Diversifying SME financing models

The small and medium enterprises (SMEs) are facing problems in financing themselves by existing financing solutions. Venture capital (VC) has come forward to solve these problems. As SMEs lack expertise in the field of accounting, marketing, finance and management, VC firms can not only finance them, but also provide support in these areas. These provide a win-win situation between the SMEs and the VC firms as they provide capital required by the risky SMEs and enjoy ownership rather than being creditor in return.
Venture capital is a new concept in Bangladesh. As interest is not applicable for this kind of financing, entrepreneurs feel interested. But when they come to know that investor firm will participate in profit, they are discouraged because they don't want their profit to be shared by others. At present, there is no legal framework for the VC firms. Some firms have started providing venture capital without having enough legal support.
Musharaka and Mudaraba are two types of Islamic investments. Under Musharaka system, Islamic investor makes a joint venture with another business entity, each with assigned responsibilities. Profit and loss are shared according to the agreement. This venture is an independent legal entity and the Islamic investor has the option to walk out after some time. Under Mudaraba system, the Islamic investor contributes and the client provides the expertise, management and labour. Profit is shared according to the agreement. But only bank is liable for the loss incurred.
Some firms have started operation and they claim that they are providing venture capital. Venture Investment Partners Bangladesh Limited (VIPB) has been established with an objective of developing SMEs. VIPB provides various direct equity and quasi-equity funding schemes, ranging from as low as Tk.300,000 to the under-served SME ventures throughout the country.
BDVL is a new venture capital firm in Bangladesh established with an objective of investing and incubating new and existing business ideas in emerging and high-growth sectors where funding is not adequately available.  
Asian Tiger Capital Partners (AT Capital) is one of the first financial institutions in Bangladesh focusing on asset management, corporate advisory and macro-economic consultancy services.
SEAF Bangladesh Ventures (SEAF BV) has been established to provide SMEs with structured capital and quasi-equity investments.
Brummer & Partners is an international firm that started operation in Bangladesh with several million dollars. Brummer & Partners Asset Management Bangladesh Limited is looking for new investment opportunities.
In the absence of any regulatory policy, the venture capital firms can not offer banking products. They can only invest in those industries where banks and financial institutions will not invest.
Banks are less interested in vulnerable sectors. Hence, the government has directed that banks will have to ensure 2.0 per cent of their investments in vulnerable sectors. If any bank fails to do that, the Bangladesh Bank (BB) deducts the money from Cash Reserve Ratio (CRR) up to the level of money not invested in vulnerable sectors. The BB refunds the money next year if the bank offers loan to vulnerable sectors.
There are a lot of SMEs which are not considered for providing loans. VC firms in Bangladesh invest mostly in ICT, food processing, beverage, light engineering, agro-based, renewable energy and tourism industries. Our software development firms have high growth potentials, but they can not undertake big projects because of lack of capital.
REGULATORY ISSUES FOR VC: Since there is no official definition of venture capital in Bangladesh, there are no eligibility criteria for a venture capital firm also. The VC firms collect No Objection Certificates (NOC) from the BB first to the effect that they will not engage themselves in banking or financial products. Then, they take NOC from the Securities and Exchange Commission (SEC) and register themselves with the Registrar of Joint Stock Companies and Firms (RJSCF).
As venture capital firms take NOC from the BB, it can not collect public money and raise capital like banks. So they run business on their own. Investment by the foreign investors is also not allowed.
The Bangladesh Security Exchange Commission (BSEC) categorises Eligible Institutional Investors (EII), under the Securities and Exchange Commission (Public Issue) Rules of 2006 that include the following stakeholder groups (clause 6b of BSEC Notification dated October 05, 2011): merchant bankers, commercial banks, asset management companies, non-banking financial institutions (NBFIs), insurance companies and stock dealers.
According to clause 14 of the same amendment to the Public Issue Rules 2006, lock-in period for EIIs is four months, compared to three years for PE (private equity) investors.   
