SMEs are the unsung heroes of the UK economy — how can we support them better?

As is often the case in life, the contributions of everyday heroes are frequently overlooked. While everyone fawns over the admittedly adorable giant panda, hardly anyone casts a thought to the hardworking bamboo plant the animal relies on for food. Nor do most know that the humble bamboo is an excellent construction material that combats soil erosion and produces 35% more oxygen than hardwood trees (the Greengage tree notwithstanding).

Such focus on the great and the good is alive and well in the UK. Large businesses are given white-glove treatment by banks with near inexhaustible access to financing even as SMEs struggle to get comparable attention. This is particularly frustrating with the mid-sized, family companies that make up the so-called UK ‘Mittelstand’, which play a quiet yet absolutely crucial role in the UK economy.

It is not commonly recognised, for example, that UK manufacturing represents the country at 9th on the global scale in terms of absolute GDP and much of this manufacturing is done by SMEs — in addition to household names like Rolls Royce and Dyson.

What is the UK Mittelstand?

So what defines the UK Mittelstand and how can we envision a future where it achieves its full potential as a globally recognised backbone of the economy?

There has previously been confusion over the definition and use of the term ‘Mittelstand’ in both the media and academia, largely due to the varying definitions attributed to the term. Often, ‘Mittelstand’ is used as a broad description for all SMEs, reducing the complexity of what it entails to purely the size of the company. However, many believe that there is more to a ‘Mittelstand’ business’s nature.

A key aspect of Mittelstand is the nature of corporate governance. This encompasses both the legal and sociocultural aspects of the business. These companies are usually operated as sole proprietorships or non-incorporated firms that do not have limited liability protections. It is so heavily focused on the idea of being family-owned and run that if a family steps back from the running of the company it is no longer deemed a true Mittelstand and rather sits on the periphery of the Mittelstand idea. With this strong sense of familial leadership, it is then evident that not every SME forms a part of the Mittelstand.

What is important in a Mittelstand company is the ‘DNA’ of the company with its values and beliefs being at the heart of the business. It is often a long-term business model instead of one looking for a quick buck. However, while it can be argued that when defining Mittelstand, you must go further than purely the empirical data of a company’s spreadsheets and look at the organisational structure, leadership, and values, this is harder than it seems.

UK vs German Mittelstand

As Mittelstand is a primarily German phenomenon, it is difficult to clearly differentiate the difference between an SME and a UK Mittelstand company, especially when trying to consider qualitative data. As a result, for the analysis and categorisation of companies, it is significantly more attainable to judge a Mittelstand company based on quantitative rather than qualitative data. Nevertheless, the UK Mittelstand, like its German counterpart, is often identified as medium-sized companies rooted in familial ownership.

The Mittelstand concept is a success in Germany due to the society the country has fostered over decades of investment and planning. Germany has the highest youth employment rate in Europe because of its focus on training the next generation of skilled labourers. Their focus on the dual education system of both university and vocational training has led to a very skilled young labour force. Moreover, the mindset that helped develop the Mittelstand was the consequence of a post-war Germany that needed to rebuild its economy. This has caused a culture which is inclined to foster workers from a young age in a family-minded organisation, creating the loyalty that will allow these SMEs to grow.

The problem with SME lending in Britain

The way that SME lending is structured in the UK causes a suboptimal experience for the small business owner which in turn causes a loss of trust in the UK’s financial institutions. Research has shown that SME owners do not feel that they get adequate information on the best financial solution and sometimes receive no explanation for a rejection. Furthermore, the FCA and CMA report that only 13% of SMEs trust their bank to act in their best interest. It is clear that the UK needs a revolution in banking and lending which bridges this funding and service gap for an underappreciated client base of SMEs that form the backbone of our economy.

A number of alternative models do exist in the UK including Community Development Finance Institutions (CDFIs), Mutuals and Challenger banks like Monzo, Starling and Tide.

Internationally, there are also several countries where finance for SMEs is structured fundamentally differently from that of the UK. Germany has a superb structure for SMEs to access finance and flourish. Their financial institutions have a ‘three pillar system’ which has allowed for the clear differentiation of the types of banking needed to provide the best support for SMEs. In addition to this, certain types of banks are legally restricted to prioritise lending to regionally based customers which emphasises a customer-based approach. Consequently, the decentralised nature of their system has enabled simpler SME lending.

The US community banking system is another example of decentralised banking, which helps promote more convenient SME lending, and in Sweden, there is also a clearly decentralised approach. One of the largest banks, Handelsbanken, gives individual branches a considerable amount of autonomy to serve the needs of the local community. What is particularly notable with this example is that Handelsbanken has been operating in the UK in a similar manner since 1982 and now has over 200 branches. This suggests that such a style of banking and SME finance is possible to implement within the UK.

SME lending post-Covid

The state of SME lending in the UK has undergone a dramatic shift since the Covid-19 pandemic began in Q1 2020. This is true across a multitude of sectors as well as for alternative funding methods such as asset finance. Multiple data sources point to a large increase in demand for SME lending due to the impact of the pandemic on the UK economy. Although there are indications that demand has plateaued in the short term, the growth of the SME sector signals a promising future.

SMEs are a massive contributor to the UK economy, both in terms of turnover and employment. However, the lending environment for SMEs does not seem to recognise this entirely. As such, many of these companies struggle to survive, let alone thrive. The sole proprietorships that would qualify to be considered as a UK Mittelstand company have unlimited liability and are thus especially vulnerable. For them to prosper, a client-centric approach needs to be adopted similar to countries like Germany.

During the pandemic, business “deaths” — or closures in common parlance — most likely decreased due to the massive increase in SME lending. Without this financing, there would have been many more casualties in the SME sector as their balance sheets are simply not as robust as those of a large corporation. Therefore, the types of government schemes and institutions that enabled this support needs to be emulated going forward.

Even as the direct impact of the pandemic fades into the distant past, SMEs will continue to face challenges that their larger counterparts can overcome through access to financing. The increased digitisation partially brought about by the pandemic will also disproportionately affect these smaller companies. This is due to the difficulty of competing with large corporations online without significant funds. Consequently, a more favourable lending environment needs to be established for the key engines of growth that are the UK Mittelstand and other SMEs. This is not only for their future but that of the UK economy as a whole.

To learn more about the UK Mittelstand and the challenges with UK sme lending, download the full white paper here: ‘UK Mittelstand: Crown Jewel in the Rough.’