House of Commons - International Development Committee

The Future of CDC - International Development Committee Contents

Written evidence submitted by The National Audit Office

NAO work on DFID's oversight of CDC and a summary of CDC's investment approach.

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The National Audit Office scrutinises public spending on behalf of Parliament. The Comptroller and Auditor General, Amyas Morse, is an Officer of the House of Commons. He is the head of the National Audit Office which employs some 900 staff. He and the National Audit Office are totally independent of Government. He certifies the accounts of all Government departments and a wide range of other public sector bodies; and he has statutory authority to report to Parliament on the economy, efficiency and effectiveness with which departments and other bodies have used their resources. Our work leads to savings and other efficiency gains worth many millions of pounds: £890 million in 2009-10.Introduction to this briefing and CDC.

AIM AND SCOPE OF THIS BRIEFING

1.1 This briefing has been prepared for the International Development Committee (the Committee) to support its inquiry into the Future of CDC.

1.2 This briefing draws on the C&AG's December 2008 report Investing for Development: the Department for International Development's oversight of CDC Group plc.[2] The report examined DFID's role as CDC's shareholder between 2004 and 2008. It considered whether DFID had set an appropriate framework of policies, objectives and incentives, and how CDC had performed against those objectives. It also examined how effectively DFID had monitored CDC to secure an appropriate contribution to economic development and poverty reduction.[3]

1.3 In conducting our 2008 examination we: reviewed DFID's documentation; benchmarked CDC against other Development Finance Institutions; consulted non-governmental organisations; reviewed key CDC procedures, such as cash management; analysed CDC performance data; and, undertook a field visit to Kenya. The NAO does not have statutory rights of audit access to CDC. CDC has not received Government funding since 1995 and is not defined as a public body. CDC and Fund Managers voluntarily cooperated with our examination, however, to provide insights into their business.[4]

1.4 We have not conducted any further audit work regarding DFID's oversight of CDC since 2008. Where this brief covers developments in 2009 and 2010 the material has been drawn from public sources. DFID had an opportunity to comment on this briefing.

1.5 This briefing is in three Parts.

¾ This Part provides a brief explanation of the rationale for CDC and an introduction to CDC's investment approach as it was operating when we prepared our 2008 report.
¾ Part 2 summarises the main findings of the C&AG's 2008 report, drawing out those most relevant to the Committee's current inquiry.
¾ Part 3 provides an overview of key reported developments affecting DFID's oversight of CDC, and CDC's investment approach, since 2008. We have not validated or assessed these developments.

RATIONALE FOR CDC AND OTHER DEVELOPMENT FINANCE INSTITUTIONS

1.6 CDC is one of a category of organisations known as Development Finance Institutions; national or international public agencies investing in the private sectors of emerging economies.[5] Typically, Development Finance Institutions aim to support private sector businesses in markets which are under-supplied by other investors.[6] Shortages of investment finance are considered by DFID and others as an important constraint to private sector development, economic growth and poverty reduction.[7] Research shows that growth is an essential, although not always sufficient, precondition for poverty reduction. Research also suggests that strong growth depends in turn on high rates of investment.[8]

1.7 Since a major reorganisation in 2004, CDC's strategy has been different from that of many other Development Finance Institutions in that it has aimed to concentrate on fully commercial investments. Whereas other Development Finance Institutions typically provide loan finance and technical support where the business environment is poor and it is difficult to make commercial returns, CDC has specialised in identifying investments which are profitable but have been under-funded due to insufficient information on business opportunities and likely returns, or because other investors have different perceptions of the degree of risk involved. By specialising, DFID has aimed for CDC to have a catalytic effect, demonstrating to private investors that good returns can be made in poor countries whilst observing responsible business standards.[9] In 2004 to 2007, CDC's resources were less than one% of international private equity to developing countries, but by influencing the behaviour of commercial investors CDC has the potential to have a bigger impact on developing countries.[10]

