Investing in Small and Medium Enterprises in Developing Countries - Term Paper Example

April 16, Introduction Private equity is one of the most important sources of funds for any business especially where there are loosely hanging funds that are not traded in the stock market. The main aim of having private equity funds is to have a return on investment for the time in which the fund is invested, in most cases 10 years. In most nations for example the United states, the private equity funds are invested in businesses that are just starting operations or which have just been found, thus known as venture capital. The advantage of private equity in developing countries is that it has higher returns on investments (Gannon 16) as compared to other forms of investing such as loans or dividends. There has been an upward trend in the acquisition of private equity funds due to a number of reasons. Apart from the high returns on investment, small and medium enterprises take up private equity because the markets have been liberalized to free market economies and there is proper disclosure and financial reforms that enable transparency to be experienced at the time of investment. PE funds also enable companies fill the gap in finance in the self-financing of the company and obtaining funds from other sources. Small and Medium Enterprises (SMEs) Small and medium enterprises (SMEs) have numerous definitions with each country having its own distinct definition depending on its own unique economic patterns. However, most countries base their definitions in the number of employees, value of assets or the annual turnover for a firm to qualify as a small and medium enterprise. For example, the European Union states the limits for the number of employees in SMEs to be between 200 -250, while Japan sets the limit as 300 employees. This starkly contrasts with the situation in USA whereby SMEs are those enterprises with about 500 employees in the firm (Murphy 7). According to the World Bank, small and medium projects are those businesses with workers not exceeding 300 in number with a yearly income turnover of $ 15 million, and resources that are valued at $ 15 million. Data made available by Organization for Economic Co-operation and Development (OECD) show that almost 100% of business entities or enterprises within the grouping are small and medium enterprises accounting for 60% of employment in the private sector thereby making a substantial contribution in the development of economies of most developing nations. Developing nations define SMEs as groups of businesses that is composed of a mixture of self-employed or enterprises that have less than 10 employees and they are often found in informal sectors of the economy. The SMEs are regulated through certain principles that allow them to thrive in any given market. These principles include the proportionality principle that establishes an appropriate comparison or balance between risks and costs and their impact on the regulation of the business. This ensures that there are no needless or unnecessary demands placed upon the business in its regulation. The policy objectives must be transparent, clearly defined and communicated to the SMEs so that they know their prime objectives and obligations and make them aware of the expectations from the regulatory authorities. There must be accountability in the preparation of proposals and consultation before the making or taking of decisions. SMEs do well in environments where the policies put in place are consistent in application. SMEs are important in the economies of developing nations in that they provide the important revenue that translates to more tax by specific nations. They also contribute to the creation of employment opportunities and revenue generated from exports. They are however restricted in the acquisition of funds as often, they possess little information that may be required to access funds from example bank loans. This has made such kind of enterprises to resort to private equity funds that is fast gaining ground in the world’s financial markets. Challenges of SMEs in Developing Nations There are numerous challenges that small and medium enterprises experience in the application of private equity funds. The challenges are felt due to constant changes in the regulatory practices of financial markets, the volatility of markets due to global, regional or local economic policies and the demand for disclosure in the acquisition of such funds. SMEs in developing countries face serious problems in accessing finance for its activities (OECD 115). The financial obstacle may be faced both at the macroeconomic or microeconomic levels which may come about due to very huge deficits in national budgets and unstable rates of currency exchange. The access to finance may also be impeded by the stringent or unreasonable legal, regulatory or administrative provisions. For example, in some developing nations, the SMEs cannot access finance with ease as it is difficult to obtain capital or the existing property laws do not allow ownership of land, or the transfer of immovable assets has been made difficult by the law. This makes it difficult for those companies that may own such property or assets to use them as collateral to access the much needed or necessary finance from the lending institutions. Other obstacles may be created at the organizational level in terms of the capacity in the services that go hand in hand in the acquisition of finance. This may include weaknesses in such important issues such as accounting, auditing or the financial management of monetary resources held or sought by the company. This makes it difficult for banks or other lenders to be reluctant to provide any financing. Related to the problem of access to financing is the short period of repayment of loans, which makes it difficult for SMEs to expand their business activities. This has the effect of preventing the SMEs from accessing sizable amounts of the much-needed finance for the expansion of the business. Banks also perceive SMEs as high-risk borrowers due to the low value or insufficient assets and low capitalization and therefore do not offer them competitive interest rates that may be favorable in their normal operations. Higher costs witnessed in the setting up of administration costs or the transaction costs in the acquisition of financing makes it difficult or not profitable for the SMEs in obtaining credit facilities. This makes banks not to be so interested in the activities of such firms. The lack of a robust and thriving capital market is one serious challenge that small and medium enterprises face in developing nations. This may be caused due to higher incidences of civil unrest or political instability in the developing countries that will eventually threaten the survival of investments