SMME Finance Sector Background Paper:

A Review of key documents on SMME Finance 1994-2004

Client: FinMark Trust

April 2004

Submitted by:

Angela Motsa & Associates strategy, research, training and project management consultants

Tel: 011 4675167 / 083 281 7248 Fax: 011 467 8656

Email: amotsa@netactive.co.za

22 Darter Ave, Norscot, Johannesburg PO Box 344 Douglasdale, 2165

File ref: 1559

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Contents Executive Summary.............................................................................................................. i 1. Introduction ......................................................................................................................1 2. Characteristics of SMMEs and the Potential Market for SMME Finance ............................1

2.1 SMMEs defined ................................................................................................................................................... 1 2.1.1 South African Definitions................................ ................................ ................................ ................................ 1

Definitions focusing on Marginalisation of enterprises ................................................................................... 3 Legal Definitions: Formal vs. Informal............................................................................................................... 4 Statistical definitions: Labour Force Survey ..................................................................................................... 4 Definitions linked to Sectors of the economy................................................................................................. 5

2.1.2 Comparison with international definitions................................................................................................... 5 Micro and Small Enterprises (MSEs) vs. Small and Medium Enterprises (SMEs)............................................. 5 Informal vs. formal sector.................................................................................................................................. 5 Opportunity vs. Necessity Entrepreneurship.................................................................................................... 6 Stage in the Life Cycle...................................................................................................................................... 6

2.1.3 Key findings and Analysis .............................................................................................................................. 6 SMME classification matrix................................ ................................ ................................ ................................ 6 An SMME focused Finscope Study?................................................................................................................. 6 Statistics South Africa data collection classifications..................................................................................... 7 Segmenting products in the micro-enterprise / survivalist category............................................................ 7

2.2. Scope, Size and characteristics of the SMME sector in South Africa................................................ 7 2.2.1 Size of sector................................................................................................................................................... 8 2.2.2 Contribution to Employment, Job creation and the Economy................................................................. 9 2.2.3 Characteristics of the Informal Sector........................................................................................................11 2.2.4 Entrepreneurship in South Africa compared to international standards................................................12

Level of Entrepreneurship...............................................................................................................................12 2.2.5 Financing requirements of SMMEs..............................................................................................................13

Sources of finance...........................................................................................................................................15 Differences between Formal vs. Informal business financing requirements..............................................16 Financing requirements of entrepreneurs from disadvantaged communities..........................................16

2.2.6 Obstacles to financing SMMEs....................................................................................................................17 2.3 Key findings and Analysis...............................................................................................................................18

Potential Demand for SMME finance............................................................................................................18 Characteristics of the informal sector............................................................................................................18 Entrepreneurship in South Africa....................................................................................................................19 Range of financial services requirements.....................................................................................................19 Obstacles and constraints on the demand side..........................................................................................19

3. Historical background to SMME Finance Sector in South Africa .....................................19 3.1 National Small Business Strategy (1995).....................................................................................................19 3.2 The National Small Business Act (1996)......................................................................................................21 3.3 Black Economic Empowerment Act..........................................................................................................22

3.3.1 Financial Sector Charter................................ ................................ ................................ ..............................22 3.4 Current Developments in the Legislative/ Policy Arena.......................................................................23 3.5 Key Findings and Analysis..............................................................................................................................23

Legislation related to Small Business Development .....................................................................................23 The Financial Sector Charter ..........................................................................................................................23 Procurement....................................................................................................................................................23

4. State Initiated Institutions involved in SMME financing ...................................................24 4.1 National Empowerment Fund (NEF)...........................................................................................................24 4.2 Industrial Development Corporation (IDC)..............................................................................................25 4.3 Land Bank ..........................................................................................................................................................25

Micro Finance ..................................................................................................................................................25 4.4 Post Bank ............................................................................................................................................................26 4.5 Business Partners...............................................................................................................................................27 4.6 Umsobomvu Youth Fund (UYF)....................................................................................................................27 4.7 Khula Enterprise Finance Limited (Khula)..................................................................................................28

4.7.1 Products........................................................................................................................................................28 Loans.................................................................................................................................................................28 KhulaSt art .........................................................................................................................................................29 Private Equity Funds................................ ................................ ................................ ................................ .........30 Credit Guarantee Scheme.............................................................................................................................30 Thuso Mentorship Programme........................................................................................................................31

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4.7.2 Findings of the Khula impact assessment..................................................................................................31 4.7.3 Critical analysis of Khula’s role in the sector................................ ................................ ..............................32

Disappointing uptake of the Guarantee Scheme by Banks.......................................................................32 Problems with institutional capacity of RFIs...................................................................................................33 Criticisms and limitations of its impact assessment methodologies............................................................34 Khula’s role in facilitating access to micro-finance.....................................................................................34 Retailing vs. wholesaling.................................................................................................................................35 Ignorance about Khula’s role and mandate...............................................................................................35

4.7.4 Khula’s Future Role?.....................................................................................................................................35 The National Apex Fund..................................................................................................................................36 Coordinating efforts ........................................................................................................................................36

4.8 Key Findings and Conclusions......................................................................................................................37 5. Private sector programmes for SMME finance................................................................38

5.1 Banking sector involvement in the lower end of the market ..............................................................38 5.1.1 Specialised Banks to exclusively service the poor....................................................................................38 5.1.2 Banks setting up specialised divisions/ programmes exclusively to serve the poor..............................39 5.1.3 Linkage Banking...........................................................................................................................................40 5.1.4 Banks role in providing Savings and Transaction services for SMMEs......................................................41 5.1.5 Key Findings and Analysis............................................................................................................................42

Developing entrepreneurial and microfinance skills in the banking sector..............................................42 Pursuing Linkage strategies with village banks and cooperatives involved in providing informal financial services to the poor. ........................................................................................................................42 Providing best practice case studies and resea rch on small bank establishment in the sector.............43 Further promoting the provision of saving facilities for the lower end of the market for formal and informal institutions................................. ................................ ................................ ................................ .........43

5.2 Banks involvement in SME lending..............................................................................................................43 5.2.1 Products provided by Banks .......................................................................................................................43 5.2.2 Reporting on scale of SMME activity..........................................................................................................44 5.2.3 Risk Assessment.............................................................................................................................................45 5.2.4 Collateral......................................................................................................................................................45 5.2.5 Customer Service Issues...............................................................................................................................45 5.2.7 Regulatory Issues..........................................................................................................................................45 5.2.8 Role of the state...........................................................................................................................................46 5.2.9 Key findings and Analysis ............................................................................................................................46

5.3 Venture Capital and Private Equity Funds...............................................................................................46 Alternative Stock Exchange ...........................................................................................................................47

5.3.1 Key Findings and Recommendations........................................................................................................47 5.4 Insurance Industry............................................................................................................................................47

5.4.1 Key Findings and Recommendations........................................................................................................48 5.5 Commercial Micro-lenders and their role (or potential role) in SMME financing .........................48

5.5.1 Historical Analysis..........................................................................................................................................48 5.5.2 Current status and potential role in SMME financing...............................................................................49 5.2.3 Key findings and Analysis ............................................................................................................................49

6. Non-commercial or community-based financiers of SMMEs.........................................50 6.1 The Non-profit micro-finance Sector..........................................................................................................50

6.1.1 Status of Microfinance in South Africa: Overview of its overall impact and factors that have influenced this.......................................................................................................................................................50 6.1.2 Factors influencing the performance of MFIs in South Africa ..................................................................53 6.1.3 Current debates regarding the segmentation of microfinance market................................................53 6.1.4 Key Findings and Analysis............................................................................................................................54

6.2 Village Banking in South Africa....................................................................................................................54 6.2.1 Key findings and analysis.............................................................................................................................56

7. Summary of key findings and recommendations ..........................................................56 7.1 Defining more accurately the potential demand for SMME finance..............................................56 7.2 Opportunities presented by recent legislative / policy processes....................................................57 7.3 Role of Government Institutions...................................................................................................................58 7.4 Role of the Private Sector ..............................................................................................................................58 7.5 Role of Non-commercial providers.............................................................................................................59

Appendices ..........................................................................................................................1 Appendix 1 - Table 1: Definitions of SMME by sector........................................................................................... 1 Appendix 2 - Table 1: Khula RFIs............................................................................................................................ 2 Appendix 3 - Findings of the Khula Impact Assessment Study................................ ................................ ........... 5 Appendix 4 - Table 1: SA Development Microfinance Sector............................................................................ 8

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Appendix 5: Case Study on: Provident South Africa .........................................................................................11 Abbreviations ASCAs: Accumulated Savings and Credit Associations AVP: Anicap Venture Partners BMR: Unisa’s Bureau for Market Research BCRS: Bay Research and Consultancy Services BSM: Business Sophistication Measure CLO: Collateralised loan obligation fund COSATU: Congress of South African Trade Unions DBSA: Development Bank of Southern Africa DFIs: Development Finance Institutions DTI: Department of Trade and Industry ECI: Ebony Consulting International ESOPs: Employee Share Ownership Plans FNB: First National Bank FSA: Financial Services Association FSC: Financial Services Cooperatives GDP: Gross Domestic Product GEM: Global Entrepreneurship Monitor HDIs: Historically Disadvantaged Individuals HDPs: Historically Disadvantaged Persons IDC: Industrial Development Corporation ILO: International Labour Organisation Khula: Khula Enterprise Finance Ltd LBSCs: Local Business Service Centres LFS: Labour Force Survey of Statistics South Africa LSM: Living Standard Measure MCOs: Micro Credit Outlets (KhulaStart programme) MEA: Micro Enterprise Alliance MFIs: Microfinance Institutions MLA: Micro Lenders Association MSEs: Micro and Small Enterprises NEF: National Empowerment Fund Ntsika: Ntsika Enterprise Promotion Agency NSBC: National Small Business Council PDIs: Previously Disadvantaged Individuals PSA: Provident South Africa RFIs: Retail Financial Intermediaries (funded by Khula) ROSCAs: Rotating Savings and Credit Associations SA: South Africa or South African SEE: Survey of Employment and Earnings SHGs: Self Help Groups SMMEs: Small Medium and Micro Enterprises SMEs: Small and Medium Enterprises Stats SA: Statistics South Africa USAID: United States Agency for International Development TACs: Tender Advice Centres UYF: Umsobomvu Youth Fund VAT: Value Added Tax

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Executive Summary

This SMME Finance Background Paper, which is a research document commissioned by FinMark Trust, is a consolidation and synthesis of key documents on SMME finance from 1994-2004. FinMark commissioned the research in order to provide those involved or intending to be involved in the SMME finance sector in South Africa with a credible and accessible one-stop source document. The document also provides an analysis which various players in the sector can build on as they seek to identify and exploit opportunities. Section 1 of the report is an introduction to the report. Section 2 of the report deals with the SMME potential market and the main finding was that there are no systematic studies on the demand for financial services in the SMME market broadly. Section 2.1 deals definitions of SMMEs and it was found that there are various and differing definitions of the term “SMME” within South Africa which makes it difficult to plan and target consistently. The development of an “SMME classification matrix” as well as an SMME focused study similar to Finscope were recommended. This would provide a more detailed picture of the SMME market in terms of its size, scope and characteristics which could then be linked to the potential demand for finance within a specific market segment. It would also give an indication of whether specific market segments are substantial enough to develop specific products for, and would thus assist financial services institutions in decisions around product development. In terms of available data on the size, scope and impact of the sector, it was further found in section 2.1 that Statistics South Africa’s (Stats SA) data collection classifications for SMMEs are problematic. Certain categories of SMMEs are not included in their figures for various reasons making it difficult to find consistent data, especially with regard to estimating the impact of SMMEs on the economy and employment. Given the reliance on Stats SA data for estimation of demand and potential market size, this issue deserves attention as it is likely to hamper effective planning and targeting. Section 2.1 further highlights the need to segment products targeted at the micro-enterprise / survivalist category. This category has on the one hand potentially viable business that have the potential to grow and, on the other hand survivalist economic activities which are simply income augmentation or survivalist strategies. Although they have different types of financing needs, it is concluded that both these markets need to be addressed, as they serve very important roles in the economy and in addressing poverty. Section 2.2 deals with the scope size and characteristics and found in terms of the potential demand for SMME finance, that while there were differing estimates, it could be estimated that SMMEs, particularly the small and medium ones, make significant contributions to both job creation and the economy. It was also found that SMMEs represent a potential demand of at least R 3 million people or businesses. Section 2.2 further deals with various characteristics of the informal sector as it represents an important starting point for most businesses. The key finding was that by far the biggest sources of finance for starting these businesses was found to be own funds or funds borrowed from friends and relatives. This highlighted the importance of savings products and services in this part of the market. Section 2.2 further dealt with Entrepreneurship in South Africa, which was found to lag behind significantly in comparison with international trends. It was argued that focusing

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on access to finance without addressing other constraints to the growth of SMMEs, such as the absence of an entrepreneurial culture and the lack of financial management skills would fail. Efforts focused in the education sphere in terms of developing an entrepreneurial culture were therefore recommended. The last part of section 2.2 deals with the financing requirements of SMMEs. A wide range of financial services requirements are identified in this section. It was found that these requirements go further than just credit; transaction services were found to be crucial as they are the basis for accessing other services. Obstacles and constraints to accessing financial services on the demand side were identified including absence of financial administration skills particularly among businesses run by PDIs. It is recommended that this be addressed as it limits their access to formal financial institutions and results in cash flow problems. Section 3 provided a historical background to the SMME finance sector in South Africa and outlines the various laws and policies that have contributed to the sector since the early 1990s. New developments show that there is a realisation by government that while the legal/ policy environment provided the framework for SMME development, implementation has not been as effective. Thus an amendment to the Small Business Act has been proposed as well as the establishment of an advocacy body to take over the role of the NSBC. While it is not clear which direction this will take, this development needs to be monitored closely. Furthermore it was found that developments in the BEE arena, particularly the Financial Sector Charter provide a framework to engage formal financial sector on issues related to SMME finance. Finally, the government’s procurement programme was found to have been hampered by the lack of appropriate financing mechanisms. The contracting of institutions by government to accept government contracts as collateral for loans – where the loan is underwritten by the government department offering the contract was also recommended. The latter part of the report deals with various sources of SMME finance in South Africa. Section 4 outlines key programmes initiated by government including the National Empowerment Fund, Industrial Development Corporation, Land Bank, Post Bank, Business Partners, Umsobomvu Youth Fund and Khula Enterprise Finance. Key issues identified in this section are around the need to improve the effectiveness of National Empowerment Fund as a venture capital provider in the SME market although the IDC does serve this market quite effectively. The Post Bank’s role is highlighted in terms of its potential to provide the full scale of services to the lower end of the market (micro/ survivalist enterprises). Furthermore the Land Bank’s Step-Up scheme was also highlighted as a source of micro-finance in rural areas, and lessons from the Land Bank’s experience with this scheme should be harnessed by other institutions involved in micro-finance in rural areas. The uncertainty regarding the future role of Khula and a possible mandate change is identified as an opportunity, as it provided scope to influence the debate related to its future focus given the imminent removal of its micro-finance portfolio. It is also argued that the way in which sustainability is conceptualised and as applied by Khula in its RFIs needs to be reviewed as it tended to limit innovation and the development of solid MFIs. The possibility of initiating micro-finance fund that is not linked to SMME finance (and thus not through the DTI), potentially through the Department of Social Development is also identified as there is a gap in the market in terms of state sponsored programmes. It is also recommended that government consider more partnerships with the private sector for SMME finance outside of the banking sector where guarantee funds have had limited

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impact. These could be partnerships with commercial micro-lenders and private venture capital funds. Chapter 5 deals with private sector’s existing and potential role in the SMME finance market. Initially looking at Banks (section 5.1); on the micro-finance side various approaches that have been used internationally and locally for banks to get involved in this market were identified and evaluated. It was recommended that banks:

• Develop entrepreneurial and microfinance skills; • Pursue Linkage strategies with village banks and cooperatives involved in

providing informal financial services to the poor; and • Further promote the provision of savings and transaction facilities for the lower

end of the market. It was also recommended that best practice piloting, case studies and research on small bank establishment in the sector be developed to overcome negative perceptions regarding the role of small banks based on experience so far in South Africa. Furthermore it was found that banks can, beyond specifically servicing this market, provide a back-up line to non-bank financial intermediaries, by for example, providing services to business owners in their individual capacity, which are then used to access services in the non-bank financial institutions. However it was also found that changes may be required in the regulatory environment to give impetus to such developments. The need for better research and disclosure on the exact extent of banks involvement in the sector was also identified as well as the need to address the mutual misunderstanding of each other’s requirements between bank staff and SMMEs. Finally, it was proposed that government conduct another regulatory review of legislation that impacts SMMEs, based on the findings and progress since the Ntsika review conducted in 1999. In terms of Venture Capital and Private Equity Funds (section 5.2) the main recommendation emanating from this section was the assessment of the feasibility of venture capital funds focusing on the lower end of the market below R5 million. This was found to be the gap in terms of private sector provision. The insurance industry’s role (section 5.3) in the provision of services to the SMME sector was highlighted with respect to risks associated HIV/ AIDS and with respect to its support to the informal insurance industry. The Financial Sector Charter was identified as a framework through which the insurance industry could be engaged in these issues. With regard to commercial micro-lenders (section 5.4) the issue highlighted was their limited role in SMME finance. The need to further investigate this issue in term of product development and innovation was highlighted. Section 6 dealt with non-commercial or community based providers that focus enterprise finance or have the potential to do so. This included micro -finance institutions and village banks. The role of the state in both cases was highlighted in terms of subsidising operations during the slow, painstaking business of institution building; and in providing an enabling regulatory environment as well as in supporting capacity building. However it was concluded that different approaches to the concept of sustainability needed to be applied depending on which market (micro or survivalist) is being targeted by these institutions. Experience shows that institutions focusing on survivalists will tend to need longer periods of subsidisation. Section 7 consolidates the main findings and recommendations made in the report.

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1. Introduction As part of its role as a catalytic and facilitative agency in making financial markets work for the poor, FinMark Trust commissioned this background paper on SMME finance. The paper reviews key documents on SMME finance during the period 1994-2004 and thus provides an analysis of the development of the sector through this period and its current status. FinMark intended that this paper becomes a credible and accessible one-stop source document which various players in the sector can use as they seek to identify and exploit opportunities. The paper was compiled mainly as a desk top study and is subdivided into the following sections:

• Section 2: Characteristics of SMMEs and the potential market for SMME finance • Section 3: Historical background to the SMME finance sector in South Africa • Section 4: State initiated institutions involved in SMME financing • Section 5: Private sector programmes for SMME finance • Section 6: Non-commercial financiers of SMMEs • Section 7: Summary of key findings and recommendations.

2. Characteristics of SMMEs and the Potential Market for SMME Finance This section considers:

• Various definitions of SMMEs • The scope, Size and characteristics of the SMME sector in South Africa

2.1 SMMEs defined

2.1.1 South African Definitions The abbreviation “SMME” which refers to small, medium and micro enterprises came into being with the release of the White Paper on the National Strategy for the Development and Promotion of Small Business in South Africa in 1995. The categorisation of SMMEs was used as a basis for defining the policy stance taken in the White Paper. However although SMMEs were categorised in terms of their characteristics, there was no attempt to target strategies accordingly. Table 1 below outlines the various categories used in the White Paper and financing requirements within each category. The 2001 Ntsika State of Small Business Development in South Africa Annual Review although not specifically using the division between the formal and informal sector, identifies survivalist and single-person micro enterprises as constituting the informal sector. Medium and large enterprises constitute the formal sector. Micro enterprises employing one to four people, very small and small enterprises are considered to be a mix of the formal and informal sector.

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Table 1: Characteristics and financing requirements according to size of enterprise Size / class Characteristics Financing requirement1 Survivalist enterprises

• little or no collateral • no paid employees and minimal asset value

• working capital to purchase supplies and inputs, often for periods of less than a week

• alternative lending approaches, such as group lending – to overcome the collateral constraints

Micro-enterprises

• turnover below R150 000 per annum • less than 5 paid employees • may have access to collateral, (e.g. a house) but are generally

unwilling to risk their property • few have the type of collateral required by formal financial institutions.

• small fixed asset loans for equipment, such as sewing machines, deep freezes, etc.

• working capital for supplies and material inputs • longer period loans (than micro) - ranging from 3 months to

3 years (longer periods required in some industry sectors), • amounts ranging from R2,000 to R30,000

Very small enterprises

• employ fewer than 10 paid employees • their equity requirements are generally too small for equity financiers –

thus the only equity in the business is generally the owner's own contribution.

• may have established relationships with their suppliers, but generally do not buy in adequate volumes to obtain credit

• often considered formal micro -enterprises by institutions • sometimes have access to formal financial institutions but often

constrained by collateral requirements imposed by formal financial institutions

• while they may have some life insurance policies or pension funds and are often home owners, they usually are overly leveraged

• Most business failures occur in this sector

• could benefit from a combination of debt and equity, but their equity requirements are generally too small for equity financiers.

• debt financing needs are usually for fixed assets investment, capital outlay for enterprise establishment such as office equipment etc.,

• working capital needs especially bridging finance or revolving credit facilities

• leasing finance • average credit requirements of very small enterprises range

from R10,000 to R200,000

Small enterprises

• fewer than 50 paid employees • more established than very small enterprises • greater capital needs, especially for equipment and working capital. • often have some form of collateral that would be acceptable to formal

financial institutions, but it is usually not sufficient to meet their requirements – collateral thus remains a constraint

• rely more upon leasing finance and factoring • long-term outlays for machinery and equipment • overdraft facilities and suppliers credits for working capital • equity injections - but as with very small enterprises, the

equity amounts required are often too small for equity financiers to consider (below R5 million).

• loan finance requirements of small enterprises range from R20 000 to R5 million

Medium enterprises

• generally have established relationships with their bankers • more likely to seek a listing on the stock exchange.

