In this section, we briefly describe different criteria used to measure and define SMEs. Also, we review the status of debt and equity markets and consequences for small firms.
Small and Medium-Sized Enterprises: Their Contribution to the Economy
Numerous studies have explored alternative criteria for firm size. The term ‘small and medium-sized enterprise’ used here has no agreed-upon international definition. Thus, the definition of an SME varies across diverse countries and sectors. To be sure, SMEs can be defined in terms of sales volume, number of employees, or level of investment. Moreover, many countries use different criteria to measure firm size. For example, in Brazil, various organizations, such as the Institute for the Support of Micro and Small Firms (SEBRAE), have adopted criteria for firm size based on the number of employees in the firm. In contrast, both the Brazilian Development Bank (BNDES) and Brazilian policymakers use sales volume as their criterion. Brazil defines SMEs using three broad categories: micro-proprietorships, micro-enterprises and small enterprises. Micro proprietorships are defined as companies with gross revenues not exceeding BRL81,000. In contrast, micro enterprises have gross revenues not exceeding BRL360,000, while small enterprises have revenues not exceeding BRL4,800,000. The majority of SMEs shown in Table 1 are micro and small enterprises.Footnote 20 These data are consistent with earlier studies that show the presence of a large number of micro-enterprises and small firms in developing economies.
Figure 1 shows the share of the sectors with the largest share of SMEs. In terms of the three categories of SMEs, they are likely to play different roles in the economy due to the access of information and other resources. The figure shows the majority of SMEs are involved in commerce, industry, food and lodging, services and construction.
Another factor likely to influence the growth of SMEs concerns the effect of burdens created by bureaucracy and administrative procedures. In Brazil, this concern initially led 11.5 million companies to adopt the special tax regime for micro and small businesses provided under Complementary Law No. 123/06 (‘Simples Nacional’ program).Footnote 21 For the period 2007–2011, the effects of the tax burden reduction resulted in a payroll increase of 25% and a 21.5% increase in jobs for firms participating in the Simples Nacional program (with a R $2.4 M threshold).Footnote 22 This highlights the fact that such simplification strategies are particularly important for the growth of SMEs operating in developing counties with high tax compliance costs. Note that the recent introduction of a new law, MP/881/2019, in April 2019 is another attempt by policymakers to reduce the costs for new and small firms to start a company and to make it easier to obtain the necessary permits.
Our discussion so far has focused on the perceived factors impacting the growth of SMEs.Footnote 23 So the main concern is not to simply reduce the regulatory burden, but to effectively address the institutional impediments to the creation and growth of innovative SMEs. Prior studies report that SMEs with a broad diversity of strategies face obstacles to innovation. Where these obstacles are likely to play an important role, a set of broad-based reforms and methods may curtail the learning and innovation obstacles in order to achieve growth of SMEs in high priority areas, such as knowledge-intensive industries.Footnote 24
Furthermore, it has been argued that a relationship exists between the age and the type of companies that get involved in innovation. In Brazil, between 2011 and 2015, approximately 4.55 million companies with at least ten employees were approximately 11 years old. An analysis of the relative size of companies highlights the fact that smaller companies are less likely to survive, particularly in the Brazilian market. Indeed, out of all the companies existing at the beginning of 2011, 67.1% of firms with ten or more employees were still active at the end of 2015, compared with 57.8% of firms having between one and nine employees and 31.8% of firms with zero employees. That said, the evidence presented in this paper shows that there is a clear relation between the number of employees/size of the company and longevity. In short, the Brazilian experience suggests that smaller companies have a lower probability of survival than larger ones. Figure 2 also displays that there has been a downward trend in the survival rate of firms, with fewer than 37.8% still in existence at the end of 2015.
One may expect that successful SMEs have the ability to produce innovative products and services.Footnote 25 Indeed, a key challenge for governments is to promote policies associated with the development of inputs needed to produce innovations and exploit long-term outputs. An important consequence of SMEs’ innovative role is public policy support for programs linked to the development of skills and innovative activity. This type of policy focus to increase the role of SMEs in relation to innovation is seen as crucial in many developing economies, such as Brazil’s. Yet broad-based government policies to enhance the growth and development of innovative SMEs may involve considerable risk. First, there are different types of entrepreneurial SMEs that require a tailored mix of non-financial and financial policies to shape the outcome and behavior of these firms.Footnote 26 Second, there is a question that pertains to the ability of policymakers to identify high growth SMEs ex ante.Footnote 27
To get a better sense of innovative SMEs in Brazil, Fig. 3 shows that of the firms with at least ten employees, approximately 36% were involved in some level of innovative activity (either their processes or their products) between 2012 and 2014. These data confirm earlier studies that the SME performance in terms of innovations significantly lags behind other countries.Footnote 28 But, as noted above, it is expected that the recent easing of licensing and other regulatory requirements may also help encourage innovative activities by SMEs.
