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The UN General Assembly is not prone to go on at length about the virtues of the private sector. So you only need to read the General Assembly’s resolution on the Sustainable Development Goals to know that there is a remarkable amount of enthusiasm at the moment for using public resources to promote private investment in the name of development. It is not a new agenda and comes with a track record of successes and failures. But greater flows of private capital to developing countries and growing constraints on traditional donor aid have raised the stakes for the intermingling of public and private resources.
All of this was on the table during this week’s CGD discussion with Philippe Le Houérou, the CEO of IFC, the private sector arm of the World Bank, which has been working in this space for over 60 years. Le Houérou’s remarks and the comments of our expert panel deserve careful consideration, so I encourage you to watch the full session here:
Senior Fellow, Director of the US Development Policy Initiative
Here are my key takeaways, indicated in my opening remarks. The IFC has always faced three sets of challenges, which derive from the fact that, while it invests in private firms, it does so as a public investor with a public mandate. As any private investor, it has certain imperatives and challenges related to financial performance, which it has managed quite well over the years. The IFC has been profitable, maybe less so in recent years, but generally speaking, its financial performance has been strong.
But the trickier challenges derive from its public mandate: to allocate capital in the developing world in places, firms, and sectors where capital is particularly constrained; and to do so where there is strong evidence of positive externalities. For example, will the investment promote cleaner energy, gender inclusion, or broader financial intermediation in the economy?
All of this (generating a financial return, targeting capital constraints, and promoting externalities) is not easily done simultaneously, and when done successfully, it’s not easily demonstrated that it’s been done.
In this regard, Le Houérou’s remarks at CGD were striking. As we would expect from any IFC head, he was enthusiastic about his institution’s role in leveraging private capital and getting from billions to trillions of dollars for development. But he also presented a nuanced and critical judgment about the limitations of the IFC model to date, pointing to a number of ways it needs to change:
He embraced the role of blended finance, pointing to the new agreement between the IFC, MIGA, and IDA to jointly promote and finance private sector projects in low income countries.
He pointed to the need for stronger ex ante project assessments from a broader development perspective, highlighting the model pioneered by the EBRD, which relies on independent impact assessments and ratings for projects. He also acknowledged the risks of elevating financial performance above development impact, citing the problem of a firm-level investment that might have the effect of diminishing rather than promoting a competitive marketplace and thereby destroying jobs in the economy on a net basis.
Finally, as a long time World Bank senior manager, he embraced the need for greater integration of functions across the World Bank group, pointing to the instances where useful IFC firm and sector knowledge was unrecognized and unbidden by country and regional directors in the bank, who only had an economy-level view of things in their countries.
Le Houérou is still relatively new to the job, but the new IFC-MIGA-IDA window alone suggest a willingness to shake things up under his leadership. Can he use the IFC’s billions to deliver trillions for development? That may be setting the bar too high, but his agenda so far seems to be moving in the right direction.
The shareholders of the private finance operations or windows (PSWs) of the multilateral development banks (MDBs) expect them to pursue three objectives simultaneously: (1) market returns, (2) high mobilization rates (dollars of private finance raised per PSW dollar committed), and (3) high development impact. It is no surprise that in the real world there are often tradeoffs among these objectives. Yet shareholders send mixed messages about where their priorities lie. The actual PSW track records suggest more success on objective (1) than on (2) and (3).
This confused status quo becomes untenable in the context of the enormous challenges of financing the Sustainable Development Goals (SDGs), the disappointing data and trends for actual private finance flows for development, limited aid dollars, and tight fiscal constraints on developing country government capacity to fund infrastructure and other development spending. A 2018 report estimates that a total of $60 billion of private finance was mobilized by PSWs in 2016, hardly a sufficient contribution to addressing annual SDG financing gaps in the trillions.
Some inside and outside these institutions are urging them to evolve from lenders to mobilizers—a change that does not mesh well with PSW financial models that favor profitable lending for their own account. Guarantees, for example, account for only about 5 percent of PSW commitments but generate about 45 percent of private finance mobilized.
