The effect of blending formal and informal finance on firm performance

Access to appropriate finance remains one of the top constraints for small and micro businesses in sub-Saharan Africa. Less than 20% of small firms are able to access loans or credit lines from formal lenders (IFC, 2016). Market frictions driven by information asymmetries and associated agency problems contribute to significant rationing of microenterprises in formal capital markets. Evidence shows that the informal capital market, which includes family and friends, moneylenders and self-help groups, has bridged this gap. Extensive evidence supports the positive role played by formal finance in supporting small firm growth and performance. In addition, growing evidence shows that informal finance also supports firm growth and performance, this literature shows less consensus (Allen et al., 2019; Degryse et al., 2016; Ebo Turkson et al., 2020).

The historical bias towards formal finance has often led policymakers to prioritise formal finance. Recent literature increasingly recognises informal finance as a vital component of SME growth in contexts where formal financial systems are underdeveloped or inaccessible (Ayyagari et al., 2010; Beck et al., 2015; Fowowe, 2017). In many African economies, informal finance offers flexibility, speed and trust-based mechanisms, often compensating for the rigidities and collateral demands of formal institutions (Degryse et al., 2016; Allen et al., 2019).

Recent studies show that firms relying solely on informal finance face growth constraints due to limited resources and higher costs. The strategic use of informal finance alongside formal finance can leverage the strengths of both financial systems and has shown potential especially for small and microenterprises (Beck et al., 2015; Wellalage and Fernandez, 2019 Allen et al., 2019). Nevertheless, a gap persists in understanding how SMEs simultaneously utilise formal and informal financing and the implications for performance, especially in African markets where the coexistence of these systems is widespread (Arisa and Gwatidzo, 2022; Nadege et al., 2024; Allen et al., 2019; Beck et al., 2015; Wellalage and Fernandez, 2019).

As a result, a growing body of evidence is documenting the effect of informal finance. Of this evidence, the bulk focuses on the relative importance of formal and informal finance, focusing on whether there is a substitutionary complementary or complementary relationship (Beck et al., 2015; Degryse et al., 2016; Karaivanov and Kessler, 2018; Long, 2019). Very few studies investigate the simultaneous use of formal and informal finance by the same firm which is typical of small firms in Africa. The little evidence that exists suggests that this simultaneous use of formal and informal finance may be very beneficial for small firms than relying on formal and informal finance alone (Degryse et al., 2016; Karaivanov and Kessler, 2018; Long, 2019).

This paper contributes to this discourse by analysing the simultaneous use of formal and informal finance by small and micro firms in South Africa, a country with relatively advanced financial markets yet persistent SME financing challenges. Using data collected over 12 months, the study investigates whether this co-funding financial strategy enhances firm performance. The results show that the simultaneous use of formal and informal finance positively affects firm performance, controlling for formal finance does not erode this effect. Additionally, the results show that this effect is size dependent.

The study makes two key contributions to the literature. First, the main contribution is to the scanty literature on cofounding in small and microenterprises. The paper provides empirical evidence on the critical role of co-funding in Africa, challenging the dichotomy often drawn between formal and informal financial systems. The extant literature almost exclusively focuses on China. The emphasis, therefore, is on the nuances of the nature of the Chinese financial markets, which are highly dualistic in nature (Allen et al., 2019; Degryse et al., 2016). Although cofounding is prevalent in Africa, the African context remains understudied. Where African studies exist, such as Ebo Turkson et al. (2020) and Arisa and Gwatidzo (2022), tend to analyse formal and informal finance as substitutes or focus on access constraints. One study in an African context which closely tracks with our paper is the paper by Shibia (2024). The authors show that co-funding is important in coping with the effects of climate-induced shocks among micro and small enterprises in Kenya. This study uses data from South Africa's dualistic financial market, which features both sophisticated formal institutions and vibrant informal systems, as well as various government-sponsored financial instruments for small and microenterprises (Nyanchama and Gwatidzo, 2022). Our results show that although context is very important, the effect of the simultaneous use of formal and informal finance on firm performance is robust.

Secondly, the paper extends the literature by providing evidence on the importance of firm size in shaping the efficacy of co-funding strategies. The results suggest that while co-funding benefits firms of all sizes, its impact diminishes as firm size increases. The paper provides evidence for a data set that includes both formal and informal firms. We factor size in the analysis and again we show that the results are robust and in line with the existing studies. We also check the effect of firm size and find the effect of this simultaneous use of finance declines with size so that co-funding finance is most important for microenterprises.

