Private equity: A force for SME growthFurther reforms can help the market grow and attract more investments and best practices.
In just half a decade, since the private equity market first broke ground in Nepal, it has provided welcome support to local entrepreneurs. With better access to capital, small businesses can now dream bigger. Private equity funds bring more than money to the table. They help build or grow dynamic, job-creating companies that can be potential game changers, spurring the development of the business ecosystem. For Nepal, this can help stimulate its economy, especially in the face of a global pandemic. Our research shows that 17 million small and medium sized enterprises (SMEs) in the developing countries have unmet financing needs, notably because young, growing businesses lack the track record to qualify for bank loans. So, they require "risk capital"—where there is higher risk tolerance than bank loans—which is hard to access in countries with fragile economies.
In Nepal, where SMEs account for around 98 percent of all businesses and where entrepreneurs consistently rank access to finance as a major obstacle, private equity could play a crucial role in driving growth. In fact, for startups and SMEs with high growth potential, private equity can turn out to be a better deal than a commercial bank loan. This is because the former has a stronger shared interest in ensuring the business does well and is sustainable.
To elaborate, in a typical private equity investment, a fund initially acquires a minority or majority stake in a company and, with the goal of improving and expanding the business, plays an active role in managing it. However, this can also be an obstacle against the wider use of private equity in SMEs as entrepreneurs could be reluctant to relinquish control of their business. But when leveraged properly, private equity investment increases the company’s value, provides resources and expertise, and gives it a long-term future. Additionally, its shareholder value can be boosted when the fund sells its stake at a profit when exiting. A lot depends on the stage of the company, amount of stake acquired by potential investors, and how they decide to add value. Increased capital at any stage can help companies ramp up innovation, productivity, competitiveness and job creation.
Prior to the pandemic, SMEs contributed 22 percent of Nepal’s gross domestic product while employing over 1.7 million people, according to a report by Nepal Rastra Bank. Given that measures to tackle the Covid-19 pandemic are draining existing funding sources, supporting private equity funds can provide an accountable, cost-effective and sustainable market-based solution where risk capital can have a lasting impact. Apart from bringing in knowledge and expertise, these funds help companies strengthen their environmental, social and governance standards, leverage latest business and technology trends, and enhance other key drivers of business success.
Currently, there are more than 10 institutional investment firms in Nepal that have private equity-like structures, including Dolma Impact Fund, Business Oxygen (BO2), Truth North Associates and One to Watch. Given the early stage of the industry in Nepal, the operating funds (with a combined capital of approximately $100 million) are smaller—compared to other similar emerging economies.
Several factors are responsible for this limited pool of funds. Private equity is still a new concept in Nepal and banks remain the major source of capital with other commercial investors yet to enter the market. Moreover, most entrepreneurs lack a proper understanding of private equity and the resulting entry of new stakeholders which dilutes their own stake—thus making them cautious when investors approach them. But such doubts can be resolved in the initial stage, when negotiation on cash flow, board composition, liquidation, voting and other rights takes place. Further, despite Nepal’s recent efforts to initiate a Specialised Investment Fund regulation, the absence of an adequate regulatory framework for private equity or venture capital funds discourages Nepali institutional investors.
Keeping a range of similar issues in most developing nations in mind, International Finance Corporation (IFC), together with partners, created the SME Ventures programme in 2008, an innovative programme that provides risk capital in the form of debt instruments, quasi equity, and equity alongside technical assistance to entrepreneurs and fund managers in the world’s most challenging markets. IFC is one of the largest investors in private equity funds in emerging markets, with more than $5 billion invested in 280 funds. These funds have invested in more than 100 SMEs—from restaurants and call centres to clinics and digital ventures—creating thousands of jobs.
In Nepal, as part of the SME Ventures programme, IFC invested in Business Oxygen (BO2)—the country’s first private equity fund—between 2015 and 2017. BO2 has made equity investments in 17 SMEs across sectors, creating hundreds of jobs. BO2 has already successfully exited from two companies. Another industry leader, Dolma Impact Fund, has been investing in renewable energy, health care and technology since 2014. Its portfolio comprises one of Nepal’s e-commerce pioneers Sasto Deal as well as artificial intelligence service provider Fusemachines Inc, among others. This year, IFC invested $10 million in Dolma Impact Fund II, totalling its investment in the sector to $24.3 million to date. Beyond private equity, IFC has also invested in financial institutions, including micro-finance to provide financing for SMEs in Nepal. As Nepal focuses on a resilient recovery, private equity can play a critical role to strengthen SMEs, a key engine of growth, and rejuvenate the economy by creating jobs and attracting greater private investment for an inclusive and sustainable future.