How did UK small and medium-sized enterprises manage during the pandemic?

Start-ups and smaller companies were disproportionately affected by the economic shock from Covid-19. Despite their limited access to private sources of finance, many were able to stay afloat because they adapted their business models and made use of government loan schemes.

Start-ups and small and medium-sized enterprises (SMEs) are the bedrock of the UK’s economy. They account for 99% of all UK firms and employ around 60% of all private sector employees.

Despite this, it is well established that SMEs often have the lowest levels of resilience to unforeseen, external events (what economists call exogenous shocks) such as the global financial crisis of 2007-09 and, more recently, the Covid-19 pandemic.

Here, we document how SMEs in the UK managed financially during the pandemic and what lessons we can draw for future unpredictable or ‘black swan’ events.

The outbreak of Covid-19 had colossal repercussions for households, firms and governments worldwide. A swathe of economic research has examined the impact of the pandemic on certain segments of the business community, especially SMEs.

This work covers a wide array of factors that affected these firms during the pandemic, such as the impact on employment levels, employee staff hours, turnover, export behaviour, precautionary savings levels, business model configuration, and the mental health and wellbeing of entrepreneurs and employees.

Consistently, this body of work reveals that SMEs were disproportionately affected by the pandemic and that many of these firms struggled to mitigate the negative effects.

Nevertheless, research shows that while SMEs were negatively affected, many of them managed to remain in business despite the prolonged and profound uncertainty caused by the pandemic.

This applied particularly to firms that implemented adaptive strategies (such as implementing working from home policies, going online and pivoting business models) and/or those that accessed government-backed funding support to limit the negative effects of the crisis (Gull et al, 2023).

What effects did Covid-19 have on SME finances?

Small firms’ capacity to cope with shocks is affected by their ability to obtain access to external sources of finance. This is crucially important as research shows that very few SMEs have adequate levels of precautionary savings to act as a financial buffer to tide them over during exogenous shocks.

Micro businesses – those that employ fewer than ten employees – represent the largest majority of UK SMEs. These firms were the dominant form of business in both immediate and medium-term risk profiles. Indeed, recent work shows that this liquidity risk was very real with one in 12 UK SMEs holding no spare cash (Cowling et al, 2020).

Despite their need for external sources of finance, owing to the informationally opaque nature of innovative growth-oriented businesses, start-ups and SMEs are often deemed too risky and unsuitable for bank finance due to their lack of collateral and unstable cash flows.

This can result in firms either being declined credit or self-rationing themselves from credit due to the fear of being rejected. The latter group of SMEs are labelled ‘discouraged borrowers’ – good firms that do not proceed with applications for finance due to the fear of being turned down (Brown et al, 2022).

But it was also the case that previously discouraged, and particularly scarred borrowers – defined as SMEs that had a previous loan application rejected and dropped out of the debt market completely – faced with such a severe shock to their cash flows, began to re-enter the loan market and make some use of the generous Covid-19 loan guarantee schemes (Cowling et al, 2020). This was unusual behaviour as discouraged borrowers typically drop out of the debt market for up to four years (Cowling and Sclip, 2022).

It remains to be seen whether this more positive experience in the loan market will reduce the future scale of discouragement and scarring as the economy continues to emerge from the crisis.

Clearly, the onset of the pandemic played an instrumental role in shaping borrowing behaviour – with regard to the demand for finance – within SMEs.The pandemic adversely affected the business sector, and small businesses have been disproportionately affected because they were more likely to be in industries that were harder hit by the pandemic (including locally traded service sectors, such as hospitality, retail and tourism).

Yet, due to the deployment of the UK government’s two main loan schemes – the Bounce Back Loans (BBLs) and the Coronavirus Business Interruption Loan Scheme (CBILS) – initial demand for finance at the onset of Covid-19 rose markedly.

Indeed, according to a report by the British Business Bank (BBB), almost half (45%) of SMEs applied for external finance during 2020, compared with just 13% in 2019.

The strength of this enormous demand can be almost exclusively attributed to the BBB, which injected a huge amount of liquidity into UK SMEs during the pandemic via the BBLs and CBILS.

The level of support provided by the government was unprecedented. The BBB claims that around 1.5 million BBLs and CBILS debt facilities had been approved by the end of 2020.

Research shows that 92.1% of all debt funds provided in the first two quarters of 2020 (April to June; and July to September) were backed by the UK government, which compares with less than 5% under normal circumstances (Calebrese et al, 2022).