All this suggests an urgent need to change PSW business models to maintain their financial sustainability while doing much better on mobilization and development impact. Two factors are critical for meeting this challenge: enhanced risk management capability and greater flexibility regarding risk-adjusted returns. Crowding the private sector into projects with high development impact can be advanced by disciplined use of blended finance to reduce or share risk, boost returns, or form a partnership in which one party accepts delayed or below-market risk-adjusted returns.
Adapting the PSW model
PSWs need a better way to be effective and efficient partners in blended finance arrangements. To this end, I have proposed that special purpose vehicles (SPVs) with separate balance sheets be added to the PSW toolkit. They would be purpose-built for taking on more risk, while the core PSW balance sheets would retain their AAA rating and their profitability. The SPVs would target pervasive gaps in capital markets such as limited early-stage finance for firms, local capital markets, and pre-operational infrastructure projects; and scarce finance for the riskiest project tranches like junior equity or debt. The SPV financial goal would be simply to preserve shareholder equity at the entity level.
The basic idea is for the two parts of the PSW—the SPV and core operations—to offer a seamless continuum of products and services to clients. In some cases, this would make deals bankable that otherwise would not pass credit committees. In others, it would make scale and larger deals possible. And in still others, it would mean a smooth handoff from the SPV to the core PSW operations when clients or markets are ready for commercial finance and growth.
Capitalizing such SPVs would offer attractive features to MDB PSW shareholders:
The new capital requirement would be relatively small compared to PSW core balance sheet needs.
The resources funding the SPV would take the form of shareholder capital rather than one-time contributions to individual donor trust funds or reliance on IDA replenishment resources. SPV capital adequacy and the need for possible capital increases could then be periodically assessed.
The SPV shareholder and governance structure could be established de novo, that is, without dilution worries for shareholders that do not wish to participate.
Shareholders would be deploying their new capital in a way that directly advances the institutional change they seek—more openness to innovation, more mobilization, and a greater focus on areas and projects with high development impact.
A better approach than creating an SPV for each MDB would be to establish just one SPV that all MDBs could access. It could be structured in a way that facilitates both collaboration across MDBs to gain more access to SPV resources as well as healthy competition to ensure that the best projects are selected.
One other desirable innovation would be to allow private investors to participate in capitalizing the SPV. A public-private SPV would give risk-tolerant private impact investors and philanthropists a chance to participate in funding projects where mobilization and development impact are high. For their part, public shareholders would not have to bear the whole burden of capitalizing the SPV. Private shareholders would of course then rightly expect to have a seat at the governance table. This seems both logical and sensible if public and private shareholders are united around the same mission. As we’ve seen in other public-private partnership spheres, the private sector can introduce efficiencies and innovation that accelerate institutional change.
Since the 2015 financing for development agreement, donor governments and their development finance institutions (DFIs) have all been singing from the same hymn sheet: we must do more to mobilize private investment. One way of measuring mobilization is simply to count how many private dollars are co-invested alongside public dollars, in each deal. The new Blended Finance Taskforce’s report—Better Finance, Better World—has compiled some “leverage ratio” estimates, which show the average development bank private sector window brings in 1.5 private dollars for every public dollar. The report calls for banks and DFIs to set themselves targets to multiply their leverage ratios.
Is that a good idea? It’s easy to think of objections. Speaking at a recent conference, Jeremy Oppenheim, Taskforce program director, made a forceful case: “Things just don’t change unless you target them. We know that from all walks of life.” But, he acknowledged, designing the right targets won’t be easy, will require nuance, and it must be done right.
Here I will argue that setting leverage targets in isolation might not get us what we want: more investment in developing countries. Overall investment volumes in chosen markets may make a better target, but any incentives must be soft to minimize the temptation to put public money where it is not needed.
Getting incentives right
The problem of incentives within DFIs is not new. World Bank president Jim Yong Kim, who is trying to transform the institution from a lender and investor into a facilitator of private investment, acknowledged in a speech last year that DFIs have all too often “competed with each other to finance projects—especially, the low-hanging fruit that the private sector, with a little help, could finance on commercial terms.” He recognizes that his staff face incentives to get large loans agreed, so when they involve private investors in projects they are often “working against their own interests.” The development banks have between them agreed a way to define and attribute mobilization. Kim said the bank is “working to change the incentives . . . so we can reward every effort to crowd in private financing,” but so far leverage ratio targets have not been announced.
