Venture Capital for SMEs
Given its strategic role in developing economies such as the Philippines, the small and medium enterprises (SME) sector deserves more support. SMEs serve as the trickle-down mechanism to ensure that investment-led development does lead to lesser poverty.
In the Philippines, however, this role has been inhibited by low value-added performance. Relative to Asian neighbors particularly Korea, Japan and China, our local SMEs are lagging behind. Their participation in the creation/processing of raw materials has been modest. Their production efficiency has not been at par due to largely non-mechanized or low-tech operations.
These limitations give weight to the financing gap problem of the sector the need for long-term developmental funds for capital-base acquisitions and evolution of production efficiencies. The exploration and building up of sources of financing outside of the traditional debt-finding mode have to be initiated.
Venture capital, which is essentially equity financing, is an alternative that may well serve the need of local SMEs for partnerships that will help them absorb the uncertainties of business financing. Unlike debt financing, equity financing allows the business to continue operating, despite uncertainty, without the need to plow out cash resources based on a pre-fixed schedule.
The most successful models of venture capital in terms of market acceptance, size of industry and positive experience are those of the U.S., U.K. and Japan. India has also made some bold initiatives. The Philippines has lagged behind its Asian counterparts.
A closer look into the basics of venture capital financing reveal some inherent conflict with the existing nature of our local SMEs in terms of risk tolerance levels and rate of return expectations. First, the demand of small enterprises is for start-up financing. The propensity of supply by the venture capitalist, however, is for expansion or mezzanine financing. Medium enterprises need expansion capital but the preference is for debt financing in view of financial and social costs.
Second, the minimum investment size of venture capitalists is rather high relative to the absorption capacity of small enterprises. Relative to bank financing, the venture capital approach entails higher costs for due diligence/monitoring and value-added services. The capitalist is involved in many aspects of the project financed given high rate of return objectives.
Third, due to the absence of a definite way out for the investment and, thus, much higher risk level, venture capitalists demand for high return, high growth and high-tech projects. The local SME sector generally operates low-tech and has low/medium returns.
In order to turn these apparent mismatches into opportunity, it has to be understood that the two sides of the equation are related. There are opportunities on both sides. Moreover, the issue of inefficiency is shared by both sides. While existing models have often stressed solutions that outwardly address demand-side weaknesses (SME-side), it is important to pursue a complementary approach that focuses on the supply-side inefficiencies (venture capitalists-side) as well.
Supply side solutions should revolve around managing the costs of the venture capital sector. First is helping it address the problem of asymmetric information on our local SMEs. A comprehensive and dependable SME information system has to be established. This should have a strong monitoring component for addressing the true level of risk in local enterprises/industries.
A second approach is accelerating the learning curve for venture capitalists through funds and/or risk sharing. Government may offer equity in venture capital funds similar to the Japan model. Government may also provide guarantees. In both cases, limits should be provided as safeguard against moral hazard.
A third solution is increasing cost efficiencies through the setting up of regional support nodes as partly financed by national and local governments. This will be useful in bringing investments outside of NCR. A related solution is the organization/registration of SMEs in clusters. The issue of proximity is a particular concern of venture capital firms.
Lastly, tax incentives for the setting up of venture capital funds from pension and insurance funds, community relations funds of big corporations and similar small business development oriented funds may be a boost.
Demand-side solutions should entail optimizing the rate of return potential of the SME sector. First, there is a need to create a critical mass of SME projects. The concept has to be marketed to medium enterprises which are entry targets of venture capitalists. The development of entrepreneurial culture also has to be pursued. Soft entry mechanisms for SMEs have to be opened. This will require good bankruptcy laws, the adoption of streamlined procedures for business registration and monitoring and strengthened guarantee programs for start-up enterprises.
Second is by improving the value-added potential of our local SMEs, which is the most crucial and more difficult component. This goal is both a means and an end of the development strategy. There is a need to encourage human resource development which can be achieved through tax breaks for management training and education of small companies.
The establishment and operation of business laboratories and science parks have to be seriously considered. Such support system may make use of the network of resources of existing universities and research centers, scientific and professional associations, government bodies and large companies.
Higher-value added operations can also be achieved through SME clustering and web formation. Clustering together in protective groups can help small firms achieve a critical mass in everything from intellectual and management talent to administrative support services, such as raw material sourcing and marketing. It is particularly helpful in promoting the emergence of new and rival production units. Without new units the network would likely wither and stagnate.
Finally, set-up an efficient venture sales mechanism with a strong incentive system. Acceleration of the implementation of the proposed SME Board is called for. There is, however, a need to review the strategy for making a meaningful impact on the SME population even at the level of local medium enterprises at first. A very limited population of firms is likely to qualify for listing.
A local unlisted securities market (USM) should be looked into once the listed SME capital market has sufficiently evolved in the country. The flexibility provided for by a USM will likely make the system more responsive.
Tax incentives on capital gains should be carefully determined, as incentives along this line have been integral in the development of the venture capital industry in other economies.
The menu of solutions offered here call for a rationalized government participation in the venture capital development strategy. Based on the survey of other economies, the role of government is more appropriately limited to (1) pump priming the industry which, being a tactical intervention, should be time-bound; and (2) direction setting in favor of the SME side with the end of eventually reaching the smaller units and the regions.