The literature generally indicates a complex and layered impact of finance on the performance of firms. First, formal finance, which is characterized by structured financial transactions within regulated frameworks, is typically has a positive effect on firm performance (Abraham and Schmukler, 2017; Beck, 2013; Beck and Cull, 2014; Rajan and Zingales, 1998; World Bank, 2014). However, its implications are complex and warrant a critical exploration to fully understand its breadth and depth. Central to the discourse on formal finance is its role in facilitating capital access, which is integral to firm growth trajectories. The structured nature of formal financial systems provides firms with the necessary capital to undertake expansive projects and strategic investments (El-hadj and Cooper, 2015; Ajewole, 2021). This access is not merely about liquidity; it is about empowering firms to seize growth opportunities that require substantial capital outlays, such as entering new markets or developing innovative products. The availability of such financial resources is instrumental in enabling firms to scale operations and enhance productivity, thereby fostering a competitive edge in increasingly dynamic markets (Fohlin, 2007; Livnat et al., 2021).

The infusion of formal finance into a firm's capital structure also plays a crucial role in enhancing productivity and operational efficiency (Li, 2010; Raj and Sasidharan, 2020; Fowowe, 2017; Raj and Sasidharan, 2020). With access to formal financial resources, firms can invest in advanced technologies and human capital development. These investments are essential for optimizing production processes and achieving operational efficiencies that are critical in maintaining competitiveness. The ability to adopt state-of-the-art technologies and improve workforce skills translates into higher productivity levels, which are indispensable in sustaining firm growth in the long term. Moreover, formal finance is intrinsically linked to fostering innovation within firms (Ullah, 2019). The structured financial support provided by formal institutions enables firms to allocate resources towards research and development initiatives. This financial backing is crucial for the development of new products and services, which are vital for maintaining a firm's competitive advantage. Innovation, fuelled by formal financial support, becomes a driving force in a firm's ability to adapt and thrive in rapidly evolving market conditions. In addition to promoting growth and innovation, formal finance plays a significant role in risk management (Ullah, 2019). Formal financial institutions offer a suite of risk mitigation tools, including insurance products and hedging instruments, which are not typically available through informal finance. These tools are essential for firms to manage financial risks and stabilize cash flows, thereby enhancing their resilience to economic shocks. The ability to effectively manage risk is a cornerstone of financial stability and sustainability for firms operating in volatile economic environments.

However, despite the clear advantages, access to formal finance is not without its challenges. Many firms, particularly small and medium-sized enterprises (SMEs), encounter significant barriers in accessing formal financial services. These barriers often include high-interest rates, stringent collateral requirements and a lack of financial literacy. Such obstacles can limit the ability of SMEs to leverage formal finance for growth and innovation, thus perpetuating a cycle of financial exclusion and constrained growth potential (Aryeetey, 2008; Ayyagari et al., 2010; Weiping, 2023). The disparity in access to formal finance between larger firms and SMEs underscores the need for targeted policy interventions. Policymakers must prioritize efforts to enhance financial access for SMEs, recognizing their critical role in economic growth and development. This may involve implementing regulatory reforms, fostering financial literacy programs and supporting the establishment of financial institutions that cater specifically to the needs of underserved markets (Fernando, 2019; Wai, 2019). In conclusion, while formal finance is a critical enabler of firm performance, its impact is nuanced and requires a comprehensive understanding of both its benefits and challenges. Addressing the barriers to financial access remains a pivotal challenge in maximizing the positive outcomes associated with formal finance. A nuanced approach that considers the diverse needs of firms across different sectors and sizes is essential for leveraging formal finance as a tool for sustainable economic growth and development.

On the other hand, informal finance, often characterized by financial transactions occurring outside the purview of regulated financial institutions, presents a complex landscape with implications for firm performance that merit a nuanced exploration. While informal finance can provide immediate liquidity and accessibility, particularly in contexts where formal financial systems are underdeveloped or inaccessible, its impact on firm performance is multifaceted and warrants critical examination. A primary concern with informal finance is its lack of regulatory oversight, which can lead to exploitative lending practices. Unlike formal financial institutions, which are subject to stringent regulatory frameworks designed to protect borrowers, informal lenders often operate without such constraints (Wai, 2019; Weiping, 2023). This regulatory vacuum can result in the imposition of usurious interest rates and onerous repayment terms, potentially exacerbating financial distress for firms.