The most obvious concern with targeting leverage ratios is that it will bias DFIs towards middle-income countries where it is easier to attract private co-investors. Or maybe I should say, further bias. Oppenheim and his colleagues see this danger clearly and argue the bias can be offset by other incentives within DFIs to reward doing deals in difficult places.
Targeting mobilization may also further tempt DFIs to participate in projects that would have gone ahead without them. A high leverage ratio can be reported by contributing a small sum to a large private project that has no need of it. A new OECD report, Making Blended Finance Work for the SDGs, found that of all the instruments they track, guarantees appear to have mobilized the greatest quantity of private investment, but that just raises the question of whether the private participation can really be attributed to those guarantees. No private lender would turn away generously discounted credit risk insurance, but that does not mean they only invested because of it.
Not all dollars are equal
There is also a more fundamental problem with how leverage is measured. The way it is currently done uses the face value of public and private contributions, which makes little sense. We want to know how much private investment we are getting per dollar of public money, but the cost to the public sector of contributing a $10m grant is not the same as of contributing a $10m loan. Similarly, whilst blended finance instruments are intended to raise risk-adjusted returns over the threshold where private financiers are willing to invest, the value of such instruments to private investors is not measured by their face value (it would be measured by how much private investors would be willing to pay for it).
Yes, leverage targets could be differentiated by instrument, guarantees, subordinated debt, and so forth. But to the extent that DFIs are able to vary the terms of any given instrument, a leverage target could tilt them towards greater concessionality where the reported leverage ratio would be higher, but not necessarily the biggest bang for public buck. In principle leverage ratios should be calculated after first re-basing the public contribution as a grant equivalent; in practice that may be too hard to do.
A better measure of the cost to the public sector would also help with value-for-money questions. Sometimes the price we may have to pay to induce the private sector to participate in commercially unappealing projects may be too high. A price might be worth paying if, for example, the private investors learn something that leads to subsequent investments without public assistance. But in some cases, all they may learn is not to touch certain types of project without generous public support. It is hard to see why aid should be diverted simply to induce private participation in investments, if that’s all that would be achieved. Thus far the debate on blended finance has had very little to say about when mobilizing the private sector is too expensive.
Perhaps the greatest problem with leverage targets was identified in a classic management studies paper, written in 1975, called “On the folly of rewarding A, while hoping for B.” We hope to increase the total quantity of investment in the service of development, but what we are measuring is the ratio of public and private capital within a set of transactions that have public involvement. These are not the same thing. If we succeed in changing the ratio of public and private money in each DFI deal, what have we achieved? Nothing if the total quantity of investment has not changed. In principle making greater use of private money in each project could free up public money to take on more projects elsewhere, but the audience at tworecent blended finance conferences in Paris were repeatedly told that money is not the problem, investment opportunities are. Especially in Africa.
It is tempting to conclude that because what we are really trying to achieve is more investment, then that is what DFIs should target. If we knew, for example, that the global set of DFIs is only capable of investing $50bn annually off their own balance sheets, then if we set them a target of $200bn total deal volume (including private contributions) that would implicitly target a 1:3 leverage ratio. Targets could be set for each DFI and differentiated by market or sector. This approach is instrument agnostic, leaving DFIs to figure out which instruments offer the greatest value for money.
Sadly, it too suffers from the rewarding A hoping for B problem. We hope for additionality, we’d reward any investment that combines public and private investors. Pressure to “get money out the door” is bad enough already. If additionality is observable at all, it is tacit knowledge inside DFIs. Nobel prizes in economics have been awarded for research into the performance of contracts when the desired outcome is partially unobservable. In such circumstances contract theory says high-powered incentives can be inefficient. That suggests it may be better to try to reward staff when they are informally “known” to have created additional investments with private participation, rather than explicitly reward metrics that can be gamed.
So where does this leave us? The Blended Finance Taskforce is certainly right that the incentives within DFIs must change, to turn competition with private investors into collaboration. And that change should manifest itself as higher leverage ratios. Explicit leverage ratio targets are problematic, but so is the status quo; the priority is to improve on it, not to attain perfection. Soft incentives that reward increased overall investments with greater private participation, where we want it, are needed, but the incentives must not be strong enough to bulldozer those within DFIs whose job it is to hold the line on additionality.