Written evidence submitted by Dr Sarah
Bracking, University of Manchester
I am writing to submit a short Memorandum in respect
of the future of the CDC, within the published terms of the current
IDC enquiry. I am a Senior Lecturer in Politics and Development
at the University of Manchester and specialise in the political
economy of African development with particular reference to the
role of public development finance institutions (DFIs) of which
CDC is the UK national example. I have written a book on the subject
called Money and Power: Great Predators in the Political Economy
of Development (Pluto Press, 2009). More specifically I have recently
completed a project, in which I was the principle investigator,
commissioned by the Norwegian equivalent to DfID, Norad, about
the future of Norfund, the Norwegian equivalent to CDC. The study
was a comparative one, and also featured other European DFIs,
including detailed material on Norfund, Swedfund and CDC. The
focus was particularly about the consequences of the domicile
arrangements for private equity funds contributed by DFIs in the
context of the government restrictions in place in Norway and
Sweden on the use of secrecy jurisdictions/tax havens by public
DFIs.
This document was used by Norad to inform a report
to the Ministry of Foreign Affairs in Norway. These can be obtained
by contacting: postmottak@norad.no
The documents make clear, there are a number of serious
research gaps which pertain to an assessment of the developmental
impact of private sector development interventions. It is in two
separate documents:
- Future Directions for Norwegian Development Finance",
dated 14 October 2010, ref. No.: 0902364-55". (ps. 48).
- Supplementary documentation to the report "Future
Directions for Norwegian Development Finance", dated 14 October
2010, ref. No.: 0902364-54. (ps. 168).
These documents are the property of Norad according
to the contract between Norad and the University of Manchester.
Given the complexity of the issues around the developmental
impact of different types of delivery mechanism of capital to
the private sector (private equity funds, direct investments,
guarantees and so forth); their differential developmental impact
by sector (infrastructure, microfinance, industry and so forth);
by choice of partner; and by choice of domicile; I would expect
the Committees work to be challenging.
My comments below, in relation to this inquiry, concern:
- the effectiveness of CDC compared with other
similar institutions;
- the reforms proposed by the Secretary of State
for International Development on 12 October 2010 and the feasibility
of achieving desired results given the CDC's current resources,
including staffing; and
- the extent to which the proposed reforms will
be sufficient to refocus CDC's efforts, especially with respect
to poverty reduction.
I also raise issues around tax justice and domicile
(the place where CDC investments are legally registered). In general
I believe that there are critical problems in the current means
of evaluation, management and direction given to CDC in terms
of delivering a development benefit. The argument below is that
the development effectiveness of CDC as currently operating is
limited, although it cannot be accurately measured given the paucity
of public data and research. The reforms proposed are to be welcomed,
but geographic targets should be replaced by more specific criteria
on poverty reducing investments, while the issue of domicile of
companies and funds should also be addressed. The proposals are
too general at present to be significantly addressed, but increased
use of alternatives to the current exclusive use of equity funds
is to be welcomed. These could include direct investments, loans,
the provision of risk instruments, investment guarantees, mezzanine
financing and commercial and mutuals investments. Increased use
of these instruments would mean an increased coordination with
ECGD would be required. Issues of tax justice must be considered
alongside these changes, and restrictions to secrecy jurisdiction
use put in place.
EXECUTIVE SUMMARY
1. The use of the fund of funds model critically
impairs CDC's management of developmental impact, political risk,
reputational damage, consolidated and counterparty risk in the
underlying investee companies, due diligence monitoring and the
oversight of investment partners. The model relies on leverage
and influence, but the positive effect of augmenting private investment
flows is largely unproven and must be offset against the model's
disadvantages in terms of reducing the fiscal base in developing
countries, increasing business opacity and for privileging the
interest of investors unduly in relation to other stakeholders.
2. The overwhelming use of secrecy jurisdictions
for fund of funds investments (secrecy jurisdictions are also
termed "tax havens" or "offshore financial service
centres") exacerbates most if not all of these investment
governance problems.
3. The overwhelming use of secrecy jurisdiction
domicile for CDC investments reduces the rightful and morally
just fiscal resources available for developing country governments,
which would otherwise be available to them had the funds and companies
in which CDC invests been domiciled in their countries of actual
operation. This impairs the development of education, health and
public services upon which development critically depends.
4. It is hard to accurately calculate a developmental
impact which includes tax losses and offsets these against figures
for employment created and tax paid, which are the indicators
most often used by DFIs in order to promote the benefit of their
work (see EDFI, 2009). Public announcements by DFIs of developmental
benefit generally rely on a thin evidence base and weak methodology.