The absence of standardized contracts and legal enforceability further compounds these risks, leaving firms vulnerable to arbitrary changes in lending conditions. Moreover, the limited scale of capital accessible through informal finance constrains firms' capacity to pursue growth-oriented investments. Informal lenders typically provide smaller loan amounts, insufficient for financing substantial capital expenditures or scaling operations (Su and Sun, 2011; Seibel and Parhusip, 2019). This limitation restricts firms' ability to achieve economies of scale, thereby impeding their competitive positioning in the market. The inability to invest in technology upgrades, workforce expansion or market diversification can stifle innovation and reduce operational efficiency (Sanderatne, 2019; Onchan, 2019; Napwanya, 2019).

In addition to capital constraints, informal finance lacks the comprehensive suite of financial products and services offered by formal institutions, such as credit scoring, risk management tools and financial advisory services. The absence of credit scoring mechanisms in informal finance precludes the development of a credit history, which is critical for accessing larger, more favourable financing options in the formal sector (Li and Hsu, 2009; Liedholm, 2019; Li, Zhang, X. and Hu, 2021; Mago and Modiba, 2022). This lack of a credit profile can perpetuate a cycle of financial exclusion, as firms remain tethered to informal sources due to their inability to meet the collateral and documentation requirements of formal lenders.

Furthermore, the dependency on informal finance can hinder strategic financial planning and risk management. Formal financial institutions provide a range of risk mitigation instruments, such as insurance and hedging products, which are typically unavailable in the informal sector (Ghate, 2000; Graham, 2019). Without access to these tools, firms are less equipped to manage financial volatility and are more susceptible to economic shocks. This vulnerability can lead to suboptimal decision-making and increased financial instability. The relational nature of informal finance, often based on personal networks and social capital, introduces additional complexities. While these relationships can facilitate access to funds in the absence of formal collateral, they are inherently unstable and subject to the vicissitudes of personal dynamics (Li, 2009; Lamberte, 2019; Hou et al., 2020). Disputes or changes in social relationships can disrupt financial arrangements, leading to potential conflicts and financial losses. The lack of formal legal recourse in resolving such disputes further exacerbates these risks.

In summary, while informal finance offers an alternative avenue for accessing capital, particularly in regions where formal financial services are lacking, its impact on firm performance is fraught with challenges. These include regulatory vulnerabilities, constrained access to growth capital, absence of comprehensive financial services, perpetuation of financial exclusion and instability of informal lending relationships (Jiang, 2009; Hospes, 2019). Therefore, a critical assessment of informal finance's role in firm performance must account for these multifaceted risks and limitations, underscoring the need for strategies that bridge the gap between informal and formal financial systems to enhance firm resilience and growth potential. The prevailing discourse on the impact of informal finance on firm performance often highlights its beneficial aspects, such as increased accessibility and flexibility for small enterprises. However, a critical examination reveals several potential drawbacks and limitations that challenge the assumption of its unequivocal positive impact on firm performance.

Firstly, informal finance mechanisms, such as borrowing from family, friends or informal moneylenders, often lack the regulatory oversight and formalized structures inherent in formal financial systems (Adams and Ghate, 2019; Adams, 2019). This absence of regulation can lead to predatory lending practices, where borrowers are subjected to exorbitant interest rates and unfavourable terms. Such conditions can ultimately undermine a firm's financial stability and hinder its long-term growth prospects.

Moreover, the reliance on informal finance can limit a firm's ability to scale operations. Informal sources typically provide smaller amounts of capital compared to formal financial institutions. This limitation restricts a firm's capacity to invest in significant growth opportunities, such as expanding production capabilities, entering new markets or investing in research and development. Consequently, firms may struggle to achieve economies of scale and enhance their competitive position in the market (Bouman and Moll, 2019; Danquah and Sen, 2022). Additionally, informal finance often lacks the ancillary services and financial products offered by formal institutions, such as risk management tools, financial advisory services and credit history development.