In order to determine the financing options for SMEs, in the next section, we will examine alternative sources of debt and equity available in Brazil.
Debt and Equity Markets in Brazil
Bank loans and lines of credit remain the main sources of external financing for SMEs. The bank-lending channel was weakened during the financial crisis, as evidenced by banks’ reduced lending capacity and the increase in interest rates on new loans. The higher sensitivity to external shocks led to changes in the supply of short- and long-term financing to SME borrowers. Data from the Central Bank of Brazil show that, as of February 2016, more than 173 financial institutions were approved to conduct bank-clearing operations in the country (see Fig. 4). There are also striking differences across regions in terms of total banking-sector assets. Notably, most financial institutions are headquartered in the State of São Paulo, the richest of the Brazilian federation. This number includes foreign banks doing business in Brazil, as well as state-owned or state-controlled banks. This number is not large by any standard, mainly when considering that Brazil has the 9th largest economy and 6th largest population in the world. Yet the financial system in Brazil cannot be considered small and is mostly bank-oriented.Footnote 29
In fact, many parts of the country are largely without adequate bank-branch coverage. Significantly, even in the most populated areas, approximately only half of the potential market is actually serviced by banks.Footnote 30 Figure 5 shows that most banks are located in the SoutheasternFootnote 31 and SouthernFootnote 32 states. Moreover, more than half of the Brazilian states have no banks headquartered in their jurisdiction, suggesting a greater overall need for banks.
With a population of approximately 206 million people distributed across 5570 municipalities,Footnote 33 Brazil still has relatively few bank branches. Moreover, their distribution varies significantly across states, and the great majority of branches are located in the states of São Paulo and Rio de Janeiro (see Fig. 6).
Although there are 26 states and a Federal District in Brazil, 16 have fewer than 500 bank branches. Starting from a very low base, the population would seem to be seriously underbanked if no alternatives were available. However, a different approach, based on Brazilian regulation, has attempted to address this problem by allowing banks to create banking service stations. As a result, there are now 10,645 banking service stations in Brazil, most of which are in São Paulo (3124). As the case of banks, it is worth noting that, as Fig. 7 shows, there are fewer than 500 banking service stations in the other states.
As banking service stations are limited and under-resourced, ‘bank correspondents’ may often provide an alternative.Footnote 34 While bank correspondents are not financial institutions, they can enter into a contractual relationship with a full-fledged bank to offer a wider range of financial products and services. On the supply side, the mere existence of bank correspondents is not equivalent to a larger number of banks or more credit being available. To be sure, there is a definite potential to expand the number of bank correspondents, as evidenced by increased numbers until 2013 (reaching a total of 375,315), but then a sharp drop reduced the number in February 2016 (see Fig. 8).
In recent years, there has been growing concern that the Brazilian banking market is extremely concentrated.Footnote 35 We see that, as of December 2016, the four largest banks—Banco do Brasil, Itaú, Caixa Econômica Federal and BradescoFootnote 36—together, held 72.70% of all banking assets, 78.48% of all deposits and 78.99% of all credit transactions in Brazil, compared with 52.58%, 59.32%, and 54.67%, respectively, in December 2007.
On the whole, this represents a steep and important increase in bank concentration and is likely to have a strong influence on interest rates across the market (see Fig. 9). In particular, the concentration in the Brazilian banking system plays an important role in the SME financing gap. In practice, smaller (local) banks with low-scale operations tend to develop long-term relationships with borrowers, which may facilitate greater availability of loans.Footnote 37 As noted above, evidence suggests that closer relationships with creditors is an important mechanism to reduce information asymmetries. Consequently, the information gained may lead banks to offer lower rates.Footnote 38 However, larger banks have a more difficult time developing long-lasting relationships with SMEs, as loan officers constantly rotate, and merged banks (which makes them grow bigger) may shut down offices and transfer employees from the location where the firm typically obtains its bank financing.Footnote 39 Also, larger banks tend to be more focused on transactions than on long-term relationships, preferring a smaller number of larger deals to a large number of loans. We note that banks undergoing growth tend to devote a smaller percentage of their portfolios to small firms, which suggests that the greater the consolidation, the lower the percentage of credit that will be available to SMEs.Footnote 40 In addition, we can observe a similar influence on financial institutions that have SMEs as borrowers.