They are not subject to systematic publically available evaluation.
5. The current impact methodology in use by DFIs
and the European Development Finance Institutions (EDFI), their
representative body are inadequate. Most centrally there has been
an erroneous, but widespread use of aggregated figures for employment
created and tax paid in companies in which DFIs have contributed
investment capital, rather than a pro rata calculation relating
to their actual proportional ownership within the enterprises.
6. There is a dearth of relevant research within
the DFIs or within the wider research community which can accurately
assess the developmental impact of different forms, types and
scales of private sector development intervention. This is due
to the uncritical assumptions that have been held by DFI managements
that any investment must be good for growth, and that growth is
roughly commensurate with development, and also, in turn, with
poverty reduction. Each link in this associational chain is problematic
in practice.
7. The current instructions issued to CDC by
DfID concerning the deployment of funds are only roughly related
to actual outcomes, partly because of these flaws in logical association,
and partly because of the globalised and multi-layered complexity
of sovereign domicile in corporate structures and in the funds
and companies in which DFIs invest. For example, the requirement
to put certain percentages of invested funds into geographic areas
such as sub-Saharan Africa, or "the poorest countries"
are impossible to accurately measure, even by CDC itself, since
it places the vast majority of its funds in key secrecy jurisdictions
under investment contracts. It is the Fund Managers who agree
to meet these DfID criteria by proxy. However, they again are
not required to disclose the degree of on-lending of DFI-originated
funds to underlying portfolio companies which are similarly routed
to secrecy jurisdiction based holding companies, parent companies
and trust companies. The level of reporting of Funds to DFIs is
not exhaustive in this regard since they do not routinely practice
country by country accounting. It is not always clear where the
final destination of funds invested actually is from these reports.
In short, it would be a challenge for the participating parties
- the Fund Managers and their DFI contributors - to know themselves
what actual scale of funds are truly delivered into the national
geographies to which they are mandated.
8. There is a perverse effect of mandating investment
to the poorest countries in anticipation of an enhanced poverty
reduction effect, in that the local capacity to absorb such funds
tends to be highly concentrated in enclaved, extractive and export-oriented
sectors owned by a small proportion of the population. The political
economy effect of this is to increase inequality and frustrate
efforts to make political and economic elites accountable, particularly
since many of these transactions occur "offshore". Much
more empirical evidence should be generated on the types of investment
that DFIs support, the sectors in which they invest and the ability
of these to catalyse broad based and poor-poor growth. The mandating
of funds to the "poorest countries" does not at present,
and as currently operationalised, have a provable beneficial developmental
effect, and could quite easily be contributing to these adverse
social and political consequences which may in fact hinder growth.
9. DFIs align themselves to the investment models
and prerogatives of private sector actors in order to augment
the total amount of capital available for investment, by pooling
their resources with these partners in Funds, normally domiciled
in a secrecy jurisdiction. However, there is currently no convincing
evidence that total capital flows to Africa are expanded as a
consequence of this investment model. But there is evidence of
this structure being harmful in many other respects, including
in a reduced fiscal base, in reduced corporate accountability,
in patterns of "round-tripping" investment, and in the
privileging of the "international investor" and Fund
Manager in comparison to other local stakeholders which include
nationally domiciled shareholders, workers and affected communities.
The issue of tax justice should preclude any further use of this
"offshore" intermediated model.
10. Given the above, and the problems with risk
assessment given in more detail below, the use of public funds
in this manner by CDC must be of critical concern to the
public interest and UK tax payer. The governance of CDC must be
reformed in order to increase its public accountability, the quality
of its accounting and transparency of reporting of its accounts,
and its monitoring and assessment of risk and development impact.
The influence that it believes it has as a contributing investor
to private funds must be proven in terms of its ability to actually
induce reforms and best practice in those firms as a condition
of its participation, and not as something aspired to and
promised by a third party Fund Manager. An increased use
of direct investments is to be preferred.
THE SUBMITTER
11. I have been researching and writing on development
finance for close to 20 years, and have cognate interests in the
political economy of development, political corruption, democratisation
and poverty reduction. I am currently employed as a Senior Lecturer
for the International Development programme at the University
of Manchester, UK.
