Call it what you will, but in smallholder finance, subsidy is here to stay. Like many nascent markets, particularly those that target bottom of the pyramid consumers, investing in global smallholder finance requires some form of subsidy to mitigate risks and create an investable opportunity. While funders and investors can leverage many different types of subsidy our new ISF Briefing Note examines the dynamics shaping one particular and important form — grant funding from international donors. In 2016, our state of the sector report Inflection Point coined the term “smart subsidy,” referring to the strategic use of private and philanthropic capital to mitigate risks in smallholder investments. Understanding the current subsidy dynamics is a first step on the path to making subsidy “smarter” going forward.

For smallholder financial solutions to succeed, providers require support from an enabling environment. Previous ISF and Lab research identified components of this environment, from Inflection Point which demonstrated the relationship between financial service providers (FSPs) and capital providers, to ISF’s research on the role of government policy and smallholder finance and the market for technical assistance providers in developing countries.

The relationship between the enabling environment and smallholder finance is complex, and to date, there is limited research on the link between the success of specific smallholder products and services and factors in the enabling environment. However, the Mastercard Foundation’s rural and agricultural finance portfolio – ten programs spanning 26 countries in sub-Saharan Africa – should provide an opportunity to understand more about this relationship. Part 6 of the Pulse series highlights some early learnings from this portfolio and makes recommendations for future research to close the knowledge gap.

Defining the smallholder finance enabling environment and ecosystem

The smallholder finance environment is determined by at least four key elements, including the regulatory, financial, knowledge, and digital infrastructure of a given country or context.

Within this environment, there is an ecosystem of players operating to provide smallholder farmers financial and non-financial services, including microfinance institutions and savings and credit cooperatives (SACCO); state bank, commercial banks and niche lenders; digital service providers; TA providers; agribusinesses and off-takers; and farmer organizations.

Early learnings from the Mastercard Foundation’s RAF portfolio

While more research is required, some early learnings are emerging from the Lab’s work with Mastercard Foundation RAF partners.

1. Policies by government and regulators can encourage or discourage lending to smallholders. AGRA found that if governments regulate the use of collateral and streamline land registration procedures, the risk of agricultural lending decreases and financial institutions (FIs) are encouraged to enter the market. As a result, farmers in Burkina Faso with no registered land, for example, are seeing increasing access to finance.  In Kenya, interest rate caps are preventing some FIs from serving the SHF market, as they cannot factor the estimated risks of this new segment into their pricing.
2. Market understanding generally, FSPs lack a mature understanding of smallholder farmers, constraining potential borrowers from designing effective services and products. In Rwanda, ICCO observed that limited sector-specific knowledge kept SACCOs from lending to the agriculture sector.  More broadly, lack of data on the SHF market has typically made it difficult and costly to identify and target specific segments of smallholders.
3. Capital availability both the availability and price of capital affect the success of new business models.  In Kenya, digital financial services (DFS) offer great promise for smallholder solutions but require heavy upfront investment. Mercy Corps notes that many DFS start-ups are progressing slowly because they are self-funded, unable to find venture capitalists or even donors to take on the risk.  In Ghana, central bank interest rates of 21% lead to market interest rates of over 30%, even for low risk customers.  Here AGRA observes that the cost of capital is making it unattractive and too expensive for FSPs to lend to new or challenging segments such as SHFs.
4. Digital infrastructure Including agent networks, is needed for cost-saving mobile-based solutions to take off. A Mercy Corps Ecosystem Review in Zambia identifies a lack of sufficient, affordable and trusted cash agents, merchant acceptance and other digital service points in rural areas as key constraints for SHFs to access and use DFS. The study also finds that financial institutions are making limited investments in providing services to rural areas because of high operational costs and low investment opportunities as a result of small and infrequent transactions.
5. Ecosystem players for FSPs, building connections between value chain actors and smallholders is challenging and costly but critical to boosting product development and uptake­. In Rwanda, ICCO found that linkages between informal village savings/loan groups and formal FIs allow organizations to overcome geographic limitations and assymetric information.