1.8 DFID aimed for CDC to fill a shortage of finance for investment that is a major constraint to economic growth in poor countries. CDC investment can also make a valuable direct contribution to poverty reduction and social development. CDC has reported that companies it invested in employed 733,000 people and paid local taxes of US$2.8 billion in 2009.[11]

CDC's investment approach as at 2008

1.9 DFID completed a restructuring of CDC in 2004, and as a result, when we examined CDC in 2008 it no longer invested in companies directly or provided loan finance. Instead it was employing fund management professionals who selected and funded intermediary private equity "Fund Managers" (Figure 1). Other than the Department and CDC, the key parties in the "fund of funds" business model were and, we have confirmed with DFID, currently remain:

¾ private equity Fund Managers. Fund Managers select the individual companies (not normally listed in stock exchanges) into which CDC and other investors' money is invested. Fund Managers then monitor and sell the investments and return the proceeds, including any profit, to CDC and other investors. In 2008, Fund Managers were receiving an annual management fee of around 1 to 2% of the value of investments, and a proportion of profits (usually 10 to 20%) when investments were sold, typically after five to 10 years. CDC's largest Fund Manager in 2008 was Actis. Actis was created in 2004 when the direct investment management part of CDC's business was separated. DFID retained a minority 40% stake in Actis, although it did not exercise any management control; and
¾ the Shareholder Executive. A UK government body which helps departments to be effective shareholders of government owned businesses. In relation to CDC, the Shareholder Executive's role in 2004 to 2008 included advising on business objectives, governance, strategy, performance monitoring, board appointments and remuneration.[12]

1.10 In 2004, CDC made £200 million of new investments; by 2007 this had risen to £412 million.[13] CDC had received no Government funding since 1995, and thus these investments were financed from its own resources.[14] By mid 2008, CDC was investing through over 50 Fund Managers in over 120 funds, and through these had stakes in around 600 businesses. The funds specialised in particular regions or sectors such as energy or small enterprises. CDC's underlying investments were diversified across sectors, with financial institutions, infrastructure and minerals, oil and gas companies making up over half of the total portfolio.

1.11 Between 2004 and 2008, DFID maintained a deliberate policy of avoiding direct involvement in CDC's business. This relationship reinforced the practice that individual investments were made on commercial grounds, and that civil servants lacking commercial expertise did not intervene in specialised investment decisions. Such an arms-length relationship is standard practice in departmental oversight of government-owned companies. It required DFID, as the shareholder, to state the extent to which CDC was to be run as a commercial business, to set appropriate objectives and exercise effective oversight to hold CDC accountable for its performance.[15]

1.12 At the time we undertook our examination, DFID had a number of key mechanisms for influencing CDC and, indirectly, its Fund Managers.

¾ Investment Policy. The Investment Policy for 2004-08 was the principal instrument through which DFID ensured that CDC invested so as to create and grow viable businesses in poor countries, and thus support the Department's overall objectives for poverty reduction. The Investment Policy included a set of targets on where CDC should invest, including the percentage of investments which should be in poor countries.[16] In 2008 a new Investment Policy was established for 2009-2013, setting higher targets for investment in poor countries.[17]
¾ Business Principles about how CDC should invest. CDC's Business Principles were designed to ensure that investments met high ethical standards so that, in addition to their impact on poverty through economic growth, profitable investments contributed directly to poverty reduction and had no harmful side effects. The Business Principles were updated at the start of 2009 and are now captured in an Investment Code. The Business Principles continue to cover the environment, social matters (including working conditions and health and safety) and business integrity, including good corporate governance.[18]
¾ Business plan, including targets for rates of return to be achieved. CDC's 2004 Business Plan acted as a medium term corporate plan.[19] The Plan included financial forecasts agreed with DFID, and the Treasury's requirement that CDC's returns should exceed a 5% threshold.[20]
¾ Remuneration policy. The right for DFID to be consulted on, or consent to, the remuneration policy for CDC's executive staff was an important part of the governance levers at DFID's disposal, and affected CDC's value for money.[21] In 2008, DFID and CDC were putting in place a new remuneration framework.[22]

