The Case for Patient Capital: Small Business Funding in South Africa

Current trends in traditional commercial lending and the role of development finance

Maria Nkhonjera & Nicholas Nhundu

Small and Medium Enterprises (SMEs) are key drivers of inclusive growth in the South African economy, contributing about 55% to the gross domestic product, while their contribution towards employment is as high as 60%. In addition, small firms and new entrants enhance competition within different economic sectors, resulting in lower prices and greater variety for consumers, as well as dynamic and productive efficiencies.

Despite the importance of small and medium-sized enterprises and their significant economic contribution, they face limited funding options from both traditional financing institutions and government initiatives. For smaller businesses, building scale and being able to compete effectively in a market takes considerable time. This is exacerbated by the long periods it takes to develop the business including investing, trying out new approaches and strategies, innovating and expanding, along with obtaining regulatory approvals in some sectors. As such, these businesses need to have patient capital to support their growth.

This article reflects on the status quo of traditional commercial lenders in South Africa while considering the importance of development finance. We make recommendations on how the financial system can better address capital market constraints in the provision of finance to underserved sectors of the economy.

This article reflects on the status quo of traditional commercial lenders in South Africa while considering the importance of development finance. We make recommendations on how the financial system can better address capital market constraints in the provision of finance to underserved sectors of the economy.

A series of CCRED studies on barriers to entry and inclusive growth in different economic sectors highlighted the lack of funding for new entrants and the need for patient capital to grow smaller firms. This was evident in the agro-processing sector, such as the case of Grain Field Chickens (GFC) as a poultry entrant. GFC, which is jointly owned by Vrystaat Koöperasie Beperk (VKB) and the Industrial Development Corporation (IDC), took four years before making a profit. The diverse operations of its parent company (VKB) and development finance from the IDC assisted greatly in sustaining the business during this period while it built scale and capabilities. This case highlights the size of the barriers to firms which do not have owners such as these.

Similarly, Capitec Bank in the retail banking sector did not manage to grow to scale for a considerable period (2002 – 2009), largely due to a lack of adequate funding. Capitec survived this difficult period largely due to the support of PSG (an investment holding company) that acted as a shareholder of reference and provided financing for the entity to survive. Similar small banks like Ubank (formerly Teba Bank licensed in 2000) have stagnated largely due to a scarcity of patient capital, such as from a shareholder.

The cases of Soweto Gold and Lethabo Milling, black industrialists in beer and maize milling respectively, demonstrate the challenges faced by small firms and the impacts. In its early years of establishment, Soweto Gold met with potential funders for over four years without success. After failing to secure funding from commercial banks and DFIs, the company managed to get funding from Europe to complement the partners own funding. The company ultimately received a loan facility from the IDC through the Agro-Processing Competitiveness Fund which arose as part of the remedy imposed by the Competition Tribunal on Pioneer Foods for engaging in cartel activity in the bread and flour markets. Similarly, it took Lethabo Milling four years to obtain start-up capital after approaching several banks and public entities (including DFIs) who were unconvinced of the bankability of the business. The enterprise later obtained financing from the Massmart Supplier Development Fund 1 which facilitated and supported entry into the milling sector. Both companies have succeeded in growing and being financial viable.

The above examples speak to a widely recognised failure of traditional financial markets. 2 One solution to this challenge has been through state-controlled DFIs. DFIs mobilise financial resources for developmental purposes through investing in markets deemed too risky for the private sector to enter alone, but which are essential for the growth of the broader economy. They do so in partnership with the private sector, but initially carry most of the risk. Thus, they initiate sustainable development by supporting opportunities that are not addressed by the market, and by providing risk capital to companies and individuals in partnership with the private sector. Once these markets are developed, DFIs gradually withdraw and focus on developing other underdeveloped markets.

The state of traditional lending in South Africa

The South African banking sector has grown significantly (measured by total assets) since 1994, however the growth of the financial services sector has not translated to better funding for new entrants nor assisted in the growth of small firms. 3 This is largely attributed to the risk aversion of traditional banks (including partly because of regulatory requirements) which means they tend to fund established enterprises with a financial track record. In other words, the lending activity of traditional financial institutions continues to undermine rivals and entrants. Financialisation debates further suggest that firms increasingly invest in reversible short-term financial assets instead of long-term fixed assets, essentially crowding out the accumulation of productive assets. Figure 1 below provides evidence of this practice, showing that credit extension by banks appears to be more focused on investing in non-productive sectors of the economy. Banks also tend to extend a larger pool of credit towards consumers than they do to business enterprises.

