House of Commons - International Development

Select Committee on International Development Eighth Report

THE FUTURE OF THE COMMONWEALTH DEVELOPMENT CORPORATION

THE PUBLIC/PRIVATE PARTNERSHIP

7. The purpose of the transformation of CDC into a Public/Private Partnership appears to be to expand the activities of CDC by increasing the amount of funds available to it. Clare Short also aims to enhance its role as an example to other private sector investors by introducing private capital, rather than simply increasing government funding,[15] whilst retaining its development focus by maintaining a significant level of Government ownership. We note, however, that according to Earl Cairns:

8. The key difference between the PPP framework and full privatisation will be embodied in the Government's retention of a substantial minority share, in addition to the golden share which has been retained by previous Governments in some privatised companies.[17] The agreed objective is:

9. Two key assumptions are implicit in the Government's plans:

(b) the increased pressure on CDC to achieve high returns — resulting from the need to attract private investors — will be compatible with its development focus.

In this Report we examine these assumptions, and discuss the implications for accountability and monitoring of CDC once the PPP has been established. Our key concern is that CDC retain its developmental role. The commercial feasibility of the PPP is inextricably linked to this concern, because if the Partnership fails commercially, it will obviously not be able to attract private investment, and will ultimately founder, resulting in the loss of an important and valuable developmental institution.

The Introduction of Private Capital to CDC

10. The precise mechanism for the introduction of private capital to CDC has not yet been decided.[19] There is an important issue to be resolved concerning the status of the concessional government loans currently owed by CDC, which amounted to £755 million at the end of 1997.[20] It seems likely that the loans will be converted to equity to be sold as part of the flotation of the company, although Ms Stevenson, Head, Business Partnerships Department, DFID, told us that the precise method of sale depended upon circumstances at the time of implementation of the PPP.[21]

Attracting Private Investors

11. CDC is currently required by DFID to achieve a return of at least 8 per cent on its investments. Both the Government and CDC acknowledge that CDC will need to increase its returns considerably in order to be attractive to private investors.[22] It is proposed that CDC will achieve such an increase by expanding its equity (shares) portfolio. Equity investments tend to involve greater risk, but can attract higher returns. Dr Roy Reynolds, Chief Executive of CDC, explained in his Executive's Report in CDC's 1997 Report and Accounts:

CDC has already been increasing the proportion of its investments in equity. At present, equity investments represent 25 per cent of CDC's gross portfolio of £1.6 bn,[24] compared to 22 per cent in 1996. Twenty six per cent of new investments in 1997 were in equity, compared to 21 per cent in 1996.[25]

12. The plan to increase the proportion of CDC's investments in equity and quasi-equity originates from the premises that such investment opportunities exist in developing countries in the first place, secondly that equity investments are generally more profitable than loans, and thirdly that CDC's investments in equity will act as a catalyst for the development of financial markets and further investment. A review carried out in 1996 by the United States Agency for International Development (USAID) challenged these assumptions, concluding that "the allure of equity investment in emerging companies in developing countries is a mirage".[26] The USAID study cited the 1995 Development Alternatives Study, which stated that "it is clear that the market for conventional venture capital is narrower and less profitable that might have been originally anticipated",[27] and the UK Government itself pointed out in its memorandum to this inquiry that "equity is a scarce resource in many developing countries".[28]

13. Table 1 shows that most of CDC's equity investments in 1997 were in low-income countries, which would imply that at least some opportunities do exist in the poorest countries. We are concerned, however, that there may be limited opportunities to expand further. The possibility of such a limitation should be borne in mind when discussing the economic viability of the PPP.

Table 1 : CDC Equity Investments 1997 (£000)[29]

Countries	Agribusiness	Financial Markets	Infrastructure	Manufacturing and Commerce	Minerals, Oil and Gas	Total Equity / Quasi-Equity
Upper-Middle Income	-	-	£2,486	-	-	£2,486
Lower-Middle Income	£1,347	£12,458	-	£26,411	£4,572	£44,788
Low-Income	£14,715	£6,277	£8,565	£47,263	£8,059	£84,879
Least-Developed	£8,832	£540	-	£3,629	£4,992	£17,993
TOTAL	£16,062	£18,735	£11,051	£73,674	£12,631	£132,153

Source: Evidence pp. 27-33, CDC Report and Accounts 1997 pp. 69-77.