• those with growth potential are also targeted by equity financiers a range of institutions serve their financing needs

Source: Adapted from Department of Trade and Industry 1998, cited in Bathuthukazi Consultancy cc, 2000

1 Note: based on 1998 prices and economic conditions

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While medium sized enterprises were included in the White Paper, this focused only on those that faced obstacles and constraints which could not be solved through normal market forces and private-sector action. The White paper gave a lot of focus to survivalist and micro-enterprises due to their potential as a vehicle for poverty alleviation particularly for the unemployed and unskilled. The 1997 UNDP Microfinance Assessment Report for South Africa indicated that:

“The smallest microenterprises tend to be run by people unable to find a paid job. Little capital is invested and the individuals running the microenterprises often have no skills training and limited growth opportunities. ……. Self-employment in the form of such enterprises remains critically important survival strategies for the poorest sectors of the economy, especially for women living in rural areas” (Ashe et al, 1997: 2)

As such survivalist enterprises have been described as “pre-entrepreneurial” and involved in activities such as hawking, vending, household industry; the argument being that shortage of financial resources, social barriers and lack of access to markets prevents this group from being entrepreneurial (Ntsika, 1999). It has also been argued that although some survivalists have grown into micro enterprises and formal SMEs the majority are likely to remain poor (Baumann, 2002) since they are ‘constrained by a number of factors which constantly reinforce their position at the bottom of the pile’ (Horn, 1995: 35, cited in Rogerson (undated): 133). This most affects women. This implies differing strategies for addressing constraints faced by SMMEs at different levels. The lumping together of SMMEs and the resulting tension between micro-enterprise development for poverty alleviation as against small and medium business development for employment creation and economic development is often identified as a reason for the limited impact of policy on SMME development in South Africa. A report by David Porteous (2002) also further identifies the conflicting policy objectives in South Africa that result in promoting small businesses for job creation (which are likely to be mainly white owned) versus transformation efforts in the form of black economic empowerment to achieve socio-political stability. In a similar vein the 2002 GEM SA report (Foxcroft et al, 2002) argues that policy interventions need to distinguish between social upliftment/ poverty alleviation programmes and targeted small business support and that the former should be aimed at unregistered businesses and the latter at registered businesses. This links in with definitions that argue for a distinction between formal and informal and targeted support based on these definitions. (see below).

Definitions focusing on Marginalisation of enterprises Other definitions differentiate and target SMMEs based on their marginalisation. For instance, the Small Business Strategy differentiated SMMEs in terms of the constraints they faced, placing particular emphasis in addressing constraints faced by SMMEs initiated, owned or controlled by those who were disenfranchised and/or otherwise discriminated against in the past. This included enterprises owned or controlled by black South Africans, women and all other disadvantaged and marginalised groups, including those in remote rural areas as well as the disabled, elderly people and the youth (South Africa, 1995). Similarly, Rogerson (undated) made a distinction between the established group of formal SMEs (largely owned by whites and sometimes Asians and operating in urban areas, particularly larger cities) and the group of emerging SMMEs largely under black or

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coloured ownership and operate in urban townships, informal settlements and rural areas. The 2002 GEM South Africa report (Foxcroft et al, 2002) also distinguishes enterprises in disadvantaged communities in terms of their characteristics and business support requirements. However it also notes that there are significant differences in the constraints faced on formal and informal entrepreneurs in disadvantaged communities and argues for more effective targeting of support and resources to these two groups of entrepreneurs is required (Foxcroft et al, 2002: 6).

Legal Definitions: Formal vs. Informal The GEM 2002 South African Report (Foxcroft et al, 2002) makes distinctions between informal and formal enterprises and characterises these in terms of economic contribution, education, resources, and needs. Policy implications are also outlined in the report within these categories. Porteous (2002) also makes the distinction between formal and informal based on legal status (registration), tax registration, and the keeping and auditing of accounting records. According to Porteous (2002) SAtoZ has taken this further by introducing the Business Sophistication Measures (BSMs) similar to the LSMs for consumers. BSMs use indicators such as whether a business has a separate phone line, kitchen, canteen, board room and written mission statement. However, this methodology has not yet been fully extended to informal businesses, although this is currently planned (Porteous, 2002). Furthermore, according to Porteous (2002) the credit provision industry also proposes a distinction between:

• Formal SMEs which should be treated as distinct businesses, separate from their owners; and

• Informal SMMEs which are essentially from a legal and risk position no different from lending to the owner/s, and hence would involve providing loans to individuals who do not have a pay slip.

A study conducted for the Micro Enterprise Alliance (MEA) by ECI (2000) distinguishes between ‘organised’ and ‘unorganised’ SMMEs in urban areas where organised enterprises have salaried employees and fixed premises. No reference is made to legal status however. Unorganised firms are said to consist mainly of artisans without fixed premises, few or no salaried employees (ECI, 2000).

Statistical definitions: Labour Force Survey The Labour Force Survey (LFS) conducted by Statistics South Africa (Stats SA, 2003) also distinguishes between the formal sector including businesses that are registered in any way and the informal sector which consists of those businesses that are not registered in any way, are generally small in nature, seldom run from business premises and are instead run from homes, street pavements or other informal arrangements. There are however discrepancies in the figures provided by Statistics SA in terms of their definition of informal sector employment. Stats SA provides formal sector employment figures from the quarterly survey of employment and earnings (SEE), which specifically collects information on employment in SA (excluding non-VAT registered businesses as described below) while in the LFS households, rather than businesses are sampled. Households contain people working in small industries whether the owners of those businesses and pay VAT or not. The SEE collects only information from businesses that are VAT registered and have a turnover over R 300,000. The SEE therefore misses certain formal sector and informal sector businesses that are covered by the LFS. The SEE also has a short coming in that it does not distinguish employment in terms of size of industry. SEE also excludes employment in a host of industries including agriculture, restaurants and small scale

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tourism establishments, financial institutions which are not banks, insurance companies, private educational and medical services (Lehohla, 2002). As a result while the SEE indicated that 6.6 million were employed in the formal sector (excluding commercial agriculture), a further 0.8 million people said to be working in the informal sector were covered by the LFS but not the SEE.

Definitions linked to Sectors of the economy The National Small Business Act (South Africa, 1996) further differentiated the definition of SMMEs according to the sector that the business is operating within. This is outlined according to number of employees; turnover and assets (refer to Appendix 1). There was also recognition in the Act in terms of the government's SMME support strategy, that the problems of each of these four categories need a somewhat different policy stance (South Africa 1996). Although these differences were recognized at this stage policy did not specifically address this, leaving this for more specific implementation processes.

2.1.2 Comparison with international definitions International literature on small enterprise development definitions generally focus on distinguishing between micro and small enterprises (MSEs) on the one hand and small and medium enterprises (SMEs) on the other (Mead, 1998 (cited in Rogerson, (undated)).

Micro and Small Enterprises (MSEs) vs. Small and Medium Enterprises (SMEs) According to Labie (1995) small and microenterprises (MSEs):

• Are generally more labour than capital intensive; • Have high relative production costs (because raw materials are purchased in

small quantities); • Lack technical experience in production, accounting, administration and stock

control (due to low levels of qualification); • Are mainly unregistered (or partially registered) and family-based.

The USAID’s definition of micro-enterprises as distinct from small enterprises characterizes them as:

• tiny, informally organized business activities other than crop production • low-technology, labour-intensive activities. • Mainly involving only one person, the owner-operator or microentrepreneur some

with unpaid family workers and others including paid employees. • low level of assets or income -- both of the business and of those working in it

(USAID, 1995a and 1995b) USAID limits the term "microenterprise" to firms with ten or fewer employees, including the microentrepreneur and any family workers.

Informal vs. formal sector On the other hand the International Labour Organisation (ILO) distinguishes between its programmes supporting the informal sector (including home based work) (Xaba et al, 2002) and the small business development programmes focusing on small and growing enterprises (Trulsson, 2001). The ILO also focuses on supporting enterprises that grow in a labour-intensive manner, thus focusing on size with respect to the number of employees.

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For instance ILO’s SSIYB, GYBI, SYB and IYB programmes cater for a wide range of enterprises that employ anything from the single owner up to approximately 20 people (where the majority employs five people or less). Growth Oriented enterprises are on the upper end of this (10-30 employees) but beyond this the ILO argues it would move into the territory of consultancy firms; the argument being that the upper end of ILO interventions with regard to small enterprises should be targeted towards a market niche where these firms are not yet active (Trulsson, 2001).

Opportunity vs. Necessity Entrepreneurship The GEM uses the distinction between ‘Opportunity’ and ‘Necessity’ Entrepreneurship where Opportunity Entrepreneurs are those driven primarily by the desire to take advantage of a business opportunity, while necessity entrepreneurs are those driven primarily by lack of better choices for work (Driver et al, 2001, p11). This implies different policy approaches based on understanding the factors driving the entrepreneur to start his/her busines s.

Stage in the Life Cycle Another definition that is commonly used internationally, particularly with respect to financing SMMEs is stage in the life cycle where the differences between demand for finance are distinguished based on the stage of the business from start-up through to growth or expansion finance (see table 8 below).

2.1.3 Key findings and Analysis

SMME classification matrix There are various and differing definitions of the term “SMME” within South Africa. South Africa differs from international categorisations that broadly define two categories one at the lower end of the market grouped as micro and small enterprises (MSEs) and the higher end of the market grouped as small and medium enterprises (SMEs. While South African definitions have been much more detailed, they are also varied and have not resulted in effective targeting of services to SMMEs. The Global Entrepreneurship Monitor (GEM) 2002 South Africa Executive Report (Foxcroft, et al 2002), indicated that there is a growing recognition of the need for careful segmentation of different types of entrepreneurs and targeting of specific policies and services according to different needs. The report argued that size categorizations such as “SMME”, are so wide that they are not helpful for targeted policy-making. They further argued that effective targeting requires appropriate segmentation of entrepreneurs and better understanding of the constraints facing entrepreneurs within each segment.

An SMME focused Finscope Study? The most significant finding within this section is that SMMEs require specifically tailored financial products and services which go beyond simply targeting informal and formal or small and micro. While SMMEs within each category do face some common constraints, the lack of innovative product development or packaging may be partly due to a tendency to focus on one parameter of defining SMMEs, without considering the overlap with others. Anicap Venture Partners (2003) highlight this problem by arguing that the SME marketplace, its participants and performance, are too poorly monitored and understood to be effectively managed and developed. They further argue that this results in the market being too opaque for either the public or private sector to develop satisfactory assistance programmes and in benchmarking being almost impossible to do,

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given the paucity of hard information about South African SMEs. They conclude that this area needs future attention. While it could be argued that there is a large amount of research that has been done on SMMEs since 1994, very little of this focuses on understanding SMMEs to the level of detail required to the effectively target SMMEs. To address this issue, the development of more refined SMME classification matrix (for lack of a better name) using combinations of the definitions outlined above (and perhaps others not covered here) is proposed. Each category defined using this matrix would then be linked to the potential demand for finance within that specific market segment which would give an indication of whether this is a substantial enough market to develop specific products for, and would assist financial institutions in decisions around product development. It also could be linked to existing products that address each market segment and identify where there are blockages or gaps in supply. However a key requirement for developing this matrix and ensuring it has the required detail is accurate enough information on the SMME market in the level of detail currently found in the Finscope Study. FinMark Trust developed FinScope as the most comprehensive national survey exclusively focused on financial service needs and usage across the entire population. Like the original FinScope, an SMME focused Finscope could provide a credible, regular profile of needs for and usage of financial services among SMMEs to support better policy making and innovation in service provision. The Business Sophistication Measure developed by SAtoZ could also form an important basis for this SMME Finscope much as the LSMs have formed the basis for the original Finscope study.

Statistics South Africa data collection classifications It was found in categorising the differing definitions of SMMEs, that there is conflicting information regarding the classifications used by Statistics South Africa which include or exclude certain types of businesses depending on VAT registration, sector and other factors. Additionally information on employment in terms of size of business is not included. This issue hampers effective policy making, benchmarking and the measurement of impact of the sector on the economy. What would be required to enable this is a review of the definitions or classification of SMMEs used by Statistics South Africa with a view to ensuring they coincide with DTI’s classifications.

Segmenting products in the micro-enterprise / survivalist category The micro -enterprise /survivalist portion of the SMME market clearly presents a challenge both in terms of policy and targeting of financial products. If one is focused on employment creation then this would mean only supporting businesses that have the potential to grow. However given the importance of micro-enterprise and survivalist economic activities in supporting livelihoods, particularly in marginalised communities, there is clearly a need to target financial products and services to this group. However different models of institutional sustainability would need to be applied as financial sustainability will be more difficult to achieve when targeting the latter group.

2.2. Scope, Size and characteristics of the SMME sector in South Africa Most literature on SMMEs begins with the rider that figures on SMMEs are either difficult to find or are not measured. As a result many of the figures found are based on interpretation of various types of employment statistics provided by Statistics SA; which are not provided in the same categorisation commonly used by SMME practitioners.

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2.2.1 Size of sector Various estimates for the size of the sector are outlined below:

• The Small Business Development Strategy in 1995 (South Africa, 1995) initially estimated that over 800,000 people were involved in the SMME economy. In addition it also estimated that about 3,5 million people were involved in some or other type of survivalist enterprise activities.

• Falkena et al 2001 estimated the number of SMMEs to be between 1 and 3 million

in South Africa. Excluding survivalist and micro-businesses, this number decreases to a range between 250 000 and 650 000 enterprises.

• The following estimates (table 2) are provided by Coetzee and Grant (2001) and

show the growth of the informal and micro-enterprise sector. The informal sector accounted for over 1.8 million in 1999. The figures further highlight the slightly higher grow th rates achieved in the informal/ micro -enterprise sector.

Table 2: Total Growth in number of Businesses in South Africa

1998 1999 % chg Formal private 349,720 357,780 2.3 Public service 83,430 88,100 5.5 TOTAL FORMAL 433,150 445,880 2.9 Informal 840,720 862,580 2.6 Micro enterprise 922,000 960,740 4.2 TOTAL INFORM. 1,762,720 1,823,320 3.4 GRAND TOTAL 2,195,870 2,269,200 3.3 Source: Coetzee and Grant, 2001

• Falkena et al (2001) also highlights the different size estimations of the SMME sector used by different institutions (table 3 below). This again highlights the difficulty in correctly estimating the size of the sector.

Table 3: Different Indicators for size of SME sector Source Survivalist Micro Very

Small Small Medium Large Total

Ntsika 1997 totals

184,000 466,100 180,000 58,900 11,322 6,017 906,700

Business Partners

2.3 million 600,000 35,000 Not reported

2.9 million

Management sciences group, 1999

960,740 862,580 445,880 2.3 million

Eskom Survey 1999

900,000+ ‘in home businesses’: total 3 million if one includes small/ emergent/ established

N/A

Statistics SA 2000

1, 628, 797

Source: Falkena et al, 2001

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2.2.2 Contribution to Employment, Job creation and the Economy There are also differing estimates of the employment, job creation and economic contribution of the SMME sector, making it difficult sometimes to take a consolidated view of SMMEs economic impact. Various estimates of the contribution of SMMEs to employment and the economy are outlined below. Focusing on SMEs (excluding survivalist and micro -enterprises), Falkena et al (2001) estimated that they represent a contribution to GDP of about 50% based on the figures provided in the table 4. Falkena et al (2001) also found that the contribution of SMEs to GDP is dependent on the definition used. For example, if ‘survivalist and micro firms’ are excluded, the SMEs’ value added was estimated at 39 to 42 per cent of GDP in 1997. This grows substantially however, if these are included to between 52 to 57 per cent. While these estimates were found to depend on the statistics available, the assumptions made and the definitions used, Falkena et al further argue that they do show that the material significance of SMEs in the South African economy and lead them to the conclusion that SMEs constitute the backbone of the economy and would thus have a huge impact on employment. Falkena et al (2001) estimated that the share of SMEs in national job creation is as much as 62 per cent. They also suggest that due to structural changes in the economy affecting bigger firms, the job creation capacity of SMEs is expected to be more significant and to more increasingly generate jobs that are skill intensive and well remunerated and as the economic significance of SMEs is likely to increase over time. Table 4: Contribution to total gross value added by types of enterprises (1997)

Type of Enterprise Value added Survivalist Micro Very small Small Medium Large

GVA in million R

7 622 67, 721- 81, 572

58, 061 92, 302- 106, 153

93, 076 269, 312- 297, 015

% of GDP 1.24 11.00-13.25 9.43 14.99-17.24

15.11 47.73- 48.23

Source, Falkena et al 2001 However Ntsika’s (2001) estimates for GDP are slightly lower; in the year 2000, SMMEs (excluding the survivalist and microenterprises with no employees) were said to contribute only 34.8% to GDP, up from 32.7% in 1995. Ntsika’s estimates for employment are also lower than Falkena et al as SMMEs were said to account for over 50% of employment. Table 5 below outlines Ntsika’s the estimated contribution of SMMEs to GDP per size class. Table 5: Estimated % sectoral contribution to GDP by size-class, 2000

Size Class % Total Employment Survivalist 2.2 Micro (0) 3.5 Micro (1-4) 6.5 Very Small 13 Small 15.7 Medium 13 Large 46.1 Source Ntsika, 2001

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According to Baumann (2001) nearly 40% of employment in the South African retail trade sector is in micro-enterprises2, but their contribution to the national retail trade output is only 2.3%3. Furthermore, 53% of South African personal services employment is said to be in microenterprises, but these contribute less than 10% of the national sector’s output. Overall microenterprises are said to provide nearly 20% of South Africa’s ‘jobs’ but contributes only 5% to Gross domestic product.4 Estimates from the March 200 3 LFS on employment in the sector are provided in table 6 below. The total number of workers as at March 2003 was estimated at 11.6 million people, the majority of these being employed in the formal sector (63.6%). The share of employment in the informal sector (excluding subsistence or small-scale agriculture and domestic service) as estimated at 16%, while commercial agriculture at 7.5 % and subsistence or small scale agriculture at 3.6 %, while domestic workers constituted 8.7% of the employed and 0.6 % did not specify their sector. As indicated above the SEE figures (provided by Stats SA) do not currently differentiate employment according to size of business. Table 6: Formal Sector Employment According To the LFS and the SEE of March 2003 (‘000)

Employed according to SEE 6,497

Employed in formal sector in activities not covered in SEE 825

Total 7,322

Source: Statistics SA 2003 A recent survey of the contribution of non-VAT registered small and micro enterprises (considered informal in the LFS) to the economy of the country based on the LFS (Lehohla, 2002) is summarised in table 6 below. Out of an estimated national population of 44.4 million, 2.3 million were estimated to be running an informal business. Table 7: Contribution of non-VAT registered small and micro enterprises to the economy Index Size Proportion No of people estimated to be running at least one non-VAT registered business

2.3m 5.1% of the population

Of these, proportion running the business from a fixed location.

1.9m 83% of those running at least one non-VAT registered business

Provinces with highest concentration Gauteng: 0.616m KwaZulu-Natal: 0.58m Limpopo: 0.265m Eastern Cape 209

top 3 = 63%

Proportion living in urban areas 1.3 m 57% of those running at least one non-VAT registered business

Proportion of females 1.4million 61% of those running at least one non-VAT registered business

Proportion with licenses 166,000 7.3% of those running

2 Source Baumann, 2002, note Because official statistics measure this in terms of number of employees, these micro-enterprise figures include ‘formal’ sector firms that are by nature small 3 Source Baumann, 2002 Statistics in this paragraph computed from data from South Africa Survey 2001/ 2002, South African Institute of Race Relations, Johannesburg 2001 4 Source Baumann 2002, Figures from own calculations based on data from the South African reserve Bank and Statistics South Africa

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at least one non-VAT registered business

Service levels

Piped water: 24.6%, Electricity: 63.3%, Telephone 30.6%

Sector Concentration Wholesale and retail trade industry: 69.4% Employment Total No. of Employees:

0.7m 67% of those running at least one non-VAT registered business are paid

Number requiring finance to start their businesses

1.4 million 61% of those running at least one non-VAT registered business

Proportion those requiring finance that received a grant

16,000 1% of those running at least one non-VAT registered business

Proportion that borrowed money to start 15.5% of those running at least one non-VAT registered business

Sources of finance Friends and relatives: 83%, Loans from others: 5.5%, Banks 5%, Money lenders 4.6%, Credit societies +/-1% Business associations +/-1%, Business partners: +/-1%, NGOs: +/-1%

Gross revenues per month R 2,707 million Average monthly profit R 1,807 million In terms of job creation potential the 2001GEM report (Driver et al) found that only a small proportion of entrepreneurs are likely to account for most of the job creation by new firms. In the 2002 report it was estimated that:

• start-ups created 140,000 jobs since the inception of GEM 2001; • New firms close to a million jobs in South Africa between Jan 1999-July 2002;

and • Established firms (older than 3.5 years old) have created 2.4 million jobs in

same period. Based on the February 2002 LFS (Statistics South Africa 2003) it was estimated that entrepreneurial firms account for a third of total employment (excluding the owner/s of entrepreneurial firms) and thus play a vital role in job creation in South Africa. It was found that informal entrepreneurs on average employ 0.8 people whereas formal entrepreneurs employ on average 7.2 people. Formal businesses account for 56% of all employment in privately owned businesses in disadvantaged communities. While the employment generated by SMMEs may be significant Rogerson (1997) noted that the quality of the jobs that are generated through the SMME economy may be of concern with respect to poor wage and work conditions.