Many countries in the region have eased this provision for PE investors, to encourage strategic investors who were previously deterred by lengthy lock-in periods. In Sri Lanka, there is one-year lock-in period for the sales of shares held by private equity investors, from the date of allotment of such shares. India has one-year lock-in period for all PE  investors, compared to three-year lock-in period for other promoters. Lock-in period is six months for pre-IPO (initial public offering) investors, provided they adhere to a set of conditions in Hong Kong. China has one-year lock-in period for investors that buy stakes in companies up to 12 months before floatation.
The rule (of imposing a lock-in period) does not address the differences in objectives and operations of promoters and equity investors. And given how regulators are keen to stop unscrupulous cash-in from IPOs, there should be policies and legal mechanism in place to identify the PE funds or their investments separately from the overall capital market (like eligible institutional investors or EIIs).  
Classifying all categories of investors under one roof does not provide equity investors suitable grounds for utilising IPO as an exit route. Provisions could be made to segregate PE Investors from general sponsors of a private limited company, so that they are not subjected to the lock-in period of three years.
SMEs are facing a number of challenges which are interrelated. Problem of funding with high rate of interest is one of the long-standing issues. But there are a number of alternatives available for financing SMEs. Various countries offer funding for SMEs based on their own regulations and policies. Legal statute for each sector is very important. Required institutional support along with qualified investors, e.g., banks, capital market experts, endowments and foundations, government agencies, corporations, insurance companies, asset managers, pension funds or sovereign wealth funds can be used for SMEs if the legal provisions are effective, workable and supportive for SMEs.
From the statistics of financing SMEs from banking and non-banking sources in 2012, it is seen that the number of SME borrowers in the country was 0.46 million (small and cottage were 0.35 million and medium 11 million). The number of manufacturing firms was only 16 million while most of the firms were from the trading and services sectors. It is evident that whatever funding was made available, a significant portion of it went to the trading sector. On the other hand, SME loans enjoyed by the urban (Tk.512,986 million) areas are higher than that of the rural (Tk.184,553 million) areas in 2012. The tradition is still going on. In order to address the issues of SMEs, an integrated supporting plan is required for which full coordination among different SME-supporting organisations is required.
SUGGESTIONS: In order to get a solution of the above problem, diversification of financial models is definitely a prescription, but at the same time following could be of immense importance:
1. Banks should be encouraged to invest in risky ventures with soft terms and conditions,
2. Compulsory limit of banks to invest in the vulnerable sectors should be maintained strictly,
3. Along with other definitions, there could be a definition of venture capital firms in the upcoming Industrial Policy 2015 in order to create a statute for VC firms,
4. Venture Capital regulations should be in line with the Securities Exchange Board of India (SEBI) so that already established VC firms can get a directive to move further,
5. Small exchange in line with Korea's KOSDAQ and similar other Asian countries can be an example for Bangladesh. In the meantime, OTC market can be used as an SME Exchange,
6. Factoring is working in the country at a domestic level. There is a need for preparing a Factoring Policy,
7. Bangladesh should think about enhancing financing facilities through cooperative banks like in India where most of them are operating in the rural areas and where bank branches are limited,
8. Refinancing facilities in different new sub-sectors and non-traditional sectors should be increased,
9. Terms and conditions of refinancing facilities supported by different donor organisations should be examined carefully before approving these schemes to make them really workable for SMEs,
10. Funding from the non-bank financial institutions are gradually increasing even though their interest rate is a bit higher than banks, but the NBFI (no-banking financial institution) repayment terms are sometimes more benign than the banking sector. NBFI should be encouraged to extend funding in the new segments and against diversified set of collaterals,
11. Once IFC introduced Collateral Registry as one of the options for securing loans for the SMEs, we need to revive the system and follow-up of the project is important,
12. EEF in the Bangladesh Bank should work properly for ICT and other non-traditional sectors, and recommendations made by BUILD could be helpful, and
13. Regulations for private equity could be made simple to ensure funding for business entrepreneurs.
The writer is CEO of Business Initiative Leading Development (BUILD), Dhaka, Bangladesh.
 ceo@buildbd.org