Introduction
Background to the study
Investment plays a significant role in the economic growth of a particular country. This is due to the fact that it stimulates innovation and enhances competition. Amongst the areas that governments should focus in their quest to stimulate economic growth includes the small and medium enterprises (SMEs).
One of the ways through which this can be achieved is by ensuring that entrepreneurs access the finances needed for investment (Business Innovation and Skill 2012). Financing is an important element in the success of SMEs. This is due to the fact that it enables entrepreneurs to start-up businesses, develop new products and invest in human resource development.
It is estimated that there were approximately 4.5 million SMEs in the UK by the end of 2011. This represents 99.9% of all the business establishments in the country. During the same year, the SMEs accounted for 50% of the total private sector turnover. This highlights the importance of the SMEs in the country’s economic growth.
Despite the significance of SMEs in the UK economic growth, entrepreneurs face numerous challenges. One of the major issues faced relate to inability to raise the finance that they require to fund their investment. As a result, the SMEs ability to attain their growth potential is adversely affected.
Findings of a survey conducted by Kerr and Nanda (2009) reveal that accessing adequate finance is one of the greatest hurdles that entrepreneurs face. These findings are further emphasized by a survey conducted by ICAEW. The survey shows that SMEs in the UK were not able to raise the capital that they need in 2012.
However, entrepreneurs are optimistic that this trend will change in the near future. Kerr and Nanda (2009) argue that inability to raise the necessary finance constrains SMEs ability to generate substantial cash flows to sustain their long term survival.
Aim and scope
The objective of this report is to assess the issues that SMEs face in an effort to raise finance. The report also evaluates the extent to which public policy has addressed the finance problems faced by SMEs. The report specifically focuses on SMES operating in the UK.
Analysis
Existence of market failure
According to Pretes (2002), banks are the major sources of credit finance to SMEs in the UK. It is estimated that approximately 25% of all firms in the UK source their credit finance from banks.
Despite this, the supply of financial credit to SMEs is relatively low compared to large businesses. Most banks in UK consider extending credit finance to SMEs to be riskier. This is due to the fact that most SMEs are young entities and do not have a strong financial base compared to large enterprises.
SMEs are also characterised by a high level of information asymmetry. In the course of their operation, most SMEs do not keep proper financial records. This is due to the fact that they are not subjected to any form of external evaluation. As a result, SMEs’ operations are considered to be opaque (Armstrong et al 2012).
Credit financiers such as banks demand a high level of transparency in a businesses’ operation before advancing credit services. This aids banks in minimising the probability of incurring losses emanating from a high rate of default (Armstrong et al 2012).
Another major challenge that limits SMEs ability to raise finance from external sources is that they do not have the necessary collateral. Banks require collateral as a measure to safeguard their operation from credit default.
On the other hand, SMEs that have collateral experience a challenge because the securities are usually less liquid. Consequently, banks cannot be able to recover the amount of extend extended plus the interest upon default.
Personal characteristics
A study conducted in 2001 in UK revealed that the ease of accessing credit from banks by entrepreneurs varies depending on their ethnic group (Rams & Smallbone 2003).
White entrepreneurs do not experience major problems compared to minority entrepreneurs such as Bangladeshis and African Caribbean entrepreneurs in the UK (Fisman & Love 2002). This form of ethnic discrimination on minority entrepreneurs persists despite their impressive personal resources and financial records.
Discrimination is also perpetrated on women entrepreneurs. Buckler (2011) asserts that women pay a higher rate of interest compared to men. Additionally, the rate of success amongst male entrepreneurs in accessing credit finance from banks for their businesses is five times higher compared to female entrepreneurs.
Female entrepreneurs in the UK face stringent guarantee and security requirement before they can access loans compared to their male counterparts (Marlow & Patton 2005). Discrimination amongst women in accessing bank loans will continue to hinder the UK ability to achieve full economic recovery if nothing is done urgently.
Existence of equity gap
Baldock and North (2012) argue that only a few SMEs in UK seek equity finance despite its importance in stimulating growth and innovation.
Equity finance is most suitable for enterprises that are characterised by a high growth potential, high risk and do not have the necessary security to access debt finance (Baldock & North 2012). Despite its significance in stimulating a country’s economic growth, policy makers in the UK are cognisant of the fact that a serious equity gap exists. The gap is most prevalent amongst young enterprises.
These businesses experience a challenge in their pursuit for equity finance. By 1999, it was estimated that equity gap mainly affects entrepreneurs seeking financial capital of over £ 500,000 (Storey 2005). Currently, equity gap is much wider than previously estimated.
According to a report by Business Innovation and Skills (2012), equity gap has increased to £ 2 million and beyond. It is expected that this gap will continue to increase as a result of the adverse effects of the 2008 economic recession and the recent Euro Zone sovereign debt crisis.
