One Small Step for the AfDB, One Giant Leap for all MDBs

The African Development Bank, or AfDB, has been a prime mover in advancing a new form of capital for the multilateral development banks (MDBs). It is called hybrid capital: an interest-bearing asset like a bond, but low-ranking in repayment seniority (behind regular bonds) like equity. Hybrid capital’s equity characteristics mean that it can be leveraged by MDBs to expand lending. It provides an alternative to shareholder capital from governments—critically important at a time when the politics in major shareholding countries make pursuing general capital increases for MDBs very difficult, with few exceptions. It does not confer any shareholder voting rights, so it does not change the governance structure, decision-making process, or mission of the institution.

When the AfDB successfully issued $750 million in hybrid capital to private investors at the end of January, AfDB VP and CFO Hassatou N’Sele and her team proved a raft of naysayers wrong. Many, including some inside other MDBs, predicted failure. They said:

• Private investors would not be interested;
• A development bank in Africa is not the right institution to pioneer such assets;
• The coupon rate would be ruinously high to attract private investors;
• Credit rating agencies would rate such instruments unfavorably and would not give them much equity value;
• Private investors could only be attracted at the price of weakening the AfDB’s development and climate mission.

None of these propositions turned out to be true. Let’s examine what actually happened.

Investor enthusiasm

The transaction was hugely oversubscribed by $6 billion (there was demand for eight times the amount sold). It appealed to a broad range of investors across a range of regions. Here are the breakdowns of the issuance’s allocation:

• Investor type:
  • Hedge/specialized funds (54.8%)
  • Asset managers (27.8%)
  • Central banks and official institutions (6.7%)
  • Pension funds/insurance (6.6%)
  • Banks/private banks (4.1%)
• Investor region:
  • UK (51.1%)
  • Europe, Middle East, and Africa (EMEA) (26.5%)
  • Asia (14%)
  • Americas (8.4%)

100 percent equity

The asset terms are designed to give hybrid capital value as stable, long-term equity. The perpetual notes must be held until August 2034 (10.5 years) before they can be called, and after that date, investors will have the option to redeem their principal every five years. Interest can be cancelled for any reason without reimbursement, and the principal will be fully written down if the AfDB needs to make a call on its callable capital from shareholders. Based on these terms, the credit rating agencies S&P and Moody’s give it 100 percent equity value, meaning it counts the same, dollar-for-dollar, as shareholder paid-in equity.

Favorable rates

The coupon rate was set at 5.75 percent for an instrument that rating agencies rated AA-. This is higher than AfDB’s regular bonds, which are AAA-rated and thus have lower yields. The spread of this hybrid capital instrument has been calculated as 130 basis points over comparable AfDB AAA bonds, which is lower than the initial investor demands for a 150-200 basis point spread. Our calculation, based on AfDB’s active 10-year bonds (last issued in 2019), suggests a spread of 166 basis points—a little higher but still a result that benefits both the AfDB and borrowing countries interested in keeping their cost of capital low.

Potential for scale

The size of this initial issuance is six percent of AfDB shareholder equity, which means there is a lot of headroom for additional issuance. S&P Global has said it would be comfortable with an MDB issuing hybrid capital equal to up to a third of total equity.

AfDB has blazed a path ahead of other MDBs. It has committed to using the lending headroom created by the initial issuance for environmental or social lending, consistent with the bank’s mission.

Shareholders should encourage other MDBs to be more proactive and ambitious, in terms of both timing and size. This year may offer a favorable environment as global interest rates ease and institutional investors and asset managers look for safe assets with yields above AAA bonds and credible claims as Sustainable Development Goal investments.

If all the major MDBs issued hybrid capital equivalent to 20 percent of their shareholder capital (with 100 percent credit as equity), they could add another $64 billion to their usable equity. This could be leveraged at 3-5 times to create an additional $192-$320 billion in lending headroom to be deployed over time. (Efforts currently underway to make MDB capital adequacy frameworks more efficient can increase that leverage.) That would be a major boost to collective MDB finance, and one that is well worth pursuing.

Crowding in private investors

But this is not only about increasing the volume of MDB lending; it is also about giving private investors a safe and attractive way to step up at scale. Much of the debate on MDB reform has focused on how MDBs can “de-risk” private investment. Views on how much risk should be transferred from the private to the public sector understandably vary.

The hybrid capital offer is a very different form of private capital mobilization: it lets private investors help capitalize MDBs, while maintaining MDB missions. It offers investors that profess an interest in financing development and climate-related impact a way to invest through equity, which can be leveraged. That is a highly attractive proposition for large-scale investors and asset managers, for fiscally constrained shareholder governments that now are the sole source of MDB capital (and for their citizenry and legislatures), and for borrowing countries that urgently need to invest more in reducing poverty and addressing climate challenges at a time when market borrowing is prohibitively expensive. If there is another item on the MDB reform agenda that is more of a win-win proposition than hybrid capital, we are not aware of it.