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Saving private SMEs

Venture capital mindset mixed into mezzanine funding cocktail

by Thomas Schellen

Tools designed to channel new money into Lebanon’s economy in the start of January 2022 shine in the same way as they did last year: They emit rare vibes of hopes against reason. But they do so in an uncanny semblance to the sensations which life-support machines in an intensive care unit evoke in all the unfortunate people who depend on them.

This is to say that tools which keep us alive and breathing, whether financially or physically, carry the unquestioned connotation of desperate measures. As long as the ventilator works, ICU patients will not be inclined to debate about their aesthetics, design, color scheme, or even the manufacturer’s name. (Actually, if an overly image-conscious hospital administrator were to insist that only a life support machine by a leading brand manufacturer be used in a coronavirus emergency, any number of patients might expire over the debate).

Infusion of finance is as vital to the Lebanese manufacturer as oxygen is for the COVID-19 patient. That does not mean that all great funding ideas will work out. Some of the financing treatments that opened up for manufacturing companies last year have led to questioning their compliance methodologies, and one must consider that some investment fund concepts indeed may not succeed, given the tremendous uncertainty about anything that still permeates the fabric of the Lebanese economy. But any ethical and operational investment fund that will secure a bunch of industrial jobs and contribute to Lebanon’s GDP is today more than welcome. If the fund is well constructed and operated by a reputed financial player with experience in the Lebanese market – even if not the exact same market segment – all the better.

The question is whether this unquestioned authority of an economic-life-saving tool will be proven in the case of the latest new fund, a special investment vehicle with a projected funding power of about $15 million and a five-year duration. It has been designed by IM Capital and IM Ventures, the pair of fund operators in the entrepreneurship ecosystem that has for the past years been co-financing startup ventures and acting as matching capital partner of numerous venture capital players under the regime of the Circular 331 system by the Lebanese central bank Banque du Liban (BDL) for development of the knowledge economy. IM Capital and IM Ventures respectively are implementing partners with the United States Agency for International Development’s (USAID) MENA and Lebanon investment initiatives.

Keeping it simple

The new fund goes by the abbreviated name SME Fund, the term associated with small and medium enterprises. The fund indeed targets SMEs in three broadly defined sectors of agri-food, chemicals, and paper and textile products, Nicolas Rouhana, general manager of IM Capital and IM Ventures, says in recent confirmation of plans that he first shared with Executive several months ago. According to him, agri-food sector enterprises are expected to represent about half of the fund’s portfolio while the other two manufacturing sectors of chemicals and paper/textiles together will make up the other 50 percent.

Surprisingly however, the SME in the fund’s name stands not for small and medium enterprises but for the unwieldy construct of “Scale up Manufacturing and Exports.” Semantic purists could rightfully raise a fuss about such an incongruous phrasing. Yet notwithstanding that the long form of its descriptive term doesn’t match the most common reading of the abbreviation, the new fund has been designed to help export-oriented SMEs reach new markets.  

Grammarian and wording concerns aside, the new fund has over the past few months cleared important hurdles in terms of concept, registration, structuring and targeting. According to Rouhana, up to 15 enterprises will be financed with investments of, on average, one million mostly “fresh” dollars each. “We are now [undertaking] due diligence with up to seven companies while also talking to others and putting them into the pipeline, and we are creating the vehicle for investing into these SMEs,” Rouhana tells Executive.

The new vehicle is the second emergency rescue fund that IM has created since liquidity tremors and policy miscalculations sent heavy shockwaves through the financial markets and banking system in late 2019. IM’s SOS Fund (nope, the abbreviation is close but does not spell out as “Save Our Souls”) was developed last year in collaboration with venture capital firms and similar financing houses. The “Save Our Startups” Fund has injected a total of $12 million into 11 mature startup companies that found themselves in the financial desert after the funding channels of BDL’s Circular 331 financial irrigation systems suddenly ran dry.

SMEs to be funded by the new vehicle need to be growth-stage companies, meaning that they are ready to tackle new markets and already have to achieve at least 30 percent of their revenue from exports. Companies with annual revenue below $500,000 also don’t need to apply, says the fund’s basic fact sheet of selection criteria. However, pointing to the fact that definitions of an SME show quite some variances in terms of company size and headcount, Rouhana emphasizes that structuring of the portfolio will prioritize diversification and that the fund’s focus in assessing companies for investment is on revenues and growth potentials rather than on technical definitions of SME status. “We are looking to build a diversified portfolio in terms of the sectors and in each sector in terms of company size and risk level,” he says. Investment tickets are not going to exceed $2 million per company, he adds.

Need for speed

Both the SOS and the SME Fund are focusing on Lebanese companies that have strong economic potentials but would be stunted in their growth or even doomed without access to new finance. Both funds thus have been designed under a paradigm of speedy fundraising from investors and allowing their beneficiaries to run as fast as possible in the difficult Lebanese economic terrain.

But these parallels of approach are juxtaposed with major differences in the constitution of the contestants that they support in the economic survivor race. In financing companies in the broader economic habitat of SMEs, IM Capital has ventured from its previous ecosystem of entrepreneurship into the jungles of privately-owned enterprises.  

