The future of CDC
Evidence from 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.
13 January 2011
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