Most private equity market investors are considering entering into deals with large and well established entities to be more lucrative compared to young venture capital investors. McGlue (2002) asserts that private financiers perceive investing in start-ups to be less attractive. Some of the reasons that explain this behaviour include the prevailing information asymmetry, lack of liquidity in the assets used as collateral and lack of transparency.
In addition to the above risks, equity financiers perceive start-ups to be characterised by numerous managerial uncertainties (Wessner 2002). In order to receive their expected return from such investments, a substantial amount of managerial input is required from the venture capitalists. Baldock and North (2012) argue that past history shows that early-stage venture capitalists receive minimal returns.
In certain instances, such funds have failed. As a result, most venture capitalists prefer extending credit finance to such enterprises at later stage. Early stage investment in the UK declined significantly during the period ranging between 2000 and 2008 as illustrated by the table below.
Source: (Mason et al 2010)
The chart shows that that there has been a significant decline in the number of early stage investment from 2000 to 2008 despite the rate being very irregular. From 2000 to 2008, total early stage investment declined from 11.0% to 4.1%. Despite this, the number of early stage investment increased to 455 businesses by 2008 (Mason et al 2010).
Debt financing gap
SMEs also experience structural market failure in their effort to access debt finance. The market failure arises from existence of information asymmetry. Mason et al (2010) assert that it is difficult for debt financiers to differentiate between low and high risk entrepreneurs.
This is due to the fact that a substantial amount of cost is incurred in the process of gathering information. When issuing debt finance, most banks rely on the financial track record of the SMEs.
This strategy has a gap in that banks fail to assess the SMEs economic viability and sustainability. By relying on such information, numerous young businesses which have great growth potential are prevented from accessing the finance that they need for their growth and expansion (Baldock & North 2012).
Currently, reliance on the SMEs financial record by banks in their process of issuing debt finance is ranked as one of the greatest hindrances to entrepreneurs’ pursuit for debt finance.
Adjustment of the risk model by banks
One of the reasons that explain the 2007/2008 economic recession is the high rate systematic risk that banks tolerated. During the years preceding the recession, banks advanced credit to individuals who were characterised by low credit rating. This exposed most banks to high credit and interest rate risks.
In an effort to minimise these risks, banks in UK are increasingly reviewing their in-house models. In the course of their operation, large banks in the UK have integrated complex models that they utilise in the process of evaluating the likelihood of borrowers defaulting and the amount of financial capital that they should hold so as to enable them cope with possible losses (Wehinger 2012).
Wehinger (2012) further asserts that most banks have undertaken a permanent downsize on their balance sheet. One of the ways through which banks have achieved this is by reducing the amount of credit available for loans.
Banks in the UK are also imposing quantitative barriers on the amount of credit that investors can borrow. This strategy is widely referred to as equilibrium quantity rationing. As a result, entrepreneurs are not able to access credit.
Moreover, banks have also reviewed the interest applicable on loans. According to Armstrong et al (2012), the interest rate that borrowers are subjected to influences the degree of risk of a particular loan in a number of ways. First, it attracts borrowers who are willing to pay the high interest rate but they are characterised by high rate of default.
Secondly, a high interest rate may attract investors who are good risks. However, such borrowers may invest in projects that are characterised by a low likelihood of success but very profitable if they succeed. This depicts a high moral hazard on the part of the bank.
In summary, Armstrong et al (2012) assert that “higher cost of credit, quantitative credit rationing or lack of collateral will have adverse effects on the overall economic performance of the UK, since investment in SMEs will tend to be limited to what is available from holding of liquidity and flows of internal finance” (p.9).
Public policy
The UK government appreciates the fact that the country’s economic recovery will be greatly boosted by SMEs investments. In an effort to address the prevailing imperfections with regard to the SME finance market in the UK, the government has instituted a number of measures. Some of these measures are discussed herein.
Government strategy
In an effort to help SMEs, the government developed a comprehensive strategy titled Backing Small Business. The strategy is composed of a number of policies which include improving the entrepreneurs’ access to finance and boosting the ease with which entrepreneurs do business (Legge & Hindle 2004).
The UK government is also committed towards ensuring that SMEs access bank credit more efficiently. To achieve this, the government has entered into a lending agreement with the Lloyds Banking Group and the RBS. In the agreement, Lloyds and RBS are required to ensure that they make £ 44 billion and £ 50 billion respectively available to SMEs by the end of the year.
Additionally, the government has put pressure on commercial banks in the UK to extend credit finance to the British Bankers Association. Through this strategy, the government has been able to set aside £1.5 billion in a Business Growth Fund. The fund will be used to offer loan facilities to SMEs seeking between £ 2 million and £ 10 million.
The government has also established a committee that is composed of government officials and a number of business representatives. The objective of the committee is to monitor the banks’ lending practices. Through the strategy, the likelihood of eliminating discrimination amongst minority groups will be increased.