Figure 1

DFID'S INVESTMENTS THROUGH CDC

The C&AG's 2008 report on DFID's oversight of CDC

2.1 The report's findings were brigaded under four themes:

¾ CDC's financial performance;
¾ focusing on poor countries through Investment Policy targets;
¾ tracking CDC's impact on development and poverty; and
¾ governance of CDC.

CDC'S FINANCIAL PERFORMANCE

2.2 During 2004-07, CDC achieved exceptionally good financial performance against the forecasts agreed with DFID in 2004. As a result its total assets grew by £1.1 billion in 2004, to £2.7 billion by the first half of 2008.[23] Sales from CDC's portfolio of investments had generated cash in excess of the extent to which CDC and its Fund Managers could reinvest responsibly. By mid-2008, CDC held £1.4 billion of cash on deposit in the UK, some £0.2 billion more than it had invested overseas. CDC pointed to the need to finance a £1.7 billion pipeline of future investments, equivalent to 121% of cash held, to most of which it was legally committed in 2008. Between 2004 and 2006, however, CDC consistently overestimated the rate at which Actis would convert pipelines of proposed deals into actual investments.[24]

2.3 By 2008, DFID had not set any polices on the use of cash. Though CDC as an organisation could make better returns on investments than on cash holdings, individual staff were rewarded for the performance level of the investments they oversaw, and not according to the amount of resources which were invested. In 2008, DFID and CDC were looking to see how incentives for judicious investment of available resources could be strengthened.[25]

2.4 Between 2004 and 2007, Actis and Aureos[26] raised over £1.5 billion from commercial investors and other Development Finance Institutions in the funds in which CDC invests, exceeding DFID's target of £950 million. The extent to which CDC's investment catalysed such funding had not been established.[27]

FOCUSING ON POOR COUNTRIES THROUGH INVESTMENT POLICY TARGETS

2.5 Over the period 2004 to mid 2008, CDC exceeded DFID's requirement - as set down in CDC's Investment Policy - to invest 70% of its resources in poor countries, and at least 50% in sub-Saharan Africa and South Asia. During this period CDC's investment portfolio was significantly more focused on poor countries than other Development Finance Institutions.[28] At the end of 2007, CDC had 66% of its investments in poor countries compared to an average of 24% in other Development Finance Institutions, with only one other having more than 50% of investments in poor countries.[29] A new Investment Policy for 2009-2013, was announced in November 2008, which set CDC higher targets for investment through new funds in poor countries.[30]

2.6 By 2008, four countries - Nigeria, India, South Africa and China - accounted for 64% of CDC's portfolio. Although all of these countries had achieved at least lower-middle income status by 2008, they nevertheless contained many of the world's poorest people. From 2004 to 2008 China and Nigeria had received high inward investment from other sources.[31]

2.7 There was in 2008 no systematic evidence on the extent to which CDC investment added to overall investment in poor countries. Assessing this aspect of performance presents technical challenges for all Development Finance Institutions.[32]

TRACKING CDC'S IMPACT ON DEVELOPMENT AND POVERTY

2.8 In 2008, CDC's Business Principles were updated to reflect international best practice, and were broadly consistent with those of other Development Finance Institutions. Reporting to DFID by CDC, and to CDC by Fund Managers, on compliance with principles was during 2004 to 2008 highly selective, saying nothing about levels of compliance or trends. Most Fund Managers' reports lacked a clear evidence base or independent verification. In October 2008, CDC instituted enhanced arrangements for monitoring Business Principles, which provided for deeper CDC scrutiny of high risk investments. The arrangements did not however provide aggregated, validated information on the extent of adherence to those principles across CDC's portfolio.[33]

