The Future of UK Development Co-operation: Phase 1: Development Finance - International Development Committee Contents

5  Working with the private sector

DFID's private sector strategy

51. Helping developing countries to build a stronger private sector can be an effective way of supporting economic growth and job creation and is a key part of DFID's private sector strategy. The Secretary of State has highlighted the increased focus on private sector support in a number of recent speeches.[106] This strategy is currently delivered through DFID's bilateral programme, key multilaterals (including the World Bank, IMF and Development Banks), CDC and the Private Sector Infrastructure Group (PIDG). The DFID-funded Trademark East Africa is an example of a multi-sector, multi-donor initiative to boost prosperity. Both the State (through supply side strengthening via education, health, public infrastructure etc) and the private sector (through innovation, entrepreneurship, private investment, marketing etc) contribute to economic growth and therefore to providing employment and raising living standards. In this Chapter we consider whether these programmes could be strengthened by extending DFID's range of bilateral finance instruments. For example, more finance provided as returnable capital,[107] rather than grants, could potentially play a greater role in a future strategy, and repayments received from investments in successful private sector enterprises could be recycled and used to fund further ventures.

52. CDC is the UK's development finance institution and is a major element of DFID's private sector strategy. It is wholly owned by the Government, but operates independently under the governance of an independent board. CDC last received DFID funding in 1995, since when it has been self-sufficient, investing from its own balance sheet and recycling profits into new investments. It aims to invest in projects which are commercially viable and achieve a fair return on capital, but for which other commercial capital is not readily available, and for projects which will have a significant development impact, primarily by creating jobs.[108] It takes equity stakes, both directly and through Fund Managers, and provides non-concessional loans to businesses in developing countries.

53. In 2011, we conducted an inquiry into the future of CDC and recommended making a number of changes to CDC's structure and remit so as to achieve a greater focus on development impact.[109] Since then, CDC has created two new teams to invest equity directly in business and to provide debt and structured finance. It has also created a tool to help it direct capital to investments which have the greatest chance of creating jobs, especially in the most difficult areas.[110] Although we recommended that CDC make changes, we also advised it to be cautious about taking on too many new roles and diversifying its investment tools too rapidly, and recommended that CDC work alongside the other development finance institutions to provide the range of tools needed by developing countries.

54. In, December 2012, DFID launched a £75 million Impact Investment Fund[111] under the management of CDC, with the aim of investing in impact investment intermediaries that provide capital to businesses and projects which improve the lives of poor people in sub-Saharan Africa and South Asia. Backed by expert technical assistance, the Fund is designed to attract new investors to promising impact investment intermediaries. In early 2013, CDC opened a 'Request for Proposals' process and received over 100 proposals from fund managers, holding companies, non-profit organisations and other investors. It then assessed the proposals in order to determine which would be selected for funding.[112]

55. The Private Sector Infrastructure Group (PIDG) is another vehicle used by DFID for its private sector support. PIDG is a multilateral, funded by nine, mostly European donors. DFID was one of the original members, and makes the biggest financial contribution.[113] PIDG has a number of specialised financing and project development subsidiaries which are designed to overcome the obstacles to generating private sector investment in infrastructure projects in developing countries, and which support projects across four continents and nine infrastructure sectors.

56. In our 2011 Report on DFID's Role in Building Infrastructure in Developing Countries, we commended DFID for its role in establishing PIDG, and noted that for every £1 of aid funding, PIDG had brought in £20 of private sector capital. We recommended that DFID increase its funding of PIDG, which it has done,[114] and that it consider how the model might be replicated in the agricultural sector.[115] Since then, PIDG has acquired an affiliate, AgDevCo, which is a specialist provider of finance to smaller agricultural businesses in Africa, and is considering how best to develop the necessary sector skills to expand its investments in agriculture projects.[116]

Benefits and risks associated with private sector support

57. Research indicates that partnerships with the private sector can be advantageous for donor organisations. Some of the reasons proposed for this are that businesses can help to direct the impact and to increase the scale and reach of donor activities; the private sector has developed management expertise and efficient operational processes which donors can harness or adopt to make their processes more efficient; businesses can play an important role in improving the local or national governance of the countries in which they operate; and private sector partners can provide a way of leveraging private financing through public funds, in order to achieve developmental goals. [117] Graduation from aid to upper MIC status is typically associated with private sector growth.

