CryptocurrencyInvestingBanksReal Estate

In developing economies, equity beats microfinance

April 20, 2011, 7:26 PM UTC

A new effort is underway to advance entrepreneurship in the developing world. The U.S. State Department recently launched a program to promote business creation in emerging markets known as the Global Entrepreneurship Program. Leading entrepreneurs, investors, and corporations in the public and private sector met in Washington to discuss the best ways to achieve social and economic impact in underserved markets. This included mobilizing capital, scaling businesses, and working with large corporations. These initiatives are beginning to transform the way many think about economic development abroad.

Over the past decade in the developing world, microfinance institutions (MFIs) attracted an increasing number of private equity investors. It was believed that these organizations, which have multiplied over recent years, were the answer to stimulating economic activity. In just the past three years, an estimated $300 million has been invested in MFIs.

However, while MFIs do play an important role in development, there is an even greater need to support small and medium-sized enterprises (SMEs), which have shown to have the greatest potential for job growth in most places around the world. These businesses can act as the catalysts for sustainable economic development, employment, and the production of affordable goods and services in both developed and developing countries.

SMEs provide over 30% of total employment and generate 16% of GDP in low-income countries. In middle-income countries, SMEs capture an even larger share at 57% and 39%, respectively. But they are often considered too risky for commercial investment and need much more investment capital than can be provided by microfinance.

Oftentimes, it is venture capital firms and angel investors that fill this “missing middle” in the U.S., but in the developing world this kind of capital is not readily available in any significant amount. No successful company in the U.S. started with loans. Steve Jobs, Michael Dell, and Mark Zuckerberg did not borrow from their local banks to start Apple (AAPL), Dell (DELL) and Facebook. They got angel investors and venture capitalists to provide them with risk capital in the form of equity and quasi-equity.

In the past, there have been frequent calls for the development of a new model for SME investing that recognizes the huge potential these businesses can have on local economies, understands the unique challenges faced by SMEs, and seeks to address the lack of available capital. This alternative model, better known today as “impact investing,” can help fill the critical financing gap and is the next leap forward from microfinance.

Ideally, investors work in partnership with local governments to provide equity or quasi-equity, often with returns linked to increased revenues, in the range of $100,000 – $2 million. These investments can be coupled with grant funding for technical business assistance. The impact, especially when targeting SMEs that have a high social-economic impact, can improve the lives of millions of people at the base of the economic pyramid.

Organizations taking a novel approach to development while providing significant resources are springing up around the world. One such example of new thinking, new instruments, and a new vision is Fanisi (in Kenya), which provides equity investments of as much as $3 million to promising SMEs across East Africa. It also has a Business Advisory Services Facility, which offers consulting advice either prior to taking on capital investment or after.

Following this dual-blended approach is the Grassroots Business Fund in Washington, DC — another example of a company investing patient capital and grant-funded technical assistance to SMEs in developing countries. Consider its work with the coffee industry in East Africa. The majority of coffee cooperatives use outdated processing equipment, resulting in lower quality coffee and higher costs. With investment capital and an expert consultant provided by the Grassroots Business Fund (GBF), BrazAfric Enterprises (BEL) extends credit to coffee cooperatives in Kenya to enable them to purchase coffee wet mills, which are more reliable, efficient, and environmentally friendly than the machines currently used by most coffee cooperatives in East Africa. BrazAfric’s wet mills enable more stable and increased incomes to smallholder coffee farmers through the sale of higher quality coffee. The company currently employs 66 people, compared to 59 people prior to GBF’s investment last year, and their work has impacted the lives of more than 4,000 farmers.

Yet a third company is India-based SONG Advisors, which is similarly investing in sectors like affordable health care, education, and agriculture, and in doing so, helping develop an ecosystem for entrepreneurship and innovation in the region.

SEAF (Small Enterprise Assistance Fund) provides growth capital in 22 countries, supporting SMEs in sectors as broad as housing, health care, and renewable energy. SEAF Funds have invested more than $371 million in 338 investments. One of its many examples is Gomex, a grocery chain operating in northeast Serbia. SEAF’s Serbia fund invested $1.7 million in equity into the company in 2007. Two years later, employment has increased from 302 to 521, or an annual rate of 31% at a time of stagnant growth in Serbia and growth in employment of only 2%. These jobs provide hope and stability, while the SMEs themselves pay taxes, social security contributions and make local charitable donations.

There are more than a dozen similar groups following a similar model emerging in various parts of the developing world. The results of all these efforts are economic benefits on a scale that is simply unachievable with microfinance.

By helping local entrepreneurs grow their businesses through equity capital — not just debt assistance — businesses can scale and in turn have a multiplier effect on employment and economic activity. This creates wealth of the sort that lifts people sustainably out of poverty.

In this way, investors are helping to create thousands of jobs over an extended period of time in the areas of the world where it is most needed.

For those commercial investors who are interested in promoting global economic growth and worthwhile social objectives, the nascent impact investing space should be of vital interest.

The writer is Founder and Managing Director of Greycroft Partners, a venture capital company, and serves on the Leadership Council of the Initiative for Global Development.

More from Fortune: