However, the negotiation process between investors, participating entities, and other institutions is ongoing and could result in adjustments to the proposed structure. Figure B.3.3.1: Financing model RURAL SECTOR GUARANTEED DEBT LEVEL SECURITIZATION LEVEL CAPITAL MARKET Debtors Banks Refinancing Vehicle Institutional Investors Universalidad GD RFV Microloans • Pension Funds • Mutual Funds Guarantee GD • Insurance Comp. Bonds • Banks • Other... GD Microloans Guarantee Source: Carlos Senon Benito, financial sector specialist, World Bank Group. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 21 22 SECTION 4 Direct Mechanisms For SME Financing Until recently SMEs had very few mechanisms types of solutions. Some of those solutions aim to to access the markets directly. In general, two bring capital markets investors to the table. mechanisms have been used: venture capital (VC) and private equity (PE) funds and small securities In this report receivables-based solutions offerings via private or public placements. However, encompass different arrangements that enable VC funds have been restricted to start-up companies SMEs to obtain liquidity via the sale of receivables and PE funds to more established/larger companies, to investors. Such solutions can be grouped into and small securities offerings have been an option two options: (a) platforms for the sale of receivables mainly for the larger SMEs. Since the crisis other and (b) securities in which the underlying assets are solutions are emerging that have the potential to receivables. In this report, the focus for the latter serve a wider range of SMEs. type of solution is on funds, although other solutions, such as securitizations, also could be structured. Debt solutions The benefits of receivables-based solutions for Receivables-based solutions SME financing are clear. These solutions have the potential to expand SMEs’ access to working Even before long-term finance, what most SMEs capital, both by expanding the range of SMEs that need is working capital. Although many factors could get access to financing and by providing affect the cash flows of SMEs, a key element refers better conditions than those offered by more to the contractual terms under which SMEs sell traditional solutions, in terms of the spreads paid. their goods and services, terms which in many cases The key to obtaining such benefits lies in increasing require them to sell at credit and under extended competition in the factoring industry via the payment terms.28 While late payment terms help entrance of additional “financiers”—in this case, in buyers optimize their own working capital, from the form of investors. the SME perspective late payments increase their costs and financial uncertainty and could result in From an investor’s perspective, receivables bankruptcies of otherwise viable businesses.29 solutions provide access to a new asset class that can deliver attractive yields. Before the emergence In practice, this situation forces many SMEs to sell of these solutions, only banks and factoring their receivables (credits) to banks or factoring companies generally had access to this asset class. companies to obtain liquidity. However, in many But, particularly after the global financial crisis, cases the spreads are high, to some extent because the interest in these assets accelerated because they of lack of competition. Financial technology and can provide investors with attractive returns at a in some cases also the financial condition of banks time of low interest rates. Those attractive returns, have opened space for competition to the factoring however, are associated with higher credit risk and industry and have improved the conditions under limited liquidity. Interest in these instruments has which SMEs obtain short-term funding via different spanned both retail and institutional investors. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 23 All receivables solutions can be structured using Particularly in EMDEs, some of the platforms reverse factoring and traditional factoring.30 In have been developed with government support. this report, reverse factoring refers to solutions in In some cases, domestic development banks which the initiative in choosing the receivables have been directly involved in the creation and to be sold comes from the buyer of the goods and implementation of the platforms, including services.31 From an investors’ perspective, this leads Nafinet in Mexico—which was developed by to an easier credit risk analysis, because reverse Nacional Financiera (NAFIN), a development factoring is usually promoted by large companies, bank that focuses on SMEs—and the Receivables for which information is usually available in Exchange of India (RXIL), which was the result the market. Because it is associated with large of a joint venture between the Small Industries companies with good credit quality, the credit risk Development Bank of India and the National Stock is lower. Traditional factoring refers to solutions Exchange of India. In at least one case (Nafinet), whereby the SME itself chooses the receivables to the platform operator provides guarantees/lines of sell; thus, in principle it is not limited to receivables credit to the financiers. of large companies to which they supply goods and services. From an investor’s perspective, the The operators of the platforms vary. In some analysis involved is likely more complex and the cases, the platforms are operated by “traditional” credit risk, potentially higher. exchanges (for example, Bolsa miPYME in Chile and RXIL in India), while in others they are operated by fintech companies (for example, Workinvoice in Receivables platforms Italy, and MarketInvoice in United Kingdom). In this report receivables platforms are defined as electronic platforms that enable SMEs to Some of the platforms operate under a reverse sell their receivables directly to a wide range factoring model (such as Nafinet); others are of investors. The platform acts exclusively as based on traditional factoring. But some of an intermediary that prescreens the receivables those traditional factoring examples impose certain using proprietary technology, but ultimately the restrictions on the receivables that may be sold credit risk is borne by investors. In many cases the (for example, limiting them to receivables against platforms offer collection services. The focus of this medium and large companies), thus bringing them report is on platforms that create a marketplace for close to reverse factoring, at least in terms of the receivables by allowing the entrance of a plurality risk borne by investors (an example is Workinvoice of investors (box 4.1). in Italy.) Finally, others support both factoring and reverse factoring (Bolsa miPYME and RXIL). Available data indicate that volumes traded on this type of platform are growing significantly, Platforms have evolved in terms of the options although from a very low base; as a result, they give investors to decide on their investment. their impact is still limited. From 2013 to 2017 In general, platforms allow investors to choose the volumes of financing raised in these platforms manually the receivables they want to invest on grew from $0.3 billion to $6.7 billion. In 2017, the basis of the information that the platform EMDEs concentrated 84 percent of total volume provides. But some platforms offer more automated raised. While most of this volume was raised in solutions, whereby investors can set parameters— China, other countries in the top 20 included Chile, for example, in terms of their target return, duration, Czech Republic, Mexico, Slovenia, Estonia, United and exposure limits—and then the platform Arab Emirates, and Poland (see table 2.3, invoice “autobids” using the parameters. trading). 24 SECTION 4: Direct Mechanisms For Sme Financing Box 4.1: Selected experiences with receivables platforms The seed for marketplaces: Nafinet in Mexico One of the first examples of electronic platforms for the sale of receivables is Nafinet, the receivables platform developed and operated by Nacional Financiera (NAFIN), a Mexican development bank. The platform went into operation in 2001. The platform is based on reverse factoring, whereby large companies (empresas de primer orden, or EPOs) affiliate with the platform and then choose the small and medium enterprises (SMEs) that will be able to “post” their receivables in the platform. EPOs from the private sector must comply with certain requirements, in particular a minimum size (level of sales on an annual basis), and they are subject to certain minimum disclosure obligations (such as providing financial statements). In addition, in 2007 the federal government required all its dependencies and entities in the public sector to incorporate to Nafinet. Several banks are affiliated with the platform in the role of “financiers”/buyers of the receivables, and in that sense Nafinet could be considered the precursor of marketplaces for receivables. NAFIN requires all participating banks to use its second-tier funding to provide credit through the system. However, the provision of credit by NAFIN is not key for the functioning of the program. NAFIN does not charge a fee for the use of the platform; rather, it covers its costs with the interest it charges on its loans. From an operational point of view, the SME chooses the receivables that will be auctioned, banks then can post their bids, and the SME chooses which bid it accepts. The bank pays the SMEs, discounting its financial cost. In addition to obtaining liquidity, the SME is able to start to build a credit history that facilitates its access to other programs of NAFIN. When the receivables are due, the large company pays the bank. The platform operates in pesos and dollars. Expanding the base of financiers: The cases of Chile and Italy The Bolsa de Productos de Chile has negotiated receivables since the early 2000s. In November 2016 it modernized its platform and created Bolsa miPYME, an electronic platform for the sale of receivables through which it seeks to expand SMEs access to financing. The model can be considered a hybrid system. While SMEs affiliate first, they can sell receivables only from companies that are registered in the platform. Such companies are large companies for which financial information is available. As of 2017 349 companies were registered in the exchange. Increasingly, factoring companies participate in the platform also selling their portfolios of receivables. As of 2017 10 factoring companies were registered as participating entities. Receivables are sold to investors, who participate in the auctions via the brokerage houses to which they send their orders to buy specific receivables. Sales are without recourse. Increasingly institutional investors, in particular banks and mutual funds, invest in these receivables. Volumes in the platform have a positive trend. For 2017 alone it transacted US$42,000 million, with growth of 7 percent from the previous year. For 2017 SMEs represented 38 percent of all receivables sold, about 20 percent of total volumes, and 73 percent of the companies that participated. In Italy, Workinvoice was established in 2015. The platform is open to Italian companies of any size (even start- ups). Companies can sell single receivables, with a minimum size of receivables of €10,000, provided that the receivable is issued against a private company with annual sales of at least €10 million. Investors compete for the receivables through an auction process. The sale of receivables is final—that is, the risk on nonpayment is transferred to the investors. Operationally, the seller (SME) decides the minimum price for the receivable, and then investors compete in the platform. The winner is the investor that offers the highest price. The platform then pays the SME 90 percent of the receivable within 48 hours and the remaining 10 percent (minus the remuneration of the buyer and the platform fee) when the receivable is actually paid. The platform charges a fixed cost (currently at €450) at the moment of adhering to the platform, and then a fee per transaction (of between 0.4 and 0.9 percent, depending on the terms agreed). As of November 11, 2018, Workinvoice had provided financing for €180 million. Source: World Bank elaboration based on information from De la Torre, Gozzi, and Schmukler 2017 (Mexico), the website of Bolsa miPYME (Chile), and the website of Workinvoice (Italy). Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 25 Overall World Bank experience in the field, The packaging of receivables into a fund increases the supported by empirical research, suggests that attractiveness of the asset class to investors. The use of receivable platforms could be a viable solution the fund vehicle addresses the scale problem that these for many EMDEs. A key reason is that the assets individually entail for institutional investors; underlying assets are already available, given that it that is, each individual receivable is too small relative is normal practice for SMEs to need to provide their to the assets under management by institutional goods and services at credit. Furthermore, empirical investors. As a result, it is not worth it for these research conducted by the World Bank suggests that investors to spend resources conducting the necessary the growth of these platforms is not associated with due diligence to invest in them. Through the fund, the wealth of countries, a finding that reinforces the institutional investors delegate such due diligence viability of these platforms across many EMDEs. and also get a diversified portfolio. Those same That said, as will be discussed further, other issues characteristics—that is, professional management might hinder their development, including, in and diversification—are also important for retail particular, the level of internet penetration and the investors. However, in practice, the suitability of requirements for the transfer of the receivables. the product to retail investors would depend on the In addition, an investor base would need to exist actual composition of the portfolio. In this regard, to make this solution scalable. Depending on the many of these funds are offered only to sophisticated country, changes to the regulations of institutional investors—that is, institutional investors and high-net- investors might be needed to allow them to invest worth individuals. in receivables, to help increase the investor base. Finally, the research conducted did find a While the interest of investors in this type correlation between the development of these of instruments has increased, there is no platforms and credit intermediation and the rule of consolidated data that can help estimate the law, findings that suggest the need for governments actual importance of this source of financing. to continue improving basic aspects of the enabling Brazil is perhaps the most significant example of environment. the use of SME receivables funds as an important alternative source of financing for SMEs, in particular in the agriculture sector (see box 4.2). Receivables funds Other countries where these funds are being used SME receivables funds are credit funds that are Chile, France, Italy, and Peru, which use invest in receivables owed to SMEs. In practice, both reverse factoring and traditional factoring. the funds often invest in a range of alternative assets, In Brazil, domestic institutional investors including consumer loans, small business loans, held about 27 percent of the total assets under and receivables, that generate interest or a similar management (AUM) by these funds (called income stream rather than investing exclusively FIDC) as of 2018. In other countries in Latin in receivables. Given the lack of liquidity of the America, institutional investors have started also underlying assets, many receivables funds are to invest in receivables funds. Such is the case of structured as closed-end funds, although they may Chile and, more recently, Peru. provide redemption at intervals. Box 4.2: Receivables funds in Brazil The fundo de investimento em direitos creditórios (FIDC) is a financial instrument widely used in the Brazilian credit markets. FIDC is a specific type of fund which invests in receivables (direitos creditórios) from different types of issuers. FIDCs in Brazil are regulated by the Comissão de Valores Mobiliários (CVM) Instruction 356 from 2001 (last amendment from 2015). 26 SECTION 4: Direct Mechanisms For Sme Financing The FIDCs operate on a traditional factoring basis, through the acquisition of receivables originated from the sales of goods and services. While the selection of the receivables is a responsibility of the fund manager, in practice many fund managers enter into arrangements with third parties who have long-standing relationships with the companies that originate the receivables, including small and medium enterprises (SMEs). The FIDCs can issue debt instruments, such as senior, mezzanine, and subordinated tranches, and thus, in practice, operate much like securitized instruments. The current regulatory framework does not require a specific level of collateralization, but it does require that the actual level of overcollateralization be explained in the prospectus. FIDCs can be both closed end or open end. The schedule of payments (amortizations, distributions, and so on) must be defined in the prospectus. The FIDCs have experienced considerable growth, with assets under management reaching about R110 billion as of September 2018. Figure B4.2.1: FIDC assets under management, in R billion, 2002–18 120000 100000 80000 60000 40000 20000 0 4 8 9 0 3 6 1 2 4 2 3 5 6 7 5 7 8 c-1 c-0 c-0 c-0 c-1 c-1 c-1 c-1 c-1 c-0 c-0 c-0 c-0 c-0 c-1 c-1 t-1 Se De De De De De De De De De De De De De De De De Table B4.2.1 Assets under management by types of FIDC, in R billions, as of September 2018 Fund AUM, in R billions FIDC Fomento Mercantil 16,812.7 FIDC Financeiro 23,290.5 FIDC Agro, Indústria e Comércio 46,817.1 FIDC Outros 22,766.9 TOTAL 109,687.2 Note: AUM = assets under management; FIDC = fundo de investimento em direitos creditórios. In general, FIDCs are distributed through a restricted public offering procedure pursuant to CVM Instruction 476, which allows for a streamlined registration procedure on the condition that the securities are offered only to sophisticated investors. As of September of 2018, about 40 percent were held by corporate entities, 27 percent by funds, 7 percent by private investors, and 5 percent by foreign investors. Source: World Bank elaboration based on information available in the ANBIMA database, as of September 2018. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 27 Recent deals show how the two types of solutions From an investor’s perspective, loan-based (electronic marketplaces and instruments) could solutions provide access to a new asset class that be linked. For example, in Italy, Factor@Work, can offer attractive yields. Before the emergence an Italy-based portfolio manager, completed the of these solutions, loans had been an asset class purchase of €5 million of corporate receivables directly available to banks and specialized lenders through a securitization vehicle in which all only. Investors’ access was indirect, mainly through the assets were originated by Workinvoice, an asset-backed securities backed by SME loans. Italian invoice trading platform. The receivables However, in particular in AEs, institutional investors being securitized were sold by SMEs through have sought entrance to new asset classes that could Workinvoice’s invoice trading platform. help them increase the yield of their portfolios in the current low-interest-rate environment. World Bank experience suggests that the Nevertheless, as with receivables-based products, expansion of this solution requires a certain level these attractive yields are associated with higher of development of the capital markets. Overall, the credit risk and limited liquidity. experiences suggest that this type of fund emerges in countries where the mutual fund industry has already achieved a certain level of development, as Lending platforms they constitute a riskier product than plain vanilla For purposes of this report, SME lending open-end funds because of both their higher credit platforms are defined as platforms that risk and their more limited liquidity. That said, as consumers and businesses can use to obtain loans indicated earlier, the availability of the underlying directly from a wide range of investors. The assets makes such funds an attractive proposition platforms act exclusively as intermediaries. Their for EMDEs, where the pipeline of traditional assets role is to prescreen the loans through a low-cost (equity and bond issuances) in the capital markets information technology that allows them to collect is lacking. As with receivables platforms, it is standardized information from dispersed borrowers likely that other issues would need to be tackled, to assess the credit risk, but the ultimate decision mainly reforms to the requirements for the transfer to invest relies on the investors who bear such of receivables and to the investment regulations of credit risk. In most cases the platforms also work as institutional investors. collection services when the debtor defaults. Lending platforms have been growing at a very Loan-based solutions fast pace and currently concentrate the bulk As indicated earlier, banks have generally been of the volume raised via fintech solutions for the main providers of external credit to SMEs, fundraising. From 2013 to 2017 volumes raised via loans. However, particularly after the crisis, in lending platforms grew from $8.8 billion to market-based solutions based on lending are $345.3 billion. For 2017, EMDEs concentrated 93 starting to appear. They mainly involve lending percent of the total volume raised. Although most platforms and SME loan funds. of funding has been raised in China, other countries in the top 20 include Korea, Georgia, Poland, India, The benefits of lending-based solutions for SME Latvia, and Brazil (see table 2.3, peer-to-peer). financing are clear. Depending on the country, such Retail investors have been a key component of the solutions expand lending to companies that have investor base; although at least in AEs there is a not had access to bank financing, or they provide trend toward institutionalization of the asset class companies with cheaper and potentially faster (that is, increasingly institutional investors buy the alternatives to bank financing. Most important, loans in “bulk”). many such solutions do not require SMEs to put up collateral, particularly real estate. 28 SECTION 4: Direct Mechanisms For Sme Financing Some governments, including the United each loan, including credit scoring performed by the Kingdom, have been promoting these platforms. platform. Other more automated options use a set of The British Business Bank co-invests in some of the parameters to automatically assign investors the loans platforms as a way to mobilize investors to them that meet such parameters. Thus, the latter perform (British Business Bank 2019). Other tools also being services that are closer to portfolio management. tested in the United Kingdom include a referral mechanism that requires nine high street banks Further, some of the platforms are providing that deny finance to particular businesses to pass “exit” alternatives to investors. One of the on the information about those businesses to three drawbacks of this asset class compared with accredited finance platforms (HM Treasury 2018). a traditional securities offering is its lack of liquidity. However, some platforms are mitigating The business model of lending platforms has the problems by providing a “screen” whereby evolved considerably, particularly in regard to investors that need liquidity can offer to sell their the role of the platforms in loan selection. Business positions in some or all the loans that they hold models vary. In some cases, the platforms enable to other investors. The liquidity in this case is investors to choose manually the loans to invest not automatic: it requires that another investor be in using information that the platform provides on willing to buy such positions (box 4.3). Box 4.3: Marketplace lending platforms in India In India, alternative lending (balance sheet business lending, peer-to-peer [P2P] consumer lending, and P2P business lending) is one of the fastest-growing financial technology segments, increasing from US$90.4 million in 2016 to US$220.7 million in 2017 (figure B4.3.1). Balance sheet business lending—that is, lending through platforms that hold most or all of the loans on their own balance sheet, earn the interest on loans, and bear the credit risk—makes up the bulk of the alternative lending market in India. But P2P/marketplace lending platforms have also grown considerably. Volumes raised by consumer and business platforms has reached US$ 110 million. Figure B4.3.1 India Total Alternative Finance Market, 2013–17, US$ millions Balance Sheet 104.65 Business Lending 45.50 P2P/Marketplace 92.32 Consumer Lending 42.52 P2P/Marketplace 28.76 Business Lending 2.42 Donation-based 20.83 Crowdfunding 15.05 Equity-based 17.62 Crowdfunding 17.22 Other 2.18 Invoice Trading 1.53 Reward-based 0.64 Crowdfunding 1.45 P2P/Marketplace 0.04 Property Lending 0 20 40 60 80 100 120 US$ millions 2017 2016 Note: p2p = peer to peer. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 29 In 2017, the Reserve Bank of India (RBI) issued regulations (NBFC-P2P Directions, 2017) to govern the operation of nonbank financial company (NBFC) P2P/marketplace lending platforms. According to the regulations, P2P/ marketplace lenders must be companies incorporated in India, with net owned funds of not less that Rs 20 million (about US$300,000), and they must obtain a certificate of registration from the RBI before offering P2P/marketplace lending services. In addition, the regulations stipulate that NBFC-P2Ps may act only as intermediaries (that is, they may not lend from their own balance sheet nor hold any funds received from lenders or borrowers on their balance sheet) and cap the aggregate lending exposure of lenders and aggregate loans obtained by borrowers at Rs 1 million (about US$15,000). Both retail and institutional investors are permitted to participate on P2P lending platforms, although investors must be Indian nationals or companies incorporated in India. Since the introduction of the regulations, 11 companies have registered with the RBI as NBFC-P2Ps, although it is estimated that about 30 P2P lenders were in operation before the regulations were introduced. It is expected, however, that the regulations will facilitate sustainable growth of the market segment. Overall 74 percent of the total volume of alternative finance (debt-based, equity-based, and noninvestment solutions) in 2017 came from institutional investors (figure B4.3.2). Figure B4.3.2 Funding Volume from Institutional Investors, by Key Countries 2017, US$ billions (Asia-Pacific countries, excluding China) 120 100 35% 80 60 90% 40 65% 20 26% 74% 81% 39% 0 10% 19% 61% Australia Korea, Republic India Singapore Indonesia Institutional volume Noninstitutional volume Source: World Bank elaboration based on CCAF 2018a; Perkins 2018; Reserve Bank of India 2017; and Reserve Bank of India list of NBFC- P2Ps registered with the RBI, as of March 27, 2019. Overall, World Bank experience in the field and SME loan funds the empirical research conducted indicate that this solution could be viable in many EMDEs. SME loan funds are credit funds that invest in As with invoice platforms, the empirical research SME loans. There are two main types of SME loan conducted suggests that growth is not associated funds: participating and originating funds.32 with the wealth of countries. Further, no correlation was found with stock market capitalization, Loan participating funds are allowed to acquire although the research did find a correlation with and restructure partially or entirely existing credit penetration and respect for the rule of law. loans originated by banks and other institutions, That said, experience indicates that other issues obtaining the loans either directly from the lender or might need to be tackled, including the need for on secondary markets where such loans are traded. an appropriate legal and regulatory framework for However, according to their investment strategy lending platforms and potentially also reforms to they are not allowed to grant loans. Thus, they are the investment regime of institutional investors. closer to an SME loan securitization and, arguably, an indirect mechanism for SME financing. 30 SECTION 4: Direct Mechanisms For Sme Financing In contrast, loan originating funds originate recent and in some cases has required changes to SME loans themselves instead of purchasing laws and regulations. Interest for this type of fund them from a bank, thus the fund manager is involved was triggered by the global financial crisis and the in selecting, analyzing, and monitoring individual subsequent bank retrenchment in SME lending. investments. Different from loan participating Currently, many European countries allow this funds, specialized funds typically cater to SMEs type of fund, but they are also available in other that are not able to access bank financing or may jurisdictions, such as Australia; Canada; Hong have financing needs that are greater than what they Kong SAR; China; and Singapore. In general, loan can access through banks. Here the fund manager participating funds are more common. Further, plays a critical role in originating and monitoring in the locations where loan originating funds are the asset portfolio; thus the manager must have permitted, a more restrictive regulatory framework specialized expertise (in, for example, credit risk has been put in place, including in regard to the type analysis), as well as ability to service the underlying of investors that can be targeted (only professionals, assets. These funds are a true direct mechanism for for example).34 SME financing. These funds exhibit a higher risk profile than For most AEs, SME loan funds are a relatively more traditional mutual funds do. Because of new asset class and thus still of limited size, but the lack of liquidity of the underlying assets, they interest in them has been growing (box 4.4). In are usually structured as close-end funds, although the United States a special type of SME loan fund, they may provide redemption at intervals. Many the business development company, was created in are also leveraged. As indicated previously, in the 1980s precisely to assist in SME financing. In many countries these funds are available only to Europe the phenomenon of SME loan funds is more sophisticated investors. Box 4.4: Selected experiences with SME loan funds United States Business development companies (BDCs) are a category of closed-end investment company under the Investment Company Act of 1940. BDCs came into being in 1980 as part of a congressional effort to jumpstart investment in small businesses, which triggered the enactment of the Small Business Investment Incentive Act of 1980 (the 1980 amendments). BDCs focus on making loans to private small and mid-sized companies. BDCs are attractive to investors because of the yields they offer, which are materially above yields offered by traditional closed-end funds. BDCs are also attractive to investors wishing to diversify their interest rate exposure. In addition to funding, BDCs are required to offer managerial assistance to their borrowers and many times may attend the board meetings for their borrowers or have outright seats on the board. The majority of BDCs outsource this function to external managers. BDCs with access to an origination platform are at the forefront of the shift away from banks. The closer relationship helps reduce credit risk for the BDC and can generate additional fee income—on top of the coupon amount—as well as a potential discount on the loan. Banks have not completely abandoned this market segment, though. They often finance the BDCs, which in turn lend to small and mid-sized private companies. This means BDCs are able to borrow from banks at relatively low costs—especially in the case of BDCs with investment-grade credit ratings—while lending at higher rates. BDCs without an origination platform purchase their assets either in the secondary market or from other lenders. Being further from the point of origination reduces the amount of fee income as well as any potential loan discounts. BDCs usually elect to be treated as regulated investment companies, meaning they bypass corporate income taxes as long as they distribute at least 90 percent of their taxable annual net income to shareholders. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 31 Most BDCs are publicly listed and traded companies accessible to both retail and institutional investors. BDCs typically charge two types of performance fees, based on capital gains and on income. BDCs file annual and quarterly reports with the U.S. Securities and Exchange Commission that include a detailed schedule of investments and a discussion of the results. Some BDCs also host quarterly conference calls, file 8-Ks, and issue intraquarter press releases or publish regular newsletters with updates on industry trends and the performance of their portfolio. Certain BDCs are subject to less stringent disclosure and audit requirements under the JOBS Act. France In 2013 the French government unveiled a new initiative to kickstart lending for small and medium enterprises (SMEs) via loan originating funds (fonds de prêts á l’économie), with the backing of the NOVO Fund. The NOVO fund was designed by the Caisse des Dépôts (CDC) with the support of the Fédération Française des Sociétés d’Assurance. It is a €1 billion fund, in which 18 insurance companies and three pension funds participate as investors. The target of the fund was midsize companies with an average of €400 million in sales. The average loan was €30 million. The initial target was for 30 to 40 projects to be funded over 10 years. As of 2016 all the money had been lent to 45 small and midsize companies. As a result, an additional tranche of €405 million was opened in 2016, backed by most of the initial investors. The NOVI Fund was launched by CDC in 2015, targeting smaller companies: companies with sales in the range of €30 million to €200 million. NOVI received backing from 23 institutional investors committing an initial €535 million. The investors included 19 insurance companies as well a retirement schemes, alongside CDC. The fund offered financing between €3 million to €30 million to target companies. NOVI distributes annual revenues, bringing yield to institutional investors from interest payments received on loans and dividends on equity investment. Similar funds have followed suit. For example, in 2016 the PME Emplois Durables (SME Sustainable Jobs) Fund was launched. This €210 million fund is sponsored by the insurers and the social protection groups AG2R La Mondiale and Klesia, with the support of the French Employers Movement (MEDEF) and state backing. Similar to NOVI, PME also targets small companies financing through a mix of debt and equity, but PME Emplois Durables has a wider risk spectrum. PME targets smaller companies (from 15 to 500 employees) through average investments of €2 million (in a range of €250,000 to €5 million). At the other end of the risk spectrum, PME will also invest in a fixed-income fund of listed bonds, to ensure liquidity. A key characteristic of these funds is that they were designed and overseen by a group of institutional investors who went after the asset managers for mandates, instead of having funds designed by asset managers who then would go after investors. Certain legal reforms were needed to enable this solution to take off. First, until recently lending was an activity reserved for banks and credit institutions, as per articles 511-5 of the French Monetary and Financial Code. Second, most institutional investors were not allowed to own such SME loans, because French regulations prohibited them from investing in unrated bonds or fixed-income securities. These obstacles were addressed by Decree 2013-717, which loosened such restrictions to open the way for new SME loan funds, labeled “funds for loans supporting the economy.” This decree also changed the French Insurance Code to allow insurers to lend money to small companies regardless of credit rating and to allocate up to 5 percent of their assets to such vehicles. This decree was followed by another one, the Decree of 2014, which expanded the type of assets in which these funds could invest to include holding companies, infrastructure projects, real estate development, or even credit enterprise commercial paper. Investment rules were also relaxed so that a range of investors could support these funds, including mutual companies, social protection groups and their satellites, welfare institutions, and complementary retirement institutions. Source: World Bank elaboration with information from Morrison & Foerster LLP 2018 and IOSCO 2017 for the United States, and Pouzin 2014, 2015, 2016, and Rust 2016 for France. 32 SECTION 4: Direct Mechanisms For Sme Financing Overall, World Bank experience suggests that this In practice, the imposition of such disclosure solution requires a certain level of development and reporting obligations has had consequences of the capital markets. As with receivables funds, for SMEs’ use of the public markets. Disclosure the emergence of SME loan funds seems to require and reporting requirements entail costs to that the mutual fund industry achieve a certain level companies, costs that are justified by the need to of development. Furthermore, it requires a higher ensure that investors have sufficient information to level of sophistication of fund managers, or at make informed decisions. In practice, those costs least fund managers with a skill set similar to that naturally establish a cut-off size for issuances as of credit officers. Alternatively, it would require well as for companies that can access the public that fund managers establish arrangements with markets. In general these requirements and the costs third parties that could conduct the due diligence associated with them leave the majority of SMEs of SME businesses while retaining sufficient out of the public markets because most SMEs are capacity to oversee these third-party providers. not prepared to provide the information needed, or Beyond that, other issues would likely need to be if they had the information, they could not meet tackled, in particular the fact that in many cases the the costs or find them to be too high relative to the regulations for mutual funds have not considered small size of their issuances. loans as an eligible asset class. In addition, a robust regulation for this type of funds would be needed, Increasingly countries are looking at which among others should tackle issues such as mechanisms to ease SME access to the market. leverage. Similar to other solutions, the investment On one hand, countries are reviewing the “space” regulations of institutional investors might also for private offerings and linking trading platforms need to be reviewed. to them. On the other hand, they are also reviewing the requirements for public offerings and making adjustments to them, as will be explained. Bond-based solutions In general, companies that want to raise debt Minibonds financing from the public via bonds are subject to a series of disclosure obligations aimed at eliminating In this report minibonds refer to debt securities the information asymmetries between investors issued by SMEs in the capital markets. This and the companies that seek to raise funding definition is intentionally broad, to cover different from them. Because investors bear the risk of their ways in which these minibonds can be offered investment, the role of securities markets regulation to investors, from pure private offers to hybrid is to ensure that they have sufficient information regimes, as further discussed in this section. to assess the risks of the companies they invest in. They do so by imposing disclosure obligations on In both AEs and EMDEs, companies have been such companies that mainly relate to the submission able to raise funding on a limited basis via of a prospectus at the moment of the offering and of debt issuances that are placed through private certain information on a periodic and ongoing basis, offerings. Each country has its own definition of including financial statements and material events. In what constitutes a private offering. In general, tandem, the intervention of the regulator is required factors such as the amount raised and the number in the form of an ex ante authorization of the offering and the type of investors that are targeted are used materials (mainly the prospectus) along with ongoing in many countries to delimitate a public offering monitoring, both aimed at ensuring that companies versus a private offering. Thus, a private offering provide complete, accurate, and timely information to should not exceed a maximum amount of money investors. Finally, through their enforcement powers, and/or a maximum number of retail investors as securities regulators seek to ensure that companies defined in the legislation or should target only comply with such obligations. sophisticated investors. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 33 Private offerings can ease SME access to the offerings (including private offerings of equity and capital markets. The key benefit of private mutual funds). Examples of this type of platforms offerings/placements for SMEs is that they enable can be found in AEs.36 the SMEs to raise funding from investors without triggering the requirements of a public offering— In addition, in some countries, SME bond thus reducing costs and time to come to market platforms have been created to provide an because in most countries a private offering does organized secondary market for SME issuances not trigger disclosure requirements nor a review (minibonds) that have been privately placed. by the securities regulator. However, the issuance Examples of this type of market can be found in Italy needs to be confined to the conditions for the and Spain.37 At least in the case of Italy changes to private offering. the legal and regulatory framework were necessary to facilitate the issuance of minibonds by SMEs (see From an investor perspective, private issuance box 4.5). In both cases, the platforms are open only represents an attractive instrument that can to professional investors and as a result can keep offer yield. In general, bonds offered privately lower disclosure requirements than those imposed usually entail higher interest rates, including an in the official markets. In both cases the platforms illiquidity premium. In addition, they provide asset show a steady increase in the number of companies diversification and long-term asset matching to that have registered issuances, but their impact institutional investors. is still limited. The evidence so far indicates that these offerings entail higher credit risk than those In practice, large private placement markets in the main markets, and their liquidity is limited. exist mainly in AEs and have catered mainly Few EMDEs have SME bond trading platforms to larger companies. The United States has the associated with bonds issued privately. One largest private market, catering to both domestic country that does is Korea, which in 2012 created and foreign companies. A key feature of the U.S. the Qualified Institutional Buyer system to expand private market is the high level of standardization opportunities for SMEs; however, its impact is still that it has achieved, compared with other private limited (IOSCO 2015). placement markets. There are also large private markets in Germany (the Schuldschein market) and The other route taken by countries to ease the more recently the Euro PPP in France. Overall, the direct access to market for SMEs is the creation of companies that use these markets are medium to proportionate regimes within the public offering large in size, given that this is essentially a market space. These regimes make it easier for SMEs to of institutional investors.35 Some private offerings issue bonds (minibonds) that can be marketed take place in EMDEs, but, except for China, large to retail investors. Here also the requirements private markets anchored in the participation are scaled down to make them proportionate to of institutional investors and with standardized the nature (SME) of the company; although the information have not developed in EMDEs. requirements are greater than those in markets that are open only to professional investors. The However, different developments are affecting reductions vary from country to country but usually the private markets. One such development is the include fewer years of financial information in the use of electronic platforms to connect companies prospectus and less frequent periodic reporting. This and investors in the private placement space. type of regime exists, for example, in the United These platforms are increasing the visibility of States, for growth companies (for both equity and private deals and streamlining the investment and debt) and in Argentina and Peru for SMEs (for both closing processes for all parties. The platforms are equity and debt). In addition, through the recent not exclusive for the placement of bonds; rather reform to the Prospectus Directive (and the Market in many cases they facilitate all types of private Abuse Directive) the EU paved the way for a more 34 SECTION 4: Direct Mechanisms For Sme Financing proportionate regime for the public offering of This solution seems to be most relevant for securities (both equity and debt) by SMEs across EMDEs where a corporate bond market all Europe. already exists. Minibonds require the same type of infrastructure that is needed for securities Likewise, some countries are developing offerings in the main market, from a trading specialized secondary markets in which these platform to securities market intermediaries that minibonds can be traded. Examples of specialized can support the issuances, including brokers SME bond platforms open to retail investors exist, for and information service providers (auditors and example, in France, Germany, Peru, and the United credit rating agencies). In addition, as previously Kingdom.38 Although these experiences are recent, explained, minibonds have a higher risk profile there are already some lessons learned from recent than bonds issued by companies listed on the main failures, in particular from the demise of the bondm market; therefore, they require a certain level of segment of the Stuttgart Stock Exchange dedicated sophistication of the investors. Depending on how to minibonds.39 While many factors played a role, the regulations for minibonds are set up, changes it is said that the branding of the bondm segment in the investment regulations for institutional using the term mittlestand, which has a very positive investors would be needed to allow them to invest connotation in Germany, may have misled investors in securities of private offerings. Finally, other regarding the risk involved in these issuances. Thus, factors would play a role in the scalability of the one of the lessons relates to the need to ensure that instrument, including, for example, the availability retail investors understand well the nature of these of programs to prepare companies to participate. offerings, and in particular that as an asset class minibonds have higher credit risk than bonds issued by companies in the main market, even though the SME bond funds return might be more attractive. Further, even in SME bond funds are specialized funds that cases in which a platform has been set up, these invest in bonds issued by SMEs. Like other instruments tend to be illiquid. Thus, it is critical that credit funds, they are usually structured as closed- offering documents provide a clear and truthful view end funds, sometimes allowing redemptions at of the risks associated with these investments. intervals. In practice, many of these funds are available only to sophisticated investors. It is still early to assess the impact of minibond regimes and, in particular, how much the The main benefit of SME bond funds for reduction of requirements will allow smaller SME financing is the possibility to increase companies to come to market. On the positive the attractiveness of SME issuances to both side, the evidence so far suggests that the issuances institutional and retail investors. For institutional are smaller than the issuances that take place in the investors, the use of a fund addresses the scale main markets. This, in turn, suggests that smaller problem that SME issuances entail for them; that is, SMEs might be able to come to market. However, each individual SME issuance is too small relative overall access still seems to be concentrated in to the assets under management by institutional more formal and organized SMEs, given that there investors. As a result, it is not worth it for them are disclosure requirements associated with these to spend resources conducting the necessary due issuances. Finally, the volumes issued in these diligence to invest in the SMEs. Through the fund, platforms are still limited (see box 4.5). The low institutional investors delegate such due diligence volumes could be the result of several factors, from and obtain a diversified portfolio. The professional challenges related to the pipeline of quality SMEs management and diversification are also important to challenges related to the risk-return appetite of for retail investors. institutional investors, as will be discussed later in this report. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 35 SME bond funds usually cater to larger across many countries in Europe. For example, SMEs that make suitable candidates for bond in Italy a number of funds have been established issuance. Although this SME segment is also the looking to invest in Italian minibonds. Experiences most bankable, bond funds could potentially offer with this type of fund are relatively new in EMDEs this subset of SMEs longer-term and cheaper but can be seen in countries such as Chile and Peru. financing than that available through bank loans. In addition, the more the larger SMEs can access In principle, SME bond funds are more relevant funding through bonds, the more the banks would for EMDEs where corporate bond markets be encouraged to move down market and increase already exhibit certain level of development. All funding to smaller SMEs. the infrastructure necessary for minibonds is also needed to develop these solutions. In addition, SME The use of SME bond funds has increased post- bond funds require that the mutual fund industry crisis. In particular, bond funds are being used has already achieved some level of development. Box 4.5: Selected experiences with SME bond offerings Italy Italy created a specific framework to allow certain small and medium enterprises (SMEs) to issue bonds under streamlined disclosure requirements. The framework was triggered by the financial crisis, whereby Italy saw a retrenchment by banks from lending activities. Thus in 2012, through the “Development Decree,” Italy made important changes to its legal framework to allow unlisted companies to access the capital markets. The framework applies to unlisted Italian companies other than banks above a certain size (at least 10 employees and an annual turnover and/or assets of more than €2 million). Tax benefits apply to both the issuer and the investors. In tandem, other reforms were approved to incentive investors to take up the bonds. • Banks were allowed to structure covered bonds using minibonds. • The decree clarified that corporate bonds and other debt instruments issued in the context of securitization transactions are eligible in terms of assets that (a) can be used by insurance companies as technical reserves and (b) are in line with the investment limits set out for pension funds, even if they are not listed. • Insurance companies may invest up to 3 percent of their reserves in minibonds issued by nonlisted SMEs, in units of funds that invest primarily in those assets, and in securities issued by securitization companies (even without ratings). Funds that invest in minibonds may be beneficiaries of the guarantees provided by the SME central fund. The fund may also give direct guarantees. (The guarantee may apply to both individual transactions to underwrite bonds or similar securities and for portfolios of transactions.) Minibonds may be traded in the ExtraMOT Pro market, a segment of the Borsa Italiana active since 2013 and dedicated to the listing of bonds, commercial paper, and project bonds. The listing is flexible both in terms of admission and disclosure requirements. No formal listing prospectus is required, but an admission document must be prepared. Some other minimum requirements apply, mainly that the issuer must have prepared financial statements for two financial years, the latter being fully audited. Post- issue obligations include the publication of (a) audited financial statements not later than six months after the conclusion of the fiscal year, (b) any information on the issuer that may have impact on the price or value, (c) any changes in the terms and conditions of the instrument or in the rights of bond holders, and (d) technical information concerning the minibonds (information on the calculation of interest and any early redemption of the securities). Some of the first issues were not really minibonds as they were issued by quite large businesses, especially those owned by private equity funds. Some smaller companies began to issue in sizes of €2 million–€20 million. However, few institutional investors were prepared to analyze these small firms. Thus, initiatives to develop funds to invest in minibonds also started to appear. 36 SECTION 4: Direct Mechanisms For Sme Financing As of September 30, 2018, there were 334 issued minibonds for a total value of approximately €16.4 billion. In the Italian minibond market: Issues with face value below €50 million (279) represented approximately 11 percent of the total value issue. • Issues ranging from €50 million–€150 million (17) represented 9 percent of the total. • ost of the total value issues originated from a handful (38) of issues characterized by large face values • M (more than €150 million each). Figure B4.5.1: Italian minibond market, 2016–18 Number of Minibond issurance Total value of issued Minibonds in €millions 400 18 350 16 300 14 12 250 10 200 8 150 6 100 4 50 2 0 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 >€150 million €50 million – €150 million €0 – €50 million >€150 million €50 million – €150 million €0 – €50 million For issues lower than €50 million, the key characteristics are average face value of €7 million, with an average coupon of 5.11 percent and average maturity of five years. The issuer average revenues were of approximately €103.1 million. Figure B4.5.2: Italian minibond characteristics, end of September 2018 Face value: Issues not exceeding Maturity: Issues not exceeding €50 million €50 million in face value 6.8% 11.8% 11.1% 33.7% Average Average 16.5% value 65.6% 26.9% maturities €7 million 5 years 27.6% < rather than <=<€5 million €10 million–€20 million <3 years 3–5 years €5 million–€10 million €20 million––€50 million 5–7 years >7 years Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 37 Peru In 2012 the Superintendencia del Mercado de Valores (Securities Commission) created a proportionate regime for public offering by SMEs, which are defined as companies with a maximum S/.200 million (US$70 million) in average annual revenues for the past three years. Companies that wish to use this regime are required to submit a prospectus and a credit rating at the time of the offering (the credit rating is not required if the offer is addressed exclusively to professional investors) and semi-annual reports and material events on an ongoing basis. This proportionate regime is linked to a specialized platform, the Mercado Alternativo de Valores (MAV) developed by the exchange, where these bonds can trade. As of November 2018, 15 companies had bond offerings listed in the MAV, of which 12 had issued short-term paper and bonds for an amount of US$86,7 million in 98 issuances. Although still modest, this amount is already important, when one considers the overall size of the market. One of the key reasons for the relatively limited number of companies in the MAV is the time that has been needed to prepare the companies to come to the market so that they can comply with all the required information previously described. It is estimated that between two and three years are necessary to prepare the companies. The initial issuances in MAV were acquired by retail investors, and there was no institutional investor appetite for these issuances. Thus, in 2013 the HMC Capital Fund was created to trigger institutional investors’ interest in these companies by pooling several small bond issues together. The fund was supported by an International Finance Corporation investment, with plans to invest in local small and mid-size companies with local credit ratings of between AA- and BBB+. Its strategy was to invest mainly, but not exclusively, in companies issuing bonds through the MAV. The fund was expected to have up to US$100 million in capital, with about 15 investments over three years with an average size of US$7 million per investment. In practice, it has been difficult for the fund to gain traction because of the time it has taken for companies to come to market. Source: World Bank elaboration based on data from the MiniBond.it website and information from Latham & Watkins 2014 for Italy and the website of the Superintendencia del Mercado de Valores for Peru. Equity solutions for SMEs’ use of the public equity markets. Governance requirements constitute a tremendous Until recently, capital markets participated in challenge for SMEs. Most SMEs are family owned SME financing mainly through private markets. and lack the governance that outside investors As indicated earlier in this report, VC has been a key require, from a board with independent directors mechanism for equity financing of innovative firms. who are able to exercise effective oversight of However, while in AEs this is a mature industry, in management to a management structure that EMDEs VC is at an earlier stage of development. is supported with robust internal policies and procedures across all activities. Furthermore, The public markets, on the other hand, have not because they are often family owned, many been accessible to SMEs. Companies that want to SMEs are reluctant to open their capital to outside raise equity financing from the public are subject to shareholders and be accountable in their decisions not only disclosure requirements but also corporate to such shareholders. governance obligations, both aimed at protecting investors. Disclosure requirements have a similar That said, increasingly countries are looking at role in equity than in debt—that is, ensuring that mechanisms to ease SME access to equity financing investors have all the necessary information to via the capital markets. In general, two types make their investment decisions. In addition, given of developments are taking place. First, countries the different position that equity investors have are revisiting the definitions of public and private compared with debt investors, corporate governance offerings in an effort to reduce the requirements for obligations are imposed on the companies seeking companies to access the capital markets under specific equity investors to ensure that the company works conditions. Equity crowdfunding is a key example of to the benefit of all its shareholders. such adjustments. Second, countries are developing specialized SME equity exchanges, with the objective In practice, the imposition of disclosure and of fostering the liquidity of SME equity issuances. governance requirements has had consequences 38 SECTION 4: Direct Mechanisms For Sme Financing Venture capital and private equity PE and VC funds usually employ a partnership structure. A fund management company, or Private equity is the umbrella term used to refer general partner (GP), raises capital from a limited to the strategy of investing in private companies number of qualified investors that become limited (or making public companies private). PE is an partners (LPs) of a fund. Typically, LPs consist of asset class in which investors purchase the illiquid pension funds, insurance companies, foundations, equity (or equity-like) securities of operating endowments, high-net-worth individuals, sovereign companies. This equity is not publicly traded but wealth funds, and DFIs. The fund manager receives instead is held in private hands. In exchange for their two types of compensation from the investors. First, capital, PE firms take ownership stakes that range the fund charges a management fee—typically 2 from a concentrated minority to majority ownership percent of the capital in the fund—to cover operating in a company. PE investors typically hold these expenses. Additionally, the GP receives a share of securities for a period of three to seven years with the gains generated on its investments—typically the expectation of generating attractive risk-adjusted 20 percent of profits—which is known as carried financial returns upon exiting the investment. interest. Carried interest seeks to align the incentives of the GP with those of the LP investors in the fund. PE investment encompasses various stages of investment, such as venture capital in early-stage PE and VC funds both provide capital and bring companies, growth equity in more established knowledge and know-how to the companies in companies looking for expansion capital, or buyouts which they invest. Apart from providing financing, in the latter stages of a company’s growth. The skill PE and VC funds typically take a “capital plus” set required to invest in these different stages varies, approach, in that they help the companies in their resulting in different team compositions and ways portfolios to enhance management capacity, improve to assess sound investments and to create value in market focus and presence, strengthen governance, a portfolio. and manage growth. In fact, it is customary that the contracts include provisions whereby the PE/ In EMDEs, private equity investments in early- VC fund takes seats on the company’s board. stage companies or SMEs take place primarily Because of this capital plus approach, PE/VC firms through the VC and growth equity strategies.40 are widely linked to job creation. Still, as will be VC firms are known for investing in early-stage explained later in this report, a paradox is at play companies that are typically riskier in nature than because companies that lack access to these types the investments made by their PE counterparts. VC of skills encounter more difficulties in attracting PE firms usually invest in companies in sectors that are and VC financing in the first place. related to technology or innovation, although they may also back businesses in other sectors. In AEs, While interest in this assets class by domestic VCs also source ideas and build new companies investors in EMDEs is growing, their investments from proprietary networks of proven entrepreneurs. are still limited. As mentioned earlier in this This seeding of investment ideas into the market is report, in both Africa and Latin America domestic less common in EMDEs but will likely become more pension funds have started to invest in PE/VC, common as these markets become more robust. although in most cases, these investments are still Growth equity firms, on the other hand, usually limited. This is particularly the case in Africa, make minority investments in more established where lack of familiarity with the asset class and companies that are looking to expand their business in some cases regulatory restrictions curtail PE/ or move into new markets. The section that follows VC investments (see box 4.6). In other EMDEs, will use the term private equity and venture capital particularly in Latin America, local institutional (PE/VC) broadly to refer to the umbrella strategy of investors’ appetite for PE/VC investment has investing in private companies, and, in particular, varied across EMDES and over time. In Brazil, SMEs in EMDEs. