The Future of CDC

Evidence from The Emerging Markets Private Equity Association

1. We are pleased to be given the opportunity to share our views with the International Development Committee as to the proposed reforms to CDC and its future role in international development, with particular emphasis on CDC’s role and value in emerging markets private equity and venture capital.

2. CDC has been an active and supportive member of EMPEA since its founding in 2004. In 2008, CDC along with peer institutions in the DFI community, provided EMPEA with critical financial support for the development of the industry’s first comprehensive database of emerging market private equity investment activity. This database, which could not have been possible without CDC’s US$100,000 contribution, serves as the foundation for most of EMPEA’s analytical work and research publications in the market today, and lies at the core of EMPEA’s success. In recent years, at our request, CDC has also played an increasingly active role in advising EMPEA on our activities and programming via various non-governing advisory councils. Additionally, 23 of CDC’s fund investees are members of EMPEA, including some of our most active members and a number of firms represented on our Board of Directors.

3. EMPEA’s focus as an organization is to promote the private equity and venture capital industries in high growth and developing countries to improve the availability of critical and efficient financing for growth. Therefore, we do not consider ourselves in a position to comment on the full range of issues within the scope of the Committee’s inquiry, such as CDC’s effectiveness compared to other similar institutions or the feasibility of the proposed reforms given CDC’s current resources. As a consequence, our comments below focus on CDC’s reputation in the marketplace and its contributions to our industry, as well as the value of the private equity and venture capital funds investment model as a sound and effective way to channel investment into small and mid-sized enterprises in emerging and frontier economies.

4. Regarding the proposed reforms to CDC’s model, EMPEA recommends strongly against any migration towards either direct investment or debt at the expense of CDC’s participation in the private equity funds investment model. While there is certainly a need for greater availability of debt-like instruments in developing countries, we respectfully challenge the notion that CDC’s stated objectives of pro-poor development can be more effectively executed by retreating from equity investing in funds.

5. EMPEA fundamentally believes that professionally managed private capital can be a powerful-and in many instances the most powerful-tool for helping to lift the poorest countries out of poverty by offering an optimal mix of long-term capital, professional investment management and governance, and alignment of incentives towards sustainable economic outcomes. A model that skews more heavily towards direct investing could be both costly to execute and challenging to administer effectively across the many countries that CDC aims to serve. Direct investment also carries limitations with respect to the scale achievable versus deploying the same size pool of assets through funds. Further, unlike the public service-minded civil servants likely tasked with managing investments under the direct model, funds are managed by professional investors armed with both the specialized skills and the right incentives to select the most promising and sustainable businesses in the most challenging of investment environments. Fundamentally, we feel there are potentially greater assurances of both financial and non-financial returns on investment from deals that are structured and managed by local business and investment professionals knowledgeable about the market and the business community, and who are incentivized to select high-growth companies with the greatest potential to succeed. This rationale is analogous to the reasons why an individual retail investor would opt to access frontier markets through a mutual fund rather than attempting to pick stocks themselves from London.

6. We would also posit that both CDC and its investees will gain from continued investment, in a targeted fashion, in managers with geographic exposure broader than that of only LDC countries. We agree that CDC’s pro-poor mission will be best executed by focusing resources as they are: 75% in low income countries and at least 50% in Sub-Saharan Africa, as these are categorically the most consistently financially underserved economies in the world. However, we would argue against any further geographic concentration or hard parameters against exposure to middle income markets such as China and India.

7. First, the notion that such markets are fully penetrated for private investment and that finance is therefore readily accessible for all is flawed. Even in markets where enterprises at the top end of the spectrum are well served by abundant sources of capital, early stage and small enterprises remain sorely underfunded. While many of CDC’s early investee funds in India and China have grown into market leading fund managers, who are now able to raise capital fully from non-governmental sources, CDC remains absolutely critical as an early source of investment for newer and smaller fund managers in these countries and elsewhere in Asia raising smaller funds that are focused on investing in small and medium–sized enterprises. There are also vast segments within many more established private equity markets –rural areas or certain sectors such as soft infrastructure – that suffer from scarcity of capital. This is true for many reasons, including: 1) the early stage or scale of many of these companies makes them unattractive lending risks for banks; 2) their size puts them below the floor of many equity investors required to put a minimum amount of capital to work; and 3) due to the challenging economics related to sourcing, managing and executing such deals, there are fewer and fewer professional investors in SMEs, as it’s becoming clear that this model must be subsidized. There is a vast and increasing need for sources of funding to sustain private investment in SMEs, not only to provide jobs, but also to create and grow those companies into the next higher tier of the economy, to fill the pipeline of potential investees for more commercially-oriented investors who are looking for companies with strong governance and controls, and responsible investment practices. DFIs such as CDC are among the few institutions that are both willing and able to absorb slightly less favorable commercial terms (e.g., lower hurdle rates or higher management fees) for what is fundamentally a more expensive business model. Without continued support for SME investment platforms, there could be a damaging ripple effect throughout many lower and middle income economies on the cusp of significant strides in per capita income growth.

