Seven years ago in the MENA region, SMEs - small and medium enterprises - were the new black.

Almost every financial institution was launching a division to cater to SME; DFIs were sponsoring researches to identify the barriers standing in the way of SMEs’ access to finance, conferences were organized, and talk shows were aired discussing the subject. Investment managers were considering starting a fund catering to SMEs, while investment advisors were advising them on setting up these funds. Everyone suddenly decided to cater to this “newly discovered” underserved and untapped market.

Seven years down the road, the MENA region is still nowhere close to effectively catering to SMEs, due to an array of impediments which have not yet been successfully tackled. This is not an understatement of the segment’s inherent challenges; undoubtedly SMEs financing and investment are not for everyone. However, the segment is still a real engine for economic growth, with GDP contribution accounting for 30% of UAE, 28% of Bahrain, 22% of KSA and 30% Egypt, serving a basis for job creation and innovation. The challenges must be identified and addressed clearly in order to capitalize on the huge potential which SMEs offer. With the fourth industrial revolution underway as the digital age disrupts business, the flexibility of SMEs, their innovative capability and ability to create jobs are crucial for MENA countries’ global economic competitiveness.

Time and effort

Clearly, the effort and time needed to close an SME transaction are equal to, if not greater than, those needed for larger corporations. SMEs are less structured than larger firms, pre-financing due diligence is accordingly key; deeper financial analysis is needed to identify areas of improvement and value creation. In the case of debt products, proper audited financial statements with supplementary data must be prepared. The pre-financing process may be lengthy and costly; and if these costs are calculated as a factor of the transaction size, they represent a significant amount of the transaction compared to larger companies. This must be factored when calculating the economics of smaller versus larger deals, affecting the profitability of SME transactions in general. It is advised to consider these costs when seeking SME transactions, and assess the profitability of the transaction to absorb these costs.

Management

It is no secret that management is a scarce commodity across the region, but it is more so for SMEs. Small businesses cannot afford the best management; for instance, their potential market capitalization is small, offering limited “stock option” upside to attract competent management. SMEs compete for human resources with larger corporations which offer fringe benefits, larger remunerations, stock bonuses and larger networks and exposure. On the other hand, SMEs have more flexible working environments, laid-back styles and swifter career development opportunities. They also allow employees room to develop their creative and managerial skills away from traditional management models.

Accounting and finance

Most SMEs lack a properly staffed and structured finance department. This is not only common to SMEs, but extends to the majority of family businesses across the world. The problem is that the absence of proper and experienced financial managers within any company negatively affects its ability to calculate product costs for instance, prohibiting it from correct pricing and determining actual margins. In addition, audited financial statements by recognized auditing firms allow SMEs to apply for bank credit. In a region where venture capital and private equity is still nascent, conventional debt is crucial for financing growth. Governments across the region have tried to motivate banks to finance SMEs; recent regulations in Egypt are an example.

Nonetheless, it is estimated that only 5% of the commercial banking activities across the Middle East is directed towards SMEs. Perhaps a focus on encouraging SMEs to seek credible auditing firms, developing mechanisms to outsource much needed financial advice, is also needed; governments may need to develop a different approach to this matter other than encouraging financial institutions to finance SMEs, they should find ways to support SMEs to qualify for this financing.

A man counts U.S dollar and Euro banknotes at a money exchange office in central Cairo, Egypt, March 7, 2017.
Image: REUTERS/Mohamed Abd El Ghany

Returns and payback

Another problem with SMEs, is that no matter how high the returns they achieve are, they still yield small amounts of aggregate cash returns. For example, if the average SME transaction is $20mn, and the investment is doubled at exit, this leaves an estimated $10mn in gains. Whereas a $500mn transaction with a 1.5x return yields an estimated of $250mn in gains. Accordingly, investors, banks and managers alike prefer larger transactions. Transaction size limitations affect payback for both banks and investors. Transaction size is a prerequisite for most public offerings, and in some cases investment banks’ requirements to extend advisory placement services. In this case, financial innovation is crucial to overcome this challenge; vertical and horizontal integration may be sought to create larger entities or develop creative financial tools that will allow various schemes of sale back to management.

