Written evidence submitted by Keith Palmer,
Chairman of AgDevCo and InfraCo
I welcome the announcement by the government of its
intention to hold a full review of CDC. There are good reasons
to believe that the current strategy is not achieving nearly as
much as it could to foster competitive private enterprise and
reduce poverty especially in low income developing countries.
This brief submission sets out my views on a number of the key
issues which will need to be addressed in depth during the government's
forthcoming review.
CDC is the UK's development finance institution (DFI)
and as such has a major role to play fostering economic growth
and relieving poverty in the developing world. CDC should act
in ways that: are catalytic ie inducing private investment that
otherwise would not take place; induce leverage ie result in the
mobilisation of private capital in amounts much greater than its
own investments; and maximise the reduction in poverty e.g. by
focusing on sectors where the poverty reduction impact is greatest.
It should also act and invest in ways that will maintain the real
value of its capital employed and generate a profit.
CDC currently operates a private equity fund of funds
model. It has been successful in mobilising capital from the private
equity markets and channelling it to businesses in developing
countries. It has also realised significant proceeds and profit
from selling assets acquired in the past, benefiting from the
sharp rise in asset prices in emerging markets prior to the financial
crisis in 2008. This has increased the resources now available
to CDC for new investment.
However there are major drawbacks with a fund of
funds business model. It is well suited to circumstances where
there are many investment-ready opportunities and a shortage of
capital. But it is poorly suited to circumstances where the major
problem is too few investment-ready opportunities. This is by
far the most common situation in most low-income developing countries
where there is often plenty of capital available but too few opportunities
offering attractive risk-adjusted returns to private investors.
With the fund of funds model capital mobilised by CDC flows to
the countries and sectors with the most investment-ready opportunities
offering the highest returns; not to the countries and sectors
where the need is greatest and the people are poorest. Moreover
making additional funds available will not increase the rate of
investment unless a means can be found to create more investment-ready
opportunities.
The review of CDC should focus on changes in six
key areas:
- Risk appetite and return expectations
- Sector focus
- Product mix
- Leveraging CDC resources
- Incentives
- Delivery mechanisms
Risk appetite and return expectations
The fund of funds model involves CDC investing
its capital alongside (pari passu with) private equity investors.
Its capital is exposed to the same risks and expects the same
return as private investors. Consequently its capital is always
invested in opportunities which the private sector would have
been willing to invest in anyway. This approach will only be additional
where there is a shortage of capital. It will be neither additional
nor catalytic in circumstances where the problem is too few opportunities
offering sufficiently attractive risk-adjusted returns.
In low income developing countries many domestic
businesses are in the very early stages of development. Investment
opportunities are frequently high cost and high risk and generate
relatively low returns. However, if investment can be kick-started
then over time as the industry grows and productivity improves,
costs and risks will fall and profitability improve. Early stage
investment kick-starts a virtuous cycle of reducing costs and
risks, rising profitability and further investment which results
in sustainable growth and rapid poverty reduction. In my view,
CDC should be acting as the catalyst to kick-start this sort of
virtuous cycle.
However, this is not possible with the fund of funds
model. If CDC is to be truly catalytic, and induce private sector
investment that otherwise would not take place, it must be prepared
to accept the greater risks and lower expected returns intrinsic
to investment in early stage private enterprises in low income
developing countries. Of course this must not be a mandate to
lose money. CDC should allocate a portion of its capital to support
these types of investments but should only commit to invest in
specific opportunities if (i) they are expected to generate fully
commercial returns in the medium term; and (ii) the investment
will result in a substantial reduction in poverty; and (iii) as
a result of its investment it will lever-in additional private
capital in amounts much greater than its own investment. We refer
to this type of capital as "patient" capital. Investment
of patient capital by CDC will restore its catalytic role and
induce high leverage of private capital which otherwise would
not take place. CDC will be much more effective stimulating rapid
growth of private enterprise and achieving more rapid poverty
reduction.
With this approach CDC would invest two types of
equity -- patient capital and private equity. The private equity
would be funded in part out of its own resources and in part mobilised
from the capital markets. Patient capital would be funded in part
from its own resources and in part by partnerships with donors
and social impact investors. Patient capital would earn a return
of 5-6% and private equity would earn fully commercial returns.
The lower average cost of capital deployed in supporting enterprises
in the early stage of development will kick-start sustainable
growth in sectors where investment otherwise would not take place.
The return on CDC's total capital employed will be lower but there
will be a major increase in its development impact and contribution
to reducing poverty.