Perhaps the most prominent feature of the banking sector is the high levels of banking spreads and interest rates charged by financial institutions. In terms of the business environment, high spreads have negatively impacted the expansion of credit and economic growth.Footnote 41 Specifically, the average annual bank interest rate was 23.7% for all types of transactions available in the Brazilian credit markets in 2014.
In terms of market segmentation, the Central Bank of Brazil divides the credit markets into (i) directedFootnote 42 and (ii) non-directedFootnote 43 transactions. For directed credit transactions, which include government and other subsidized lending, the average interest rate was 7.8%, whereas the non-directed average rate was 37.3%.Footnote 44 Brazilian companies face significantly higher interest rates than their counterparts around the world.Footnote 45 Figure 10 shows the range of interest rates in Brazil from 17 to 23 August 2017. For example, the rates charged by banks for certain types of business lending, such as short-term working capital financing, were extremely high, with a fixed interest rate between 10.8 and 83.7%.
Table 2 show the differences in the average annual interest rates on a variety of loans by the four largest Brazilian banks: Banco do Brasil, Itaú, Caixa Econômica Federal and Bradesco.
In this context, a number of scholars have challenged the existence of a competitive market. For example, some critics argue that the Brazilian banking market operates as an oligopoly, and banks have few incentives to improve market efficiency.Footnote 46 Others claimed that the Bertrand oligopoly model closely resembles the banking market in Brazil. On the other hand, Fiche raises similar concerns that spreads in Brazil are higher than in other countries.Footnote 47 However, he finds no support for the view that higher concentrations in the banking systems directly affect the rates offered to firms seeking financing. In sum, Fiche’s study is consistent with studies that have suggested bank system concentration does not explain market power.Footnote 48
Another dimension of bank market power has to do with borrower discouragement.Footnote 49 A large empirical literature on the relation between bank concentration and borrower discouragement has emerged in recent years. For example, small firms in developed economies, like the US and Europe, are less likely to be discouraged as bank market power increases.Footnote 50 Examining banking relationships, Han et al. find evidence that relationships provide banks with better performance on borrower screening, which in turn reduces screening errors and discouraged borrowers. In contrast, other studies focus on the concern that borrowers might suffer hold up problems in a relationship with their bank and reduce the demand for relationship lending as bank market power increases.Footnote 51 Also, prior literature considering the impact of bank concentration in developing economies find that bank concentration limits SMEs’ access to external finance.Footnote 52
Figure 11 below provides a summary of survey questions describing the response to SMEs applying for a bank loan between 2015 and 2017. As such, we would expect that the risk of discouragement would be high for SMEs seeking short term external financing.
Figure 11 presents the responses of SMEs who were asked about whether in the past 6 months they attempted to obtain a loan from a bank. In Brazil, 24% of the companies did manage to apply for a loan in 2015. It means that 76% of the SMEs did not manage to apply for a loan, which is consistent with prior empirical research on some countries in the European Union.Footnote 53 The figure shows that the firms that actually applied for a loan has been declining since 2015. Moreover, the loan applicants surveyed in the SEBRAE study indicated that a number of factors influenced whether or not to apply for a loan. First, 51% of firms responded that they were no longer attracted to taking out a loan. Second, a significant number of firms (39%) cited that they do not need a loan. Third, a smaller number of firms reported that they did not like loans or paying high interest rates.
Consistent with our expectations, we find, between 2015 and 2017, a significant number of SMEs did not apply for a loan because of possible rejection. In summary, these results confirm previous studies on borrower discouragement in developing economies, such as Brazil.Footnote 54
Support for Loan Granting and Guarantee Programs
Before we address alternative forms of financing for SMEs, we pose the more fundamental question about the growing concern that SMEs need guarantees to access credit. With stringent collateral and guarantee requirements, SMEs are likely to have few external funding options through traditional banking channels. In general, credit guarantee schemes are used to provide credit support in lieu of collateral granted by the SME and may be effective in reducing the risk premium charged and help them qualify for a loan under the bank’s loan policy.Footnote 55
In Brazil, two important guarantee programs provide support to SMEs. The main funds are: (i) SEBRAE’sFootnote 56 ‘FAMPE’ (Fundo de Aval às Micro e Pequenas Empresas, or Micro and Small Enterprise Co-Signer Fund); and (ii) BNDES’Footnote 57 ‘FGI’ (Fundo Garantidor para Investimentos or Co-Signer Fund for Investments). SEBRAE’s FAMPE can serve as a co-signer for eligible borrowers. Active since 1995, it has co-signed with more than 260,000 SMEs and raised approximately BRL 11 billion (of which BRL 7.81 billion became the liability of the FAMPE). The fund participates in a variety of transactions, including fixed capital, working capital, pre-export production and commerce and technological investments and innovation. Note that FAMPE will co-sign for up to 80% of the amount of the total credit granted to SMEs, according to the limits noted in Table 3.Footnote 58
In order to gauge the importance of support between 2015 and 2017, a total of 39,700 guarantees were granted by FAMPE. Table 4 shows that the vast majority of those guarantees went to small enterprises, while a very small percentage (about 5%) was granted to micro proprietorships and micro enterprises. In practice, the number of guarantees granted by FAMPE is not excessive relative to the total number of SMEs in Brazil. This also suggests that the smallest companies are more likely to be denied guarantees and have limited access to bank credit. However, the data show that the number of guarantees granted to firms in the commercial sector is more than double the number seen in the manufacturing industry.
