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Home / Opinion / Views /  Opinion | A novel way for MSMEs to lower their risk profile and access funds

As we continue to grapple with ways to increase resilience in the micro, small and medium enterprises (MSME) sector, the topic of equity capital keeps coming up. Historical efforts at addressing this issue through stock exchanges and equity funds focused on MSMEs have not had much success. One of the measures announced in the Centre’s covid relief package was a fund-of-funds to invest in MSME equity, but it is likely to face similar issues. We want to explore here a significantly different approach that seeks to address the root causes of risk faced by these entities.

One role of equity is to provide a buffer to a lender so that shocks to the business do not translate into default. In return, an equity investor has full claim on the residual profits of the business. This claim is typically enforced through active engagement by such an equity investor. This approach assumes that the business has a core of steady revenues that do not get overwhelmed by modest-sized shocks. In the case of MSMEs, this key assumption is not always validated because these businesses are exposed to large (relative to their size) shocks such as payment uncertainties, and supply as well as demand shocks. These businesses would be deemed to have no debt capacity at all, and the resultant level of equity required would be so high that it would render the entire business model unviable. Lenders to MSMEs would confirm that the expected losses are in the range of 4-8%, even for those having diversified loan books, going up to 30% during periods of uncertainty. The underlying failure rates of businesses, particularly in sectors like restaurants and apparel, are also quite high. MSMEs, by definition, cannot shield themselves from these risks on their own, since they are concentrated in a particular neighbourhood (in the context of services) or a specific supply chain (in the context of manufacturing). In fact, this micro-market specialization and localization is the very strength of their business models.

If equity cannot be a buffer for risks, and diversification of firms is not feasible, are there ways to fundamentally reduce the incidence of risk for these companies? Let us take the example of a 25-room budget hotel in, say, Kota, Rajasthan. The primary source of uncertainty for this business is its occupancy rate. More specifically, the standard deviation around the average occupancy rate. The higher this volatility, the greater the risk of default a lender to this hotel must bear. Hotel occupancy levels can vary for two sets of reasons: a) ones that are specific to the hotel and under its control, such as a sudden fall in its cleanliness standards that gets it bad reviews on, say, TripAdvisor, or the head chef joining a competitor because she was not treated well; or b) ones that are outside the control of the hotel, such as a period in which Kota experiences a negative business cycle, or even a harsher than usual summer. Given the small size of this hotel and its high fixed costs (salaries, rentals, laundry), even a few bad months may be enough to tip it over to default or closure.

This is where the concept of connected supply chains becomes very critical. In the fast-moving consumer goods industry, for example, stand-alone MSMEs seeking to supply intermediate goods face risks comparable to those being experienced by that hotel in Kota, but those that are tightly connected to a large company, such as Hindustan Unilever, get a lot of that uncertainty taken away, leaving them free to focus on their core competencies, and in the bargain becoming much better candidates for both debt and equity. Wherever these well-defined supply chains do not exist, the role of synthetic supply chains becomes critical. These can, for example, be provided by companies that connect the MSME to the broader economy and help mitigate payment, demand or supply uncertainties. For example, Oyo or Airbnb can work with our budget hotel in Kota to provide it a minimum level of occupancy through its advanced booking systems and by helping it access a much wider range of travellers than it could on its own. Additionally, because large networks see the broader consumer trends that affect demand, they can effectively nudge the hotel to do what matters, be it maintaining minimum standards of cleanliness, or menu design, or cancellation procedures. They may even run pooled kitchen and laundry services for budget hotels that would reduce the fixed costs each hotel would have to incur. The resultant reduction in a small hotel’s operating leverage will allow it to weather cyclical downturns better. These interventions would alter the risk exposure of a small hotel and its likelihood of survival in bad times.

If we view risk and mitigation in this “supply chain" sense, rather than in a standalone one, the key may well lie in creating risk-reduction platforms across multiple sectors. The more uncertainty these platforms can absorb, the lower the need for an MSME entrepreneur to commit equity capital in his or her business. As a result, these businesses would be far more attractive to a lender than otherwise. Mere membership of such a platform could be viewed as the equivalent of a good credit score for an individual. Traditional approaches to capitalizing MSMEs that replicate a large company model have not really worked. These platforms are like large companies and could help grant them improved access to debt and equity (thanks partly to the relaxation of restrictions on foreign ownership). This would allow them to bring much needed business experience and technologies to local markets. Given the growing inter-connectedness of firms and the emergence of platform business models in several sectors, we believe that it is time to look outside the MSME box when it comes to risk reduction and resilience.

Bindu Ananth and Nachiket Mor are, respectively, chairperson of Dvara Research, and visiting scientist at the Banyan Academy of Leadership in Mental Health. These are the authors’ personal views.

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