One pronounced difference between tech startups and companies outside of the entrepreneurship ecosystem is that the former are from their ideation phase onward groomed towards attracting venture capital and outside investors. The SMEs now on IM’s investment radar usually are not. “Creating a product for SMEs differs in key ways from the funding of startups. [SMEs] are family businesses, not open to capital, [and] they may be cooperatives or one-man ownership from legal aspect,” Rouhana explains.

With such structures and mindsets, most SMEs are not primed for easy valuation or capital injections. Moreover, with IM being pressed for time to come up with fast solutions for this heterogeneous group, the fund was constructed on a type of “mezzanine debt” foundation. According to Rouhana this framework uses a “one-size-fits-all approach” of debt finance and investors will rely for returns on what he called “revenue capital” over the fund’s five-year investment period.

Such a royalty-based solution generally offers investors strong returns. As applied by the SME Fund, it also allows portfolio companies to retain control of their operations and does not make an injection of money by the SME Fund dependent on the sort of collaterals that are demanded by banks in a debt finance agreement. To receive funding, companies benefiting from the SME Fund will not have to produce collateral upfront but will enter convertible agreements that act as collateral and provide investors with the assurance that their money will not disappear without trace.

The terms of these agreements are such that equity provided by the SME Fund will convert into shares if the loan is not repaid, noting that the standard grace period for start of repayments is two years, and that the injected capital and agreed royalty payments have to be returned to the investors by the end of the five-year participation period. Payments due by invested companies entail fixed and performance-dependent interest. The former component is 8 percent and the latter is 8 percent royalty on delta, or the growth of revenue.

The conversion of the investment to equity is triggered only as final recourse in case of the invested company’s failure to repay. Otherwise, the SME Fund operators will not take equity in the invested companies. “What we take is like a convertible agreement. So if [invested SMEs] don’t pay out on the loan, we will eventually convert [the investment] into shares,” Rouhana emphasizes.

On the operational side, contractual provisions are such that IM assumes a role of strong observer on board level/senior management level. To this end, IM is partnering with external audit firms and will have access to the books of portfolio companies. It will not intervene on governance but will offer hands-on technical support and organize management trainings at invested companies. 

IM Ventures will be both the manager and a shareholder in the SME Fund, meaning it will earn a one-time management fee upfront and will secondly be compensated from the equity returns. Rouhana says that IM Ventures, in addition to being entitled to the upfront management fee, will be on equal footing to any other SME Fund investor in terms of returns.

Mobilizing players and resources

In marketing the fund and finding suitable enterprises to target, IM spoke with economic organizations such as chambers of commerce and industry, manufacturing associations, the Investment Development Authority of Lebanon (IDAL), and banks. The approach to potential investors has been developed to whet appetites by presenting profiles of the three targeted sectors and subsectors, such as food and beverages in agri-food; cosmetics, beauty and pharmaceutical producers under the chemicals tag; and fashion under paper and textiles. 

Ongoing fundraising efforts are to be completed in the first quarter of 2022 and would include the presentation of the SME Fund’s concepts, mechanisms, and potential returns to institutional and individual investors.

“We will fundraise for a maximum of three months. We will put our own money in, seeding the fund with $6 million, and try to fundraise [upwards of] $6 million to be able to deploy the fund,” Rouhana says. His fundraising expectations include participation by international development finance institutions and regional investors as well as individual local investors from the network that IM Capital has already developed. “The investors that we are approaching are knowledgeable investors. This is one extra option for them to diversify where they put their money. But the safest bet will be targeting individuals, locally or in the diaspora,” he adds.

The SME Fund is open to include components of some old ”lollars” (bank deposits in US dollar currency available at a set exchange rate lower than current market rates) from local investors and convert these at the market rate where such investments make sense under the financial needs of the funded companies, but will give high preference to fresh dollars in fundraising and disbursements. Investment returns will have to be in “fresh” dollars and thus earnings which the invested companies achieve in fresh dollars from exports, ideally while relying on short local supply chains for inputs, will be key for the viability of the scheme.

The export growth and job creation journey of the up to 15 companies will run from mid-2022. Considering the country risk of Lebanon, the SME Fund could attract investors who are eager to diversify and seek between 15 and 25 percent internal rate of return, Rouhana opines. If the fund performs as planned, he and all prospective investors will see a handsome return on the money that they invested. In the worst case scenario, flow back of investments will not materialize and the outcome of the SME Fund after five years would be ownership of numerous companies that need to be managed or sold. 

This is not a desired outcome and such risk, especially given the current times in Lebanon, might not be accepted by a bank. But high risk is a normal consideration for IM as venture capital firm, Lebanon needs daring and innovative investment funds (and lots of them), and IM is on a mission, Rouhana concludes, saying, “We are venture capital by nature. We took the model of revenue capital or mezzanine debt and turned into a Lebanese type of business.  We don’t want to go to the point of converting the loan to equity. The mission for us is not to take equity but to create jobs, keep people in the country, let [companies] export more, and so on.”

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Thomas Schellen

Thomas Schellen is Executive's editor-at-large. He has been reporting on Middle Eastern business and economy for over 20 years. Send mail

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