Dr Khaled Soufani, Senior Teaching Faculty in Finance and Director of the Executive MBA Programme, writes about the roles small and medium sized enterprises (SMEs) are playing after the financial crisis.
Adaptable, entrepreneurial and strategically vital, SMEs are undoubtedly the lifeblood of the UK economy, and economic growth depends to a great extent upon their success. “They [mid-sized businesses] have the potential to be economic powerhouses… creating jobs and growth for all regions of the UK,” according to Lord Livingston, the Minister for Trade and Investment, in a speech last year.
Even with the challenges that the SME sector has had to withstand since 2007, UK SMEs still accounted for 59 per cent of the nation’s private sector employment and 48 per cent of private sector turnover at the start of 2013, according to figures from the Department for Business, Innovation and Skills.
But with sources of funding for many SMEs having contracted since the start of the financial crisis, there is a need to find new ways of helping SMEs access finance, so that they can again help drive GDP. This sector already makes a massive contribution to GDP, but could achieve much more with improved financial support.
The digital revolution has, of course, made it easier for small companies to compete more effectively and reach – and thrive in – new markets, and availability of finance has increased. But what’s needed now is a model of finance that will nurture firms through successive stages of growth and minimise business failures within the SME sector.
And this new model will need to increasingly complement the banking sector, now much more restricted in its ability to lend to smaller businesses by new regulatory and solvency requirements imposed since the financial crisis. The emphasis will need to consider more equity rather than just depend on debt finance. Debt will still have an important role, but there will need to be a greater emphasis on equity, because there is a ceiling to how much debt any company can raise.
We will need to explore different models of funding to SMEs, possibly based on a combined or syndicated funding structure, within which, for example, banks, private equity firms and invoice factoring companies can all play a role in providing credit, equity and working capital. In addition, the shadow banking system is possibly growing, as are crowdfunding platforms (more research is needed to understand the growth and role of shadow banking and crowd funding for SMEs) and sources of corporate venture capital. It may be that entities such as family offices, private companies that manage investments for individual families, also become a more widely used source of equity investment.
On the supply side, whoever is financing SMEs will need to make sure they can minimise their risks. They will need to identify the industries, sectors and firms likely to be winners in the longer term. On the demand side, business owners seeking credit need to show they are capable of managing their businesses effectively and that they understand the markets in which they are trading. One useful change may be for more new SMEs to work with incubator and accelerator companies, which allow them to gain expertise in management and benefit from business monitoring, thereby helping to reduce risk.
But what is the history that has brought us to this point, and which is now driving the need for a new financing model?
SMEs have always been at the centre of the economy. Between 1994 and 2007 the world economy experienced an unprecedented period of continued growth, due to factors such as the end of the Cold War, the emergence of China as an economic power and financial deregulation. But two other factors were also crucial: the development of internet technology that allowed SMEs to build an international customer base without having to physically establish operations in other countries; and the easy availability of credit in general.
Until the start of the financial crisis in 2007 it was relatively easy for SMEs to attract finance, in part because venture capitalists and private equity funds were also able to access plentiful funding from financial institutions. This availability of credit probably helped to inflate the dot com bubble in the late 90s. But the growth of SMEs of all kinds also had longer-lasting, positive economic effects. SMEs are creators of jobs and job creation always has a positive ripple effect, as consumer confidence and consumer spending rise, helping to boost GDP.
But in 2007 the financial crisis began. Companies in the financial sector had invested in paper financial products that created another bubble, which also collapsed. The first phase of the crisis left many banks and other financial companies facing serious liquidity and solvency problems, meaning they had to tighten up conditions governing lending to businesses.
SMEs are at a particular disadvantage during periods of economic turbulence, because most depend to some extent on loans, overdrafts and short term credit to support day to day liquidity and working capital requirements. Smaller companies are also generally more vulnerable to economic shocks, due to their smaller balance sheets, lack of collateral, less room for manoeuvre in terms of cost-cutting or diversification, and, most pertinently, the limited supply of alternative financing options. This increase in the funding gap for SMEs has been bad news for many economies, because growth within the SME sector might otherwise have helped offset the effects of downsizing and restructuring within larger enterprises.
At the same time, another consequence of the financial crisis is that many individuals unable to find employment have been forced to become more entrepreneurial: starting new companies and taking on business risk in developing and selling new products or services. Self-employed workers and microbusinesses that could grow into SMEs also have the potential to make a valuable contribution to GDP – but all will struggle to grow without adequate financial support.
So, at this hugely important moment in the sector’s development, if a new, effective, self-sustaining funding model can be created SMEs will once again be able to act as a crucial source of new jobs, of new innovation and competition in every business sector, and thus as an engine for economic growth.
On 15 April Dr Khaled Soufani will be delivering a Cambridge Judge Business Briefing in London on “After the Financial Crisis in Our Economies: The Role of SMEs”. Find out more and register