Turning to BNDES’ FGI, this fund also serves as a co-signer for eligible borrowers for bank credit. Tables 5 and 6 show FGI’s total amount and total percentage guaranteed, respectively, from 2014 to 2016. Interestingly, FGI has been active since 2010 and has provided support to more than 24,100 beneficiaries in 31,200 credit transactions totaling approximately BRL 5.8 billion (of which BRL 7.81 billion became the liability of the FGI).
In summary, despite the importance of guarantees to a small segment of SMEs, denials made to borrowers across Brazil are likely to increase as the banking system becomes less competitive, and fewer firms have access to credit.
Private Equity and Venture Capital
Recent studies have suggested that alternative sources of financing may provide credit access to support economic development. For example, many private equity and venture backed companies completed IPOs on Bovespa, which collectively raised US$ 2.29 billion between 2004 and 2006.Footnote 59 It is worth noting that analysis of the trends after the financial crisis shows an increased demand for financing coupled with a stagnation of stock markets and a significant drop in the supply of private equity and venture capital in Brazil. A further difficulty is that the numbers show that Brazilian private equity (PE) investment financing of SMEs is very small compared to that of similar countries. If we look at the breakdown of investment over the last decade, we can spot some notable features: a decline in the number of deals and capital raised through IPOs or follow-on offerings.
However, despite the low levels, Fig. 12 illustrates that the PE and VC markets have experienced steady growth in the last few years. For example, the total amount committed by investors rose from BRL 63.5 BB in 2011 to 153.2 BB in 2015.
Figure 13 also shows that, if we focus on capital distributed to investors, there is an upward trend for the period between 2011 and 2015.
Similarly, only a small fraction of capital committed by venture capitalists is invested in smaller companies. Moreover, Fig. 14 shows that of the total committed by investors, only 3.5% is allocated to venture capital, while 96.5% is dedicated to private equity. Interestingly, Fig. 15 shows that a larger percentage (60.4%) of the deals involve venture capital transactions.
In recent years, especially after the financial crisis in 2008, the sector turned to VC and PE for alternative channels of financing. Figure 16 shows that 63 companies received investments as private equity, with an average investment of BRL 277 MM and a median investment of BRL 35 MM. As far as venture capital is concerned, 96 firms received investments of BRL 12 MM, on average, with the median investment being BRL 4 MM (Fig. 17). When considering both private equity and venture capital deals together, 159 companies received investments, with an average investment of BRL 177 MM and a median investment of BRL 5 MM (Fig. 18).
Note that between 2013 and 2015, the number of deals (private equity and venture capital together) went from 186 in 2013, down to 101 in 2014, and back up to 159 in 2015, while the average investment was BRL 95 MM in 2013, BRL 132 in 2014, and BRL 177 in 2015, as demonstrated in Fig. 19.
Regarding the origin of committed capital, while the percentage of foreign capital decreased from 2011 to 2012 (from 54 to 49%), there was a steady increase in the years of 2013 (55%), 2014 (56%), and 2015 (57%). The percentages of domestic capital, on the other hand, went from 46% in 2011 to 49% in 2012 and experienced a decline in the years of 2013 (45%), 2014 (44%), and 2015 (43%), as illustrated in Fig. 20.
In this section, we lay out the importance of SMEs in the economy and map out the potential sources of capital market financing in Brazil. The data suggest that banks’ lending capacity shrank after the financial crisis, possibly due to higher risk aversion at a time when economic growth had slowed. In addition, equity financing, especially for the SME sector, declined in this period. In light of these findings, the SME sector faces increasingly limited access to financing, as it competes with larger firms for a shrinking pool of resources. In the next section, we seek to provide an estimate of the size of the financing gap for SMEs in Brazil.