Inclusive Business in Financing

Where Commercial Opportunity and Sustainability Converge

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• Publisher: Asian Development Bank
• Year: 2018
• ISBN:
  9789292611774
• Topic: Volkswirtschaftslehre
• Subtopic: Nachhaltige Entwicklung

Reducing poverty and inequality requires innovative modes of financing. By enabling the poor to engage more fully in economic activity and participate in supply chains and value chains, inclusive businesses help them to increase earnings and accumulate wealth. This is why inclusive businesses are gaining prominence as an effective response to socio-economic and environmental challenges. Understanding how best to finance them will accelerate inclusion and poverty reduction. Written as a resource for finance practitioners, financial institutions, fund managers, and development finance institutions, this report builds on the notion that engaging marginalized and commercially-excluded people is vital—and that it can be done profitably. Drawing on case studies from across Asia, it examines the two main conduits for financing inclusive businesses: bank debt and private equity.

IV The Role of Private Equity Funds in Inclusive Business Financing

A. The Evolution of Private Equity Funds in Inclusive Business Financing

The second modality for deploying capital in inclusive business (IB) is equity, which is often aggregated in funds. Given micro, small, and medium-sized enterprise (MSME) cash-flow sensitivities and the pressure of debt repayments (i.e., interest and principle) on scarce resources, equity investment can be less burdensome. Further, when well executed, private equity is often accompanied by strategic engagement in nonfinancial areas, which is often as critical as the financing.

Private equity has been a prominent development financing tool for decades, yet the smaller the company targeted, the more awkward the fit. Consequently, the rebranding of private equity as “impact investment funds” from mid-2000s is stretching the fund modality to the breaking point. Private equity should indeed remain a first-order IB financing tool, as it has the potential to attract large amounts of private capital and to transform companies, but unless fund managers and industry advocates correct design flaws specific to the IB context, as well as clearly segment private sector-ready products from experimental products, private equity will continue to perform suboptimally as an IB financing tool.

1. From MSME Funds to Thematic Funds, 1989–2009

In the late 1980s, the Commonwealth Development Corporation (now known as the CDC Group, hereinafter CDC) the United Kingdom’s development finance institution, began to adapt private equity fund structures pioneered in developed markets to developing countries. According to Robert Binyon, who set up CDC’s MSME Funds Group in 1994, “CDC had two objectives at the time: to channel third-party capital into developing economies, and to make profitable investments in companies that we thought vital for equitable, enduring growth.” That a DFI took the initiative partly reflected the realization of MDBs that they lacked the bandwidth for direct MSME investing in many countries. Moreover, providing credit lines to local commercial banks for MSME onlending had been unsuccessful. Credit appraisal methodologies were rudimentary; loan officers lacked appropriate skills, were underresourced, and were unqualified to mentor borrowers; and perverse incentives encouraged loan volume over loan quality.

With offices across Africa, Asia, and Latin America, CDC launched its initiative with a $5 million vehicle in Papua New Guinea in 1989. A challenging economy even by emerging market standards, the fund targeted start-ups, early-stage growth transactions, turnarounds, and rescues. CDC executives involved at the time recalled that such deals were thought to generate significant financial returns—the fund’s target net internal rate of return (IRR) was 22%–25%—and would contribute to development. Anecdotally, they recounted that development was defined as stimulating economic growth by getting financing to MSMEs. Poverty reduction was an implied, if not explicit, goal.

In hindsight, the boldness of the CDC experiment is striking. It was unversed in funds, and no European DFI had invested in or managed them. Furthermore, private equity as an asset class was unknown in most developing economies. Few had appropriate legal and regulatory frameworks, and fiscal authorities did not know how to treat fund vehicles, carried interest, or capital repatriation. MSME private equity funds were a pre-emerging asset class.

Although the Papua New Guinea initiative ended in disaster with an IRR of –35%, CDC was undeterred. Between 1989 and 1999, it established 14 single-country and regional funds in Central America, the Pacific island countries, South Asia, and Sub-Saharan Africa, undertaking over 100 transactions with $140 million under management. In 2001, a new entity was created to manage the fund portfolio, Aureos Capital, a joint venture between CDC and Norfund. Its mandate was to manage out the CDC funds; use the lessons from the legacy fund portfolio, then projected to produce IRRs of –35% to 8%; and create a new fund management business. CDC and Norfund, who were owners of Aureos and anchor investors in its funds; investors from Africa, Asia, and Latin America; banks; pension funds; insurance companies; MDBs; and European DFIs believed that the reformulated investment strategy would generate attractive financial returns. The investors also sought to understand the development impact of the funds; although the impact was not rigorously defined, it foreshadowed the emergence of impact investment and IB funds in the mid-2000s.