58. However, witnesses commented that not all development goals, in particular those aimed at the very poorest people, are necessarily achieved via private sector engagement,[118] and that economic growth, whilst necessary, is not always sufficient to achieve'a reduction in extreme poverty.[119] In addition, some witnesses said that private investment is primarily driven by profit rather than social benefit, and it can be difficult to achieve an appropriate balance between these different objectives.[120] For example, in our 2011 report on CDC, we noted that the commercial viability of its investments was of central importance, but recommended that CDC should allow for lower returns on parts of its portfolio in order to focus more on higher risk poverty alleviation projects.[121] Measuring the development impact of private sector investments is also difficult and not always well achieved,[122] and there is a need to develop indicators which capture wider benefits such as improved access to public services and improved productivity, as well as measuring the number of new jobs created.[123]

59. Other issues mentioned by witnesses were the risks that providing concessional finance to the private sector could lead to market distortion,[124] and concerns about future debt sustainability.[125] Support for private sector businesses based in developing countries may take the form of contracting services from private sector suppliers, providing business loans or equity, or the improvement of public sector services—such as regulatory bodies (e.g. land registries), licensing, customs, trade promotion, courts and justice—or public sector infrastructure (e.g. rural roads, strategic highways, ports etc). There are concerns about providing UK aid to support multi-national companies or companies based in developed countries. When providing aid to the private sector great care needs to be taken to avoid giving one private company a competitive advantage over others, or aiding companies in which Ministers, public officials or members of their families have a financial interest.

60. It is important to be clear where public money (ODA) is likely to strengthen the private sector and where it risks compromising the useful free play of market forces. DFID has provided effective support for the private sector (establishing land registries, strengthening support for SMEs, capital markets, trade facilitation etc). However, there are potential dangers, notably in creating non-competitive businesses through public funding.

61. Witnesses pointed out the range of specialist skills needed to manage loans and to operate in different sectors. Edward Farquharson, Executive Director of the PIDG Programme Management Unit, explained that "If one looks at infrastructure, say, the skills needed for providing finance at the very early stage of a project's life are actually very different and distinct from the skills needed to make senior debt loans to projects" and "we often talk about making loans and making investments. It is also about getting them back and therefore the skills needed to manage those portfolios and negotiate the issues where they arise during the life of the assets are equally important".[126] Diana Noble, CDC, agreed saying that:

    in the private sector the skills that are required here are to look at something that inherently does not make money today—it is uncommercial today, because otherwise it does not need concessional finance—but be able to think about what your money can do and what can be created in five to 10 years. That is a pretty high skill, to be able to judge whether your money is going to the right things and not the wrong things. I would definitely advocate thinking very carefully about the skills on the team that are necessary to deliver this plan.[127]

Private sector finance needs

62. Caroline Ashley, Director of Ashley Insight Ltd, suggested that there were three main areas in which concessional finance for the private sector could be useful: when the private sector venture generated real public good, but had a commercial return below market rate; as a temporary measure, to help a venture make the transition to become commercially sustainable; and in unstable countries where the political risk was deemed as high and the concessional finance could carry more of the risk.[128] She also pointed to the need for a clear understanding of the development objectives, before identifying appropriate interventions and finance instruments. She explained that these could range from objectives focusing on 'bigger' (ie expansion of the private sector) to 'better' (ie harnessing private sector investment to tackle poverty problems), with some in the middle which promote more inclusive growth.[129]

63. Advances in information and communications technology have supported the growth of micro-credit systems of support,[130] but witnesses suggested that there was a lack of finance to enable small businesses to grow into sustainable enterprises. Philip Schluter, Managing Director of a coffee export business working with small farmers in a number of African countries, told us that:

    the greatest need is to make finance available to smaller companies to fill the gap between microfinance institutions and the larger loans, which are typically taken up by the multinationals. There are some institutions beginning to fill this space, but there is still a large gap. Equity investments, with some risk-sharing would also be very welcome. Typically the places most in need of development are also those with the highest risks.[131]

64. Dr Chris West, Director, Shell Foundation, agreed that the challenge was how to bridge this gap, saying that small businesses "hit this wall where there is no one with the risk appetite, patience and skill support to get them to the level where they can go on to the balance sheet of, for example, the EIB".[132] He added that different finance forms and flexibility were needed, and that existing development finance institutions did not provide this.[133] Tamsyn Barton, Director General, European Investment Bank (EIB), said that development finance institutions like the EIB aimed to fill that space, but that it was very labour intensive, which was one of the reasons why multilateral administrative costs were relatively high.[134] She suggested that "it is really a question of the mandate of the institutions, and the appetite of those putting in public money to provide the flexibility for it to play that crucial midfield role."[135]

