Traditional debt finance and alternative financing instruments for SMEs

This chapter provides the rationale for the study and illustrates the objective and structure of the report. It describes traditional lending technologies and related credit- risk mitigation techniques. It comments on their limitations for financing young and small firms and for sustaining long-term investment and growth. It discusses how financing instruments alternative to straight debt alter the traditional risk-sharing mechanism and proposes a categorization of these instruments across the risk/return spectrum, i.e. by differing degrees of risk and return.

SME finance in the post-crisis environment

Bank lending is the most common source of external finance for many SMEs and entrepreneurs, which are often heavily reliant on straight debt to fulfil their start-up, cash flow and investment needs. While it is commonly used by small businesses, however, traditional bank finance poses challenges to SMEs and may be ill-suited at specific stages in the firm life cycle.

In particular, debt financing appears to be ill-suited for newer, innovative and fast growing companies, with a higher risk-return profile. The “financing gap” that affects these businesses is often a “growth capital gap”. Substantial amounts of funds might be needed to finance projects with high growth prospects, while the associated profit patterns are often difficult to forecast. The financing constraints can be especially severe in the case of start-ups or small businesses that rely on intangibles in their business model, as these are highly firm-specific and difficult to use as collateral in traditional debt relations (OECD, 2010a). Yet, for most enterprises, there are few alternatives to traditional debt (OECD, 2006). This represents an important challenge for policy makers pursuing sustainable recovery and long-term growth, since these companies are often at the forefront in job creation, the application of new technologies and the development of new business models.

While alternatives to traditional debt finance are particularly important for start-ups, high-growth and innovative SMEs, the development of alternative financing techniques may be relevant to the broader population of SMEs and micro-enterprises. Capital gaps exist also for companies seeking to effect important transitions in their activities, such as ownership and control changes, as well as for SMEs seeking to de-leverage and improve their capital structures. The thin capitalisation and excessive “leverage” (excessive reliance on debt financing compared to equity) impose costs, as loans to companies that already have considerable amounts of debt tend to have higher interest rates, and increase the risk of financial distress and bankruptcy.

In the aftermath of the 2008-09 global financial crisis, the bank credit constraints experienced by SMEs in many countries have further highlighted the vulnerability of the SME sector to changing conditions in bank lending. The long-standing need to strengthen capital structures and to decrease dependence on borrowing has now become more urgent, as many firms were obliged to increase leverage in order to survive the crisis, and, at the same time, banks in many OECD countries have been contracting their balance sheets in order to meet more rigorous prudential rules. As banks continue their deleveraging process, there is a risk that a large-scale reduction in bank assets could lead to a credit crunch (IMF, 2012a, 2012b). There is a broad concern that credit constraints will simply become “the new normal” for SMEs and entrepreneurs and that they could be disproportionately affected by the on-going financial reforms, and especially by the rapid pace of their implementation, as they are more dependent on bank finance than large firms and less able to adapt readily (OECD, 2012).

It is therefore necessary to broaden the range of financing instruments available to SMEs and entrepreneurs, in order to enable them to continue to play their role in growth, innovation and employment. Financial stability, financial inclusion and financial deepening should be considered as mutually reinforcing objectives in the quest for sustainable recovery and long-term growth. While bank financing will continue to be crucial for the SME sector, more diversified options for SME financing could support long-term investments and reduce the vulnerability of the sector to changes in the credit market. Indeed, the problem of SME over-leveraging may have been exacerbated by the policy responses to the financial crisis, as the emergency stabilisation programmes tended to focus on mechanisms that enabled firms to increase their debt (e.g. direct lending, loan guarantees), as funding from other sources (e.g. business angels, venture capital) became more scarce (OECD, 2010b, 2012).

An effective financial system is one that can supply financial resources to a broad range of companies in varying circumstances and channel financial wealth from different sources to business investments. As the banking sector remains weak and banks adjust to the new regulatory environment, institutional investors and other non-bank players, including wealthy private investors, have a potential role to play for filling the financing gap that may widen in the post-crisis environment.

However, a lack of awareness and understanding on the part of SMEs, financial institutions and governments of alternative financial instruments, their modalities and operations constitute a major barrier to their use. Through the present report, the OECD intends to help broaden the finance options available to SMEs and entrepreneurs, by improving understanding about the full range of financing instruments they can access in varying circumstances and by encouraging discussion among stakeholders about new approaches and innovative policies for SME and entrepreneurship financing.

For this purpose, the present report maps a broad range of financing techniques alternative to straight debt, providing insights about their functioning, the profile of firms that are suited for them, key enabling factors for their development, major trends in the market and access by SMEs, and policies to support a broader uptake by the SME population. The remainder of this chapter describes traditional lending technologies and related credit-risk mitigation techniques, comments on their limitations for financing young and small firms and for sustaining long-term investment and growth, and briefly introduces the main financial instruments alternative to straight debt, categorizing them across the risk/return spectrum.

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