Sector focus Agriculture
and infrastructure are sectors where the poverty reduction impact
resulting from additional investment is particularly great. The
World Bank shows that growth in agriculture has two to three times
greater impact reducing poverty than comparable growth in any
other sector. Therefore, in my view, CDC should be required to
commit a significant share of its capital to supporting investments
in those sectors in low income developing countries. In the past
CDC (and most other DFIs) had little exposure to these sectors
because there were few investment opportunities with risk adjusted
expected returns attractive to private investors. As explained
in detail elsewhere[80]
this is because these sectors are essentially "infant"
industries with high costs and risks which result from underinvestment.
If the change in risk appetite and return expectations proposed
above were adopted then CDC would invest much more in early stage
agriculture and infrastructure. Investment of patient capital
would increase leverage, stimulating a great deal more private
investment in sectors where the poverty reduction impact is greatest.
Product mix Currently
CDC is restricted to investing entirely in private equity. To
perform its catalytic role effectively it needs to be able to
deploy whichever financial instruments are best suited to fill
the "gaps" resulting from market failure. All other
DFIs have a product mix which includes a full suite of financial
instruments. There is no obvious merit, and considerable drawbacks,
in limiting CDC to equity investments only. It should be able
to make senior and subordinated loans, offer loan guarantees and
invest patient capital as well as private equity.
Leveraging CDC resources
Leverage refers to achieving many £
of private investment for every £ of taxpayer/CDC money invested.
Maximising leverage will also maximise the development benefits
per £ of taxpayer money. There are three different types
of leverage. First, at the level of each investment, patient capital
and use of loan guarantees can lever in additional private equity
and debt at financial close in amounts which exceed by a high
multiple the CDC risk exposure, thereby achieving much more development
"bang for the buck". Additional leverage can be achieved
if CDC disinvests post-completion as soon as the business is capable
of raising private finance to replace it; at which point the released
capital can be reinvested by CDC to catalyse new ventures. Second,
there is leverage of CDC's balance sheet. It should be permitted
to borrow from the debt capital markets either directly or through
funds which it sets up. This would create new opportunities to
lever additional debt into investments in developing countries.
Third, working in partnership with other DFIs and donors, CDC
can achieve development impact many times greater than would be
possible using only its own resources. The example of the UK participation
in the Private Infrastructure Development Group[81]
shows the power of leverage across the international community
to achieve large poverty reduction impact with limited UK resources.
Incentives Incentives
in fund management agreements in the fund of funds model are to
maximise profits. Embedded within these arrangements are incentives
not to invest in high risk, early stage opportunities even though
they have high development impact and great poverty reduction
potential. Therefore as well as changing the risk appetite and
return expectations, as described above, it will also be necessary
to change the incentives in fund management agreements. The aim
should be to structure incentives to reward performance: (i) for
achieving explicit development and poverty reduction objectives
set for CDC; and (ii) for achieving target returns on patient
capital; and (iii) for achieving/exceeding target returns on private
equity.
Delivery mechanisms
At present CDC operates exclusively through
intermediaries ie investing in funds. It makes no direct investments
and no longer has very much in-house expertise to do so. The government
has indicated that it intends that CDC should restore some direct
investment capability. It will take a considerable amount of time
and new recruitment to restore a team of experienced staff with
the ability to make direct investments, particularly in complex
sectors such as agriculture. Furthermore there are teams of experienced
people working in for profit and not for profit intermediaries
seeking to identify, develop and finance early stage ventures
in pro-poor sectors in low income developing countries. It would
be advisable to consider carefully the right balance going forward
between expanding CDC's capability to make direct investments
itself and funding intermediaries - funds and development companies
- with proven ability to deliver on the ground. More rapid progress
will be made and greater impact achieved if CDC funds existing
teams, particularly in the next few years while CDC re-establishes
its direct investment capability. However funding of intermediaries
needs to be done differently. Governance and incentive arrangements
must ensure that the objectives and targets set for CDC are achieved
in practice by the intermediaries.
Conclusions There is a
great opportunity to re-establish CDC as a development institution
that "punches above its weight" fostering economic growth
and relieving poverty in the developing world. The success in
the recent past building the capital resources of CDC provides
a platform on which it is possible to lever much greater amounts
of private investment to support domestic private sector businesses
in sectors in which growth is highly pro-poor. If the opportunity
is to be grasped then the CDC business model will need to be reformed
in the ways described above.
80 See "Agricultural Growth and Poverty Reduction
in Africa: The Case for Patient Capital", Keith Palmer, AgDevCo
Briefing
Paper (www.agdevco.com) Back
81
See www.pidg.org
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