Working Paper: CEPR ID: DP13698
Authors: Suresh De Mel; David McKenzie; Christopher Woodruff
Abstract: Many microenterprises in developing countries have high returns to capital, but also face risky revenue streams. In principle, equity offers several advantages over debt when financing investments of this nature, but the use of equity in practice has been largely limited to investments in much larger firms. We develop a model contract to make self-liquidating, quasi-equity investments in microenterprises. Our contract has three key parameters that can be used to shift risk between the entrepreneur and the investor, resulting in a continuum of contracts ranging from a debt-like contract that shifts little risk from the entrepreneur to a pure revenue-sharing contract in which the investor absorbs much more of the risk. We discuss implementation choices, and then provide lessons from a proof-of-concept carried out by an investment partner, KGC Equity, which made nine investments averaging $3,800 in Sri Lankan microenterprises. This pilot demonstrates that our contract structure can work in practice, but also highlights the difficulties of micro-equity investments in an environment with weak contract enforcement.
Keywords: microequity; microenterprises; microfinance; alternative financing; contract enforcement
JEL Codes: O12; O16; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Contract structure developed allows for a continuum of risk-sharing arrangements (G32) | Willingness of entrepreneurs to engage in riskier investments (G31) |
| Varying key parameters of the contract (D86) | Risk can be shifted from the entrepreneur to the investor (G11) |
| Increasing the share of risk borne by the investor (G11) | Different outcomes for entrepreneurs (L26) |
| Difficulties in monitoring and enforcing contracts (D86) | Low repayment rates (G51) |
| Moral hazard and enforcement issues (D82) | Impact success of microequity investments (O12) |