Establishment of Community Development Finance Institutions
The UK government has established a number of CDFIs which are autonomous in their operation. CDFIs serve specific geographical regions and are aimed at providing support to entrepreneurs and SMEs in their quest to access credit finance.
Baldock and North (2012) assert that CDFIs have played an essential role in promoting accessibility of credit finance amongst the disadvantaged groups such as women and other minority groups in the UK.
In an effort to improve accessibility of finance, the UK government recently announced a number of changes to the Enterprise Finance Guarantee (EFG).
EFGs refer to a product issued to credit financiers. EFGs enable lenders to extend credit to small businesses that do not have the necessary collateral. The changes are aimed at increasing CDFIs’ ability to extend credit finance to various SMEs. This strategy shows the government’s commitment in stimulating growth of SMEs.
Establishment of funds
The UK government has established a number of funds that are aimed at increasing accessibility of credit finance by entrepreneurs. Some of these funds are discussed below.
Enterprise Capital Funds
The UK government has established a programme known as the Enterprise Capital Funds (ECFs). The first fund was rolled out in 2006/2007 and was aimed at addressing the prevailing equity gap problem faced by SMEs.
The fund has played a fundamental role in enabling entrepreneurs invest in high growth potential ventures. This is due to the fact that the government provides the entrepreneurs with the necessary amount of equity finance. Through the fund, entrepreneurs can be able to access credit finance amounting to £ 2 million (Baldock & North 2012).
Currently, there are approximately 10 funds which have already been established. Each of these funds has a total value ranging between £ 10 and £ 20 million. The fund assists SMEs in their various stage of development. Thus, it does not discriminate start-ups. Moreover, the funds cover businesses in diverse economic sectors. Consequently, the funds have played a critical role in dealing with equity gap.
The Aspire Fund
This fund was set up in 2008 with the objective of assisting women entrepreneurs’ access credit finance. The fund mainly focuses on high growth potential organisations that are headed by women. It is composed of both the private and the public sector investors.
The total government investment in the fund amounts to over £ 12.5 million. As a result, the fund is able to extend £ 200,000 and £ 2 million as equity investment. Through this fund, the UK government has been able to increase the number of women entrepreneurs (Baldock & North 2012).
Early Growth Funds
The government established this fund with the intention of assisting entrepreneurs to access finance. The fund mainly focuses on SMEs that have a high potential of growth. Additionally, the fund is mainly national and regional based.
An example of regional fund established includes the Finance South East Accelerator Fund. From the fund, entrepreneurs can access approximately £ 100,000 for their start-up operation and an additional £ 100,000 to businesses that demonstrate exemplary performance (Baldock & North 2012).
The UK Innovation Investment Fund [UKIIF]
The UK government established this fund in 2010 with the objective of stimulating private venture capital investment.
Currently, the fund has received over £ 180 million from private sector investors and over £ 150 million from the government. The fund operates independently but it is reviewed occasionally by the Capital for Enterprise Limited (Baldock & North 2012).
Conclusion and recommendation
Access to finance is one of the most important elements in the success of business start-ups. However, the ability to raise the finance necessary for business operations varies between the large and the small business enterprises.
The report illustrates some of the challenges that SMEs in the UK experience in their quest to raise credit finance. One of the major issues highlighted relates to existence of numerous incidences of structural market failure. One example of such failures relates to information asymmetry.
In the course of their operation, SMEs do not keep proper financial records. This hinders their ability to access bank loans because the financiers cannot effectively assess the SMEs ability to repay the loan. Lack of proper financial records has led to most banks regarding SMEs operations as opaque.
Another challenge facing entrepreneurs in the UK arises from existence of a high rate of discrimination amongst female and minority group entrepreneurs. Women entrepreneurs in the UK required to pay higher interest on bank loans compared to their male counterparts. Such form of discrimination has adversely affected the country’s ability to stimulate economic productivity by limiting investment.
As a result of the previous economic recession and the recent sovereign debt crisis, most banks in the UK are increasingly reviewing their risk model. This has been necessitated by the need to minimise losses emanating from a high rate of credit default.
Some of the mechanisms that banks are integrating include increasing the rate of interest applicable on loans and establishing a limit on the amount of credit that entrepreneurs can borrow.
Existence of equity gap is another major challenge that entrepreneurs are currently facing. Most equity financiers in the UK are not willing to extend credit finance to start-ups. This is due to the fact that they are characterised by high risks and low returns.
In an effort to cope with these problems, the UK government has instituted a number of public policies some of which include entering into agreement with banks and establishment of various funds.
To increase the rate of survival, entrepreneurs in the UK should consider seeking information on the various sources of external finance. This will limit their overreliance on bank loans. Secondly, the UK government should continuously evaluate the public policies developed in order to improve accessibility of finance by SMEs.
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