2.2.3 Characteristics of the Informal Sector Lehohla (2002) (refer to table 6 above) found that most informal businesses were found in the wholesale/ retail sector (69.4%), are in urban areas (57%) and are run by females (61%). Important indicators of the serviceability of this market by financial institutions is highlighted be their access to services such as electricity (63.3%) and telephones (30.6%). The majority (61%) required finance to start their businesses, while the majority borrowed funds were from friends and relatives (83%). This goes against findings from Falkena et al (2001) that there challenges with SMEs owned by PDIs, particularly in the Start up phase in that have been found to have little or no savings; little or no access to family finance/

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neighbourhood finance; and little or no valuable investment in residential property. Loans from others, banks and money lenders were the other sources of finance (roughly 5% each). NGOs and credit societies were not significant sources of finance (less than 1%).

2.2.4 Entrepreneurship in South Africa compared to international standards The Global Entrepreneurship Monitor (GEM) measures, monitors and compares entrepreneurship levels across participating countries around the world. The GEM (2003) currently monitors 31countries. Key issues elicited from the various GEM surveys are categorised below: Table 8: GEM indicators for SA over time Index South

Africa’s 2001 GEM Ranking

South Africa’s 2002 GEM Ranking

South Africa’s 2003 GEM Ranking

Number of countries studied 29 • 37 31 TEA index5 14t h • 19t h 22nd Start -up index6 13t h • 15th * New firm index7 25t h • 29t h * Necessity Entrepreneurship * • 9th * Opportunity Entrepreneurship * • 29th * * not ranked in that year Sources: GEM South Africa Report 2001-2003 It was found that South Africa was consistently behind most developing countries on the GEM indicators. Falkena et al (2001) also found that South African SMEs on average grow less than first-world SMEs. In the GEM 2002 report (Foxcroft et al 2002) it was found that South Africa ranked lowest in all measures of entrepreneurship among developing countries and was in the lowest quantile of all GEM countries in two key measures, namely opportunity entrepreneurship and new firm activity. It was also found that South African start-ups have a low success rate in that South Africa has a reasonably high number of start-ups, but few of these reach a stage where they can pay their salaries and wages for longer than 3 months. The GEM 2002 report further estimated that entrepreneurs in the informal sector (unregistered businesses) account for 88% of all businesses in disadvantaged communities. Entrepreneurs in the formal sector account for about 12%.

Level of Entrepreneurship Key conclusions from the various GEM surveys were that: • South Africa is reliant on only a small number of new firm and established firm

entrepreneurs for the bulk of job creation (Foxcroft et al, 2002). • To increase economic growth and employment creation, South Africa needs to

enable a higher proportion of start -ups to progress to the stage of new firms (Foxcroft et al, 2002)

5 Total Entrepreneurial Activity (TEA) index i.e. the proportion of adults who are owner managers of a start-up, a new firm or both. (People who are owner managers of both a start up and a new firm are counted only once.) 6 The proportion of people who are owner-managers of a business that has not paid salaries or wages for more than 3 months 7 The proportion of adults who are owner managers of a business that has paid salaries for between 3 months and 3 ½ years

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• Nearly 70% of new firm entrepreneurs in South Africa are owner-managers of established businesses as well. This suggests that most new firm entrepreneurs have experience running an established business (Driver et al, 2001)

• The 2001 study also found that necessity entrepreneurship tends to be a response to poverty. It was argued that while this is important as a means for survival, it is unlikely to relieve poverty on the scale required in SA or act as a driving force in the economy.

• The key findings of the 2003 GEM report (Orford et al, 2003) were that although developing countries have a higher total entrepreneurial activity rate; South Africa’s rates are nearly 50% lower than other developing countries in the GEM. This was ascribed to the lower entrepreneurial activity rates among young men, and the lower proportion of young men believing they have the skills to start a business. It was also found that the environment in large urban areas is more conducive to entrepreneurship.

In conclusion the 2001 report questioned the view that there is a ready pool of potential entrepreneurs in SA who simply need technical and financial support to start successful businesses and that the focus should be education to expand the pool of potential entrepreneurs. The 2001 report recommended a focus on education as key factor associated with entrepreneurs progressing beyond the start up phase. The 2002 report recommended that South Africa needs to work towards encouraging more opportunity-type entrepreneurial activity.

2.2.5 Financing requirements of SMMEs On the issue of the financing requirements of SMMEs, table 1 above gave a summary of the types of financing needs of SMMEs. Table 9 below shows the growth phases and funding cycles of SMEs in the UK. Table 9: SME Growth phases & funding cycle in the UK Type of SME Start-up Phase Growth Phase Stable Exit for external

investor Traditional, providing income for an individual, family or small group of employees.

Family, friends, savings, equity in residential property

Asset -backed finance, factoring, bank debt, trade credit

Often none, but debt if required

n/a

High potential, with growth aspirations

‘Angel’ finance, team equity, some venture capital

Venture Capital, private placement of equity, asset-backed finance, some bank debt

Venture Capital; high yield debt market, bank debt

Either exit via capital markets or direct access to competitive capital markets

Attractive, with high-tech information and life sciences IPR

‘Angel’ finance, venture capital, corporates

Venture Cap, corporates, asset -backed finance

Corporates, bank debt

Exit typically via trade sale

Source: UK Banking Review (cited in Cruishank Report) cited in Falkena, et al 2001 Table 10 below provides an analysis of the growth phase and funding cycle of SMEs in South Africa. Falkena et al (2001) also estimated that category 1 represented between 25 000 and 55 000 enterprises, while Category 3 represented a category that would attract venture capitalists and represented between 60 000 to 95 000 – possibly up to 150

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000. Rough calculations of Category 2 are that it represented about 1 million enterprises (mainly micro- and very small enterprises) with a potential for double-digit growth rates over a decade (Falkena et al, 2001). It is further argued that these firms presumably would be viable and provide sustainable employment if they were sufficiently capitalised. However this category of enterprises is identified as providing the biggest financing challenge as entrepreneurs in this category have neither their own or friends/ relatives resources; no possible collateral and no access to traditional debt due to their fragility and risk of failure (Falkena et al, 2001). Table 10: SME Growth phases & funding cycle in the South Africa Type of SME

Start-up phase Growth phase

‘Steady state’ and exit

Minority: Tradition al SME (e.g. white-owned family business)

Family, friends, savings, equity in residential property

Asset -backed finance, factoring, bank debt, trade credit

Often none, but debt if required

High number: Emerging Enterprise from previously disadvantaged communities

Few resources available – dependence on external funds

Minority: High growth enterprises (high-tech, life sciences or any other sector)

Angel finance, team equity, some venture capital, corporates

Venture capital, private equity, asset -backed finance, some bank debt, corporates

High-yield debt market, bank debt, corporates. Exit either via capital markets or via trade sale

Source: Falkena et al 2001 In terms of the types of products required by SMMEs, Porteous (2002) argues that like a consumer, a business is likely to have a range of financial service needs, which will vary over time and by type and scale of business. He highlights the following range of financial service needs for SMMEs in table 11 below: Table 11: Financing requirements of South African SMMEs

Informal Formal Needs: Micro-

survivalist8 Micro—0 employees

Micro—with employees

Very small : 0 employees

Small: >0 Employees

Medium sized

1. TRANSACTION ACCOUNT • A safe place to

store money • Easy access to

money when required

• Ability to make 3 rd party payments

• A means of providing external

Store needed, but typically only overnight

Store of value needed

Start to have payment needs as well—to pay wages, etc

Need all of these

Need all of these

Need all of these

8 This is the category of ‘necessity entrepreneurs’ as defined in the UCT GEM, as opposed to the other categories, even informal, being mainly or only ‘opportunity entrepreneurs.

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Informal Formal Needs: Micro-

survivalist8 Micro—0 employees

Micro—with employees

Very small : 0 employees

Small: >0 Employees

Medium sized

financial statements 2. FUNDING • Capital

• Own • External

Typically have none or little of own

May have some of own capital saved; or else family and friends

May have some of own capital saved; or else family and friends

Typically own capital —maybe from bond on house

Typically owner capital only; but may require expansion capital to grow

More likely to have external capital providers

• Debt • Liquidity facility • Working capital • Asset finance

Need debt to finance stock

Probably accesses through informal lenders or formally employed family member

Probably accesses through informal lenders or formally employed family member

Liquidity facility (overdraft type) usu. required Rest depends on type of business

Liquidity facility (overdraft type) usu. required Rest depends on type of business

Liquidity facility (overdraft type) usu. required Rest depends on type of business

3. INSURANCE • Assets • Debtors • Owner/ life

insurance/ medical

Typically no assets held for any term Very vulnerable to sickness & death of owner

Few business assets to protect Very vulnerable to sickness & death of owner

Maybe assets to insure, but unlikely to take unless required by financier

Maybe office equipment to insure—probably self insure Very vulnerable to health and death risk

Equipment to insure Still vulnerable to health and death risk

Equipment to insure May still be ‘key man’ risks

Source: Porteous, 2002 Porteous (2002) further highlights the importance of the transaction account to the range of financial services required by SMMEs, as the backbone on which credit needs can be better assessed and loans disbursed and collected.

Sources of finance The 2001 GEM report (Driver et al, 2001) found that self-finance from income savings is the most common source of finance among start-up entrepreneurs, regardless of race, location, and gender or education level. The majority of recipients of angel finance were either close family members (37%) or friends and neighbours (35%). 45% of start -up entrepreneurs reported they would invest their own savings or income in the business. The second most common source of finance is immediate or extended family. Only 1.1 % of South African adults provided angel finance for someone else’s businesses over the period reviewed (compared with an international mean for all GEM countries of 2.9%). The 2003 GEM report (Orford et al, 2003) found that although lack of financial support is viewed as the main problem facing entrepreneurs in South Africa, compared to other GEM developing countries, South Africa does not stand out as having a financial system reluctant to support entrepreneurs. In general throughout the GEM environment

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internationally, formal financial institutions appear to provide funding to a small minority of entrepreneurs. As found in the GEM 2002 (Foxcroft et al), entrepreneurs’ savings and their ability to access informal investment from friends, family and colleagues appear to be far more important sources of start-up finance.

Differences between Formal vs. Informal business financing requirements

The 2002 GEM report (Foxcroft et al, 2002) began to make distinctions between the financing constraints and needs of informal and formal entrepreneurs. Research findings indicate that lack of finance is a problem to a significantly larger proportion of informal entrepreneurs. Only 21% of informal businesses have tried to borrow money and of these only 63% were successful. Informal businesses found it more difficult to obtain finance from banks or micro-financiers than formal entrepreneurs and were more reliant on funding from friends and family. Although there some examples of financing initiatives in South Africa, including community and village banks were identified, it was also found that there are only a small number of organisations in South Africa that have low default rates on small business loans and are easily accessible to the informal sector. Formal businesses which requested R 10,000 were more likely to secure finance from banks. Overall it was argued that the formal-informal categorisation of entrepreneurs was useful because it identified businesses with clearly differentiated profiles and can assist with developing targeted delivery systems and channels of delivery for each category (Foxcroft et al, 2002). Table 12 below summarises their findings and differences regarding the constraints faced by formal and informal enterprises. Table 12: Financial support key issues affecting formal vs. informal entrepreneurs: Issues Informal • Lack of community-based micro-finance infrastructure

• Finance not available for amounts under R 10,000 and also not accessible due to lack of collateral, well developed business idea or business plan

• Banks are not in a position to service this sector profitably • High interest rates are charged by micro-lenders • There is a lack of awareness and information about Khula and other financial

institutions • There is limited availability of micro-loans to rural and women entrepreneurs (e.g.

Khula Start offering R300 – R 3500 loans) Formal • Average success rate for applying for finance is 33%. A substantial proportion of

the remainder does not qualify. Access and availability of finance are therefore problematic

• Collateral; is a problem for the bulk of disadvantaged entrepreneurs in the sector • Banks are the key service provider to the majority seeking finance • The IDC and business partners service a small minority at the upper end of this

market reasonably well • The perspective of the experts was that there was a poor relationship between

banks and the entrepreneurial sector • The venture capital market caters for a tiny high-potential section of this market

Source: Foxcroft et al, 2002

Financing requirements of entrepreneurs from disadvantaged communities The 2002 GEM Report (Foxcroft et al, 2002) focuses specifically on the financial issues affecting entrepreneurs from disadvantaged communities. The study found that among businesses operating in townships:

• Lack of money for running costs or capital items is the most widespread problem facing them.

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• Over half of all formal township businesses in the sample did not report lack of finance as being a problem.

The financing issues facing disadvantaged SMMEs in urban areas identified included:

• Bank loans were the preferred option for overwhelming majority of entrepreneurs in the sample. In aggregate over a ¼ (25%) of entrepreneurs seeking finance were offered finance and took up the offer. 2 out of every 3 entrepreneurs obtaining finance received a bank loan. In industrialised countries the success rate is significantly higher, often about 50% in the case of bank loans (no comparison was provided for developing countries).

• Only 9.3% of entrepreneurs whose loan applications w ere successful had benefited from Khula’s services. One reason for this is insufficient awareness of among these entrepreneurs of Khula’s products. Only 54% of entrepreneurs who made applications to banks said they knew about Khula’s products. From the entrepreneurs’ perspective there appears to be no coordinated marketing of financial assistance to small and medium businesses and there is also little information available on the type of financial products available to the SME sector and how to apply for these products.

• 52% of applicants who were made offers for finance considered the loan conditions and options of repayment inadequate, however, 8 out of 10 accepted them, indicating that banks are currently the best available source of funds for entrepreneurs.

2.2.6 Obstacles to financing SMMEs Khula has recently identified obstacles faced by entrepreneurs in accessing finance, particularly from banks:

• Collateral; • Refusal to use own collateral; • Own contribution; • Blacklisting; • Financial records & Business Plans; and • High risk entrepreneurs (Mofokeng, 2003).

The 2002 GEM report (Foxcroft et al, 2002) also considered some of the obstacles preventing unsuccessful candidates from borrowing money for business purposes. These are summarised in Table 13 below. The report found that lack of collateral is the most widespread problem, particularly if the entrepreneur is applying for working capital. Other issues affecting the decision provide finance include blacklisting, and inadequate financial records. The report concluded that, based on international comparisons, for a significant proportion of unsuccessful applicants, the failure of the application would not seem to be entirely unreasonable. Table 13: Obstacles preventing unsuccessful candidates from borrowing money for business purposes Proportion of unsuccessful applicants who

indicated a problem (%) Blacklisted 12.9 Do not keep adequate financial records 11.7 Lack of collateral 45.0 Seeking working capital 28.1 One or more of the above 74.9 High risk 1 or 2 or (3 and 4) 32.7

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Source: Foxcroft et al, 2002 Another obstacle to SMMEs accessing finance is the issue of the also considered the issue of the financial health and administration in black-owned small and medium enterprises which was considered in the GEM 2003 report (Orford et al, 2003). The study and found that cash constraints are wide spread among entrepreneurs from disadvantaged communities with registered businesses. It was found that this could be linked to the financial administration where the probability of cash flow difficulties being experienced is was found to significantly decrease in those firms that kept cash books, records of accounts receivable, records of inventory and practiced active debtor management. It was also found that implementing these reduced probability of exhausting over draft facilities, and significantly increased the probability that a firm would succeed in a loan application for term loan finance. The GEM 2003 report also argues that additional external finance, in isolation, is unlikely to resolve the cash flow problems experienced by many of the firms surveyed and that the primary policy focus on finance providers and financial products does not therefore, appear to represent and optimal solution to the problem of cash constraints. Rather the report recommends a focus in improving the administrative and financial management capabilities of entrepreneurs in this sector as this would not only resolve many of their cash difficulties, it would also make banks more willing to finance them.

2.3 Key findings and Analysis

Potential Demand for SMME finance

Due to the difficulties experienced in estimating the size and scope of the sector, as outlined above, it is also very difficult to find an accurate enough estimate of the demand for SMME financing. However one can conclude based on the estimates that:

• SMMEs make a substantial contribution to employment and the economy and are expected to play an increasing contribution to the South African economy in line with international trends.

• A figure of about 3 million is an estimate of the scope of the sector over all, with SMEs estimated at between 250,000 - 650,000. The micro-enterprise and survivalist sector is estimated to be at least 2.3 million based on estimates provided by Lehohla (2003) of non-VAT registered businesses.

Clearly this represents a potential demand for financial services of up to R 3 million SMMEs, possibly more. However the most significant finding in this section relates to the inadequacy of the information used to calculate demand in the SMME sector, based on substantial differences being found in the statistics from different reports on the size of the SMME sector. It was believed also that there is a strong possibility of undercounting. Clearly this is an area of concern that needs to be addressed as the lack of an empirically based indication of the size of demand the sector will hamper effective servicing of the sector and lead to a lack of focus on the sector as it may be seen as less substantial in size than it actually is.

Characteristics of the informal sector In terms of characteristics of the informal sector, it was found that this sector is dominated by women (61%); it is mainly found in urban areas (57%) and involves mainly the wholesale/ retail sector. Although only 30.6% of this sector is said to have telephone services, the majority (63.3%) has electricity. These factors are relevant indicators for the

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types of products that would be accessible to this market. By far the biggest sources of finance for starting these businesses was found to be own funds or funds borrowed from friends and relatives (83%). This indicates that availability of savings services represent an important strategy for making financial services accessible to this sector.

Entrepreneurship in South Africa

South Africa was found to be significantly lagging in the entrepreneurship stakes, particularly when compared to developing countries with respect to GEM’s total entrepreneurial activity index. This was ascribed to the lower success rate of start-ups, which meant there were fewer new firms established (refer to table 8 above); and the lower entrepreneurial activity rates among young men, particularly young black men. The issue of access to finance was turned on its head by the first GEM report (2001), by questioning the assumption that South Africa has a ready pool of entrepreneurs who simply need finance to start their businesses. Various other constraints to entrepreneurship resulted in the recommendation of focusing efforts in the education sphere in terms of developing and entrepreneurial culture.

Range of financial services requirements It was found that SMMEs have a range of different types of financial services requirements depending on the stage in the life cycle and their size category. It is important to note that the range of financial needs go much further than credit and include transaction services which form the basis for accessing other financial services. There are also a range of sources of finance. Self-finan cing and borrowing from friends and family represented the most common source of finance for start -ups. While perceptions may differ, the GEM report has found that South Africa’s formal financial institutions do not differ from their international counterparts in terms of the proportion of entrepreneurs financed by them. It was also found that financing requirements of the informal sector need to be distinguished.

Obstacles and constraints on the demand side While specific obstacles to financing black entrepreneurs in townships were identified, the GEM report also concluded that banks were not unreasonable in turning down these finance applications as they were a result of the lack generally accepted requirements for accessing finance such as a lack of collateral, blacklisting, lack of adequate financial records. The improvement of the skills of these entrepreneurs in the area of financial administration was recommended as one response to this problem.

3. Historical background to SMME Finance Sector in South Africa Table 14 below provides a chronology of key legislation, policies and institutions that affect SMME finance in South Africa from the early 1990s to 2004. The most significant pieces of legislation which set out the current environment for SMME finance are discussed in more detail below.

3.1 National Small Business Strategy (1995) Initiatives over the last 10 years in the development of SMMEs in South Africa began in 1995 with the White Paper on National Strategy for the Development and Promotion of

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Small Business in South Africa. The preparatory phase for the White paper apparently began before the 1994 elections based on ANC economic planning and some foreign support groups (Ntsika, 1999). The White Paper was presented at The Presidential Small Business Conference in Durban in March 1995. The broad goals of the Strategy were: to

• Improve access to finance • Expand access to business information and advice • Strengthen access to training • Improve the business infrastructure • Improve access to markets and public procurement for SMMEs; and • Expand the capacity of business organisations to support member SMMEs

Table 14: Summary of key legislation, policy and strategy affecting SMME finance - early 1990s-2004 Year Legislation/ policy development 1992 The 1992 Usury Act exemption by a Government Notice (No. 3451 of 31.12.1992) was in recognition

that cost -effective microlending is only possible at higher interest rates. The bulk of MFIs have since then invoked this exemption and are subject to no limitations on interest rates Staschen, 1999

1993 The Mutual Banks Act provided a legal framework for mutual banks which legalized the activity of informal ‘common bond’ type entities such as ROSCAs (called stokvels in SA) and credit unions. According to Staschen, 1999, a large gap had occurred in the South African financial system where these entities and the banks regulated under the Banks Act. The Act was thus introduced to close the gap and give the South African financial system greater depth. Staschen (1999) provides an analysis of the difference between Mutual Banks and Equity banks.

1994 The 1994 Banks Act Exemption provided further exemptions from the Banks Act which exempted MFIs designated as common-bond institutions from the Banks Act, thus enabling them to take up deposit business, without being registered as banks. This applied to institutions such as cooperatives, stokvels and employees' savings clubs. The exemption' also enabled these institutions to take deposits as a non-bank by applying for exemption from the Banks Act. The Exemption also required that these entities have membership in an umbrella organization in order to apply these exemptions. Staschen (1999) provides further analysis of how this provide indirect and self-regulation of these entities.

1995 White Paper On National Strategy For The Development And Promotion Of Small Business In South Africa proposed the development of a National Small Business Act, a Transaction and Procurement Act and a Small Business Finance Act. The latter was intended to include steps to encourage:

• existing financial institutions to become more active in the SMME-market segments, • the facilitation of deposit-taking by lender-NGOs, • the recognition of certain non-conventional collateral types, and • The widening of scope for more specialised lending and investment institutions focusing

primarily on SMME needs. (South Africa, 1995). The Strategy also proposed the streamlining of regulatory conditions. National Small Business Act, (Act No. 102 Of 1996) Formation of Khula, Ntsika and NSBC in terms of the Small Business Act

1996

Strauss Commission (Commission of Inquiry into the Provision of Rural Financial Services). Considered demand in the rural financial sector, at least in qualitative terms, described the financial services of the different financial institutions and made extensive recommendations based on this. The recommended measures were aimed primarily at improving access to financial services in rural areas, where there was a lack of supply.

