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Gaps in SME Financing: An Analytical Framework

Introduction

Canadian business owners, lobby groups, financial institutions, and the popular media have all suggested that particular categories of deserving small businesses have systematically been denied access to capital. The common theme of these positions is that financing "gaps" are present in the capital markets in which Canadian SMEs operate. In addition, academic theorists have drawn on information-theoretic models to suggest that imperfections in the capital markets can indeed lead to certain categories of small businesses being refused capital, and, even to market failure. If the capital markets are subject to such imperfections, it is argued that government intervention is required.

Conversely, others contend that financing gaps, or the inability of some businesses to acquire capital, effectively manifests reasonable business decisions. This argument posits that firms unable to access capital are inherently too risky or otherwise unsuitable for the type of capital being sought. For example, in his empirical investigation of the determinants of UK business startups and survival, Cressy (1995) concludes that,

Given this debate, it is essential to determine the extent to which, if any, particular categories of small firms are systematically disadvantaged 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. According to Brierley (2001), Head of the Domestic Finance Division of the Bank of England:

Public policy initiatives are therefore best served when they are based on clear evidence of market imperfections, imperfections that impede economic growth. Therefore, 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. The empirical challenge is that the impact of such a rationing variable cannot be measured directly. The methodological problem is that numerous other variables can legitimately affect financing-related outcomes (for example, factors such as attributes of the firm or its management). Thus the problem at hand is to develop appropriate methods for arriving at an empirically sound plausible causal inference with respect to the impact of rationing variables that controls for legitimate determinants of access to capital.

Even if a gap is identified, there also remains a substantial debate about the role of public policy interventions, particularly with respect to financial markets. For example, Lerner (1998, p. 773-774) notes that government' efforts, in general,

Vogel and Adams (1997) address this debate by arguing that public policy interventions are justifiable on the condition that they address specifically the particular imperfection, or gap, that is identified. This emphasizes the imperative to pinpoint accurately the nature and position of capital market gaps so that public policy measures can be suitably designed.

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 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 will outline further steps that might be undertaken in future stages of the Financing Data Initiative to further address the hypotheses and empirical issues described here.

What is a "Gap" in a Capital Market?

Before presenting the study objectives and findings, readers are cautioned that the analysis of issues pertaining to a capital market "gap" is complicated by a number of conceptual and empirical challenges. These have been categorized as:

• actual versus perceptual market gaps;
• definitional challenges;
• suitability of capital;
• willingness or ability to pay; and,
• with respect to each of these issues, the perceived role of public policy.

Actual versus Perceived Market Gaps

According to Brierley (2001) it is essential to distinguish between actual gaps or imperfections, and perceptions of gaps. The issue of gaps in the financial markets is therefore complicated because in financial markets it is an accepted industry practice for suppliers of capital to refuse to sell to some potential buyers. Furthermore, a potential buyer of a loan must not only be willing to pay the going price of the loan (e.g., interest rates), but must also satisfy the bank that the capital loaned will be returned. For example, one can think of suppliers of capital as "the purchasers of risky promises to pay" (Hillier and Ibrahimo, 1993). This argument suggests that some firms will be, and should be, denied financing. The observation that some firms cannot obtain capital is therefore not prima facie evidence of a gap. A gap or imperfection may, however, be implied if particular categories of firms that ought to receive financing are systematically unable to obtain it.

Definitional Challenges

The word "gap" does not have a generally accepted meaning. One extreme definition of a gap in economic activity occurs when a market for a particular good or service does not exist. In such instances, the role of government has been the creation of institutions and structures to create certain capital markets where none previously existed (e.g., publicly financed facilities for farmers' markets and initiatives undertaken by the Bank of Canada to facilitate a commercial paper market in Canada).

A related usage of the word gap refers to a shortage: a sense that the supply of the commodity in demand is insufficient and that the demand cannot be satisfied. Economic theory has straightforward meanings for the term shortage (gap) and its opposite, a surplus: a shortage (surplus) exists when the price for the product/service is too low (high). Taking the broad view, there is a "shortage" of everything good - there is just not enough to go around if everyone is to get the quantity each individual would like to have (at zero price).