To investors’ surprise, an unlikely aggregate cash multiple of 1.8 times was achieved on the legacy portfolio, though individual fund IRRs varied wildly. The lessons from the CDC experiment must be revisited by today’s impact investment and IB fund communities for two reasons. First, current offerings are repeating many early design flaws. Second, the introduction of explicit social/environmental objectives in fund designs, such as impact or inclusion, make an already challenging modality even more complex. The key takeaways from the CDC legacy portfolio are presented below.

2. Key Lessons Learned

Fund parameters and fund structure. MSME private equity requires the fund manager to engage in most aspects of investee operations. This necessitates seasoned equity investment executives, usually in short supply in emerging markets. It also makes retention paramount, which requires the ability to compensate staff well over fund lives, typically 10–12 years. Even with annual management fees of 3% on committed capital,²⁵ it was clear that vehicles capitalized with less than $40 million were insufficiently resourced to create and to manage portfolios of 15 or more deals.²⁶ For example, the Aureos Central America Fund, raised by Aureos in 2002 and capitalized at $36.3 million, covered 7 countries from 3 offices with 10 staff members and a target deal size of $500,000–$3 million.²⁷ Clearly, the annual management fee of $1.09 million was insufficient to fully cover operating costs, salaries, travel, and other recurring expenses. Furthermore, because management fees are levied on cost, not capital commitments, resources available to the fund manager declined with each exit from the end of the investment period onward.

The implications of this basic fund arithmetic are obvious in hindsight—below a certain threshold (e.g., $50 million), management fees barely cover costs, let alone afford deep investee engagement. Further, the more complex the fund—by geography, transaction profile, or theme—and the more transactions done, the more intensive the hand-holding needed. Finally, the smaller the average transaction size, the larger the portfolio, squeezing resources still further.

Thus, the arithmetic linking fund size, geography and tenor, average deal size, deal profiles, and headcount is essential. Absent subsidies or additional revenue streams to the house from other funds or business lines, it is uneconomical to combine small funds and small transactions. As donors and DFIs cannot pay annual management fees of 4%–5% or higher, the amount needed to manage such funds effectively has been obscured by using TA funding. This said, very few DFIs allow managers to use TA funding for running costs.

Transaction profile and size. Venture capital, start-ups, early-stage growth companies, turnarounds, rescues, and recapitalizations are much riskier than larger deals. For this reason, funds focused on them usually offer higher returns. The same applies to transaction size. A $250,000 investment in a start-up almost always requires more time from a fund manager than a $4 million expansion capital transaction.

Thus, fund design must triangulate between fund size, transaction profile (i.e., risk profile), and average transaction size. With this in mind, it can be seen how unlikely the CDC fund in Papua New Guinea was going to succeed. It was capitalized at just $5 million with a target deal size of $50,000–$500,000 and an exceptionally demanding investment strategy. Although it was able to draw on local infrastructure (14 offices across Africa, Asia, and Latin America) and administrative services provided by CDC London headquarters, Aureos estimated that some £20 million–£25 million (around $40 million) had been spent setting up the necessary physical infrastructure worldwide. This was done long before the establishment of Aureos, so it had not been priced into the cost of Aureos as a stand-alone business. Thus, for a new fund manager to establish a physical presence in one or several areas, significant resources would be needed.

Fund geography. Of the 14 funds raised and managed by CDC, 11 were country funds and 3 were regional funds. The merits and drawbacks of a single- and multi-country approach emerged over time. Clearly, covering one country is cheaper and more manageable than several of them. From an administrative and operational perspective, it removes the need for cross-border fiscal, legal, and regulatory arrangements, which can be complex and expensive. Local presence and local teams are essential to effective MSME investing, and opening and maintaining offices is a large line item in any fund budget. This said, from a performance perspective, the risk profile of country funds can be high. Exposure to macroeconomic and political volatility, currency depreciation, and ad hoc policy changes is total. For instance, in the case of the Ghana Venture Capital Fund, raised by CDC in 1994, currency depreciation of over 1,000% translated an impressive local currency IRR into double-digit losses in United States dollar terms. By the same token, the strictures of single country funds can also spark innovation. For example, as the Zimbabwean economy nosedived in the early 2000s, CDC’s Takura Fund took as many investees regionally as possible, generating earnings in multiple currencies and maintaining a positive United States dollar IRR.

The advantage of regional funds is diversification. Portfolios can anticipate and react to country risk by shifting geographical focus. Regionalizing businesses can be easier when funds have local teams in various countries. Where competition for deals is vigorous, a fund manager’s ability to realize a sponsor’s regional expansion plans can aid deal sourcing and execution. Nevertheless, regional funds have challenges. Beyond the infrastructure expense, it can be hard to achieve team cohesion, especially when country conditions and quality of investment opportunities vary. If asymmetries persist, team members in buoyant countries or subregions may begin to question peers. They may demand that salary and carried interest arrangements be revisited. In extreme cases, spinoffs by one country or subregion can pose an existential threat to the house. Strong management is key here, a rare quality in private equity.