14. The Government memorandum to this inquiry stated that "the requirement to turn-over the equity positions, normally through local capital markets, will also develop the local financial sector".[30] The USAID study challenged the suggestion that the investment activities of one venture capital organisation would lead to growth in local financial markets, stating that:

We would bring this observation to the attention of DFID.

15. A further potential difficulty is that those opportunities which exist for equity investment may not be as profitable as CDC hopes. Dr Reynolds told us in evidence that in order to attract private investors, CDC would have to demonstrate returns on equity investments of "20 per cent plus",[32] and overall returns of at least 15 per cent.[33] The review by USAID of venture capital efforts of donors stated that "conceptually, [equity] appears likely to pay high returns. In practice, it does poorly",[34] concluding that "there is no evidence so far suggesting that [successful private enterprise funds investing in developing countries'] portfolios will yield as much as a 10 per cent rate of return, and the return could well be much lower".[35] Table 2 shows that, in 1996 and 1997, CDC's equity portfolio yielded returns which, whilst they were higher than returns on the loan portfolio, yielded only around 11 per cent. This brings into question the assumption that, by increasing its equity portfolio, CDC will be able to improve sufficiently its returns to attract private investors in the short term.

Table 2: Returns on CDC's investments in 1995, 1996, and 1997 (Per Cent)

Year	Three-Year Rolling Return on Capital Employed (Government Target: 8 Per Cent)	Gross Interest Rate on Loan Portfolio	Income on Equity Portfolio
1995	8.1	9.5	13.6
1996	8.3	9.5	11.3
1997	7.6	9.8	11.4

Source: CDC Report and Accounts 1997, p. 31

16. CDC will need to demonstrate a convincing record of good returns on its investments if it is to attract private sector investment. The Rt Hon Earl Cairns told us:

Until the downward trend in the Commonwealth Development Corporation's returns is significantly and sustainably improved, it seems unlikely that the Public/Private Partnership will be a commercially viable venture.

17. The Government memorandum to this inquiry stated that it had commissioned research which concluded that: "provided the Partnership was designed satisfactorily, there would be private sector interest in participating".[37] Given this proviso it will be important, once the details of the framework have been decided, to evaluate whether the private sector find the Partnership "satisfactory", whilst at the same time ensuring that the development focus of the organisation is maintained.

18. CDC's memorandum to this inquiry stated that:

This is a compelling argument in itself for delaying the PPP until CDC is capable of sustaining the associated changes in its structure and work.

19. The requirement stipulated by the Commonwealth Development Corporation that a transition period be allowed for the implementation of the changes necessitated by the increase in equity investments, the need for the Commonwealth Development Corporation to improve significantly its rates of return, our concerns about the validity of the assumptions inherent in the planned increase in equity investments, and issues surrounding the design of the Partnership, all need to be resolved before the Public/Private Partnership can be successfully established. If the Public/Private Partnership is established before these issues have been resolved, it could be unable to function effectively and unable to increase its returns sufficiently to attract private investors. We therefore recommend that the establishment of the Public/Private Partnership be delayed until:

(a) the precise details of the Public/Private Partnership have been decided, and further research has been undertaken to establish private sector interest in the transformed Commonwealth Development Corporation;

(b) the Commonwealth Development Corporation has undertaken the necessary shift in management focus and skills-base necessitated by the move to increased equity investments; and

(c) the Commonwealth Development Corporation's equity portfolio has been expanded sufficiently for a track record to have been established which demonstrates the profitability of equity investments in developing countries.