It remains to be seen whether or not the Covid-19 loan guarantee schemes were effective, as many loans are only three years into their payback term. But the empirical evidence to date suggests that default rates are quite modest given the severity of the crisis, and hard fraud was only a minor feature given the volume of loans advanced (Cowling et al, 2022).

There is also evidence that the regional distribution of Covid-19 guaranteed loans was more equal than conventional lending to businesses in normal times, and slightly favoured less economically advantaged regions.

These loans thus contributed in a modest way to the government’s levelling-up agenda (see Figure 1).

Figure 1: BBL and CBIL loans and business population shares by region

Source: Cowling et al, 2023

That being said, as UK inflation and interest rates have risen significantly since the pandemic began, there is also evidence that many SMEs have accelerated their loan repayments to reduce their debt exposure (see Figure 2). This was particularly true for CBILS, the larger of the two loan guarantee schemes in terms of the size of lending allowed (Cowling et al, 2023).

Figure 2: Inflation and early repayment of BBL and CBIL loans

Source: Cowling et al, 2023

Since 2021-22, demand for finance by SMEs has become much more muted, especially because the downturn in the economy has adversely affected confidence levels in these firms. The withdrawal of the bespoke Covid-19 loan guarantee schemes has also contributed to this trend (see Figure 3).

Figure 3: Gross lending to SMEs via loans and overdrafts

Source: UK Finance

What about other important sources of finance for SMEs?

Faced with extreme liquidity constraints, some SMEs often turn to non-traditional, high-cost sources of finance – such as credit cards – as they attempt to meet their financial obligations.

But this could hinder or jeopardise their longer-term sustainability as excessively costly lending can jeopardise a firm’s viability in the long run (Brown et al, 2019).

While the vast majority of SMEs use bank finance, innovative growth-oriented start-ups and SMEs often use equity finance, such as venture capital and business angel finance. Research suggests that these sources of entrepreneurial finance often fall dramatically during periods of crisis and recession.

Indeed, this was the case during the pandemic when levels of finance in the UK reduced by between 30-40% in the first quarter of 2020. This form of funding also dropped dramatically following the global financial crisis in 2007-09 (see Figure 4).

This suggests that the decrease is likely to be sustained throughout 2020 and perhaps into 2021 (Brown et al, 2020).

Figure 4: Number of UK equity funding deals by deal size, 2007-2020

Source: Brown et al, 2020

The deals and firms most negatively affected are seed-stage investments in the newest and most nascent start-ups (see Figure 4). In other words, the smallest, most innovative and growth-oriented firms may be starved of cash by the crisis with powerful knock-effects that could reduce innovation in the longer term.

This could mean that start-ups currently being created may be hindered by a lack of funding opportunities for years to come. Research shows that start-ups that are under-capitalised at birth are then unable to grow throughout the early stages of their lifespan, which impedes their longer-term growth prospects (Sedlá?ek and Sterk, 2017).

What can policy-makers learn from the pandemic?

Examining the impact of the pandemic alongside the effects of the government’s pro-active policy response provides a picture of how exogenous shocks unfold and affect SMEs.

First, SMEs have lower levels of resilience to exogenous economic shocks than their larger counterparts. This is due to having fewer internal resources such as precautionary savings. The disproportionate impact of the pandemic on local service sector businesses made this especially acute.

Second, the magnitude of the government’s response was crucially important in mitigating the magnitude of the liquidity shock from the pandemic. While mistakes were made, the speed of the response was vital.

For example, the rapid rollout of the Future Fund by the BBB helped to mitigate the negative headwinds from the pandemic for innovative start-ups. This fund was established in May 2020 and deployed £1.14 billion of funding to 1,190 equity-backed companies.

Evaluation evidence suggests that the BBB’s short-term objective of increasing the supply of finance to potentially viable UK equity-backed companies was broadly met (BBB, 2022).

Finally, in terms of entrepreneurial finance for innovative start-ups, exogenous shocks such as the pandemic and the global financial crisis disproportionately affect seed funding. In other words, the most nascent innovative firms are at greatest risk from these unforeseen events.

Due to the unique relational nature of entrepreneurial finance, which requires close engagement between investors and investee firms, the pandemic led to a crucial form of ‘financial distancing’. This is why support like the Future Fund was in such high demand during the pandemic.

Going forward, governments across the world need to ensure that they have measures in place so they can execute and rapidly deploy multiple debt- and equity-based financial instruments to help combat the malign effects of these rare black swan events.