Directed Lending to SMEs: Current practices and challenges
One way of targeting investment to the businesses that need it the most is through an approach known as ‘directed lending’ (DL). It is a tool increasingly used by development finance institutions (DFIs) in recent years and involves lending to financial institutions so that they, in turn, lend to specific types of customer. MSMEs is the most common DL customer segment.
On June 23rd, the SME Finance Forum organized a webinar to share the findings from a CDC/GBRW study about Directed Lending practices across the DFI community, and to stimulate discussion on that type of lending activity.
The findings presented in GBRW’s study are based on interviews with nine DFIs in the second and third quarter of 2020, supplemented by a review of publicly available documents. The DFIs interviewed included three National DFIs and six Multilateral Development Banks.
Key Features of Direct Lending
DL is defined by DFIs as “term loans extended to financial intermediaries with a defined use of proceeds” The targeted use of proceeds is defined in the loan agreement through eligibility criteria for the Sub-loans and/or Sub-borrowers (e.g. SMEs, female entrepreneurs or climate -based projects) and key performance indicators (KPIs).
In addition to the term financing facility to the Participating Financial Institution (PFI), DL might include technical assistance (TA) such as capacity building and financial incentives (for example a margin reduction or a grant). DL operations also involve:
Impact monitoring and assessment: Reporting on sub-loans depending on their type and expected number, monitoring to confirm the use of proceeds towards sub-loan, and the impact of the line based on the PFI's reporting. Verification may also be required to ensure the eligibility criteria for Sub-loans are correctly applied by the PFI.
- Impact governance and PFI performance: PFI commit to deploy the DFI funds towards Sub-loans as expected. To align size of facilities with expected volume of Sub-loans, they can be tranched and period of availability adjusted. In case of failure to use best efforts/commit resources, the lack of disbursement may eventually lead to an event of default / mandatory prepayment.
Why do DFIs do Directed Lending?
DL aims to improve access to financing for projects or customer segments with high development impact (incl. meeting SDG). DFIs can achieve this by:
- Accessing eligible projects or customers in the target segment at scale by lending through financial intermediaries.
- Building capacity within the PFI itself so that it can provide the financing required by the target segment sustainably.
- Selecting the right PFIs that has a strategic commitment to the targeted client segment.
- Providing additional funding (e.g. longer maturity).
Why could financial institutions find DL facilities attractive?
Support for its strategy: PFIs can find support from its partner DFIs in entering a new market segment, or developing their exposure: e.g. market standards, experience sharing, TA, support in implementation.
More adapted terms: DFIs have strong credit ratings and higher risk appetites than their private sector counterparts, meaning that they can offer more adapted terms: longer tenors, currency, availability period, competitive interest rates. DFIs also tend to play a countercyclical role, financing during economic downturns.
- Technical assistance: DFI financing may be accompanied by technical assistance. Technical assistance can help financial institutions to access new market segments and to address wider institutional issues. Capacity building can also be offered to the level of borrowers/sub-lenders to improve performance and accelerate sustainability practices.
- Financial incentives: DL facilities may benefit from concessional elements when required to achieve the development impact (e.g. overcome market constraints) or mitigate a perceived higher risk.
- The ‘Halo Effect’: DFI financing demonstrates that a financial institution has successfully undergone a detailed due diligence process. The financing relationship may also provide the financial institution with access to valuable intellectual resources through DFI contacts, seminars and other knowledge sharing events.
Direct lending facilities are helping DFIs working with financial institutions around the world have a real impact in terms of SME access to finance and growth. The core objective of DL is to achieve an end-state where the PFI can continue lending in a sustainable manner once the DFI funding and incentives are withdrawn. DFIs need to find a way to work together to offer more sustainable finance through DL in particular to MSMEs which have a big appetite for green finance.
The speakers who participated in that webinar discussion were:
- Wasim Tahir, Financial Institutions Sector Strategist at CDC Group.
- Thomas Girod, Financial Services Debt, Investment Director at CDC Group.
- Paul Rex, Managing Director at GBRW.
- Philippe Belot, Director at GBRW.
- Mariana Chamorro, Investment Manager at DEG.
The CDC/GBRW study can be found here: Direct-Lending-Current-Practices-and-Challenges.pdf