1998 National Empowerment Fund (NEF) Act was set up mainly to establishing legislative instruments for the promotion and facilitation of ownership of income generating assets by historically disadvantaged persons through a Trust. The Act also provided for the sale of shares in State Owned Commercial Enterprises at a discount to the trust or by the trust to the beneficiaries. The NEF Corporation was also set up through the Act and the NEF has been set up as a pre-eminent funder of black empowerment initiatives.

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Year Legislation/ policy development Preferential Procurement Act. The Department of Public Works initiated an affirmative procurement programme in 1996. It is designed to benefit SMMEs owned by Historically or Previously Disadvantaged Individuals (HDIs/ PDIs i.e. black people, women, disabled etc). SMMEs tendering for government are weighted in terms of their empowerment of HDIs/PDIs. According to Roussos and Ferrand (1999) the initial targets set by the procurement programme was that 30% of all government procurement should be through the S MME sector. However this target has not been met because SMMEs have been unable to tender for these projects due to issues including access to finance.

The 1998 Banks Act Exemption (Government Notice 18741 of 10 March 1998) exempted village banks from the Banks Act requiring them be registered as a cooperative, operate in a clearly demarcated unbanked area and have a business arrangement with a bank. As with common-bond institutions, the maximum permissible deposit is R 10 million. The task of supervision is entrusted to the Registrar of Co-operatives.

1999 The revised Usury Act Exemption notice provided for the creation of regulatory bodies for micro-finance with the power to supervise and regulate under the exemption. The Card and PIN collection methodology was outlawed. Withdrawal of payroll deduction facilities for civil servants on unsecured loans (and insurance policies) affecting the microlending industry

2000

Launch of the MFRC’s National Loans Register which records details of the micro-loans supplied by registered lenders. The Register made it possible for a registered lender to enquire about a prospective borrower's lending commitments and thus to form an opinion of his/her repayment capacity. Since 1 July 2002 it is mandatory for registered lenders to submit information to the Register and to do enquiries before lending. The MFRC also implemented 'truth in lending' disclosure requirements to protect the borrower, a one-page summary of the loan agreement containing the crucial elements of the loan.

2001 Release of the Black Economic Empowerment Commission report. The BEE Commission was mandated to evaluate the direction, pace and results of BEE initiatives in South Africa Strategy for Broad Based Economic Empowerment represented the first efforts by government to ensure the transformation of the distribution of wealth, income and skills in the South African economy is dealt with comprehensively.

2003

The Financial Sector Charter was developed as an industry negotiated commitment to achieving the objectives of the Broad Based Economic Empowerment Act. Specific commitments related to access to finance and small business development were made by formal financial institutions

2004 Broad Based Economic Empowerment Act. The Act empowers the Minister of Trade and Industry to legislate on various aspects of Broad-based Black Economic Empowerment. It also defines Broad-based Black Economic Empowerment to incorporate small business development

Sources: Staschen, 1999; South Africa 1995, 1996, and 1998; Porteous, 2003a; Roussos and Ferrand, 1999; Schoombee, 2003

3.2 The National Small Business Act (1996) The Act passed in 1996 established the National Small Business Council and Ntsika Enterprise Promotion Agency. Khula Enterprise Finance Limited was formed through a separate initiative of the Department of Trade and Industry (DTI)9. The National Small Business Council (NSBC) was set up in 1995 and was intended to represent and promote the interests of small business, and advise all spheres of government on social and economic policy that promotes the development of small business. It was however closed after allegations of mismanagement in 1997/98. Ntsika is considered briefly below as it was seen to be the other necessary side of the coin from Khula in terms small business development.

9 Khula will be considered in detail as a case study in section 4 below

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Ntsika10 was set up in 1996 to essentially facilitate provision of non-financial support and business development for SMMEs. Ntsika currently has various programmes focused on supporting SMME service providers including:

• Developing a network of business development Service Providers including Local Business Service Centres (LBSCs);

• Mentorship programmes for SMMEs • Facilitating and coordinating access to technology • Supporting and developing Tender Advice Centres (TACs) • Trade and Industrial Development Programme. • Enhancing the skills of small business Trainers

Ntsika repositioned itself in 2003 in an attempt to address its negative public image, shifting its focus to market development and business linkages (Wadula, 2003a). It intended to do this by helping develop small and medium-sized enterprise suppliers, design programmes, conduct research and provide information on how to serve the service providers for small business.

3.3 Black Economic Empowerment Act The government released the “Strategy Document for Broad-Based Empowerment” in March 2003 and promulgated the Broad-Based Black Empowerment Act (No 53 of 2003) in January 2004 as the first integrated and comprehensive effort by government to ensure the transformation of the distribution of wealth, income and skills in the South African economy. Some of the strategies identified in the current policies and legislation were based on the findings of the BEE Commission (2001). The BEE policy and legislation outlines various instruments including Codes of Good Practice, partnerships with the private sector and the development of Charters outlining commitments of private sector companies to transform in line with the objectives of BEE. Various Charters are in place including the Financial Sector which will be an important instrument through which commitments related to access to financial services, enterprise financing, and consumer education can be accessed from financial institutions and also monitored.

3.3.1 Financial Sector Charter The Financial Sector Charter represents one of the first collective and comprehensive initiatives by the financial sector to deal with transformation of the sector. Commitments of the Charter that are particularly significant for SMME finance include:

• Commitments to enterprise development including measurable financial support. • The financial sector support for third tier financial institutions. • Commitments to sustainably increasing access to financial services across the

scope of transaction, savings, credit and insurance products. Particular commitment is made to providing credit for micro-enterprise development.

• Financial commitment to consumer education include programmes that are aimed at empowering consumers with knowledge to enable them to make more informed decisions about their finances and lifestyles (Financial sector Chart 2003).

10 Information sourced mainly from the website: www.nepa.org.za unless otherwise referenced

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3.4 Current Developments in the Legislative/ Policy Arena Recent media reports indicate that there is a proposed amendment to the Small Business Act (Wadula, 2003b and 2004). The amendment, which has reportedly been tabled in parliament (Ensor, 2003) has apparently come about due concern from the government that the current small business legislation, which has been in place for eight years, has had minimal impact in developing the SMME sector (Wadula 2002). This was seen to be an acknowledgement by government that the small business development agencies (Ntsika and Khula) had not delivered to expectations. The reviewed strategy is intended to also realign DTI’s enterprise organization institutional framework to enhance its assistance to small business. Amendments to the Act are also aimed at removing regulatory constraints and improving the small business sector's access to finance and markets (Wadula, 2004). Additionally the amendment is intended to allow for the creation of an advocacy body for small business and to address the overlapping mandates of Ntsika and DTI (Ensor, 2003). The advocacy body is expected to take over the role of the National Small Business Council (Ensor, 2003). No further reports could be found regarding the progress of this legislation. Other developments that have been documented and reported include the possibility of establishing an advisory body for small business, an annual small business review and the holding of a regional rotating annual summit were the critical issues can be considered by the DTI (Wadula, 2004). Another significant current initiative is the establishment of a National Apex Fund which is expected to take over some of the role of Khula in the lower end of the market. This is discussed in some detail in section 4.7 below.

3.5 Key Findings and Analysis

Legislation related to Small Business Development It is not clear what the direction of the government will be in terms of new legislation on small business development, although significant developments such as the Small Business Act Amendment need to be monitored closely. The formation of the new National Apex Fund (discussed in detail in section 4.7 below) is likely to have great impact in the micro-finance sector and is a potential area of involvement for anyone interested in the lower end of the SMME finance market.

The Financial Sector Charter On the BEE side, the major significance of the Financial Sector Charter is the opportunity it presents as a framework through which the formal financial sector can be engaged on issues related to SMME finance. Commitments to consumer education, increasing access to financial services and enterprise development can therefore be used to initiate a dialogue with banks and the insurance industry with regard to SMME finance.

Procurement The potential for government procurement in growing the scope of the SMME sector has long been recognised but has been hampered by SMMEs’ access to finance after having secured contracts. The 2002 GEM report (Foxcroft et al, 2003) recommended that the government contract more institutions to accept government contracts as collateral for loans – where the loan is underwritten by the government department offering the

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contract. This should be considered as a possible strategy which Khula could facilitate, perhaps through its guarantee scheme.

4. State Initiated Institutions involved in SMME financing Several state initiated institutions exist which provide financial services to SMMEs. Each of these is briefly covered below, highlighting their focus within the range of SMME funding. Khula is the only government institutions set up by government to specifically facilitate access to financial services for a range of SMMEs and given its potential importance in the sector, a detailed case study of Khula is provided in section 4.7 below.

4.1 National Empowerment Fund (NEF)11 The National Empowerment Fund was created by the National Empowerment Fund Act of 1998. It was eventually established in 2001 as part of the DTI’s group of development finance agencies. It has a BEE focus in that its aim is to promote economic participation of historically disadvantaged persons (HDPs) and has a mandate to facilitate successful and sustainable black economic empowerment through finance and investment activities. According to its website, the NEF has three main product offerings:

• Private Equity, which provides acquisition and enterprise finance in the form of equity, quasi-equity and debt, to support empowerment focusing on transactions requiring funding between R 25 million and R200 million. Typically, it will focus on medium to large and mature companies with a profit history.

• Venture Capital, which provides seed, early stage, start-up, expansion and acquisition capital to entrepreneurs in the form of debt, equity and quasi-equity. This division offers funding of between R200 000 and R40 million per transaction.

• Investment Services are also offered which focus on design and packaging of mass empowerment products, which seek to address participation of HDPs in financial markets. This division’s emphasis is on the development of mass empowerment investment and savings products supported by targeted programmes of investor education. Investor education programmes intended to create investor awareness, thereby encouraging the development of a competitive and effective equities, and investment market inclusive of all South Africans are also provided.

NEF is therefore placed to an important role in financing in the upper end of the market for SMME finance although it does overlap to a certain extent with Khula’s (see section 4.7) and IDC’s (see section 4.2) role. It has also been widely criticized for having been slow to take off and has been branded by black entrepreneurs as “another white elephant set up to benefit only a few blacks” (Wadula 2003d). It has also been in the past criticised for not being able to carry out its mandate due to being notably under-funded and not having capacity (Wadula 2003d and 2003f). Furthermore NEF has been hit by uncertainty over its mandate in comparison to the role of other Development Finance Institutions (DFIs) such as Khula and IDC resulting with the DTI withdrawing its funding at one stage (Wadula, 2003e and 2003f). The potential impact of NEF based on this analysis would therefore be seriously limited although it is an important aspect of the

11 Information sourced mainly from the website: www.nefcorporation.co.za unless otherwise referenced

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financing equation for SMEs. Its investor education programmes should also be investigated as they are an important part of the SMME finance equation.

4.2 Industrial Development Corporation (IDC)12 IDC is the most established of the development financiers and offers a large variety of products aimed at the upper end of the market of medium sized businesses requiring a minimum financing requirement of R 1million. Entrepreneurs must also generally make a meaningful financing contribution of at least 33 % or between 10 -20 % for HDPs. According to its website, IDC’s products range from bridging finance and sector based schemes in the Manufacturing, Tourism, Ago-industries, Techno-industries, and Entrepreneurial Mining & Jewellery. They also offer products for exporters and importers. IDC has also in recent years been one of the leading empowerment financing institutions with a scheme focusing on emerging industrialists/entrepreneurs who wish to acquire a stake in formal businesses. IDC also overlaps with Khula’s functions by offering wholesale finance for Intermediaries looking for wholesale funding to lend on to individual entrepreneurs.

4.3 Land Bank13 The Land Bank has a range of products for agricultural entrepreneurs including loan equity and venture finance targeting a wide range of clients from start-ups, established commercial farmers, agri-businesses and micro-enterprises. Land Bank also has a focus on promoting black economic empowerment within the primary agriculture and agri-business sectors. Farmers are provided with various products including mortgage loans, instalment sale finance, medium and short term loans, a large livestock product and a social discount product. The latter provides incentives for existing and new clients to initiate development projects with previously disadvantaged communities resident on their farms or in surrounding rural communities. This can include worker housing, training, education, ownership projects and retirement planning. Finance is also provided to companies and cooperatives in the form of mortgage loans, medium and short term loans, deposits (corporate clients only) and guarantees. Development projects also have mortgage loans, instalment sale finance, working capital, medium and short term loans, establishment loans, and micro finance. This is dealt with in detail below.

Micro Finance Land Bank provides micro finance to resource-poor individuals and farmers. The loans can range from R250 to R18 000. They can be used by anyone who plans to engage in any legal income generating activity whether in farming or not. No security is required for micro finance loans. This loan is extremely flexible. A bank account is required and a fixed monthly interest rate of 2% is calculated.

12 Information sourced mainly from the website: www.idc.co.za unless otherwise referenced 13 Information sourced mainly from the website: www.landbank.co.za unless otherwise referenced

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The Land Bank established this micro-financing scheme called Step-Up in 1998 to address a widespread need for micro financing, particularly in rural areas (Sukazi, 2003). The scheme is an incremental scheme which enables people with no security - including developing farmers as well as small business owners in general - to borrow an initial amount of R250 which if re-paid increases periodically up to a maximum of R18 000. By this time the borrower would have been expected to build up a credit record with the Land Bank - and become "bankable". The accumulative value of the Step-Up loan book stood at R365-million in 2003 with about 130 000 people having taken out loans since April 1998 and the repayment rate being 91% (Sukazi, 2003a). Most of these people have established a track record that qualifies them for the Land Bank's high to medium -risk categories. The Land Bank also offers capacity building to potential Step-Up clients in the form of a free course in business and financial management. The bank also provides incentives to commercial farmers who are empowering either their workers or their emerging counterparts. The potential impact and relevance of the Land Bank scheme in the micro-finance market has not been widely documented. It is probably the largest single micro-financer in terms of the client base for the lower end of the market and more needs to be learnt about its potential role and impact in the sector.

4.4 Post Bank14 The Post Bank has increasingly been seen as a significant vehicle to extend financial services to the poor, particularly the rural poor, since 1996 when it was identified by the Strauss Commission as potentially playing a leading role in savings mobilization and transfer facilities (Staschen 1999). Strauss further argued for the maintenance or extension of the branch network as a ’society entitlement’ and therefore recommended state assistance to uneconomic branch offices as well (Staschen, 1999). Post Bank offers savings facilities through its over 2000 post offices across the country. Post Bank is thus drawing unbanked South Africans into the banking system (Sukazi, 2003). Most of the growth occurred during the past 4-5 years. Post Bank is the largest outreach of any single financial institution in South Africa. Coetzee (1997, cited in Staschen, 1999) estimated that by 1997 the Post Bank had 2,400,000 savings accounts in its portfolio, 80 per cent of which with a credit balance of under R 500. Due to extremely high costs, however, it had not yet managed to reach break-even point at that time. Criticisms made of the Post Bank by the Strauss Commission was that low interest on credit and hence negative real interest in deposit-taking was used as implicit cross subsidisation for other its business (Strauss 1996b: 14f, cited in Staschen, 1999). Other criticisms were that the Post Bank did not participate in the inter-bank market of the commercial banks, offered only relatively few products and its branch network density differed greatly by province (ibid.: 55ff, cited in Staschen, 1999). It has also been reported on the Post Bank website that the government has decided to restructure Post bank to create a commercially viable institution that caters for the financial needs of the "unbanked" part of our population, especially in the rural areas of the country. This restructuring is intended to include the introduction of an expanded

14 Information sourced mainly from the website: www.sapo.co.za/postbank unless otherwise referenced

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product range such as insurance and other financial services through the wide network of the South African Post Office. Additionally Post bank in restructuring Post Bank may form strategic partnerships with other institutions, as part of the plan to diversify its products. The NFHC has reportedly already done this. Staschen (1999) concludes that the great hopes attached to the Post Bank have not been met although it would be of interest for other financial institutions to use the infrastructure, since setting up their own structure is very costly.

4.5 Business Partners15 Business Partners Limited is a specialist investment group, and describes itself as the only investment group providing debt and equity investment, mentorship and property management services for formal small and medium enterprises (SMEs) in South Africa with the exception of on-lending activities, farming operations and non-profit organisations (Business Partners website). Business Partners Ltd was established as the Small Business Development Corporation in 1981 and re-launched as Business Partners after a change in strategic direction in 1998. Government remains a shareholder together with other shareholders including corporate bodies, banks, insurance companies and individuals. During the 2002/2003 financial year, Business Partners invested R400 million into 496 entrepreneurial businesses and plans to increase this to R500 million in the 2003/2004 financial year. Although it does not specifically target enterprises owned by previously-disadvantaged individuals, of its 496 investments made during the 2002/2003 financial year, 150 were made in businesses owned and run by such individuals (both male and female). Business Partners also provides a range of independent added-value services including property broking, property management, mentorship, consulting and counselling services. Business Partners invests up to R15 million in viable small and medium enterprises. Applications for Investment financing of below R250 000 are usually not considered while the average investment is between R500 000 and R7 million. Business Partners’ investments are structured using equity, shareholders’ loan accounts, royalties and term loans or any combination of these. Clearly Business Partner’s focus is in the small and medium size of the market.

4.6 Umsobomvu Youth Fund (UYF)16 The fund was founded in January 2001 to facilitate the creation of jobs and skills development among the youth. The UYF provides Business Advisory Services through its Voucher scheme and finance through partnerships with various service providers such as Nations Trust, Nicro Enterprise Finance, FNB/Momentum, and Business Partners. The types of funds vary from micro finance to loan or equity finance up to R 5 million17. The fund has reportedly (Bu siness report 2004) initiated South Africa's first public-private partnership in venture capital and private equity, conducted the first comprehensive research project

15 Information sourced mainly from the website: www.businesspartners.co.za unless otherwise referenced 16 Information sourced mainly from the website: www.uyf.org.za unless otherwise referenced 17 Information sourced from UYF consultant Mark Burke of ITSD Consulting

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on youth in co -operatives in this country and has become the leading provider of micro-finance to youth in the country.

4.7 Khula Enterprise Finance Limited (Khula) Khula was set up through a Department of Trade and industry initiative as a wholesaler with the mandate to create and develop SMMEs by making loan and equity capital, available particularly to previously disadvantaged SMMEs (Khula 1998 Annual report). Khula does this through the medium of Retail Financial Intermediaries (RFIs) and Banks, by providing guarantees to the banking sector. The rationale for wholesaling as opposed to direct retailing was to establish an appropriate mechanism for leveraging private capital for SMME finance (Tati, undated). Khula operates as a private company with the government as the sole shareholder and has its own board of directors. Khula started operations in August 1996 with a government grant of R 162, 388,000. This was subsequently increased to R 300m. In addition it has over the years received grants and loans from a number of foreign sources.

4.7.1 Products Khula’s products include:

Loans This product provides debt financing, seed loans and capacity building to RFIs. Loan sizes of RFIs range from R100-R 2million. Average loan size amongst all RFIs in 2001 was approximately R 29 323. Business loans to RFIs are interest-bearing (although lower than the prime lending rate of banks) and are intended to be “on-lended” to SMMEs. Seed loans are intended to cover the operational shortfall of emerging/start -up RFIs and are non-interest bearing. Additionally, capitalization is provided as non-interest bearing debt to emerging/start-up RFIs for on-lending to SMMEs. Capacity building can also be provided to RFIs to assist with training, management, and systems for emerging/start-up RFIs. Khula currently has 11 RFIs spread across all provinces except Northwest Province (List sourced from Khula, see Appendix 2) although one RFI was reportedly opened in the 2002/2003 financial year and then subsequently sold to African Bank (Khula 2003). Loan sizes generally range from as little as 500 up to 150,000 although Ithala Bank pushes this up (up to R 2million). RFIs use both individual and group based lending methodologies. According to Khula’s minimum criteria, an eligible RFI should have an average repayment rate of 85%; have 50 active clients, an operational self sufficiency ratio of 20%, a cost per rand lent of R1.00 and 25 clients per loan officer (Tati, undated). It is not clear whether this is still applied. In its 2003 Annual report Khula reported that it in the past 3 years it had placed emphasis on the quality of the book. It apparently had managed to exceed the approval targets and performed reasonably well in terms of draw downs. Performance of RFIs is outlined in table 15 below: Table 15: Performance of RFIs since inception RFI programme Impact and Outreach Indicators from

inception to March 2003 Total facilities approved R 549,1 m

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RFI programme Impact and Outreach Indicators from inception to March 2003

Total facilities disbursed R 419,7m No. of RFIs 32 now 16 No. of loans disbursed by RFIs to their clients 165,880 Rand value of business loan bad debt write off R 39.7m Males 30% Females 70% Black 96% White 4% Urban 70% Rural 30% First time borrowers 55% Manufacturing 21% Retail, service and small contractors 79% Job creation estimates 719,606 Source: Khula, 2003

KhulaStart Khula Start is Khula’s entry-level programme targeted mainly at the micro/survivalist sectors. The product utilises group-lending methodology with loans being made available to groups of rural women in the survivalist and/or micro enterprises. These loans are provided through a broad range of intermediary organizations called Micro Credit Organizations (MCOs). The loans are between R 300-R3500 and are primarily made to first-time borrowers who need small amounts of money to maintain their dependants through survivalist economic activities (Ntsika, 2002, and Khula website). In 2001 there were 22 MCOs servicing about 16,000 clients (Khula 2001). Black women represented the vast majority at 97%. This had gone down to 17 by the 2002/2003 financial year (Khula, 2003). The programme was reviewed in 2001 and the following were revealed as serious deficiencies:

• Operational procedures are not always followed leading to a lack of group cohesion and the loss of the power of group peer pressure to re-pay loans;

• Loans were being approved for enterprises that were not always viable because loan officers had failed to carry out thorough appraisal prior to approval; and

• Record keeping for management information systems were frequently deficient This resulted in a portfolio review with stricter criteria and monitoring of the MCOs. The current performance of the portfolio is outlined in table 16 below: Table 16: Performance of the KhulaStart Programme KhulaStart/ MCO programme Impact and Outreach Indicators from

inception to March 2003 No. of MCOs established 22 No. of KhulaStart lending 17 Facilities disbursed for on-lending R6,7m Facilities disbursed for operating expenses to MCOs R14.3m Capacity building grants for MCOs R7.1m Total facilities Approved & Disbursed R28.1m No of loans granted by MCOs 46,293 Males 13% Females 87% Black 100%

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KhulaStart/ MCO programme Impact and Outreach Indicators from inception to March 2003

White 0% Urban 5% Rural 95% Job creation estimates 88,882 Source: Khula 2003

Private Equity Funds Khula also provides funds for private equity funds that cover an under-serviced sector of the markets, that of those with transaction values of between R250 000 and R5 million. A significant highlight was the launch in 2003 of the AngloKhula Mining Fund (Khula 2003). The performance of the Equity Fund Programme is outlined below: Table17: Performance of Khula’s Regional Equity Funds Regional Equity Funds Impact and Outreach Indicators from inception to March 2003 No. of approved deals 11 Rand value deals R18.0m Rand Value of bad debts 0 Males 91% Females 9% Black 91% Urban 82% Rural 18% Job creation estimat es 535 Source: Khula 2003

Credit Guarantee Scheme The Scheme provides guarantees to banks for loans to SMEs where there is insufficient or lack of security. ABSA and Standard Bank have been the major performers under the Scheme with both banks writing over 70% of total applications (Ntsika, 2001, Khula 2001). There are three other guarantee products: Institutional Guarantees, Portfolio Guarantees, and Individual Guarantees. Loan sizes being advanced to SME clients are said to range between R 50,000-R 1,000,000. On average the scheme was reported to pay 1% of the amounts committed for claims. In addition, Khula currently and has in the past warehoused specialized donor-funded guarantee schemes such as:

• The DANIDA Business-to-Business Programme. • The Technology Transfer Guarantee Fund • The Rehabilitation Fund – A Kwa-Zulu Natal initiative to assist entrepreneurs who

suffered financial loss as a result of political violence in KZN. • The Land Reform Credit Facility

Table 18: Performance of Khula Credit Guarantee Scheme Credit Guarantee Programme Impact and Outreach Indicators from inception to

March 2003 Total authorised Guarantees R 920,4m Total committed Guarantees R 344.m No. of participating banks 13 No. of guarantees authorised 5617 No of guarantees committed 1707 Males 58% Females 42% Black (was 10% during SBDC Scheme) 47%

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Urban 85% Rural 15% Claims Paid R47,3m18 Job creation estimates 67,404 Source: Khula 2003 Khula has continuously struggled with this programme. In order to try and increase uptake of banks within this programme Khula set up a dedicated business development unit in their Marketing Division to liaise with banks on a constant basis (Khula 2003). Additionally the training of bank staff was intensified and meetings with senior management were conducted (Khula 2003). The performance of the Specialised Credit Guarantee Programmes, Danida Business to Business Programme has been described as slow due to difficulties in matchmaking between Danish and South African companies (Khula 2003). Khula also reported that it has struggled to find new clients for the Portfolio Schemes and had to withdraw its facilities due to non-payment of fees (Khula 2003).