In terms of economic theory the idea of a gap is usually expressed by the term "imperfection", a factor that impedes supply and demand from clearing with the result that that markets do not function efficiently. For example, imperfections may be conceptualized as a physical (or administrative barriers) such as geography, laws, transactions costs, or regulations that impede supply and demand from clearing. Market imperfections can also the lack of a central meeting place at which suppliers of capital can encounter those seeking financing. The literature postulates that such barriers can be overcome at a cost. For example, Chan (1983) shows that, in theory, the venture capital market may disintegrate if it is costly for venture capitalists to seek out deals.

The more usual imperfection discussed in economic theory are those that relate to information asymmetry. Informational asymmetry is usually theorized to occur when suppliers of capital have less access to salient information than the owners of the firms that are seeking financing. When this occurs, economic theory contends that either adverse selection or moral hazard problems can ensue and that, under some conditions, the market may disintegrate.

Finding appropriate types of capital

The type of financing needs to be suitable to that firm. For example, Brierley (2001) states that,

Willingness or ability to pay

Two related perspectives suggest that: (a) enterprises that need capital are unable and/or not willing to pay the current market price or (b) businesses are precluded from paying a higher price by some imperfection. The first situation is not a capital shortage (gap) in any economic sense but rather a pricing dilemma. The second scenario reflects a capital shortage, as firms are not allowed to increase the price they pay for capital as much as they desire. These problems, when they exist, are real and significant, but using the terms "shortage" or "gap" can confuse the issue.

Scope and Objectives of the Work

Objectives

This report is the final stage of a study that examines existing research to identify imperfections, discrepancies, and potential failures in the financial marketplaces in which SMEs must operate. The goals are to advise Industry Canada and its partners with respect to data collection methodologies and analyses of data. To accomplish the objectives, each of the major sectors of the capital markets in which SMEs operate are examined separately. For each segment, this study:

1. examines the research and professional literature to ascertain the extent to which imperfections in that segment of the market have been identified;
2. advances, based on the literature reviews, a series of hypotheses regarding gaps or imperfections in the various segments of the financial markets. The hypotheses are articulated to form a basis for empirical testing using data from the Financing Data Initiative.
3. designs a gap analysis framework and methodologies to ascertain the existence and importance of gaps, imperfections, and market failures in the Canadian context;
4. reviews 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. suggests 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.

On the equity side, these sub-sectors are:

• the market for informal capital;
• the market for institutional venture capital;
• the market for IPOs.

On the debt side, the study reviews research related to market failures and imperfections (along with the more important public policy initiatives currently in place) with respect to:

• the market for commercial loans;
• the market for non-bank debt (asset-based finance, factoring);
• the market for mezzanine financing (subordinated debt).

For each segment, the work includes a review of the literature that relates to perceived gaps. 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.^{Footnote 1}

The data collection is based on searches of the research literature. The work searched research databases such as ABI-Inform, Ingenta-Uncover, and others. Published proceedings of relevant conferences were examined and, through the good offices of the project authority, relevant government documents were identified and examined.

Report Framework

An important starting point for the report was recent work published by the Business Development Bank of Canada (BDC, 2001). This work postulates that there are four potential "gaps" in the market for debt capital for SMEs and four potential "gaps" in the market for venture capital. Table 1 presents the taxonomy for the various financial markets segments in which SMEs operate. This collection of widely held understandings also provided the research team with an initial series of propositions or null hypotheses that could be tested against evidence from the literature.

^{Footnote 1} Such firms, for example, might well include those with high levels of sales growth. However, some firms may lack the skills to manage effectively working capital and the demands on cash – and therefore for financing – that growth often entails. While such firms might qualify as growth businesses, the lack of management may render them too risky for commercial lenders or investors.

^{Footnote 2} Source: Supporting Small Business Innovation: Review of the Business Development Bank of Canada, Montreal, 2001.

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