There is a growing consensus between politicians, policymakers, development professionals and private sector representatives that a thriving private sector is the silver bullet for Nepal’s economic development. In a country like Nepal, the contribution of small and medium enterprises (SMEs) plays an instrumental role in the overall advancement of the private sector. SMEs are a major source of employment generation. These enterprises also spur innovation, productively and invigorate the local economy. A recent study shows that in a developing country, every dollar of investment in an SME has a multiplier effect, generating additional 12 dollar in the local economy.
According to some estimates, as of 2010, SMEs (excluding microenterprises) in Nepal employ approximately 57 percent of total work force. Despite SMEs being the major driver of economic growth and poverty alleviation, the contribution and challenges faced by SMEs have long been overlooked by both the government and leading private sector organizations. SMEs face constraints in terms of access to finance and markets, poor managerial skills and difficulties in negotiating the regulatory environment.
Besides macro challenges like political instability and inadequate power, majority of SME operators single out access to finance as their biggest constraint. Research suggests that local financial institutions are often reluctant to cater to SMEs for various reasons. One, SMEs often lack adequate collateral and audited financial records required for bank loans. Two, the marginal cost of lending to SMEs is relatively high as loan sizes are small, and the due diligence cost is at par with large size loans. Three, SMEs primarily require long term capital and banks generally rely on short term deposits for expanding its loans and advances; thus, there is a mismatch between the nature of demand and supply of capital.
Four, banks often seek business with predictable cash flow where interest payment can be covered with net income, whereas, SMEs usually have an unpredictable cash flow. Five, banks typically earn attractive returns in core geographical areas and sectors giving them less incentives to venture into new areas. For example, more than 60 percent of the credit from commercial banks flows into Kathmandu. Sectors like agriculture and tourism where SME activities are usually concentrated receive only 2.4 percent and 2.3 percent of the total credit provided by commercial banks.
While banks are afraid to take risks in order to protect the financial interest of their depositors and shareholders, there is an urgent need to craft a strategy and devise an incentive structure that will encourage external financing in SMEs. Introducing the concept of venture capital will play an important role in the entrepreneurial ecosystem growth and can enhance access to finance. The objective of a venture capital investor (VC) is to inject equity or quasi-equity capital in small and medium companies, especially in their early stages when banks are reluctant to fund them because of their uncertain and erratic cash flows. VC invests capital in return for a partial long term ownership of the business.
Unlike banks, VC does not base its investment decision on the monetary value of the collateral but on intangibles like feasibility of the business model and capability of the entrepreneur. Recognizing that capital is not the only ingredient required to run a business successfully, VC also assists its investee with hands-on management, monitoring and governance. The areas of support include strategic decision making, structuring management teams, daily operations, market access, relationship and network building—areas where SMEs often lack expertise. Hands-on support in critical areas increases the survival rate and thereby, the return on investment. One major difference between a loan and an equity investment is that bank loans are ‘upside restricted’. This means, even if the invested company is extremely successful and the returns are high, the bank will only get its principal and interest back. On the other hand, a VC firm investing in equity will get returns proportionate to the size of its investment.
Historically, the concept of venture capital financing was limited to high growth technology companies in developing countries, but the trend is gradually changing. It is estimated that there are close to 200 SME venture funds operating in emerging and frontier markets like Nepal, investing approximately US $7 billion in sectors like agriculture, healthcare, tourism, microfinance and technology. Nepal is still, however, waiting for its maiden venture fund.
Besides macro challenges like political instability and inadequate power, majority of SME operators single out access to finance as their biggest constraint.
Time and again, the idea of introducing venture capital funds for Nepali SMEs has found a voice in the financial world, entrepreneurial focused forums and parliamentary halls of Nepal. In 2011, during a Constituent Assembly sub-committee meeting for amendment of Banks and Financial Institution Act, lawmaker Sapana Malla proposed that banking and financial institutions should allocate at least 5 percent of their total loan exposure for venture capital to encourage entrepreneurs. However, little progress was has been made in this regard. In recent years, a growing number of investors, both domestic and foreign, are interested in setting up a venture capital fund exclusively for Nepal. But due to red tape-ism, lack of regulatory clarity and proper incentives, investors are either waiting on the sidelines or putting off their plans.
In the spirit of Nepal Investment Year and to harness the true potential of Nepali entrepreneurs through a flourishing venture capital industry, the government and central bank need to act decisively to devise a clear strategy on venture capital investment. Issues like fund raising, investment criteria, investment routes, capital gains taxes, dividend and repatriation laws should immediately be addressed. The regulatory, legal and tax environment should be investment friendly and should protect the interests of both the investor and the investee. In addition, in tune with best international practices, foreign venture capital investors (FVCI) should be treated as foreign institutional investment (FII) and not as foreign direct investment (FDI). Once registered with the concerned authority (still not clear who the apex regulator is in Nepal), FCVI should have access to hassle-free investment without requiring additional approvals. Currently, FDI needs approvals from department of industries and Nepal Central Bank during all the phases—investing, repatriating dividends and disinvestment.
If proper incentives and mechanisms are put in place, the SME sector has the potential to attract a huge inflow of risk capital, managerial and technical expertise and the best and brightest business minds, including thousands from the Nepali diaspora. This could invigorate the entrepreneurial culture that in the long run will lead to sustainable and inclusive development of the Nepali economy.
The writer is a social entrepreneur and has an MBA in Global Social & Sustainable Enterprise from Colorado State University