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 39 for example, local pension funds and DFIs had effort to kickstart the industry, develop domestic long played a key role in private capital markets, fund managers, and mobilize other investors. but after facing sharp declines in investment These programs have used different modalities, returns during the 2008 recession, they became including direct investments and co-investments less active in the private capital markets (EMPEA via funds and funds of funds. For many EMDEs, 2018a). The current low-interest-rate environment these programs are relatively new and thus the is nevertheless prompting funds to free up capital track record is still limited. for new commitments to alternative investments. In Mexico, where pension funds (AFORES) Given the limited number of local institutional are permitted to invest only in publicly offered investors that can commit large amounts of securities, the introduction of listed investment capital to PE/VC in EMDEs, DFIs have tended vehicles to facilitate investment in private to dominate the LP landscape. Impact investors equity and other alternative assets contributed to also regularly participate as LPs in EMDEs’ considerable growth in fundraising for Mexico- funds, specifically in funds with social aims. This dedicated PE/VC vehicles.41 impact-investing segment includes philanthropic institutions, corporate and family foundations, In some EMDEs, governments have and high-net-worth individuals. Most of this established programs to invest in VC, in an investment takes place via off-shore PE/VC funds. Box 4.6: Mobilizing institutional investors for SME finance in Africa: The use of private equity/venture capital funds Over the past two decades, private equity (PE) and venture capital (VC) have become an important source of financing for small and medium enterprises (SMEs) in Africa. In 1997, there were 12 PE funds in Africa, focusing mainly on the South African market. By 2016, there were 140 PE funds targeting Africa, with an investment footprint across the continent (figure B4.6.1). Figure B4.6.1: Investments in African SMEs, 2010–17 $6 $5 4.8 4.1 0.7 $4 0.8 0.9 US $ billions $3 2.8 2.5 2.2 2.1 1.9 1.9 $2 0.7 3.0 3.3 0.8 $1 1.8 2.0 1.7 1.5 1.6 $0 2010 2011 2012 2013 2014 2015 2016 2017 Private equity Infrastructure and real assets Private credit Source: EMPEA. Data as of December 31, 2017. Note: Unless otherwise specified, exhibits inclyde Sub-Saharan Africa and North Africa. In other EMPEA reports and data releases, “North Afric” may be included in Middle East and North Africa regional totals. 40 SECTION 4: Direct Mechanisms For Sme Financing Development Finance Institutions (DFIs), such as the International Finance Corporation, the United Kingdom’s CDC Group and the African Development Bank, have traditionally been the main source of institutional capital for Africa-focused PE/VC funds; however, North American and European pension funds, endowments, and asset managers have also become increasingly interested in private equity investments in Africa. Although recent regulatory reforms have sought to encourage greater participation of domestic institutional investors in PE, in particular pension funds, few African pension funds—with the exception of the Government Employees Pension Fund in South Africa—have made significant allocations to PE/VC to date because of a complex set of issues, including lack of familiarity with the asset class. Recent dampened economic growth and exchange rate volatility in Africa’s largest economies led to fundraising decline in 2016 and 2017. However, according to the African Private Equity and Venture Capital Association (AVCA) 2018 limited partner (LP) survey, Africa remains an attractive investment proposition over the long term. Specifically, the AVCA survey noted that 53 percent of LPs plan to increase their PE allocation to Africa over the next three years. Growth equity, venture capital, and direct investing were indicated as the preferred strategies for Africa PE investments, whereas financial services, consumer goods, and agribusiness were cited as key sectors of interest. That LPs highlighted financial services as a sector of interest suggests that expanding financing for smaller, early-stage SMEs is likely to be through indirect investment in SME financiers, particularly because direct PE investment in African firms has traditionally targeted midsize to large corporations. The emergence of tech-enabled start-ups with high growth potential, particularly in Kenya and Nigeria, has nevertheless stimulated the development of VC funds focused on smaller, early-stage ventures. Even as PE/VC funds have become an important vehicle for mobilizing institutional investment for SMEs in Africa, challenges remain. For example, exit opportunities via initial public offerings are severely limited, forcing the development of secondary PE markets, in which exits are made via strategic sales to other PE firms or financial buyers. Additional challenges highlighted by general partners in the AVCA survey include a constrained fundraising environment, scarcity of talent for general partners or portfolio companies, macroeconomic risks, and limited investable opportunities. For limited partners, the main constraints included currency risk, a limited number of established general partners, political risks, relatively long holding periods for portfolio companies, and the small scale of investment opportunities. Source: World Bank elaboration based on information from AVCA 2016, 2018; EMPEA 2015, 2018b. Overall, the global PE/VC industries in EMDEs reasons can be identified for this phenomenon. remain small. Emerging Market Private Equity First, PE is a relatively new financing source in many Association (EMPEA) data show that total PE/VC EMDEs, and investors do not lack opportunities investment in EMDEs amounted to approximately to invest in large and established companies with $75 billion in about 2,500 deals in 2018 (figure lower risk profiles. Second, investing in SMEs is 4.1).42 However, the market for SME PE and VC more challenging than investing in more established in many EMDEs represents a small fraction of the companies because of higher execution risk, overall quantity of fund investment. Figure 4.2 elevated transaction costs, and greater information shows that aggregate investment in ticket sizes barriers. Finally, although the pool of investment $100,000–$3 million represents about 1 percent of management talent in these markets is growing, total PE/VC investments, and is below 20 percent there is a more limited number of professionals in the number of deals. capable of operating PE funds. This means that the overall pool of PE firms remains shallow relative to Overall, the vast majority of PE firms target the potential size of these markets. larger or more established enterprises. Several Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 41 Figure 4.1: Total private equity/venture capital investment in emerging markets and developing economies, 2009–19, first quarter 80,000 74,609 70,000 60,000 55,268 50,000 US$ millions 41,019 38,646 40,000 36,973 32,231 30,476 29,764 30,000 26,845 20,979 20,000 11,368 10,000 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Q1 Total PEVC capital invested (US$ millions) Source: EMPEA (Emerging Markets Private Equity Association). Note: Per EMPEA methodology, this figure includes all African countries, including North Africa; Asia Pacific, excluding Australia, Japan, and New Zealand and including Afghanistan and Pakistan; European Union accession countries (2004); Southeastern Europe (excluding Greece) and Turkey, as well as Russia and other Commonwealth of Independent States countries; Mexico, Central and South America, and the Caribbean (excluding Puerto Rico and other overseas territories and departments); Gulf Cooperation Council countries, Iran, Iraq, Jordan, Lebanon, Palestinian Territories, Syria, and Yemen. PEVC = private equity/venture capital. Figure 4.2: Percentage of private equity/venture capital investment in SMEs in emerging markets and development economies (ticket size = $100,000– $3 million) 25 19.4 19.8 20 18.3 16.9 17.6 16.4 15.4 14.9 15 Percentage 13.4 12.3 11.1 10 5 1.0 1.0 1.4 1.4 0.9 1.1 0.8 0.8 0.7 0.9 0.7 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Q1 % of number of deals that are ticket size $100k - $3mn % of amount invested in $100k - $3mn deals Source: EMPEA (Emerging Markets Private Equity Association). Note: Per EMPEA methodology, this figure includes all African countries, including North Africa; Asia Pacific, excluding Australia, Japan, and New Zealand and including Afghanistan and Pakistan; European Union accession countries (2004); Southeastern Europe (excluding Greece) and Turkey, as well as Russia and other Commonwealth of Independent States countries; Mexico, Central and South America, and the Caribbean (excluding Puerto Rico and other overseas territories and departments); Gulf Cooperation Council countries, Iran, Iraq, Jordan, Lebanon, Palestinian Territories, Syria, and Yemen. 42 SECTION 4: Direct Mechanisms For Sme Financing Equity crowdfunding Equity crowdfunding provides retail investors access to an asset class (early-stage companies) For purposes of this report equity, equity that in the past was restricted to sophisticated crowdfunding is defined as electronic platforms investors. Previously, the main vehicle to invest in that allow companies to raise equity or equity- start-ups was VC funds, to which only institutional like funding directly from investors. In general, and high-net-worth individuals had access. Retail the platforms act as conduits, putting together investors were mostly confined to the public investors and companies in need of resources. markets, which in most countries target companies The platforms are obliged, however, to conduct that have a track record and are already profitable. due diligence on the companies that want to raise capital through them, in order to ensure that the In practice, two main models of equity companies do exist and that the information they crowdfunding have appeared. In one, called provide to investors is true, thus mitigating the company-led crowdfunding, the company sets risk of fraud. the terms and conditions for the participation of investors, including the valuation of the company. From a company’s perspective the key benefit In this case the due diligence that investors can of equity crowdfunding is the possibility to conduct is limited. In the other, called investor- raise capital from retail investors, with much led crowdfunding, a syndicate of investors invests lower requirements than what is required in the in the company led by a lead investor, which public markets. While frameworks differ, in most is usually an angel investor or a person with countries companies need to provide only some expertise in this type of investment. The lead basic information about their business or project to investor engages with the company on behalf of the platform, and such information is not subject the syndicate, conducts enhanced due diligence, to review by the regulator. Periodic and ongoing and negotiates the terms and conditions for the requirements are also limited. Given the more investment. The negotiated terms then apply to all limited disclosure and regulatory intervention, the investors in the syndicate (that is, all investors limits are usually imposed on the amount of invest under the same class of shares and at the money that companies can raise through these same price per share as the lead investor). It is platforms and the maximum amount that investors common that investors will pay a carry on their can invest through them. profits to the lead investor for playing that role, similar to what is paid to a GP in a VC fund. In many countries the possibility of raising funding through equity platforms is open to any Available data indicate that equity SMEs. However, in practice the platforms are crowdfunding is also growing, although at a being used by early-stage companies that still slower pace than lending or even receivables- do not have a track record. In addition to ordinary based platforms. From 2013 to 2017, equity equity, other types of equity-like instruments, raised via crowdfunding grew from $0.2 billion to such as preferential shares (stocks that offer $1.3 billion. Of this amount, 19 percent was raised limited voting rights) and convertible bonds, in EMDEs. Although China was responsible for are being used by companies to access capital. most of that amount, other EMDEs—India, Korea, From the SME perspective, the latter two types Malaysia, Brazil, the United Arab Emirates, and of instruments offer the advantage of limiting Indonesia—also made the top 20 countries by investors’ participation in company decisions. total volume (see table 2.3, equity crowdfunding). (See box 4.7.) Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 43 Box 4.7: Selected experiences with equity crowdfunding Brazil Equity crowdfunding platforms (ECPs) have become increasingly important for small and medium enterprises (SMEs) looking to raise venture capital in Brazil. In the past three years, the number of ECPs has more than doubled, from 4 in 2016 to 14 in 2018, while the total amount of funding raised via ECPs increased substantially from R$8.3 million (US$2.0 million) in 2016 to R$46.0 million (US$12.0 million) in 2018 (figure B4.7.1). Figure B4.7.1: Equity crowfunding in Brazil, 2016-18 Number of platforms Amount of the offers +250% 14 Target amount R$ 58.992.856 Total amount raised R$ 46.006.340 +180% +25% 5 4 R$ 20.064.000 R$ 17.954.928 R$ 8.342.924 R$ 12.836.000 2016 2017 2018 2016 2017 2018 The recent surge in equity crowdfunding appears to be driven mainly by the new Investment Crowdfunding Regulations (Regulation 588/2017) introduced by the Securities and Exchange Commission (Comissão de Valores Mobiliários, CVM) in July 2017. Important requirements under Regulation 588/2017 include • ECPs must legally incorporate in Brazil, register with the CVM, and obtain an authorization to conduct equity crowdfunding business. • ECPs are required to comply with obligations related to transparency, technological infrastructure, entrepreneurial know-how, and investor redress mechanisms. • Companies incorporated in Brazil and with an annual turnover of less than R$10.0 million (US$2.5 million) are eligible to raise capital through ECPs. • Public offerings not registered with the CVM are limited to R$5.0 million (US$1.3 million) for a period of 180 days. • Nonaccredited investors with annual income or total net worth of less than R$100,000 (US$25,000) can invest up to R$10,000 (US$2,500) per year via ECPs. Lead or accredited investors, and nonaccredited investors with annual income or total net worth of more than R$100,000 can invest up to the lower of 10 percent of their annual income or total net worth. • Investment syndicates, or groups of investors, may be created for the purpose of investing in start-ups via ECPs. Each syndicate must be led by a qualified lead investor and is permitted to invest in only one public offering. A key outcome of the new regulations has been a marked increase in the success rate of ECP offerings—from 24 percent in 2016 to 82 percent in 2018—suggesting an improvement in the quality of companies coming to market as well as in the due diligence undertaken by ECPs (see figure B4.7.2, panel a). Moreover, as shown in figure B4.7.2, panel b, the number of investors in ECP offerings has increased between 2016 and 2018, indicating a growing interest in ECPs from both retail and institutional investors. Malaysia ECPs dominate the online alternative finance market in Malaysia, unlike in other countries where debt-based lending and noninvestment crowdfunding platforms remain the most popular alternative finance platforms. Between 2013 and 2017, the volume of funding raised on Malaysian ECPs increased significantly from US$0.06 million in 2013 to US$7.96 million in 2017, accounting for 50 percent of the volume of Malaysia’s online alternative market in 2017. 44 SECTION 4: Direct Mechanisms For Sme Financing Figure B4.7.2: Investors in equity crowfunding in Brazil, 2016-18 Number of offers Number of investors 120 8.966 +715% 98 100 +263% 80 55 56 +124% 60 46 2.467 40 1.099 24 22 20 82%* 24%* 40%* 0 2016 2017 2018 2016 2017 2018 Offers launched Successful offers As in Brazil, the rapid growth and increasing dominance of ECPs in Malaysia can be largely attributed to the conducive regulatory environment created by the Securities Commission (SC). In December 2015, the SC issued Guidelines on Recognized Markets (revised in 2019), which set out the requirements and obligations of recognized market operators. According to the guidelines, a recognized market is defined as an alternative trading venue, marketplace or facility that brings together purchasers and sellers of capital market products. Under the guidelines, recognized markets, including ECPs and P2P lending platforms, are subject to less stringent requirements than approved markets (that is, stock exchanges) and are regulated under a risk- based approach. In particular, chapter 13 of the guidelines spells out the requirements for ECP operators, investors, and issuers. The guidelines also allow for innovative investment activities, such as the offer of Islamic or Sharia-compliant instruments and the hosting of microfunds. Important provisions include • An ECP operator must be locally incorporated and is permitted to invest in the shares of issuers hosted on its platform, provided its shareholding does not exceed 30 percent and it makes disclosure of such shareholdings to the public. • ECP operators are responsible for conducting due diligence on prospective issuers on their platforms, including taking reasonable steps to conduct background checks and verify the business proposition of the issuer. • Only locally incorporated private companies or limited liability partnerships are permitted to raise funding via ECPs. Microfunds managed by registered venture capital companies may also be hosted by ECPs, provided they raise funding only from sophisticated and angel investors, and they have a specific investment objective. • Issuers may not be hosted concurrently on multiple ECPs but may be hosted on an ECP and a P2P lending platform, at the same time, subject to disclosure requirements. • An issuer that is not a microfund may raise up to RM3 million (US$750,000) within a 12-month period and may only use ECPs to raise a maximum of RM5 million (US$1.25 million). • Retail investors may invest up to RM5,000 (US$1,250) per issuer, up to a total of RM50,000 (US$12,5000), within a 12-month period. • Angel investors may invest up to RM500,000 (US$125,000) within a 12-month period. There are no investment restrictions for sophisticated investors (venture capital and private equity corporations registered with the SC). The SC has since registered seven ECP operators in Malaysia, which have provided a much-needed avenue for microenterprises and SMEs to raise early stage financing from a wide base of investors. In particular, 49 percent of funding raised via ECPs were for amounts below RM500,000 (US$125,000), suggesting mainly startup and small companies are raising funds through ECPs. Retail investors made up 56 percent of the investor base. Sources: World Bank elaboration based on CVM 2019 for Brazil and CCAF 2018a, and Securities Commission of Malaysia 2019a and 2019b for Malaysia. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 45 Overall, World Bank experience and the offering and, as a result, the disclosure requirements empirical research conducted suggest that equity are further reduced. In such scenarios, the exchanges crowdfunding might face more challenges for its are usually not open to retail investors.43 growth in EMDEs than other platforms analyzed in this report. It is still early to offer definitive As of 2018, there were 37 exchanges classified conclusions, but the slower pace of growth of equity as SME equity exchanges or alternative equity crowdfunding platforms seems to reflect a reluctance markets globally, with 25 of them in EMDEs, from companies to open to outside investors as well listing over 7,000 companies (World Federation as the higher level of risk that this type of investment of Exchanges database) (figure 4.3). In spite of the represents for investors. As indicated, the former relatively large number of SME equity exchanges, concern could be mitigated through the use of the bulk of listings are concentrated in a few instruments different from ordinary shares (such as exchanges. Of the top 10 SME exchanges measured preferential shares or convertible debt). The latter by market capitalization, 7 are located in six AEs, concern could be partially mitigated though the use while the remaining 3 are located in two EMDEs— of the investor-led crowdfunding model. However, China (which has two SME exchanges, ChiNext the fact remains that in practice these investments and the Growth Enterprises Market) and Romania.44 are much riskier than investments in shares of public Most of the listings and market capitalization are companies, because they are investments in start-up concentrated in the Asia-Pacific region. companies, which have greater risk of failure; thus, investors need to be prepared to lose all their capital. In most cases, the SME exchanges operate Further, even if the companies do not fail, returns as a second board within the structure of a may take years to materialize. Finally, the empirical traditional exchange. In only a very few cases are research conducted suggests that equity crowdfunding there stand-alone SME exchanges. The definition is associated with stock market capitalization, which of SMEs used by these exchanges varies. In some means that it is more likely to appear in countries cases, the criteria used include variables such as the where the equity markets are more developed. In any revenues/number of employees of the company, event, experience indicates that other issues would whereas in others the market capitalization is used. also need to be tackled, including the need for a legal In some cases, the exchanges target specific SMEs, and regulatory framework for equity crowdfunding. such as high-growth or innovative SMEs. In general SME exchanges are significantly Equity issuances and specialized smaller than traditional exchanges, both in terms SME markets of market capitalization and the number of listings. Over the past 10 years, many countries have A 2018 report by the World Federation of Exchanges sought to develop specialized SME exchanges, (WFE 2018) based on information from 33 exchanges based on proportionate requirements, on which showed that in two-thirds of the markets covered, the SME equity offerings could be listed and traded. capitalization of the SME board is less than 1 percent Such exchanges seek to alleviate the burden and of the total market capitalization of the main exchange. cost of regulatory compliance that may deter SMEs Seven SME exchanges had a market capitalization from listing. The proportionality principle usually of between 1 and 5 percent, and the remaining five applies to performance, disclosure, and governance exchanges had a ratio of 15–30 percent. In 50 percent requirements. How far these requirements are of the SME exchanges, the number of listed companies reduced depends on the branding and positioning of in the SME exchange was 10 percent or less of the the exchange, including the type of investors to which total listed on the main exchange. In seven markets, it caters. For example, some SME exchanges allow it was over 30 percent. These numbers illustrate the companies to list by introduction, whereby their potential difficulty in developing an SME exchange listing does not need to be associated with a public where a strong main market does not exist. 46 SECTION 4: Direct Mechanisms For Sme Financing Figure 4.3: SME exchanges There are 37 alternative SME stock markets around the world... ...with 7,064 listed companies... Number of SME stock exchanges by region in 2017 Number of listed SMEs by region in 2017 25 4,500 4,060 21 4,000 20 3,500 3,000 15 13 2,500 2,006 2,000 10 1,500 998 5 1,000 3 500 0 0 Americas Asia-Pacific Europe-Middle Americas Asia-Pacific Europe-Middle East-Africa East-Africa ... and a capitalization of US$1,385 million, 91% of which ...and a value traded of US$3,769 million, once again mostly from Asian-Pacific markets... explained (99%) by Asian-Pacific markets... SME stock market capitalization (US$ bill.) by region in 2017 SME stock value traded (US$ bill.) by region in 2017 1,400 4,000 1,265 3,734.1 1,200 3,500 3,000 1,000 2,500 800 2,000 600 1,500 400 1,000 200 500 41.3 78.3 17.8 18.5 0 0 Americas Asia-Pacific Europe-Middle Americas Asia-Pacific Europe-Middle East-Africa East-Africa However, the turnover ratio indicates that these markets display low liquidity, ...and the volume of capital raised remains low. with the exception of ChiNext (China) and Kasdaq (korea)... SME turnover ratio by region in 2017 Capital raised by SMEs (US$ bill.) by region in 2017 3.5 35 2.95 31.8 3.0 30 2.5 25 2.0 20 1.5 15 1.0 10 0.43 4.9 5.0 0.5 0.24 5 0.0 0 Americas Asia-Pacific Europe-Middle Americas Asia-Pacific Europe-Middle East-Africa East-Africa Source: World Bank elaboration based on World Federation of Exchanges data. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 47 SME equity exchanges face several challenges. accept the limited liquidity of these issuances; The first is the availability of a pipeline of however, even then some level of liquidity SMEs that are able and willing to comply is necessary. Exchanges are trying different with the listing requirements. In practice, some approaches to increase liquidity, from auctions exchanges, such as AIM (United Kingdom) and to market makers. For example, some exchanges, Warsaw Stock Exchange New Connect (Poland) such as BIST and Bovespa Mais (Brazil), in AEs and JSE Security Exchange’s AltX (South encourage market making via incentives, while Africa), GreTai (Taiwan, China), and BIST a few SME exchanges such as New Connect and (Turkey) in EMDEs, have made use of specialized the NSE Emerge (India) impose market makers as intermediaries (advisers or sponsors) to support a requirement to list. Nevertheless, the existence SMEs. The advisers or sponsors are in charge of of market makers has not guaranteed liquidity; at vetting the issuers and supporting their ongoing best it has provided the market with a reference compliance with listing requirements; thus they price and an exit mechanism for small investors. provide comfort to investors about the quality of the issuers. The intermediaries are licensed by Lack of research about the companies is the the exchange, the regulatory authority, or both. third key challenge. Very little research coverage In most cases, they are securities intermediaries is available for listed SMEs, because research (broker dealers), although in some cases, such as analysts do not find it commercially profitable New Connect, the category has been expanded to cover them. This in turn affects the visibility to cover other entities, such as legal firms and of these firms within the securities intermediary auditing firms. In practice, reputational risk has community, and ultimately their attractiveness not been enough to ensure the quality of the work to investors. As a result, some exchanges pay of sponsors; rather, the existence of a robust or subsidize research for a period of time. For supervisory and enforcement program has proved example, NSE Emerge pays for research on all to be critical. The use of advisers may be more SMEs for a two-year period and Bovespa Mais difficult for smaller EMDEs, whose SMEs are subsidizes it also for a two-year period. smaller and require a low-cost structure and whose advisers are less established. In these cases, it is In many countries, particularly in EMDEs, the critical then that the exchanges perform the role sustainability of the SME exchange itself is an of screening SMEs for the benefit of investors. ongoing concern. In many, if not most, countries However, it is not clear whether the exchanges in the success of these exchanges has been limited at EMDEs have the capacity to do so. best, in terms of the number of listings, the capital raised, and their role as a feeder of companies to A second key challenge relates to liquidity. the main exchange. The struggle is due both to Secondary market liquidity on an SME the nature of the issuers themselves, which even exchange is typically much lower than on the under proportionate requirements find it difficult main exchange or market. This situation is a result and costly to comply with listing requirements, of the characteristics of SME issuances, which and the lack of an investor base to support are far smaller and often riskier than those in the them, because these types of issuances have not main markets. This also makes them less attractive attracted institutional investors and thus have an to certain classes of investors, particularly investor base mostly composed of high-net-worth institutional and foreign investors. Therefore, the individuals. Therefore, many SME exchanges, investor base in SME issuances has been mostly particularly in EMDEs, need to be subsidized by composed of high-net-worth individuals, and thus the main exchange. In countries where the main usually has been of limited size. To some extent, exchange already struggles, the need to subsidize investors who invest in SME exchanges need to the second board becomes a bigger challenge. 