Synopsis –  This article is part of NextBillion’s series “Enterprise in the Time of Coronavirus,” which explores how the business and development sectors are responding to the pandemic.

The world has experienced many different crises and pandemics over the years, which have disrupted national, regional and even global economies – sometimes gravely. Although the disruption due to COVID-19 is not novel, its magnitude may be greater than any crisis we’ve faced in many years. Whether it was the economic recession in the United States and Europe in 2008, or the microfinance crisis in India in 2010, the effects major crises have on the economy of a country and region are profound, and they can vary greatly depending on the regional context.

For instance in East Africa, the COVID-19 crisis is having particularly far-reaching consequences due in part to the prevalence of small and medium-sized enterprises (SMEs). To take just one example, 98% of the businesses in Kenya are SMEs – and other economies in the region are also heavily dependent on the SME sector. These businesses are especially vulnerable to the current crisis due to factors such as the disruption in supply chains, which has increased the cost of doing business for companies with already tight margins, and the loss of income due to pay cuts or job lay-offs, which has reduced the purchasing power of these enterprises’ customers. For this reason, many resources have been rightly focused on helping these entrepreneurs survive the pandemic.

But though it’s true that entrepreneurs will need financing to ensure that their businesses survive the economic downturn, it’s also important to look at the other side of the coin – the funders that are supporting them. Most institutional funds are currently focusing on their well-performing portfolios by providing monetary support to ensure these enterprises’ survival, so they may not be deploying capital to new investee companies unless the deal was negotiated to term-sheet level prior to COVID-19. The burden thus lies with angel investors to support these companies in order to ensure their short-term survival – and subsequently, to ensure a healthy pipeline for the institutional investment funds after the crisis has passed.

However, angel investing in East Africa is still nascent, with high net worth individuals opting to invest in asset classes like real estate and money markets, among others. Further, some of these wealthy investors are unaware of the opportunities that early-stage companies present. Therefore, the region’s angel investors will need to exercise some level of aggressiveness and adopt a high-risk tolerance in seeking out new investment opportunities.

If you’re an angel investor focused on East Africa, how can you ensure that you not only select companies that are likely to succeed, but also that you will get some level of returns from your capital? Below we’ll discuss some practical considerations that can guide your investment thesis.

DIVERSIFY YOUR PORTFOLIO

You can consider diversifying your investments based on the sectors you invest in, the financial instruments you use, your geographical focus and the stages of the companies you select. The aim of diversification is to reduce the risk of your investment, while ensuring that financial returns are maximized. In the process, it’s good to optimize your diversification efforts by mixing different strategies.

BET ON THE JOCKEY, NOT ON THE HORSE

Consider selecting potential investee companies that have a team and leader who is not only visionary, but is also agile enough to pivot and adapt to quickly-changing situations. This type of leadership will carry the business through the COVID-19 crisis by ensuring that it is responsive to current market needs, which will ensure that your investment survives.

BE SELECTIVE WITH YOUR MONEY

During these times of crisis, be very selective about where and how you invest your capital. You may want to consider how potential investee companies performed pre-crisis, and whether they already had the potential to scale. Equally importantly, consider companies that have lower burn rates and that do not spend their available cash fast. This will ensure that the capital you invest carries the company for a longer period. It might also be prudent to consider the type of currency that you will use when supplying capital to the potential investee company, as this has the potential to greatly affect your potential returns.

DON’T BE A SHARK

Though this crisis presents an opportunity (and a temptation) to undervalue companies, as sharp declines in available capital may make them more likely to accept less favorable terms, be careful not to be a predatory shark. This might seem to provide an advantage to investors, but it also has the potential to significantly affect the motivation of a company’s management team, potentially reducing performance (and returns) in the longer term.

INVEST WITH OTHER ANGELS

Co-investment during these times will give you some level of comfort in the investment you make. Look for other like-minded investors who are willing to take the risk and invest together, because if managed properly, co-investing has more potential to generate returns than investing in a deal single-handedly. That is, when more than one investor comes together to invest in the deal, there is higher likelihood of the enterprise succeeding due to the different perspectives and networks that each investor brings. Co-investing can therefore be viewed as a de-risking mechanism.

GET CREATIVE WITH DUE DILIGENCE

Since physical movement remains restricted in many markets, seek out innovative ways to build and enhance trust with the entrepreneurs you’re supporting. This can include using technology-driven solutions, such as conducting a virtual field visit tour over Zoom, and/or working with local on-the-ground partners, who may include accelerators and incubators or local consultants. Such partners will be responsible for assessing the market perception of the product/service, getting insights from customers/users of the product, and even speaking to other on-the-ground financiers who have previously evaluated the deal to understand its attractiveness. These measures will ensure that you’ve established some confidence in the investee company (and vice-versa) before you make the investment.