especially the private equity investments. Such incidences may cause a total overhaul or interference in the local financial system of the particular market. Internal corporate governance structures are usually developed poorly or are weak in the developing countries to allow for the thriving of private equity investments by small and medium enterprises. This is because most small and medium enterprises in developing countries are run by families and their allies as promoters making accountability and transparency in the management of funds difficult. This in turn makes those who would be willing to invest I the funds to shy from doing so. Lack of transparency in the tax structure of countries that are developing is one major challenge or problem experienced by investors in acquiring private equity especially in small and medium enterprises. This occurs through tax evasion whereby there is investment made preferably in tax havens that have soft or little hold on taxation of income or capital. This absence of regulation, accountability and obligations to report any form of fraud or money laundering in most developing countries makes it easy to lose returns on investment by an investor who invests his money in such jurisdictions. The evasion of tax in these countries also makes it easy to have outflows of funds that are untaxed every year. Effect of Private Equities (PE) on Investment SMEs have always resorted to private equity for a number of reasons but the basic reason for such type of funding is the fact that most SMEs are start-ups or have just been started and therefore have a difficulty of uncertain futures and fluctuation of funds that cannot be financed through debts or loan financing. Such SMEs resort to the private equity financing in what is normally referred to as venture capital initiatives. Therefore, private equity funding can be defined to mean the financing model or mode for private business enterprises in their initial stages of development with the expectation for higher returns in future. Private equity comes in the form of venture capital, growth capital or private equity funds of which the most preferred is the venture capital often taken by such business start-ups (Muller 11). Companies normally utilize private equity as the risks involved in them or their profiles as startups make them difficult to raise capital or finance from external sources such as financing from banks. The SMEs therefore bridge the financial gap by acquiring private equity funds from investors in their private capacities. The private equity acquired can be listed at the security markets in the future after the companies attain stability in its books of accounts either through initial public offerings or through the coming in of a potential buyer or investor. Private equity uptake has the overall effect of adding value to the operations of firms or businesses that were otherwise poorly run or operating with few resources. This happens due to the development and implementation of business strategies, which eventually improves the daily operations of businesses. To attain this, firms harness the human resource that in most cases is superior from the private equity investors to improve the performance of the company in both the capital markets and normal firm operations. The upward trend in the economic development of developing nations has made private equities a financial choice for most companies. For example, the 1989 Brady Plan was applied in several Latin American countries that enabled them restructure their economies in terms of external debts (Marois 74). The result of this is that the countries were able to boost investor confidence as the economic markets in these nations have been stable which is conducive for private equity financing. A successful example of an investment that has flourished through the utilization of private equity funds is the establishment and expansion of Precision air, a private airline in the United Republic of Tanzania. This was successfully done by the promoter raising local venture capital fund of US $ 733,000 through the Africa Project Development Facility. The airline company has now expanded to a successful entity contributing to the economy of Tanzania due to its importance in tourism activities and offering reliable and affordable air travel to local investors. Reform in taxation systems in most developing nations has partly contributed to the uptake of private equities as a way of financing SMEs. This has been achieved through macro-economic policies that have made the countries lower the rate of taxation on the capital gains to encourage investment in equity and sustained growth of the stock market. Improvement of accounting and financial disclosure rules in the financial markets has enabled a good environment that allows the thriving of private equity funds. The overall effect is the lowering of costs in investment and attracting foreign investments. Private equities therefore have the overall effect of improving access to financial services. It has been found that countries with better or higher volumes of private equity investment tend to have well developed banking services through the provision of credits and business loans. This is partly derived from the fact that such countries have higher rates of protection of investors, which translate to ease of obtaining finance and the anticipation of returns on the investment. Conclusion Private equity financing play a significant role in the development of small and medium enterprises and there is therefore need for it to be strengthened especially concerning the rights held by shareholders. This can only be achieved through the strengthening and the boosting of the confidence of shareholders, for example allowing the minority shareholders in an SME to vote on matters affecting the nation and increasing access to relevant information about the country, what is normally referred to as disclosure. The allowing of entry of SMEs to public equity markets is also important, as this will attract investment capital for the private companies. Works cited Gannon, Paul. Business Knowledge It in Private Equity. London: Essvale Corp, 2009. Print. Marois, Thomas. States, Banks and Crisis: Emerging Finance Capitalism in Mexico and Turkey. Cheltenham, UK: Edward Elgar, 2012. Print. Muller, Kay. Investing in Private Equity Partnerships: The Role of Monitoring and Reporting. Wiesbaden: Betriebswirtschaftlicher Verlag Dr. Th. Gabler / GWV Fachverlage, 2008. Print. Murphy, Marian. The Oecd Small and Medium Enterprise Outlook, 2000 Edition. Washington: Organization for Economic Cooperation & Development, 2000. Print. OECD. The Sme Financing Gap (vol Ii): Proceedings of the Brasilia Conference, 27-30 March 2006. Washington: Organization for Economic Cooperation & Development, 2007. Print. . Read More