Evidence submitted by Lord Cairns
THOUGHTS ON A FUTURE ROLE FOR CDC
This paper was written as an introduction to conversations
with officials at DFID on the future of CDC. Officials at DFID
indicated it would be helpful to send this also to the Select
Committee.
1. THE BACKGROUND
The implied conclusion of this paper is that the
creation of a separate Actis has been overwhelmingly successful
in achieving the primary objective of the restructuring of CDC,
namely to raise significant private sector funds into early stage
emerging economies and also, through demonstrating this success,
to encourage the creation of other funds which have mobilised
a range of different pools of risk capital for large scale investment
in major developing economies.
The separate development of Aureos has filled, but
probably in part only, the requirement for funds to flow into
the small economies and small company sector. It appears, however,
that CDC, the remaining Government-owned organisation, has chosen
to follow a profit-maximising route rather than concentrating
on focussing on meeting the much broader development objectives
that seems a more appropriate role for a government agency, albeit
within the underlying need to assist the establishment of sustainable
private enterprise.
The paper is written by someone who was intimately
concerned with creating the structural reorganisation to meet
specific objectives but who has had no formal contact with any
of the organisations, Actis, Aureos or CDC since retiring from
his role as Chair of Actis in December 2005, after nine years
in redeveloping the "old" CDC to meet these various
objectives as its Chair. Information, from which conclusions are
drawn, relies on limited informal exchanges with subsequent participants
in the relevant organisations and from a continuing range of commitments
to the development arena mainly in Africa as well as a substantial
involvement in development aspects of a social enterprise marketplace
here in the U.K. The terms "social returns", "development
returns" and "externalities" are used broadly to
cover desirable development impact but no attempt is made to define
precisely what these outcomes should be and how they are best
measured.
The paper attempts to suggest ways CDC's role should
be rebalanced over time, not to recreate the "managed business
role" but to fill an undoubted gap for largely fixed rate
funding where an initial element of subsidy in rates can be used
to create maximum development outcomes for the private sector,
which surely is the role of public funds in this arena, while
the motivation of the organisation is fundamentally changed from
financial to development returns.
2. RECENT HISTORY
CDC was asked by the Labour Administration to find
ways to attract private sector capital into early stage emerging
economies. This was presumably seen by HMG as the highest priority
social goal for the corporation. After a great deal of discussion,
it was agreed that it would be difficult to attract any worthwhile
quantity of non DFI funds until (a) it was possible to demonstrate
high risk adjusted financial returns in these markets and (b)
that the management of funds, thus procured, were in the hands
of those motivated to seek maximum financial returns, insulating
private investors from the prospect of sharing the costs of the
non profit maximising objectives of HMG. Actis was specifically
designed to meet these criteria. With a mixture of luck and endeavour,
not only were outstandingly high returns achieved but very substantial
third party funds were attracted through Actis into markets which
a few years earlier had been off limits to private investors.
Subsequently, several new venture fund managers entered the emerging
market arena.
The distinction of CDC and Aureos from Actis gave
HMG the opportunity to divert their funds to meet other social/development
objectives, once the initial support for Actis had become effective
in attracting private investors. This indeed was the expectation
of many of those concerned with devising the structural divisions.
HMG and CDC, however, appear to have decided that
the highest priority use of its funds was to encourage alternatives
to Actis, despite the fact that, after the success of Actis, emerging
private sector investment had become fashionable. It appeared
acceptable that CDC should continue to invest in other funds,
notwithstanding the motivation of the funds in which they invested
must have been to achieve financial returns rather than any broader
social objectives. Presumably while Actis's success reduced the
absolute social returns from further support for this activity,
they were still considered greater than any alternative development
objectives - a conclusion which is surprising.
To an outside observer, the proliferation of alternatives
to Actis seems to have resulted in substantial capital being available
to invest in relatively large sums ($25 million plus) in many
emerging economies, particularly since this was allied to a much
greater willingness from international corporates to invest in
many emerging markets. From experience elsewhere, it seems a usefully
competitive investment marketplace in many economies exists without
the need for public funds to subsidise it. In the African context,
however, much of the activity is confined to economies of a size
to throw up sufficiently large transactions to cater for high
transaction costs, leaving some smaller ones underserved even
though the increasing emphasis on creating free trade areas within
Africa may offset this problem in the medium term.