Regional footprints can also cause conflict on three levels: within the management team, between the fund manager and investors, and among investors. Stakeholder geographical priorities and risk appetites may differ. Where some team members see opportunity, others may see unwarranted risk. The status of individual portfolio companies may be cited as evidence. Where some investors stress return maximization, others may value the economic and developmental benefits of making available risk capital in distressed geographies. Further, there may be disagreement on country allocations as the investment period ends. Resolving these issues is challenging unless the fund investment policy provides clarity.

Therefore, fund geography must be carefully scrutinized during fund design. Country risk cannot be considered in isolation, and no country or region affords a stable 10-year view. Private sector and financial sector depth matter—that is, the size of the potential investment universe, sophistication of the business community, availability of debt and equity (i.e., competition and likely effect on valuations), capital market depth, and liquidity. It may be argued that India or the PRC are sufficiently deep markets to carry a single country strategy, whereas a Myanmar-only fund gives pause. Additionally, the professional experience, track record, and cohesion of the investment team must be evaluated against the difficulty of the proposed geography, as well as target deal profiles—critical for new fund offerings especially.

Exit planning and execution. The fund manager must be focused on exit from screening onward. An exit plan must be discussed with sponsors during due diligence, and reviewed regularly. Further, to the extent possible, multiple investment instruments and structures must be used to generate liquidity during the holding period. In other words, cash-generating opportunities (e.g., income, dividends, or royalties) must be sought throughout the investment life. Relying on sales of equity stakes alone is risky.

Exit viability, usually referred to as liquidity risk, concerns fund managers and investors in all markets. It is a function of many factors (e.g., macroeconomic conditions, financial/capital market depth, and legal and regulatory environments) and fluctuates over the fund life. Nevertheless, exiting small transactions is much harder than exiting large ones. Further, it must be noted that well-managed, well-governed businesses rarely struggle to find buyers, even in the most challenging markets. The scarcer such businesses, the more coveted they are.

Portfolio divestment is often more challenging than portfolio construction. All aspects of fund design must take exit viability into consideration. The manager must plan for all contingencies throughout the investment cycle. Cash generation can have a significant bearing on the financial health of the fund management company (i.e., fund profit and loss); currency risk mitigation (i.e., returning reflows to investors in the base fund currency over the fund life); and reducing the difference between gross and net returns.

Fund returns. Fund returns are a function of the above factors combined with others. Of all of the lessons from the CDC legacy portfolio, one in particular stands out: every fund offering promised a net IRR to investors of 22%–25% in United States dollar terms, but net IRRs ended up ranging from –35% to 8%. Today it is known that small funds composed of small transactions do not generate such returns; a “home run” from one investee could, in theory, produce such a return at the portfolio level, but this is highly unlikely. More to the point, would this not be a venture capital offering, likely demanding even greater returns for risk incurred? Would it not undermine the rationale for aggregating risk capital to enable growth in as much of the MSME sector as possible?

It is key that fund managers and investors interrogate return projections thoroughly. Investors are learning to do so, but fund managers are often inclined to exaggerate. Perversely, many feel compelled to exaggerate to attract investors. More dangerously still, new and even second-time fund managers lack the experience or impartiality to triangulate the investment thesis with portfolio construction and fund operating costs. Few managers are brave enough to underpromise and outperform.

Without the 10-year CDC experiment, the fund management community and availability of risk capital in emerging markets would be diminished. As Aureos and its peers developed investment theses, as well as fund and management company models, MSME funds became recognized as a significant development finance strategy and, in some cases, a source of attractive financial returns. Over the same period, consensus was building among development financiers and academics that the contribution of the MSME sector to economic growth, private sector development, and poverty reduction had been underestimated. More compelling still, the aftermath of the global financial crisis and ensuing economic slowdown revealed that many emerging market MSME portfolios had proved robust and were uncorrelated to developed markets and mainstream asset classes.

Two important developments occurred over the same 10-year period. First, capital deployment for positive social and environmental outcomes, as well as financial returns, gained a name: “impact investing.” Second, the impact investment tent expanded from sector/thematic funds, such as health care, education, agriculture, or access to finance, to IB funds. J.P. Morgan, the Rockefeller Foundation, and Global Impact Investing Network prophesied with arriviste alacrity the birth of this new multibillion-dollar asset class in ...

Table of contents

• Cover
• Title Page
• Copyright Page
• Contents
• Tables, Figures, and Boxes
• Acknowledgments
• Abbreviations
• Currency Equivalents
• Executive Summary
• I. Poverty and Inequality in Asia
• II. Defining the Inclusive Business Opportunity in Asia
• III. The Role of Financial Institutions in Inclusive Business Financing
• IV. The Role of Private Equity Funds in Inclusive Business Financing
• V. The Case for a New Hybrid Inclusive Business Financing Product
• VI. Conclusion
• Footnotes
• Back Cover