Figure 1: Credit extension, 2016 4

  Source: South Africa Reserve Bank Quarterly Bulletin

Source: South Africa Reserve Bank Quarterly Bulletin

South Africa's development finance system

South Africa has a plethora of DFIs at both a national and provincial level, all with different organisational structures and institutional mandates. These institutions also differ in the weight of their financial resources and the scale of their projects. But while provincially-based DFIs tend to be more localised, given their ‘proximity’ to local communities, there tends to be an unavoidable mandate overlap with funding institutions at a national level. This lack of coordination naturally results in a duplication of effort across DFIs, substantially undermining their role as development financiers. The mandates of provincial development finance institutions (PDFIs) are also broadening as they become more like economic development agencies, thus losing their focus as key financiers and supporters of small businesses enterprises.

A great majority of PDFIs are further limited by internal operational inefficiencies. The Gauteng Enterprise Propeller (GEP) for example, spent 70% (R90 million) of its annual budget (R130 million) on wages and salaries (2011 - 2015), leaving only R30 million to be disbursed as loans to SMEs. On average GEP’s wage bill is 220% larger than its loan disbursement budget. High write-offs and impairment rates exhibited by all PDFIs further suggest a lack of internal operational efficiencies, where these are as high as 60% for the Free State Development Corporation.

A lack of sources of funding appears to be a key challenge that makes PDFI operations unsustainable; however this is exacerbated by the existing inefficiencies outlined above. The importance of establishing partnerships between DFIs and traditional finance institutions for raising and effectively allocating finances has been widely emphasised. Partnerships offer an effective and cost-efficient alternative of mobilising resources for long-term investments.5 The European Commission notes that partnerships not only relieve pressure on public finances but safeguard private institutions by providing stability of long-term cash flows from public finances while bringing in socially strategic investments.6 It however appears that there is a great lack of cooperation between these two financing entities in South Africa. We note here that co-funding initiatives(between DFIs and commercial banks) can potentially enhance the risk appetite of traditional finance institutions and also facilitate financial additionality, that is, the synergies created through collaboration between DFIs and commercial lenders.

The positive outcomes associated with the close cooperation between commercial banks and DFIs is best exemplified in the relative success of the Brazilian development bank, the BNDES.7 In the BNDES case the partnerships created between the two financing entities are extended beyond project co-funding to partnering on distributing development finance to farmers through banks. This allowed the BNDES to dispense funds effectively through the commercial banks’ wide footprint across Brazil. The disbursement of loans through commercial banks also meant cutting down on costs through leveraging off the systems and operations of commercial banks.8

  1. This unique fund was established as a condition following the Massmart/Walmart merger to provide financial assistance to small and medium enterprises in the form of zero-interest grants backed by guarantees to commercial lenders.
  2. Adesoye, A.B. and Atanda, A.A. (2012). Development Finance Institutions in Nigeria: Structure, Roles and Assessment, Munich Personal RePEc, Archive Paper No. 35839.
  3. Abor, J. and Quartey, P. (2010). Issues in SME development in Ghana and South Africa. International Research Journal of Finance and Economics, 39(6), 215-228.
  4. Productive sectors comprise of Electricity, gas and water (2,2%); Transport, storage and communication (3,3%); Agriculture, forestry and fishing (2,2%); Manufacturing (4,7%); Construction (0,9%); Quarrying and Mining (2%).
  5. Wehinger, G. (2011). Fostering Long-Term Investment and Economic Growth: Summary of a High-Level OECD Financial Roundtable. OECD Journal: Financial Market Trends, Vol. 2011, Issue 1.
  6. European   Commission.   (2009).   Communication   from   the   Commission   to   the   European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions -Mobilising Private and Public Investment for Recovery and Long-Term Structural Change: Developing Public Private Partnership. Commission of the European Communities, Brussels.
  7. BNDES is Brazil’s National Bank for Economic and Social Development.
  8. Colby, S. (2012). Explaining the BNDES: What it is, What it does and How it Works. Centro Brasilierio de Relações Internacionais Artigos, 3.