When the coronavirus busted out as a global crisis in March, private equity funds, banks and other commercial investors largely pulled out of Africa and other emerging markets. Even most impact investors pulled in their horns.
Virtually the only investors who stayed in the game were development finance institutions, including bilaterals like the U.K.’s CDC Group, Germany’s DEG, the Netherlands’ FMO and the U.S. International Development Finance Corp., formerly known as OPIC, and multilaterals like the International Finance Corp., part of the World Bank Group.
“The crisis has made a risky area even more risky,” CDC’s Nick O’Donohoe says on ImpactAlpha’s latest Agents of Impact podcast. “It is critically important that development finance institutions step forward, be countercyclical and provide funding and liquidity at a time when commercial investors wouldn’t.
“That means you’ve got to take on considerable amount of risk in order to do that.”
Just how much additional risk publicly owned development finance institutions, or DFIs, have been willing to bear, especially in the current crisis, is one of the most hotly debated topics in impact investing. O’Donohoe acknowledged that DFIs in the past have been criticized as having much the same risk-return profiles as any commercial investors, but says that has changed in the last five to seven years.
“You have to take higher risk and you particularly have to take higher risk in context of the COVID crisis.”
That’s not the impression of many veteran practitioners, who say there’s been little change in the risk parameters by which DFIs approve and underwrite loans.
Last month, in a guest post in ImpactAlpha, Courageous Capital’s Laurie Spengler, a member of CDCs board, criticized many impact investors, including DFIs, for putting decades of social impact progress at risk by their untimely aversion to risk. “What we are hearing and seeing is not just a hesitation to act, but an unwillingness to price for impact at a time of global pandemic, social unrest, and the incontrovertible exposure of deep systemic bias,” Spengler wrote.
As one example, Spengler cited the reaction to a 3% loan note supporting women-led small and growing business in sub-Saharan Africa. Several DFIs, including those with mandates to support small businesses and gender-lens investments deemed the investment “concessionary and therefore ‘not possible,’” Spengler wrote. “In a 0% interest rate environment and with demonstrable impact, how is it that this loan note rejected out of hand and taken off the table?”
O’Donohoe has priced risk for both commercial and impact investors. He spent 15 years at Goldman Sachs before becoming global head of research at JPMorgan and sponsor of its social finance unit. He was a co-author of the bank’s 2010 research note, “Impact Investments: An Emerging Asset Class,” one of the first mainstream financial publication’s to herald impact investing.
He teamed up with Sir Ronald Cohen to found and lead Big Society Capital, an early social investment bank that was capitalized in part with unclaimed bank account balances. He moved to the Bill & Melinda Gates Foundation to spearhead blended-finance transaction and was named head of CDC three years ago.
The CDC, founded in 1948 as the Colonial (later Commonwealth) Development Corp., is the world’s oldest DFI. Sir John Reith, the founder of the BBC and later chair of the CDC, described its mandate as “Do good without losing money.” Every investment is screened to make a difference to people lives on the ground, O’Donohoe said, “and at least preserve the capital.”
The CDC has a portfolio of about $6 billion in investments, by charter exclusively in Africa and South Asia. Last year, the CDC invested about $2.1 billion.
Most of the investments are what the CDC calls its growth portfolio, which included infrastructure, bank financing and private equity funds. “We try to do that – in common with the European impact investment firms – at a reasonably commercial rate,” O’Donohoe said. In recent years, returns have averaged nearly 7%, almost double the CDC’s required return of 3.5%.
A smaller portion of the portfolio, now about $700 million, are designated as “catalyst funds,” in which the CDC can take higher risks in pursuit of deeper impact.
The CDC may be the biggest equity investor in Africa. Since the wave of “African Renaissance” stories peaked in about 2014, falling commodity prices and poor governance and inadequate infrastructure in many markets has made the continent a difficult place to invest, O’Donohoe said. “Our equity returns, you’d have to say they are not consistent with commercial, risk-adjusted rates.”
That, of course, has been exacerbated by the liquidity crunch brought on by the COVID crisis, which has made it difficult for even healthy businesses to access needed working capital, trade loans and other basic business financing.
“Business stops. When business stops, you have this immediate working capital gap in many companies,” O’Donohoe said. “Either they find a way to fill that gap, or they go out of business. And jobs are lost.” McKinsey & Co. estimates the pandemic could affect the livelihoods of 150 million Africans, or about one-third of the workforce.
Typical of the CDC’s financing is a recent $100 million facility created with the French bank Societe Generale to encourage West African banks to continue lending to local businesses. CDC will share the risk of default on the part of borrowers in proportion to its funding contribution to the facility.
“Somebody has to do it,” he says. “Otherwise these companies will not have liquidity to survive and jobs will disappear. But clearly there’s significant risk involved.”
Such loans do not reach down to the many small businesses that don’t qualify for bank loans or have pre-existing banking relationships. For those, new types of financing vehicles were needed before the current crisis, and are even more urgently needed now.
O’Donohoe’s 2010 research note at JPMorgan estimated that impact investing assets could total between $400 billion and $1 trillion by 2020. And indeed, the Global Impact Investing Network last month estimated such assets at about $715 billion. The IFC, using a different method, figures impact assets at about $2.1 trillion. O’Donohoe thinks the COVID crisis could turn out to be an accelerator.
“In the same way the Great Financial Crisis was, it’s going to be another great catalyst for mainstreaming impact investing,” he said. “Every time you invest capital, you should be asking, not just about risk and return, but about risk, return and impact.”