Challenges in catalysing SMES: Bridging missing link?

Developing small and medium enterprises (SMES) has always been a priority for the government and there is a renewed push to catalyse SMES to aid POST-COVID-19 recovery. From directed credit to technical assistance programmes, successive governments and development agencies have tried many methods to develop SMES.

However, the success of such programmes appear to be mixed – at least from the capital market perspective, where Sri Lanka has not seen many (successful) SMES going public or raising third party/institutional equity/growth capital. Even commercial banks shy away from providing growth finance to SMES (other than mortgagebacked lending). Lack of integration of (formal) capital market and SMES suggests a gap in the entrepreneurship finance eco-system.

Vital missing link?

Creating (realisable) wealth plays an important role in the sustainable entrepreneurship-finance ecosystem. Creating wealth for entrepreneurs provides funds for further capital formation. Sri Lanka’s case of comparatively mature private sector enterprises (as evident by various surveys) and lack of domestic capital is probably due to this missing link.

Lack of adequate domestic wealth creation has resulted in Sri Lanka to depend on foreign capital to fund growth. When we examine if the missing link is due to the inefficiency in the capital market or due to the weaknesses in the SME segment, we can observe that both sides are responsible for the missing link. In addition, there are country-specific factors affecting the integration of the two segments.

Discussed below are several possible causes associated with the SME sector that probably discourage the SME sector to integrate with the formal capital market.

Low value-add businesses

For a business to generate good value, it should have a solid and competitive business model. Unfortunately, many Sri Lankan SMES do not qualify this criteria, as the majority of businesses are based on very low value addition or providing low margin services.

In Sri Lanka’s case, it is essential that businesses to have strong defensible business models with adequate margins to withstand period expansionary and contractionary policy cycles as well.

Lack of originality

Lack or originality and investing based on ‘herd-mentality’ are common among Sri Lankan entrepreneurs and investors. This results in many SMES having weak business models, resulting in not only waste of resources but also harming the viability of the entire industry concerned.

One example of such wasteful investment driven by the herd mentality is the recent rush to invest in taxi-hailing app-based services – even large state-backed institutions like Sri Lanka Telecom is believed to have lost money following the herd mentality to invest in taxi services.

Another commonly observed problem that deters many (successful) SMES from creating and realising tradable equity value is their adoption of inorganic and diversification-driven growth strategies. This often results in gradual dilution of value and is commonly observed in Sri Lanka as the small local market size encourage businesses to expand into other businesses.

Wealth creation is not part of business plan

Majority of Sri Lankan SMES do not focus adequately on a wealth creation and realisation strategy. For a successful business, it is essential to have a good plan to create tradable equity value for owners. In countries like India, where capital market is more integrated with the SME landscape (compared to Sri Lanka), it is not uncommon to find business plans those focus primarily on wealth creation than actually running a business.

For the entrepreneurship-finance eco-system to thrive, there should be a large number of SMES with well-balanced strategy to both grow business while aiming to create a tradable equity value. Plans to create and realise equity value should be incorporated and adopted as part of the business plan from very early stage. It is very common to find many successful Sri Lankan businesses failing to realise any value because they have not thought about it until it is too late – resulting in loss of value to owners.

Sri Lanka’s plans to catalyse SMES should also accompany a plan to integrate SMES with the capital market. This will ensure there will be enough capital accumulation locally to finance future growth. To achieve this, there should be a plan to change entrepreneur/investor mindset as well.

(Indika Hettiarachchi, an independent consultant in project, venture and private market investment, can be reached at Indika.h@ jupitercapitalpartners.com)