Discussion of the financial instruments available to challenge funds: grants, loans and other forms of returnable capital
Commercial investors have a simple job compared to challenge funds. Their choice of investment instrument balances financial risk and financial return. Challenge funds, however, drawing on donor money, are investing in growing businesses, but wanting to leverage social impact. To best achieve their goals, should funds be deployed as grants, as regular loans, as non-recourse loans? This depends on weighing up a host of subtle issues and strategic factors. Experience of the African Enterprise Challenge Fund has led us to understand some of these, so I want to share what we have learnt about the pros and cons of grants and loans.[1]
AECF started as a light-touch mechanism: an US$35m challenge fund, running the same competition twice a year, for businesses in agribusiness and rural finance that could deliver benefits to rural households as they grew. Funding was provided to businesses as matching grants. After seven years, the AECF has raised about US$250m and has become eight funds rather than one, supporting over 200 businesses in 25 countries in Sub-Saharan Africa in the agriculture, renewable energy, financial services and information sectors. While 50% of capital is provided as a grant, the other 50% is now interest free loans. Originally these loans were all “interest free and non-recourse” meaning they bear no interest, with repayments made only when certain targets are met. Latterly, the AECF has started to offer “normal” interest free loans that are repayable in instalments on agreed dates.
In any discussion on financial instruments and challenge funds it is important to understand the focus and goal of the fund in question. For all AECF’s donors, achieving development impact at scale is the core ambition which guides how grantees are selected and supported. AECF has maintained its primary focus on increasing the incomes of large numbers of rural poor households and, to a lesser extent, creating jobs. But as with most challenge funds, there are a range of other objectives that come into play: acting as a risk-tolerant capital provider to step in where others will not; feeding the pipeline for other, more commercial, financial service providers who will take success to scale, stimulating innovation; influencing market systems. Another question for any challenge fund to consider is whether financial sustainability of the fund itself is important or will success be measured purely on development impact achieved? Prioritisation between such objectives will affect the choice of financial instruments used.
It is also important to consider the perspectives and incentives of the business that the Challenge Fund aims to support and influence. A grant and a loan may be perceived differently, be treated differently, be used for different innovation or growth stages, and have different long term results.
In favour of loans:
- Loans are more likely to be taken seriously than grants, because of the commitment to repay. There is less chance to ‘take a risk with someone else’s money’. The borrower will want greater confidence that the venture will grow and support repayments (though this varies with terms and whether it is a non-recourse loan).
- Loans, even on soft terms, ensure the business mentality is to handle commercial capital not a stream of grants, which can be helpful on the journey to scale.
But against loans:
- To take high risks and truly innovate, entrepreneurs may need grants.
- Even if the business is successful, loan repayment may inhibit their impact. Successful businesses are growing businesses that frequently face cash flow problems just at the time their loans become due.
From the perspective of a challenge fund, the result is a host of advantages and disadvantages of the grant and loan instruments.
Advantage of providing capital as loans
The advantages to a challenge fund (CF) of using loans as well as (or instead of) grants include:
1. Generating funds to extend reach or sustainability of the challenge fund
- Repaid loans could be recycled to assist more businesses and, in theory, to achieve more impact.
- Repaid loans could help cover the costs of running a CF. Indeed, if a CF uses loans only, and if some level of interest is charged, in theory the CF could become financially sustainable.
2. Creating incentives for more successful businesses
- A Challenge Fund with a loans only portfolio would have a significant incentive to only fund businesses with good prospects of their own financial sustainability.
- As noted above, businesses signing up to loans have a strong incentive to ensure their plan is viable and delivers and have to adopt the mentality that goes with handling loans not grants.
Disadvantages of loans
The disadvantages of using loans instead of grants (or a higher % of loans) depends on the hierarchy of objectives of the CF:
1. Influence on project selection if repayment rates are prioritized
- Business ideas and businesses would be selected on their ability to repay rather than their potential development impact, if loan repayment is set as a priority. Although ability to scale is usually a determinant of both, it is not as simple as that. One the key USPs of a challenge fund such as the AECF is finding and funding innovative and risky projects. High risk businesses may have potentially high development impact but would score lower on ability to pay – so would lose out.