2.9 Gaining a worthwhile assessment of the impact of investment on economic development and poverty reduction is inherently difficult. No standard group of simple indicators can fully represent all the development effects of a diverse range of investments. CDC had originally expected to have evaluated 22 of its funds by 2008 but revised its evaluation programme after the first four evaluations - which all focused on investments before 2004 - had been completed. The four evaluations lacked depth beyond financial and governance issues, offering little insight into the effects of constituent investments. CDC subsequently continued its evaluation programme by focusing on funds in which it had invested in since 2004.[34]

Governance of CDC

2.10 CDC's internal arrangements for governance were well designed and consistent with good practice on corporate governance. But arrangements for DFID oversight between 2004 and 2008 had not been as strong. DFID had a small team - 1.5 people - to oversee CDC. It was unclear from CDC's Business Plan which forecasts were for internal use and revision by CDC's Board and management, and which were targets designed to apply unchanged for the period 2004 to 2008, and under which CDC should be accountable to DFID. DFID and CDC agreed a remuneration framework in 2004, but there were lapses in handling CDC executives' pay. Unilaterally CDC awarded its executives pay packages which were well above thresholds set in 2004 as requiring consultation with DFID. In late 2007, DFID began working with CDC to improve its framework for oversight, and in 2008 DFID and CDC started a process to put in place new arrangements governing remuneration.[35]

OVERALL CONCLUSION ON VALUE FOR MONEY AND RECOMMENDATIONS

2.11 Overall we concluded that, by achieving financial performance which exceeded global emerging markets between 2004 and 2007, and with a portfolio weighted towards poor countries, CDC had made a credible contribution to economic development in developing countries whilst also encouraging other foreign investors to engage with them. In these respects, and in securing a good return on the public funds invested, CDC had achieved good value for money.[36]

2.12 We pointed out, however, that whilst economic growth is a precondition for pulling and keeping people out of poverty, the direct effect of specific investments on poverty reduction for poor people is harder to demonstrate. The extent to which CDC's investments were an effective way of providing, directly or indirectly, economic benefits for the poor was an issue on which further evidence was needed. In 2008, DFID and CDC were working to improve the evaluation of such impact.[37]

2.13 We made recommendations covering areas where DFID could further improve value for money while avoiding interference with the day-to-day management of CDC's business. The recommendations addressed matters relevant to each of the four themes examined in the report.[38] The large majority of our recommendations were reinforced and developed by the Public Accounts Committee in 2009. The Committee's recommendations and subsequent reported developments are set out in Part 3.

OVERVIEW OF KEY REPORTED DEVELOPMENTS SINCE 2008

Public Accounts Committee report and subsequent action

3.1 In April 2009, the Public Accounts Committee produced its own report on DFID's oversight of CDC, after taking evidence from both the Department and the company.[39] The Public Accounts Committee's report made a series of recommendations. Figure 2 sets out the actions DFID has reported taking in response to the Public Accounts Committee's recommendations. We have not validated or assessed these actions.