Closing the knowledge gap to build an enabling environment

Although there is no unified theory of how to build an enabling environment for smallholder finance, a number of organizations are providing data and conducting adjacent research that can help address the knowledge gaps:

1. The World Bank’s 2016 Enabling the Business of Agriculture dataset provides country data on a range of key indicators – including market, policy, and ICT measurements – that provide insight into the enabling environment.
2. Nathan Associates’ 2015 study found that traditional public goods for information-sharing among FSPs must be adapted to the rural agriculture context. They also found that training of credit officers to understand smallholder profiles and needs can dramatically improve the performance of agricultural finance.
3. CGAP found that without an adequate infrastructure and an extensive agent network, shifting from cash to digital payments requires a substantial upfront investment and can result in additional burden on smallholders.
4. New Markets Lab takes deep looks at specific policy settings with implications for smallholder finance. Their recent work with IFAD addresses legal and regulatory issues to scale up value chain development, which includes assessments of legal and regulatory issues related to land tenure, seed and input markets, financial services standards, and trade.

Filling knowledge gaps

Going forward, we are exploring whether the industry could benefit from a typology of country enabling environments that can help FSPs determine which types of services are likely to be successful, and how products/services and business models might need to be adapted when expanding into new countries.  In addition, there is a need for better understanding of best practices for coordination between ecosystem players, and the potential for such coordination to overcome inherent challenges in the enabling environment.

Financial institutions, agribusinesses, funders and other ecosystem players could use this knowledge to navigate and foster strong smallholder finance environments that can lead to better financial solutions.

Sector actors are increasingly aware that progressive partnerships are one of the most promising ways to feasibly structure finance and financial services for smallholder farmers. As our recent state of the sector report Inflection Point pointed out, these partnerships allow providers of finance to strengthen business models and increase reach. As partners align on pre-competitive or symbiotic goals to develop inclusive markets, we are learning lessons about how best to facilitate them and how to make them highly productive.

Progressive partnerships: Broad sector trends

At a pre-competitive level, actors who may compete with one another in the market are forming partnerships based on their common interests to mitigate risk across their value chains. We have seen pre-competitive alliances within different commodity markets through associations such as the African Cashew Initiative, the Cocoa Livelihoods Program, and Compaci, the Competitive African Cotton Initiative. Some, like the Better Cotton Initiative, connect players across the supply chain – from farmers to retailers. Others, like Developing Local Extension Capacity, are working to develop more effective technical assistance models.

There are also symbiotic partnerships at the level of financial service provision, between financial institutions and last mile firms. The term “last mile firms” refers to businesses working directly with farmers, such as off-takers and extension providers, or technology platforms that target and engage smallholders. Agribusinesses like Barry Callebaut subsidiary Biopartenaire in Ivory Coast are partnering with microfinance institutions (MFIs) like Advans to introduce savings products and potentially expand the reach of input loans. Kifiya developed a transaction platform in Ethiopia, through which micro-insurance providers can reach farmers. AGRA is exploring the potential for partnerships between financial institutions and farmer management systems providers, to enable credit underwriting based on farmer data.

And partnerships have emerged across sectors, as we describe in our 2016 briefing note, The Climate Conundrum. Agricultural finance and climate finance sectors are combining forces to invest in climate smart agricultural practices for smallholder farmers. Impact funds like Althelia and the Livelihoods Fund for Family Farming are developing new models that provide market returns by combining revenue from commodity sales with mechanisms like carbon credits. We are also seeing funder / government collaboration, as in the case of the Action Plan to support Brazil’s Forest Code and the Indonesian Tropical Landscapes Finance Facility, which leverages public funding for long-term investments in green growth and rural livelihoods.

