#InDevelopment: Forging the right path- the investment gap in agricultural development
There is widespread agreement that investment in agriculture is central to global development. While investment in agriculture is increasing, there remain key funding gaps for early-stage, small and medium enterprises that lie at the heart of developing country agribusiness sectors. How can donors help support sustainable investment in these SMEs beyond simply “plugging the investment gap”? Virginia Schippers investigates why the traditional grant approach to agricultural development just isn’t working, and three principles the development community can adopt to promote sustainable growth of viable agribusiness SMEs and broader agricultural development.
INVESTMENT TRENDS IN AGRICULTURE, THE IMPORTANCE OF SMES AND THE CONSEQUENCES OF PRIVATE INVESTOR CONSTRAINTS
In most developing countries, farming remains the main source of income for people in rural areas. According to the World Bank and FAO, earnings from agriculture make up approximately 30% of GDP across Sub-Saharan Africa, 20% across Southeast Asia, and more than two-thirds of Africans and one-half of Southeast Asians depend on farming for their incomes. Because agriculture is so intrinsically tied to livelihood, food security and poverty reduction, investment in agriculture in developing countries is absolutely essential to broader human development.
In general, agricultural investment across the developing world is increasing, but there remain key funding gaps for early-stage, small and medium enterprises (SMEs). SMEs are essential for sustainable development in the developing world. They have high potential for innovation, as well as the ability to grow indigenous expertise and boost long-term employment opportunities. In short, they are the only long term option.
Unfortunately, the private investor faces many constraints to investing in agribusiness SMEs in developing countries. Investing in this industry is inherently risky. Agricultural production is notoriously unpredictable – particularly in countries with poor infrastructure. Whether you’re in London or Lagos, SMEs always represent potential investment risks: in many cases, these business models are not yet proven, and often require substantial technical or management support to grow and increase revenue. What’s more, in the developing world, business services that help SMEs evolve to a position where they are investment-ready are in short supply.
The reality is, most traditional debt or equity impact investors demand relatively rapid returns, and as such their investment timeframes are often not compatible with early-stage agribusinesses. Due to high transaction costs in sourcing and due diligence, it’s generally not commercially viable for private investors to focus on early-stage firms that can only absorb smaller sums of money. All of these constraints create an “investment gap” for SMEs looking to continue their development and scale their businesses.
The consequences of this investment gap are severe. It prevents new business ventures from investing in innovative products, improving their productivity, financing their growth, covering working capital requirements, and meeting market demand.
Perhaps more significantly, it places wider constraints on the market and threatens the potential for broader economic development. When SMEs are not financed through early-stage development, the pool of opportunities for investors that seek to invest larger sums of capital at later stages of the business development cycle is necessarily reduced. Inevitably, without adequate financing to help broader agricultural value chains grow and innovate, most SMEs will remain in the early-stage phase of development. The consequence of this is clear – the market is stunted and capital will flow elsewhere. In the developing world, this is a potential hammer blow to human development.
THE PREDOMINANT MODEL AND WHY IT'S FLAWED
Traditionally, development funding has sought to plug this investment gap. This is understandable; it’s a quick fix for an important issue. However well-intentioned though, this is a trap to avoid. It is important that the development community does not attempt to make up for a shortfall in investor confidence simply by making its own direct investments where private investors won’t. SMEs cannot achieve commercial credibility if their financial viability is underwritten by short-term funding.
This is an approach taken by some grant programs that use donor money to subsidise businesses that may not be considered commercially viable by private investors. A more effective route would instead see resources addressing constraints faced by the private investors that seek to reach the firms themselves. Without this systemic change, investor obstacles are no closer to being removed.
WHAT CAN WE DO DIFFERENTLY AND HOW CAN WE DO IT?
Clearly then, if the development community has the ambition for large scale impact and sustainability through the development of agricultural sectors, we should adopt an approach that goes beyond just providing isolated agribusiness SMEs with grant funding. Hoping that this money may help businesses scale to the point where they might become commercially viable for private investors is simply not enough. Instead of limited ‘firm-level’ tactics, development programs that take a more nuanced, partner-centric and analytical approach to addressing the underlying causes of investor constraints present a more effective path to positive impact.
1. Mobilise analytical capabilities that enable programs to identify and unlock broader constraints to growth faced by multiple market actors. Unlike programs that are built almost exclusively around large grant pools, these programs are more likely to use a combination of technical assistance and cash. Flexibly deployed, this approach can stimulate and measure systemic change. The correct application of technical assistance and investment in analytical capability has the potential to identify and remove constraints to private sector investment.
2. Adopt a systems-based approach (rather than a firm-level approach) by also channelling resources to help improve the broader investment ecosystem. Although firm-level investments have the potential to help individual companies overcome their own specific obstacles to growth, a systems approach seeks to address broader market constraints through disruptive innovation. By combining capital investment with an active investment approach, systemic change looks more likely. Add in technical assistance, and programs may be better placed to address the specific and unique underlying causes of low productivity and inclusion of the poor in particular agricultural industries or sub-sectors.
3. Build the capacity of the local market actors. In many countries, there is a lack of service providers capable of offering investors pre-investment services in project development, deal-sourcing, due diligence and transaction advisory; as well as post-investment services in consulting and technical support for agribusiness SMEs. Building the capacity of local service providers is essential. If further supported, these providers can deliver their own technical assistance to market actors, thus reinforcing development and innovation. Rather than relying exclusively on international expertise, this approach would potentially benefit a wider market ecosystem by promoting crowding-in.
DRIVING GROWTH AND DEVELOPMENT
Wherever these programs choose to expend their resources, it must be to remove constraints for other private investors to follow-suit. The less effective "road well-travelled" would see programs continue to simply address any given SME’s inability to attract private investment. If these three principles are considered, development programs have the potential to facilitate transformative change in agricultural industries across the developing world. Programs can enable many businesses across the broader ecosystem to innovate and expand, driving growth and development in the market. And when connected to markets, the smallholder farmers integrated in these agribusiness SMEs can generate increased incomes and create a multiplier effect for human development. At its core, success for agribusiness SMEs means sending more children to school, providing nutritious food and financial independence for more families, and stimulating the economy in order to help lift communities out of poverty for the long term – positive impact worth pursuing.
InDevelopment is Palladium’s blog series exploring emerging, cutting-edge and profound themes in global development. You’ll hear from our global experts and guests every two weeks. For more from Palladium’s International Development work follow us on Twitter, LinkedIn, Facebook and at #InDevelopment.