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Developing countries have a large number of microenterprises and some large firms, but far fewer small and medium enterprises. In high-income countries, small and medium enterprises (SMEs) are responsible for over 50% of GDP and over 60% of employment, but in low-income countries they are less than half of that: 30% of employment and 17% of GDP.1 This SME gap is called the 'missing middle'.
The Firm Size Distribution
Some researchers suggest it is because developing country consumers demand different kinds of goods.2 Other studies point to costly business environments with high taxes and restrictive regulations, which mean that only large firms can survive and others have to fly under the radar by staying small and informal.3
But time and time again, access to finance is held up as the major problem. Firms in this segment consistently rate access to finance as the top barrier to growth.4 But how can we tell if the problem is really access to finance?
The answer is returns to capital. If SMEs are missing because regulations make it too costly to be an SME, or because consumers don't demand their goods and services, then these firms should not be very profitable: their rate of return on an additional $100 should be low. If instead they would be profitable, but are missing because they are locked out of the financial system, then their rate of return on an additional $100 should be high.
The evidence clearly shows that returns to capital are high in this segment.5 SMEs aren't missing because they wouldn't be profitable: they are missing because finance is not reaching them in an effective way. This shows that access to finance is a significant barrier, and that there is a massive profit opportunity for those who are able to successfully finance these firms. There is a one-hundred dollar bill lying on the table, it is just a matter of figuring out how to pick it up.
Existing lending models - microfinance, banks, and VCs - face fundamental barriers in this so-called 'meso-finance' segment.
Microfinance may reach microenterprises, but such firms often do not graduate to formal employment-generating SMEs. The microcredit model falls short when larger and riskier investments are needed and cash flows are not immediate. Group liability works because neighbors and friends can monitor and evaluate simple microenterprises, but it is much harder to monitor and evaluate larger and more complicated SMEs.
For VCs, SMEs in developing countries are not the next Microsoft, meaning there is not a clear exit, nor exponential returns from a handful of successes to compensate for the failures. VCs are experts in evaluating the potential of the entrepreneur and their business proposition, but the transaction costs are so high that only the highest-potential investments can be considered.
Similarly for banks, having an experienced officer evaluate a business plan and build up cash flow estimates is too expensive. As the SME segment represents a larger numbers of smaller loans, it is only viable if transaction costs in screening applicants are low. This was also a problem in the advanced economies. Banks finally penetrated the SME segment in the United States in a large scale only in the 1990s, when they shifted focus from reading business plans to evaluating the entrepreneurs themselves, and were able to do it cheaply using individual credit histories and automated scoring.6