2. IFC Support for SMEs Highlights  IFC identifies SME support is a strategic objective based on job creation potential.  IFC’s TSME portfolio is significant, constituting 17 percent total projects and 16 percent of commitments.  Most IFC investment projects do not define SMEs or root SME support in a clear theory of change that would connect the intervention to correcting a market failure.  The most credible theory of change underpinning much of IFC’s TSME support lies in its contribution to developing sustainable private markets for SME finance, rather than the direct benefits it delivers to firms. IFC is most effective when it works strategically through its targeted investments, often in conjunction with more systemic approaches, to expand the supply of SME oriented financial (or other) services, increase competition, and improve market functioning.  IFC’s relevance is greater when it operates at or near the frontier.  Many clients value IFC’s support, professionalism, and standards, especially when it is able to tailor its products to their needs  TSME projects were generally less successful than the overall portfolio and the rest of the financial markets portfolio. However, these projects improved their performance over time.  In general, IFC lacks sufficient monitoring and evaluation information about its TSME projects to truly understand their development impact, both in terms of beneficiary impact and impact on market development.  IFCs TSME advisory services overall have performed better than the rest of the advisory portfolio, except in low-income countries. 

Rationale IFC has had a long-standing commitment to the support of SMEs, starting with the establishment of its first project development facility more than 30 years ago, and most recently manifested in its Roadmap for FY14-16. Over the course of three decades, it has shifted its focus from direct assistance to SMEs to indirect assistance to financing SMEs through commercial banks and financial institutions. IFC began providing direct technical assistance to SMEs in the 1980s through its donor-funded project development facilities, and then started financing them directly in several parts of the world. The technical assistance was tailored to help SMEs access finance by helping companies develop sound investment projects and find financing from banks for these projects. In parallel with the project

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development facilities, IFC set up small pools of funds (about $100 million in total) to support direct SME investments mainly in Africa and the South Pacific.18 IFC learned several lessons from its experience in providing direct assistance and financing for SMEs. From a financial standpoint, IFC's experience was disappointing. Although the amounts involved were relatively small, their gross non-accrual rates were much higher than IFC's portfolio as a whole. Also, the success rate of advisory services offered through the project development facilities and cost recovery were limited (Cohn 2004). Generally, only a small proportion of clients provided contributions, which were often very small compared to the overall costs of the programs. Even though the services were essentially free, IFC's SME clients were dissatisfied with the lack of local knowledge of many IFC technical consultants, and donors funding these programs were uncomfortable about use of their funds to assist what IFC defined as SMEs but what they saw as large companies in many developing countries and the high overhead costs of IFC's advisory operations. With regard to facilitating SME finance through financial institutions, IFC first started investing in banks in FY94, mainly in the Latin America and the Caribbean Region. IFC’s Global Financial Markets Department used the SME focus to justify its assistance to commercial banks in middle-income countries, especially in their frontier markets, and in IDA countries. IFC made the case that frontier markets existed even in large middle-income countries, given regional disparities, and that investing in financial institutions that targeted SMEs in specific areas had an important development impact. Working with financial intermediaries allowed IFC to support far more MSMEs than it would be able to support on its own, and it enabled IFC to meet its targets on reach indicators such as the number and volume of loans to SMEs. In addition, portfolio performance improved. To further address these concerns, IFC introduced the Private Enterprise Partnership (PEP) model in the former Soviet Union countries in 2000 and then expanded it to other regions. PEP consolidated IFC’s existing large Advisory Services program in the Commonwealth of Independent States to install a more specialized management structure and to address donor requests for a long-term IFC commitment to the region. PEP management was organized by core product areas; their objective was to deliver Advisory Services in financial markets, corporate governance, business enabling environment, linkages with large firms, and SME development. PEP became a model for a number of multidonor, regionally focused project development facilities. In recent years, IFC has done much to mainstream facility staff and standardize core products in its advisory services.