The absence of these services impedes a firm's ability to manage financial risks effectively, make informed investment decisions and build a credit profile necessary for future access to formal finance. This deficiency can result in suboptimal financial management and constrain a firm's strategic planning capabilities. Furthermore, the dependency on informal finance can perpetuate a cycle of financial exclusion. Firms that rely heavily on informal finance may find it challenging to transition to formal financial systems due to the lack of documented credit history and collateral. This situation can lead to persistent barriers in accessing formal finance, thereby limiting the firm's growth potential and integration into the broader financial ecosystem. Lastly, the informal nature of these financial arrangements can lead to issues of trust and enforceability. Informal agreements are often based on personal relationships and social networks, which can be unreliable and prone to disputes.

In the absence of legal recourse, firms may face challenges in enforcing repayment terms, leading to potential conflicts and financial losses. In summary, while informal finance can provide immediate and accessible funding solutions for firms, particularly in contexts where formal financial systems are underdeveloped, it is accompanied by significant risks and limitations. These include regulatory vulnerabilities, constrained growth potential, lack of comprehensive financial services, perpetuation of financial exclusion and challenges in enforceability. Therefore, the overall impact of informal finance on firm performance may be more complex and nuanced than the prevailing literature suggests, warranting a more cautious and critical evaluation. Against the literature on formal and informal financing, studies that examined the effects of cofounding finance, which involves the concurrent use of both formal and informal financial sources, on firm performance is relatively nascent (Degryse et al., 2013, 2016; Seibel and Parhusip, 2019). However, there is no empirical evidence from Africa where it is necessary mostly.

The dominant theories on capital structure include the Modigliani and Miller's capital structure irrelevance theory, the pecking order theory (Myers and Majluf, 1984) and the financial growth cycle (Berger and Udell, 1998). Modigliani and Miller (1958, 1963) theory suggests that a firms capital structure depends on the cost of the sources of capital and is independent of the firm's value. Firms choose their sources of capital based on the cost of each source of capital. This theory relies on homogeneity of information which makes it inconsistent with the characteristics of small and micro businesses. However, the relevance of cost as a determinant of capital structure has been evidenced in the literature.

The pecking order theory suggests that firms will always choose to use internal funds first over external funds for fear of negative signalling and dilution of ownership and control suggesting an order in which choices on sources of capital are made. Similarly (Berger and Udell, 1998) model suggests an order in which capital choices are made. They suggest that a firm's choice of capital varies over its life cycle depending on its level of development. Young and small firms are more likely to be informationally opaque and reliant on internal and informal forms of finance such as family and friends. As firms grow and become more experienced with better information and transparency, the firm gets access to intermediated external formal finance graduating with public equity and debt markets as they grow. The three theories therefore suggest that cost and information are key determinants of the choice of capital.

Effectively, therefore, we would expect that small firms typified by information asymmetries would make capital choices to circumvent market frictions associated with cost and information asymmetries. The literature suggests that both formal and informal finance have desirable characteristics addressing costs and market characteristics but are highly reliant on information and therefore firm transparency for decision making.

Formal finance has the advantage of cost and scalability. The initial loan application costs and registration of collateral requirement can be relatively significant especially for small firms. On the other hand, as loan amounts increase, the variable costs associated with the loans decrease resulting in the negative relationship between loan amounts and interest rates observed in the literature. For that reason, formal lenders who have the advantage of scalability will have lower interest rates in the credit market. Despite this advantage, formal lenders are highly reliant on hard information. This information allows them to assess risk and manage agency problems like moral hazard and adverse reaction. In the absence of this information, formal lenders ask for physical collateral. Because most new and small firms are primarily formation in your pain and lack physical collateral, formal finance will not be their primary choice even though it might be cheaper. However, former finance has scalability allowing firms to increase their level of borrowing when they need it for expansion. As a result, formal loans would be very suitable for long-term growth and expansion of the firm because of the associated long repayment terms (Wellalage and Fernandez, 2019).

Informal finance on the other hand has lower initial costs and greater contracting flexibility but higher variable costs. Informal lending decisions are primarily based on soft information gathered through social networks. Informal lenders will often be more informed about the personal circumstances of borrowers resulting in low initial information costs. This gives informal lenders an advantage over formal lenders who often incur high information gathering costs. Furthermore, this allows them monitoring advantages. As a result, informal lenders offer more flexible application processes. In addition, the use of social sanctions and cohesion for enforcement means that informal lenders have a monitoring advantage with lower enforcement costs (Lee and Persson, 2016). These advantages allow them to circumvent contracting frictions associated with information asymmetries such as moral hazard and adverse election. Evidence indicates that formal lenders sometimes take advantage of the low cost of monitoring by outsourcing their monitoring and screening task to informal lenders (Dybvig et al., 2016). Nevertheless, informal finance lacks the scalability available with formal finance. In the case of small businesses, the loan sizes also tend be quite small. As a result, variable costs will be high.