Thuso Mentorship Programme This programme is intended to provide capacity building to SME s in terms of pre-loan support (i.e. business plan development and advisory service) and post-loan assistance (i.e. rescue services and “after care” or mentoring) to small and medium entrepreneurs applying for commercial bank loans. The scheme was set up to stimulate and increase commercial banks’ use of the Khula Credit Guarantee Scheme. The scheme was expanded to cover RFIs over the 2001 financial year. The performance of the scheme is outlined below: Table 19: Performance of the Thuso Mentorship Scheme Thuso Mentorship Programme Impact and Outreach Indicators from inception to

March 2003 No. of business plans approved 330 R value of approved business plans R 75,3m No. of post-loan mentoring visits 1019 Males 72% Females 28% Males 84% Urban 16% Rural 85% Job creation estimates 3,724 Source: Khula, 2003

Khula therefore segments its market as follows:

• Small enterprises (upper end) – Equity Funds • Small enterprises (lower end) – Credit Guarantees • Very small enterprises - RFIs / KhulaStarts/Portfolio Guarantees/ Sizabantu • Micro enterprises and Survivalists - KhulaStarts/ RFIs (Mofokeng, 2003).

4.7.2 Findings of the Khula impact assessment

18 R 17.1 or 36% of this was during the 2002/2003 Financial as a result of a high amount of bad debt as Standard Bank consolidated its portfolio

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Khula commissioned an Impact Assessment Study of all its programmes in 2001. The study conducted by the Bureau for Market Research considered the impact of Khula with respect to:

• Job creation • Gender breakdown • Rural Urban Break downs • Income and wealth effect • Household Support • Average loan sizes • Financing of new vs. existing businesses

Detailed findings are attached as Appendix 3 below. The key findings were as follows:

• Most of the businesses financed through Khula intermediaries are in the retail sector (particularly with respect to the KhulaStart, RFIs and the Guarantees.

• Regional equity funds have the highest proportion of manufacturing enterprises • In terms of loan features this indicated that the vast majority of loan beneficiaries

relied only on a Khula supported loan only • In terms of employment features average number of employees varied from 1.92

in KhulaStart to 12.01 for the Credit Guarantee scheme • The gross number of jobs created by Khula supported businesses since inception

was 787,697. This figure included employment by existing and defunct businesses. The number of jobs created by new businesses was estimated at 521,307 representing 66% of the total employment.

• At least 1.5 million people are said to have benefited in one way or another financially from Khula supported businesses since Khula’s inception in March 1996

4.7.3 Critical analysis of Khula’s role in the sector Although part of the problem Khula faces is that it suffers from poor public perception and understanding of its role, the most common misperception being that Khula is a retail institution, Tati, (undated); most would agree it has not managed to achieve the high impact that was expected at its set up. This is partly because of issues related to limited institutional capacity and experience to effectively engage and service the small business sector (Tati, (undated) both within Khula and within intermediaries. Discussions on other reasons for Khula’s failure to meet expectation are outlined below.

Disappointing uptake of the Guarantee Scheme by Banks Khula and the government’s expectations regarding the role of guarantees in providing an incentive to lenders to supply micro enterprises with loans have not been met. The 2002 GEM report (Foxcroft et al, 2002) found that Khula’s guarantee scheme was regarded to be a good idea in principle, but was believed to have been poorly implemented and ineffectively marketed. It was further argued that Khula should consider the possibility of offering loan guarantees to accredited micro-finance institutions. Schoombee (2000) argues that Khula's portfolio guarantees have not been successful in providing additionality i.e. additional credit and/or credit supplied on less onerous conditions. He argues however that this should be compared with international evidence from both developed and developing countries that shows that there is very little evidence of additionality found in dozens of such schemes. It has also further been found that issuing guarantees is costly and funds seldom succeed in rapidly generating a large

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enough volume of business to lower the unit cost to acceptable levels. He further gives the example of Western Europe which has some of oldest and largest schemes in the world which are still subsidy-dependent due to low volumes of operations and high operating costs (Schoombee, 2000). Additionally it has been found that no guarantee funds to date has succeeded in pricing its guarantees to at least preserve its capital base (Schoombee, 2000). It has also been argued that bankers will tend to select high-risk loans resulting in a low quality loan portfolio for the fund, which is very costly (Schoombee, 2000), although one would argue this is exactly what the fund is set up to do. Schoombee (2000) concludes that the Khula scheme should continue given recent increased uptake, but that international experience should temper expectations on additionality and profitability. He also proposes the use of Khula’s capacity building grant funds or subsidized funding to re-train staff in banks and to encourage new or novel ways to serve micro entrepreneurs (Schoombee 2000).

Problems with institutional capacity of RFIs In the 1999/2000 financial year widespread collapse of RFIs occurred which were ascribed to poor governance, inefficient management information systems, mismanagement and fraud. This came as “shock” to Khula management as these were RFIs that were perceived to be sound (Khula, 2000). Khula argued that its checks and balances and reporting mechanisms were being rigidly enforced but were clearly inadequate for the scale of mismanagement and fraud that was taking placed (Khula, 2000). As a result of these collapses, for the first time in its history losses of R 25, 855, 819 were reported for financial year. Bad debt written off was close to R 24 million as compared to less than R 3 million in the previous year was reported by the Chairman in the Annual Report (Khula, 2000). Steps were taken to ensure that this situation did not occur again. These included improving governance, the appointment of specialist risk managers, regular audits of RFIs by specialist professionals and other financial management control systems (Khula, 2000). As a result of these interventions no RFIs collapses were reported during the next financial year (see table 20 below). Legal action in both criminal and civil courts was also taken. The collapse of major RFIs (Ikusasa and the Start Up Fund) were seen by Khula to have serious repercussions for the sector, especially with regard to the attitudes of traditional lenders towards advancing credit in this market (Khula, 2000). Table 20: Business Loans: Bad Debt Write-offs: 1999 t0 2001/2002 Budget 1999/2000

Actual 1999/2000

Budget 2000/2001

Actual 2000/2001

Budget 2001/2002

Actual 2001/2002

R5.8m R28.1m19 R31.6m R11.6m R6.6m R0m Source: Khula 2002 On the positive side, in 2000 Khula prevented the loss of the loan book from another RFI by incorporating it into a new company with a new board of directors and management. The loan book and clients of Get Ahead Financial Services and Rural Finance Facility were incorporated into Marang Financial Services which is now one of Khula’s largest and best performing RFIs with over 20,000 clients.

19 This figure differs from the close to R 24 million quoted from the Chairman’s report in the paragraph above. It could not be clarified at the time of completing the report where the discrepancy came from.

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During the 2001 financial year a consolidation plan was put in placed focusing on the introduction of risk management reviews, organisational development, and preparation of marketing st rategy and review of debt portfolio. In retrospect Khula management acknowledged that it had been naïve to assume RFIs could mature within 5 years. A shift in policy was taken which involved reducing the number of new RFIs each year to 2-3 to ensure that Khula was able to give them the guidance they needed to grow in a controlled and profitable manner.

Criticisms and limitations of its impact assessment methodologies The job creation figures resulted in some controversy when they were reported at the Annual 2002 report launch as there was potential double counting and not all employment was as a result of the Khula intervention. BMR did acknowledge and note these limitations in their study however (Khula and BMR, 2001). For instance, employment was calculated based on the average number of employment per firm per loan and could be double counted if the person received more than one loan during the period under review. Given the short terms of micro -loans (as little as 4 months in some cases) this is obviously likely to occur extensively. Additionally new jobs created may not be sustainable, particularly with SMMEs that fail. Another factor in over-counting may be the fact that the jobs had already existed at the time that the enterprise received the loan and therefore was not created because of Khula funding.

Khula’s role in facilitating access to micro-finance There are currently arguments in favour of segmenting the market for micro-finance between those who are seeking finance for entrepreneurial activity and those who are the poorest of the poor requiring finance for various reasons among which an economic activity may only play a small role. For instance Baumann (2001 and BRCS, 2004) argues that whilst there is no doubt that Khula-supported MFIs are important, they are not easily able to reach the large majority of South African households that live on the very fringes of the formal economy, or as dependent recipients of cash transfers from it. He further argues that the imposition by Khula’s orthodox “sustainability approach may actually prevent innovation in MFIs and hamper the development of products that can effectively target this market. He therefore argues for policy exploration of alternative uses for, and models of, microfinance outside of the Khula orthodoxy, that is, micro-finance that targets survivalist households who cannot use microcredit as defined in the orthodox SMME model, and who may constitute the majority of South Africa’s economically marginalised population. The debate around the mandate and role of Khula in microfinance provision has been highlighted by van de Ruit (2001) who outlines how the high failure rate of the Khula supported entities both in terms of poverty outreach and financial sustainability, have led donors to review their role and is leading some donors to abandon funding directed toward the poorer end of the market and beginning to show a greater interest in the small and medium enterprise sector. Van de Ruit (2001), like Baumann (2001) and BRCS, (2004) further highlights the concern that the sustainability paradigm forces NGOs onto a commercial track, thus moving them away from the poverty alleviation agenda further. He also believes that the state is unlikely to cross subsidise these innovations from the more profitable and sustainable programme components and that experience reflects that the market is unlikely to provide pro-poor financial services and that subsidies seem to be an inevitable component of the strategy. He concludes that in practice, micro-credit is more relevant to the moderately poor than to the destitute and that the

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challenge for donors, NGOs and state actors supporting the pro -poor agenda is to design and implement programmes which meet the financial needs of both the entrepreneurial and non-entrepreneurial poor. Clearly within these debates there needs to be a clearer mandate for Khula in which to operate. Whilst Khula’s mandate has clearly been linked to the entrepreneurial poor, being the main provider of wholesale finance to MFIs, and while departments such as the Social Development Department do not have their own microfinance initiatives, the DTI and Khula are going to continue to be put under pressure to deal with the micro -finance needs of the non-entrepreneurial poor.

Retailing vs. wholesaling

The issue of whether or not Khula should be a retailer was first raised by Khula in its 2001 annual report given the reasoning why the issue came under consideration in the first place. Khula’s Chairman indicated that while the banking sector is particularly well developed, it has been designed to serve only one segment of the overall market. He also indicated that because basic banking principles and practices were not comprehensively focused on SMME financing the volume of banks in the sector was still far from adequate. This had lead to calls for Khula to be come active as a retailer. The Chairperson’s view was that Khula should not compete with the retail sector, but should use its products and capital to provide them with the support Banks need to reach out into the wider community. However he also concluded that should the rate at which commercial banks committed themselves to SMME financing accelerate, Khula would have to re-examine its role. The issue of whether or not to retail has been taken quite seriously by Khula management. In 2003 Khula invited tenders for research into the feasibility of extending its mandate to retailing of its financial services products directly to customers in, in line with DTI’s initiative to review the mandates of all its developmental DFIs (Wadula, 2003a). Khula’s CEO at the time was reported as saying that the decision to consider retailing was motivated by the fact that despite being in the market for seven years, retail finance institutions had not had the desired effect on small business development (Wadula, 2003a). However these plans were put on hold after the feasibility study concluded that it would be too costly (Wadula, 2003d). This will continue to be a debate for Khula unless it becomes an effective wholesaler. Anicap Venture Partners (2003) argue that government may be more effective if it additionally offered retail support, instead of strictly wholesale support to HDI SMEs.

Ignorance about Khula’s role and mandate While it should be acknowledged that Khula’s operational model may have been difficult to communicate to its target market, it is also clear that Khula’s communication efforts have not been effective. The GEM 2002 report (Foxcroft et al, 2003) reported widespread ignorance about Khula while among those aware of Khula; there is disappointment about its impact and performance. It was recommended that Khula reprioritise, recapitalise and specialise in the provision of finance to a particular sector of the small business market.

4.7.4 Khula’s Future Role? AVP (2003) argues for the DTI to encourage the formation of PPPs by adopting more accommodating partnership structures. It is argued that these would create incentives

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and facilitating structures that invite their driving private sector-led initiatives. This is based on the analysis that the government is relatively new, its capacity is limited, support programmes tend to be driven from the national level and it is still developing better ways to partner with collaborators outside government. AVP further argues that a recent DTI task force coordinated by ECI recognized several of these same problems and suggested that perhaps the best solution to SME financial support ought to centre around the state adopting a “financial market systems approach”. Current initiatives could therefore be structured along these lines.

The National Apex Fund At a workshop hosted by the WDB and Marang Financial Services (WDBT Research, Documentation and Policy Development Unit 2003) which was one of the initial discussions on the Apex with micro -finance practitioners the following recommendations were raised:

• A focus on “poverty outreach” as opposed to financial sustainability. • Khula supported the formation and implementation of the National Apex Fund

and recommended that the National Apex Fund initiative provide a clear distinction between the pro-poor MFIs and commercialized MFIs and that the Apex Fund should only target the micro credit institutions that are poverty focused MFIs.

• The need for the formation of an association of MFIs It has also been reported in the media that government intends setting up this new agency to focus on supporting institutions that lend to microenterprises and survivalist businesses (Wadula, 2002). This was seen to be an admission by government of its failure in the microfinance sector of the market. This initiative would take over the microfinancing elements of Khula, and would also support the operations of village banks. It would also, it is argued, address Khula’s difficulty in hav ing to serve a broad spectrum of needs from survivalists or micro to medium sized companies. This new agency or Apex Fund has reportedly received a lukewarm response from the small business sector with practitioners viewing it as another bureaucratic instrument to camouflage funding assistance for small business (Wadula, 2004a).

BRCS (2004) raise concern about the shifting focus of the concept behind the Apex Fund; it was initially expected to deal with a broad range of micro-finance needs and programmes and has now been more narrowly defined within the Khula/ DTI mandate to focus on micro-enterprise linked finance. The concern raised here is around the lack of government support for broader pro-poor micro-finance programmes which are not exclusively focused on micro-enterprises. This will continue to be an issue as long as DTI remains the only department concerned with micro-finance.

Coordinating efforts AVP (2003) argue that integrating development assistance programmes, especially at the lower end of the SME spectrum, may be well informed. They recommend the setting up of an Integrated Financial Institution (IFI), which would bring together an institution to deal with both Black Economic Empowerment and SME needs such as venture, private equity, guarantee and incentives (currently housed under NEF, Khula and TEO respectively).

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Some of the questions raised by stakeholders interviewed by AVP (2003) regarding the IFI and whether this is a viable option relate to its location within government and whether it would make a significant contribution to the efforts already made by Khula and the NEF Corporation. It was also suggested that perhaps a private sector led apex structure would be a more valuable option for the DTI to consider at this point. Possible public-private partnerships were suggested around this model. It was also argued that more stakeholders should be involved and suggested that this model may not work without also considering new banking sector solutions devised around better SME identification processes.

4.8 Key Findings and Conclusions This section highlighted the scale of government involvement across the spectrum of SMME financing. The following issues can be highlighted:

• The effectiveness of the National Empowerment Fund needs to be upscaled given its mandate in the SME sector of the market, particularly with regard to types of business not specifically covered by IDC and Business Partners.

• The Land Bank’s Step-Up scheme’s impact in the micro-finance sector needs to be further investigated as it appears to be the largest single provider of micro-finance services in the sector.

• The re-structuring of the Post Bank presents potential opportunities for institutions involved in micro -finance to for strategic partnerships.

• The current slight uncertainty about the role of Khula given (a) the change of leadership with the new CEO, b) talk about potential change of mandate by DTI and c) the removal of its micro-finance loan portfolio with the new Apex provides opportunities to engage about its potential role. The spectrum of possibilities include continuing with the remaining portfolio and focusing improvements and growth of the equity and guarantee funds and potentially retailing and becoming a SMME finance provider. Khula’s experiences in the micro-finance sector will also form a useful basis for the new Apex and need to be carefully documented.

• The possibility of initiating a non-enterprise-linked micro-finance fund should be considered potentially through the Department of Social Development. Given the New Apex Fund’s location within DTI, it is likely to face the same pressure as Khula did from “Pro-poor” micro-finance practitioners.

• That being said, another area where work needs to be done, and another issue which affected Khula was conceptualisations related to sustainability frameworks of microfinance providers. The pressure to fall into the same trap needs to be tempered by learning from the experience and maturity of micro-financiers such as the Land Bank, SEF and Marang Financial Services (see section 6.1.1 below).

• The partnership between government and the private sector also needs to be configured outside of the Guarantee Scheme. More innovative approaches to partnerships with institutions like Khula and (possibly the new Apex) need to be investigated. This could also be within the model of wholesaling of funds for SMME finance. Potential private sector partners outside of the banking sector are commercial micro-lenders (see section 5.5 below) and venture capital funds (see section 5.3 below).

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5. Private sector programmes for SMME finance Private sector programmes are considered below including:

• The Banking Sector • Venture Capital and Equity Funds • Insurance Products • Commercial Microlenders

5.1 Banking sector involvement in the lower end o f the market Since the promulgation of legislation affecting SMME development Commercial banks have been criticized as not having been involved enough in SMME financing, especially among businesses run by PDIs. This section looks at the involvement of banks in the lower (microfinance) and upper end (SME financing) of the market respectively. Schoombee (2000 and 2003) provides a useful categorisation of strategies that have evolved internationally for banks to get involved in serving very small to micro enterprises in a sustainable manner, two of which involve banks emulating the way in which informal financial intermediaries solve the high risk, high cost and low return problems banks are confronted with when serving these enterprises. These strategies include setting up from scratch, a bank dedicated to providing basic banking services to the “unbanked”; creating a separate division within an existing bank to serve this market; and linking banks with informal financial institutions (Schoombee, 2003). Additionally there have been international examples of MFIs transforming into fully-fledged banks although South Africa’s microfinance industry is probably too young for this to occur. Each strategy is outlined below and together with experience in South Africa.

5.1.1 Specialised Banks to exclusively service the poor According to Schoombee (2000), the first strategy involves the establishment of specialised banks that serve the poor exclusively, using the innovative forms of collateral used by informal lenders where there is commitment to save, because future borrowing depends on members' past savings record and the use of social networks as an incentive to repay loans. He gives the example of the Community Bank established in the mid 1990s in terms of the Mutual Banks Act with support from Absa, Nedcor, Standard Bank and the Development Bank of Southern Africa. Community Bank was set up to encourage an alternative approach to supplying banking services for the poor. However, the Community Bank failed, and he attributes this to not so much the failure of the model itself, but the rather, the too rapid opening up of new branches - 16 in less than two years - and the high establishment costs associated with it, which resulted in liquidity problems. The failure of Community Bank is likely to deter the private sector from engaging in this strategy and internationally it has been found that large scale private sector participation in this type of strategy has been limited (Schoombee 2003). Although it has been a successful strategy globally, it has been more successful where NGO MFIs have upgraded to banks. This is largely due to the labour intensiveness of micro-finance and the time taken to develop staff and the resulting delay in achieving profitability. Schoombee (2003) therefore recommends Public-Private Partnerships which have worked better internationally which consist of a commercially oriented donor institution,

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and a private investment company specialising in micro-finance which has experience in and knowledge of micro-finance and appropriately experienced and trained staff. He again argues for state involvement as current legislation (namely the Banks Act of 1990 and Mutual Banks Act of 1993) is seen not to be conducive to the establishment of small, dedicated banks due mainly to the high minimum capital requirement. Although not specifically mentioned by Schoombee, the experience of Teba Bank20 as a recently established example of a bank set up to provide appropriate, affordable and quality micro-financial services needs to be further investigated. Teba Bank provides end-user savings and credit products as well as corporate paymaster solutions. Teba Bank uses its experience in the mining industry and rural network to develop products in line with their target market low-income employees and their dependants in the rural areas, the un-banked and the informally employed. Products include savings accounts, fixed deposits, home loans, funeral insurance and micro-loans up to R 10,000. The microloans are operated as a joint venture between Teba Bank and Mineworker Credit Guarantee (MCG).