48 SECTION 4: Direct Mechanisms For Sme Financing Box 4.8: SME equity exchanges: New Connect New Connect is a multilateral trading facility that caters to smaller companies in Poland. As of the first quarter of 2017, there were 400 domestic companies and 7 foreign companies listed in New Connect for a market capitalization of about €2.3 billion. In 2016, there were 16 new listings in New Connect, though the number of new listings has been declining. Roughly half of the new listings on the Warsaw Stock Exchange (WSE) are companies that graduated from New Connect. New Connect has benefitted from a number of factors, including a dynamic SME base and a large and knowledgeable investor base composed of individual investors. Most of the companies in New Connect issue their shares via private placements to no more than 149 investors. Issuers are required to sign a contract with an authorized adviser, whose function is essentially to ensure issuers’ compliance with their obligations. New Connect considers its well-regulated authorized advisers a key to its success. Disclosure requirements in New Connect are less onerous than those of the main market. However, over time changes have been implemented to strengthen the quality of information available to investors. For example, in 2015 the WSE incorporated the obligation for issuers to submit annual audited financial statements and expanded the list of events covered by the obligation to submit current reports. In tandem, requirements for authorized advisers have been strengthened, with the inclusion of the requirement for authorized advisers to have employees with the status of certified adviser (granted following an examination offered by WSE). In addition, the period of mandatory relations between issuers and authorized advisers was extended from one to three years after listing. This more rigorous regulatory approach has been complemented with a reorganization of the New Connect market, which provides potential investors with a clearer view of the risks of different companies. Under New Connect 2.0, issuers have been divided in three segments: NC Lead, NC High Liquidity Risk, and NC Super High Liquidity Risk. The WSE has implemented measures aimed at improving the liquidity of New Connect, including the requirement that new issuers have a market marker for the first three years of listing. In practice, liquidity remains a challenge, but this requirement has at least ensured that a price reference exists. Individual investors make up the bulk of trading in New Connect, and participation by foreign investors is limited. As of the first quarter of 2017, individual investors represented 77 percent, institutional investors were 16 percent, and foreign investors were 7 percent of the turnover (table B4.8.1). Table B4.8.1: New Connect data, 2014–17 New Connect 2017 2016 2015 2014 Number of listed companies at end of the year 408 406 418 431 Total market capitalization at end of the year (million ZI) 9,616 9,457.94 8,416.54 8,752.35 Market capitalization of the top 10 listed companies at end 2,567.87 2,718.23 2,252.54 2,327.97 of the year (million ZI) Number of new listings during the year 19 16 18 22 Value of new listings during the year (thousands ZI) 155,758,329 40,919,201.96 78,463,015.46 117,305,195.89 Annual turnover (thousands ZI) 1,321,479 1,197,396.40 1,705,753.06 1,219,939.22 Annual turnover of top 10 listed companies (thousands ZI) 492,019 455,597.89 709,440.34 462,497.08 Average daily trading volume (number of shares traded) 10,960,280 13,815,726 15,665,424 9,296,665 Average daily turnover (thousands ZI) 5,285 4,771 6,796 4,899 Number of delistingsa 15 30 32 36 Number of members at end of the year 31 34 31 32 €/ZI 4.17 4.42 4.24 4.31 Number of trading days 250 251 251 249 Source: World Bank elaboration based on information from the Warsaw Stock Exchange (WSE). a. For 2017, 7 of 15 delistings were moves from New Connect to WSE; for 2016, 7 of 30 were moves from New Connect to WSE; for 2015, 13 of 32 were moves from New Connect to WSE, and for 2014, 10 of 36 were moves from New Connect to WSE. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 49 50 SECTION 5 Preconditions and Challenges As explained in previously, the emergence of found a strong correlation between all the platforms many of the solutions described in this report analyzed in this report and both the level of credit requires a certain level of development of the intermediation and the respect for the rule of law. capital markets. This is clearly the case for indirect solutions, because they rely on the existence of This finding highlights the need for EMDEs to corporate bond markets and build on them. It seems continue tackling basic preconditions, which are also to be the case for direct solutions that rely on important for capital markets to develop. World funds because the mutual fund industry needs to be Bank experience in the field, empirical research, developed even at a basic level for those products to and a survey of market participants conducted in take off. The same applies to solutions that rely on 2019 all point to a series of preconditions for capital securities offerings, in particular those that rely on markets to take off (World Bank forthcoming). These the existence of traditional markets to anchor them.45 preconditions can be grouped into three categories: Finally, in order to thrive, venture capital requires the macroeconomic stability, financial sector development, existence of a robust capital market that can provide and a robust institutional and enabling environment. an exit mechanism for such investments. This report does not delve into the challenges faced by EMDEs in regard to these preconditions; however, Some of the fintech solutions might not require if these essentials are not in place it is unlikely that a similar level of development of the capital authorities would be able to develop many of the markets. Given that these platforms are a recent solutions this report has described. development, definitive conclusions cannot be made. That said, research conducted by the World In addition, it is important to acknowledge that Bank suggests that the development of these the health of the SME sector and more generally platforms is not correlated with the size of the of the more traditional SME finance market can economies nor their income level, a finding that affect the viability of the solutions described in can be considered hopeful for EMDEs. Research this report. Indeed, at the basis of all these solutions also suggests that the development of lending and must lie a healthy SME sector. Furthermore, as the receivables platforms is independent from the level experience of AEs during the global financial crisis of development of the capital markets, or at least no suggests, the situation of banks and other specialized correlation was found. However, a correlation was SME lenders can affect—either positively or found between equity crowdfunding platforms and negatively—the development of some of the stock market capitalization. solutions analyzed. Nevertheless, even those fintech solutions require Beyond these preconditions specific challenges that some basic preconditions are in place. In affect the emergence of capital markets solutions particular, to be scalable and have impact, many for SME financing in EMDEs. The challenges of the solutions discussed would require a sizable affect the supply side, the demand side, the market investor base. In addition, the World Bank research infrastructure, and the enabling environment. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 51 Supply side have on closing information asymmetries. Further, these scoring systems are relatively new and have not Existence of the underlying assets yet been truly tested through different economic cycles. The first basic element for the development of A related challenge affecting some indirect solutions, the solutions described is the existence of the particularly SME loan securitization, is the lack of a underlying assets. sufficient volume of quality and standardized SMEs loans. In many cases, in both AEs and EMDEs, a single Both indirect mechanisms for financing and direct SME loan provider might not have sufficient volume mechanisms that are based on loans require a of SME loans to offset the costs that a securitization pipeline of suitable SMEs loans. This pipeline transaction entails. In some AEs and more recently in might be difficult to develop in many EMDEs. a few EMDEs, multi-origination platforms are being Many SMEs do not have a stable source of revenue used to overcome volume constraints; however, they and, as is particularly relevant to indirect mechanisms, themselves are complex (see box 5.1). lack the type of collateral that is usually required by banks, primarily real estate. That said, in some cases In the case of receivables-based solutions, the the challenge of not having enough quality SMEs pipeline of underlying assets is likely to exist; might actually relate to the (limited) ability of lenders although other challenges might affect their use. to assess their creditworthiness. In the past this hurdle Indeed, in most if not all countries SMEs sell at credit, was very hard to overcome, because many SMEs thus the underlying assets (the receivables) exist. But lack the type of information that is traditionally their use as collateral for financing might be affected used by banks to assess credit risk. However, more by the legal requirements for their transfer, which recently this challenge is being addressed through can make such transfer cumbersome and costly, the development of alternative mechanisms to assess and by the potential for fraud inherent in paper- the creditworthiness of SMEs, such as credit scoring based receivables. Some countries, such as Italy, mechanisms based on nontraditional information. have implemented legal reforms aimed at easing the Equally, lending platforms are making use of their own requirements for transfer. In addition, increasingly proprietary systems, leveraging big data. It is still early countries are implementing electronic receipts, which to assess the overall impact that the use of big data will could significantly reduce transfer costs and mitigate Box 5.1: Multi-origination platforms Multi-origination platforms offer advantages for lenders that want to access the markets, such as sharing transaction costs, enhancing the visibility of transactions toward the market, and increasing the size and granularity of the securitized portfolio. These features in turn reduce the costs and difficulties of fundraising. However, key for the platforms’ success is the alignment among originators. At a minimum this requires that the participating SME lenders agree on general eligibility criteria for the loans and on other important aspects of the planned transaction, which should ideally be accompanied by standardized loan agreements and related documentation. Generally, the suitable loans are mid- or long-term financing (no revolving loans or overdraft facilities), fully disbursed (not in the phase of approval or finalization), and not in arrears. Loans securitized may be both secured or unsecured. The success of a multi-originator securitization also depends on the quality of servicing providers. Although the service providers needed are similar to those in a single-originator transaction, the key difference is the increased workload for the arranger of the transaction and other agents related to the collaboration with multiple originators and multiple portfolios. In practice, multi-origination transactions remain challenging because of difficulties in the alignment between the participating SME lenders. This is particularly the case when the model used requires that each participant bears a counterparty risk toward other participants (that is, when portfolios are commingled). In these cases, one mechanism to reduce the risk is the provision of a guarantee to cover the counterparty risk for the benefit of the originators and investors. Source: World Bank elaboration. 52 SECTION 5: Preconditions and Challenges fraud risk. Furthermore, one of the lessons learned the hurdle is even higher, because most SMEs from countries that have implemented (or are in are family-owned businesses that are reluctant the process of implementing) electronic receipts in to change their management culture and include EMDEs is the benefit of incorporating requirements to outside shareholders. In addition, information facilitate their easy transfer along with those needed barriers persist, making valuation of SMEs difficult from a tax perspective, with a view to increasing the and leading to gaps in perceived valuation between possibility that a marketplace for receivables emerges. potential investors and the companies (and in the For example, in Peru the legal framework provides that case of PE/VC between the manager and potential the electronic receipt can be “deposited” in a central partners). However, such bank financing might not securities depository; once this is done, the receipt be available for many SMEs, including higher risk acquires the characteristics of a security, which allows start-up companies for which equity financing is key. its easy negotiation.46 Understanding these challenges, many countries Finally, securities offerings solutions also have programs to prepare companies to come require the availability of quality SMEs, which to market. In many countries, the exchanges have is a challenge in many EMDEs. In general, initially been the developers of such programs, many SMEs lack knowledge about capital markets sometimes subsidized by DFIs. Initially the solutions. But even when they know the options programs focused on bringing listings to the market. available, those that can obtain financing from banks More recently certain exchanges are developing usually prefer that option because it requires less more comprehensive programs that involve (a) the information and organizational changes from them evaluation of companies along with assistance and than what is required to access the capital markets capacity building, (b) a network of investors, and via a securities offering. In the case of equity, (c) a mechanism to bring together those two legs without involving a listing (see box 5.2). Box 5.2: The ELITE program ELITE is a company owned by the London Stock Exchange Group and established in 2012. Its objective is defined as being a “global community” that seeks to provide companies with access to capital, networks, and the knowledge and skills necessary to increase their scale in a sustainable way and with economic impact. To do this, ELITE seeks to create an ecosystem in which investors, corporate advisers, entrepreneurs, and other institutions can interact with transparency and collaboration. The program offers companies a route that consists of three stages: first, an assessment of the potential of the companies; then, strengthening of the business to scale it; and, finally, capital raising. The evaluation of the company focuses on 10 key aspects (risk management, quality of administration, corporate governance, soundness of the business plan, competitive position within its industry, growth potential, financing structure, management of marketing and sales, level of digitalization, and form of information reporting) to identify strengths and areas for improvement, as well as business opportunities. After the evaluation, ELITE offers support to develop skills and obtain the necessary knowledge to improve the management of the company and increase its scale. Approaches include mentoring programs, business support or education courses, as well as access to networks of experts, advisers, and academics. Finally, the network is complemented with a platform of private placements for the raising of financing through various instruments (shares, traditional debt instruments, convertible instruments), all through a standardized process in which the issuer can choose the type of investors to which it wants to direct the offering. The offering platform provides the investors information on the companies in standardized formats, to which a network of financial advisers (who can show offers but not take orders) and of agents is added. Through the end of 2018, ELITE had within its network more than 1,100 companies, from 36 economic sectors and 42 countries, that consolidated more than 487,000 employees and sales of over $84.2 billion. Source: World Bank elaboration based on information from the ELITE website. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 53 But technical assistance has also been needed Indirect mechanism for financing in connection with early financing. Capacity constraints hinder many promising candidates for PE/ Many EMDEs have frameworks in place to VC investment. In this context, technical assistance support plain vanilla issuances by SME lenders; (TA) serves to strengthen the case for PE and VC however, even then some improvements might in EMDEs (see box 5.3). As a result, the notion of be needed. In general, World Bank work in the TA facilities working with PE and VC funds is now field indicates the importance for EMDEs to work more accepted by LPs and GPs and is becoming a in mechanisms to make the authorization process more common market model in the SME segment of these issuances more expedient, for example by in EMDEs. establishing streamlined procedures for programs of issuance or for seasoned issuers. Regulations supporting the instruments Other more complex products require specialized regulatory regimes that might not yet be in place. All the instruments this report has discussed carry Such is the case for SME loan securitization. risks to investor protection and, depending on In general, the larger jurisdictions have already the country, potentially also to financial stability. developed a framework for securitization, but a Thus, an appropriate regulatory framework must be review might be warranted to ensure that the lessons in place that should strike the right balance between from the crisis have been incorporated, in particular the need to ensure investor protection and financial the need for standardization and robust disclosure stability and the objective of expanding SME access and retention requirements. For smaller jurisdictions, to financing. Many EMEs still have significant work the task might be larger, including the need to ensure to do in this area. Box 5.3: Technical assistance in the context of early financing Technical assistance (TA) has two main benefits. First, it provides funding that enables fund managers to extend their reach to smaller companies. Second, it mitigates risk and increases the probability of successful investments for both private equity (PE) and venture capital (VC) funds by funding targeted operational improvements. Although the potential benefits of TA are clear, many funds investing in small and medium enterprises (SMEs) in emerging markets and developing economies (EMDEs) are small and lack the scale and financial resources to fund TA projects themselves. Thus, dedicated TA facilities financed by third parties such as development finance institutions, governments, or other donors have emerged to fill this need. Technical assistance is typically categorized as either pre- or post-investment TA. Pre-investment TA finances support for SMEs that have been identified as attractive investment targets yet require additional preparation before a deal can be finalized. Support might target improvements to financial reporting, operations, or legal and governance concerns. Post-investment TA, on the other hand, finances support for portfolio companies that develop capacity needs during the life cycle of the investment. Such support might address governance improvements, training, access to expert technical advice and mentorship, and business strategy or operational improvements. This targeted support could, in turn, help improve the quality of the investments and prepare the company for exit. Currently TA paired with investment in EMDEs is largely restricted to post-investment support for portfolio companies. In some limited cases, however, TA is provided pre-investment, or support is extended directly to an investment firm as part of its efforts to explore a particular investment thesis and to build a pipeline of potential target companies within a specific theme. Such cases are far less common, however, given donor preference to support portfolio companies. The combination of pre- and post-investment technical assistance facilities during the life cycle of the investment is recognized to be about 7–15 percent of the value of a given investment. Usually, a technical assistance facility ranges between 6 and 20 percent (average around 10 percent) of the size of an associated investment fund. Source: World Bank elaboration based on information from Divakaran, McGinnis, and Shariff 2014. 54 SECTION 5: Preconditions and Challenges that vehicles that are bankruptcy remote are available also mean, rationalizing the requirements for public and to create a framework for securitization itself, offering, with a view to making it easier for SME to with a focus on ensuring the granularity of disclosure tap the public market. In both cases, regulators need (at the loan level). to be mindful of the need to ensure investor protection and thus, a right balance needs to be sought. As stated earlier, SME-structured notes might be a useful instrument for first-time banks and As part of this effort, regulators should consider specialized lenders in EMDEs but would likely the development of custom-made regimes for require a specialized regulatory framework to equity crowdfunding and lending platforms. scale up. For the reasons explained earlier, the Regulators have adopted different approaches World Bank recommends that a separate instrument toward fundraising platforms. In some countries the (with the characteristic of having dual recourse) sector has been allowed to grow without regulation, accompanied by a specific framework, along the lines while in others governments have adopted specific of European Banking Authority recommendations, regulations for it. Only in a few countries is there could be the best way forward. an outright prohibition of these solutions.4 Although it is still early to make definitive conclusions and causation cannot be proven, early research shows a Direct mechanisms for financing strong correlation between the existence of a clear In general, securities regulators need to ensure regulatory framework for platforms for fundraising that proportionate regulations are in place for the and the activity in such platforms (Rau 2019). Thus offering of securities by SMEs. That might mean without proper regulation these mechanisms might ensuring the availability of exemptions of public not be able to succeed on a large scale. Box 5.4 offering, whereby under certain conditions SMEs provides an overview of the key elements of the can access the capital markets without triggering regimes developed so far. the requirements of a public offering. But it can Box 5.4: The regulation of crowdfunding Precisely because of its potential impact on the access to finance for small and medium enterprises (SMEs), countries are increasingly seeking to ensure that their legal and regulatory framework provides room for crowdfunding as a form of capital raising. Some countries have enacted a single framework to encompass both securities-based crowdfunding and lending crowdfunding, whereas other countries subject them to separate regimes. The latter is a more frequent approach in countries where there are specialized regulators for securities and banking; however, that is not always the case. For example, in Spain there is a single framework for all such types of platforms, and in the United States many of the lending platforms fall under the jurisdiction of the Securities and Exchange Commission (because they fall under the definition of an investment contract). Regulatory understanding of crowdfunding and its risks is still evolving, and thus no single model can be considered best practice yet. That said, following are key features of the regulation for securities-based crowdfunding that can be extracted from the regulatory frameworks enacted by both advanced economies and emerging markets and developing economies. Requirements for the companies seeking funding: These frameworks are generally restricted to domestic companies. Some countries add other restrictions. For example, in some countries the framework can only be used by SMEs, or by companies that have not issued a public offering. In general, the framework focuses on disclosure requirements and no corporate governance requirements are imposed (although some basic requirements based on corporate law would apply). Disclosure requirements are lighter than those applicable under the traditional public offering regime. In general, a prospectus is not required, but some basic information on the business of the company or the project that it is seeking to fund is required. In some countries, companies are required to present financial statements (and for issuances above certain size, some countries require that the financial statements be certified or audited, but this is not common to many regulatory frameworks). The information is not subject to ex ante review by the regulator. Periodic and ongoing Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 55 disclosure requirements are also more limited. In general, companies are required to provide information only about the progress of the offering and, in some cases, about certain adverse events. Given the more limited disclosure, there are limits to the amount that companies can raise through this mechanism. Regulations applicable to the investors: In light of the more limited disclosure available, many countries are imposing limits on the participation of nonprofessional investors (retail investors); for example, some countries limit the amount that nonprofessional investors may invest in the platforms in a given period. Regulation of the platforms: The platforms themselves are subject to licensing. In many cases a specialized license has been created (for funding platforms) that limits the type of activities the new licensee may undertake to operating the crowdfunding platforms. In a few countries, this activity is considered subsumed into an already existing license (for example, of a recognized exchange) or may be undertaken by an existing type of intermediary (for example, a broker dealer). Many, but not all, countries subject the platform operators to minimum capital requirements. Most frameworks do require them to comply with certain basic organizational requirements, including risk management standards. The platforms must also abide by business conduct obligations, the most important being the need to (a) ensure that the investors meet the requirements set forth in the platform, (b) keep investors’ money segregated, (c) conduct a basic due diligence of the companies raising funding in the platforms and the information they provide, and (d) provide investors information about the progress of the offerings. Source: World Bank elaboration based on the review of the regulatory frameworks in place in Brazil, Canada, India, Indonesia, Malaysia, Spain, the United Kingdom, and the United States. In addition, many regulators in EMDEs might are not subject to registration/authorization with need to strengthen the regulatory frameworks the securities regulator. In some EMDEs, specific for mutual funds. Although basic frameworks regulations for PE/VC have been adopted to establish for mutual funds exist in many EMDEs, many of these industries. The regulations may restrict the the SME funds described in this report, such as type of financing that PE/VC funds can give, such the SME loan funds,48 have characteristics that as limiting the ability to offer debt instruments to require that a specialized framework be developed SMEs. The rules also may prevent PE/VC funds from to address investor protection and financial stability divesting their shareholding in portfolio companies, concerns. Frameworks should address issues through restrictions such as lock-in periods that such as the minimum eligibility criteria for the lengthen the holding period for an investment, thus assets, the level of leverage, and the need to match increasing uncertainty. redemption periods to the liquidity profile of the portfolios. Further, consideration should be given to the extent to which some of these funds should Demand side be targeted only to sophisticated investors. In For many EMDEs, the lack of a robust investor parallel the regulations should ensure that the fund base remains a key challenge that hinders the managers have the appropriate expertise as well as potential to develop capital markets solutions not risk management capabilities. just for SMEs, but more generally to finance the real economy. Thus, for many EMDEs the priority Concerning PE/VCs, at the regulatory level still lies in implementing policies that foster the the key concern relates to potential rigidities development of a broad investor base. Assuming that introduced in the frameworks for this type of such investor base is in place, additional issues need investment. In many AEs, there is no specific to be taken into consideration. securities markets regulation for PE/VC funds; rather, regulators use legal structures available in corporate law (usually limited partnerships) and take Institutional investors advantage of the private offering regime existent in As demonstrated by the experience of AEs, there securities regulation, which means that the funds is potential for institutional investors in EMDEs 56 SECTION 5: Preconditions and Challenges to play a stronger role in SME financing, but AEs and EMDEs. In general, institutional investors many challenges would need to be overcome. have a sizable amount of assets under management and Institutional investors are often some of the most thus require that their investments be of a certain size long-term oriented and therefore could supply a to make an impact on their profitability. SME-related crucial additional source of patient capital to help assets are usually small, yet the effort to monitor SMEs flourish. Nevertheless, in many EMDEs, them is similar to that of more sizable investments. institutional investors face regulatory challenges As a result, institutional investors choose not to that limit their investments in SME-related assets. invest in SMEs. The challenge could be mitigated In addition, structural issues related to the nature of by choosing an indirect route of investment—that the underlying assets either need to be addressed is, by investing in funds that pool the SME assets. through careful design or explicitly accepted by This is the way institutional investors have invested institutional investors, options which would affect in PE/VC funds and are investing now in minibonds the size of their investments in these solutions. and SME loans in AEs. A similar strategy has been Those issues are discussed in this section. used by institutional investors when participating in receivables and lending platforms, whereby they buy In many EMDEs, the investment regime for receivables and loans in bulk. However, even then, institutional investors could limit the possibility particularly in EMDEs, size might still be a problem that they invest in many of the capital markets if there are no other investors in the market and, by solutions described in this report. Few EMDEs either internal policy or regulations, institutional have gone the route of some AEs that have applied investors are prevented from being sole investors in the “prudent person” standard to institutional a particular vehicle. investments.49 In most EMDEs, the regulatory framework has largely remained rules based, with The lack of liquidity of many of these solutions quantitative limits placed on investments by pension is also a challenge. Defined contribution pension funds and insurance companies. This approach plans usually include a feature that allows switching contributes to a lack of flexibility in asset allocation between multiple portfolios, which requires across various asset classes, and it typically favors increased liquidity in the asset portfolio and large allocations to government securities and serves as a disincentive for nonliquid investments. listed corporate securities. Furthermore, in some Insurance asset portfolios, especially for general EMDEs the framework does not allow investment in insurers, likewise will need to ensure a certain level alternative assets, which is the bucket in which many of liquidity in their portfolios and will be similarly of the nontraditional solutions for SME financing constrained in their investment decision making. would fall. Alternatively, the limits are too low, and In contrast, many of the solutions discussed here thus investments in SME assets compete with other are inherently illiquid, given the nature of the asset classes; or the process to obtain regulatory underlying assets. That is the case, for example, of authorization to invest in alternative assets is very those based on loans and receivables. This challenge protracted, thus discouraging these investments. can be partially mitigated through careful design Equally, in some countries there are outright of the capital markets solutions, for example by prohibitions for investment in securities placed via creating close-end funds that are listed themselves a private offering, which is the preferred placement or by creating close-end funds with intervals that method for many alternative investments, including allow liquidity windows. In other cases, such as for PE/VC funds. PE/VC funds, the capacity to exit the investment is largely constrained by the lack of an active initial In addition to regulatory issues, other challenges public offering market. This situation might lead that arise from the characteristics of the solutions investors to look for other forms of investment with might limit investments by institutional investors. self-liquidating features, such as subordinated debt, The need for scale is one of these challenges, in both that mitigate exit risk. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 57 The lack of transparency has also been noted as Retail investors a key explanation for inadequate institutional investment in SMEs. Many of the SME solutions A key challenge in connection with SME-related described in this report are executed in private solutions is the extent to which they are suitable markets, which are not subject to the same level for retail investors. Many of the solutions of disclosure and transparency as the markets analyzed in this report have a higher risk profile of public offerings. To some extent the lack of than more traditional products, such as equity and transparency can be mitigated by the institutional bonds offered in the main market. That is why in investors themselves if they request information AEs some of the products described are offered from the issuers of the products irrespective of the only through private placements, which limit the regulatory regime that applies to the offering. But access that retail investors have to them. However, the private nature of the transactions can also affect in the cases in which such solutions can be offered price formation and liquidity. to retail investors, it is critical that regulations (a) require appropriate disclosure about the risks Finally, some of the solutions could have leverage imbedded in the products, and in the case of funds imbedded. That is the case of some of the credit impose an appropriate regime for them that deals funds discussed. Thus, institutional investors need with issues such as eligible assets, leverage, and to be in a position to determine whether this is an liquidity; (b) ensure that the products are correctly acceptable risk for their portfolios. labeled; and (c) compel the intermediaries that recommend the products to investors to comply All the challenges point to the need for institutional with robust conduct obligations—in particular, investors to have the capacity to assess and the obligation to recommend only products that monitor alternative assets. This is not always the are suitable to the investor. Many EMDEs have case in EMDEs. In practice, the lack of capacity has significant work to do in all those aspects, as will prevented institutional investors in some EMDEs be discussed later in this report. from investing more actively in SME solutions. In Kenya for example, pension funds were permitted Foreign investors to invest up to 10 percent of assets in private equity and venture capital in 2015; however, to date, Aside from more general issues related to the actual allocation to PE/VC funds has remained level of development of the markets in EMDEs, low (Divakaran, McGinnis, and Schneider 2018). many SME solutions are not attractive to Although other issues are at play, such as the structure foreign investors. This is particularly the case of of the pension system overall, a lack of internal direct solutions due to a combination of factors, capacity and knowledge of alternative instruments including the lack of information about these within Kenyan pension funds have remained a solutions, issues of scale, and the fact that these key barrier to investment in SMEs. This is likely a solutions are not aligned with their risk/return similar scenario in other EMDEs. To remedy this, appetite. Similar to retail investors, fund-based local pension funds in Nigeria are permitted to invest solutions could help mitigate some of these in private equity only where other DFIs are among challenges. That is, in fact, the vehicle that foreign the LPs so that the DFIs can transfer knowledge investors have used for their investments in PE/ and skills (MFW4A and EMPEA 2014). Addressing VC funds, in many cases via off-shore vehicles these capacity challenges will be key to ensuring that due to taxation issues. However, foreign direct an enhanced use of capital markets solutions does investment controls can significantly slow down not lead to a buildup of risks to investor protection or the operations of an offshore PE/VC fund in a financial stability. In addition, the regulatory regime country. for pension fund managers and insurance companies should contain provisions on risk management. 58 SECTION 5: Preconditions and Challenges Market infrastructure platforms and act as a bridge between investors and companies. These intermediaries can be traditional Most of the solutions require the existence of exchanges or securities firms, but they can also be capital markets infrastructure. new entities that would be subject to authorization requirements. In addition, lending and receivables In general, indirect mechanisms of financing platforms will need to have mechanisms in place require that a fixed income market is already to conduct due diligence and assess the credit risk in place. This means the existence of securities of the SME seeking a loan or the company issuing intermediaries that are able to structure the the receivables that are being sold. The platforms instruments as well as to distribute them. They also usually have proprietary systems that leverage require information service providers—auditors, at a big data to assess the credit risk. Equity platforms minimum, but potentially also credit rating agencies will need to have in place mechanisms to conduct and securities research analysts—that follow the due diligence on the companies that want to raise securities and provide analysis to investors about funding through them. In addition, for this type of their performance. Finally, investors would also fundraising internet penetration across households expect that there be trading platforms where such is key. Finally, strong payments infrastructure is instruments can be traded in the secondary market. critical for the success of these platforms. Fund-based mechanisms of direct financing also Some of this infrastructure is deficient or missing require that basic elements of capital markets in many EMDEs. For example, securities infrastructure are in place. In particular, these intermediaries lack expertise, particularly for mechanisms require specialized intermediaries, fund more complex structures such as securitization, and managers who must be able to conduct credit risk would require capacity building. Certain categories assessments of nontraditional assets such as loans of intermediaries, such as the sponsors that have and receivables. Alternatively, they would need to be been a critical component of the market model of able to contract the services of third parties that could many SME exchanges, are not yet contemplated perform the corresponding due diligence for them. by regulations in many EMDEs. Moreover, many PE/VC funds also require specialized fund managers EMDEs face more general problems concerning the with expertise not just to select the assets but also regulatory framework and in particular the licensing to provide managerial assistance to the companies in regime that applies to traditional intermediaries. In which they invest. this regard, such EMDEs need to move toward a licensing regime that is based on activities and that The same applies to securities offerings solutions, aligns capital and other authorization requirements which would require that many components of with the level of risk imbedded in the activities the capital markets infrastructure already be for which the license is being sought. Doing so in place. Requirements include intermediaries that would ensure that risks are appropriately taken into can assist companies in determining the structure consideration but that undue entry barriers are not of the issuance and the method for their placement created. Some of these challenges can be found in and can conduct the placement as well. In addition, the fund management industry as well, because experience indicates that investors increasingly in many EMDEs fund managers do not have the expect secondary trading platforms through which skills necessary to manage products such as PE/VC they can exit their investments. funds or the credit funds discussed in this report. Further, business conduct obligations might not be In contrast, platforms-based solutions do not sufficiently developed in many EMDEs. require traditional capital markets infrastructure, but they do require certain services to be available. Further challenges involve information service First, intermediaries are needed to operate the providers. Although auditors are present in many Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 59 EMDEs, the quality of their work can be a challenge, hurdle. Network quality and quantity is an issue even in AEs. Regulators have moved to establish in some EMDEs. In addition, the lack of online stronger oversight regimes for auditors, but concerns mechanisms to easily transfer funds has proven to be remain. In addition, some EMDEs lack credit rating a barrier in some EMDEs. For example, in Tunisia agencies. Credit rating agencies can perform a or Morocco, the fact that banks are the only payment critical role in mitigating information asymmetries gateways and that the currency is not convertible, in EMDEs by providing an easy-to-understand has translated into a lack of digital payment options assessment of the quality of companies seeking (World Bank 2015a). debt funding. That is why in some EMDEs the use of ratings in the regulatory process is mandatory. However, to mitigate potential misalignments, Supervision credit rating agencies need to be subject to strong The need for authorities to have robust oversight, which is still a work in progress in many supervisory arrangements in place is as great EMDEs. Finally, research analysts are missing in as the need for sound regulations (box 5.5). most EMDEs—and even when they are available, As indicated previously, many of the solutions they usually do not cater to small issuances. As a discussed in this report have a higher risk profile result, investment firms are not familiar with SME than traditional offerings in the main markets. issuers and are less likely to recommend them to Thus it is key that authorities have arrangements their clients. Thus some exchanges have programs in place that allow them to effectively monitor the to subsidize research for SME issuances, at least for evolution of these solutions in order to detect early a period of time. on any potential buildup of risks either to financial stability or investor protection and to take measures Finally, in the context, of electronic platforms, to address them in a timely manner.50 information technology issues are still a big Box 5.5: The need to monitor developments and adjust regulations: The case of marketplace lending in China The marketplace lending business in China is the largest in the world. According to the Cambridge Centre for Alternative Finance (CCAF), as of the end of 2017, about US$321.4 billion had been raised on lending platforms, of which 224 corresponded to marketplaces for consumer lending and the remaining to marketplaces for business lending. As of August 2018, there were about 1,500 platforms. However, the industry is highly concentrated. For 2017, 44 platforms with a turnover of at least Y 10 billion accounted for 66.30 percent of the volumes raised. The average loan was between Y 100,000 and Y 400,000. The average interest rate was about 9.45 percent, with over half of the platforms charging between 8.00 percent and 12.00 percent (and about 3.25 percent of platforms charging interest rates of over 15.00 percent). The bulk of the loans were short term, with about 80.6 percent of the platforms facilitating loans with a maturity of less than six months. The average investment amount by a typical lender was between Y 10,000 and Y 30, 000. Since 2017, the rate of growth has deaccelerated, and the industry is going through a process of consolidation. The first online platform was launched in 2007. Since then and until 2017, the industry went through rapid growth, in large part because the platforms were promoted by the public authorities as a way to support small and medium enterprises. In 2015, a broad internet finance policy framework, which promoted the growth in the industry, was introduced. The public support along with word of mouth made China the largest peer-to-peer lending market. The number of platforms rose from 10 in 2010 to more than 3,000 in 2015 and to about 6,000 at the peak. As more platforms entered the space, the new platforms started to promise interest rates much higher than their competitors. Compared with an interest rate of less than 2 percent from banks, many peer-to-peer platforms promised a return of 10 percent—and some even higher. Lack of transparency made it hard to assess how the platforms were using the money. As a result, fraud occurred. The first important fraud took place in 2016, when Ezubao scammed investors over Y7.6 billion through a Ponzi scheme. 60 SECTION 5: Preconditions and Challenges This scandal prompted the establishment of a more rigorous system of regulation and supervision called the 1+3 system (one method, three guidelines) with the objective of monitoring, managing, and mitigating industry risks. In this context, the China Banking and Insurance Regulatory Commission issued the Interim Measures for the Administration of the Business Activities of Online Lending Intermediary Institutions (2016). The regulations aim to transform the industry into pure information intermediaries: the platforms can gather information from borrowers and lenders and match their needs, but the platforms are not allowed to pool investors’ funds nor to provide any credit services themselves (as most of the platforms had been doing). The measures further compel the platforms to rely on real investors to fund the businesses. In addition to these key changes in the nature and scope of services provided, the regulations call for self-review and report of statistics of unpaid and nonperforming loans, as well as disclosures to investors about the way the platforms operate. The regulations also call for on-site inspections of the platforms and provided inspection powers to the National Internet Finance Association (a self-regulatory organization) and to the provincial governments. The regulations provide for penalties for platforms that infringe on their obligations and legal consequences for operators of Ponzi schemes. Borrowers who fail to pay are to be penalized in the credit rating system. Additional guidelines provided for a specific timetable for implementation to be set up. A combination of factors, in particular (a) tightening of the credit environment, (b) increased compliance costs, and (c) panicked withdrawals, led to the failure of many platforms during June–July 2018, either because they were not able to repay investors or because of fraud by the platform operators. During this industry turmoil, the authorities accelerated the process of improving the regulatory system and launched several initiatives to accelerate filing, implement comprehensive inspections, and ensure orderly exits. By 2018, there were about 1,595 platforms remaining. Although the market has gradually stabilized, it is expected that the process of consolidation will continue. Source: World Bank elaboration mainly based on information from CCAF 2018a. Active supervision is dependent on a set of Ensuring the existence of a robust supervisory preconditions. First, authorities need to have program is a challenge for many EMDEs, mainly enough information to monitor the growth of because of capacity issues. Indeed, in many different products. Second, they need to ensure EMDEs the supervisory programs in place follow a that a supervisory program is in place, and third, compliance-based approach. These regimes provide a a strong enforcement program has to be in place false sense of security as they focus on breaches to because regulation and supervision are only as laws and regulations and not enough attention is given strong as enforcement. These conditions are not to the identification of intermediaries, activities, or always met. products that pose undue risk to the markets, either from an investor protection or a financial stability In EMDEs and AEs alike, many supervisors angle. Thus, it is critical that regulators implement lack the necessary information to monitor risk-based supervisory programs. The implementation the markets, especially those products placed of such programs in small markets is relatively under a private offering. Just a few countries, simple; however, it does require a good understanding such as Canada and the United States, have of the market, its functioning, the business models of imposed notification requirements in the most market participants, and the characteristics of different important exemptions of public offerings, which products with a view to understanding where potential in turn allow them to effectively monitor the misalignments might take place. Furthermore, as evolution of the private markets and determine the importance of capital markets solutions grows, whether intermediaries are complying with the securities markets supervisors in EMDEs will need conditions attached to the exemptions. Some to enhance their coordination arrangements with EMDEs, such as Kenya, are incorporating this other financial supervisory authorities to facilitate the notification into their frameworks. detection of potential channels of contagion. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 61 Finally, robust enforcement is a challenge for supporting the expansion of SME financing is the most EMDEs because of a complex set of factors. use of nontraditional typologies of data to assess Those factors range from gaps in their authority and the creditworthiness of SMEs (box 5.6). Such capacity challenges to more political issues such as the information includes, for example, data on payments perception in many countries that strong enforcement to mobile telephone companies and utilities, as well can stifle market development. However, experience as mobile or other electronic payments received indicates that weak enforcement ends up weakening from customers for the purchase of SME goods and the credibility of the supervisor and, by inference, services. In the past few years these data have proved investors’ confidence in capital markets. Thus, the important to build a credit history for those firms key lies in ensuring that regulations are proportionate that do not have it (“informal,” nonbankable, micro/ and that when enforcement is used, it is applied SMEs). Fintech solutions are taking this concept in a proportionate manner, whereby the remedies further by allowing the use of the data footprint of imposed are aligned with the nature and significance SMEs on the internet to build a credit profile. of the offenses. Movable collateral Other components of the enabling Improvements in the type of collateral that may environment be given could benefit SME access to finance, not just through traditional means but also The tax system through capital markets solutions. The lack In many EMDEs problems with tax asymmetries of recognition of movable assets as collateral is still affect the development of capital market among the top reasons that SMEs face difficulties solutions for SMEs. In some countries, certain capital accessing finance. Traditional lenders such as banks markets solutions are at a disadvantage from other require collateral to lend to businesses and, in financing mechanisms from a tax perspective. For practice, have a preference for real estate. However, example, in Peru loans originated by entities regulated assets owned by any given business are typically by the banking supervisor are exempted from the 75 percent movables (inventory, equipment, farm sales tax, while alternative lending mechanisms in the products, accounts receivable, and intangibles) and capital market (such as lending platforms and loan only 25 percent real property (land or buildings). In originating funds) are subject to the tax. this context, legal reforms aimed at expanding the universe of assets that may be used as collateral to In addition, in many countries there are still include movable assets (such as inventory, accounts problems with the tax treatment of funds. receivable, intellectual property rights, companies’ In general, funds need to be structured as tax- shares, livestock, crops, equipment, and machinery), transparent vehicles, whereby only the final along with implementation of the corresponding investors are taxed, not the vehicle. However, many registry, are critical to improving SME access EMDEs still have double taxation (to the fund and to credit via both traditional lending and capital to the investor), thus making fund investments a markets solutions, because they expand the universe tax-inefficient instrument. of “quality” SMEs. See box 5.7. Credit reporting Insolvency Credit reporting systems are critical to Implementing a robust insolvency system that addressing asymmetries of information. Credit promotes the reorganization of viable enterprises bureaus frequently do not provide information on and gives honest entrepreneurs a second chance SMEs, so other type of servicers, such as credit is also critical to improving SME access to finance scoring firms, may serve as an alternative. Key to via traditional and capital markets solutions. A 62 SECTION 5: Preconditions and Challenges Box 5.6. Selected experiences with credit scores Thailand In May 2016, the National Credit Bureau of Thailand began offering FICO scores for small and medium enterprises (SMEs) to banks and financial institutions to enable them to better assess the creditworthiness of SMEs in May 2016. The FICO SME Score, which predicts the probability of delinquency of more than 90 days in the following 24 months, is computed using an empirically derived model that is supplied with data collected by the National Credit Bureau of Thailand and Business Online Public Company Limited, a private research firm. It generates a three-digit number between 490 and 813 in eight risk bands from AA to HH, which rank-orders SMEs according to risk. The higher the score, the lower the risk. Up to five “reason codes” are returned to the lender to help with the interpretation of the score. The FICO SME Score provides lenders in Thailand with an effective tool for rank-ordering the credit risk of SMEs. Using the scores, lenders can make lending decisions that are faster, more accurate, and more consistent. Lenders can also use the FICO SME Score to support their internal-ratings-based (RetailIRB) approach to calculating the required minimum regulatory capital. The score applies to different types of products, and lenders can use scores to make decisions across the entire life cycle of an account’s SME. Chile Equifax Chile launched the predictor inclusion score, a risk score derived from encrypted mobile usage data, in February 2017. When Equifax receives a credit inquiry from an unbanked person who may work for a microenterprise or small business, it checks its traditional credit database. If no record is found, Equifax then (with consumer consent) queries the telecommunications database using the mobile number for matching. Equifax returns a score on exact cell phone number matches, calibrated to a credit score. The score enables retailers and financial institutions to evaluate financial services requests from microenterprise and small business owners, many of whom lack traditional credit and financial data. In addition to collecting telecommunications data, Equifax is developing analytical tools based on socio-economic relationships and retail and agricultural data to supplement traditional credit data. Thus the program provides new insight on the SME segment that enables financial institutions to make differentiated credit offers to microenterprise and small business owners they previously could not evaluate for credit purposes. Source: World Bank 2018. Box 5.7: A well-functioning collateral registry in Australia The Personal Property Securities Register in Australia is an example of a well-functioning collateral registry. Under the oversight of the Australian Financial Security Authority—with more than 100 full-time employees—the registry records security rights on personal property, fiduciary transfer of titles, financial leases, assignment of receivables, retention of title sales, and judgment claims. Following its launch on January 30, 2012, the registry implemented a two-year transitional period, during which secured parties were provided temporary perfection of security rights. In 2014, the number of new registrations reached 2,364,310. Searches soared from 5,886,945 in 2012 to 7,315,379 in 2014, underscoring rising confidence in the new collateral registry and regime. Registrations can be made against individual and organizational grantors, and no physical presence is required. A standard registration form is provided with free text for some collateral classes. No additional documentation is required to be uploaded to the system. A flat fee, which is based on the registration duration, is charged. Any interested party can search online using the debtor’s identifier, a serial number, or a registration number, among other criteria. The registry then produces an “exact match” search. If someone is unable to perform an online search, the contact center of the collateral registry provides technical support, performing the search on behalf of the user and sending the results via email. Despite the high volume of records, the collateral registry has yet to receive any complaints. An administrative mechanism—known as the amendment demand process—is in place to resolve disputes, if they arise. The registrar of the personal property securities register is responsible for its administration. If the registrar were to receive a complaint that the registration of a party is invalid, the registrar would be tasked with ascertaining whether the registration should be discharged from the registry. Source: Australian Financial Security Authority website referenced in World Bank 2018. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 63 reorganization-oriented insolvency regime plays are particularly important for SMEs, because they a crucial role in mitigating investor and creditor can reduce the cost of insolvency proceedings for risk, which in turn contributes to improving access them, enable viable firms to be preserved during to credit and lowering the cost of credit, as well as the OCW procedure, and also preserve the financial providing for a more stable financial system. As a relationship between the SME and its creditors result of reorganization procedures, creditors are (Ramalho and others 2018) (box 5.8). willing to extend more credit, debtors are provided an opportunity to stay in business, and employees keep their jobs. The Judiciary A strong judiciary underpins all the capital Out-of-court workout (OCW) procedures for markets solutions described. Capital markets insolvency can be an essential component of the are built on trust. When such trust is broken credit infrastructure, especially in jurisdictions either because companies do not provide accurate where judicial insolvency procedures are time information or because intermediaries do not fulfil consuming and expensive and where the courts may their obligations, the system must have mechanisms be overburdened or lack sufficient capacity to deal in place to ensure that investors are compensated. In effectively with insolvency proceedings (Ramalho most countries, such compensation takes place via and others 2018). OCWs involve voluntary the judiciary.51 Yet many EMDEs face challenges in agreements with creditors to restructure the debtor’s using the judiciary, sometimes because of a lack of an composition of assets and liabilities without independent judiciary but most often because judges judicial intervention. They are informal and can be lack the necessary knowledge of capital markets initiated by any party—the distressed company or issues. For many EMDEs, these will require long- its creditors. Such procedures can be used to ensure term efforts. In the short term, working on measures rapid recovery of a distressed company and, if viable, to strengthen alternative resolution mechanisms preserve the value of the company. As a result, they might help mitigate the challenge. Box 5.8: The importance of out of court workouts: Out-of-court workouts in Latvia In response of one of highest levels of indebtedness in Europe, the Latvian authorities designed a strategy which included the implementation of voluntary debt restructuring mechanisms such as out-of-court workouts (OCWs). A consultative committee was established, made up of representatives from the Ministry of Justice, the state Insolvency Administration, the Latvian Commercial Bank Association, the Latvian Certified Insolvency Process Administrator Association, the Latvian Labor Confederation, the Foreign Investor’s Council in Latvia, the Latvian Chamber of Commerce and Industry, and the Latvian Borrower's Association. The consultative committee approved voluntary out-of-court settlement guidelines in August 2009. The guidelines provided a set of high-level practices, based on the INSOL principles, modified to fit the Latvian insolvency framework. The guidelines were published on the website of the Ministry of Justice, and the government organized workshops and training to increase awareness of the guidelines among stakeholders (banks, insolvency practitioners) and promote their use. Latvia's top banks identified the OCW guidelines as pivotal in addressing the widespread debt distress in the corporate sector caused by the financial crisis. Information from the Financial and Capital Market Commission indicates that most banks in Latvia have incorporated these guidelines into their internal procedures and creditors and debtors can now agree more easily to change the terms of debt repayments, allowing debtors to continue to do business without initiating insolvency proceedings in court. Resources have been freed up in the court system as a result. The OCWs also allow creditors and debtors to address collective action problems through the provision of standstills or moratoriums, and they can encourage transparency and good faith in negotiations. Source: World Bank 2018. 