Getting ‘smarter’ on subsidies to enable more financing for agri-SMEs

Photo: ISF Advisors

The last decade has seen increasing recognition by policymakers, capital providers, and finance practitioners of the vital role played by agricultural small- and medium-sized enterprises (agri-SMEs), as well as their limited access to finance. As a result, new funding structures and specialised financial intermediaries have emerged, complementing a financing landscape previously dominated by local banks and government-backed lending programs.

However, of the USD 160 billion in demand for agri-SME financing in sub-Saharan Africa and Southeast Asia, only USD 54 billion (34%) is currently being met—leaving an annual financing gap of USD 106 billion unaddressed. To address the economics of agri-SME lending and bridge the supply-demand gap, subsidies are widely used by all financial service providers (FSP) channels. But little transparency exists on the different tiers within this sub-commercial market of agri-SME lending, the efficiency of subsidies, and how well they address the different market bottlenecks.

In a forthcoming report with Commercial Agriculture for Smallholders and Agribusinesses (CASA), we seek to improve the investor’s understanding of the state of agri-SME finance globally. In this blog, we explore further the sub-commercial part of the market and evaluate the current state of blended finance, including gaps and opportunities to facilitate more financing transactions and agri-SME adaptation to climate change.

A complex market that struggles to clear

Agri-SMEs have three primary goals that require finance:

  1. Sustaining current growth

  2. Accelerating growth-to-market potential

  3. Adapting to changing circumstances, particularly climate change

In sub-Saharan Africa and Southeast Asia, there is an estimated USD 160 billion in demand for agri-SME financing to achieve these goals. However, only USD 50 billion (31%) is currently being met through formal finance channels—leaving an annual financing gap of USD 110 billion.

Challenges on both the demand and supply sides prevent the agri-SME finance market from clearing in full, thereby contributing to this gap. To start, agri-SMEs are a much more difficult investment asset class, operating in an industry with higher exposure to exogenous risks—such as yield, climate, and price variability. Secondly, their articulated demand often doesn’t correspond to an investment-ready demand aligned with the expectations of financial service providers and investment profiles of agri-SMEs. Similarly, on the supply side, financing is influenced by access to different sources of capital and the products and investment strategy deployed by financial service providers—which may not always be appropriate for agri-SMEs.

Blended finance as the linchpin of the agri-SME finance market

As with many nascent markets, Capital Providers and Financial Service Providers (FSPs) deploy subsidies to mitigate these real and perceived risks and reduce the high—transaction and opportunity—costs to serve agri-SMEs. These subsidies are used to mobilise private capital in so-called blended finance structures which are applied across all channels of agri-SME financing (e.g., commercial banks, non-banking financial institutions, or impact-oriented funds) with different tiers of sub-commercial capital.

At one end of the spectrum, commercial banks may leverage Development Finance Institutions’ (DFI) capital with commercial pricing but a higher risk appetite and more flexible terms to lend to more mature agri-SMEs with the collateral requirements and product requirements (e.g., receivables finance) to make lending possible. At the other end of the spectrum, specialised funds or state banks will use high levels of subsidy to support their pipeline development, directly support their agri-SMEs with complementary technical assistance (TA), and reduce their costs of capital with guarantees or grants.

However, fully unpacking the approaches and tiers between these two extremes is more difficult. Moreover, for an appropriate comparison, the amount of subsidy deployed by different sub-commercial, blended finance approaches needs also to consider the anticipated impact associated with the agri-SMEs being supported, or, said differently, “the impact case for going downmarket with more subsidized finance.” Structures such as Aceli Africa seek to link the amount of subsidy to this impact case in an adaptive way, where subsidies are applied on a loan-by-loan basis. Other funds and financial institutions make this case for subsidy in the initial design and targeting of the product with reporting over time.

We believe that for the sector to truly start to make substantive progress in the more efficient and effective use of subsidy to facilitate sub-commercial lending, a more sophisticated way of comparing the subsidy to impact tradeoffs—inherent in different approaches and models—is imperative. While our forthcoming report will not fully establish this comparison model, it will offer a first step in laying out the different blended finance approaches and examples that can be observed in the market, as well as the current ways in which capital is allocated by some of the leading public sources.

A more sophisticated landscape of approaches

In recent years, the landscape of these blended finance approaches has become more sophisticated. Capital providers are more nimble in trying to match the different investment profiles of agri-SMEs, in terms of growth ambition, profitability, value chain, risk exposure, and investment readiness.

In our research, we have observed seven key ways in which blended finance is structured to address pain points in the market (see Figure 1). For instance, local commercial banks will primarily make use of risk share, incentive payments, and, at times, investment facilitation or technical assistance. Social lenders and impact-oriented funds will typically leverage a broader set of those approaches—in particular, raising catalytic capital, attaching a technical assistance facility (externally-funded and operated) to their investments, and using investment facilitation and business development services (BDS) support in their value chain(s) of activity.