The Missing Middle —Part 1
By Mercedes Politi
Root Capital is a rising star in the NGO world with quite a unique mission – to eventually disappear. Ok, I’m definitely being too simplistic here, but there is a point to be made. Please bear with me while I go over some of the main lessons learned that Brian Midler, the Director of Strategy and Innovation at Root Capital, brought to us at our last Finnovation class.
Root Capital
For the past twenty years, Root Capital has provided about $180M in financing to over 250 export-oriented agro-enterprises in Latin America and Africa, serving 360K farmers and artisans at the BOP. These companies are small but growing and have come up against dead ends to raise funds in their local capital markets.
These are not start-ups or companies that haven’t produced before. We’re talking about companies that have a management team, a proved demand for their product, clear production capabilities, but are credit constrained nonetheless. (Imagine how credit constrained first-time entrepreneurs must be!) These companies have contracts with buyers but cannot afford the upfront cost of actually carrying out the production process in order to deliver the goods and self-sustain. That is, they lack short-term loans and working capital. Think for example, that you are a farmer and need to cover the costs of the growing season until harvest time arrives and you can recoup your investment.
Seems unbelievable, right? Somebody should be willing to offer them a loan. The problem is that these small companies usually don’t have assets that are accepted as collateral by local banks. This is where Root Capital comes in. Root Capital has innovated by accepting contracts from buyers as a collateral. So Root Capital lends to the company against its future sales contract, and once the products are shipped, the buyer pays Root Capital directly. Root Capital keeps the interest and principal and sends the company the remainder. The buyers include the likes of Starbucks, Whole Foods, Marks & Spencer, Green Mountain Coffee Roasters, so the repayment rate is very high – a whopping 99%. Loans are typically 6 to 9 months long and between $25K to $1.5M (on average $350K).
The “Missing Middle”
Root Capital sees itself working in a niche that has been greatly overlooked. The companies Root Capital works with are too big to be served by microcredit institutions and too small and lacking in traditional collateral to be served by local banks. This “missing middle” represents a market failure to supply lending when there is clearly a need, a solid repayment capacity, and ultimately, a profit to be made for financial institutions. Why does this happen? Let’s take a look.
There are three main failures that have contributed to creating this “missing middle”. These stem from the market, the financial institutions, and the external situation.
- Market: businesses lack traditional collateral, lack strong managerial capacity, and are geographically isolated from financial institutions (companies are in rural areas, while banks are in urban areas)
- Financial institutions: banks misperceive the risk of these loans, there is a cultural bias towards rural businesses, they are inexperienced in agriculture businesses, and in some places there are regulations against lending without collateral
- External: political uncertainty and economic risk reduce the number of players willing to get involved
In this complex context, Root Capital will need to think big in order to succeed. Solving failures from markets and financial institutions is a very ambitious goal and can only be achieved by getting other players involved and by radically changing the way banks develop and manage their risk and business models to serve this segment. Tune in next time for an overview of Root Capital’s goals and the challenges that lie ahead.
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