reDebt Capital: The Transaction Cost Roadblock
By Scott Hartley
In the economically developing world, as in other parts of the planet, growth is driven by capital, labor, and multi-factor productivity, or technological improvement. In markets where excess capital and labor are relatively thin, innovation is the surest means to growth. In economically under-developed markets, however, there may be a surfeit of labor, and a deficiency of capital that can be addressed through financial innovation.
In many emerging markets, access to entrepreneurial capital is insufficient. As I argue in a Yale Journal of International Affairs article, “Bringing Africa Online,” the transaction costs associated with counter-party risk assessment are too high to avail debt capital to down-market entrepreneurs. Dearth of centralized credit history and information makes the transaction costs associated with risk assessment high, and this in turn creates an inherent bias for debt capital providers; they will pragmatically provide loans to entrepreneurs with greater capital demands because the transaction cost of risk assessment as a proportion of the loan value makes up-market lending more economically viable, therefore preferable.
One of the keys to addressing the putative “missing middle” is to address credit history, and the centralization of information that facilitates risk assessment. This will necessarily involve not only financial services companies, but working with technology and telecom providers to cohere various data-points that corroborate borrower financial stability. If due diligence can be streamlined, and proof of creditworthiness simplified, this will lower the costs of assessment. When costs decrease, the viability of lending to entrepreneurs with smaller capital demands will facilitate the expansion of debt capital to down-market borrowers.
If access to credit can expand down-market through facilitated risk assessment, this could address part of the problem. Enhancing the viability of equity capital, whether expansion private equity or seed venture capital, completes the other half of the equation. While international equity investments will necessarily hinge on considerations of political, economic, social and legal risk assessment as well as security considerations, they will also depend on the development of formal capital markets, and capital markets of sufficient depth and liquidity to support a variety of exit options. This could involve regional cohesion of exchanges, growth of domestic capital markets, or dual-listing partnerships with regional or European stock exchanges that enable more diverse, and more liquid investor exits.
Only by addressing some of the systemic challenges of both debt and equity finance can the developing world attract the type of capital necessary to fuel the innovation of today that will power the growth of tomorrow. These solutions will require the cooperation of technology and telecommunications firms to work with financial services to cohere diverse data points facilitating counter-party risk assessment, and bringing down the transaction costs associated with entrepreneurial debt capital due diligence. These solutions will also require the political and economic will to enhance stability and security, and to expand capital markets through regional integration and international partnership.
Only if the above challenges are addressed will emerging market countries be able to attract capital, and will entrepreneurs finally have access to both debt and equity finance in quantities sufficient, and time horizons acceptable, to truly innovate without inhibition.
Scott Hartley has worked for Google, Inc and Google.org in the U.S, India, and Africa. He writes for Harvard’s Internet and Democracy Project and Stanford Social Innovation Review. Scott is pursuing a dual-degree MBA/MA at Columbia University, and holds a B.A. from Stanford University.