8. The second argument against greater concentration of CDC’s footprint at the expense of middle income countries is the lost opportunity for cross-market business opportunities that a multi-market or regional footprint can afford. For example, Olam International, which received US$20 million in seed capital from Hong-Kong based AIF Capital in 2002, grew from a small family business in Singapore into a leading global agricultural supplier serving more than 60 countries. Part of Olam’s successful growth was attributable to the network and the broader lessons that AIF had gained through their other investments in markets such as India and China, and which AIF could in turn make available to Olam. South Africa-based Ethos exited their investment in Dunlop’s South African and Zimbabwean businesses to Apollo, the largest Indian tire manufacturer, which was eager to take advantage of Dunlop’s footprint in Sub-Saharan Africa to grow into the 12th largest tire company in the world. Fund managers with relationships and investment mandates spanning multiple markets have access to a greater array of exit options, particularly important for investors in low income countries with underdeveloped or nonexistent local stock markets. Given concerns about the illiquidity of private equity investments, maintaining some measure of controlled geographic diversification in CDC’s portfolio could enhance the overall exit prospects for the portfolio and therefore the availability of capital to be redeployed into other markets or instruments, wherever it’s needed most.

9. Regarding CDC’s reputation in the industry, both as a source of development finance and as an active investor, we can unequivocally state that CDC has an excellent reputation as a thorough, thoughtful and sophisticated provider of capital, particularly in markets where sources of capital are lacking. In Sub-Saharan Africa alone, CDC has played a critical role as a source of funding, not only in seeding the industry’s future leaders but also in playing a catalytic role in drawing other investors to the region. CDC-backed fund managers account for approximately 77% of all capital raised for private equity investment in Sub-Saharan Africa over the last decade.

10. Further to this point, CDC is also viewed as an influential source of best practices and a professionalizing influence in markets where professional business and investor culture is nascent. In fact, we at EMPEA believe that our members, the majority of whom were seeded by DFIs such as CDC, employ the strictest standards in the global industry with regards to the environmental and human rights records of the companies in which they invest. This speaks volumes to the influence of investors such as CDC in inculcating robust environmental, social and governance (ESG) standards and expectations in both the investment process as well as in reporting. Further, this level of influence on business practices could not have been guaranteed through a pure debt model, as the tenure of those requirements is specifically tied to the maturity of the debt, i.e., those obligations end with repayment, whereas shareholders providing an equity investment can enact governance and other provisions that will outlast the participation of any single shareholder.

11. CDC requires its fund managers to adhere to its Business Principles (or similar standards such as the IFC Performance Standards) as a condition for investment. We find, however, that fund managers in emerging markets absorb these principles and standards into their DNA and in turn expand on them, even after they have graduated from reliance on funding from DFIs. For example, Hong Kong-based AIF Capital, first seeded by IFC and ADB along with a few others in 1994, and subsequently backed by CDC, has gone on to cultivate one of the best reputations in the industry with local governments in Asia, due in large part to the standards inherited from their DFI sponsors and deftly implemented across their entire portfolio and successive funds. In another example, Aureos Capital has built on the reporting requirements inherited from CDC to create a robust firm-wide system for capturing ESG impacts at the portfolio company level in a way that can be easily aggregated for reporting purposes. Aureos, among others, has made a very clear case for the advantages of a clear commitment to ESG in both raising funds from commercial investors, and in cultivating relationships with investees and the communities in which they invest, which is critical to their success at the local level.

12. That said, we cannot objectively assess how well CDC measures or achieves development impact through their private equity investments relative to other institutions. This is not because CDC has performed poorly in this regard, but rather because this information continues to be reported on an institutional basis in aggregate by each of the multilaterals, obscuring the relative development impact of individual portfolios or assets, although these institutions now capture and report impact across very similar metrics. EMPEA is in conversations with the DFI community exploring practical ways to provide a more integrated impact assessment, in which CDC will certainly be a participant.

13. In sum, we would urge the Committee and other relevant bodies engaged in decisions regarding the future of CDC to acknowledge the value of the private equity and venture capital funds model in pursuit of economic development, including in the poorest countries, and to be mindful that reducing or eliminating this critical, efficient, professional investing source of capital would unnecessarily retard the growth of sustainable SMEs in Africa, emerging Asia, and other developing economies.