PLAN TO PROVIDE MORE THAN JUST MONEY

During this time of crisis, companies require more than just the money. Plan to also provide strategic support, knowledge and access to networks to your portfolio companies, to ensure that they have the tools and contacts they need to survive the pandemic. This approach is worth the time and money it will require, because without it, your capital may be used inefficiently, and you could lose your investment entirely.

HAVE REALISTIC EXPECTATIONS ON EXITS

Have an open and honest conversation with potential investees about your return and exit expectations. This is important because, during this crisis period, investment-holding periods may be longer than anticipated, which ties up capital and delays returns for all investors. You may therefore need to work harder and explore other avenues for exits, such as strategic buy-outs, in which a potential acquiring company will acquire the shares from the angel investor, based on the assumption that the acquiring company and the investee company may have synergies in the value chain, thereby increasing the acquiring company’s market share.

Intellecap has compiled more guidance around some of these practical steps here. We hope it will help angel investors navigate the many challenges – and find beneficial opportunities – during these unprecedented times.

Mumbai, Aug 7: Santosh Kumar Singh , Director Climate Energy and Agriculture, Intellecap and Ankit Gupta, AVP, Clean Energy and Climate Change, Intellecap coauthored the article ‘Climate Finance for MSME’s’ as part of our strategic content tie up with India Development Review (IDR)

The article delves around why we urgently need to make climate finance accessible for micro, small, and medium enterprises (MSMEs), and how we can begin to do so.

Micro, small, and medium enterprises (MSMEs) have a dual relationship with climate change. On one hand, they are contributing to it, and on the other, they are vulnerable to its risks.

There are a number of studies that establish the fact that MSMEs have quite a significant footprint when it comes to greenhouse gas (GHG) emissions. For example, according to a study conducted by CSTEP, in 2015-16 the informal sector (which is largely composed of MSMEs) consumed approximately 13 percent (81 million tonnes or mt) of coal and lignite, seven percent (8.5 mt) of petroleum products, and eight percent (3.3 billion cubic metres) of the natural gas supplied in India. Further, this sector emitted 110 mtCO2e (110 million tonnes of CO2 equivalent) in 2015–16, owing to fossil fuel usage.

“MSMEs are also disproportionately affected by climate risks.”

Both physical risks (damage to infrastructure and assets such as buildings and factories, as well as to people and communities), and transitional risks (policy changes, reputational impacts, and shifts in market preferences and technology) slow down or halt the operations of a MSME, leaving them in need of immediate and considerable financial support.

Given this, it is understandable why MSMEs require an urgent push towards the adoption of technologies that lower their emission footprints and reduce their vulnerability to climate change. Climate finance can help MSMEs make this transition. However, this has remained elusive to a large number of eligible enterprises.

What makes climate finance hard to access for MSMEs?

The credit gap for MSMEs in India was pegged at about USD 240 billion (about INR 16.66 lakh crore) in 2018. Considering the fact that a large number of MSMEs still struggle to get traditional finance in India, climate finance is a distant dream. Here are some factors that contribute further to the difficulty:

1. Lack of awareness

Lack of awareness about climate finance mechanisms and provisions is a major concern among MSMEs. Majority of the MSMEs in India are micro enterprises (approximately 99 percent). These enterprises are located across the country, including in remote geographies.

The lack of available information on climate finance and low financial literacy levels limit their understanding of how their businesses could benefit from climate finance. They would not know, for instance, that leveraging climate finance can help them manage some of their business risks, or about the availability of newer, cost-effective technologies that reduce carbon emissions. As a result, they would not know to go looking for these opportunities, let alone think through how they could benefit from them.

2. Formal financing structures

It has been observed that only around 16 percent of MSMEs, are being financed by the formal banking system in India. Given that climate finance in India flows mainly through formal financing structures with stringent rules and regulations such as Union Budgets, State Budgets, national climate funds (National Clean Energy Fund [NCEF] and National Adaptation Fund [NAF], for example), private climate finance (Clean Development Mechanism [CDM], for example), and international climate finance (Green Climate Fund [GCF] and Global Environment Facility [GEF], for example), this acts as another barrier.
What’s more, international climate finance institutions and facilities such as the GCF require applications from a dedicated accredited entity or a qualified financial institution working with an entity accredited by the GCF, to propose approaches that deploy financial solutions for MSMEs.

3. Extensive procedural requirements

There have been a number of mechanisms and programmes supported by the World Bank, GEF, and others, that have been successfully implemented to bring the benefits of climate finance or development finance to MSMEs, specifically to help them transition to modern, energy-efficient technologies.

However, participation of MSMEs in these schemes has been limited due to a number of factors, including the necessity of an upfront investment, procedural requirements such as preparation of detailed project reports, energy and emission audits, and so on. These are not feasible for a large number of small and micro enterprises since they don’t have the capabilities or resources to do this.