The benefits of social networks and associated collateral are limited by its indivisibility. Whereas physical collateral can be adjusted to compensate the lender for the portion of default, the breakdown of the relationship between the lender and borrower in an informal contract can result in the complete breakdown of the lender borrower relationship since that relationship is not divisible (Karaivanov and Kessler, 2018). Firms that could take advantage of social relations to access cheaper informal finance may choose not to use it or limit the amount borrowed depending on the associated risk and size the social collateral. For that reason, a firm whose social capital is large enough may choose to diversify their loan portfolio by combining formal with informal finance. For instance, although family and friends provide a cheap source of finance, it also comes with shadow costs which can be detrimental to firm performance and discourage its use (Lee and Persson, 2016). Consequently, firms may choose informal loans such as from family and friends only to a limit to minimize the possibility of default and thus eroding their collateral and complement the shortfall with formal loans despite the cost differentials (Karaivanov and Kessler, 2018).

Informal finance also has the added advantage of shorter processing periods. Even where borrowers can access for more loans, there is evidence which suggests that the speed of obtaining such loans is much lower in the formal market than it is in the informal market leading to firms opting to finance with informal loans (Armendáriz and Morduch, 2010; Wu et al., 2016). The disadvantage however is that these loans are rooted in short-term maturities which can disrupt businesses.

Accordingly, if we assume that firms make rational borrowing choices to minimize the risk and cost, it is possible that you to borrow as assessment of risk a firm could combine the use of formal and informal finance ^[1]. A small firm will primarily rely on informal finance. However, overtime as the firm develops, more information will become available on the firm. In addition, it is likely to have built up valuable assets that can be used as collateral. Consequently, the firm will be able to seek out and access formal finance. However, because of its small size, accessing short-term loans from formal funders means that associated transactions costs are likely to remain high. On the other hand, the flexibility and reliance of informal lenders on soft information means that low-cost short-term financing can still be extended. The result is that firms would find it more efficient to borrow from informal market for small and short-term loans which provide working capital while at the same time borrowing from formal markets for larger and scalable loans which allow for expansion. Therefore, the use of both formal and informal finance could stem from a rational decision by businesses to take advantage of the benefits of both forms of finance in a market fraught with information asymmetries.

Prior studies show a positive association between external finance and firm performance. Most of this literature is based on studies that investigate the impact of formal finance on small firm performance. However, market frictions and distortions in formal banking sectors in many developing countries entail that informal finance is a popular choice among many small and micro businesses (Degryse et al., 2016). For that reason, a small but increasing amount of research investigates the relative effect of informal finance on firm performance. Two strands of literature exist. The first strand takes a comparative view and investigates whether formal or informal finance has a greater effect on performance. The second and most nascent strand investigates the effect of a joint use of formal and informal finance on performance, what has been termed co-funding.

Evidence from studies that look at the relative effect of formal and informal finance show a mixed picture. The first group of studies suggest that formal finance is superior to informal finance in that it is better at promoting both firm growth and innovation. Using data on Chinese firms Ayyagari et al. (2010) find that formal finance promotes faster growth than informal finance amongst SMEs. Ullah and Wei (2017) find similar results. They show that formal finance results in faster firm growth than informal finance in a number of transition economies. Related Ullah (2019) finds that formal finance has a significant effect on innovation while informal finance has no effect. A second group of studies contradicts these studies and finds that informal finance has greater efficacy on firm performance. For example (Beck et al., 2015) results show that informal finance is positively associated with sales growth in rural enterprises with multiple employees, especially those who have employees outside the family while formal finance has no effect. Similarly Posti and Maiti (2025) find that access to formal credit has a stronger positive impact on firm productivity than informal credit among informal firms in India.