Zeroing in on the last mile: Models ready to scale

The new developments in last mile partnership opportunities are particularly promising. Currently, few of these partnerships are operating at capacity in Africa – a situation ripe for change. The Learning Lab’s recent baseline research on Last mile partnerships for smallholder finance looked at last mile firms that want to partner with financial institutions (FIs). At least three models (which are not mutually exclusive) look particularly ready to scale:

• Off-taker (input lender): This is a partnership model with a long history. Agribusinesses that provide inputs on credit are often looking to outsource this financing, and financial institutions can deliver a broader array of other financial services to smallholders. Off-takers can facilitate direct relationships between farmers and FIs, as opposed to just on-lending bank finance. In the Biopartenaire example above, introducing savings accounts is a first step in a longer journey of connecting Advans with farmers.
• Delivery channel partnerships: In these partnerships, FIs can leverage the distribution infrastructure built by last mile firms that already provide products and services to farmers. The well-known ACRE insurance model uses existing agro-dealers to provide bundled seed insurance. Kifiya, cited above, provides a digital platform as a channel for insurance companies who can realize a 60% cost reduction. Agribusinesses like ECA in Mozambique (that want to move away from cash) can be a channel to introduce digital payment products to farmers.
• Data partnerships: Here the key value addition of the last mile partner is data. What AGRA, listed above, is exploring hinges on a data partnership. Similarly, an alternative data approach advanced by Mercy Corps AFA involves data sharing from input providers. In Ghana, off-taker and extension provider Prep-eez is developing a platform over which multiple FIs can access farmer data to provide loans and insurance.

Overall, FIs and last mile partners can share risks and transaction costs, expand offerings, and increase revenue, all of which improves the return on investment in serving smallholders.

Sharing our lessons learned: Working together in partnerships

In our work researching and facilitating partnerships like those outlined above, we have learned a few critical lessons:

• Lesson 1: Effective communication requires structure, openness, and neutrality. Partners need to balance clear and structured channels of communication with transparency and openness. Because there are frequently so many players, a neutral facilitator in the early stages can enhance successful design, facilitation, and management.
• Lesson 2: Flexible agreements are essential. All actors need room to adjust as the partnership evolves. As partners pilot their initiative, each will learn more about their goals and needs. Flexibility allows partners to take advantage of this learning and shift resources as appropriate.
• Lesson 3: The bigger the prize, the greater the complexity. Ambitious goals that require risk, innovation, and scale mean complex partnerships – ones that must be carefully built. For partnerships with big innovation agendas, it’s essential to have realistic expectations about what can be achieved in the short, medium, and long term. The team will need to build trust and get quick wins before building toward a greater mobilization of money and clients.

One of the biggest obstacles to financing smallholder farmers has been understanding who they are and – by extension – what their needs are. Without detailed data, it has sometimes been difficult for people sitting far away in donor programs to see the ways in which farmers are a heterogeneous and varied group.

However, as seen in Dalberg’s 2011 Listening to the Farmer Voice and CGAP’s 2013 Segmentation of Smallholder Households, the sector has begun to identify key distinctions among farmers including their place in a skill-will matrix and their relationship to the market. With this information, financial service providers could begin to define and target addressable market segments. It was a great start to a new way of thinking. CGAP’s 2016 work on two fronts – granular exploration of farmers’ lives in the Smallholder Diaries and the rigorous quantitative National Surveys – has created a more nuanced understanding of higher level definitions, and helped quantify more precise segments incorporating behavioral and attitudinal components. Additionally, broader efforts in the financial inclusion space such as insight2impact are working together to collate and analyze big data sets of clients, including farmers.

Farmer voice is increasingly on the mind of people in the sector. A client-centered approach allows us to close the gap between farmer need and farmer demand by offering what farmers really want. The Learning Lab has hosted two annual gatherings (prior to The MasterCard Foundation’s “clients at the center”-themed Symposium on Financial Inclusion) where financial service providers came together to eagerly learn how to better listen to farmers.  And this reflects a broader trend that is changing the nature of the offering to smallholders.  For instance, MyAgro’s design work in Senegal took into account farmers’ reluctance to take out loans for planting equipment purchases; in response, MyAgro developed a layaway model. Safaricom just launched a digital finance solution for the dairy sector in Kenya based on insights developed from human-centered design support from the Mercy Corps AFA program.  And Proximity Designs is providing short-term crop loans in Myanmar, based on what farmers told them they need.