Figure 1

ACTION TAKEN BY DFID SINCE THE PUBLIC ACCOUNTS COMMITTEE's 2009 REPORT AND OTHER DEVELOPMENTS

Theme	Topic	Public Accounts Committee recommendation	Action reported by DFID in the July 2009 Treasury Minute response to PAC's recommendations & in its July 2010 Resource Accounts	Other developments and comment
CDC's financial performance	Financial targets for CDC	DFID should set medium-term financial targets for CDC relative to relevant market indices, clarify its attitude to risk in investments, and define measures of efficiency which capture all the costs of the business model that CDC uses.	Medium-term financial targets, risk measure triggers and operational cost measurements are included in CDC's latest five year (unpublished) Business Plan for 2009-13. (Source: DFID 2010)
	Cash balances	DFID should routinely be consulted on the nature and scale of major CDC commitments and on their effect on cash balances.	CDC obligations to consult with DFID on major strategic options not covered in CDC's Business Plan are set out in the July 2009 Memorandum of Understanding between DFID and CDC (unpublished). DFID will monitor levels of cash held by CDC to ensure they are not excessive and will discuss corrective action with CDC if needed. (DFID 2010)	By December 2009, CDC had reduced its cash balances to £980 million and its investments overseas were valued at £1,410 million.
	Reporting CDC's results	CDC's reporting should clearly distinguish results achieved from its different types of business.	DFID agrees with the Committee's conclusion. Going forward, CDC reporting, including its new annual Development Impact Report, will distinguish where feasible between the results achieved from different types of business. (DFID 2009)	CDC published its first annual Development Impact Report in July 2009 and its second in June 2010
Focusing on poor countries through Investment Policy targets	Focus of CDC investment activity	DFID should ensure that CDC concentrates its resources in deprived areas and markets.	A new Investment Policy for 2009-13 was announced in late 2008 and focuses CDC operations more tightly on the poor countries of sub-Saharan Africa and South Asia going forward. (DFID 2010)	Under its Investment Policy for 2009-13, more than 75% of CDC's new investments are to be in low income countries, and more than 50% in sub-Saharan Africa. The new targets apply to low-income countries with gross national income of less than US$905 per annum in 2006. The previous policy for 2004-08 covered poor countries with income levels equal to or less than US$1,750 per annum.[40]
	Mobilising additional investment	DFID needs to improve the way CDC measures and reports its effectiveness in mobilising additional investment in deprived areas and markets in order to help guide future CDC Investment Policy.	DFID and CDC will work together to develop a methodology for assessing CDC's effectiveness in mobilising 3rd party capital. (DFID 2010)
	Using a wider range of financing instruments	DFID has encouraged CDC to look for ways in which it can invest more in low income countries, which may require CDC to increase its use of financing instruments other than equity. Instruments such as loan finance may imply different balances of risk, reward and administrative cost. DFID needs to make sure that CDC's financial targets, business model and incentives do not restrict such changes where they represent an appropriate response to the needs of poor countries.	CDC's plans for introducing new financing instruments were included in the five year Business Plan finalised in November 2009. (DFID 2010)
Tracking CDC's impact on development and poverty	Business Principles	DFID now accepts it must work with CDC to strengthen the governance of Business Principles. It should ensure that assurance and assessment are independent of CDC and Fund Managers, and that the assessments cover the portfolio as a whole, with an agreed format of reports.	From 2009, CDC has commissioned an independent audit of compliance of a sample of its portfolio of investments, including compliance with the Investment Code (which includes the Business Principles). Target going forward is to do 50% of these audits independently. (DFID 2010)	CDC's auditors provided an assurance report on CDC's processes to implement its Investment Code (which includes its Business Principles). This report was included in CDC's 2009 Development Impact Report published in July 2010.[41]
	Developmental effects of investments	CDC is working to collect improved information on the developmental effects of its investments, and DFID should require CDC to report the results systematically and in a way which fairly represents its portfolio.	CDC is reporting its development effects via the new annual Development Impact Report. (DFID 2010)	As mentioned above, CDC published its first annual Development Impact Report in July 2009 and its second in June 2010
	Developmental effects of investments	DFID should commission an independent evaluation of CDC's impact, timed to inform the next five yearly business review, and building on improved CDC fund evaluations.	DFID is planning to commission an independent evaluation of CDC impact, to inform the next five-yearly review of CDC's business. (DFID 2010)
	Promoting transparency and openness	CDC should use its influence with Fund Managers to advance openness and transparency around reporting on fund plans and performance.	DFID agrees with the Committee's conclusion, but it and CDC must be careful to maintain a balance between the Government's commitment to openness and transparency on the one hand, and the need to understand and respect commercial confidentiality on the other. (DFID 2009) Promoting openness and transparency is a medium-term objective. CDC's Development Impact Reports include the overall results of funds evaluated. (DFID 2010)
Governance of CDC	Remuneration	Steep increases in remuneration for CDC executives since 2004 reflected CDC's exceptional financial performance, but CDC did not properly consult DFID as required under the agreed remuneration policy. DFID failed to ensure that the governance arrangements worked as intended.	A strengthened Remuneration Framework for CDC was put in place in 2009. The Framework sets out clear responsibilities for CDC's Remuneration Committee, degrees of flexibility and ways in which DFID will provide oversight. In addition overall governance arrangements have been strengthened. A revised Chairman's letter written in May 2009 sets out roles and responsibilities more clearly and provides for higher level and more frequent formal discussions between DFID and CDC. (DFID 2009)
	Remuneration	The remuneration arrangements led to extraordinary levels of pay in a small publicly-owned organisation charged with fighting poverty, with the Chief Executive receiving £970,000 in 2007.	More than three quarters of the Chief Executive's pay in 2007 was performance-related. A new Remuneration Framework was put in place in November 2008. (DFID 2009)	CDC's Chief Executive received total payments of £495,000 in 2009. This included base salary, benefits and payment from the CDC wide long-term incentive plan. He was also entitled to a bonus given his performance against objectives in 2009, but he waived this payment.