The literature suggests two factors which can help to explain these discrepancies. The first suggest that firm size influences the way the financial structure influences a firm's performance. Degryse et al. (2016) study distinguishes between large and small firms. They find that informal finance is positively associated with higher sales growth for small firms but lower sales growth rate for larger firms. In the same vein Du and Girma (2012) use Chinese firm data and demonstrate that informal finance is more effective for small firm growth than formal finance. They find that while bank loans are effective for large firm growth, informal loans offer more benefits to small firm growth. Related results are reported by Wellalage and Fernandez (2019) for selected developing countries. In the African context, studies show that informal finance is particularly important for start-ups and small firms (Arisa and Gwatidzo, 2022; Nadege et al., 2024). The second factor relates to the type of informal finance employed. Allen et al. (2019) distinguish between constructive and underground financing and find that constructive informal financing is positively associated with firm growth while underground financing has a negative association ^[2]. Their results also confirm that this effect is size-dependent.

Studies that investigate the joint effect of formal and informal finance on firm performance largely find a complementary relationship. The results suggest that firms that combine formal and informal finance perform better than those that use only formal or informal finance. For example, Degryse et al. (2016) use Chinese firm data to investigate whether simultaneously using formal and informal finance is advantageous. They find that small firms that use both formal and informal financing have a significantly higher growth rates relative to those that only use formal or informal finance. However, they find that combining finance has the opposite effect on large firms. Similar results are reported by (Long, 2019; Allen et al., 2019). Long (2019) shows that using both formal and informal finance increases the likelihood of a small firm becoming a high growth firm than a firm that uses only formal or informal finance. Allen et al. (2019) show that the positive effect of combined funding is size dependent; the effect on firm growth declines as firm size increases. The one study we could access on Africa that investigates the joint use of formal and informal finance is by Shibia (2024) who investigates the impact of cofounding micro and small enterprises' ability to cope with climate change shocks in Kenya.

In view of this literature, this study investigates whether co-funding has an effect on small and micro firm performance. Furthermore, we address related questions suggested by the findings in the reviewed studies. First, we ask whether the effect of co-funding is size dependent. Secondly, we ask whether the effect of co-funding is robust to access to finance. Finally, we check the suggestion that mature firms may benefit from co-funding more than newer firms.

The study uses data sourced from a survey conducted over 12 months in four South African provinces. The data are part of a broader small study investigating the financial behaviour of small and micro loans. The data were collected in two phases between February 2021 and June 2022. First, background data were collected between February and April 2022. This data included information on firm owner characteristics such as education, age and gender as well as firm characteristics including the age of the firm, source of startup capital and use of finance and social startup capital. The second set of data was collected monthly from participants of the baseline survey using online surveys. This data focused on collecting information on income and expenditure of the firms.

The sampling was done in two phases. The first stage was to select the provinces that would be covered in the study. The main attribute used was the level of urbanization resulting in the choice of Gauteng, KwaZulu Natal, Western Cape and the Eastern Cape provinces. It is understood that urban areas house most of the small and micro businesses in Africa. In the second stage, urban centres were selected where enumerators were asked to randomly select participants with small businesses paying attention to gender and age. These attributes were important because the literature suggests that they are important determinant of financial behaviour (Archer et al., 2020; Nguyen and Canh, 2021; Simatele and Kabange, 2022). A baseline survey was administered to 336 small and micro firms. The baseline survey was used to contact potential respondents. The primary criteria were that the firm needed to be small or micro based on the number of employees and revenue of the firm. No businesses were excluded based on this criterion. 169 firms participated in the study. The firm owners were overwhelmingly female. On average over the period, 67% of the participants were female and 33% were male.

The data description is presented in Table 1. The results show that the mean age of the firms is 9 years. There is a significant age variation with a minimum of less than a year and a maximum of 60 years 43% of the firms used in the study are formally registered. Profitability also shows a high variation. The most profitable firm earns as much as R61,778 in a month while the highest loss incurred amounts to R8000 during 12 months. Regarding the age of the owners of the firms, the youngest owner is 23 years year old compared to the oldest owner at 79 years of age. Also, most of the informal firms' owners are female. Table 1 shows that 67% of business owners are female. The informal business owners are averagely educated, with a secondary school education with a mean of 11 years. Only 18% of the firms were identified as using formal and informal finance simultaneously (co-funding).