What can we do to enable climate finance flow to MSMEs?

There have been a number of attempts to reimagine climate finance and work on the challenges that exist in the current ecosystem. For example, the Ministry of Micro, Small and Medium Enterprises has ongoing initiatives to create awareness among MSMEs about new technologies, along with several incentives and schemes to support them.
However, the attempts so far have been inadequate, in part because most of them require MSMEs to proactively explore climate finance, which, given their informal nature and lack of technical know-how, is difficult. Here’s what can be done to change this:

1.Make the climate finance ecosystem MSME-friendly

Instead of eligible MSMEs chasing climate finance, the ecosystem should look for eligible enterprises and deliver climate finance to them. While this may sound like wishful thinking, it can actually be built on the blocks of the new initiatives currently being provided by the ministry.

The existing MSME databank can be further developed to collect data which tells MSMEs whether they are suitable for climate finance, and then guide them accordingly.

The existing Data Analytics and Technical Coordination (DATC) wing set up to support the MSME sector can be leveraged to understand the vulnerability of a given enterprise to climate risks and develop support measures for them.

Direct benefit transfers (DBT) can be leveraged to deliver subsidies and social welfare benefits to MSMEs.

2. Change eligibility requirements for MSMEs and financial institutions catering to them

The next set of measures needs to focus on the existing eligibility requirements of MSMEs for climate finance. Currently, the eligibility criteria vary from scheme to scheme and from mechanism to mechanism (GCF, NCEF, and others). For example, MSMEs cannot directly avail climate finance from GCF and other similar sources since their funding requirements are significantly smaller than what the GCF provides.

“There is also a need to have simpler processes of registration for climate finance, as well as for verification of climate benefits.”

Currently, both these serve as deterrents for MSMEs because of their inability to invest upfront in these processes.

The other requirement is to have a dedicated climate finance facility for non-bank financial companies (NBFCs) and microfinance institutions (MFIs) catering to MSMEs. Financial institutions access climate finance from GCF or other such sources and then deliver it onwards. This does not work for MSMEs, as a majority of NBFCs or MFIs who are the main providers of finance to MSMEs are either not eligible (due to stringent eligibility criteria) or find it very difficult to access climate finance.

Thus, eligibility requirement of financial institutions delivering climate finance need to have specific provisions for NBFCs and MFIs that enable them to avail of climate finance themselves. (It is worth mentioning here that climate finance often has restriction of exclusivity on its use, so the financial institutions delivering it have to showcase that the pool of capital that they have accessed from these sources is only being used for financing projects or interventions that have climate benefits.)

There is need for processes and mechanisms so that not just MSMEs, but the financial institutions catering to MSMEs are also able to leverage climate finance in order to build a MSME-friendly financing ecosystem.

3. Reimagine the role of financing institutions

Overall, there is a need to develop a mechanism that enables climate finance to reach MSMEs proactively. For this, there is a need to revisualise the role of financing institutions that cater to the MSME sector. SIDBI, NABARD, and IREDA (for green finance) have been primarily focusing on direct financing or refinancing of loans to NBFCs and other financial institutions catering to MSMEs, which are quite insufficient considering the total credit requirement of MSMEs.

These institutions (or probably new ones) should focus on unlocking more capital to the MSME sector by first loss default guarantees or other risk mitigation measures that enable more credit to the MSME sector. As we bring more formal credit to them, enabling climate finance will become easier.

“As we bring more formal credit to them, enabling climate finance will become easier.”

Furthermore, there is a need to build the capacity of financial institutions and include them in the process of origination, application, and delivery of climate finance. This requires building their capacity and providing them easier access to climate finance as well. They should also be leveraged to serve as a guide to the MSMEs. Financial institutions can easily identify potential climate finance beneficiaries by having a few additional questions in the loan applications; they can use this to guide their MSMEs through the process.

Financial institutions catering to MSMEs are the most critical stakeholders in enabling climate finance for MSMEs, and it is almost impossible to think of an effective climate finance ecosystem for MSMEs if we do not leverage them optimally.

1 Billion People Live in Informal Settlements Worldwide: Here are Seven Key Challenges They’re Facing During COVID-19 : The article in Next Billion by Margaret Nakunza, Associate, Intellecap Africa was based on the AVPA and Sankalp Dialogues webinar series, which explores how the business and development sectors are responding to the pandemic.

AVPA, in partnership with Sankalp Dialogues, kicked off a webinar series in April, to find out what various organizations across the continent are doing to #CrushTheCurve .
The virtual convening is ongoing, and it aims to:

-Share examples of how program implementers are responding to the outbreak, ranging from preparedness to mitigation

-Hear from voices on the ground and discuss how best to address upcoming challenges and reduce their impact

-Share solutions that can be easily embraced and implemented effectively, efficiently and quickly