Smallholder farmers’ lack of access to finance inhibits economic growth and slows poverty alleviation efforts around the world. Globally, smallholder demand for finance is estimated at US$300 billion, excluding China, and most of that demand is unmet. Social lenders play an important role in addressing this financing gap. Social lenders are impact investors that provide financing to small and growing agricultural businesses, including producer groups and private enterprises, in low- and middle-income countries.
In April 2014, seven leading social lenders – Alterfin, Oikocredit, Rabobank’s Rural Fund, responsAbility Investments AG, Root Capital, Shared Interest, and Triodos Sustainable Trade Fund – launched the Council on Smallholder Agricultural Finance (CSAF), an industry alliance that will ‘convene regularly to exchange learning, identify best practices, and develop industry standards.’ Recently, Dalberg worked with the Initiative for Smallholder Finance to publish a guide for investors and funders looking to improve smallholder access to finance by supporting social lenders. The guide points to an important element of smallholder finance that needs more attention: pipeline building.
What is Pipeline Building?
Pipeline building is the process social lenders use to reach clients that are new to the sector, thereby growing the lenders’ collective reach. To do this, lenders need to first identify new potential clients, often through their local networks, and then assess whether they are credit-worthy and mission-aligned, through document review, analysis and site visits.
In core social lender markets – the coffee market in many Latin American countries, for example – these new clients are typically earlier stage agricultural businesses with limited financial track records. Social lenders report that it is often unprofitable to lend to these early-stage businesses, as it can take three to five years for revenue from these clients to cover their loans’ operating costs.
In non-core social lender markets – new geographic and commodity markets for the sector – new clients may be larger and more mature businesses. Thus, although pipeline building always involves reaching new clients, these new clients could be small, or relatively large, depending on the market they are in.
By reaching new borrowers in core markets, non-core geographies, and non-core commodities, pipeline building promotes growth and diversification in social lenders’ portfolios. Such diversification reduces systemic risk, and helps ensure the long-term financial sustainability of the social lender sector. Specifically, pipeline building enables:
Lending Growth in Core Markets
While many existing social lender clients require additional trade finance or other financial products as they grow, social lenders’ growth opportunities among current borrowers may be limited as competition for their business increases.
For example, in the Peruvian coffee market, 50% of CSAF clients (representing nearly 90% of disbursements) are borrowing from multiple CSAF members. Pipeline building promotes additional growth in these core social lender markets.
Social lender activity is heavily concentrated in Latin America; 70% of 2013 CSAF disbursements were located in the region. This concentration is largely due to the relatively higher prevalence of well-managed producer groups in Latin America, given the region’s strong historical tradition of farmer cooperatives.
Such geographic concentration leaves social lenders vulnerable to macroeconomic fluctuations. Social lenders can mitigate this vulnerability through pipeline building activities that bring in new clients from a broader range of geographies.
Diversification of Commodities
Coffee clients represented more than 50% of CSAF members’ 2013 disbursements. In addition to the relatively stronger producer groups found in the coffee sector, this concentration is also driven by the coffee sector’s progress towards socially responsible and environmentally sustainable production.
However, this concentration leaves social lenders vulnerable to the effects of market fluctuations, as the recent coffee rust outbreak in Latin America demonstrated. The outbreak caused significant crop damage and losses, resulting in decreased demand for financing among coffee farmers. Pipeline building can therefore increase the sustainability of the social lender market through commodity diversification.
The Role of Social Lending
Although social lenders typically share similar missions and goals, they differ from one another across a number of dimensions – particularly, what level of net returns they target. This differentiation influences how specific social lenders go about building the client pipeline.
Social lenders with lower return targets (0.5% to 2.5%) typically have lower minimum loan thresholds that allow them to work with clients in less mature stages of development and with smaller loan requirements. These social lenders can work to build the client pipeline across markets, including in core social lending markets where the larger and more mature borrowers are already served.
Social lenders with relatively higher return targets (ranging from 2.5% to 5%), on the other hand, typically focus on lending to larger and more mature businesses. These lenders typically only work to build the client pipeline in new geographic and commodity markets, where some new clients may have larger financing needs.
Pipeline building can help the social lending sector improve its long-term financial sustainability and achieve its social objectives. Investors interested in supporting the growth of the social lender sector should encourage pipeline building by allowing for:
Investors targeting net returns of 0.5% to 2.5% can support lenders who focus on bringing smaller and less mature businesses into the sector as new clients – a need observed across both existing and new markets.
Investors targeting higher net returns of 2.5% to 5% can support social lenders who are building pipelines in new geographic and commodity markets, where some new clients will have large financing needs sufficient to meet investors’ return expectations.
Early Stage Financing
Currently, there is a gap in the provision of financial products and services to meet small agricultural businesses’ needs for asset financing in the US$10,000-US$50,000 loan range. It is difficult for most social lenders to make these very small loans within their current capital structures with their existing products.
An early-stage financing facility with ‘right-sized’ financial products could help address this gap. This facility would include diligence and underwriting processes that fall somewhere between the ‘character’ lending of microfinance (in which lenders assess borrowers’ reputation, community relationships, etc.) and extensive cash-flow analysis for larger working capital loans and trade finance.
Technical Assistance to Complement Investments
Technical assistance can develop and strengthen new producer groups, while helping other early-stage agricultural businesses become eligible for social lender loans. Investors should consider coupling their investments in social lender pipeline-building with grant capital for technical assistance, either by providing it directly through the social lender or through a partner technical assistance provider.
With these opportunities in mind, investors and funders should be cognisant of how critical pipeline building is to the sustainability of the social lender market and proactively encourage this work, improving the livelihoods of the world’s 450 million smallholder farmers in the process.
Source: Skoll World Forum