Furthermore, Table 2 presents the correlation matrix. Overall, the results show that the variables are moderately correlated with expected signs. Specifically, the results show that there is a significant positive relationship between co-funding and informal firm profitability, informal and formal finance. Overall, none of the coefficients is higher than 50%, hence, the issue of multicollinearity is not expected to arise in the models.

To investigate the effect of co-funding on business performance, we estimate the effect of the joint use of formal and informal finance on firm profitability. Formal finance is defined as finance sourced through a bank or bank related service such as a credit card ^[3]. The precise definition of informal finance differs across studies especially with the emergence of new forms of finance such as peer-to-peer funding as well as crowd funding. In this study, informal finance is defined as finance sourced from non-intermediated sources such as family and friends, savings, credit and help groups and money lenders. Co-funding is measured as a dummy variable which takes the value of 1 if a firm uses both formal and informal sources of finance. We also include control variables indicated in the literature (Ayyagari et al., 2010; Ebo Turkson et al., 2020) to influence firm performance such as age of the owner and business, education level and gender of the owner.

An important variable that affects access to formal finance is whether the business is formally registered or not. Formal registration in south Africa entails businesses can have access to tax incentives and additional funding. We include a variable to capture the effect of formal registration. In addition, a number of business owners indicated having more than one business. Multiple business ownership allows owners to benefit from learning across businesses as well and have a diversified income base which could help subsidise the performance of other businesses within the portfolio or cushion them during business downturns. We capture this using a dummy variable that indicates whether a business has more than one business or not. In addition, we found that there were a number of business owners whose businesses were supplementing another source of income such as grant or salary income and vice versa. We surmise that access to other sources of income other than the business could allow the business to perform better by giving the owner alternative sources of income to support the business during downturns. We capture this effect by including a dummy to indicate whether a business has another source of income. The measurement of data and sources are presented in Table A1 in  appendix.

The empirical model is effected by estimating equation 1. The model is estimated using panel data via random effect method. The relationship between finance and profitability could result in endogeneity problems. This is because access to finance can increase profitability while at the same time, increase profitability results in firm growth which in turn increases the likelihood that the firms will access external finance. However, the data collected spans only 12 months. The likelihood of significant feedback from profitability to finance is low. Nevertheless, we check for robustness of the results by estimating the model with GMM. The results are robust.

The results of the analysis are shown in Table 2. The focus of our analysis is to investigate whether the joint use of formal and informal finance affects firm performance. Column one in Table 3 addresses this question. The results show a consistent positive effect of co-funding on performance. On average, we find that using co-funding is associated with a 20% increase in firm profits. Firms can increase their profit by simultaneously using both formal and informal finance. Like most small and micro firms in developing countries, South African firms struggle to access finance despite the various instruments put in place by the government. The financing measures put in place by the government all focus on formal finance, through the creation of quasi-intermediaries to provide funding to small and micro firms. However, most of these firms still use the same processes and criteria used in mainstream lending, undermining the effectiveness of the programs put in place to help improve performance. This result suggests that using both formal and informal financing could help relieve the financing constraints on performance. To check whether this effect is reflecting the impact of formal finance, we add a measure of formal finance using bank loans. We find that formal finance has a positive effect on firm performance but does not cancel the effect of co-funding.

Third, the literature reviewed suggests that the effect of both co-funding and informal finance is size dependent. Both Degryse et al. (2016) and Allen et al. (2019) find that the significance of co-funding decreases in firm size. We check data to see if this result holds by interacting co-funding with firm size. These results are shown in column three. Our results show that interacting size with co-funding results in a negative effect on profitability. Therefore, in line with the literature, our results indicate that small and micro businesses benefit the most from co-funding. This result is unsurprising. Smaller firms are more likely to have strong social networks that allow them access to informal finance. They are most unlikely to access formal finance. Accordingly, additional funding through formal means which could also allow them to increase their production scales should improve firm performance.

Firms that are formally registered are likely to have better access to formal finance. We ask whether firms that are formally registered and therefore have opportunities to access more formal finance benefit from co-funding. We check this by interacting the co-funding variable with the registration variable. Empirical results are reported in Table 4. The coefficient on the interaction between co-funding and registration is negative suggesting that co-funding negatively affects firms that have increased access to formal finance.