64 SECTION 5: Preconditions and Challenges SECTION 6 Aligning Incentives The experiences reviewed suggest that even if the guarantee schemes; however, measuring economic preconditions are in place, in some cases other additionality has proved more difficult, in part types of interventions by governments might because of data and methodological limitations be needed to mitigate market failures that cause (see Cusmano 2013). Nevertheless, such studies investors to pay insufficient attention to the SME point to the need to carefully design guarantees and asset class. In addition, those interventions might effectively monitor them. Both recommendations also be needed to better align the risk-return appetite are equally applicable to guarantees provided in the of investors, in particular institutional investors, with context of SME securitization.53 specific capital markets solutions. Following are brief descriptions of the types of interventions that Multilateral development banks have also have been used in AEs and EMDEs. provided credit risk guarantees to spur the development of fixed income products that can expand SME financing. For example, the European Credit enhancements Investment Bank Group has a standing facility Credit risk guarantees have been used by to guarantee SME securitization and is used on a governments to encourage the development of regular basis for the credit enhancement of senior fixed-income products that can expand SME and mezzanine tranches (€0.5–0.8 billion annually in financing. A key example described in this report past years), but its role remains small. In addition, as is Spain’s SME loan securitization program,52 in discussed in this report, the World Bank is currently which the government provides a partial guarantee to testing hybrid solutions in Colombia. Finally, MDBs bonds issued by specialized SME funds that abide by have been key providers of credit guarantees in first specific standards. In exchange for such guarantee, issuances by microfinance institutions. originators are required to use an important percentage of the capital freed by the transaction to As indicated in a previous report, there is a originate additional SME loans, therefore creating a delicate balance between credit enhancements multiplier effect. This guarantee has been critical to and the economics of the instruments (World aligning the product with the risk-return appetite of Bank, IMF, and OECD 2015). While credit institutional investors. Furthermore, it is unlikely that enhancements might bring instruments to a desired this product would be viable without such guarantee. rating, in practice depending on the magnitude, they might render the instrument financially unviable, Empirical research on the role of credit guarantees either because there is no third party willing or has mostly focused on its use in connection able to provide such enhancement due to costs or with bank lending. Most existing studies provide because the resulting rate of return is no longer positive evidence of the financial additionality of attractive to institutional investors. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 65 Direct investments and co- in which that objective has been achieved, such as in investments Australia and the United States, where co-investment models have been used. Other studies have found no Many governments have established programs support for the crowding-in effect, particularly in to invest in VC.54 Information asymmetry direct programs. The evidence of the impact of these surrounding these firms leads to adverse selection programs at the level of the firms, in their ability to and agency problems, which in turn lead to exit via initial public offerings and in their sales and market failure. The financing gap is alleviated by growth is also mixed. Overall, positive effects have VC, which reduces the information asymmetry been found in some co-investment programs. That via the intensive scrutiny of the firms and active is why co-investment programs have become the involvement of the GP. However, in some countries preferred method for interventions. this early stage market is underdeveloped. Given its importance, governments in some countries Challenges are also present when other DFIs have established investment programs in an effort participate in the VC/PE, including in SMEs to jumpstart the industry.55 Government programs located in EMDEs. DFIs, in a quest for demonstration to foster VC were initially used in the United States effect, often exert multiple (and perhaps untenable) and the United Kingdom and have increasingly requirements on fund managers (Divakaran, been implemented by other AEs such as Australia, McGinnis, and Shariff 2014). For example, they Canada, Israel, and New Zealand. They have also may expect PE/VC funds to simultaneously adopt been implemented by EMDEs such as Chile, traditional-style economic models that generate China, the Arab Republic of Egypt, Ghana, India, internal rates of return in excess of 20 to 30 percent, Korea, Jordan, Morocco and Turkey. while at the same time requiring these firms to move downstream to invest in SMEs, which inherently No generally accepted taxonomy for these involves greater investment challenges and risks. programs has been developed, but overall there Even when fund management fees are slightly have been three modalities for government above the industry standard, the restriction of the programs: (a) direct investment programs through management fee to about 2 or 3 percent of what are government-supported VC-like schemes, (b) co- typically small average fund sizes results in limited investment programs in which the government streams of operational capital. This situation often invests alongside the private sector in VC funds compels the GP to restrict the team composition and (sometimes called hybrid VC funds), and (c) co- in turn impedes the ability of a firm to attract talent. investment programs in which the government Without sufficient capital to fund operations, PE and invests alongside private investors through funds VC firms struggle to establish a strong local presence of funds. In the case of co-investment programs, and to build the networks, relationships, and sector contractual arrangements aim to foster private know-how that drive pipeline and investment quality. sector participation, including through profit Given investor expectations and fund structures, distribution arrangements that range from pari passu a concerted move is made by many SME funds in to arrangements in which the governments caps EMDEs to invest in large, established companies. its participation in profits or compensates private Moreover, firms may collaborate to cofinance large investors for losses (Brander, Du, and Hellmann deals. Follow-on investments are also common, thus 2010; Colombo, Cumming, and Vismara 2014). reducing the need to source new deals or increase the population of investable companies. These factors In general, evaluations of the impact of these can combine to further exacerbate the financing programs can only be found in a few AEs. A key gap for SMEs while creating incentives for fund objective for the VC funds has been the crowding-in managers in EMDEs to seek less risky deals in more of private investors. Some studies have found cases established companies. 66 SECTION 6: Aligning Incentives More recently some governments have used co- Tax incentives investment to foster the emergence of alternative finance mechanisms for SMEs. For example, Tax policies are also used by many countries as noted, the U.K. government has co-invested in as part of the tools to incentivize investment lending platforms and direct lending funds in an in SMEs. Many countries, particularly but effort to expand alternative finance mechanisms. In not exclusively AEs, have implemented tax these cases, the funding is given to platforms not to incentives for VC investors. The rationale for capitalize them but to support their role as a market supporting VC investment via tax incentives can where investors and companies meet. be summarized in two key convictions: that VC investment is beneficial for the economy as a whole Co-investment by MDBs is also taking place to and that VC investment is not adequately provided foster the emergence of market-based solutions for by the market itself. This type of incentive is offered SME financing. For example, the EIF has invested in in many AEs, including Australia, Canada, many SME securitizations (Fund Circle 2018); the EIB is European countries, Israel, and Japan. They have investing in lending marketplaces (Bakie 2019), and also been implemented in some EMDEs, such as the IFC is investing in receivable funds in EMDEs. Korea and Turkey. (See box 6.1.) Box 6.1: Tax incentives for equity Tax incentives for investors In many cases tax incentives do not apply exclusively to venture capital and private equity but rather to investment in small and medium enterprises (SMEs) in a broader context—so long as the investments are not listed on the main market (but they can be listed on an SME exchange). Three groups of tax incentives are available to investors: Back-end exemptions on stamp duties, capital gains tax, or both. Countries where this has been applied include Poland, which eliminated stamp duty for trades on its SME exchange, New Connect; the United Kingdom, which eliminated the stamp duty tax for shares in the Alternative Investment Market; and India, which eliminated the capital gains tax on SME equity investments. Tax offsets based on the value invested directly into SME equity. Investors may deduct a percentage of the value they invest in shares of new offerings of SME equity (to encourage investment in primary markets) and hold for a set period of time (which may discourage secondary market activity). Such incentives exist in Spain and in the United Kingdom, where investors may offset some of the value invested in new offerings if the shares are held for and a two-year and a five-year period, respectively; Tax offsets based on the value invested into SME pooled investment vehicles. In the United Kingdom, tax incentives are given for listed venture capital trusts. In France, investors can access a tax credit of 18 percent of the value invested in Fonds Commun de Placement dans l’Innovation (innovation mutual funds—French acronym, FCPI). FCPI invest at least 60 percent of their portfolios in SME equity (including those listed on the SME Exchange). Tax incentives for issuers Most tax incentives for issuers involve a reduction in the corporate tax rate. Some countries offer the same reduction for both the SME market segment and the senior (main) board. That is the case for Kenya. Other countries have incentives explicitly directed to the SME segment. That is the case of Jamaica and Thailand. Some SME exchanges consider these reductions to be key to their success. For example, Thailand introduced tax incentives for issuers on its main board and SME exchange in 2001 by reducing the corporate income tax rate for listed firms (from 30 percent to 25 percent on the main board and to 20 percent on the SME Exchange, Mai) and saw a spike in listings. Thai officials designed the incentives to reduce over time, once the Mai board had established a track record of successful SME offerings. During the first phase of tax breaks the MAI board grew from 3 to 60 listings. Source: World Bank elaboration based on information from Schellhase 2017. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 67 Studies on the impact of these tax incentives are Overall, tax incentives in connection with fixed limited. To some extent this is because the use of income issuances by SMEs do not seem to be tax incentives is relatively new and until recently used often. Italy does offer incentives in connection very few countries had implemented them. Data with the minibonds, by applying a withholding tax and analysis are available for individual schemes, exemption to the minibonds and the funds that invest but such analysis is not directly comparable with on them,57 and offering tax relief through a “substitute studies conducted in different jurisdictions. Instead tax.”58 From an issuers’ perspective, in general tax of trying to quantify the impact, a recent study of the systems provide an incentive to rely on debt versus effectiveness of tax incentives in the VC industry in equity, because the interest paid is usually deductible Europe identified a set of best practices in structuring for purposes of the income tax. these incentives based on an analysis of the scope, qualifying criteria, administration, generosity, and stability of the schemes.56 Other types of interventions Other forms of interventions by governments In some countries, tax incentives have also include investments in the creation of electronic extended to equity investments in SMEs listed on platforms for fundraising. This form of SME exchanges. The reasons for providing these intervention has been used in Mexico and, more incentives are similar to those stated for venture recently, in India. In the former, a receivable capital, in terms of the existence of market failure platform was created by NAFIN, while in the latter, that has created a financing gap for SMEs and thus the Small Industries Development Bank of India the need to align investors’ risk-return appetite. formed a joint venture with the National Exchange Countries that offer tax incentives for investments to create a receivables platform. in listed SMEs include France, India, Poland, Spain, and the United Kingdom. An innovative program offered in the United Kingdom is a referral program. This program Tax incentives for the companies (issuers) created by the U.K. government requires nine of themselves are less common. They are given the biggest U.K. banks to pass on the details of to encourage new listings and to offset the costs small businesses they have turned down to three of listing for SME issuers, for whom they are government-designated alternative platforms. disproportionately high—thereby expanding SME These platforms, in turn, are required to share the access to capital. Many exchanges have concerns details, in anonymous form, with alternative finance that these incentives would attract companies that are providers. Funding available through the schemes mainly interested in avoiding taxes but are otherwise covers term lending, receivables finance, asset not ready or suitable for listing on an exchange. If finance, commercial property finance, and online the quality of companies coming to market is poor, lenders, as well as government-backed and not-for the reputation of the exchange could be damaged. profit lenders. None of the three finance platforms Some tax authorities are concerned about the loss currently designated support equity finance. It is of immediate tax revenues through tax incentives, still early to assess the effectiveness of the program. while others consider that the increased transparency However, the initial information shows a positive and the potential for growth of listed firms (versus (albeit modest) impact.59 those that lack access to such capital) will lead to an increase in tax revenues in the medium to long term Softer forms of intervention include information once the tax incentives have expired and firms have programs. While many governments have programs grown. This is a decision that needs to be weighed to support SMEs including through interventions by policy makers. Tax incentives for the companies such as those described above, in many cases SMEs themselves exist in countries such as Kenya, are not aware of their existence, for many reasons Malaysia, and Thailand. 68 SECTION 6: Aligning Incentives including the fact that in many cases the programs are aware of the programs available to them, but also are implemented by many different entities and as a with the complementary purpose of understanding result the information is disperse. Thus, a key action where gaps or overlaps exist. An example of such needed in many countries is a consolidation of all such efforts was the first Report produced by the Kingdom information, both with a view of ensuring that SME of Morocco (see box 6.2). Box 6.2: The importance of consolidating information: The experience of Morocco The public authorities in Morocco have begun a project of elaboration of a national financial inclusion strategy to define priorities and coordinate the actions and contributions of the different stakeholders. In this context, and in order to promote the financial inclusion of start-ups, self-entrepreneurs, and very small, medium and small enterprises, the Ministry of Economy and Finance developed the first edition of an annual compendium intended to consolidate and present all the instruments of support for start-up and small and medium enterprise (SME) financing offered in Morocco. The government developed the program in consultation with various partners and with the support of Germany (through GIZ). Several ministerial departments have set up different financing instruments dedicated to start-ups and SMEs directly or through trusteeships, some of which are backed by sectoral development programs. The objectives targeted through the compendium were (a) strengthening communication and dissemination of projects and products, (b) improving the knowledge and visibility of different public and private sector stakeholders, and (c) contributing to a better convergence of stakeholders’ efforts. It is expected that the compendium will be integrated and disseminated as part of an interactive digital platform, under construction, that will be dedicated to supporting financing for SMEs. The compendium provides start-ups and micro, small, and medium enterprises with information related to • The type of instruments available to provide financing and support to SMEs, including financing, investment subsidies, loans, and guarantees • The organizations that provide each type of finance or support, with their address, references of services, and people to contact either directly (telephone, email, or postal) or by way of a search on a website. Source: World Bank elaboration based on information from Royaume du Maroc 2018. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 69 70 SECTION 7 Conclusions The experiences reviewed indicate that capital solutions, including regulations for the products markets solutions can play a larger role in SME and conduct obligations for the intermediaries financing than what has been traditionally the that distribute them. In addition, authorities case. To achieve this, nontraditional solutions need need to review the investment regulations of to be part of the toolkit—both indirect solutions institutional investors to ensure that they are able that offer refinancing facilities to SME lenders and to invest in these solutions, while at the same direct solutions that offer SMEs direct access to time the risk management requirements for fund capital markets through mechanisms different from a managers need to be strengthened. In parallel, straight/traditional public offering of securities. The robust supervisory programs need to be in place research also suggests that the potential to develop to enable early detection and management of the channels that provide SME access to credit and risks that these solutions might pose to investor working capital is greater than for access to equity protection and financial stability. financing. In principle, equity solutions require both that SMEs open their capital to outside shareholders, • Third, government authorities need to consider which many SMEs are reluctant to do because of whether additional interventions are needed their family structure, and that investors demonstrate to jumpstart some of these solutions. Such a much higher risk appetite than many do. interventions might include (a) credit guarantees for some of the debt instruments, (b) co- However, in the majority of EMDEs most of these investments for VC as well as for newer solutions, solutions have not yet appeared or are at an early such as lending platforms and loan originating stage of development. To leverage the solutions funds, and (c) tax incentives, mainly in relation analyzed in this report, EMDEs have significant to early equity investment. These interventions work to do: have a fiscal impact and, as a result, it is critical that government authorities determine before • First, government authorities need to continue implementation what assistance is needed and working to improve the preconditions necessary whether a specific intervention planned is the for capital markets to develop, because most of the best tool to address the market failure identified. solutions require a certain level of development of The interventions should also be set in a way the capital markets. Although some of the fintech that allows for the assessment of their impact. solutions do not seem dependent on the existence In addition, other softer interventions must be of a capital market, they do require that certain considered, including information and capacity basic preconditions necessary for capital markets building for different stakeholders. to develop are in place. Further, to scale up the solutions require a sizable investor base. • Fourth, market participants need to ensure that the necessary components of market infrastructure • Second, government authorities need to work to are in place, in some cases with support from develop appropriate regulations to support these the government. Technology is of particular Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 71 importance for all of the solutions described but strategies mentioned, along with capacity building. especially for newer solutions such as electronic The support should be anchored in a comprehensive platforms for fundraising. analysis of the SME financing gap in a country, with a view to ensuring that market-based solutions • Fifth, because the tasks are complex and involve enhance competition and complement bank funding, many different stakeholders, there is a need as appropriate. To the extent possible, policy advice to prepare comprehensive strategies for the should be complemented with transaction support, development of capital markets solutions for SME so that one reinforces the other. Furthermore, financing that set a clear prioritization of actions. transactions should be structured in a way that brings These strategies should be well articulated into additional private sector funding to SME financing. comprehensive strategies for SME access to finance MDBs should periodically assess the impact and on the one hand and capital markets development replicability of different transaction solutions being strategies on the other. On the former, many of tested and share information accordingly. Likewise, the solutions that address SME access to finance MDBs could assist EMDEs in periodically evaluating leverage traditional funding sources, and thus it is the effect that government interventions are having in critical that the strategies are well articulated into expanding SME financing via market-based solutions. SME finance strategies and also more generally into comprehensive SME development strategies More time and analysis are needed to assess the that rely on a clear understanding of the interplay role that these new solutions can have in financial between addressing financing limitations and inclusion. Existing analysis has focused on electronic overcoming other obstacles to firms’ performance. platforms, given the hypothesis that they could have a On the latter, many of the capital market solutions more significant role in financial inclusion because of require that a capital market with a certain level of their characteristics. At the global level, the research development already be in place, thus authorities conducted by the World Bank did not find that these need to be careful in assessing which solutions platforms are developing in the countries where they could work in their jurisdictions. It is likely that in are needed the most—that is, where the size of their less developed EMDEs, only solutions that require credit and equity gaps are greatest. Nevertheless, it very basic preconditions, such as lending and is early to assess whether these trends will remain. receivable platforms, might initially be feasible. At the country level, third-party research conducted on individual platforms concluded that some • Six, government authorities need to start percentage of the clients that use such platforms are collecting data on SMEs and their financing unbanked clients. However, such findings cannot channels to anchor these strategies. In many be extrapolated. Furthermore, data from the CCAF countries, particularly in AEs, governments have suggest that the patterns on the use of these platforms developed frameworks to collect quantitative by banked, underbanked, and unbanked clients differ data on SME access to finance, including by significantly on a country basis. conducting surveys on SMEs and their lenders. However, such efforts usually focus on traditional The World Bank plans to continue enhancing banking finance, while the evidence about its capacity to assist countries in mobilizing alternative instruments, including those reviewed capital markets solutions for SME financing. In in this report, is more fragmented. this context, the World Bank plans to (a) develop a policy note on the topic, along with (b) a toolkit Development institutions should continue to that practitioners can use as a starting point to assess support EMDE governments as they seek to the potential of different capital markets solutions to mobilize private sector funding to SME financing be implemented in a particular jurisdiction, and to via capital markets solutions. This assistance can (c) delve deeper into the financial aspects of these encompass support in preparing and implementing the solutions compared with banking solutions. 72 SECTION 7: Conclusions ANNEX SECTION A2 Capital Markets in Emerging Markets and Developing Economies and Their Potential Role in Reducing the SME The Financing SME Equity Gap A long-standing debate in SME finance is the the equity gap). The resulting outside-to-total equity measurement of the SME finance gap—that is, the ratio was multiplied by the potential SME debt, as distance between the optimal and the actual level of estimated by the IFC, to obtain the potential equity external finance available to SMEs. Most efforts have demand. The actual outside equity in each country been placed on estimating the credit gap, which is was proxied by the World Federation of Exchange’s understandable given the overwhelming reliance of data on SME equity capitalization. The difference these firms on bank loans. However, the same concern between actual and potential (benchmark) equity, applies to the equity gap. In this context, this annex divided by GDP, constitutes the equity gap. As seen in aims to fill the void by calculating the SME equity figure A.1 and table A.1, this gap ranges from less than gap for a broad sample of countries. It is important 5 percent to 35 percent of GDP, with a significantly to acknowledge that this is a very preliminary effort. negative correlation to GDP per capita—that is, the equity gap tends to decrease as countries get richer. In this context, the calculation of the SME equity The phenomenon may likely have to do with the fact gap builds on the methodology developed by the that GDP per capita, institutional quality, and better International Finance Corporation (IFC) to estimate investor protection (a necessary precondition for the credit gap.60 As a first step, a benchmark was equity contracts to flourish) tend to go hand in hand. constructed relying on balance sheet data for a number of European countries, using the BACH database, The equity gap shown in figureA.1 focuses on the outside from which the average equity-to-bank debt ratio for equity raised through public markets—in particular, via European SMEs in 2015–17 was calculated. Because specialized SME boards created to facilitate the entry BACH reports only overall equity, the European of smaller firms. Table A.1 adds other forms of SME Central Bank data on European nonfinancial equity, such as crowdfunding and venture capital, to corporations as of 2017 was employed to eliminate compute a more comprehensive measure of the supply the internal equity component (retained earnings) currently available, which amounts to just 11.7 percent and focus on outside equity (the one of interest for of the potential demand for equity. Table A.1: Equity current supply and gap in 2017 in emerging markets and developing economies, in US$ millions Instrument Volume SME equity raised 35,779 Equity crowdfunding 276 Venture capital 423,326 Current supply 459,381 Equity gap 3,921,797 Current supply to equity gap (%) 11.7 Source: World Bank elaboration based on data from International Finance Corporation, Organisation of Economic Co-operation and Development, World Federation of Exchanges, and Cambridge Centre for Alternative Finance. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 73 Figure A.1 Ratio of SME equity finance gap to GDP, data as of 2017 (%) Czech Republic Switzerland Ukraine Venezuela, RB Brazil Kenya Hungary Micronesia, Fed. Sts. Belize Madagascar Estonia China Slovenia Sudan Fiji Bahamas, The Vanuatu Guatemala Suriname Russian Federation Iraq Bulgaria Guyana Burundi Georgia Turkey Nicaragua Armenia Jordan Ghana Trinidad and Tobago Ecuador Sri Lanka Albania Tajikistan Myanmar Colombia Cental African Republic India Burkin a Faso Indonesia Peru Afghanistan Cambodia Uruguay Tanzania Bhutan Bolivia Lao PDR Djibouti Lesotho Benin Guinea Guinea-Bissau South Sudan 0 5 10 15 20 25 30 35 Source: World Bank estimations. Note: GDP = gross domestic product; SME = small and medium enterprise. 