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How to assess entrepreneurial potential? A new tool for SME lenders

Today, as part of our initiative to Fuel the Growth of Small and Medium-Sized Enterprises (SMEs), we're announcing a grant to the Entrepreneurial Finance Lab (EFL) for the development of a new screening tool for SME financing in developing countries. EFL is housed at Harvard University’s Center for International Development (CID). The Lab team is led by Asim Khwaja, an Associate Professor at the Kennedy School of Government and Bailey Klinger, a CID Fellow and EFL Director.

The Lab aims to address the “missing middle" of finance, a term that describes the shortage of capital available to SMEs in developing country economies. In developed countries, SMEs represent half of GDP and two-thirds of jobs, but they're largely absent in developing countries. Access to finance is a critical constraint, despite evidence that there are highly profitable untapped growth opportunities. It requires taking some risk. We saw this firsthand when we met Joseph Tackie in Ghana, an entrepreneur whose sales quintupled after getting a relatively small amount of seed capital.

The mission of EFL is to develop a screening test that could be a criterion for loans to SMEs. Because these businesses often lack formal accounting ledgers or established credit histories, it's very difficult for investors and lenders to gauge risk or finance-worthiness of businesses. When evaluating developing country SMEs, financial institutions have little information to be able to make investment decisions or measure the trustworthiness of clients. Does she have a good track record at repayments and money management? Is he good at numbers and bargaining? Does she understand the market and how to run a business? Evidence suggests information such as credit scores helped banks penetrate the SME market here in the US.

We hope the EFL test will address the information asymmetry and help entrepreneurs get their foot in the door at banks and investment firms. The test, a psychometric screening tool, will assess “soft traits” of psychological, social, and cognitive characteristics to measure a person's entrepreneurial potential. Financiers can then use the information to make lending decisions. The test could be an initial step toward the goal of expanding profitable lending to the missing middle.

EFL is already working with SME financiers in Africa, India and Latin America to refine their tool through field testing and pilots. The team is currently looking for institutions to partner with on these pilot tests, and offers financial institutions early access to the screening technology (interested parties should contact is supporting the team in their work in Africa and India in particular as part of our efforts to expand financial access to SMEs in these regions. We’re excited to see how this cutting edge effort progresses!

Swati Mylavarapu, Senior Associate, SME Initiative

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