Even Aureos, which initially relied on DFIs support
as it invested in markets which others considered of sub-economic
scale, appears to have been able to attract some private sector
support (even though this will be particularly driven by the prospect
of financial rather than broader development returns). The high
level of transaction costs in investing less than $10 million
per transaction will have made achieving the necessary level of
financial returns quite a considerable hurdle but success thus
far, perhaps because there is little competition in this part
of the market, must have been encouraging.
3. THE WAY
FORWARD
Where, therefore, should CDC seek to contribute in
future? As an agency of government, it is axiomatic that it be
driven to achieve broad development returns through its support
for enabling private enterprise to play a full role. The particular
social returns will need to be set out by HMG and the Board of
CDC. It will presumably include a wish to maintain the real value
of the capital of CDC on the one hand, while on the other, to
support enterprises which can, at a minimum, become financially
self-sustainable and beyond that, meeting such other social returns
as increasing employment; assisting technology transfer; creating,
either directly or indirectly, internationally competitive enterprises
as HMG/CDC feel should have priority. The list of social goods/externalities
is clearly much longer than this.
It is likely that support for the areas, where major
private sector players operate, should end and endeavour be focussed
on areas where the financial returns on a risk adjusted basis
are, ab initio, below market but where the potential social returns
justify investment. It may make sense to use some funds to support
fund managers in the smaller markets, where few private sector
players venture. It would also be useful to develop funds to provide
fixed interest funding, again at less than the cost of funding
from the private sector, where the social returns justify an element
of initial subsidy. This might be relatively short term funding,
say five years, while some equity-type attachment would ensure
that any super-profit to equity owners was shared through warrants/convertibles
or overrides, once the higher risks undertaken by the equity investors
had received a fair minimum reward.
It may be possible for a few reasonably sophisticated
employees, with real experience both of financial structuring
as well as development issues, be engaged to work in chosen locations
to interact with local intermediaries, venture funds, as well
as bankers, accountants and lawyers, to identify potential investments,
where others may provide equity or commercial debt, usually in
single investments rather than funds. They would be encouraged
to co-invest with others but only in specific projects which meet
certain development criteria, which are unlikely to be achieved
without an element of subsidy. It seems possible to identify some
such executives without paying anything approaching the salaries
that appear to have been awarded in CDC's fund of funds operations
in recent years. Overall, providing finance for such enterprises
should be aimed to break even after costs and in line with CDC's
objectives of, on average, maintaining the value of the group.
It may also be possible, in this area, for CDC to
bring in grant-making as an adjunct to the funds it provides,
if social returns are sufficiently high and transparent. There
are examples of providing some grant funding alongside cheap debt
if this is necessary to give a reasonable chance of a worthwhile
organisation reaching sustainability. However, grant decisions
are probably best made separately. In smaller markets, DFID may
need to maintain a facility to help start-up managers.
The other significant area where CDC might play a
role is in infrastructure investment where externalities will
be significant. However, this is an area of public/private sector
and is populated by many other donor agencies, which can make
the role of promotion of private enterprise less easy. There may
be local infrastructure projects which can be organised as pure
private sector operations, where either debt or equity funding
could become a distinct CDC operation.
4. The Development Bottom Line
In conclusion, CDC, as agent for HMG, to justify
its existence, will always have objectives which are different
from those of the private sector. They may not be incompatible
but they are broader and different except in cases where the private
sector does not function sui generis and HMG decides that resolving
this shortcoming is the overriding priority. The range of countries
in this category appears to have diminished. With a different
class of capital, when working with private sector enterprise,
should be easier to ensure any separate objectives are carried
through.
If this mixture of approaches was seen to have merit,
as CDC funds become available from maturing investments, support
should be provided to promote the maximum development objectives
consistent with maintaining the real financial value of funds.
It should be possible to encourage equity investors to look at
investments with particularly high social returns so long as quantum
and price of the debt from CDC is sufficiently compelling. It
may also be possible to influence investment interest in smaller
transactions, from which many managers migrate. Management of
CDC should, in future be judged largely on achieving non-financial
results. Some support for venture funds operating in non - or
marginally - economic circumstances could be one strand. However,
a more innovative enterprise taking calibrated risks in working
as a below market debt provider where the potential development
gains justify such an approach, could provide an important new
role for CDC. A relatively small new executive team should be
able to develop this approach in due time.
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