74 ANNEX A: The SME Equity Gap ANNEX B Importance of Alternative Platforms Table B.1: Total alternative platforms volumes, by region, in US$ billions Region Crowdfunding Invoice trading P2P total P2P business P2P consumer Total volume East Asia & Pacific 0.31 5.78 323.15 98.02 225.13 361.60 Europe & Central Asia 0.67 1.62 6.48 3.07 3.41 11.84 East Asia & Pacific 0.08 0.17 1.29 0.59 0.69 3.32 (without China) Latin America & Caribbean 0.01 0.16 0.26 0.08 0.18 0.69 Middle East & North Africa 0.13 0.01 0.14 0.02 0.11 0.34 North America 0.25 0.11 16.20 1.44 14.76 43.64 South Asia 0.02 0.00 0.13 0.03 0.10 0.28 Sub-Saharan Africa 0.00 0.00 0.05 0.02 0.04 0.08 Total 1.38 7.68 346.41 102.69 243.72 418.47 Source: World Bank elaboration based on CCAF database on alternative finance. Note: P2P = peer to peer. Table B.2: Total alternative platforms volumes, by economic category, in US$ billions Country Group Crowdfunding Invoice trading P2P total P2P business P2P consumer Total volume Advanced countries 1.11 1.89 23.57 5.02 18.55 58.52 EMDE 0.28 5.79 322.84 97.68 225.17 359.95 EMDE (without China) 0.05 0.19 0.98 0.25 0.74 1.68 Source: World Bank elaboration based on CCAF database on alternative finance. Note: EMDE = emerging markets and developing economies; P2P = peer to peer. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 75 Table B.3: Total alternative platforms, by region, in percentage of total world volumes Region Crowdfunding Invoice trading P2P total P2P business P2P consumer Total volume East Asia & Pacific 0.07 1.38 77.22 23.42 53.80 86.41 Europe & Central Asia 0.16 0.39 1.55 0.73 0.81 2.83 East Asia & Pacific 0.02 0.04 0.31 0.14 0.17 0.79 (without China) Latin America & Caribbean 0.00 0.04 0.06 0.02 0.04 0.16 Middle East & North Africa 0.03 0.00 0.03 0.01 0.03 0.08 North America 0.06 0.03 3.87 0.34 3.53 10.43 South Asia 0.00 0.00 0.03 0.01 0.02 0.07 Sub-Saharan Africa 0.00 0.00 0.01 0.00 0.01 0.02 Total 0.33 1.84 82.78 24.54 58.24 100.00 Source: World Bank elaboration based on CCAF database on alternative finance. Note: P2P = peer to peer. Table B.4: total alternative platforms, by economic category, in percentage of total world volumes Country Group Crowdfunding Invoice trading P2P total P2P business P2P consumer Total volume Advanced countries 0.26 0.45 5.63 1.20 4.43 13.98 EMDE 0.07 1.38 77.15 23.34 53.81 86.02 EMDE (without China) 0.01 0.05 0.23 0.06 0.18 0.40 Source: World Bank elaboration based on CCAF database on alternative finance. Note: EMDE = emerging markets and developing economies; P2P = peer to peer. 76 ANNEX B: Importance of Alternative Platforms ANNEX C Empirical Research on Alternative Finance: Impact and Key Preconditions This annex seeks to contribute to deepening the the whole alternative finance portfolio (as opposed understanding of (a) the impact that alternative finance to a few specific platforms and experiments) in each mechanisms, and in particular electronic platforms for country, in particular whether the majority of clients fundraising such as those analyzed in this report, can are first-time borrowers or recurring formal credit have in closing the SME financing gap and increasing users. In this regard, data from the CCAF at a country financial inclusion and of (b) key preconditions for level suggest that the patterns on the use of these their development. platforms by banked, underbanked, and unbanked clients differ significantly from one country to another Overall, electronic platforms have the potential to (CCAF 2019, 2018a, 2018b, 2018c). contribute to closing the SME financing gap by improving SMEs’ access to finance (in this case, by In terms of preconditions, Rau (2019) studies more accessing capital markets investors).61 However, the than 3,000 crowdfunding platforms in 161 countries existing empirical research on their actual impact, and asserts that they are more likely to emerge in including in connection with financial inclusion, is countries with larger GDP and better institutions (rule still scarce, as expected in a nascent industry. Recent of law, common law, control of corruption, and so studies and surveys show that fintech solutions are on). Claessens and others (2018) look at 63 countries able to expand the frontiers of financial inclusion. In and uncover a positive but decreasing relationship the United Kingdom, CGFS and FSB (2017) find in between business fintech credit and GDP per capita. a survey that 79 percent of the P2P borrowers had previously applied to a bank loan, but only 22 percent had not been turned down. Jagtiani and Lemieux Working Hypotheses and Data (2018), in assessing the LendingClub platform, To contribute to information on those topics, the World conclude that borrowers that were not eligible based Bank conducted empirical research using four sets of on the usual FICO score were granted a loan using regressors: (a) macroeconomic variables, including the the internal rating and displayed good repayment GDP level (total and per capita) and growth rate, to test behavior afterwards. Frost and others (2019) report whether platforms are more likely to appear in larger, similar evidence for the Mercado Crédito platform richer and faster-growing economies; (b) financial in Argentina. Arráiz and others (2018) implement an variables, including the ratios of private credit and experiment in Peru and find that firms with thin files stock market capitalization to GDP, to test whether that are approved on the basis of psychometric scoring platforms are more likely to appear in countries with become better able to borrow. high or low initial financial depth; (c) institutional variables, comprising the rule of law, legal rights Despite this promising research, more work is protecting creditors and minority shareholders and the needed to state conclusively that alternative finance effectiveness of the legal framework as measured by is substantively pushing financial inclusion. For the time and cost of enforcing contracts and resolving example, little is known about the characteristics of insolvency to test whether institutions matter, as they Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 77 do for banks and traditional capital markets solutions, because most of the driving factors display little for the investors that invest through these platforms; variance over time, a cross-country dataset was and (d) financial constraints variables, to test whether used. The regression analysis relies on the ordinary the platforms are developing in the countries with least squares (OLS) technique, with the explanatory the greatest financial constraints.62 For purposes of variables measured as 2010–12 averages.63 The this exercise the variables listed in table C.1 have analysis covers three instruments in particular: P2P been used as a proxy for financial constraints, on the lending—total, to consumers and to businesses— understanding that this is an area in which there is still equity crowdfunding, and invoice trading, which have much controversy (See Farre-Mensa and Ljungqvist, been the focus of this report.64 2016; Bebczuk 2018). The summary statistics in table C.2 reveal (a) a sharp The CCAF’s database on alternative finance has difference between the mean and the median for been used for this exercise. The exercise covers a most variables, as well as high variances (despite low maximum of 159 countries over the period 2013–17. volumes in many other countries, this difference is Because these are flows and not stocks (which are largely due to the dominant position of China, which usually much more stable than flows), to mitigate data holds 86 percent of world volumes), and (b) a less noise the dependent variable is the average, scaled by widespread presence across countries of business population, over this five-year period. Furthermore, versus consumer-oriented alternative finance. Table C.1: Country-level Proxies for Financial Constraints Measure Definition Internet Address SME credit gap Difference between potential SME Finance Forum https://www.smefinanceforum.org/ SME credit demand (based on data-sites/msme-finance-gap advanced countries’ benchmark) and actual availability in the country SME equity gap Similar methodology for the credit World Bank elaboration gapa Credit bureau coverage Number of firms and individuals, World Bank’s Doing Business www.doingbusiness.org as a percentage of the adult population, listed in a credit bureau, regardless of whether they have debt or not Bank interest margin Accounting value of bank’s net World Bank’s Global Financial https://www.worldbank.org/en/ interest revenue as a share of its Development Database publication/gfdr/data/global- average interest-bearing assets financial-development-database Bank lending-deposit spread Difference between the lending World Bank’s Global Financial https://www.worldbank.org/en/ rate and the deposit rate Development Database publication/gfdr/data/global- financial-development-database % of credit-constrained SMEs Percentage of firms in the survey World Bank’s Enterprise Surveys http://www.enterprisesurveys.org/ identifying access to finance as a major constraint % of SME investment financed As reported by firms participating World Bank’s Enterprise Surveys http://www.enterprisesurveys.org/ with bank credit in the survey % of SME investment financed As reported by firms participating World Bank’s Enterprise Surveys http://www.enterprisesurveys.org/ with internal funds in the survey Note: SME = small and medium enterprise. 78 ANNEX C: Empirical Research on Alternative Finance: Impact and Key Preconditions Table C.3 shows the average degree of financial Results constraints in countries with levels of private credit and stock capitalization above and below the world Starting from a baseline specification containing median. Overall, the table leads to the conclusion the GDP level and growth as well the level of that financial deepening has little to do with the private credit to GDP, tables C.6 through C.11 degree of financial constraints. In the case of market display the regressions for the alternative finance capitalization, most differences turn out to be instruments analyzed.66 The results can be insignificant. In the case of private credit, although summarized as follows: six of eight financial constraints proxies display the expected sign and are significantly different, the • GDP enters positively in several equations, but the economic effect appears to be oddly low in some effect vanishes once a dummy for China is included. cases. For instance, the mean private credit ratio to GDP is 82.6 percent (21.1 percent) for countries above DP growth also delivers a positive and significant • G (below) the world median. However, as an example, estimate in a few cases, but the effect substantially the difference in the percentage of SME investment weakens after including the China dummy. financed with credit is just 8.6 percentage points (22.7 percent against 14.1 percent). Furthermore, • Credit depth exerts a strong and positive effect, despite the fact that the private credit ratio is about which in this case is reinforced after controlling four times higher in the first group, the difference for China. in credit gap and percentage of credit-constrained SMEs is not significant. s expected, when stock market capitalization • A replaces private credit as the measure of financial Table C.4 shows that the correlation between the depth, the former is significant only for equity various proxies of financial constraints is quite low, crowdfunding (that is, not for the other, debt-based with the exception of those based on the same kind of vehicles). data, such as interest margin and interest spread, credit gap and equity gap, and the percentage of investment DP per capita does not appear to add any • G financed with credit and with internal funds. explanatory power. The correlation of the alternative finance measures nstitutional quality plays a significant role on the • I with all the proposed explanatory variables is development of alternative finance. Although not presented in table C.5. Correlations display the all of the institutional measures are significant for expected sign and are significant for the most part in all instruments, at least one is (rule of law). the macrofinancial and institutional block, although the average correlation is just 20 percent and only one of the financial constraint proxies were • N the one with total GDP exceeds 50 percent. In turn, statistically significant. The only variable yielding the majority of the correlations with the financial a significant coefficient is the percentage of credit- constraints proxies are insignificant.65 constrained SMEs. However, for most of the categories, the sign is negative, suggesting that alternative finance is more likely to emerge where it is a priori needed the least. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 79 Table C.2: Alternative finance volumes: Summary statistics, in US$, as % of total population, 2013–17 averages Variables Number of Countries Mean Median Standard Deviation Total volume 159 354 11 1287 Total P2P 105 322 11 1139 Business P2P 66 153 26 458 Consumer P2P 98 278 15 885 Equity crowdfunding 60 54 2 149 Invoice trading 38 164 30 274 Note: P2P = peer to peer. Table C.3: Financial depth and financial constraints variables Variables Number Mean Median Standard Mean values above and Mean values above and of deviation below world median below world median Stock countries Private credit to GDP market capitaliz. to GDP Above Below Diff. Above Below Diff. Private credit to GDP 170 51.9 40.5 40.4 82.6 21.1 61.5 85.5 51.0 34.5 Stock market 105 46.2 30.6 43.9 54.2 23.9 30.3 76.6 15.3 61.4 capitalization to GDP Credit gap to GDP 120 14.1 13.4 9.5 13.1 15.1 -2.0 12.0 14.0 -2.0 Equity gap to GDP 112 14.3 14.0 6.6 16.4 13.2 3.2 13.8 15.0 -1.1 Credit bureau coverage 180 23.5 0.8 33.6 36.2 9.7 26.5 40.1 32.9 7.2 Bank net interest margin 178 4.7 4.5 2.5 3.4 6.1 -2.7 3.1 5.1 -2.0 Bank lending-deposit 128 7.2 6.0 5.3 5.4 8.7 -3.4 5.7 6.7 -1.1 spread % of credit constrained 132 24.9 21.7 16.9 21.6 26.7 -5.1 18.7 21.4 -2.7 SMEs % of SME investment 132 17.3 16.5 11.8 22.7 14.1 8.6 21.6 19.6 2.0 financed with credit % of SME investment 132 68.9 69.6 14.7 64.5 71.3 -6.8 65.3 64.8 0.4 financed with internal funds Note: Mean differences significant at 5% or less in bold; GDP = gross domestic product; SME = small and medium enterprise. 80 ANNEX C: Empirical Research on Alternative Finance: Impact and Key Preconditions Table C.4: Financial constraints proxies: correlation matrix Credit gap Equity Credit Bank net Bank % of credit- % of SME to GDP gap to bureau interest lending- constrained investment GDP coverage margin deposit SMEs financed spread with credit Equity gap to GDP 0.8315 Credit bureau coverage 0.0364 0.1472 Bank net interest margin 0.1007 -0.104 -0.2625 Bank lending-deposit spread 0.097 -0.0169 -0.1752 0.463 % of credit-constrained SMEs -0.1217 -0.2046 -0.2673 -0.1801 0.0571 % of SME investment financed with credit -0.0805 0.0239 0.2932 -0.047 -0.0472 -0.0875 % of SME investment financed 0.1058 0.0415 -0.2305 -0.0377 -0.0563 0.0501 -0.7767 financed with internal funds Note: Correlations significant at 5% or less in bold. GDP = gross domestic product; SME = small and medium enterprise. Table C.5: Alternative finance volumes: correlations with proposed explanatory variables Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading Macro-financial variables GDP level 0.73 0.74 0.54 0.72 0.02 -0.10 GDP growth 0.02 0.04 0.05 0.02 -0.01 -0.25 GDP per capita 0.20 0.10 0.14 0.22 0.31 0.31 Private credit to GDP 0.39 0.31 0.34 0.33 0.19 0.41 Stock capitalization to GDP 0.19 0.12 0.19 0.04 0.31 0.10 Institutional variables Rule of law 0.30 0.20 0.17 0.28 0.33 0.47 Legal rights 0.25 0.18 0.13 0.22 0.35 0.22 Investor protection 0.28 0.21 0.12 0.26 0.30 0.30 Enforcing contracts -0.20 -0.17 -0.17 -0.24 -0.06 -0.06 Resolving insolvency -0.24 -0.18 -0.25 -0.23 -0.16 -0.38 Financial constraints variables Credit gap to GDP 0.00 0.02 0.00 0.01 0.03 0.08 Equity gap to GDP 0.09 0.08 0.10 0.12 0.16 0.38 Credit bureau coverage 0.24 0.17 0.03 0.14 0.26 0.26 % of credit-constrained SMEs -0.20 -0.16 -0.17 -0.23 -0.25 0.01 % of SME investment financed -0.05 -0.06 -0.12 -0.08 0.08 0.16 with credit % of SME investment financed 0.12 0.11 0.23 0.17 0.11 0.05 with internal funds Bank net interest margin -0.23 -0.16 -0.21 -0.22 -0.24 -0.37 Bank lending-deposit spread -0.15 -0.12 -0.15 -0.16 -0.10 -0.16 Note: Correlations significant at 5% or less in bold. GDP = gross domestic product; SME = small and medium enterprise. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 81 Table C.6. Correlates of alternative finance, baseline specification Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading GDP level 0.456** 0.410** 0.137** 0.254** -0.00938 -0.0122 [0.181] [0.160] [0.0467] [0.121] [0.00592] [0.0106] GDP growth 30.95** 14.56** 19.19 18.60 8.748 -6.371 [15.10] [7.351] [13.10] [19.36] [5.761] [11.55] Private credit to GDP 7.148** 3.060 2.439** 3.014 0.898** 2.266** [2.965] [1.927] [1.219] [1.929] [0.356] [0.997] Constant -414.4** -229.9** -244.5** -190.7 -40.64 5.692 [143.7] [87.61] [103.8] [130.8] [32.65] [74.67] Observations 150 170 69 94 63 45 R-squared 0.444 0.497 0.490 0.393 0.062 0.187 Note: GDP = gross domestic product; P2P = peer to peer. Table C.7. Correlates of alternative finance, baseline specification, with China dummy Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading GDP level 0.0129 0.0133 0.0130 -0.0712 -0.0104 -0.0280 [0.0992] [0.0585] [0.0311] [0.0477] [0.0109] [0.0231] GDP growth 21.92** 9.718 4.322 -10.20 8.706 -8.191 [13.10] [6.031] [10.83] [13.16] [5.763] [11.53] Private credit to GDP 8.548*** 4.388** 2.296* 3.993** 0.897** 2.164** [2.824] [1.762] [1.268] [1.784] [0.361] [1.040] China dummy 9296.4*** 8362.3*** 2532.8*** 6619.9*** 20.68 298.4 [1474.1] [851.2] [493.7] [561.0] [123.3] [303.3] Constant -294.0** -153.0* -92.31 44.25 -39.69 33.65 [144.9] [82.21] [101.7] [85.01] [35.95] [88.28] Observations 150 170 69 94 63 45 R-squared 0.599 0.716 0.641 0.645 0.062 0.195 Note: GDP = gross domestic product; P2P = peer to peer. 82 ANNEX C: Empirical Research on Alternative Finance: Impact and Key Preconditions Table C.8: Correlates of alternative finance, baseline specification, with China dummy (not reported) and GDP per capita Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading GDP level 0.0117 0.0134 0.0123 -0.0732 -0.00892 -0.0267 [0.1000] [0.0589] [0.0315] [0.0490] [0.0101] [0.0244] GDP growth 20.71 10.46 5.789 -9.474 8.615** -8.365 [13.44] [6.670] [9.813] [13.77] [4.124] [11.35] Private credit to GDP 8.083** 4.548** 1.860 3.497 0.287 1.584 [3.289] [2.003] [1.507] [2.340] [0.395] [1.215] GDP per capita 0.00174 -0.000561 0.00207 0.00199 0.00263** 0.00249 [0.00293] [0.00121] [0.00238] [0.00457] [0.00117] [0.00225] Constant -294.5** -154.2* -113.4 39.33 -59.02** 10.50 [144.4] [83.97] [93.53] [86.02] [29.14] [78.34] Observations 150 170 69 94 63 45 R-squared 0.600 0.716 0.645 0.645 0.126 0.211 Note: GDP = gross domestic product; P2P = peer to peer. Table C.9. Correlates of alternative finance, baseline specification, with China dummy (not reported) and stock market capitalization Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading GDP level 0.360*** 0.224*** 0.0127* 0.188** -0.00259 -0.0194** [0.109] [0.0666] [0.00702] [0.0766] [0.00492] [0.00741] GDP growth -31.57 -14.30 -15.36 -41.79 -0.0803 -32.97** [23.91] [14.56] [12.36] [28.73] [3.482] [15.09] Stock capit. to GDP 3.353 0.925 1.699 -1.419 0.951** 0.916 [2.700] [1.479] [1.045] [1.182] [0.401] [0.753] Constant 141.4 82.70 65.48 364.6 2.318 236.3** [152.1] [95.41] [57.29] [220.1] [19.50] [91.67] Observations 100 105 64 69 62 45 R-squared 0.591 0.695 0.631 0.611 0.096 0.127 Note: GDP = gross domestic product; P2P = peer to peer. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 83 Table C.10: Correlates of alternative finance: Estimated coefficients for institutional variables, additional controls (baseline specification, with China dummy) not reported Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading Rule of law 259.4*** 112.6** 73.72** 230.7*** 72.72** 134.1** [84.06] [46.07] [35.24] [73.94] [27.58] [51.14] Legal rights 82.08*** 42.08** 23.22 52.44** 20.98** 9.810 [29.21] [16.17] [16.18] [22.21] [10.42] [16.33] Investor protection 105.8*** 58.59** 29.84 102.7** 27.44 50.36 [38.73] [28.05] [23.50] [45.59] [20.39] [41.39] Enforcing contracts -0.295** -0.199** -0.136 -0.368** 0.0237 0.0308 [0.120] [0.0781] [0.0826] [0.152] [0.101] [0.0710] Resolving insolvency -84.68** -33.69** -37.12** -46.80 -14.86 -64.61 [34.39] [20.35] [18.47] [28.95] [14.11] [44.65] Note: P2P = peer to peer. Table C.11: Correlates of alternative finance: Estimated coefficients for financial constraints variables, additional controls (baseline specification, with China dummy) not reported Total Total Business Consumer Equity Invoice volume P2P P2P P2P crowdfunding trading Credit gap to GDP 0.0821 0.710 -1.965 -1.543 0.0494 2.334 [5.080] [2.923] [1.378] [6.091] [0.0952] [3.037] Equity gap to GDP 4.369 2.856 -0.0973 3.306 0.0653 1.552 [3.731] [2.553] [0.599] [3.791] [0.0854] [2.227] Credit bureau coverage 4.124** 2.075* 0.678 1.331 1.012 1.518 [2.004] [1.253] [0.893] [1.605] [0.733] [1.257] Bank net interest margin -24.75 -1.462 1.643 -21.00 -25.23* -21.57 [30.13] [17.13] [20.94] [26.08] [14.37] [18.75] Bank lending-desposit spread -1.644 -1.057 -0.296 -4.105 -1.730 -0.784 [3.695] [2.496] [0.929] [4.013] [3.178] [1.649] % of credit-constrained SMEs -4.796** -2.639** 0.290 -3.910** -3.036 2.814* [2.381] [1.315] [0.715] [1.924] [2.879] [1.493] % of SME investment financed -2.642 -1.344 0.690 -2.272 0.680 2.337 with credit [3.834] [2.082] [0.893] [3.923] [1.500] [2.038] % of SME investment financed 2.714 1.289 -0.423 2.131 1.617 -0.359 with internal funds [1.697] [0.929] [0.502] [1.570] [1.457] [1.571] Note: GDP = gross domestic product; P2P = peer to peer; SME = small and medium enterprise. 84 Title References ACCA (Association of Chartered Certified BCBS (Basel Committee on Banking Supervision). Accountants). 2014. “A Study of the Business 2016. Basel III Document: Revisions to the Case for Supply Chain Finance.” Prepared by Securitisation Framework, Amended to Include Enrico Camerinelli, the Aite Group, for ACCA, the Alternative Capital Treatment for ‘Simple, London, June. Transparent and Comparable’ Securitisations.” Bank for International Settlements, Basel, Switzerland. Aiyar, Shekhar, Ali Al-Eyd, Bergljot Barkbu, and Andreas A. Jobst. 2015. “Revitalizing Securitization BCBS. 2017. “Basel III: Finalising Post-Crisis for Small and Medium-Sized Enterprises in Europe.” Reforms.” Bank for International Settlements, Basel, IMF Staff Discussion Note SDN/15/07, International Switzerland. Monetary Fund, Washington, DC. BCBS (Basel Committee on Banking Supervision) Armstrong, Angus, and Monique Ebell. 2015. “Small and IOSCO (International Organization of Securities and Medium Sized Enterprise Securitisation.” Commissions). 2015. Criteria for Identifying Simple, Research report, British Business Bank, London. Transparent and Comparable Securitisations.” Bank for International Settlements, Basel, Switzerland. Arráiz Irani, Miriam Bruhn, Claudia Ruiz Ortega, and Rodolfo Stucchi. 2018. “Are Psychometric BCBS and IOSCO. 2018. “Criteria for Identifying Tools a Viable Screening Method for Small and Short-Term ‘Simple, Transparent and Comparable’ Medium Enterprise Lending? Evidence from Peru.” Securitizations.” Bank for International Settlements, Development through the Private Sector Series, Basel, Switzerland. Technical Note 5, Inter-American Investment Corporation, Washington, DC. Bebczuk Ricardo. 2018. “SME Investment and Financial Constraints in Argentina: Evidence AVCA (African Private Equity and Venture Capital from Survey, Balance Sheet and Banking Data.” Association). 2016. “Guide to PE in Africa.” AVCA, Unpublished report, Department of Economics, London, August. Universidad Nacional de La Plata, Argentina. AVCA. 2018. “2018 Annual Limited Partner Ben Naceur, Sami, and Caroline Roulet. 2017. Survey.” AVCA, London, November. “Basel III and Bank-Lending: Evidence from the United States and Europe.” IMF Working Paper Bakie, John. 2019. “EIB to Lend €100 Million to 17/245, International Monetary Fund, Washington, Dutch and German SMEs through Funding Circle.” DC, November. Private Debt Investor, April 15. Board of Governors of the Federal Reserve Board Bank for International Settlements. 2018. “Sound System. 2017. Report to the Congress on the Practices: Implications of Fintech Developments for Availability of Credit to Small Business. Washington, Banks and Bank Supervisors.” Basel Committee on DC: Federal Reserve Board. Banking Supervision, Basel, Switzerland, February. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 85 Boschmans, Kris, and Lora Pissareva. 2018. Colombo, Massimo G., Douglas J. Cumming, and “Fostering Markets for SME Finance: Matching Silvio Vismara. 2014. “Governmental Venture Business and Investor Needs.” OECD SME and Capital for Innovative Young Firms.” Journal of Entrepreneurship Papers 6, OECD Publishing, Paris. Technology Transfer 41 (1). Brander, James, Qianqian Du, and Thomas F. Cusmano, Lucia. 2013. “SME and Entrepreneurship Hellmann. 2010. “The Effects of Government- Financing: The Role of Credit Guarantee Schemes Sponsored Venture Capital: International Evidence.” and Mutual Guarantee Societies in Supporting NBER Working Paper 16521, National Bureau of Finance for Small and Medium-Sized Enterprises.” Economic Research, Cambridge, MA, November. OECD SME and Entrepreneurship Papers 1, Organisation for Economic Co-operation and British Business Bank. 2019. “Enabling Smaller Development, Paris. Businesses to Grow and Prosper: Annual Report and Accounts 2019.” CVM (Comissão de Valores Mobiliários). 2019. “Equity Crowdfunding: Evolution of the Market.” CCAF (Cambridge Centre for Alternative Finance). Rio de Janeiro, Brazil. 2018a. The 3rd Asia Pacific Region Alternative Finance Industry Report. Cambridge, UK: CCAF. De la Torre, Augusto, Juan Carlos Gozzi, and Sergio L. Schmukler. 2017. “An Online Platform for CCAF. 2018b. Reaching New Heights: The 3rd Reverse Factoring: NAFIN’s Experience in Mexico.” Americas Alternative Finance Industry Report. In Innovative Experiences in Access to Finance: Cambridge, U.K.: CCAF. Market-Friendly Roles for the Visible Hand?, by CCAF. 2018c. The 2nd Annual Middle East and Augusto de la Torre, Juan Carlos Gozzi, and Sergio Africa Alternative Finance Industry Report. CCAF, L. Schmukler, Latin American Development Forum. Cambridge, U.K. (Washington, DC: World Bank). CCAF. 2019. Shifting Paradigms: The 4th European Divakaran, Shanthi, Patrick J. McGinnis, and Alternative Finance Benchmarking Report. Masood Shariff. 2014. “Private Equity and Venture Cambridge, U.K.: CCAF. Capital in SMEs in Developing Countries: The Role for Technical Assistance.” Policy Research Working Carvajal, Ana Fiorella, Tamuna Loladze, James Paper 6827, World Bank Group, Washington, DC. Walter Hammersley, Jeffrey David Anderson, Simon Christopher, and Richard Kemmish. 2017. Divakaran, Shanthi, Patrick J. McGinnis, and Sam “Fixed Income Instruments to Mobilize Institutional Schneider. 2018. “Survey of the Kenyan Private Investors for SME Financing in EMEs.” FCI in Equity and Venture Capital Landscape.” Policy Focus, World Bank, Washington, DC. Research Working Paper WPS 8598. World Bank Group, Washington, D.C. CGFS (Committee on the Global Financial System) and FSB (Financial Stability Board). 2017. “FinTech EBA (European Banking Authority). 2018. EBA Credit: Market Structure, Business Models and Report on the European Structured Notes (ESNS). Financial Stability Implications.” Report by the London: European Banking Authority. working group of the CGFS and FSB, Bank for EMPEA (Emerging Markets Private Equity International Settlements and FSB, May 22. Association). 2016. “Special Report: Private Equity Claessens Stijn, Jon Frost, Grant Turner, and in Mexico.” EMPEA, Washington, DC, May. Feng Zhu. 2018. “Fintech Credit Markets around EMPEA. 2018a. “The Shifting Landscape for Private the World: Size, Drivers and Policy Issues.” BIS Capital in Brazil.” EMPEA brief, Washington, DC, Quarterly Review, September. May. 86 References EMPEA. 2018b. “The Road Ahead for African Loans Originated by Funding Circle.” News release, Private Equity.” EMPEA brief, Washington, DC, Funding Circle, London, May 3. May. GIIN (Global Impact Investing Network). 2018. ESMA (European Securities and Markets Authority). “Annual Impact Investor Survey,” 8th ed. New York. 2016. “Opinion: Key Principles for a European Framework on Loan Origination by Funds.” ESMA G20/OECD (Organisation for Economic Co- 2016/596, April 11. operation and Development). 2015. “High Level Principles on SME Financing.” G20 meeting in ESMA Securities and Markets Stakeholders Group. Antalya, Turkey, November. 2017. “Access to Public Capital Markets for SMEs.” Report ESMA22-106-535, European Securities G20/OECD. 2016a. “Support Note on Diversification and Markets Authority, European Union, Paris, of Financial Instruments for SMEs.” July. November 8. G20/OECD. 2016b. “Supporting Note to the European Commission. 2016. “Evaluation of the Guidance Note on Diversified Financial Instruments, Late Payments Directive: REFIT Evaluation,” SMEs.” Commission Staff Working Document SWD 2016 Harwood, Alison, and Tanya Konidaris (2015). (278), European Commission, Brussels, August 26. “SME Exchanges in Emerging Market Economies: European Commission. 2017. Effectiveness of Tax A Stocktaking of Development Practices.” Policy Incentives for Venture Capital and Business Angels Research Working Paper 7160, World Bank Group, to Foster Investment of SMEs and Start-Ups: Final Washington, DC. Report. Brussels: European Commission. HM Treasury, United Kingdom. 2018. “Bank Farre-Mensa Joan, and Alexander Ljungqvist. 2016. Referral Scheme: Official Statistics.” Statistical “Do Measures of Financial Constraints Measure release, August 31. Financial Constraints?” Review of Financial Studies Hubbard, R. Glenn. 1998. “Capital-Market 29 (2): 271–308. Imperfections and Investment.” Journal of Economic Flunder, Andrea, Tanja Schlösser, and Andrea Weber. Literature 36 (1): 193–225. 2018. The New European Framework for ABS IFC (International Finance Corporation). 2017. Transactions, White paper 81, Deloitte, Düsseldorf, “MSME Finance Gap: Assessment of the Shortfalls Germany. and Opportunities in Financing Micro, Small, and Frost Jon, Leonardo Gambacorta, Yi Huang, Hyun Medium Enterprises in Emerging Markets.” Working Song Shin, and Pablo Zbinden. 2019. “BigTech and paper, IFC, Washington, DC. the Changing Structure of Financial Intermediation.” IMF (International Monetary Fund). 2019. Global BIS Working Papers 779, Bank for International Financial Stability Report: Lower for Longer. Settlements, Basel, Switzerland, April 8. Washington, DC. FSB (Financial Stability Board). 2019. “Evaluation IOSCO (International Organization of Securities of the Effects of Financial Regulatory Reforms Commissions). 