65. Dr Chris West suggested that DFID needed to acquire more 'business DNA' which he defined as the ability to assess and take risk, to look at a market opportunity and provide the best form of product or service to satisfy it, so as to escape subsidy dependence and create something that can stand on its own feet.[136] He added that investing in growing businesses required time and patience and that:

    We need a project preparation facility, coupled with finance that will take a lower-yielding, marginal return on those deals, and leverage off that, and then bridge into other types of finance, which are amply developed. It is those two sets of DNA. At the moment, we have got one that is development DNA—grant based—and financial DNA.[137]

66. The Secretary of State told us that DFID had a number of ways of investing in the private sector, including its recently launched Impact Investment Fund.[138] She also described a number of different ways in which DFID was supporting growth in developing countries including reducing red tape, streamlining customs processes, improving access to finance and microfinance, helping to encourage entrepreneurship and promoting responsible UK investment.[139] She explained that DFID had a number of possible routes for extending its range of private sector financing, which could include new innovations with multilaterals, developing CDC's remit or providing direct lending from DFID.[140] The Secretary of State recognised that skills within DFID would need to change "to match a changing agenda".[141] On 31 January 2014DFID launched its new economic development strategy, which indicates that DFID has begun to identify some of the new types of financial  instruments required to support development adequately.[142]

67. Supporting the private sector can have significant benefits in terms of boosting economic growth, creating jobs and raising incomes in developing countries and helping to deliver projects with other social benefits. Finance provided as returnable capital could potentially play a greater future role, and enable the finance which has helped businesses to become sustainable and profitable, to be reinvested in other projects. We think that there is significant scope for support to the private sector, but as such projects are expected to make a return, we recommend that when DFID is dealing with the private sector, the presumption should be that finance will be provided as returnable capital.

68. We welcome the launch of the Impact Investment Fund and ask DFID to supply further details of the role and operation of this fund, including details of whether finance will be provided as grants or loans or other instruments.

69. We recommend that private sector support should be an integral part of DFID's finance strategy, and that support for the private sector could be scaled up. We recognise that this will require new skills. We recommend that DFID's finance strategy includes an assessment of the following factors:

·  How can DFID target its private sector support such that it supports inclusive growth?

·  How can DFID assess and measure the development impact of its private sector support so as to take account of broader outcomes such as improved livelihoods, income growth and leverage, as well as jobs created?

·  Should the remit of CDC be extended? Have the recent CDC organisational changes increased its development impact? Would bringing CDC under more direct DFID control improve DFID's development impact?

·  Can the success of PIDG be further extended or replicated for other countries and sectors?

We propose in a future inquiry to look at DFID's private sector work.

106   Eg Speech on 11 March 2013, DFID Back

107   Returnable capital is a term used to refer to loans, equities, guarantees and other similar financial instruments Back

108   Ev 92 Back

109   International Development Committee, Fifth Report of Session 2010-11, The Future of CDC, HC 607, pp 39-43 Back

110   Q 156 Back

111   Impact investment" is a term used to describe investments which are made with primary objectives of social or environmental impact, and may have a financial return below market rates Back

112   CDC, DFID Impact Fund,  Back

113   Private Sector Infrastructure Group Annual Report 2012, p 16 Back

114   DFID Annual Report and Accounts 2012-13, p99 reports that DFID funding to PIDG has increased from around £10m in 2009-10 to nearly £70m in 2012-13 Back

115   International Development Committee, Ninth Report of Session 2010-12, HC 848, DFID's Role in Building Infrastructure in Developing Countries, para 23 Back

116   Q 161 Back

117   ODI, How donors engage with business, William Smith, July 2013, Back

118   Ev 94 Back

119   Ev w48 Back

120   Q 15 and Q 68 Back

121   The Future of CDC, para 69 Back

122   Q 35 Back

123   Q 135 Back

124   Ev 92 and Ev 100 Back

125   Eg Ev w40 Back

126   Q 176 Back

127   Q 190 Back

128   Q 130 Back

129   Ev 94 Back

130   ODI, Inclusive and sustainable development, Norton and Rogerson, September 2012, p17 Back

131   Ev 100 Back

132   Q 94 Back

133   Q 95 Back

134   Q 94 Back

135   Q 94 Back

136   Q 106 Back

137   Q 106 Back

138   Qq 233, 234 Back

139   Q 248 Back

140   Q 234 Back

141   Q 243 Back

142 ) Back

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Prepared 13 February 2014