The Future of CDC

Evidence from 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 [1] 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 [2] 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.

[1] See ‘Agricultural Growth and Poverty Reduction in Africa : The Case for Patient Capital’, Keith Palmer, AgDevCo Briefing Paper ( )

[2] See