20. During the interim period between legislation and implementation, CDC will need to expand its equity portfolio significantly if it is to achieve the required level of returns. Dr Reynolds told us:

"We have now got to show that track record and that is why we believe there is a certain transition period. Those who know us well can understand the potential. Those who do not know us well will say, "Where is your track record?" and I think this is the issue that we now have to manage that transition period".[39]

21. During this transition period, CDC may need access to additional finance. CDC's borrowing from the Government is limited to £1,100 million, and the current outstanding balance is £755 million.[40] This means that the Government, within present legislative boundaries, could lend CDC up to a further £245 million. We recommend that this possibility be explored in some detail. The initial outlay by the Government would surely be worthwhile in the long-term, if it ensured the success and sustainability of the PPP. In 1997, CDC borrowed a net amount of minus £10 million from the Government (ie the amount lent was smaller than the amount repaid). We recommend that the Government consider significantly increasing the net amount of its loans to the Commonwealth Development Corporation during the period of its transition from a wholly Government-owned statutory corporation to a Public/Private Partnership, in order to allow it to expand its equity portfolio. This will provide an opportunity for the feasibility of increased equity investments to be tested before the introduction of private capital is invited.

The Tax Status of the PPP

22. Most investment companies bank offshore to take advantage of favourable tax regimes.[41] Clare Short told the Committee that this would be an "intolerable" proposition for CDC.[42] She proposes the creation of a new category of investment company, of which CDC would be the first, to allow special tax treatment of development investment organisations within the UK, along similar lines to the treatment of pension funds.[43] This would ensure that CDC remained based in the UK, which Clare Short described as "a highly desirable outcome".[44] Such an arrangement would allow CDC to benefit from a reduced tax bill which may be attractive to investors. This could offset potential commercial disadvantages of the Government's retention of a substantial minority share and golden share. The creation of a new category of investment organisation could also result in the establishment of more venture capital organisations in the UK. We look forward to monitoring progress in the establishment of a special tax category for development investment institutions.

The Developmental Impact of Equity Investments

23. It is the belief of both the Government and CDC that the planned increase in equity investments is compatible with CDC's development focus. Earl Cairns told us:

"I do not see us being driven into less developmental undertakings, as I believe very strongly that the best returns come from the most prospective investments, which are also the best development. So there is not a conflict between maximising the development returns and maximising the commercial returns".[

24. The Government also suggests that equity investments are better developmentally than loan investments, since equity offers opportunities for much-needed knowledge-transfer and capacity-building, and a generally greater level of involvement in the businesses.[46] Christian Aid agreed with this analysis, citing equity investment as perhaps "the most sustainable contribution CDC can make towards development and poverty eradication", whilst stressing the importance of a capacity-building strategy to ensure these potential benefits were fully exploited.[47] Whilst it is clear that the increased level of involvement may improve the success of the enterprises in which CDC makes equity investments, this does not necessarily correlate directly with good development. For example, a particular investment may be successfully managed but entirely inappropriate to the social or economic environment of a country. It is for this reason that we do not accept the argument put forward by the Government and the Commonwealth Development Corporation that successful equity investment automatically equals good development.

25. The Government stated in its memorandum that "the focus on agribusiness, infrastructure, manufacturing and financial services is expected to continue"[48] after the introduction of the PPP. As we have already noted, most of CDC's equity investments in 1997 were in the manufacturing and commerce sector. We are concerned that the shift towards equity investments may lead to a greater emphasis on commercial sectors rather than agribusiness and infrastructure enterprises which have a directly developmental focus, but which may not be so conducive to equity investments. Given the importance of the agriculture sector in least-developed countries, we would welcome comments from the Government on how the move to equity investments will affect the sectoral composition of the Commonwealth Development Corporation's portfolio.

15 Q. 5. Back

16 Q. 67. Back

17 See Annex II, p. xxiii. Back

18 Evidence pp. 2 and 16. Back

19 Q. 13. Back

20 CDC Report and Accounts 1997, p. 52. Back

21 Q. 13. Back

22 Evidence pp. 4 and 17. Back

23 CDC Report and Accounts 1997, p. 6. Back

24 CDC Report and Accounts 1997, p. 31. Back

25 CDC Report and Accounts 1997, p. 10. Back

26 "The Venture Capital Mirage: Assessing USAID Experience with Equity Investment" USAID Programme Operations and Assessment Report No, 1, Center for Development Information and Evaluation, August 1996, p. v. Back