SUSAN DE WITT: It takes a village to raise a small business finance ecosystem

Small businesses in emerging markets remain a critically underfunded asset class, a situation that is widely acknowledged to stifle local economic development and resilience efforts.

While there is a substantial pool of domestic savings in Africa — and a willingness to channel capital locally into enterprise development — concerns about risk, too-small investments, dispersed returns and a lack of experience on the part of emerging fund managers conspire to keep most investors on the fence.

Now, a group of fund-of-funds is taking the initiative to reshape the finance ecosystem and ensure more of these domestic savings (for example, from pension funds) find their way into the real economy. Once there, this capital can be put to work to develop small- and medium-sized businesses, create jobs and boost transformation and gender equity. An added benefit is that wealth stays within country borders.

According to a report by Collaborative for Frontier Finance, a multi-stakeholder initiative that aims to increase access to capital for small and growing businesses in emerging markets, fund managers investing in small and growing businesses across the continent expect to raise about $310m of their targeted $1.5bn from international and local fund-of-funds. And they are likely to hit this target as multiple new vehicles start to deploy capital over the coming year.

Fund-of-funds aren’t new — they are essentially an investment strategy in which one fund invests in other investment funds, allowing capital to be pooled and diversified. But what is interesting is how they have evolved in Africa in recent years. Specifically, they have been working more closely together to drive system-level changes. Over the past year 19 public and private fund-of-funds working at different parts of the continuum of capital have come together to share lessons learnt and explore ways to achieve scale by addressing systemic barriers. The shift has the potential to be a game-changer.

Proving the concept 

The great thing about fund-of-funds is that they can diversify risk and match ticket size by pooling large amounts of capital and distributing it in smaller ticket sizes. Fund-of-funds increase investment capabilities and decrease risk, either directly by raising guarantees and through first-loss mechanisms, or by supporting investees’ investment readiness and fund economics. 

As such, these novel investment platforms have already made great strides across the region, harnessing institutional funds to create access to markets, address capacity gaps and boost transformation. For example, a partnership between 2X Global and Kuramo Capital Management led to the launch of the Ignite Africa Warehousing Facility, which will develop female fund managers and help them build track records.

This is important as, despite having large numbers of female entrepreneurs, less than 1% of capital allocated on the African continent is going to women-led businesses. Elena Haba from 2X Global, who is quoted in our recent report, says: “Gender lens investing isn’t just about addressing gender disparities; it’s about harnessing the economic potential that remains untapped.”

Women invest in women, and considering that over 50% of small business growth funds are managed by female-led teams, this bodes well for more equitable allocation. In SA, 27four’s FundHERforward and Standard Bank’s African Women Impact Fund will be doing the same.

In Ghana, the Venture Capital Trust Fund has attracted private investment into the market by providing risk capital, technical assistance and a suite of tax incentives. These include 10-year tax breaks, a five-year loss carried forward, and tax exemptions on the fund vehicle. 

In SA, the SA SME Fund has successfully attracted capital from institutional investors, including a pension fund, a compensation fund and a university endowment fund, making it one of the largest domestic institutional investors in the venture capital (VC) asset class with over R630m ($35m) committed to multiple VC fund managers thus far.

A fund-of-fund can derisk co-investments for local pension funds by undertaking rigorous due diligence and building the capacity of emerging fund managers. This signalling effect works to attract more private investors into the market over time. As such, pension funds such as Stanbic Investments Managers have built internal capabilities to allocate and manage investment into funds such as Oasis Capital and Mirepa Capital.

Additionally, fund-of-funds can offer downside protection to private investors by introducing a first-loss layer of capital if the fund-of-fund does not deliver a stellar performance. However, the performance of fund-of-funds to date makes it clear that there is often more upside than downside. Fund-of-funds are beating inflation and the performance of government bond yields in some countries.

For example, the 27four Black Business Growth Fund II, a blended finance partnership between the SA government through the Jobs Fund and SA institutional investors, has raised more than five times the local retirement fund capital for every rand of concessional capital. Five years into the fund life, net returns for investors were exceeding the target of consumer price index (CPI) plus 10%, and all the underlying funds in the portfolio were performing at or above expectation.

Dismantling barriers to scale

Fund-of-funds platforms have demonstrated that the model can be a force for small business finance market building in Africa. They have shown that to build an investment ecosystem in which local fund managers can flourish, provision must be made for the support of emerging teams alongside the supply of capital and systems engagement. Furthermore, they’ve helped demonstrate that relatively small amounts of derisking monies can attract the large local savings pools needed to provide local currency funding to small businesses. These demonstration effects are moving the market towards greater validation. But more can be achieved.

Fund-of-funds can work together to harmonise reporting systems, create co-investment opportunities, and share hard-won technical experience to build the ecosystem further. Valuation methodologies and due diligence models could also be shared between fund-of-funds, development finance institutions (DFIs) and local institutional investors to enhance investment competencies over time.

In addition, while fund-of-funds have proven effective in lobbying for effective legal frameworks for private funds, a closer alignment with DFIs on domiciliation requirements and regional allocation could help to ensure domestic pension funds are not excluded from the investor base.

While it is still early days, it is inspiring to see how diverse groups of funds and funders have come together in different parts of the investment landscape to address these challenges and committed themselves — and their capital — to African growth and economic development.

Given the vast system-level challenges facing the small business sector, only this kind of "all hands on deck" innovation has the potential to create breakthrough change. As 27four private markets principal Mardé van Wyk comments in our report: “It is important to take an ecosystem approach to building a new asset class — it is not sufficient to simply invest in emerging fund managers and assume the market will develop independently.”

• Dr De Witt is a director at Collaborative for Frontier Finance.