Can Crypto Solve the $4 Trillion SME Financing Gap?

Hey everyone.

Welcome to the Portico Podcast. This is Mike Casey, the founder of Portico Advisers and your host.

Today’s episode is going to be a little different.

I was recently invited to give a lightning talk on a topic that’s been capturing much of my mindspace of late: whether crypto can be a better technology for capital formation than legacy options, such as banks, capital markets, and non-bank financial intermediaries.

I’ve spent most of my adult life working on the problem of access to capital in the so-called ‘emerging’ and ‘developing’ economies. 

So, I focused my presentation on the $4 trillion financing gap besetting small and medium-sized enterprises ( — or SMEs — ) in these markets.

That said, I think an open, permissionless protocol for capital formation would be a boon to innovation and entrepreneurship everywhere.

My talk is freely available on YouTube and you may also download a copy of the deck from Portico’s website — links to both are below in the show notes.

But I wanted to tweak it a bit for an audio-first audience and share what I’d like to build.

Send me a note at mike@porticoadvisers.com and let me know what you think!

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Alright, so the question I have is: can crypto solve the $4 trillion SME financing gap?

So, I *think* it can, and I’ll try to explain why.

I’m going to discuss four items.

First, I’ll talk about the problem — what it is, where it is, and why it exists

Second, I’ll discuss the shortcomings of existing non-bank intermediaries, with a focus on private equity funds. PE firms have tried to fill the financing gap — largely with the support of the development finance institutions — but they have generally failed to deliver solutions at scale.

Third, I’ll point out crypto’s potential solution to the problem.

And finally, I’ll lay out some challenges that could throttle the development and adoption of such a solution.

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So what is the problem?

In a nutshell, more than 130 million businesses in developing countries have an unmet demand for financing of $4.75 trillion

Now, anytime people talk about trillions of dollars, it gets a bit nonsensical and absurd, but these figures can give us confidence that this is a pretty big problem

Of those 130 million businesses, 115 million are micro businesses that employ fewer than 10 people. 

Despite representing 90% of financially constrained businesses, they account for only 13% of the financing gap, or approximately $600 billion

By contrast, roughly 13 million SMEs — defined as businesses that employ between 11 and 250 people — account for more than 85% of finance gap when measured by dollars

I am going to focus on this segment — the SMEs  — as it has the greatest capital requirements, 

But it should be said that there’s no reason why it wouldn’t apply to micro businesses

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Alright. That’s the problem. Where is it?

One answer is: a handful of countries. 5 economies represent 68% of the unmet capital needs

And two of these — accounting for half of the market opportunity — are effectively off-limits:

China, with a closed capital account, a command credit system, and copious restrictions on foreign investment and crypto

And then Russia, which is sanctioned

The other answer is: it’s everywhere

In every country — and I want to stress this … including in so-called developed markets like the United States  — there are enormous unmet capital needs and underserved populations.

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So why does this massive finance gap exist? 

The first challenge pertains to local banking systems — and this challenge takes two forms.

First is outright access to banks — despite advancements in fintech and financial inclusion, it remains exceedingly difficult for companies to secure loans.

And the second is that the banks themselves are quite risk averse. In general, they extend plain vanilla loans … engaging in asset-backed, collateral-based lending ... and they eschew cash-flow-based lending 

And this dampens the availability of credit

The other piece is that local capital market development has been extremely disappointing

To illustrate, real GDP in IDA & IBRD countries — which is World Bank speak for low- and middle-income countries — grew by 178% in the two decades since the year 2000, representing an incremental growth of $21 trillion

In contrast, the number of listed companies in these markets grew by only 25% 

So capital market development has lagged far behind the pace of economic growth

——

So local banks aren’t fit for purpose and most businesses are locked out of local capital markets

Many people — myself included — believed private equity funds could fill this financing gap, providing expansion capital as well as human capital and business-building expertise

Alas, private equity has generally proven to be a disappointment in emerging markets

But I want to highlight three key shortcomings — each of which has cascading consequences for capital formation

The first is that PE firms raise capital from institutional investors

·       These investors take a long time to make decisions — fund managers are taking two to four years to close their funds in Latin America and Africa, respectively

·       Also, there is a mantra these investors tout about needing to have a local presence to invest well; I won’t deny that strong local knowledge and networks are vital; however, this lust for “boots on the ground” leads to an over-indexing of country-focused managers that ignores the conflicts of interest that may be at play amongst local elites; moreover, most of these investors are lemmings, jumping into markets when they're priced for perfection and their currencies are overvalued