5.1.2 Banks setting up specialised divisions/ programmes exclusively to serve the poor. All four of the big four banking groups in South Africa have apparently created divisions to serve the unbanked in the economy (Schoombee, 2000) although he makes a distinction between those that aim to serve salaried low income individuals, and those that aim to provide loans to micro entrepreneurs. The most significant example of the former is the Standard Bank's E Plan. Significantly he does note also that while all four banking groups were involved in the first category, there has been much less interest in the second aim. He also further notes that although South African banks are prepared to provide low -income clients with deposit and withdrawal services, very little has been done by them to accede to the large demand for credit facilities and the growth in the formal moneylender industry in the last number of years is testament to this. He argues though that the majority of these loans are required to refinance existing consumer debt, which business banks would not normally undertake in any case. Examples are outlined below. Standard Bank's Business Growth Plan, was introduced as a pilot project in 4 black townships in April 1993, granted loans between R1 000 and R6 000 to micro entrepreneurs without requiring conventional forms of collateral. Although Standard succeeded in keeping bad debts below 4 per cent of the portfolio, in part by adopting some proven informal procedures, the project was terminated at the end of 1996 for the following major reasons:

• High level of operating costs (due to relatively high South African wage rates, and security costs for staff operating in areas with a high incidence of violence);

• the unwillingness to charge full-cost and consequently very high interest rates, because of concern for the image that could be created of a powerful bank charging excessive rates to their poor clients; and the low loan level at which the Usury Act became applicable.

According to Falkena et al, following the success of E Plan, the Standard Bank started extending the concept to include small loans (originally, less than R500) relying on the utilisation of past account balance information (electronically available within the bank)

20 Information sourced from the Teba Bank website

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as a credit check. While it was found that a restrictive consequence of such practice is that it gives a strong preference to long-term clients’ over start-ups and ‘external firms’, it has managed to develop a large portfolio indicate a significant outreach (Falkena, 2001). Another example of this is the Sizanani/ Sizabantu scheme set up by the Banking Council in 1998 in conjunction with the four big banks to supply loans ranging from R10 000 to R50 000 to micro entrepreneurs. The scheme was based on the analysis made by the Banking Council that the major problem banks face when trying to engage micro enterprises is the lack of viable enterprises due in most part to a lack of managerial skills (Schoombee, 2000). The Scheme therefore included mentoring as a crucial element in supplying loans to micro enterprises. Sizanani Advisory Services (a not-for-profit company) was set up by interest free loans contributed by the four big banking groups and a grant received from the WK Kellogg Foundation to provide mentors to help entrepreneurs in drawing up their business plans and to assist in supervising the business for a maximum of two years. Interest rates on the loans provided by the banks were levied at the banks' prime overdraft rate plus 6 per cent per annum; three years is the maximum repayment period. On the other hand the Sizabantu Guarantee Company, financed through Khula, was set up to provide participating banks with loan-loss guarantees up to 95 per cent of the value of a loan for a period of two years. Sizabantu was discontinued in 2002 following advice that it would have to be set up as an insurance company and Khula has since then been providing indemnities of 90%. Schoombee (2003) argues that this init iative has not shown that this strategy works in South Africa as by June 2003 only 239 loans to the value of R 8.4million had been approved. There has also been low levels of uptake as the mentors have been found to introduce only 10% of the applicants who meet the minimum requirements of the banks, due to poor credit records, lack of experience and commitment, and non-viable business plans. Loans in arrears have also been high growing reaching 33% in June 2001 although this has apparently improved currently at 12.8% for new loans since then (Schoombee, 2003). So what are the reasons for this strategy not having worked as well as it should? The following reasons are highlighted by Schoombee (2003):

• The lack of technical assistance from those experienced in serving this market; • Lack of appropriate service delivery and proper training of mentors, loan

applicants and loan recipients; and • No operational champion.

Schoombee (2003) therefore recommends Public-Private Partnerships which have worked better internationally which consist of a commercially oriented donor institution, and a private investment company specialising in micro-finance which has experience in and knowledge of micro-finance and appropriately experienced and trained staff. He again argues for state involvement as current legislation (namely the Banks Act of 1990 and Mutual Banks Act of 1993) is seen not to be conducive to the establishment of small, dedicated banks due mainly to the high minimum capital requirement.

5.1.3 Linkage Banking An example of this type of strategy is FNB’s People Benefit Scheme which linked the bank to informal financial intermediaries, in this instance to stokvels Loans in the range R1 500 to R20 000 were also linked to borrower savings. Savings were used for both screening and for collateral purposes. However the scheme was operational for approximately 5

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years and was shelved in 1997, due to a lack of demand for loans as members mainly used the scheme for savings purposes while the intention was as a credit programme. Possible reasons for its failure to attract credit seeking clients, identified by Schoombee (2000) is the absence of the non-governmental organisation (NGO) that could identify and train prospective borrowers as is commonly done in linkage schemes. Schoombee (2003) further identifies the linkage bank requirement for village banks as another example of the linkage bank strategy. In the case of village banks a regulatory requirements is that members' savings and payment for shares are deposited in the linked bank and may serve as collateral for a loan from the linked bank to the village bank, subsequently to be retailed to individual members by a loan committee. Lending through village banks has been of a small scale (Schoombee, 2000 and Dallimore, 2003) possibly due to the collapse of the umbrella bodies under which they are regulated. Falkena et al (2001) identified this issue as a major weakness of sub-Saharan African countries, compared to their counterparts in emerging Asian countries, where banks provide refinancing and saving facilities to informal lenders. This was found to be barely the case in Africa generally, resulting in market fragmentation and inefficiencies. They identified the current formalisation of the micro-lending industry, as a potential opportunity for strengthening of ties between bank and non-bank intermediaries. This issue needs to be investigated further in terms of the actual demand for this. The Linkage Bank strategy has been found to have some limitations internationally as not all banks find it profitable, as in many cases there is no NGO involved to establish and the banks have finance the establishment and training of new self-help groups (SHGs) themselves (Schoombee, 2003). He concludes that it may no longer be the preferred strategy for the big four banks due to the absence of an NGO that can establish and train SHGs following the demise of FSA and Finasol. He further highlights the uncertainty of the effectiveness of SHGs in urban areas and the limited demand for lending as potential concerns. He recommends the involvement of the state and donors to subsidise the support, training and advice link banks offer to FSCs.

5.1.4 Banks role in providing Savings and Transaction services for SMMEs Another role for banks in facilitating access to finance for SMME is in providing savings and transaction services particularly for micro and survivalist enterprises. For instance, it has been found that in rural areas, there is more demand for savings products than lending products (Coetzee 1997: 4, cited in Falkena, 2001). This is significant as it has been found that start-ups rely largely on savings to start and operate their businesses. For instance 93.3% and 73.3% of small start -ups in Limpopo and KwaZulu-Natal resorted to private savings respectively (Coetzee 1997, cited in Staschen 1999). A study done by Moyo, Musona, Mbhele, and Coetzee (2002), entitled: The use and impact of savings services among low Income People in South Africa, commissioned by Micro Save Africa, studies how low income people save using a sample of urban and rural low income people in the KwaZulu-Natal province. The study pays particular attention on how low income people use different savings services/ systems and the impact of those savings facilities on their household budgets/lives. The study also draws important lessons for MFIs and Banks seeking to develop poor-responsive savings services using Ithala Bank as a case study. The study found:

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• Low income people use various forms of savings to manage their household and business budgets and these financial services enable them to acquire physical assets for establishing or expanding businesses.

• Of the thirty-five savings products identified (of which 17 were Ithala products), among the most often mentioned are:

o short-term loans from omashonisa (informal sector moneylenders), o cash saving (through stokvels - Accumulating savings and Credit

Associations or ASCAs), o targeted saving (through Ithala) and o funeral schemes or burial societies

• Only half of the twelve most often mentioned, were Ithala products while the rest were from the informal sector. The researchers concluded that informal sector competition is significant and that the informal sector appears to have a competitive advantage in terms of offering flexible financial services.

• There was a multiplicity of informal financial mechanisms which suggested the existence of needs that are not adequately met by the semi-formal or formal financial sectors. This was seen to be a market opportunity for banking institutions like Ithala.

Recommendations were made that banking (formal) institutions develop mutually beneficial relationship/ linkages with the informal sector for instance to mobilise savings from the low income people. The study made recommendations regarding the possibility of Ithala Bank incorporating some informal sector features into the existing and future products and linking informal saving systems into semi-formal or formal sector financial service operations.

5.1.5 Key Findings and Analysis Key findings and recommendations for section 5.1 are as follows:

Developing entrepreneurial and microfinance skills in the banking sector. The 2001 GEM report (Driver et al) argues that commercial banks are not geared to financing entrepreneurs due to the fact that they developed in an economy dominated by large corporations. This has meant that they do not have the skills set for assessing start-ups and small enterprises and their assessment and decision making is not individualized to the specific entrepreneurs being dealt with. Skills related to this area need to be developed by banks as this is a barrier towards their involvement in the sector.

Pursuing Linkage strategies with village banks and cooperatives involved in providing informal financial services to the poor. Linkage Banking will continue to be the main strategy through which banks will be most required to facilitate access to financial services for the micro-enterprise / survivalist market, particularly in rural areas. Banks should also monitor developments regarding the new Apex Fund proposed by DTI as this may provide a vehicle through which NGOs involved in establishing and training cooperatives may gain access to capacity building funds. Successful Linkage banking would also serve to alleviate some of the pressure from banks to directly provide financial services to this market.

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Providing best practice case studies and research on small bank establishment in the sector.

Experiences, particularly with Community Bank’s failure have been greatly highlighted making the idea of setting up a specialised small bank a bad one. However other models that are currently operational such as Teba Bank and African Bank could be studied in terms of their impact and experience operating in the “small bank” sphere. Research and perhaps even experienced-based staff exchanges with commercial banks in this area is therefore important.

Further promoting the provision of saving facilities for the lower end of the market for formal and informal institutions. This is an important issue given the role that savings (whether own or friends/ relatives) have played in Start-ups. However reasons for the limited the take up of lending based on savings products needs to be investigated. This strategy is also dependent on the issue of village bank regulation and coordination also which is considered in section 6.2 below.

5.2 Banks involvement in SME lending The Task Group of the Policy Board for Financial Services and Regulation (Falkena et al, 2001) found that although it is generally accepted that most SMEs lack sufficient equity finance, it is not certain whether there is a similar lack of debt finance for SMEs. For example, the Task Group found no indication that the quantum of debt finance available to SMEs that have a turnover of more than R2 million is insufficient that although there is a presumption that such debt finance might be skewed towards too-short maturities, there is still a need to produce evidence on this. However the Task Group argues that since the credit-risk profile of SMEs may be too high, banks can risk only a relatively small percentage of their depositors’ money in SMEs. Their findings were that the problem is not so much the availability of debt finance, but inefficiencies in terms of product range, the cost of debt finance and the service provided to SMEs. The reasons for these inefficiencies relate mainly to competitive factors, to barriers to the entry of potential new providers of financial services and to SMEs’ need for non-financial services. Importantly, given the focus on credit, they further argue that there needs to be a recognition that, for SMEs, access to debt cannot be separated from the broader topic of access to banking services.

5.2.1 Products provided by Banks Falkena et al, 2001 identify the following products which are available to SMEs from Banks:

• Business owner’s access to credit through their access to personal finance in the banking sector and micro-lending industries. They argue that nearly all micro - and small enterprises, and even the majority of medium-sized enterprises, have to access debt finance in the names of the owners (i.e. in their personal capacities).

• Direct financing of SMEs on the capital markets where an SME looking for debt finance can either approach ultimate investors indirectly, through a financial intermediary (usually a bank, but also, say, an insurer).

• Bank products specifically geared for SME financing such as:

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o Bank-overdraft facilities. o Bank loans. o Factoring and invoice discounting. o Asset finance (including commercial mortgages). o Equity finance.

They further argue that the issue of appropriate non-financial support remains critical as long as there remains the problem of emerging small entrepreneurs not separating their personal finances from those related to their business. This issue was dealt with extensively in section 2 above.

5.2.2 Reporting on scale of SMME activity The Task Group found that it is difficult to report about commercial banks’ involvement and experience in providing finance to SMEs, as they tended to be fairly discreet about their practices in this regard. The following table provides some estimates on SME financing by banks. Table 20: Very rough estimate of the main Bank’s SME books Standard

Bank Nedbank ABSA FNB21 Total

SME Clients 360,000 N/a 170,00 N/a Borrowers 226,800 N/a N/a N/a 370,000 Non-Borrowers

133,200 N/a N/a N/a

Total Book22 R5 bn R5-8bn R3-7bn R2-4 bn R20bn Average loan size

R39, 039 N/a R47, 058 N/a R54, 000

Market share 34% 33% 20% 100% Source: Presentations to the Parliament Portfolio Committee for Trade and Industry on the role of banks in financing SMMEs (June, 2000) and South African Banking Council – (figures computed by MFRC), cited in Falkena et al, 2001. The following issues were identified based on the table:

• The R20 billion in SME banks exposure approximates to 5 per cent of total bank exposure (excluding mortgages and credit cards), while Khula Guarantee’s exposure to commercial banks is approximately R168 million which is only 0,8 per cent of aggregate commercial bank SME exposure.

• The 370,000 SME borrowers represent between 16 percent and 40 per cent of the estimated number of SMMEs in the country depending on statistics use.

• Although these statistics show an average loan size of R54 000, it is believed that, of the 370,000 borrowers, only 18 per cent (i.e. some 66,600) borrow above R50,000.

• In terms of loan usage (by overall SME loan exposure), approximately: o 61 per cent of the amount comes from instalment sale finance; o 27 per cent is (short-term) overdraft facilities;

21 Figures for FNB are pure guestimates. FNB, according to South African Banking Council, was not required to present to the Committee (Falkena, 2001) 22 This is the most hazardous of all guesses as nearly all commercial banks have various definitions of what constitutes an SME (Falkena 2001).

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o 11 per cent comes from term/revolving loan facilities; o 1 per cent is other forms of financing (factoring, discounting finance, etc.).

Standard Bank is seen to be the leader with Nedbank estimated to be the second (Falkena et al, 2001).

5.2.3 Risk Assessment The Task group also found that there is little evidence that methods for risk assessment and credit decision are adequate, and a lot of research is required to improve knowledge in this important regard. Credit providers (Porteous, 2002) also identify the lack of credible, easily available information about SMMEs which can speed up the origination process by allowing better application and behavioural scoring as a problem in providing credit to SMMEs. The report by Porteous (2002) also indicated that the industry is committed to sharing information on SMME performance with reputable credit bureaux and authorities.

5.2.4 Collateral The issue of collateral and the lack of easily available collateral replacements are also of importance to commercial finance institutions. In relation to this, the performance of SME loans is also an issue. According to Falkena et al 2001 loans among the major banks average roughly as follows: non-performing loans 18 per cent; bad debt 4 per cent

5.2.5 Customer Service Issues The 2001 GEM report (Driver et al) found that financial institutions were not able to interact effectively with entrepreneurs. On the other hand the report found that South African entrepreneurs and would be entrepr eneurs are often ill-equipped to develop a business concept and present it confidently. They may also be intimidated by financial institutions, especially if they are not confident about their language and numeracy skills. The GEM 2002 report (Foxcroft et al, 2002) considered the issue of communication between banks and entrepreneurs further and found that the majority of entrepreneurs in the sample expressed dissatisfaction with the process of applying for finance. The problem appeared to centre on the quality of communication and the level of understanding of their businesses by bank officials; this finding is not affected by whether or not their application was a success. Entrepreneurs indicated that banks did not understand the difficulties they faced in their businesses and implied that the negative sentiment toward the approach to customer relationship management adopted by financial institutions is widespread among disadvantaged SME entrepreneurs, regardless of whether they obtained finance. It was also argued that there needs to be a greater understanding among entrepreneurs of how the financial sector operates and a greater understanding among financial institutions of the needs and challenges of entrepreneurs.

5.2.7 Regulatory Issues The inability to price for risks and costs adequately under the present Usury Act limitation for loans above R10 000 was identified by credit providers (Porteous, 2002) as on of the key barriers to provider loans over R 10,000. It was further recommended that the Usury

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Act be repealed so that it would not to apply on all business related loans because it prohibits larger more reputable credit providers from being able to price for risk of credit.

5.2.8 Role of the state Credit providers (Porteous, 2002) have recommended various initiatives related to government to aid the transition from informal to formal such as assessing the impact on all new legislation to ensure that the costs and complexities of registration for SMMEs are not increased by new legislation; strengthening SMME lobby groups; proposing a national audit of legislation affecting/ constraining small business (an update on the Ntsika report of 1999) with government committed to review the results.

5.2.9 Key findings and Analysis Falkena et al (2001) makes the following findings and recommendations on banks’ involvement with SME debt financing:

• While banks were found not the sole actors able to provide debt finance to SMEs, their potential to affect the volume and quality of SME finance by going beyond the direct granting of SME loan. This can be done through their particular refinancing capacities, by providing a back-up line to non-bank financial intermediaries, for example, or to business owners in their individual quality.

• Changes may be required in the regulatory environment to give impetus to such developments to lessen the divide between banks and non-bank lenders particularly the emerging ‘middle class’ of formal, registered and better -administered small lenders.

• There is a need for better research and better disclosure on the exact extent of banks involvement as it is argued that banks are getting more involved but are not reporting it adequately.

• The costs of administering loans and granting borrowers the necessary business support were seen to still be a “massive challenge” and more efficient and innovative mentorship schemes were recommended to overcome this challenge.

Additionally the following issues were identified:

• The need to address the mutual misunderstanding of each others requirements between bank staff and SMEs.

• It was proposed that government conduct another regulatory review of legislation that impacts SMMEs.

5.3 Venture Capital and Private Equity Funds A study by ECI (2001) found that although South Africa has quite a developed venture capital market, very few institutions concentrate on the micro and small segment of the SMME finance market. Only 3 out of these were found to provide minimum investment in the range R500-R10000, 1 in the R10,001 -R100,000 range, 7 in the R100,001-R250,000 range, 6 in the R250,001-R500,000, 23 in the R500,001-R5 million range and the rest above R 5 million (ECI, 2001). The criteria used by Venture Capital funds are further highlighted in the ECI report. However the lack of entrepreneurial and management skills is likely to limit SMMEs in the lower part of the market from accessing these resources. The report further notes that there has been recent expansion of funds to provide equity for SMMEs.

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However the following recommendations were made regarding improving the use of private equity among SMMEs:

• Focusing on those areas where more information is available first including firms working with SMMEs and facilitating transactions and opportunities;

• Identifying how information constraints can be alleviated over the longer term; and

• Identifying opportunities and support for the formation of funds that are willing to make smaller investments (ECI, 2001).

In relation to the last point, it is also important to note that credit providers (Porteous 2002) have also indicated a willingness to supporting the feasibility investigation into other types of financing vehicles which can (i) mobilize venture capital at the appropriate level required (i.e. below R5m); and (ii) syndicate funding to spread risk and leverage available guarantees to the maximum extent. This was to be focused on encouraging local provision of venture capital to support start-ups. It was therefore proposed that there be the creation of a new small investment fund class with tax benefits but that a ceiling on size be further investigated to stimulate the flow of local risk taking capital to local entrepreneurs (Porteous, 2002).

Alternative Stock Exchange The DTI, 1998 Discussion Document: Towards a New Strategy for Small Business Financing23 identified The Stock exchange as a potential source of capital for SMEs and the expanding of the number of SMEs listed on the Johannesburg Stock Exchange was further identified as a potential strategy for increasing access to finance for SMMEs. The Alternative Stock Exchange (Alt-X) was set up last year in line with this and it is still too soon assess its impact.

5.3.1 Key Findings and Recommendations The main recommendation emanating from this section was the identification and the assessment of the feasibility of venture capital funds focusing on the lower end of the market below R5 million. This was to be focus on investigating the potential to encourage local provision of venture capital to support start -ups. Additionally the potential for tax benefits woul d also be investigated.

5.4 Insurance Industry The insurance industry has not been under as much pressure as the banking industry to provide services to the SMME sector. However, with the increasing spread of the HIV/ AIDS pandemic and the risks that will be by SMMEs, this is going to become an increasing priority. Furthermore, ECI Africa (2003a) noted that this is significant to the micro finance sector because of the associated costs incurred by a household affected by HIV/AIDS. If micro-finance programmes are affected by HIV/AIDS they may collapse further decreasing the available avenues SMMEs have to access finance. ECI Africa (2003a) further recommended that there should be further consideration of insurance as a risk mitigation strategy for households affected by HIV/ AIDS. This should also be considered for SMMEs, particularly those at the lower end of the market not able to access formal insurance products.