FACTUAL INFORMATION
12. The CDC provided a list of its domiciles
by number of funds invested in each place, but not by value to
a recent University of Manchester research team (see Bracking
et al, 2010a, Bracking, 2010b). The majority are domiciled
in secrecy jurisdictions. The CDC currently invests solely using
a "fund of fund" model, investing in private equity
funds in an intermediated model. From the data presented by CDC
in 2010, it is clear that the intermediated model relies heavily
on OFCs, with 71.67% of all its funds and subsidiaries - by number
not value - domiciled in either London, Mauritius or Cayman, which
deductively act as three central business hubs. Using the IMF
list of tax havens for 2007, it is possible to classify the domicile
of its funds (excluding subsidiaries) in 2010, which adds up to
144 in tax havens, or 80% of all the CDC's investments by number
(Bracking et al, 2010, para 1.7, page 10).
13. The CDC has a "fund of funds" structure
and about half its portfolio by value is routed using domiciles
out of London. Actis, which includes the legacy investments, is
managed from London and probably accounts for the majority of,
if not all, London-based domiciles. CDC has 59 fund managers overall,
one each for Actis and Aureos, and a further 57 with whom it sub-contracts.
Actis employs 49% of CDC's overall capital - USD 3,361 million.
It attracts to its funds a further USD 80 million from other DFIs,
and USD 2,789 million from commercial investors. Aureos, a joint
venture with Norfund aimed at SMEs, invests a further six per
cent of CDC capital. CDC's 57 other managers direct 45% of its
capital (Bracking et al, 2010, para 1.8, page 10).
14. There is an intimate connection between one
particular type of investment model - the intermediated private
equity investment fund - and domicile in a secrecy jurisdiction.
The lesser association of direct investments with this type of
domicile is clear from the domicile patterns of Norfund and Swedfund,
but is still prevalent for larger direct investments (see Bracking
et al, 2010a, 2010b).
15. There is some evidence from CDC that using
sub-contracted in this way does augment private investors' participation.
Data from the CDC Development Report 2008, suggests that the
leverage rate of different types of fund is indeed better for
funds that are sub-contracted, rather than in funds and subsidiaries
in the "legacy" portfolio. Thus, Actis has USD 3,361
million invested, with USD 80 million from other DFIs (making
USD 3,441 million), which manages to attract USD 2,789 million
from the commercial sector. Expressed as a ratio, this is approximately
1: 0.81. Conversely, the 57 new fund managers between 2004 and
2008 had USD 7,137 million invested by CDC, with an additional
USD 1,433 million from other DFIs (making USD 8,570 million),
which together attracted a further USD 19,718 million from commercial
investors, giving an equivalent ratio of approximately 1: 2.3
between the "public" and private sectors, or nearly
three times as much per unit of invested DFI capital.
16. CDC is unique among DFIs to employ all its
capital through private sector Fund Managers, albeit that the
fund with nearly 50% of its capital is managed from London, in
the new private fund company Actis, jointly invested by DfID and
private owners (who used to be CDC public employees). Ergon explains
that the objective of this arrangement was to achieve a "step
change in CDC's economic impact and catalytic role" (quote
assigned to DfID, 2010: 14), in that CDC resources are less than
one per cent of total international private equity to developing
countries, so to have a bigger impact it was thought that they
should invest though private equity Fund Managers to influence
commercial investors in the same companies available to them (see
Ergon, 2010: 14). This model thus relies on leverage, influence
and perhaps more critically, following the pack, rather than directly
investing in stand-alone projects. However, it is hard to attribute
to CDC alone the responsibility for the behaviour of these investors,
since the counterfactual case - that they would have done it in
any case - is unclear. It is certainly possible that this investment
model attracts investors who would otherwise have invested "onshore"
in any case, displacing local savings and investment. It is not
clear that this is additional capital in terms of the investment
market as a whole.
17. There is little evidence that using sub-contracted
funds in this way produces any developmental impact that
couldn't be attributed to a like volume of private investment
per se. The additionality is not proven such that the deployment
of CDC funds in other structures must be seen as desirable given
the adverse tax effects.
18. DFIs and investors view secrecy jurisdictions
as protecting them from expropriation of their investments, and
as guaranteeing them an effective disputes mechanism for conflicts
between co-investors. Leaving secrecy jurisdictions is generally
associated with an increase in investment risk, in particular
in the categories of political risk, expropriation risk and exchange
rate risk. However, the risk "protection" offered by
funds could concentrate rather than spread risk, in a similar
fashion to the manner in which off-balance sheet items from financial
institutions, opaque structured investment vehicles and structured
investment products, such as offshore SPVs and CDOs concentrated
risk, triggering the current global financial crisis (see Government
Commission Report (NOU, 2009)).