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STRATEGIC UNDERPINNINGS IFC’s FY14–16 Roadmap states as one of its five objectives developing local financial markets through institution building, the use of innovative financial products, and mobilization, focusing on MSME). It emphasizes the job creation potential of SMEs, which “may account for up to four-fifths of job creation and two-thirds of employment in developing countries.” This has become an often repeated phrase used to justify SME interventions by IFC, yet its own jobs study arrives at a much more nuanced conclusion, characterized in the Roadmap as follows: In general, while MSMEs tend to have higher rates of job growth in developing countries, larger companies provide more sustainable jobs, are typically more productive, offer higher wages and more training, and support a big multiple of the direct jobs they provide through their supply chains and distribution networks (which in particular provide opportunities for the poor) (IFC 2013b). Read through the lens of longitudinal research on job creation, this means that although MSMEs create more jobs, net job creation is not necessarily higher because more firms exit the market. The jobs study provides no grounds on which to differentiate firms by size beyond addressing systemic constraints that may disproportionately handicap a particular class of firms’ ability to generate employment. In this regard, access to finance, power supply, and informal competition are especially highlighted as constraining SMEs, based on enterprise surveys. In particular, the Roadmap states that SME finance can result in significant job growth. It calls for a customized strategy: “Using a job lens in country, regional, or sectoral strategies can help identify key constraints to job creation in specific contexts, since jobs challenges differ.” Only some of the key constraints to SMEs will be connected to the TSME portfolio, whereas others, such as support for broader financial sector reforms, electric power investments, and regulatory reform, may not. Many of these constraints, though, are addressed through other IFC or Bank Group instruments. Looking forward, from the point of view of jobs creation, this suggests the need for country-specific diagnostics to identify leading constraints to job creation in firms of all sizes, in multiple sectors, and in both leading and lagging regions. It also highlights the importance of amending existing metrics such as enterprise surveys and subnational Doing Business reports to provide sufficient information to shape strategy and project interventions.

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IFC Investments for Targeted Support to SMEs INVESTMENTS PORTFOLIO OVERVIEW Figure 2.1. Distribution of IFC TSME Portfolio, by Number of Projects

Source: IEG portfolio review. Note: FM = financial markets; TSME = targeted small and medium-size enterprise.

The portfolio review, which covers projects approved FY06-12 (see Figure 2.1), finds that 17 percent of IFC’s overall portfolio in terms of number of investment projects and 16 percent in terms of value can be classified as targeted SME. IFC investments that supported SMEs during this period were primarily indirect—by financing institutions (banks, funds, risk guarantee facilities, and so forth) that support SMEs, IFC has increased access to finance for SMEs, enhanced the financial system’s capacity, and built or strengthened financial markets in SME financing. This product line, which facilitates SME finance through financial institutions, constituted 55 percent of projects and 74 percent of net commitments for targeted SME support in dollar terms. Within this product line, loans to banks accounted for 73 percent of projects (representing 65 percent of commitments), equity investments in banks accounted for 15 percent of projects (representing 18 percent of commitments), and the remaining 12 percent of projects (representing 18 percent of commitments) were combined loan and equity investment projects. Other significant product lines include equity and venture capital funds aimed at financing SMEs (representing 18 percent of targeted SME projects and 14 percent of TSME net commitments), partial credit guarantees (representing 6 percent of TSME projects and 4 percent commitments), and leasing (representing 8 percent of TSME projects, and 5 percent 36

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of TSME net commitments). Direct investments in SMEs, largely rejected in the early 2000s as a strategy for targeting SME support, has dwindled to less than 1 percent of TSME net commitment value, although numerically it still accounts for 10 percent of projects. In terms of industry composition, TSME investments were overwhelmingly focused in the financial markets industry group, which accounted for 97 percent of the total value of commitments to TSMEs. By number, 10 percent of projects were in manufacturing, agriculture, and services (MAS), but these accounted for only 2 percent of commitment value (see Figure 2.2). Figure 2.2. Distribution of IFC TSME Portfolio, by Commitment Value ($ millions)

Source: IEG portfolio review. Note: FM = financial markets; TSME = targeted small and medium-size enterprise.

The product mix is somewhat different in different countries. Most IFC TSME commitments were in upper-middle-income countries and heavily focused in the Europe and Central Asia Region (Figure 2.3). Low-income countries benefited from less than seven percent of TSME investments committed in the 2006-12 period, whereas lower-middle-income countries received 31 percent of commitment value. Overwhelmingly, the TSME investment portfolio is focused on financial markets.