23 Not to be quoted as government policy

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A study by Bester et al (2003) on: Making insurance markets work for the poor in South Africa - scoping study, provides insights into the informal insurance market as playing a very important role in the risk mitigation strategies of lower-income households. These should be taken into account in developing strategies for SMME financing. It was also found that due to the informal nature of most of these insurance organisations, services are not always defined and products often overlap, straddling the division between insurance, savings and credit (Bester etc al 2003) highlighting the role these institutions could play in providing financing for micro-enterprises. Most of these institutions are burial societies which in South Africa have an estimated 8 million members and these members contribute in excess of R10 billion every year. Due to the nature of insurance industry, most of these institutions operate with a “link” insurance company. The formal insurance industry thus also has a role to play in SMME finance. Bester et al (2003) recommends that burial societies may benefit from appropriate linkages with formal institutions may help burial societies to manage their risks better. However the absence of a clear regulatory framework for assistance business that also covers informal insurers is identified as a problem as it complicates the management of risks in this sector. Credit providers (Porteous (2002) agreed that further research is required in the area of insurance products for SMMEs, terms of access to short term insurance for assets in certain areas, which is a pre-condition of forms of asset-based finance.

5.4.1 Key Findings and Recommendations The insurance industry’s role in the provision of services to the SMME sector has long been ignored. Given the risks associated with SMMEs generally and the increased risks related to HIV/ AIDS, this needs to become a priority. The framework of engagement with the Insurance industry is provided by the Financial Sector Charter and should revolve around how insurance companies can better service the sector and increasing their interaction with informal providers.

5.5 Commercial Micro-lenders and their role (or potential role) in SMME financing The commercial micro-lending in South Africa as distinct from micro-finance for enterprise development has long been ignored or regarded in negative terms by those interested in micro-finance for enterprise development, as it is seen to be a consumer credit driven sector. This has largely been because it has been dominated by consumer loans to salaried workers and with little evidence of pro-poor focus; and consequently not really forming part of global micro-finance.

5.5.1 Historical Analysis Porteous (2003a) provides a historical analysis of the developments of the micro-finance sector and the reasons why it has developed differently, to be dominated by commercial lenders. A summary is provided below as it important to understanding why the sector has not been as active in the SMME market. Porteous (2003a) outlines the growth and formalization micro-lenders which began serving those outside of the traditional bank credit system and largely functioning outside the law (Usury Act of 1968). Bank card and pin and salary deductions based lending began during the early nineties by commercial lenders and resulted in the commercial growth of the sector. The 1992 Usury Act exemption effectively legalised their operations. This together with the success of some of the commercial pioneers attracted further entrants to the market. This in turn

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led to in the late 1990s the growing SA retail banking sector’s involvement in the sector. There was large growth in the sector mostly occurring in the cash loans, or short term, end of the market, where small one branch lenders predominated. There was no state support given to this sector; as it was perceived in negative terms due to high rates charged (averaging 30% per month) and the retention of card and PIN as a practice subject to abuse. The over-saturation of the market largely based on salaried employees not able to access formal bank credit and the implementation of new regulations for micro-lending (revised Usury Act Exemption notice of 1999 resulted in large scale fall-out in the sector. Most significantly, the new exemption notice provided for the creation of Micro - Finance Regulatory Council which had the power to supervise and regulate under the exemption. Card and PIN collection methodology was outlawed. Finally in 2000 the government withdrew payroll deduction facilities for civil servants on unsecured loans (and insurance policies). Banking industry collapses due to micro-credit exposures also occurred during this period.

5.5.2 Current status and potential role in SMME financing Micro-lenders in terms of their sheer numbers represent a much larger pot from which SMMEs could potentially gain access to financial services. As can be seen in table 21 below, they represent the largest chunk of micro-lenders in terms of volume at over 65% and represent almost half the outstanding portfolio in loans. Table 21: Microloan sector by institutional type

Institutional type Motivation Number Registered

% of new volume

% outstanding portfolio

Banks For profit 8 30.6 49.2 Retailer & cash lenders

For profit 1263 65.1 48.6

Trust Unknown 61 1.5% 0.2% NGOs (section 21 & cooperation)

Not for profit 21 2.8 1.8

Source: MFRC Quarterly Statistics cited in Porteous 2003a. However in terms of use of loans only 2-4% of loans are reportedly used for business purposes although apparently this may be under reported as the Micro Lenders Association MLA estimates that 10-15% of loans made by its cash lenders members are for business/ entrepreneurial activity ECI (2003). The study also recommended further research on this issue. As this study was broadly on the use of loans and specifically investigating the use of loans in for business/ enterprise purposes it would also be useful and interesting to do detailed research specifically on the issue of factors that would enhance SMME lending among commercial micro-lenders.

5.2.3 Key findings and Analysis So why hasn’t there been a greater proportion of micro-lending funds used by SMMEs? There has not been much analysis of this, although the reasons are probably similar to those for why commercial banks do not lend to this market. The reason also lies in their methodology, which relies mainly on proof of employment. The lack of innovation in the industry has also been noted as a concern by Porteous (2003a).

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6. Non-commercial or community-based financiers of SMMEs

6.1 The Non-profit micro-finance Sector

6.1.1 Status of Microfinance in South Africa: Overview of its overall impact and factors that have influenced this A 1999 study of microfinance in South Africa (Roussos and Ferrand, 1999) found that the supply of microenterprise in South Africa falls far short of the demand across all areas of the sector, and that this remains a significant constraint to the development of enterprise. The study identified the major constraint being the lack of retail capacity and a lack of private sector investment. According to Baumann (2003), SA’s MFIs straddle the formal and informal sectors, and are mainly rural. An issue of concern is that South Africa’s educational system at all levels is unprepared to produce the kind of skills and aptitudes needed by MFIs. Baumann (2003) conducted a study of 4 MFIs and compared their performance against benchmarking standards set in the Micro Banking Bulletin. A summary of this study is provided to shows the potential and capacity of SA’s best MFIs to sustainably provide credit to survivalists and the micro-enterprise sector. The study considered Small Enterprise Foundation (SEF), Marang Financial Services (Marang), Finca and Beehive. In terms of size and focusing on MFIs that are traditionally focused on credit for income generations, Marang Financial Services is the largest MFI with about 21,000 clients. Marang has grown significantly over the last two years. SEF has also grown significantly and now has over 20,000 clients (see table 22 below). Both the experiences of Marang and SEF are interesting to note. Although relatively new, Marang grew out of the collapse of the Get Ahead Foundation and Rural Finance Facility, and used the experience, infrastructure and personnel of the two organisations, and thus has a longer institutional history. SEF also has a long institutional history. Both MFIs reportedly have high rate of women borrowers (95% for Marang and 98% for SEF) (Baumann, 2003). A comparison with international standards found the following:

• In terms of scale, SA’s MFIs are at the bottom of the scale in terms of av erage clients and the number of offices serving them. They also have a much lower absolute portfolio on average than all other categories of MFIs except their African peer group.

• In terms of outreach, average loan balance per client for the SA MFI is on the low end of the scale, but score well in terms % of women clients.

• Expenses are significantly higher in South Africa with regard to total expenses / operating expenses and non-staff administrative expenses as a percentage of total assets, financial expense and personnel expense.

• SA also performs badly with respect to efficiency measures such as personnel expense as a % of loan portfolio which is 6 times the global average, 3.5 times the African figure, and 2.5 times the African peer groups norms. However SA MFIs were found to pay relatively low salaries in terms of the local economy.

• In terms of productivity SA’s MFIs perform poorly with respect to borrowers per staff member, but are less top heavy in terms of ratio of loan officers to total personnel (Baumann, 2003).

Roussos and Ferrand (1999) make a distinction between

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• Mature sustainable organisations with more that 20,000 clients; • Developing organisations with clients between 5000 and 20000; • Emerging organisations with clients between 1000 and 5000 clients; and • Start-up organisations with less than 1000 clients.

At the time of the study only the Start-Up fund (now collapsed) and the Land Bank’s Step-up fund had reached these targets. This is a useful categorisation for targeting capacity building assistance.

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Table 22: Statistics for the Developmental Microfinance Sector Institution Savings Principal Outstanding Clients / members Branches / groups 2002 2003 2002 2003 2002 2003 2002 2003 ACAT KZN 150 000 270 000 88 257 298 800 475 1 105 95 221

Beehive EDC n/a n/a 652 311 2 300 000 3 623 6 094 3 3 FINCA KZN 4 950 000 n/a 1 100 000 1,000,000 2 500 778 290 133 Homeless People’s Federation

2 572 791 2 860 000 2,000,000 1 500 000 68 789 44 165 800 1 270

Kuyasa Fund 1 600 000 3 500 000 1 700 000 5 00 000 5 603 4 620 250 400 Marang Financial Services 2 894 000 4 196 300 8 529 994 14,000,000 14 470 21 000 12 19 Poor People’s Movement 0 200 000 n/a n/a 0 7 000 0 70 SA Youth Federation 0 17 147 n/a n/a 0 8 290 0 250 SACCOL 17 500 000 20,000,000 14,000,000 16,000,000 7 900 8 000 28 27 Small Enterprise Foundation

2 170 000 3 010 000 8 350 000 15 600 000 13 387 20 048 300 550

Women’s Development Banking

n/a 300 000 930 000 1 500 2 500 1 1

TOTAL 31 856 791 35 453 447 36 720 562 56628 800 118 247 123 6 00 1 529 2 544 Source: Bay Research and Consultancy Services cc, 2004

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6.1.2 Factors influencing the performance of MFIs in South Africa The analysis above puts into question whether SA MFIs are geared towards productively and sustainably service the micro-enterprise market. Some of the obstacles preventing them achieving this include:

• Distances and mobility due to the geographic distribution of the population in rural areas. This in turn relates to limited penetration levels which can be achieved per village due to the low population concentration and limited economic opportunity.

• Greater need for client training input resulting in loan officers being more productive as they have to spend more time on this.

• Skills levels and attitudes to work of staff • Labour relations issues • Limited MFI management experience in SA • Under-management • Comparatively low salary levels of loan officers • Lack of appropriate capacity support for NGOs

Table1 in Appendix 4 also provides the range of institutions providing development microfinancial services. A case study of closure of Provident South Africa (PSA) (see Appendix 5 below) which became one of largest MFIs in South Africa with over 34,000 clients raises many of these issues, particularly the issue of management and field capacity. Although they based on tried and tested model from the UK PSA also struggled with issues related to acclimatising to the South African environment which made their controls ineffective.

6.1.3 Current debates regarding the segmentation of microfinance market There have been and are continuing debates related to the lack of clarity related to the role of microfinance in South Africa. For instance Baumann (2001) argues for recognition of two views on the role of micro finance:

• one implicitly assuming an SMME microcredit focus, that is to provide sustainable microfinance facilities to the poor to facilitate income generation or reduce the costs of poverty; or

• Another with a social mobilisation focus; that is to use microfinance to develop, mobilise, and leverage hidden social assets in resource-poor communities to address poverty and vulnerability.

For this reason he believes state-sponsored SMME microenterprise/ microfinance programmes are not a solution to the financial service needs of the so-called ‘unbankable’ households which exist within the ‘informal economy’, as SMME microcredit policy is a subset of growth and employment policy, and is not directly oriented to poverty relief or social development. On the other hand he also argues that the commercial microcredit industry is also largely unsuitable to poverty relief, both in that it caters for the employed and/or those with formal bank accounts, and that it is not developmentally oriented. He further argues that most attempts to provide ‘traditional’ microfinance services to economically marginalised households in South Africa will fail – in the sense of reaching

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the poorest of the poor effectively – without elements of subsidisation, cross-subsidisation, and/or voluntarism on the part of the implementing agencies. The “hegemonic” Khula-style microcredit orthodoxy South African paradigm of ‘SMME microfinance’, with its attendant foci on ‘sustainability’ and ‘professionalism’ is therefore criticised for obscuring the social ben efits of alternative forms of microfinance, both lending and saving, as well as the developmental opportunity costs of not exploring these options. He also criticises the SMME microcredit paradigm for its tendency to focus on a quantitative approach using an income approach to poverty, as opposed to the more holistic sustainable livelihoods/asset vulnerability approach implicit in alternative microfinance. This also results in inadequate assessment of need for alternative microfinance systems, and lack of innovation and experimentation as a result of their evaluation criteria.

6.1.4 Key Findings and Analysis While Baumann’s argument is geared at moving the South African micro-finance environment (as supported by the state) away from a focus exclusively on micro-credit for micro-enterprises, he also does provide some important lessons for micro-finance for micro-enterprise development. Most important are the role of the state and the limited understanding that has occurred thus far on factors that have led to the collapse of many RFIs and Khula’s resulting under-performance. Porteous (2003a) has called this the impatience of ‘patient’ capital, whether from donors or state funded apexes, which have lead to low tolerance for the slow, painstaking business of institution building. His analysis points to a longer term focus and longer lead times towards sustainability. Another key area in terms the micro-finance sector relates to lack of effective and coordinated capacity building efforts in the sector. Past efforts have been fragmented and ineffective and have been based on international best practice models, without sufficiently taking into account the realities in the South African environment. Local experiences with Pro -poor micro-finance (see Appendix 4) need to be incorporated in capacity building efforts.

6.2 Village Banking in South Africa

South has had a wide array of “Third tier”24 member-based structures providing financial services to their members including “stokvels”, and burial societies which follow the rotating savings and credit associations and the more formal savings and credit cooperatives (ECI Africa, 2003). Additionally there are the registered financial service associations, sometimes categorized as mutual banks. Exemptions in banking regulations are used as a means to regulate and allow the existence of this sector. The sector has been characterized by largely uncoordinated approaches to support and expansion (ECI Africa, 2003). The sector has been seen as a potential vehicle to augment existing microfinance initiatives for microenterprise and local economic development. There appears to be a large demand for member-based financial institutions with an estimated potential of at least 1,500 formal member-based financial institutions in the rural and urban areas in South Africa.

24 Most of the findings in this section are based on a study by ECI Africa

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Dallimore (2003) also found that in terms of their market, Village Banks tend to target poorer households that cannot afford traditional banking services but who wish to use formal financial services. Dallimore also further found that business use came low on the list of items that respondents were saving for. Two of the organisations set up to coordinate the sector, Financial Services Association (FSA) and FINASOL collapsed resulting in “disillusionment and uncertainty” about the about these types of institutions. Schoombee (2003) argues that this was a result of their dependence on donor and government funding which was later withdrawn. Although a number of Financial services Cooperative (FSCs) operating under both FSA and FINASOL also collapsed, there are a number still remaining that have continued to operate independently on the communities’ own initiative. FSCs have been found not to be as effective in lending as they are in savings. This has been partly because savings, and not loans, were emphasised by both FSA and FinaSol (Schoombee, 2003). Both institutions required FSCs to save for a certain period of time and allowed a loan based on the proportion of savings, using this as a form of collateral. However given the amount of savings that was mobilised, Schoombee (2003) argues that lending did not reach its potential. For instance FINASOL had savings totalling R5,3 million in the middle of 2002, which would have enabled them lending of R3,71 million according to their own policies (Schoombee, 2003). Some key lessons from the research done by ECI (2003) that should be noted should this be considered as a vehicle to financing microenterprises:

• The development of a member-based financial sector will require substantial financial commitment, skills and resources.

• Support organizations are essential in the establishment and development of membership-based financial institutions.

• Almost all member-based financial institutions are linked to commercial banks in some way; none of them, except the conventional stokvels, can operate without

• Effective external regulation is required to ensure legitimacy, stability, growth and continued investment.

Various proposals were made in the ECI report with regard to legislation and regulations including the development of new legislation for membership-based financial institutions and the amendment of the existing Mutual Banks Act be amended. Criteria for registration are also proposed encouraging a phased approach to development in a manner that allows the gradual addition of services and responsibilities over time. Support organisations were found to be essential in the establishment and development of membership-based financial institutions (ECI 2000). Proposals on support are based on an incremental approach including external finance which is needed to establish a support service of this nature to membership-based financial institutions. Support would also have to focus on systems that allow these institutions to management microenterprise loans effectively. ECI (2000) also found that the sustainability of member-based financial institutions is dependent on proper support with capacity building during the establishment process. The role of commercial banks in facilitating the establishment of these institutions was also found to be crucial as almost all member-based financial institutions are linked to commercial banks in some way (ECI (2000).

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Government also plays a crucial role. Self-regulation has been found to be unsuccessful, partly because of capacity and funding problems, but mainly due to a conflict of interests and the lack of oversight by the Registrar of Banks in that the self-regulatory bodies were left to their own devices (ECI, 2000). It was also found that the same institution providing both functions of support and regulation (as was the case with the FSA) is not advisable as this results in conflicting objectives The government also has a role to play in capacity building in the sector. The DTI’s new apex initiative may revive interest in the sector as it may be a channel for the revival of coordinating structures for village banks and for village banks to gain access to capacity building funds (WDBT Research, Documentation and Policy Development Unit, 2003, and Bay Research and Consultancy services, 2004). New legislation for membership-based financial institutions was proposed including the amendment of the existing Mutual Banks Act allowing institutions to develop a continuum from informal to formal (ECI 2000). It was also recommended that a Registrar dedicated to membership-based banks be appointed.

6.2.1 Key findings and analysis Village Banking in South Africa has had a chequered experience in South Africa, due largely to two factors:

• The issue of regulation with respect to both the legal and coordination/ supervision issues;

• Financial Support for the establishment and capacity building for the “umbrella” bodies.

Attention needs to be focused on both these issues. Additionally, the issue of the use and take up of loans products that can be used by SMMEs needs to be investigated within village banks, although this may have been a factor of the “umbrella” bodies’ failure or eminent failure.

7. Summary of key findings and recommendations A summary of key findings and recommendations is made below:

7.1 Defining more accurately the potential demand for SMME finance In terms of the size of the sector and demand for SMME finance the key finding was that there are no systematic studies on the demand for financial services in the SMME market broadly. In terms of the potential demand for finance it was found that SMEs make significant contributions to both job creation and the economy and represent a potential demand of at least R 3 million businesses, possibly more. There are various and differing definitions of the term “SMME” within South Africa which confuses policy making and product development. The development of an “SMME classification matrix” as well as a SMME focused study to provide a regular profile on needs for and usage of financial services among SMMEs, similar to the Finscope study commissioned by FinMark Trust is therefore recommended. This would regularly provide a more detailed picture of the SMME market in terms of its size, scope and characteristics, which could then be linked to the potential demand for finance within that specific market segment. This would then give an indication of which market segments provide substantial demand to develop

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specific products for, and would assist financial institutions in decisions around product development. Another area of concern highlighted related to Statistics South Africa’s data collection classifications for information on SMMEs. The main issue is that Statistics South Africa’s definitions for SMMEs do not always coincide with those used by DTI. This results in inconsistency and difficulty in analysing data. It also hampers effective policy making, benchmarking and the measurement of impact of the sector on the economy. It is recommended that there be a review of the definitions or classification of SMMEs used by Statistics South Africa to ensure they coincide with DTI’s classifications. Micro-enterprises have commonly been treated as one group with consistent needs and constraints. However it was found that this category needs to be segmented further in terms of financial services requirements as there is a difference between micro-enterprises, which are potentially viable business or have the potential to grow, and survivalist activities. Another way to look at this would be to differentiate between opportunity and necessity entrepreneurship as defined by the GEM. The importance of savings products and services also needs to be highlighted with respect to starting new businesses as it was found that the biggest sources of finance for starting businesses are own funds or funds borrowed from friends and relatives. It is commonly believed that the major constraint with respect to access to financial services for SMMEs is related to the supply side. However, on the demand side it was found that South Africa lags behind significantly in entrepreneurship in comparison with international trends. This is related to both the lack of an entrepreneurial culture and a lack of skills necessary to operate successful enterprises. For instance, the absence of financial administration skills particularly among businesses run by PDIs was identified as a serious constraint to gaining access to financial services from formal financial institutions. Based on this finding it can be seen that efforts focused on the supply side will not be effective unless they address the absence of an entrepreneurial culture. It is therefore recommended that more initiatives focused on developing entrepreneurial culture in both schools and tertiary institutions be developed. Investigating whether commitments to consumer education within the Financial Services Charter could be used for this purpose should be a priority. A wide range of financial services requirements were identified and it was found that this goes further than just credit and includes transaction services which become the basis for accessing other financial services. Therefore simply accessing a bank account can be an important basis for accessing other services down the line. This also becomes important in drawing informal sector businesses into the mainstream economy.

7.2 Opportunities presented by recent legislative / policy processes New developments that present fresh opportunities for improving the accessibility of finance for SMMEs include the Financial Sector Charter and the proposed amendments to the Small Business Act. The Financial Sector Charter provides a framework through which role-players and stakeholders in the sector can engage formal financial sector institutions on their commitments related to SMME finance. The proposed amendments to the Small Business Act also provide opportunity to redefine the SMME sector and target more effectively. Government’s procurement programme could be made more effective by developing specific products for SMMEs that have been awarded contracts, using the contract to provide a guarantee for those with a lack of collateral. This could

58

also be applied to SMMEs that have been awarded contracts by private sector companies in line with BEE targets.

7.3 Role of Government Institutions Various government initiated institutions other than Khula currently do and can potentially provide financial services to SMMEs. Key issues identified were around the need to improve the role of National Empowerment Fund as a venture capital provider in the SME market. On the lower end of the market, the experience and involvement of the Land Bank and Post Bank need to be further emphasised in terms of their potential to provide the full scale of services to micro-enterprises and survivalist activities. The uncertainty regarding the future role of Khula and possible mandate change is an opportunity as it provides scope to influence the debate related to its future focus given the imminent removal of the micro-finance portfolio. One key recommendation is that Khula’s institutional memory and lessons learnt need to be acknowledged and absorbed by those involved in setting up the new National Apex Fund. For instance, there needs to be re-think about the conceptualisation of sustainability that was used by Khula as it has tended to limit innovation and hinder the development of solid MFIs. The need to develop broader micro-finance programmes outside of the DTI mandate was also identified potentially through the Department of Social Development. It was also recommended that government consider other types of partnerships with the private sector beyond the current partnerships with banks in the Khula Guarantee model. Other potential private sector partners could include commercial micro-lenders and venture capital funds. It was proposed that government conduct another regulatory review of legislation that impacts SMMEs.