Legal constraints

Legal frameworks, regulation and enforcement are a big challenge within the majority of MENA economies. The problem is not only with legal frameworks, and the absence of regulations for new financial products and hybrid instruments that may protect financiers while at the same time motivate entrepreneurs, but enforcement of court rulings in case of disputes is another major challenge. Very few economic courts in the region have the understanding to grasp financial contractual obligations. Enforcing a court ruling is a tedious and lengthy process. Another major legal constraint is the criminalization of debt; entrepreneurs are faced with long-term jail sentences if they are unable to repay their debts. No proper bankruptcy laws exist to ring-fence the liability involved, especially in the absence of any fraudulent wrongdoings by the entrepreneurs. Clear insolvency laws are desperately needed to allow the swift saving of businesses, as well as frameworks for restructuring and reorganization of assets.

Data and information

Accurate and readily available data is a huge challenge in most developing countries. Finance is based mostly on the accuracy of data, making the right decision in the absence of accurate and reflective data is more like a shot in the dark. Sometimes data is available, but is scattered, random and tedious to collect and verify. Government agencies focusing on SMEs must work on filtering and consolidating this data through online portals or regular publications.

Supply chains

A major challenge for SMEs is the absence of proper supply chains catering to their needs. Professional supply chains require economies of scale; small sized contracts make it uneconomic for professional service providers to deal with SMEs, and they prefer larger corporations. Some Asian countries initiated attempts to consolidate purchase orders for several companies in bulk to capitalize on economies of scale and outsource them to tier one suppliers.

Scalability

Scalability starts with entrepreneurs turning their idea into a startup, but it doesn’t stop there; the biggest challenge is to move this startup to the next level: “Beyond Startup”, and the level after that: “Growing Company”. Not all ideas and businesses are generally scalable, but there seems to be an inherent hindrance to scale businesses in the region for various cultural and skill-set constraints that are beyond the scope of this article. The main advice that should be given to founders and seed capital providers is to ensure the company has this scalability seed within its structure from the start.

Ironically, sometimes SMEs in the region are inclined to do the exact opposite; they focus much more on scaling too soon and too fast. Personally, I call it the “Pyramids Syndrome”. It seems the region is stuck in the hype of building “big pyramids” - huge malls and high skyscrapers - more than regular projects. We seem to forget that we must first build the small pyramids, and the bigger ones will follow.

The case for SMEs – now more than ever

In the MENA region, where SMEs represent between 80-90% of enterprises – according to studies by the World Bank – unemployment among the youth of the population who are under 25 is close to 40%. These active, vibrant young people, full of new ideas, need to fulfill their aspirations with jobs that will allow them wealth and creative fulfillment. This can only be achieved through the innovative and flexible SME sector. The region must move past the rhetoric that SMEs drive growth, create jobs, contribute to product innovation and enhance the competitive landscape, because this fact is already proven. Instead, it must address the various challenges, eliminate obstacles, encourage entrepreneurship, and provide policy frameworks that move beyond talk and more into action.

SMEs’ biggest challenge is not absence of finance, their biggest challenge thereof is employing this finance in order to grow and create value. Governments across the MENA region need to focus on this approach more; consolidate efforts to provide necessary vocational training, highlight case studies, formalize mentorships, advise on business plans and strategies and in short, provide SMEs with the expertise they lack to grow and develop.

Nevertheless, in the region, we sometimes seem to forget that every large corporation in the world was one day a small company. Small cap companies and startups are no doubt risky; they require dedication, commitment and effort. They strive on innovation, grow through multiple rounds of finance and more importantly they are a stroke of luck as much as they are a stroke of genius, but every financier worth their while will tell you that when these companies and startups strike gold, all these risks and challenges are definitely worth it.