19. Also cross investments and repeated ownerships
in the underlying portfolio can also concentrate risk, such that
the "consolidated risk" - which aggregates that of the
underlying companies could be extremely toxic. European DFIS are
only beginning to account for this, although to the author's knowledge
CDC may not. Relatedly, the Government Commission in Norway correctly
concluded that tax havens enhance counterparty risk (NOU, 2009).
Moreover, the public is the risk carrier of last resort, through
the respective central banks of DFI owner countries. Thus, it
would be prudent to remove certain business types and organisational
forms from the risk-bearing chain - such as secrecy domiciled
Funds and international business companies (IBCs) - since these
contribute only opacity, and work only in the interests of capital
holders at the expense of capital receivers. International companies
which are not obliged to keep proper accounts are unsuitable as
business counterparties, since the transaction risks are too great.
Thus, the depiction of secrecy jurisdictions as a means of managing
some types of risk to the investor - expropriation, payments -
must be offset against their contribution to the inflation of
other types of risk - counterparty risk, consolidated risk and
reputational risk. Withdrawing from secrecy jurisdictions will
have the likely result of enabling a more systematic means of
risk accounting, as well as a reduced exposure to non-transparent
risks (see Bracking et al 2010a, para 2.2.2, page 19).
20. The issue of management of risk. In Bracking
et al (2010, 19-20) it states that:
"It is clear from the financial crisis of 2007-09
that when the risk management agencies were under the employ of
the organisations releasing the financial products, they were
bound to have a conflict of interest, which would lead to error.
The system here has a similar flaw, wherein those defining and
benefiting from the fund product, are also calculating the investment
risk, or assigning it to third parties. That the DFIs are significantly
cross-invested adds to the image of safety, but actually - particularly
with the type of investments that DFIs do best in, which by their
nature tend to be high risk - this herd effect gives another false
veneer of safety. DFIs could be subject to significant reputational
damage, should this risk concentration fail them. The current
arms-length due diligence and risk management of intermediated
funds is thin. It is efficient and cuts down administrative costs
in order to plough more money back into "development",
but that will prove a short-sighted strategy if a political or
reputational scandal emerges. DFIs should calculate counterparty,
consolidated, reputational, social and political risk, as well
as financial and investment risk themselves, or assign this role
to an impartial third party, such as an office within the home
Public Accounts Department. A European development finance regulator
should be able to conduct ad hoc tests of procedures in
member states."
This holds equally true as a recommendation for this
review.
21. Due diligence. CDC does not carry
out due diligence on all their co-investors. The argument that
they check all major shareholders but the very small ones is an
argument incorporating much hazard: a "small" investor
in a large equity fund is often a very "big fish" once
he or she is back in their domestic context, capable of wielding
much power and control over local markets, communities and workers.
Thus the moral hazard is that such people are empowered in relation
to others, with no apparent checks on their business practice
or legal record. The due diligence of small investors is left
to contracted Fund Managers.
22. DFIs sometimes point to the reductions in
administrative costs attribute to the use of funds. However, fees
for fund managers are born by the fund as a whole, deducted before
the fund is closed. These fees are taken from the pool of investable
capital, and are contributed in part by tax avoidance in the country
of effective residence of the underlying portfolio company. In
other words the cost structures of different types of investments
are not commensurate as some costs which would be accounted for
in a public organisation are subsumed into the fee structure of
a fund. Further research is required on relative cost structures.
Suffice to say that an increased use of direct investments by
CDC would require more in-house investment managers, the cost
of which could be born in part from the reduced indirect cost
of fees and expenses in sub-contracted funds.
23. DFIs also assert that the use of secrecy
jurisdictions reduces the transactional costs of administering
investments, and thus allows for a better flow of funds to the
end user. However, Bracking et al (2010a, 21-22) argue
that:
"Increased transactional costs due to withdrawal
from secrecy jurisdictions in terms of red tape, bureaucracy,
and in altering the culture of facilitation payments can be expected
in the short and medium term. Overcoming such high transactional
costs could be part of the core developmental remit of a DFI by
supporting domestic finance markets, enhancing institutional quality,
which would eventually lead to better developmental outcomes.
Operating guidelines could be changed to reflect the increased
role DFIs would have in the reform of soft and hard market infrastructures
and operating cultures. In order to ameliorate the increased costs
associated with the active search for investment opportunities
(a role previously assigned to the Fund Manager), DFIs could consider
advertising available funds through a calls to tender type system,
directed at the private sector in target countries, with clear
investment criteria that potential firms and funds must demonstrate
that they can meet."