We at ISF and Learning Lab are learning how to apply this information on the ground. With support from The Bill and Melinda Gates Foundation and research led by Dalberg Design Group (DIG), ISF’s work in Tanzania provides a real-life model of what we can do. We knew that digital credit products offer real potential for Tanzanian farmers, and wanted to find out why they weren’t buying or using them. By identifying five different farmer personas and tracing the credit experience of each, DIG was able to improve the design of financial products and their delivery to fit farmers’ needs. The Emerging Striver, for instance, is comfortable with technology and mobile credit, and hopes to buy her own plot or a small taxi and start a family – very different than the Burdened Breadwinner, whose goals are subsistence and paying her grandchildren’s school fees. DIG mapped each persona’s journey through the lending experience to identify obstacles and developed an idealized digital credit product with five new features including flexibility, integrated savings, and connections with real-world agents. Now a provider is working to deploy a new product with these features.

In the past few years, providers increasingly acknowledge that financing smallholders requires us to deeply understand a farmer’s reality and think differently about how we serve them. Even as we strive to design better products targeted at the needs of specific target farmer segments, we need to delve further into the skill-will matrix. Variations in ability and attitude exist even within a group having similar external characteristics like demographics, geography, and value chain. One farmer may effectively use an input loan to become more profitable while a similar-looking farmer may struggle to earn enough to pay off the interest and find himself trapped. To understand the difference, FSPs may turn to ground-level partners with close relationships to farmers, or to sophisticated analysis of farmer data (including psychometric profiling).

As the new farmer-centric mindset is emerging, sector players – such as investors, funders, providers, etc. – are realizing:

• We need to better segment customers before designing products
• We need to use customer-centric principles in that product design
• We need to build in ongoing feedback from farmers at every stage

Moving forward, if we want to find the models that will scale to market need, we need to go bigger and bolder with this farmer-centric approach and push for data-rich consumer-focused solutions.

Our landmark state of the sector report, Inflection Point, makes a bold call to action, asking for a concerted effort from sector actors  – FSPs, funders, TA providers, and others – to cut the smallholder financing gap in half by 2025.  To do this, stakeholders across the sector will need to systematically increase collaboration and break down silos between actors. Now more than ever, players ranging from agribusinesses to fintechs have the opportunity to work together and build new market opportunities to better serve smallholder farmers.

Our understanding of how to approach agricultural finance is much more sophisticated than it was even a year ago, is in part thanks to 2016’s Inflection Point and rigorous research dating back to Dalberg’s 2012 Catalyzing Smallholder Agricultural Finance. We observed that actors were approaching the sector with a “channel-based” framework.  They had the skills and knowledge to serve smallholders within their primary distribution channel and its function, but didn’t have the know-how to design products that could work more effectively through cross-channel collaboration.

Recently, a few companies have started to cross channels and functions with great success. For instance, low customer usage of its mobile app drove Smart Money to cross channels and partner with kiosks and agro dealers to increase awareness and penetration in rural consumers. And solar home system provider and financier M-Kopa has worked to cross functions – recognizing that most of their customers are also farmers, they are collateralizing the solar asset in order to finance agricultural products.  Historically, most actors’ focus on perfecting distribution channels has limited the potential for more, and more appropriate, financial services for smallholder farmers.

Following our findings in Inflection Point, we are working from a whole new model of the sector. Instead of seeing a parallel series of distribution channels, we see a complex and interconnected ecosystem of different stakeholders. The graphic below provides a simple framework for organizing some of the key actors and relationships in this ecosystem.  It does not attempt to capture the critical role of agricultural markets, or details of non-financial services.

Looking at the sector in a holistic way, focusing both on the actors (boxes above) and the relationships (arrows), we identified three key barriers to growth – limited and mismatched capital availability, low business model sustainability, and a shortfall of “demand” relative to “need”. From there we have targeted three key areas needed to unlock progress in the face of these barriers: smart subsidy, progressive partnerships, and customer centricity.

In light of this new systems approach, the sector needs to rethink the ways in which we navigate farmer financing demand and answer big questions on what tools we use to address it. Are we offering the right financial products to the right types of farmers? What constraints need to be resolved together at a country level to unlock services for smallholder farmers locally? How can we facilitate the relationships between funders and investors and financial markets?