SME Finance: Looking for Growth in All the Wrong Places

Ask most anyone in Washington, DC about what to do to improve the United States’ economic condition and chances are they will say to help “small business.” Yes, a number of studies say that small and medium-sized enterprises, or SMEs, have been largely responsible for not just U.S. job growth since the 1980s but also much of the innovation since that time. The question is what specifically is needed to help small business.

In Washington, the mindset, not surprisingly, is that SMEs need better access to credit. Of course government officials would think that; after all, the federal government has borrowed nearly $5 trillion of investment capital since 2008 to cover its own deficits, capital that might have been productively put to use by many, many small, medium, and large businesses.

And because this is Washington, any effort to help SMEs will have to overcome, compensate for, or even contradict some other policy or policies that are already on the books. In this case, there are several, beginning with those of banking regulators whose efforts to increase lending standards — a laudable if belated effort— has combined with the abysmal performance of the banking industry’s legacy mortgage portfolio to bring SME and most other lending to a drip.

Dodd-Frank Draining Resources
Dodd-Frank has had its own harmful effects on SME finance, as well. It imposed higher systemic regulatory oversight for the venture capital industry under the view that these entities had the potential to undermine the global financial system in the same way that big banks or leveraged hedge funds could.

Then there is the fiscal drama in the nation’s capitol. To cover years’ worth of trillion-dollar deficits, Congress is considering significant tax increases, including increases on many SME owners whose business income flows through their personal tax returns. Even if Congress does nothing, many SMEs will get hit by one of the biggest tax increases in history when the so-called Bush tax cuts expire at the end of next year.

So if regulators won’t let banks lend, venture capital is backing away from all but the surest of home runs, and tax increases are coming, then it should come as no surprise that official Washington is looking to the capital markets for salvation. (Haven’t we seen this movie before, just with a different title?)

This is fine, as investors are anxious to invest in new companies, new markets, and new innovations — anything to boost their returns. The problem is that those most anxious to boost their returns are often retired people living on a fixed-income from some fixed-income instrument earning zero-dot-nothing percent. They need a boost to supplement their pensions and Social Security income, and this might be seen as a way to make an extra couple of grand.

Consequently, it is critically important that these SME financing efforts do things the right way that balances the needs of SMEs with the transparency and other protections investors need. We don’t want another financial market mess, particularly one that affects those most vulnerable in the case of loss.

Proposals floating around Congress largely include a combination of reduced financial reporting, increases in the number of investors who can participate in unregistered offerings, not to mention increases in the dollar amounts of such offerings. There also are efforts to make it easier for companies to use “crowdfunding” mechanisms — online, word-of-mouth structures often used to raise money for artists — to raise capital for SMEs. A House bill would limit crowdfunding investors to a maximum investment of $10,000 per year, while the Senate version would set the limit at $1,000 per investor per year.

In general, CFA Institute is willing to live with these changes, but believes there are some additional safeguards needed:
• First, such companies should still have to get audited annually and include the auditor’s report in an annual report to investors.
• They should provide at least semi-annual updates on performance and financial condition.
• They should have to publicly disclose important company news, both good and bad, through normal distribution channels.
• Company principals should be liable for fraudulent representations made in offering documents, financial statements, or company announcements.
• And, most importantly, those companies that take advantage of these reduced offering requirements should be segregated/corralled into special exchanges where investors are well aware that companies aren’t playing by the same investor protection rules required of traditionally listed companies. Companies solely going the crowdfunding route will likely remain outside of the public funding structure and therefore would not have to list on special exchanges.

Risky Business
Even with these safeguards in place, there is a risk of adverse selection. Particularly at this point in the economic cycle, companies going these routes may be those more likely to need the capital to survive than to grow. As a banker friend noted recently, SMEs that want to borrow are the ones that the bank has no interest in serving, while those they would like to lend to either don’t want or need them.

A better government response from my perspective would be one that removes tax, regulatory, and legal barriers while improving domestic and global intellectual property protections so that companies can grow by creating new products and jobs. Such policies would have better success in creating demand for new capital that these markets could ultimately fill. Given that we are unlikely to see anything like that in the near future, however, we are left with the product of the Washington mindset.

We have argued that reduced reporting and governance requirements ultimately hurt companies over the long term rather than help. Investors recognize the higher risk they are taking and impose higher capital costs to compensate for the higher risk that comes with less transparency. Nevertheless, that train left the station with the Dodd-Frank-imposed exemption from internal control audit requirements for SMEs with market capitalizations of less than $75 million. The goal now is to make things workable, both for issuers and, most importantly, for investors.