Because investments in developing countries are considered
hard to implement in a direct fashion is not a good enough reason
to stop trying, since the market environment improvements that
a DFI presence can catalyse have multiplier effects for other
investors. This is part of the developmental benefit that can
be expected from PSD intervention.
24. Active ownership by DFIs in more embedded
national structures can make a real difference to institutional
strengthening, regulatory improvements, and measures of market
and risk perception, in order to catalyse capital market growth.
Institutional strengthening and enhanced institutional quality
is positively correlated to further growth in investment flows,
savings and investment in a virtuous cycle. Research from Kaufmann
et al (2005) and others around the "governance and
institutions matter" theme, suggests that local investment
and savings growth is just as, if not more important, to sustainable
economic growth and development in the long-term than short-term
injections from "outside" (also see Addison, 2010; Chang,
2002; Di John, 2010). Recent development success stories generally
start with a strong, developmentally oriented state, not a private
sector which is designed to bypass it (See Chang, 2002).
25. Richard Murphy has recently estimated the
tax loss to developing countries from the DFI use of tax havens
for the EDFI portfolio as a whole, using data produced by the
DFIs, at in excess of EUR 430 million, a year on average over
the last five years. Actual corporate taxes paid on the EDFI portfolio
might be as low as EUR 270 million per
annum in direct conflict with the EDFI claim that their investments
generate approximately EUR two billion3
of tax revenues per annum for developing countries
(Murphy, 2010).
26. In Bracking et al (2010a) we estimated
for 29 companies in which Norfund invested, the tax loss (or gain)
for developing countries for 2008, as compared to what the same
companies would have been liable to pay had they been domiciled
in the country of actual operations. For these, the amount of
tax underpaid, or tax losses for developing countries because
of domicile in secrecy jurisdictions has been calculated for 2008
at over (gross) USD 14.6 million. This is tax that would have
been paid, at the rates prevailing in the countries of their actual
operations, for these 29 companies if they had been domiciled
in the same jurisdictions as their operations, rather than in
a secrecy jurisdiction. [An explanation for how these figures
are derived is found in the accompanying report Supplementary
Documentation for the report "Future Directions for
Norwegian Development Finance", Bracking (2010b)].
RECOMMENDATIONS FOR
ACTION
27. DfID should make provisions in law, policy
and practice to ensure that:
- CDC does not invest in private equity funds in
secrecy jurisdictions as determined by the existence of 1) differential
tax treatment for non-nationals and 2) company law which allows
beneficial owners to remain secret and company accounts to remain
private. CDC invests in funds in which at least 10% of the onlending
to the underlying portfolio companies occurs in the legal jurisdiction
of the domicile of the fund. This is in order to enhance the developmental
impact and accountability of Funds to developing countries' regulatory
authorities and the transparency of corporate structures.
- CDC should not make direct investments to companies
where the parent is in a secrecy jurisdiction and the funds are
routed through it. There is no positive developmental function
that can be attributed to a firm having an offshore parent, but
many negative consequences thereof.
- DfID should redesign the directions given to
CDC for the deployment of funds so that they can be realistically
and accurately measured in terms of territorial domicile, rather
than the deceptive data which is currently published by CDC about
the geographical spread of its investments.
- DfID should redesign investment management criteria
to ensure that CDC activities maximise developmental impact and
poverty reduction. This will require use of a new development
impact matrix which should include criteria concerning direct
poverty reduction effects, downstream and upstream business generated,
employment, environmental impact, governance effects, economic
displacement effects and modelling of the type of growth effects
to be expected by sector and type of enterprise. In other words,
a systematic means of monitoring developmental impact should be
employed by CDC.
- If CDC maintains the use of private equity funds
its participation should be conditional on their adherence to
international accounting, environmental and human rights standards
and to fair remuneration.
- HM Government should support moves to establish
a European regulator of European DFIs to carry out independent
checks of DFI operational procedures.
SUMMARY
28. The development effectiveness of CDC as currently
operating is limited, although it cannot be accurately measured
given the paucity of public data and research. The reforms proposed
are to be welcomed, but geographic targets should be replaced
by more specific criteria on poverty reducing investments, while
the issue of domicile of companies and funds should also be addressed.
The proposals are too general at present to be significantly addressed,
but increased use of alternatives to the current exclusive use
of equity funds is to be welcomed. These could include direct
investments, loans, the provision of risk instruments, investment
guarantees, mezzanine financing and commercial and mutual investments.
Increased use of these instruments would mean an increased coordination
with ECGD would be required. Issues of tax justice must
be addressed alongside these changes and restrictions to secrecy
jurisdiction use put in place.
17 November
2010
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