7.4 Role of the Private Sector With respect to Banks, on the micro-finance side various approaches that have been used internationally and locally for banks to get involved in this market were identified and evaluated. Based on this, it was recommended that banks:

• Develop entrepreneurial and microfinance skills within their staff and management to better equip them to deal with and understand the financial needs of SMMEs. Consumer education was also identified as a priority. This was based on the need to address the mutual misunderstanding of each other’s requirements between bank staff and SMMEs.

• Pursue or continue to pursue linkage strategies with village banks and cooperatives involved in providing informal financial services to the poor.

• Further promote the provision of savings facilities for the lower end of the market for formal and informal institutions.

It was also recommended that best practice case studies and research on small bank establishment in the sector be developed to overcome negative perceptions regarding the role of small banks. It was found that banks play a vital role in the SMME financing sector, simply by providing bank accounts to business owners in their individual capacity, which can then be used

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as a basis to access other financial services from non-banking institutions such as village banks, MFIs and commercial micro-lenders. The need for better research and disclosure on the exact extent of banks involvement in the sector was identified. In terms of Venture Capital and Private Equity Funds the main recommendation was the assessment of the feasibility of venture capital funds focusing on the lower end of the market below R5 million. The role of the insurance industry is crucial in the provision of services to the SMME sector to deal with risks faced by SMMEs, particularly risks associated with HIV/ AIDS. The insurance industry also has a role to play with respect to supporting the informal insurance industry. The Financial Sector Charter again provides an opportunity to engage the insurance industry on this issue. Commercial micro-lenders have played a relatively limited role in SMME finance and there has been little innovation in this area. Perhaps through government support or other forms of subsidized funding, product innovation could be encouraged as commercial microlenders represent a potentially large supply base for SMME finance.

7.5 Role of Non -commercial providers In the cases of village banks, MFIs and mutual banks, both the state and private sector play a vital role in ensuring the success of this sector as highlighted above. The state plays a role particularly with regard to providing appropriate enabling legislation, supporting capacity building and in subsidising operations during the slow, painstaking business of institution building. The private sector can also play a facilitative role, particularly with regard to making accessible transaction services and providing insurance services.

1

Appendices

Appendix 1 - Table 1: Definitions of SMME by sector

Sector or subsector in accordance with the Standard Industrial Classification

Size or class Total full equivalent of paid employees Less than

Total turnover Less than

Total gross asset value (fixed property excluded) Less than

Agriculture Medium Small Very small Micro

100 50 10 5

R 4m R 2m R 0.4m R 0.15m

R 4m R 2m R 0.4m R 0.1m

Mining and Quarrying

Medium Small Very small Micro

200 50 20 5

R 30m R 7.5m R 3m R 0.15m

R 18m R 4.5m R 1.8m R 0.1m

Manufacturing Medium Small Very small Micro

200 50 20 5

R 40m R 10m R 4m R 0.15m

R 15m R 3.75m R 1.5m R 0.1m

Electricity, Gas and Water

Medium Small Very small Micro

200 50 20 5

R 40m R 10m R 4m R 0.15m

R 15m R 3.75m R 1.5m R 0.1m

Construction Medium Small Very small Micro

200 50 20 5

R 20m R 5m R 2m R 0.15m

R 4m R 1m R 0.4m R 0.1m

Retail, Motor Trade and repair service

Medium Small Very small Micro

100 50 10 5

R 30m R 15m R 3m R 0.15m

R 5m R 2.5m R 0.5m R 0.1m

Whole sale trade, commercial agents and allied services

Medium Small Very small Micro

100 50 10 5

R 50m R 25m R 5m R 0.15m

R 8m R 4m R 0.5m R 0.1m

Catering accommodation and other trade

Medium Small Very small Micro

100 50 10 5

R 10m R 5m R 1m R 0.15

R 2m R 1m R 0.2m R 0.1m

Transport storage and communications

Medium Small Very small Micro

100 50 10 5

R 20m R 10m R 2m R 0.15m

R 5m R 2.5m R 0.5m R 0.1m

Finance and Business services

Medium Small Very small Micro

100 50 10 5

R 20m R 10m R 2m R 0.15m

R 4m R 2m R 0.4m R 0.1m

Community, social and personal services

Medium Small Very small Micro

100 50 10 5

R 10m R 5m R 1m R 0.15m

R 5m R 2.5m R 0.5m R 0.1m

2

Appendix 2 - Table 1: Khula RFIs

NAME OF RFI TELEPHONE NUMBER CRITERIA LOAN

AMOUNTS LOCATION

GAUTENG PROVINCE Nicro Enterprise Finance (NEF) (011) 339- 3177/8 Individuals including ex-offenders R 750 – R 10

000 Braamfontein

Basani Business Development Services

(011) 333 – 3831 and (011) 336 – 0047

Individuals with existing businesses for more than 6 months. No working capital provided.

R 6 000 – R100 000

Johannesburg

Sankofa Financial Services (011) 331 – 1902 Individuals who own spazas or small shops – for purchasing at METRO wholesalers only

R 5 000 – R 50 000

Johannesburg

Khethani Business Finance (011) 781 – 7224 Head office Randburg Khethani Business Finance (011) 832 – 3222 Individuals with existing businesses for more

than 2 years R 6 000 – R150 000

Johannesburg

Marang Financial Services (012) 320 – 1745 Head office Pretoria Marang Financial Services (012) 804 – 0248/0819

Speed code *13 Solidarity Groups R 500 – R 3

000 Mamelodi/Silverton

Marang Financial Services (016) 422 – 2003 Speed code *16

Solidarity Groups R 500 – R 3 000

Vereeniging/Evaton

Artpac Lending Services (011) 838 – 5137/3895/3730 Construction and related industries R1 000 –R100 000

Johannesburg

WESTERN CAPE Khethani Business Finance (021) 683 – 7656 Individuals with existing businesses for more

than 2 years R6 000 – R150 000

Claremont

Nicro Enterprise Finance (021) 462- 0017 Head Office Cape Town Nicro Enterprise Finance (NEF) (021) 374 – 9521 Individuals including ex-offenders R 750 – R10

000 Mitchell’s Plain

EASTERN CAPE Business Finance Promotion Agency

(041) 487 –0190 Individuals with existing businesses R5 000 – R100 000

Port Elizabeth

Marang Financial Services (039) 737 – 4974 Speed code *11

Solidarity Groups R 500 – R 3 000

Matatiele

Marang Financial Services (039) 255-0685 Speed code *02

Solidarity Groups R 500 – R 3 000

Mount Frere

3

NAME OF RFI TELEPHONE NUMBER CRITERIA LOAN AMOUNTS

LOCATION

Marang Financial Services (047) 532 – 3929 Speed code *15

Solidarity Groups R 500 - R 3 000

Umtata

Marang Financial Services (039) 253- 1804 Speed code *45

Solidarity Groups R 500 – R 3 000

Lusikisiki

MPUMALANGA Marang Financial Services (013) 755 – 1807

speed code *07 Solidarity Groups R 500 – R 3 000 Nelspruit

Marang Financial Services (013) 737 –6723 Solidarity groups R 500 - R3 000 Hazyview Marang Financial Services (082)674 –9476

speed code *01 Solidarity Groups R 500 – R 3 000 Bushbuckridg

e Marang Financial Services (013) 790 - 1763

speed code *05 Solidarity Groups R 500 – R 3 000 Komatipoort/

Malelane Marang Financial Services (017) 883 –1934

speed code *17 Solidarity Groups R 500 – R 3 000 Elukwatini

Beehive Entrepreneurial Development Centre

(013) 235 –1695 Individuals and Groups R 800 – R10 000

Lydenburg

Beehive Entrepreneurial Development Centre

(013) 656 –0840 Individuals and Groups R 800 –R10 000 Witbank

Beehive Entrepreneurial Development Centre

072 632- 6041 Individuals and Groups R 800 – R10 000 Carolina

LIMPOPO PROVINCE Small Enterprise Foundation (SEF)

(015) 307- 5837/5418 Solidarity groups R 500 – R10 000 Tzaneen

Marang Financial Services (013) 262 - 3242 Speed code *52

Solidarity groups R 500 – R 3 000 Groblersdaal

Marang Financial Services (015) 291 - 4830 Speed code *10

Solidarity groups R 500 – R 3 000 Pietersburg

Marang Financial Services (013) 795- 5343 Speed code *00

Solidarity groups R 500 –R 3 000 Acornhoek

Marang Financial Services (015) 307- 5753 Speed code *14

Solidarity groups R 500- R 3 000 Tzaneen

NORTHERN CAPE Remmogo Business Finance (053) 831- 6013/4 Individuals with existing business R6 000 – R150

000 Kimberley

FREE STATE

4

NAME OF RFI TELEPHONE NUMBER CRITERIA LOAN AMOUNTS

LOCATION

Remmogo Business Finance (051) 448- 6279/6285 Individuals with existing businesses R6 000 –R150 000

Bloemfontein

KWAZULU NATAL Ithala Development Finance Corporation

(031) 907- 8784 Individuals Up to R2 000 000

Umlazi

Khethani Business Finance (031) 261-6657 Individuals with existing businesses for more than 2 years

R6 000 – R150 000

Durban

Marang Financial Services (031) 301 – 2295 speed code *03

Solidarity groups R 500 – R 3 000

Durban

Marang Financial Services (033) 701 – 1486 speed code *73

Solidarity groups R 500 - R 3 000

Underberg

Marang Financial Services (033)394 – 1655 speed code *09

Solidarity groups R 500 – R 3 000

Pietermaritzburg

Marang Financial Services (035) 792 - 1756 Solidarity groups R 500 – R 3 000

Empangeni

Marang Financial Services (035) 831 -0800 Solidarity groups R 500 - R 3 000

Nongoma

5

Appendix 3 - Findings of the Khula Impact Assessment Study TABLE 1: TOTAL NUMBER OF BENEFICIARIES AND SECTORIAL DISTRIBUTION OF RESPONDENTS, 1996 TO 31 MARCH 2001

Khula- Start

RFI Credit Guarantee Scheme

Credit Guarantee Scheme

Thuso Mentorship Scheme

Regional Equity Funds

Individuals Portfolios Total number of beneficiaries Number of respondents

11 875 566

89354 407

1 420 232

762 56

677 181

282 30

Economic sector of beneficiaries % % % % % % Retail 59,9 46,4 34,5 73,2 35,9 6,7 Wholesale 0,5 2,7 4,3 0,0 8,2 0,0 Construction 0,5 4,2 6,9 0,0 3,9 6,7 Manufacturing 21,4 16,2 14,7 3,6 12,1 20,0 Catering 2,1 7,9 9,5 12,5 4,4 3,3 Motor vehicle repairs 0,7 3,7 6,9 0,0 1,7 0,0 Agriculture 7,1 0,5 0,0 0,0 1,7 0,0 Personal services 4,6 9,3 8,2 7,1 13,8 10,0 Art and culture (handcraft) 1,6 1,0 2,2 1,8 4,9 13,3 Repairs and household goods 0,7 1,0 0,4 1,8 0,0 0,0 Cleaning services 0,2 1,0 1,7 0,0 0,6 0,0 Crèches and after-school centres 0,7 1,5 2,2 0,0 0,6 0,0 Security 0,0 0,5 0,9 0,0 2,2 0,0 Information services 0,0 1,0 3,4 0,0 1,7 16,7 Transport services 0,0 2,5 1,7 0,0 4,4 13,3 Bookkeeping 0,0 0,0 0,4 0,0 1,1 6,7 Accommodation 0,0 0,0 0,4 0,0 0,0 1,7 Other 0,0 0,7 1,3 0,0 1,1 3,3 Total 100,0 100,0 100,0 100,0 100,0 100,0

6

TABLE 2: LOAN FEATURES

Khula- Start

RFI Credit Guarantee Scheme

Credit Guarantee Scheme

Thuso Mentorship Scheme

Regional Equity Funds

Individuals Portfolios Percentage of beneficiaries with only a Khula supported loan %

97,7 95,1 95,3 96,4 - -

Average Loan size R 1 127,62 109 973,24* 252 288,64 12 239,29 193 916,53 2 404 800,00 % of beneficiaries assisted to secure a loan % 19,1 29,7 15,1 10,7 - 3,3 Source of assistance Khula mentorship % 44,4 37,2 28,6 16,7 - - Non-governmental organization % 26,9 28,1 14,3 0,0 - - Friend/ Family/ colleague % 25,9 28,1 2,9 83,3 - - Other % 2,8 6,6 54,3 100,0 - - Application of loan Start-up of business % 30,2 52,6 67,0 26,8 - 56,7 Extend business % 69,1 41,8 23,7 17,9 - 36,7 Consolidate credit % 0,9 2,2 2,2 0,0 - 0,0 Continuation/ maintenance of business % 0,0 2,9 5,4 32,1 - 0,0 Other % 0,2 0,5 3,6 25,0 - 6,6

*SINCE SIZES OF RFI LOANS VARY SUBSTANTIALLY AND THE SAMPLE MAY BE 11.3 %, THE AVERAGE LOAN SIZE CAN BE AS LOW AS R85 667.

7

*GROSS JOBS CREATED, MAINTAINED AND LEVERAGED FROM MARCH1996 T0 MARCH 2001

TABLE 3: EMPLOYMENT FEATURES Khula-

Start RFI Credit

Guarantee Scheme

Credit Guarantee

Scheme

Total

Individuals Portfolios Average employment size Male 0,34 4,90 8,17 1,95 - Female 1,58 3,44 3,84 1,50 - Total 1.92 8,34 12,01 3,45 - Full-time 1,85 7,19 10,68 2,98 - Part-time 0,07 1,15 1,33 0,47 - Total 1,92 8,34 12,01 3,45 - Estimated total employment* Male 4 038 437 835 11 601 1 486 454 960 Female 18 763 307 378 5 453 1 143 332 732 Total 22 801 745 213 17 054 2 629 787 697 Full-time 21 968 642 455 15 166 2 271 681 860 Part -time 833 102 758 1 888 358 105 837 Total 22 801 745 213 17 054 2 629 787 697 New jobs created by Khula loans 15 489 109 505 12 847 721 521 307

8

Appendix 4 - Table 1: SA Development Microfinance Sector Institution Location Type Individual

savings facilitated

Self-managed group savings

Loans from Group Savings

MFO loans for non-microenterprise loans

MFO microenterprise loans

Poverty Profile Targeting strategy

Origin

ACAT KZN KZN Micro credit and business development services

Yes Yes No No Yes Generally poorest in community in community

Participatory wealth ranking to identify poorest

Christian rural development NGO

Beehive EDC Mpumalanga Microenterprise MFO and business services centre

No Yes Yes but only for some clients

Housing microloans

Yes Claims to reach very poor

Ad hoc Business development centre

FINCA KZN KwaZulu –Natal, Eastern Cape

Microenterprise MFO

Yes No No No Yes Claims to reach very poor

Ad hoc FINCA International Affiliate

Kuyasa Fund Cape Town Hybrid housing microloans / micro saving

Yes Yes but not centralised

No Housing microloans

No Very poor to poor women in urban townships around Cape Town who have not yet received housing subsidies and who are members of independent savings groups

Community self-selection

NGO programme evolved to stand- alone

9

Marang Financial Services

Gauteng, Mpumalanga, Free State, Eastern Cape, KZN

Microenterprise MFO

No No No No Yes Unemployed households in a given area with microenterprise

Geographical targeting

Created to absorb Get Ahead Financial Services and Rural Finance Facility

Poor People’s Movement

Western Cape Savings and credit network

No Yes Yes No No Mixed including street dwellers, farm workers

Community selection

Church welfare project

SA Youth Federation

National Savings and credit network

No Yes Yes No No Varied Community self-selection

Offshoot of SAHPF

SACCOL National Support and statutory umbrella for SACCOs

No Yes Yes Only at start -up for SACCO running costs

No Average member income around R1 200

Geographical

Statutory umbrella for SACCOs

Small Enterprise Foundation

Limpopo rural Microenterprise MFO

Yes No No (but patching used within loan groups)

No Yes To programs roughly equal in size. One works with existing poor entrepreneurs. The second targets those below 50% of the poverty line. Most are women in rural villages in ex- homelands who have household- based micro enterprises.

Conscious Strategy of poverty wealth ranking when new branches formed

Start -up initiative

Homeless National Savings and No Yes Yes Housing and land No Very poor to Community Homeless

10

People’s Federation

credit network poor women (85%) in urban informational settlements and recently- developed townships around major cities and towns

self- selection

people’s movement

Women’s Development Banking

No No No No Yes Unknown Community self-selection

Start -up initiative

11

Appendix 5: Case Study on: Provident South Africa

Source: Cadogan, 2002 Background Provident South Africa (PSA) closed its operations entirely in December 2001 due to the following actors. The key reasons were:

• Lack of UK investor support • Lack of available suitably qualified staff • Higher than anticipated levels of fraud from staff and agents

The case study provides important lessons regarding the application of models that have succeeded elsewhere in the South African context. The Provident Financial Model Provident Financial (PF) has been in the credit business for 120 years with a head office in the United Kingdom. The international division had five branches in Poland, Czech Republic, Slovakia and Hungary and South Africa (now closed). Following a successful report on the viability of market entry to SA, Provident South Africa (PSA) was established in April 1998 as a pilot project. Targets were set to achieve annual objectives and measure performance on a weekly basis. The basis of these targets was to achieve break even in 3 years. The model is based on the Home Credit (HC) model, a well established, financial service, which has its origins back in the 19th Century. This service is provided to customers in their home (hen ce the term, Home Credit) and mainly serves people, who wish to borrow relatively small sums on a fixed-term basis. It is a “friendly service” with an agent of the company calling at customers' homes each week, to collect repayments. The model works because of the relationships developed between customers and because agents have weekly agent/customer contact which establishes a regular repayment pattern. Small, personal, unsecured short term loans are offered to lower income groups. Having completed this investigation into the development of the home credit in the South African market the conclusions were overwhelmingly in favour of entering that market. This was based on the strength and depth of community spirit found in rural South Africa, and the desperate need for access to credit experienced by previously disadvantaged people to assist them to make a living. The following products were offered in South Africa: Designation Product 1 Product 2 Product 3

Lending Methodology Individual lending

Indiv idual Lending Individual Lending

Loan Size R700-1, 500 R1600 – R3, 000 R3000 – R7, 500

Interest 14.5% per month 9.5% per month 7.5 % per month

Repayment Frequency Weekly Weekly Weekly Collateral None None None Repayment Period 14 weeks 23 weeks 33 weeks Savings None None None

12

Growth of Provident SA Provident SA experienced phenomenal growth where at the beginning of 2000 Provident SA had 11,000 active customers supported by 250 self-employed agents and 36 full-time staff. Twelve months later, in January 2001, PSA had over 34,000 active customers, 620 self-employed agents and 113 employed staff. PSA had the ability and the systems to expand access to its potential target market. The uptake of its existing financial products by the clients was a powerful indication of the need and was reflected in the growth of PSA during the period of its operation. SA’s growth was reflected in its move from being a small operation, to being in a position to serve over 60% of the Limpopo Province and to be rated as a leading micro-finance organisation in the Province. However, whilst customer targets were met, by the end 2001 when PSA did not achieve the year’s operational and financial targets and PSA conducted a critical review of its situation and identified the following problems that had threatened the business’ viability:

• poor collection performance, • unacceptable levels of bad debt, and • fraud.

These problems impacted on the overall profitability of the operation. The analysis further revealed that the current market situation could not be improved to the extent where the business in its current form or structure would become viable, and given this the business had to close down. Provident therefore decided to dispose of its interest in the South African micro -finance business. Problems experienced Problems related to personnel issues, field operations, marketing, and so-called socio-cultural issues. Personnel and field operations issues were most significant. Personnel issues included the lack of quality staff in the Limpopo Province; the lack of commitment and accountability; and the lack of application of control systems. Field operations problems related to the rate of expansion, which was found to be too great for the quality of staff in place; ineffective and inadequate measures for bad debt recovery process; and a high incidence fraud levels among agents and staff which increased as PSA expanded. The slow response of the police and justice system also exacerbated this problem. Marketing issues included the inadequate “South Africanisation” of the UK model and inadequate customer motivation and loyalty. Rates of lapsed customers remained high throughout the time PSA operated. Little motivation or loyalty for customers to remain as clients with PSA and agents were also not motivated to retain customers they had recruited. Socio-cultural issues according to Cadogan were the lack of repayment and savings culture in most sections of the South African community and particularly in the rural areas. Various interventions were attempted as outlined by Cadogan (2002) including shortening of the maturity period of loans to help improve the quality of business and improve cash flow; the tightening of lending and field operations criteria, the removal of poor performing agents; improvements to recruitment and training methods and the introduction of post office banking to stop fraud and the temptation to steal by taking

13

more cash out of the system. However these were not enough to assure shareholders that there would be a turn around or were too little too late. Lessons learnt: Some of the other lessons learnt relate to the application of a model that has been successful in one context to another context. Some of the issues which need to be taken into account include: differences in consumer behaviour, environmental threats and opportunities in the market, and cultural differences. He concludes that to be effective in international marketing the most important requirement is to undertake thorough market analysis before and after entering the market. He concludes that remaining challenges to MFIs in South Africa include:

• Effective Staff, agents and customers • Social – cultural behaviour change • Effective Fraud Prevention • Leadership and investors paradigm shift • Effective outreach decentralisation • The impact of the justice system and police service on industry fraud • Recruitment of experience, responsible and committed staff and agents

In the light of above, it can be concluded that the most critical success factors that determine the operational and financial sustainability still remains controversial and debatable. This implies that each MFI has its own unique critical success factors that may need continuous monitoring and refinement.

14

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