·       Finally, because these institutions write large checks, it incentivizes private equity firms to scale rapidly and pursue large deals, leaving the SME segment unfinanced

The second shortcoming is exit risk

·       Recall the discussion a couple minutes ago re: anemic capital market development; well — that has constrained managers’ ability to exit investments; which isn’t an excuse, mind you — most managers, candidly, may be good at selecting deals but they have lacked the discipline to exit investments and take money off the table during follow-on rounds

·       And this poor performance has led to billions of dollars of trapped capital in so-called Zombie funds — firms that are unable to raise a subsequent fund … with the follow-on effect that the lack of distributions means institutions can’t recycle money into new funds that could invest in other SMEs

Finally, the third shortcoming is these vehicles are expensive

·       They contain substantial fee drag — not only with management fees, but also through transaction and monitoring fees — that can enrich managers at the expense of investors

·       In addition, the quality of reporting varies across managers, with investors frequently relying on e-mailed Excel spreadsheets for quarterly updates

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Okay. 

So, if local banks aren’t going to lend at scale, local capital markets aren’t developing, and private equity funds aren’t fit for purpose, what’s the answer?

I think it’s an open, permissionless protocol for capital formation

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In principle, I think crypto can solve the problems we just discussed.

First, crypto rails enable a shift to individual investors that should lead to faster decision-making, enabling capital to get to work faster.

It also opens up the universe of investors to just about everyone, just about everywhere. 

And this expansion of the universe of investors also increases the odds of an SME finding the right size of funding for their requirements, as well as an investor to find a company with an attractive financial and even impact return profile.

Second, it significantly reduces exit risk — the tokens investors receive in return for their investments are liquid effectively immediately, convertible to stablecoins or crypto currencies on a DEX … admittedly pricing might be a challenge given the size of the liquidity pool — but that’s a subject for another time. 

In addition, the tokens would be able to receive airdropped dividend payments, and embed structure (such as liquidity preference or seniority in the cap structure) that would automatically and instantly convey to new owners when transferred.

Third, tokenization could also create greater alignment and transparency. With respect to alignment — the tokens could alleviate the principal-agent problem and even drive value creation (through, for example, leveraging the network of token holders to reduce marketing spend or CAC, and drive revenue growth). 

Tokens could also provide access to pecuniary and non-pecuniary benefits (such as limited-release products, discounts, exclusive content, etc.). 

Finally, assuming there are oracles mapping real-world activity to the blockchain — a big assumption — owners could audit the business’s cash flows in near-real time and map it to the stated strategy and priority objectives.

———

Now, that is an optimistic view — the challenges are many and immense

The biggest macro challenge is the question of crypto adoption, which effectively governs the total number of businesses and investors that use the protocol

And candidly, the space is teeming with scams and scumbags — some of which get backed by tier-one VC firms — so the demonstration effects are working in the wrong direction

But three that are specific to the protocol in question are regulation, aggregation, and validation

The most obvious one is regulation — these effectively are security tokens, and when you multiply the complexity of regulation across scores of jurisdictions, your brain explodes

You also face the problem of aggregation — getting companies and investors to use the protocol

Last but not least, you face the problem of validating that the participants in the protocol are legit. 

Part of this is tied to the development or implementation of oracles that bring meatspace data onchain. 

But I think it also requires the development of a tokenomics that can leverage extant networks of professional advisors, intermediaries, and investors to:

(a) originate investments, 

(b) hold them accountable for the quality of the deal flow, and 

(c) allow them to participate in the upside of the business in question.

———

But the beauty of an open, permissionless protocol is you don’t have to solve all these problems, everywhere

It’s extensible, so people can develop innovative solutions across jurisdictions —  leveraging the underlying protocol that facilitates the flow of funds to entrepreneurs who are building all around the world

You know, several years ago I saw the head of International Finance Corporation bang the drum on the need to mobilize trillions of dollars to attain the Sustainable Development Goals. I wrote a piece about it at the time, called “Trillions” in which I suggested that this thirst for large-scale solutions was likely to exacerbate the financing gap for SMEs.

I would submit to you that — in a world polluted with large institutions trying to jam through top-down solutions at enormous scale — the answer lies in decentralization, emergent origination, and the aggregation of small investments at global scale.

——

So that’s my view — I hope it was thought-provoking and maybe even inspiring … would love to hear what you think.

Hit me up at mike@porticoadvisers.com or you could try me on Farcaster @mc or twitter @mcaseyjr