We also examine the assertion that more mature firms would benefit from co-funding via increased product innovation as suggested by (Wellalage and Fernandez, 2019). Given that product innovation is likely to result in higher levels of profitability, we check whether mature firms' profit will increase if they use co-funding. We do this by interacting the co-funding variable with the age of the firm. We find that this result does not hold in our case. The interaction between co-funding and firm age is negative suggesting that older, more mature firm profit is negatively affected by co-funding.

Many SMEs in Africa continue to face significant constraints in accessing formal finance. These constraints are exacerbated by structural barriers such as collateral requirements, excessive administrative costs and information asymmetries. Informal finance has largely bridged this gap by offering accessibility, flexibility and reduced information requirements. Additionally, the growing joint use of formal and informal finance has shown significant promise in addressing the financing constraints of small businesses. This study provides empirical evidence from South Africa on the effect of co-funding on firm performance. The results indicate that co-funding positively impacts firm performance. Microenterprises benefit the most from co-funding as it allows them to optimise their access to both short-term, flexible, informal finance and scalable, long-term formal finance.

The study also highlights important differences in the impact of the size and maturity of firms. While co-funding benefits small and microenterprises, its effectiveness diminishes as firms grow larger or gain greater access to formal finance. Similarly, more mature firms benefit less from co-funding, suggesting that their reliance on informal finance may decline as they build up collateral and improve their transparency for formal lenders. Accordingly, it is important to tailor financial policies and interventions to the needs of different firm categories. Current government programs primarily focus on formal finance, often mimicking traditional banking processes that inadvertently exclude the smallest and most vulnerable firms and, therefore, limit the impact that such funding programs could have on the performance of these firms. Policymakers must broaden their focus to support co-funding through mechanisms that integrate formal and informal finance.

Lessons from other developing countries can provide valuable insights. For instance, India's Self-Help Group-Bank Linkage Program demonstrates how informal savings groups and microfinance institutions can be integrated into formal financial systems (Kadir et al., 2025). In this framework, informal lenders act as intermediaries for formal credit. Similar programs could be piloted in South Africa. Evidence shows that South Africa has large self-help informal financial groups in the form of stokvels (Dermineur and Kolanisi, 2023). These can act as intermediaries for formal credit, bridging the gap for micro and small enterprises.

Similarly, Kenya provides an example of co-guaranteed mechanisms, where formal financial institutions partner with informal lenders or community-based organisations to share the risks of lending to small firms (Crawford et al., 2024; Klapper et al., 2016). This approach allows informal lenders to leverage their extensive knowledge of local borrowers while enabling formal institutions to extend credit without stringent collateral requirements. Another useful model is the tiered lending model used in Bangladesh (Armendáriz and Morduch, 2010). Informal lenders provide initial working capital, and formal institutions offer scale-up financing. This process ensures that firms can access the correct type of financing at different stages of their development, fostering collaboration between the two financial ecosystems.

We therefore argue that there is a need for a shift in policy framing if SMMEs are to be the drivers of development that the South African government hopes for. Informal finance must be seen as a strategic complement to formal finance. Institutions that have been set up to support small business development must proactively explore cofounding partnerships with informal services such as stokvels and rotating credit associations, which already provide accessible, flexible capital to underserved micro and small businesses. In addition, Posti and Maiti (2025) find that access to formal finance has a stronger positive effect on firm productivity compared to informal credit in India. Support could leverage such relationships by encouraging cofinancing arrangements through hybrid lending products, co-guarantee mechanisms or shared risk frameworks such as the ones mentioned above. Investing in such arrangements can foster a trust-based environment in which financial inclusion efforts can be effective and can promote inclusive growth and development.

While this study provides important insights into the relationship between co-funding and firm performance in South Africa, it is not without limitations. The study uses a 12-month period dataset, which may not fully capture longer-term dynamics or the sustainability of co-funding effects over time. Additionally, while the study distinguishes between formal, informal, and mixed finance, it does not delve into the specific types of informal instruments used, such as rotating savings schemes vs informal moneylenders. This may be very useful in thinking about the most effective types of cofounding partnerships. Future research should consider longer panel horizons, richer disaggregation of financing types and comparative studies across regions. There is also scope for qualitative work that explores the relational and trust-based dimensions of co-funding, as well as experimental or quasi-experimental designs to test the impact of hybrid financing interventions. While recognising the limitations, we believe that there are enough similarities across micro and small businesses in African countries for these results to be relevant in other African countries with similar township ecosystems.