2015. “SME Financing through on Small and Medium-Sized Enterprise (SME) Capital Markets: Final Report.” FR11/2015. Financing.” Consultative document, FSB, Basel, Switzerland. IOSCO (International Organization of Securities Commissions). 2017. Findings of the Survey on Funding Circle. 2018. “European Investment Fund Loan Funds: Final Report.” FR03/2017, IOSCO, and German Development Bank, KfW, Invest in Madrid. UK Small Businesses through Securitisation of Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 87 Jagtiani Julapa, and Catharine Lemieux. 2019. “The Nassr, Iota Kaousar, and Gert Wehinger. 2015. Roles of Alternative Data and Machine Learning in “Unlocking SME Finance through Market-Based Fintech Lending: Evidence from the LendingClub Debt: Securitisation, Private Placements and Bonds.” Consumer Platform.” Federal Reserve Bank of OECD: Journal Financial Market Trends 2014 (2). Philadelphia Working Paper 18-15, Revised January. Navaretti Giorgio Barba, Giacomo Calzolari, and Jenik, Ivo, Timothy Lyman, and Alessandro Nava. Alberto Franco Pozzolo. 2017. “FinTech and Banks: 2017. “Crowdfunding and Financial Inclusion.” Friends or Foes?: European Economy: Banks, CGAP working paper. Consultive Group to Assist Regulation, and the Real Sector 3 (2). the Poor, Washington DC. OECD (Organisation for Economic Co-operation Kaplan, Steven N., and Luigi Zingales. 1997. “Do and Development). 2015a. OECD Business and Investment-Cash Flow Sensitivities Provide Useful Finance Outlook 2015, OECD Publishing, Paris. Measures of Financing Constraints?” Quarterly Journal of Economics 112 (1). OECD. 2015b. “Opportunities and Constraints of Market-Based Financing for SMEs.” Report to the Kraemer-Eis, Helmut, Francesco Battazzi, Remi G20 Finance Ministers and Central Bank Governors. Charrier, Marco Natoli, and Matteo Squilloni. 2014. OECD, Paris, September. “Institutional Non-Bank Lending and the Role of Debt Funds.” Working Paper 2014/25. European OECD. 2015c. New Approaches to SME and Investment Fund, Luxembourg, October. Entrepreneurship Financing: Broadening the Range of Instruments. Paris: OECD. Kraemer-Eis, Helmut, George Passaris, Alessandro Tappi, and Giovanni Inglisa. 2015. “SME OECD. 2017. Pension Markets in Focus. Paris: Securitisation—At a Crossroads?” EIS Working OECD. Paper 2015/31, European Investment Fund, OECD. 2018a. Pension Markets in Focus No. 15. Luxembourg, December. Paris: OECD. Latham & Watkins. 2014. “Destination Italy OECD. 2018b. OECD Survey of Investment Decree—New Legislative Measures to Encourage Regulation of Pension Funds 2018. Paris: OECD. Debt Capital Markets Transactions.” Client Alert: News Flash 1655, Milan, Italy, February 24. OECD. 2018c. “Survey of Large Pension Funds and Public Pension Reserve Funds, 2016.” OECD, Paris. MFW4A (Making Finance Work for Africa) and EMPEA (Emerging Markets Private OECD. 2019a. “Initial Coin Offerings (ICOs) for Equity Association). 2014. “Pension Funds and SME Financing.” OECD, Paris. Private Equity: Unlocking Africa’s Potential.” Commonwealth Secretariat, London. OECD. 2019b. OECD Insurance Statistics 2018. OECD Publishing, Paris. Morrison & Foerster LLP. 2018. “Frequently Asked Questions about Business Development Companies.” OECD and European Commission. 2010. “Facilitating Access to Finance: Discussion Paper Murray, Gordon, Marc Cowling, Weixi Liu, and on Credit Guarantee Schemes.” OECD Publishing, Olga Kalinowska-Beszczynska. 2012. “Government Paris. Co-financed ‘Hybrid’ Venture Capital Programmes: Generalizing Developed Economy Experience and Owen, Robyn (Baldock), David North, and Ciaran Its Relevance to Emerging Nations.” Kauffman Mac an Bhaird. 2019. “The Role of Government International Research and Policy Roundtable, Venture Capital Funds: Recent Lessons from the Liverpool, U.K., March 11–12. U.K. Experience.” Strategic Change 28 (1). 88 References Perkins, David W. 2018. “Marketplace Lending: Schweizer, Denis, Juliane Proelss, and Mark Fintech in Consumer and Small-Business Lending.” Mietzner. 2015. “Hidden Champions or Black Congressional Research Service Report 44614, Sheep: Evidence from German Mini-Bonds.” September. Securities Commission of Malaysia. 2019a. Pouzin, Gilles. 2014. “France: SME Cash Lifeline “Guidelines on Recognized Markets.” First issued Gains Investors’ Attention.” IPE, May. December 2015; revised May 17. Pouzin, Gilles. 2015. “France’s Novi Fund Targets Securities Commission of Malaysia. 2019b. Liquidity.” IPE, May. “Crowdfunding Statistics as of March 2019.” Pouzin, Gilles. 2016. “SME Lending: Finance Funds Shi, Lin. 2016. “Case Study: Bayport Financial for Business.” IPE, May. Services—How Can Businesses Tap Local Capital Markets to Expand?” EMCompass 2, World Bank, Ramalho, Rita, Nan Jiang, Olena Koltko, Édgar Washington, DC. Chávez, Klaus Adolfo Koch-Saldarriaga, and Maria Antonia Quesada Gamez. 2018. “Improving Stein, Peer, Tony Goland, and Robert Schiff. 2010. Access to Finance for SMEs: Opportunities through “Two Trillion and Counting: Assessing the Credit Credit Reporting, Secured Lending, and Insolvency Gap for Micro, Small, and Medium-Size Enterprises Practices.” working paper, World Bank Group, in the Developing World.” Working paper, IFC and Washington, DC. McKinsey & Company, Washington, DC. Rau, P. Raghavendra. 2019. “Law, Trust, and the USAID (United States Agency for International Development of Crowdfunding.” working paper, Development). 2016. “Microfinance Securitization: University of Cambridge. Raising New Sources of Capital through Local Bond Markets.” Fact sheet. Development Credit Authority, Reille, Xavier, and Sarah Forster. 2008. “Foreign USAID, Washington, DC. Capital Investment in Microfinance: Balancing Social and Financial Returns.” CGAP focus note 44, Wehinger, Gert, and Iota Nassr. 2015. “SME Debt World Bank, Washington, DC. Financing Beyond Bank Lending: The Role of Securitization, Bonds and Private Placements.” Reserve Bank of India. 2017. “Master Directions: Organisation for Economic Co-operation and Non-Banking Financial Company–Peer to Peer Development, Paris. Lending Platform.” Updated Feb. 23, 2018. Wilson, Karen E. 2015. “Policy Lessons from Royaume du Maroc. 2018. “Recueil Annuel des Financing Innovative Firms.” OECD Science Instrument et Programmes Publiques de Financement Technology and Industry Policy Papers 24, OECD Destines aux Start-Ups et aux TPMEs.” Publishing, Paris. Rust, Susanna. “French Asset Owners Top Up Novo World Bank. 2015a. “Crowdfunding in Emerging SME Bond Funds by €400M.” IPE, June 3. Markets: Lessons from East African Start-Ups.” Info Schammo, Pierre. 2019. “‘Undisruption’ in the SME dev report, World Bank Group, Washington, DC. Funding Market: Information Sharing, Finance World Bank. 2015b. “Capital Markets Instruments Platforms and the UK Bank Referral Scheme.” to Mobilize Institutional Investors to Infrastructure European Business Organization Law Review 20 (1). and SME Financing in Emerging and Developing Schellhase, John. 2017. “Promoting Participation Economies.” Report to the G20, World Bank, in SME Boards through Tax Incentives: A Washington, DC. Global Overview.” Viewpoints, Milken Institute, Washington, DC. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 89 World Bank. 2018. “Improving Access to Finance World Bank Group, IMF (International Monetary for SMEs: Opportunities through Credit Reporting, Fund), and OECD (Organisation for Economic Co- Secured Lending, and Insolvency Practices.” operation and Development). 2015. “Capital Market Washington, DC, World Bank. Instruments to Mobilize Institutional Investors to Infrastructure and SME Financing in Emerging World Bank. Forthcoming. “Capital Markets Market Economies: Report for the G20.” World Development: Causes, Consequences, and Bank, Washington, DC. Sequencing.” World Economic Forum. 2015. “The Future of World Bank and CCAF (Cambridge Centre for FinTech: A Paradigm Shift in Small Business Alternative Finance). 2019. Regulating Alternative Finance.” Geneva, October. Finance: Results from a Global Regulatory Survey. Washington, DC: World Bank. World Federation of Exchanges. 2018. “An Overview of WFE SME Markets.” London. World Bank and FIRST Initiative. 2015. Principles for Public Credit Guarantee Schemes for SMEs. World Bank, Washington, DC. 90 References Endnotes 1. This report focuses on the immediate ecosystem 6. In addition, the World Bank has taken into required for these instruments to develop. consideration available research from the However, the need for a favorable ecosystem OECD, which focuses on experiences in OECD for “doing business” and entrepreneurship is a countries. See, among others, Boschmans necessary precondition for a healthy development and Pissareva 2018, G20/OECD 2016a, G20/ of capital market solutions in general. OECD 2016b, OECD 2015b, OECD 2015c, and Nassr, Kaousar, and Wehinger 2015. 2. In this way the report supports the G20/ Organisation for Economic Co-operation 7. There are no global databases with information and Development (OECD) High Level on SME bond exchanges or SME funds. Some Principles on SME Financing and in of the data, mainly for AEs, can be found in particular Principle 3, which calls for enabling information from private data vendors, but the SMEs’ access to diverse nontraditional level of disaggregation is not useful for the banking instruments. See G20/OECD 2015. purposes of this report. Data on private equity and venture capital were obtained from the 3. Although the report focuses on SME Emerging Markets Private Equity Association financing, many of the solutions described (EMPEA); on SME equity exchanges, are useful also for microenterprises; in from the World Federation of Exchanges; fact, some of the examples presented have and on platforms solutions (receivables, microcredits as the underlying assets. lending, and equity crowdfunding), from the Cambridge Centre for Alternative Finance. 4. In 2015 the World Bank Group coordinated a note on capital markets instruments 8. For example, angels are a distinctive investment to mobilize institutional investors for source that usually invests earlier than VC, invest infrastructure and SME financing at the in more geographically and sectorally diverse request of the G20. The report did not cover ranges of investees and potentially in many equity solutions nor solutions brought by more businesses, often playing an active role fintech, which were left for a later review. See in building the entrepreneurship ecosystems. World Bank Group, IMF, and OECD 2015. In this context, some of the interventions to support angel investment can be different. This 5. By definition, this report excludes other forms report mentions one type of tool (tax incentives) of alternative financing that do not involve that applies equally to VC and angel investors. capital markets investors. That comprises, for But support for angel groups, angel capacity example, “pure” factoring or leasing. However, building, and seed investment readiness are some capital markets solutions that leverage additional interventions offered either as asset-based financing are covered in the report. standalones or more typically in integrated entrepreneurship development approaches. Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 91 9. For more information on the role of yield previously available from this portion initial coin offerings in SME financing of the portfolio has steadily decreased. and their risks, see OECD 2019a. 16. Overall pension funds have increased 10. According to research from IFC’s investments in alternative asset classes such as MSME Country Indicators (for 2014), private equity, real estate, and infrastructure, this is the most widely used definition which often involve long-term lock-up periods by individual countries. See IFC 2017. and significant embedded leverage. Life insurers have also increased their holdings of lower- 11. As will be explained later in this report, that rated and long-duration bond investments. See advantage is now being contested given the IMF 2019, chap. 3, “Institutional Investors.” progress made with the use of nontraditional information to assess credit risk, including 17. These assets include loans, land and the data footprint of SMEs on the internet. buildings, unallocated insurance contracts, hedge funds, private equity funds, structured 12. Empirical research on the effects of Basel III on products, other mutual funds (that is, those bank lending in the United States and Europe was not invested in equities, bills and bonds, or conducted by Ben Naceur and Roulet (2017). cash and deposits), and other investments. 13. The report did note that in certain jurisdictions, 18. To some extent, banks’ investments in Basel III’s risk-based capital requirements plain vanilla issuances can foster SME caused SME lending to slow and lending financing, particularly in cases in which conditions to tighten among institutions that a bank’s business model caters to SMEs. were least capitalized precrisis relative to other However, for purposes of this report, the banks. The report also noted that SME lending emphasis is on issuances by specialized SME growth appears to have resumed in recent years lenders because the connection is clearer. after falling, but it remains below precrisis levels today. See Financial Stability Board (2019), 19. The exception would be if they are placed via a Evaluation of the effects of financial regulatory private placement. In some EMDEs some types reforms on small and medium-sized enterprise of institutional investors are prohibited from (SME) financing, Consultative Document. investing in securities that are not public offerings. 14. Determined from a combination of the World 20. In Germany, the KfW Promise synthetic Bank’s 2015 global financial data library for securitization program, which had insurance assets ($26 trillion) and 2017 OECD government support, was instrumental for the pension data from OECD 2017 ($28 trillion). development of the German securitization market. However, Germany issuance of SME 15. Fixed-income instruments typically play ABS collapsed after 2010, when changes an important role in relatively lower-risk in Basel rules made the KfW program insurance portfolios. Likewise, many OECD uneconomic. See Armstrong and Ebell 2015. countries have large and relatively mature pension obligations that require conservative 21. The Italian securitization market shows asset allocation decision making. Fixed- interesting features, including the use of income instruments also play an important multi-origination platforms. However, most diversifying role in almost all these portfolios, of the successful multi-originator transactions regardless of risk appetite. In the current involve originators that belong to the same environment, however, the dependable banking group—although the participating 92 Endnotes banks act as separate entities, often with sector and 48 days for private companies. distinctive characteristics of their portfolios There was, however, significant variation and different operating standards related to among countries. In the case of public sector loan origination and servicing procedures. buyers, payment periods ranged from 144 and 103 days for Italy and Spain to 18 and 15 days 22. See BCBS 2016. The document was for Latvia and Lithuania, respectively. In the later affected by BCBS 2017. Also see case of private buyers, payment periods ranged Flunder, Schlösser, and Weber 2018. from 85 and 80 days in Cyprus and Italy to 17 and 15 days in Germany and Lithuania, 23. See Aiyar and others 2015; Armstrong and respectively. See European Commission 2016. Ebell 2015; and Kraemer-Eis and others 2015. 29. The consequences of late payments for SMEs 24. The FSB has made recommendations have prompted different countries to enact regarding the securitization markets generally, laws of “prompt payment.” The European in particular the need for improvements in Union is the key example; but some Latin standardization and transparency and the American countries are following suit, imposition of retention requirements. In starting with Chile, and similar laws are tandem the Basel Committee on Banking being considered in Colombia and Peru. Supervision (BCBS) and the International Organization of Securities Commissions 30. In some countries factoring is used to refer (IOSCO) worked on a definition of a “high to the sale of the whole ledger of receivables, quality securitization” to which beneficial while invoice discounting is used to refer to the regulatory treatment could be associated. selective sale of receivables. In this report, the See BCBS and IOSCO 2015 and 2018. terms are used interchangeably to encompass mechanisms to obtain liquidity based on 25. Anecdotal evidence suggests that in this the sale of receivables, whether selectively scenario, synthetic securitization might be an or whole ledger, with or without recourse. important tool for banks that, depending on how it is structured, could also provide benefits 31. Increasingly, reverse factoring is associated to SMEs. For example, SMEs could benefit with supply chain financing, whereby large from securitization if a bank were to use part of companies have lines of credit with financial the capital freed to continue lending to SMEs. institutions (usually banks) to pay off their short-term obligations to the SMEs that provide 26. However, the China Bank Regulatory them good and services. The large company Commission (CBRC) introduced additional chooses the SMEs whose receivables would prudential requirements for this type of be paid (bought) by the banks. The banks, in entity, which in practice led to a decline turn, define the terms at which they buy the in the use of SME loan securitization. receivables from the SMEs; the terms are usually better than those that the SME would 27. This feature has recently been taken a step further be able to obtain on its own credit standing. through the Covered Bond Label initiative, which From the large company’s perspective, supply aims to have a broader international standard, chain financing allows it to, at a minimum, creating a truly global pool of investable ensure the health of its supply chain, but assets that investors can fund with confidence. it also leads to an extension of payment terms for the large company (through the 28. For example, in the EU for 2014 the average bank) and, depending on the relationship payment period was 54 days for the public between the company and its bank, it can Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 93 also lead to rebates (based on the difference by the London Stock Exchange in between the rate of its line credit and the connection with its Elite Program (box 5.2). terms offered to the SME). See ACCA 2014. 37. For European SME bond platforms, see 32. The definition is intentionally broad, in terms ESMA Securities and Markets Stakeholders of encompassing as SME platforms both Group 2017 and Nassr and Wehinger 2015. those that target consumers and those that As explained in this report, in some EU target businesses. Experience indicates that countries these platforms are open only to a portion of consumer loans are dedicated professional investors, while in others they are by people to starting a business. That is open to both retail and professional investors. why for the purposes of this report, both are included in the statistics and analysis. 38. See ESMA Securities and Markets Stakeholders Group 2017 and Nassr and Wehinger 2015. 33. There are no uniform labels to refer to these funds. The labels used in this report are aligned 39. Approximately one-fifth of all minibonds with the IOSCO Survey on Loan Funds (IOSCO issued in the bondm segment ultimately 2017). But other terms are used to identify defaulted between May 2010 and November them. For example, “co-origination funds” and 2014, losses which may have contributed to “specialized loan funds” are used by Kraemer- the shutdown of the market. These defaults Eis and others 2014 to refer to the same funds. came as a surprise to retail investors given the initial favorable ratings that these bonds 34. IOSCO conducted a survey on SME loan had and the perception that they were the funds in 2017 and received responses from hidden champions of Germany’s economy. 24 jurisdictions: Australia; Belgium; Brazil; See Schweizer, Proelss, and Mietzner 2015.. Canada (Ontario and Québec); China; France; Germany; Hong Kong SAR, China; 40. This refers to equity investments that do not India; Ireland; Israel; Italy; Japan; Jersey; take place through friends and family financing. Luxemburg; Portugal; Romania; Saudi Arabia; Singapore; Spain; Switzerland; Turkey; 41. For example, the introduction of CKDs United Kingdom, and United States. Of those (Certificados de Capital de Desarrollo) in jurisdictions, 14 allow loan originating funds: 2009 led to growth in PE/VC funds from Australia; Belgium; France; Germany; Hong US$574 million in 2009 to US$2.1 billion in Kong SAR, China; Ireland; Italy; Jersey, 2015. The creation of a more flexible vehicle Luxembourg; Singapore; Spain; Switzerland; for investment in PE/VC funds, the CERPIs United Kingdom, and United States. Seventeen (Certificados de Proyectos de Inversion), allow loan participating funds: Australia; appears to have prompted a surge in listings Belgium; Brazil; Canada (Ontario and Québec); on the stock exchange. By the third quarter France; Germany; Hong Kong SAR, China; of 2018 alone, US$1.5 billion had been Ireland; Italy; Japan; Jersey; Luxembourg; raised via four CERPIs. See EMPEA 2016. Singapore; Spain; Switzerland; United Kingdom, and United States. See IOSCO 2017. 42. Per EMPEA methodology, this figure includes all African countries, including 35. For information on the European private North Africa; Asia Pacific, excluding placement markets see Nassr and Wehinger 2015. Australia, Japan, and New Zealand and including Afghanistan and Pakistan; 36. See for example the platform DealSquare European Union accession countries in Canada, and the platform developed (2004); Southeastern Europe (excluding 94 Endnotes Greece) and Turkey, as well as Russia 50. For example, in the context of AEs, the and other Commonwealth of Independent International Monetary Fund has called for policy States countries; Mexico, Central and South makers to address the buildup of vulnerabilities America, and the Caribbean (excluding that results from increased holdings of riskier Puerto Rico and other overseas territories and more illiquid assets by institutional and departments); Gulf Cooperation Council investors through appropriate incentives, countries, Iran, Iraq, Jordan, Lebanon, minimum solvency or liquidity standards, and Palestinian Territories, Syria, and Yemen. enhanced disclosures. See IMF 2019, chap. 3. 43. For additional information on the type of 51. In general, monetary disputes are considered adjustments made to disclosure, corporate part of the contractual relationship between governance and performance requirements the investor and the companies to which they see Harwood and Konidaris 2015. provide funding (issuers) or the intermediaries that assist them in their investments (brokers, 44. It must be noted that many of the 299 SMEs advisors, and so on). In a few countries, mostly listed on the Bucharest Stock Exchange AEs, supervisory authorities have been given AERO market were required to list as disgorgement and restitution powers which a result of the mass privatization of the comprise the power of the supervisory authority 1990s. They are unable or unwilling to to take back money illegally obtained by a meet the requirements of the main market. participant and return it to the victim, as part of an enforcement proceeding. The exercise of 45. Prima facie private offerings do not require the these powers requires a high level of maturity same level of development of capital markets; of the legal system as well as resources. however, their scalability does seem to depend on having more traditional mechanisms 52. In the case of the United States, the guarantee to provide exit to investors (platforms). is given for the origination of SME loans. However, the market started to securitize 46. Peru provided this role to the central the guaranteed portion of the loans. securities depository, but other options might include assigning this function 53. A set of principles has been developed in to the credit collateral registry. connection with public credit guarantee schemes. See the World Bank and FIRST Initiative 2015. 47. For an analysis of the regulatory approach and state of regulation of both lending 54. The World Bank’s forthcoming “Innovation platforms and securities-based platforms, Instrument Guide” contains a detailed discussion see World Bank Group and CCAF 2019. of government programs to support VC. 48. A recommendation regarding a framework for 55. For information on government programs to loan originating funds can be found in ESMA2016. foster VC, see Murray and others 2012; Colombo, Cumming, and Vismara 2014; Wilson 2015; 49. Only eight countries globally do not impose and Owen, North, and Mac an Bhaird 2019. any ceiling on pension fund investments for asset classes: Australia, Belgium, Canada, 56. The study found 46 schemes in 36 countries, the Netherlands, New Zealand, the United which were ranked according to these best Kingdom, and the United States in the practices. “The highest ranked scheme is OECD, and Malawi. See OECD 2018b. United Kingdom’s Seed Enterprise Investment Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 95 Scheme. SEIS provides individuals making of the asset). The Destination Italy Decree investments in young companies with an extended the applicability of the substitute upfront tax credit, a capital gains tax deferral tax regime, which had existed for bank loans, for reinvestment, a capital gains tax exemption to bond issuances and certain other securities, for chargeable gains realised on disposal and thereby harmonizing their tax treatment. The loss relief on more favourable terms than the substitute tax provides for 0.25 percent tax baseline tax system for capital losses realised on the aggregate amount of bonds issued. on disposal. The scheme's ranking was driven by high scores across scope, qualifying criteria 59. Since November 2016, when it was launched, and administration. SEIS uses a combination nearly 19,000 small businesses that were of age, size and specific sector exclusions rejected for finance from one of the big banks to target entrepreneurial firms. It restricts have been referred under the scheme. Over 900 the participation of related parties, but has businesses had secured more than £15 million. introduced allowances for business angels. It Since the Q4 2017, the conversion rate for SMEs targets newly issued ordinary share capital, that make contact with a platform has been over imposing a maximum investment value 10 percent, in line with market expectations. See attracting tax relief and a minimum holding U.K. HM Treasury 2018 and Schammo 2019. period. In terms of administration, SEIS is administered on a non-discretionary basis and 60. On practical grounds, the problem in estimating is subject to transparent annual monitoring of the finance gap (whether credit or equity) fiscal costs.” See European Commission 2017, 4. comes from the fact that supply and demand cannot be observed separately—only the 57. The withholding tax generally applies to market equilibrium can. Consequently, the interest and other amounts paid in relation to directly unobservable potential demand needs bonds, certain other securities, and promissory to be estimated. One alternative is to use a very notes. Article 32 of the Development Decree specific and well-designed survey of small established an exemption to the 20 percent businesses, but such surveys are costly, not withholding tax for payments made on bonds always representative of the universe of firms, issued by nonpublicly traded Italian companies and often country specific. A more efficient provided that the securities are listed on a solution is to proxy potential demand for the regulated market or multilateral trading facility typical SME on the basis of an international or are held by professional investors who are benchmark. This assumes that domestic firms not shareholders of the issuer and not resident in in EMDEs have the same willingness and certain tax havens (so-called blacklist countries). ability to tap external sources of financing The Destination Italy Decree further extended as a similar firm in a developed country. the withholding tax exemption to collective Compared with the actual availability of investment funds so as long as their units are external resources, this figure provides a rough held by qualified investors and the assets under measure of the gap. This is the methodology management are primarily invested in bonds, followed by the IFC to construct the SME similar debt instruments, or promissory notes. credit gap for a large number of countries. 58. The Destination Italy Decree abolished the 61. For a discussion on opportunities and previous tax regime for bonds (which involved challenges of crowdfunding and financial the application of registration tax, stamp duty, inclusion, see Jenik, Lyman, and Nava mortgage tax, and duty register, with costs 2017. A broader discussion of the impact ranging from €168 to 3 percent of the value of fintech in small business finance can be found in World Economic Forum. 2015. 96 Endnotes 62. The literature defines a firm as being financially 64. CCAF defines P2P as loans to consumers constrained when, due to informational or businesses by individual or institutional frictions, it faces a wedge between the cost of funders, equity crowdfunding as the purchase internal and external capital (see Farre-Mensa of equity stakes by these funders, and invoice and Ljungqvist 2016, and references therein). trading as the purchase, at a discount, of In graphical terms, this would translate to a invoices or receivables notes from a business. horizontal supply of funds function up to the point at which internal funds are exhausted, 65. Low leverage may also be a preliminary and then a positive slope as external sources indication of financial constraints, but are tapped (see Hubbard 1998). In the extreme, because this ratio is available for a small set the supply curve becomes vertical when the of (listed) firms in a small set of countries, firm is shut down from the credit market. this issue has been kept out of the analysis. Equivalently, one may define a financial However, it is interesting to note that, in line constraint as a situation in which the firm with the proxies under study, the international is prevented from making an investment differences in leverage are narrow in spite it would have made using internal funds if of huge differences in financial depth. available (see Kaplan and Zingales 1997). 66. Because many of the explanatory variables 63. Other than using lagged regressors, causality are highly correlated, thus giving rise to is not a key concern because it seems highly multicollinearity, each regressor was entered unlikely that such new and small alternative separately and not simultaneously, with the finance markets have any causal impact only exception being the baseline regressor on any of the right-hand-side variables. set (GDP level and growth and private credit). Capital Markets and SMEs in Emerging Markets and Developing Economies: Can They Go the Distance?: 97