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Gaps in SME Financing: An Analytical Framework

Executive Summary

Public sector initiatives to support the financing of small firms are best justified if market imperfections result in the private sector not providing capital to firms on competitive terms. Conversely, in the absence of market failure, such initiatives may themselves cause distortions: non-viable firms may be subsidized, at public expense, and may compete with other viable firms. It is therefore essential to determine the extent to which, if any, particular categories of small firms are systematically disadvantaged, rationed, with respect to access to capital. For public policy on this matter to be most effective, it is necessary to develop a widely accepted and empirically supported framework around the notion of capital market imperfections. Otherwise, unfounded perceptions of specific types of financial market "gaps" may inappropriately drive public policy.

To show that a capital gap exists, one must be able to demonstrate that firms unable to obtain financing actually merit financing. Thus, from a general methodological standpoint, the problem posed by gap analysis is to determine the extent to which a particular variable, an "illegitimate" rationing criterion such as size of firm or technology orientation, affects financing outcomes or terms of financing. Thus the problem at hand is to develop appropriate methods for arriving empirically sound, and conceptually defensible, causal inferences with respect to the impact of rationing variables while controlling for legitimate determinants of access to capital.

Therefore, this document presents a review of the empirical and theoretical literature on market failures, gaps, and imperfections. On the basis of this review, this report advances a series of hypotheses that relate to various perceptions of financing gaps that pertain to SMEs. This report then proposes an analytical framework based on the Financing Data Initiative currently being undertaken by Industry Canada, the Department of Finance, and Statistics Canada. Finally, the work outlines steps that might be undertaken in future stages of the Financing Data Initiative to further address the hypotheses and empirical issues described here.

The report begins by noting that there is no consensus regarding the definition or interpretation of the idea of a "gap". Researchers and policy makers must sort through perceptions, differential interpretations, anecdotal evidence, the economic notions of shortages and imperfections, and the extent to which firms may or may not have a reasonable eligibility for particular types of financing.

This report is the culmination work that seeks to advise Industry Canada and its partners with respect to data collection methodologies and analyses of the data. The work:

1. examined the research and professional literature to ascertain the extent to which imperfections in that segment of the market have been identified;
2. advanced, based on the literature reviews, a series of hypotheses regarding gaps or imperfections in the various segments of the financial markets. The hypotheses were articulated to form a basis for empirical testing using data from the Financing Data Initiative.
3. designed and described methodologies to ascertain the existence and importance of gaps, imperfections, and market failures in the Canadian context;
4. reviewed the current state of the Financing Data Initiative to determine the extent to which the initiative is likely to be able to identify gaps in the particular segment; and,
5. suggested changes to aspects of the Financing Data Initiative that will more effectively document potential market gaps.

This study is organized around the two major capital market segments within which SMEs operate: debt and equity financing. Within each of these, the literature on gaps and market failures will be investigated for each of the primary sub-segments: the market for commercial loans, the market for non-bank debt financing, the market for mezzanine financing, the market for informal capital, the market for institutional venture capital, and the market for IPOs. In addition, the work considers the perspectives of suppliers of capital and investigates potential gaps on the demand side of the marketplace. Suppliers of capital, both lenders and investors, have decried a "gap" in the form of a shortage of "investable" opportunities and "bankable" SMEs.

Overall, the SME FDI is currently an extremely valuable initiative. Through appropriate and careful analysis of the data, public policy can be directed yet more efficiently to further improve competitive advantage of Canada's SMEs. In particular, the baseline survey associated with the SME FDI is an extraordinarily valuable research undertaking. It provides the potential to assess directly the extent to which financing gaps might occur in the capital markets on which SMEs rely. This is an important issue in practical terms, in terms of the role of public policy, and in terms of economic and finance theory. The SME FDI baseline survey data provides, for the first time internationally, a means of empirically testing Nobel prize-winning ideas related to information asymmetry and capital rationing. The data provides a means of providing yet better guidance for public policy with respect to addressing potential capital market imperfections that might constrain growth and economic development of SMEs. As designed, the research initiative can and will provide valuable information about these issues.

To derive this information, it is essential that analysis of the data be conducted carefully and, to the extent possible, in ways that provide for unambiguous conclusions. The baseline survey data has several extremely positive features. First, the data are as random a sample of a population of business enterprises as is possible to collect anywhere in the world. Second, through the knowledge and experience of Industry Canada, Finance Canada and Statistics Canada, a comprehensive questionnaire has been designed and data collected in a rigorous manner. Third, the response rate far exceed that typical of surveys conducted by the private sector, arguably eliminating selection and non-response biases. The implications of this effort include that the expense of collecting these data, its quality, and the issues at hand are simply too great to leave to a superficial (and perhaps misleading) analysis.

With this in mind, this study presents a comprehensive review of the theoretical and empirical literature of the issues that relate to this endeavor. It develops testable hypotheses that relate to the issues at hand and presents a variety of empirical tools and approaches for using the SME FDI data to address the issues. Inevitably, the discussion surrounding these tools is rather technical and as with all such empirical analysis, success will depend on the knowledge and vision of the analyst and the available quantity and quality of responses to the survey.

Several suggestions are presently offered with a view to making an extremely valuable start to this work even more useful. These include:

• Adding questions regarding human capital. The human element in all financing decisions is crucial. Without a yet better sense of the education, experience, and other attributes of the owners and managers of the firms, models of access to capital may be susceptible to biases arising from missing variables.
• The inherent iterative nature of this type of research will allow revision of the questionnaire such that some questions might be removed and others added. This report tabulates a series of variables and factors that may need to be better defined if conclusions regarding the impact of certain types of imperfections is to be unqualified.
• Use the baseline survey as the first step in longitudinal analysis. That is, it is strongly urged that the sample, in whole or in part, be followed for a period of time. This would allow:
  
  
  • Increased focus on growth firms. Previous research has shown that rapid growth is characteristic of a very small fraction of businesses and that the owners of many firms do not seek growth at all. Thus, the frequency of high growth firms (so-called gazelles) is rare. By using successive samples, future surveys would be able to increase further the reliability of findings with respect to the financing needs of high-growth enterprises. Successive future administrations of the surveys could advantageously retain growth oriented firms so that, after several administrations, the sample will be relatively richer in terms of the numbers of firms most likely to seek expansion and equity capital.
  • Only through ongoing follow-up can the consequences of financing or turndowns be assessed. Particular issues that are related to longitudinal assessment include, among other advantages:
    
    
    • an improved ability to assess the economic impact of loan guarantee programs and other public policy interventions;
    • documentation of growth and survival trajectories of businesses seeking (successfully and unsuccessfully) various forms of equity capital.
    • development of in-depth case histories of business development and financing experiences;
    • investigation of the linkages between business evolution and the ownership structure and managerial and innovative capabilities of the ownership teams.

In summary, the baseline survey undertaken as part of the SME FDI is a potentially invaluable resource with respect to the design, targeting, implementation, and follow-up assessment of public policy approaches to nurturing SME growth and viability. The outcomes of this research process could help Industry Canada and its partners to provide Canadian SMEs with substantial competitive advantage through policy measures that are yet more precisely targeted, effective, and efficient. It is therefore essential that this valuable resource be used with appropriate and careful study. Analysis of these data may allow for the resolution of several long-standing contentious issues with which policy makers, researchers, lobby groups, and, indeed, SME owners have had to wrestle.

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