Source: National Audit Office summary of material from a range of sources including: DFID's Resource Accounts 2009-10, page 113; Treasury Minutes on the Seventeenth to the Twenty Third and the Thirty First Reports from the Committee of Public Accounts Session 2008-09, Cm 7636, July 2009; and, CDC Group plc, Annual Report and Accounts 2009, April 2010, pages 8 and 23 to 25

DFID'S PLANNED REFORM OF CDC

3.2 In a written statement to the House of Commons on 12 October 2010 the Secretary of State for International Development announced the Government's decision to reconfigure CDC with the aim of radically increasing its development impact.[42] DFID has said the purpose of reforming CDC is "to maximise its additionality and capital mobilisation in those countries, regions, businesses or sectors where it will make the greatest contribution to economic development and poverty reduction over time, both directly through its investments, and indirectly through its catalytic and demonstration effects".[43]

3.3 The key strands of the proposed reforms are for CDC to:

¾ resume direct investments, including with other investors (co-investment), in addition to the current "fund of funds" investments;
¾ have a wider range of financial instruments at its disposal, including equity, loans, credit lines and guarantees; and
¾ focus afresh on the poorest regions in the world, in particular in sub-Saharan Africa and South Asia.[44]

3.4 DFID is consulting on the reforms. It is also commissioning four studies, to be completed by early 2011, which will:

¾ review the activities of other Development Finance Institutions and International Finance Institutions;
¾ look at the development returns to investing public funds and catalysing private investment into private sector enterprises;
¾ review what constrains private investment in business in the poorest countries, in particular the issue of the lack of access to capital; and
¾ compare remuneration structures between Development Finance Institutions, the financial sector and other comparable organisations.

2 C&AG's report, Investing for Development: the Department for International Development's oversight of CDC Group plc, HC18, Session 2008-2009 Back

3 C&AG's report, paragraph 3 Back

4 C&AG's report, paragraphs 3 to 4 and Appendix One, pages 32-34 Back

5 C&AG's report, paragraph 2 Back

6 C&AG's report, paragraph 3.5 Back

7 C&AG's report, Appendix Three, page 40 Back

8 C&AG's report, paragraph 4.2 Back

9 C&AG's report, paragraph 3.5 Back

10 C&AG's report, Appendix 3, page 40 Back

11 CDC Group plc, Development Review 2009, June 2010, page 1 Back

12 C&AG's report, paragraphs 1.1 to 1.3, Figure 1 and Appendix 3, page 41 Back

13 C&AG's report, Figure 8 Back