Banks and Entrepreneurship in Africa

I’ve been studying how the financial sectors of most Sub-Saharan African economies work; particularly how their lending practices influence patterns of entrepreneurship.

When I started the ad hoc study, I made the mistake of examining them through the frame of reference of an economist; I looked more at numbers and statistics than stories. Because of this, I got lost in the complexity of numerals and I missed the dynamics that were at play.

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Sub-Saharan African countries have got some of the highest Gini coefficients in the world; incomes (and assets) are generally concentrated in the hands of a few, see the chart below (2011 data):

Click on illustration to Zoom in

As a risk mitigation measure, banks prefer to lend money to entities that own assets that can be collaterized; i.e. bank funding can only be accessed by a few entities (owing to the above-mentioned inequality). In this blog post, these "few entities" will be termed the "asset-rich".

At the opposite end of the spectrum, are the marginalized "asset poor". Banks don't cater to their needs for capital, and, the capital markets in most Sub-Saharan African economies lack the depth and sophistication that would allow the “asset poor” to access funding.


 ...The Questions I had when I was studying Sub-Saharan Financial Sectors

What happens to the capital that is accessed by the "asset-rich entities"? And, how do entrepreneurs without assets access capital? 

I thought that these were two distinct questions; until I studied the recent bank failures in Zimbabwe.

When the "asset-rich" get loans from the banking system, they do either of the following:

• Use the loans to finance the expansion of their ventures. There are, of course, natural limits to this (The Law of Diminishing Returns). [1]
• Hunt for start-up entrepreneurs who require funding. They can either "bolt them onto their corporate infrastructure" or acquire preferred equity stakes in the ventures (or convertible debt). To do this effectively, the asset-rich require competences in talent spotting and the identification of emergent trends.[1]

...The Hierarchy of Asset "Irreplaceability" 

Generally, the assets of a venture have the following hierarchy of "irreplaceability":

Click on illustration to Zoom in

By and large, Money and Physical Assets tend to be easier to replace than Human Capital and Social Capital: From a value-generating standpoint, Human Capital and Social Capital tend to be superior to Money and Physical assets.

Nascent ventures tend to possess more Human Capital than; Social Capital, Money and Physical Assets. In most cases, Money and Physical assets are the scarcest "assets" in start-up ventures. Without Money and Physical Assets, the value-generating potential of Human Capital and Social Capital remains dormant.

Therefore, to unleash the value-generating potential of their Human Capital and Social Capital stocks, start-up entrepreneurs tend to partner "asset-rich" entities (in a bid to access funding).


...It's a Buyers' Market

There are generally more start-up entrepreneurs with great ideas than there are asset-rich entities with access to funding (i.e. the opportunity cost of capital is high) [2]. If one takes the start-up entrepreneurs as sellers of investment opportunities and asset-rich entities as buyers of investment opportunities, the market for start-up funding can best be described as a buyers' market. Otherwise stated, the Human Capital and Social Capital of start-up ventures in most Sub-Saharan African markets tends to be undervalued in most capitalization agreements that they enter into (with "asset-rich" entities). Hence, in equity capitalization transactions, start-up entrepreneurs end-up with much less equity in their ventures than they "deserve" (as determined by the Hierarchy of Irreplaceability Principle, i.e. the more Irreplaceable an asset is, the higher its value).


...Scaling-up Operations and the Reduction of Bargaining Power

For start-up ventures to scale their operations, two things have to occur:

1. The skills and knowledge of the entrepreneurs have to be transferred to, and supplemented by the skills of their employees. This process unleashes more human capabilities for use in expansion.
2. The tacit knowledge of the entrepreneurs has to be codified and embedded into the ventures' business models, operations, systems and processes. This process makes it possible for ventures to apply, in a scalable fashion, efficiency-enhancing management techniques like Total Quality Management (TQM).

Owing to the above-mentioned factors, the "irreplaceability" of the ventures' Human Capital stocks diminishes (refer to the second illustration). When this happens, the relative bargaining power of the entrepreneurs, vis-à-vis the bargaining power of the asset rich entities, diminishes.


...What effect does this have?

When the start-up ventures are in the high growth phase of their respective business lifecycles, they tend to require regular incremental fixed and working capital injections to shore-up their operations.

To minimize the risk in their capital structures, most of these start-up ventures prefer to use equity funding to bolster their operations. The avenue of choice for equity financing tends to be a rights issue, which generally tends to be associated with the following chain of causation:

Click on illustration to Zoom in

As the illustration above shows, in such scenarios, start-up entrepreneurs' equity holdings tend to be progressively diluted with every rights issue that occurs. Eventually, the people who benefit most from entrepreneurs' talent tend to be the "asset rich" entities [3].

Clearly, this doesn't bode well for the incentivization of entrepreneurship.


...What can be done to remedy this?

To remedy this, Africa needs:

1. Financial sector reform.
2. Deep public debt markets that increase the efficacy of financial intermediation.
3. A high-yield bond revolution that is akin to Mike Milken's "Junk Bond Revolution".

[1]  The Zimbabwean bank failures that recently occured materialized because Zimbabwean asset-rich entities did not quite get the Law of Diminishing returns and they did not have competencies in talent spotting and the identification of emergent trends. Owing to this, they lost money in their ventures and they were unable to repay the banks. 
[2]  The asset-rich have got a preference for different types of opportunities, they include; 1) Opportunities that generate a positive ROI quickly - these tend to be prefered by entities with a short term outlook and high risk aversion, 2) Opportunities that will remain profitable even if Zimbabwe returns to great turbulence - these tend to be preferred by entities that seek "all-weather returns" and 3) Investment oppetunities that will profit if Zimbabwe becomes stable - these tend to be preferred by entities with a positive outlook.
[3]  These asset-rich entities end-up being called "serial entrepreneurs" or "magnates". And, everyone admires them for their "entrepreneurial talent" that spans across different sectors and industries.