2. Imposing constraints on the company that may limit development impact
- If development impact, not repayment, is the priority, then financial instruments selected should be the ones that give the most “bang for buck” in development terms. In some cases grants are likely to provide the best development rate of return as it encourages businesses to take more risk and innovate, puts less stress on the businesses’ finances and allows the businesses to raise more debt on the back of the grant. From this perspective, loans provide the same amount of capital in a format that is less catalytic of development impact.
- If the focus is on impact, then the challenge fund’s top priority is for its successful businesses to grow and scale. So if the business is succeeding, the optimal action given the challenge fund’s mission is to continue to re-schedule the loans, to allow the businesses to use the funds for reinvestment and leverage more commercial capital.
- It is important to note that banks do not seek their money back from their best customers, rather they seek to lend them more. Similarly, the best CF grantees would much prefer to pay interest on the CF’s loan than have to pay back the principal.
3. Low repayment rates
- Non-recourse loans will automatically have low repayment percentages as the number of businesses that meet or exceed their targets will be few. Low repayment rates may be a reputational risk to any challenge fund. They would also be a financial risk if financial sustainability is premised upon repayment.
4. Organisational structure and processes
- If the CF is expected to make and recover loans it would have to be structured in such a way as to accept repayment/governance of repaid funds and have expertise in these fields.
- The bureaucracy involved in a CF becoming a registered loan provider (with loans being registered with the appropriate authority) would be challenging should the CF have a wide geographic scope. Similarly, the costs involved in loan recovery across many geographies and domains may end up being greater than the recoveries made.
5. Higher transaction costs and smaller portfolio
- The current approach of many challenge funds is to surface lots of deals, back lots of deals and then hand them over to others. A focus on developing a high performing loan portfolio will reduce the number of deals that can be done in a given period due to the higher transaction costs associated with each, and thus reduce the impact of the CF. This is even more so with other financial instruments such as equity, for instance, venture capital managers typically complete relatively few deals a year.
If loans are used, there are as many questions as to whether they should be non-recourse loans or not. Non-recourse loans give more flexibility, but my view is that the principle of “non-recourse” results in perverse incentives and should be not be used, contracts should be enforceable as far as possible, and consideration should be given to channeling these loans through third parties (primarily banks) using credit lines and guarantees.
There are many ways in which a challenge fund can align better with existing financial structures. It could increase business access to loans by providing credit lines and guarantees. A more practical way forward might be to limit the challenge fund itself to providing grant finance and then establish an investment unit (similar to AECF Connect) which has funds it can invest (debt, convertible debt, equity etc.) in those grantees showing real potential for growth and impact. Basically, taking a “running with the winners” approach.
Conclusions and Initial Recommendations
Challenge Fund’s should be true to their purpose - whatever that may be - and select the financial instruments to use with that key purpose in mind. In the AECF’s case this means a fund focused on development impact, doing lots of deals, while working as a feeder fund for itself and others who can take its successes to scale. It is also expected to fund innovation to achieve market systems change by funding business ideas that others will not – i.e. be the source of ultimate risk capital and ensuring that the funds it provides are truly additional. This would suggest, perhaps, a greater focus on grants than loans, plus the flexibility to deploy those instruments that best lead to impact for each business.
Further information
AECF is funded by multiple donors including DFID, IFAD, and C-Gap, and is implemented by KPMG as fund manager. Hugh Scott has been Director of AECF since its inception. He and a team of over 30 oversee the Fund Manager’s work. Hugh has over 35 years of experience in Africa both with the private sector and development organisations.
More detail about the Fund, the portfolio, and lessons learned from seven years of operation, can be found in the 2014 Impact Report with related blogs and webinar, available here.
This post is a part of the January 2016 series on Access to Finance for Inclusive Business. View the whole series for more blogs, information and stories to help you navigate the finance landscape for businesses and investors, in partnership with Inclusive Business Accelerator.
[1] The views expressed in this blog are the views of Hugh Scott, Director, AECF. They do not necessarily represent the views of the funders, KPMG, or other organisations and individuals associated with the AECF.