75658 February 2013 – Number 81 SUPPORTING INNOVATION IN SMES IN LEBANON THROUGH A PUBLIC/PRIVATE EQUITY FUND: THE ISME FUND Randa Akeel1 gaps that the government of Lebanon (GoL) via the Ministry of Finance requested support from Introduction: In addition to weak institutional the World Bank for a US$30 million project to structures and inefficient business regulatory encourage the equity investment market to increase environments, access to non-bank financing is a early stage investment finance for financially viable, key constraints highlighted in the World Bank’s new, and existing innovative firms. This will be the (WB) MENA Financial Sector flagship report 2. World Bank’s first project of this kind in the For innovative start-ups in particular, a main MENA region. barrier to finance is the high aversion to risk – as well as the collateral demanded from investors – Project description: The project, “Supporting by the banks. Lebanon is a typical example of a Innovation in Small and Medium Enterprises� country where the banking sector is stable with was approved by the Council of Ministers and high levels of liquidity, and where the signed by the World Bank and the Minister of government has put in place various incentive Finance on February 13, 2013. It will be mechanisms and programs to encourage lending implemented by Kafalat s.a.l. the country’s for small and medium enterprises (SMEs). credit guarantee agency. The project’s main These include subsidized interest payments, component comprises an Innovation in SMEs exemptions on compulsory reserves on funding program (the iSME Fund). The iSME creditors, and a credit guarantee program – yet Fund will provide two sources of financing: i) lending still largely remains confined to large US$2.5 million for Concept Development Grants firms. (CDGs); and ii) US$25 million for equity investment in Seed, Early/Venture, and Growth Lebanese start-ups suffer from three substantial stage firms. The remaining project amount will gaps in their country’s financial environment: (i) support project management, strategic training funding at the early concept stage where activities, marketing, and outreach to the entrepreneurs need to develop their ideas into a business community, venture capital partners, viable concept and product; (ii) early stage seed the diaspora and community at large to promote funding needed when starting a company; and the project and the fund’s beneficiary (iii) absence of venture finance needed for the entrepreneurs firm to reach its growth stage and beyond (a critical stage in firm expansion when a large Components of the iSME Fund: There are two number of jobs are created). It was to fill these funding components in the fund: 1 Randa Akeel, Finance and Private Sector Development A. Concept Development Grants are for Department, the Middle Eeast and North Africa region, entrepreneurs to develop their innovative (MNSF1), The World Bank. This Quick Note was cleared by Simon C. Bell, Sector Manager, MNSFP. ideas and can be used to collect information 2 Rocha, Roterto, et al 2011.“Financial Access and Stability, A and proof of concept to attract external Road Map for the Middle East and North Africa�. MENA investment by addressing key risks. These Development Report, Washington D.C. can include a business plan, marketing/sales strategy, sector or market Project Beneficiaries: Beneficiaries will be assessment, other supportive tools, potential and existing entrepreneurs with new documents and presentations. commercial ideas and existing SMEs that are on the verge of expansion. The other key B. Equity investments will be made in an beneficiary groups are institutional small enterprise alongside another institutional investors and angel funds (the partner investor3. To qualify for the equity investors), whose financial incentive is an investment, the entrepreneur needs a important mechanism to ensure the success of commitment from an investor after which the project and achieve its development he or she would approach the iSME Fund objective. By providing an incentive to eligible seeking a matching participation. Co- small investors, the project ensures that these investments by the iSME will be made at investors will then source, review, and guide three stages of risk finance corresponding new entrepreneurs. This will increase early stage broadly to: (i) seed capital (US$25,000 – equity investments in new and innovative firms US$200,000); (ii) venture capital and create a critical mass of such firms. (US$200,000–US$500,000); and (iii) growth capital (US$500,000–US$2,000,000). A small Key Design Challenges and Issues: percentage of the iSME funds will be invested in growth capital of US$2 million The Pipeline of potentially successful innovative to ensure the viability and sustainability of entrepreneurs is low. It is not enough to simply the iSME funding program over the longer have financing and a great new idea. Would-be term. entrepreneurs need to go beyond a static business plan or filling out a financing Hence, the equity investment scheme relies application. Entrepreneurs need to have soft on partner investors to both identify and skills to manage a start-up enterprise, motivate promote new business projects and provide employees, assemble diverse individuals into a the active mentoring and professional cohesive team, tailor a product to a well-defined inputs that characterize truly effective market, adapt rapidly to fast-changing markets equity investments. A registry of carefully and consumer sentiment, and understand how screened and approved co-investors will be to convert an innovation into a viable business. developed and updated on an ongoing The Project team members addressed this issue basis. Registration for investor partners is by receiving separate funding from the open throughout the year and investors can Development Grant Facility (DGF) for a register at any time. Approved investors are program called “Supporting the Ecosystem for required to have: (i) a capital structure that Fostering Dynamic Entrepreneurship in MENA� allows them to finance high risk start-ups (EFDE). This 3 year regional initiative will work and/or growth-oriented existing companies; to increase the level of new viable businesses (ii) the capacity to appraise investment through a program that will scale up best opportunities on a professional basis; (iii) practice regional incubators/accelerators and the capacity to offer mentorship and other service providers willing to work with local support for the companies and partners in each country to support potentially entrepreneurs in which they invest; and (iv) innovative entrepreneurs to start a business and additional financing to sustain the firm in make it attractive for investors who would help case of a change of plans. them grow. 3 Institutional investor in this case is defined as standalone Equity Investments and their High Risk profile. funds, holding companies, formal business angel groups, Public sector stakeholders and others should be and investment banks (excludes regular commercial banks). made aware upfront that risk capital is by They should have