I came away from the recent FSD Africa Sustainable Capital Markets conference in Nairobi with lots of ideas, but one question has stayed with me: who actually builds the investment pipeline?
I’ve long felt that the local capital mobilisation and market development agenda deserves far greater attention from multilateral development banks (MDBs), development finance institutions (DFIs), and donors. It’s also an agenda where we have just embarked on a new research programme—watch this space! In a forthcoming article for France’s DFI, Proparco, I outline the wider challenge of mobilising local capital and developing local capital markets and discuss the constraints across the system and argue that no single intervention will solve them. Several conversations in Nairobi made me think more deeply about one particular part of the problem, namely origination, finding and preparing deals for investment, and the lack of local institutions that do it.
The pipeline does not build itself
In development finance, we talk a lot about the shortage of “bankable” projects and businesses, but the pipeline doesn’t build itself. Intermediaries must do the work to make these opportunities investable and investment-ready and then connect them to investors. Finding those businesses and opportunities, understanding their financing needs, working with them to get them investment, structuring the financing and connecting them with investors take time and expertise and cost money.
An origination economics problem?
One conversation in Nairobi particularly stuck with me and made me wonder whether part of the pipeline problem is actually a problem with the economics of origination—the risks, the reward, and the timing of these.
Imagine a local intermediary spending months working with a small or medium enterprise (SME) and trying to get it investable and investment ready and then get the SME to financial close. They may only get paid if the deal closes, but many deals won’t. The smaller the transaction, the smaller the potential fee. For an intermediary trying to run a viable business, the incentive to concentrate on larger and easier transactions is obvious. This is especially problematic, as in many cases development finance wants to reach exactly the firms in markets where transactions costs are high relative to deal size.
A spectrum of development finance responses
Development finance already responds to this problem in different ways. At one end of the spectrum, MDBs and DFIs do much of the origination and structuring themselves. They find opportunities, work with sponsors (the companies behind a project), and bring transactions to the point where they and others can invest.
Another spot on the spectrum is to fund project preparation or investment-readiness facilities. Public or concessional resources cover some of the costs involved in getting a project or business to the point where investors are willing to finance it.
Institutional incentives can reinforce this transaction-by-transaction approach. Where technical assistance is judged by whether it helps the MDB or DFI itself close an investment, supporting an individual deal is easier to justify and attribute results than investing in local intermediaries.
Both approaches are valuable; transactions that otherwise might never happen get done. But the question I am increasingly interested in is what is the market impact of these approaches—what do they leave behind once the transaction closes? If the MDB or DFI originates the transaction, or a project-preparation facility gets it over the line, who originates the next one?
There are other ways of intervening which potentially have greater lasting impact. MDBs, DFIs, and donors can invest in building local intermediaries who can originate transactions and build a pipeline that they can continually work to replenish. They can also change the economics facing local intermediaries that serve smaller or more difficult clients, for example by making use of stage payments so local intermediaries don’t have to front all the cost upfront or the use of contingent repayment grants, which fund local intermediaries to do the work and which are repayable if the transaction closes.
These four broad approaches aren’t mutually exclusive, and at this stage I am not presuming that the latter end of the spectrum is always better. What is appropriate will depend on the market and the constraint being addressed. But what is important is to start thinking about the quite different implications for what remains in the market after the MDB, DFI, or donor investment and/or support ends, especially if concessional finance is being used.
Some interesting initiatives
Here are some interesting initiatives that have caught my attention in this context.
The Uganda Deal Flow Facility works with growth businesses to assess their financing needs and prepare them for investment, once businesses are investable and investment-ready, they are connected with investors. The facility also works with local transaction advisers. What interests me is whether an intervention like this can help create a stronger local ecosystem for originating transactions that becomes progressively less dependent on the facility itself.
Aceli Africa is interesting in terms of addressing the origination economics problem through incentives. Its model recognises that the economics of serving agricultural SMEs can be unattractive for lenders in terms of service cost relative to revenues earned, and uses financial incentives to change that calculation. For me, it demonstrates that concessional resources can be used to help change the incentives facing local financial institutions where the economics of serving smaller or more difficult transactions don’t stack up. It would be worth exploring how far this idea travels beyond this particular model and sector.
The new Manager Finance Facility, launched by FSD Africa and the Dutch DFI FMO last month, takes the thinking further towards building the local intermediary itself. Emerging African investment managers face a difficult chicken-and-egg problem. They need a track record to raise capital, but without capital and sufficient working capital it is difficult to execute the transactions needed to establish one. The facility provides support for pilot transactions and operating capacity. The idea I am interested in here is investing in building the local financier, shifting the unit of intervention from supporting one business/transaction to helping build an institution capable of financing many businesses over time.
What does this all mean for catalytic capital?
It also got me thinking about a central question that underpins much of my current research—what does good catalytic capital deployment look like?
Much of the blended concessional finance discussion focuses on how concessional resources can be used to overcome the risks and/or costs preventing a particular transaction from happening. There are good reasons for doing this. But I think MDBs, DFIs, and donors need to ask a second question—could some of that catalytic capital have greater and longer-lasting impact if it were used to help build local institutions capable of originating and financing transactions themselves?
The experience of the Private Sector Window (PSW) at the World Bank’s International Development Association (IDA) provides a useful caution. Making substantial concessional resources available has not translated into a material increase in the share of International Finance Corporation (IFC) long-term investment going to countries eligible for the PSW. Money alone cannot compensate for institutional incentives and business models that struggle to generate pipeline in difficult markets. How concessional capital is deployed matters as much as its availability.
My emerging proposition is that deploying concessional capital today to build local intermediary capacity, which could potentially enable much greater mobilisation tomorrow, is an attractive option vis-à-vis using it to get a deal done. I don’t know when that will be true, or in which markets. And nor do I think there is a simple choice between getting transactions done and building institutions. So the question I am left with is where and how development finance, and more importantly concessional finance, should be deployed if we want to get investments financed today while also building the local capability to originate and finance the next transaction, and the one after that. That is one of the questions we will be exploring through our new research programme at CGD.
This question also immediately raises another challenge. Building local institutions, capabilities, and markets takes time, and progress may not show up in today’s private capital mobilisation numbers, the stats MDBs and DFIs report about how much private investment their financing has attracted. If we want funders to put money behind this work and stick with it, how do we show that it is working? That is the second reflection I came home from Nairobi wanting to explore and which will be the subject of my next blog.