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Figure 2.3. Distribution of IFC TSME Investment Portfolio by Industry Group, Region, and Income Level, by commitment value ($ millions)

Source: IEG portfolio review. Note: For figures 2.3 and 2.4, country income status is determined as of 2013. The “high income” countries category includes mostly countries that “graduated” to high income status from upper middle income status after project initiation, including Chile (2012 graduation), Lithuania (2012), Oman (2007), Russia (2012) and Uruguay (2012). Saudi Arabia graduated in 2004. Note: Income level and regional figures exclude "regional" projects ($1,116 million) and industry figure excludes GPD ($1 million).FM = financial markets; Infra = infrastructure; MAS = Manufacturing, Agriculture, and Services. Regions: AFR = Africa; EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MNA = Middle East and North Africa; SAR = South Asia.

Figure 2.4. Portfolio Distribution by Country Income Level (commitment value, $ millions, 200612)

Source: IEG portfolio review.

The story by number of projects is somewhat different: Europe and Central Asia remains the region with the most projects (32 percent); Africa is the second leading

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region with 21percent of projects. Over two-thirds of projects are in middle income countries, roughly evenly divided between upper- and lower-middle-income. Seventeen percent were in low-income countries and 11 percent in high-income countries. Eighty-six percent of projects were in financial markets. Organized by income level and as measured by either number of projects or commitment value, leasing, financing of banks to on-lend to SMEs, and risk sharing facilities levels are the highest in upper-middle-income countries. By contrast, the prominence of projects utilizing equity or venture capital funds is highest in lowermiddle-income countries (Figure 2.4). This may indicate that the legal and financial regulatory systems in higher-income countries are more amendable to risk-sharing facilities and lease finance. However, the heavy emphasis on on-lending in highand upper-middle-income countries seems to be in direct contravention to the logic of using resources to redress poorly developed capital markets. Although even wealthy countries may have lagging regions, banking is generally far more developed in upper-middle- and high-income countries. Survey data indicate that SMEs in these countries are much more likely to already have access to bank finance. The likelihood of crowding out private sources of capital is also greater in these better-developed capital markets. Furthermore, it is not clear how providing longer-term foreign exchange financing to banks—often on terms better than those prevailing in local markets—helps in the development of the financial markets or increases the availability of local currency funding for SMEs. RELEVANCE OF INVESTMENT PORTFOLIO Who is targeted? For the TSME investment portfolio to be relevant, projects should be relevant to the defined beneficiaries and connected to some defined challenge they are seeking to resolve. IFC has clearly defined its standards for what constitutes an SME, although that standard has questionable relevance in some country contexts. However, whether or not the standard is ideal, IEG’s review finds that it is generally not applied (see Table 2.1). An IEG review of 250 Board documents of TSME investment projects found that 82 percent contained no definition of SME.19 A further 7 percent had a definition higher than the standard IFC criteria, and 4 percent contained a definition with thresholds lower than IFC official criteria. For example, for an on-lending project for a Brazilian bank, IFC’s loan agreement defined eligible subborrowers as companies with sales of no more than 300 million Brazilian reals (about $140 million at current rates). Thus, only 6 percent of IFC’s portfolio (14 projects) defines SMEs in accordance with IFC’s established criteria. A review of 166 legal agreements for IFC TSME investment projects in the Financial Markets line shows that only 38 percent contain a definition of SME in their legal 39

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agreement (Figure 2.5). Furthermore, 60 percent of projects that say they are targeting SMEs have no provisions mentioning SMEs as beneficiaries. Overall, only 20 percent of the targeted SME Financial Markets portfolio both define SMEs and have provisions mentioning them. Comparing 2006-09 with 2010-12, the percent of projects without definitions or provisions actually increased, driven by a sharp decrease in 2010. Failing to define SMEs or add specific provisions can increase the risk that clients do not adhere to the intention of projects (Box 2.1), whereas specificity can strengthen the focus of lending on SMEs (Box 2.2). By contrast, the use of SME monitoring indicators has grown dramatically. IEG’s review of IFC investments suggests that 80 percent committed since 2006 had TSME monitoring indicators. These indicators became far more prevalent after 2005, rising from 7 percent of projects committed before 2006 to the current 80 percent level. IEG believes this reflects the widespread use of reach and Development Outcome Tracking System indicators, which made such monitoring mandatory in certain types of projects. For financial institutions, these indicators generally track loans of less than $1 million, although for over 20 countries, they track loans of less than $2 million.20 However, it is not at all clear that these monitoring data are being used as a management, learning, or accountability tool.21 Table 2.1. Definition of SME in IFC TSME Board Documents SME definition in Board report

No. of projects

% of projects

Not defined Greater than IFC criteria IFC criteria Less than IFC criteria Average loan or loan proxy (