a track record in investing in early stage definition high risk and that a key development and/or mature companies and present evidence of their professional capacities and capital availability. objective of the project is to correct a market failure in start-up and early stage equity February 2013 · Number 81 · 2 funding. In other words, foster a more robust record that need to be turned around and risk-taking culture, learning from failure, restructured This was confirmed through thereby stimulating entrepreneurship and over discussions with Lebanese venture capitalists time enhancing the potential for additional and angels and validates the need for the private sector jobs. Another important point is government to step in and fill this gap. Despite that while risk capital will incur some losses, the risks involved, investors and angels can still when it succeeds, it will assure monetary be lured by the high returns that can come from returns that in most cases can compensate for investing in early enterprises. Indeed, the iSME the financial losses. The iSME fund incorporates fund is designed to provide a funding platform a balanced risk portfolio approach with the goal that can scale this up by sharing that risk. The of generating a positive aggregate return. This key is to find an entity that can manage the fund will allow funds to be rolled back into the effectively as a private sector player, while facility, creating a sustainable source of ensuring the development objective of financing for seed and early stage financing into facilitating access to equity financing for early the future. This is still no guarantee that there stage firms and supporting economic growth. To will be positive returns but the lessons from achieve this balance the project design failure are invaluable and will serve to improve encompassed the following: performance and productivity of entrepreneurs and other related market agents in future  The government as a partner works at-cost ventures to create a more sophisticated and and thus is able to cede the higher returns to competitive market. the enterprise and private sector partners as long as it can retain enough to cover its Nevertheless, measures to mitigate some of the costs. This will serve as the incentive for the investment risks have been put in place: private sector;  The government as the main stakeholder is 1. A list of approved and vetted Institutional important as it will put development investors (VC funds, holdings, etc.) will be objectives as a condition in the prepared. The iSME will invest in deals that implementation and management of the have been committed to by the institutional project; investors thereby establishing the first risk filter on company viability and potential  A flat fund management fee will be used. Even though incentives are important for success. ensuring quality performance based on returns, working based on a flat fee allows 2. Background review and secondary due the fund manager to be neutral and able to diligence is performed by Kafalat – this ensure meeting the development objective constitutes the second risk filter on the of supporting very early stage firms. This partners, governance, and soundness of the makes the next point very important; proposal.  Broaden the search of implementing 3. Review and approval by an independent managers/entities beyond traditional fund Investment technical committee effectively managers and find one that (a) works with establishing the third and final filter on the all players in the ecosystem; (b) is vested in commercial viability and potential success achieving socio-economic development and of the venture as vetted by an independent upholds its reputation in this perspective as body. much as its professionalism and (c) reputation as a private sector financial Aligning public and private sector incentives - Profit institution. Lebanon has this structure in vs. national development – Most Venture capital Kafalat. However, where there is no funds in the region, rather than playing their comparable organization, it may well be true role of seeking out and structuring worth investing in building the promising start-ups, tend to focus on private appropriately qualified private management equity in existing firms with an established track entity. February 2013 · Number 81 · 3 give its no-objection to the list of Evaluators in Sound governance structure and transparency – key terms of meeting the project criteria of relevant to ensuring participation entrepreneurs and expertise, diversity and representation. investors. The success of the project rests on the trust that entrepreneurs and investors have in For the equity investments Kafalat will establish the process. Decision-making must be an Investment Committee (IC) to review and undertaken by those that are most qualified decide on the best proposals. IC members will technically but also independent so as not to be high status individuals, averse to face conflicts of interest. The government who is reputational risk from the private sector, who responsible for the funds must also be able to will perform this role and will not receive properly monitor and take action when financial remuneration or benefits. They will necessary. Yet if the government is placed too have strong entrepreneurship experience and close to the operational process there is a risk of complementary commercial and technical political capture. Having a private sector entity expertise. The composition of the IC is intended manage the fund is essential but the fund to reassure investor partners that there is no manager and government employees alike must capture by vested interests in the public or be protected from being solicited and lobbied private sectors. The WB will give its no-objection for awards. Therefore it is imperative that the to the IC once it meets the project’s IC structure decision-making process is well structured, and criteria. transparent for proper monitoring by the MOF, while being independent to ensure decision- The decision-making authority of the IC is making based on sound commercial and bound by strict terms to ensure proper checks investment principles. and balances between the IC, iSME management, and the public sector. For the Grants a pool of evaluators consisting of technical experts will review and decide on the Government oversight - The MOF will have broad winners. The evaluators will be selected from oversight of the project and receive quarterly across the spectrum of industry, finance and reporting from Kafalat regarding project business across all of Lebanon to ensure the activities. proper availability of an adequate range of expertise and knowledge. The World Bank will Contact MNA K&L: Gerard Byam, Director, Strategy and Operations. MENA Region, The World Bank Regional Quick Notes Team: Omer Karasapan, and Roby Fields Tel #: (202) 473 8177 The MNA Quick Notes are intended to summarize lessons learned from MNA and other Bank Knowledge and Learning activities. The Notes do not necessarily reflect the views of the World Bank, its board or its member countries. February 2013 · Number 81 · 4