Why should donors subsidise the private sector?

Why should the public sector subsidise the private sector?

Why subsidise the private sector with aid? This was the question discussed at a workshop I chaired recently at the Overseas Development Institute (ODI). The question posed by ODI is this: can we better understand the rationale and value for money of spending aid money on support to the private sector by looking at

1. the effective subsidy that DFID or other donors put in (the gap between a market return and what the donor provides/achieves)
2. the net additional impact achieved due to the support.

This question is an obvious one if you come from a public expenditure background, as the author of ODI’s report, Paddy Carter, does. Paddy is from ODI’s Centre for Aid and Public Expenditure, and his paper looks at the case for public subsidy from the perspective of market failures addressed, positive externalities secured, and additionality achieved. Our conversation was more practical, about who is doing what with what money and how could we judge if it’s a good use of money. But in both the economic theory and the practitioner discussion, the fundamental challenging issue of 'additionality' featured large: what happens thanks to the subsidy that would not have happened anyway?

Our panellists ranged from those that deploy or receive private and public investments, and those that scrutinise or set the policy framework for public support for the private sector. We had two leading multilateral players – the Director for Sustainable Growth and Development in the EU’s Commission's Directorate-General for International Cooperation and Development (DG DEVCO) and International Finance Corporation’s (IFC) Director of Global Economics and Development Impact. On the operational private sector side, Sarona Asset Management (an impact investor), Doreo Partners (a Nigerian social enterprise and investee), and Impact Value (advising funds). On the UK policy and scrutiny side, panellists came from The Department for International Development (DFID- the UK aid agency), UK Aid Network (non-profit), and the UK’s Independent Commission on Aid Impact (ICAI).

From a rich and varied discussion, ten points struck me most strongly.

1. ‘No we can’t’

It’s no surprise at all, that panellists could not simply say ‘the amount of effective subsidy is $x, and the value of net additional impact is $y’. The field is a long way from that.

2. It happens

Many different examples were given of how public subsidy into investment structures or deals helps leverage net development impact.

Sarona Asset Management is a private equity investment firm, raising commercial capital to invest in impactful business across Africa, Asia and Latin America. Vivina Berla explained how three types of soft money have helped:

• $50mn of financing from Overseas Private Investment Corporation (OPIC) underpinned by a US guarantee which enabled Sarona to borrow at a discount. As a result of this potential return enhancement, Sarona could raise much larger sums from the commercial market because investors could achieve attractive commercial returns. (You will notice the logic here – the guarantee enables others to achieve a commercial return. Such a return is the means not the end. The development logic is that because the return is now commercial, more money comes in to Sarona, and hence more investment flows into impact enterprises).
• $15mn grant from the Canadian development agency (through a non-profit fund) is used as first loss guarantee – this catalyses more commercial money by reducing risk to levels that mainstream investors can tolerate.
• $5mn of additional grant money from the same Canadian agency is deployed through an associated non-profit organisation for technical assistance (TA). It’s well known in the industry that good quality TA can make a significant difference to an enterprise’ success.

Ladipo Akoni from Doreo Partners works with Babba Gona, a social enterprise which helps Nigerian farmers to double and triple their yield. He explained how less than $0.5mn from DFID is enabling Babban Gona to expand from 100 farmers to 10,000 farmers. DFID was the first subscriber to their Poverty Bond (a 2 year fixed deposit bond). This enabled the business to grow rapidly to a scale where it can now operate commercially, and thus draw in commercial finance to achieve scale.

3. Three types of investment, 2 types of impact

There is no one type of private sector nor one type of public sector investment. Broadly we used a typology kicked off by Alice Chapple: (i) investment in Development Finance Institutions (DFIs) which make large near-commercial investments in emerging markets; (ii) support for impact investment (focused more on businesses that combining commercial and social return), and (iii) direct investment by donors into business, including through challenge funds. But boundaries blur.

The types of impact of the deal or investment fell into two broad types:

• Direct impacts of an investment, such as energy generated, jobs created.
• Market-building or system-wide changes due to an innovative investment.

It’s important to note that any type of investment can generate both types of impact. DFIs increase energy capacity and transport capacity directly, and they also derisk the sector for others to follow. Leaders in impact investment are building an ecosystem, as well as supporting growth of specific impactful businesses.

4. Impacts of subsidy: leverage vs additionality?

The discussion distinguished two ways in which public subsidy makes a difference. Rob Davies from DFID described how some donor investments will achieve more financial leverage or mobilisation, and others more additionality:

• ‘Leverage’ or ‘mobilisation’ is crowding in more investment from others, thanks to the guarantees, cheaper capital, or first-loss structure provided by public input. Leveraging in more private capital substantially increases the scale of the deal or model. Such deals are already close to commercial terms and just need just a bit of donor input to push them over the line. So while leverage is high, the practice or model is not going to be very different to what the market would have funded anyway.
• Additionality: funding something that wouldn’t otherwise have happened, such as developing a new business models or market ecosystem. Such investments cannot offer a near-market return so will achieve less leverage, but additionality is high because they clearly deliver something that would not have happened otherwise.

Conceptually, I struggle with separating the two, because leverage should be one kind of additionality: lots of commercial capital flows into a model that would not have flowed otherwise. That’s additionality. But in this case, it’s the scale not the model that is different. And it’s harder to prove than in cases where risky, innovative and pro-poor market models are developed with public input.

The key take-away however was this: any donor investment needs to be high on at least one of them: catalyse much bigger scale through leveraging funding, or catalyse something new that markets would not fund.

5. Blended finance

Blended finance is about combining public and private capital. Blending can be over time: Roberto Ridolfi, Director for Sustainable Growth and Development in DG DEVCO explained how the EU paying $20mn for a feasibility study for a huge energy plant takes risk when no one else would. A $1bn DFI investment at the next stage reduces risk for others to come in. He predicted a shift from blending 1.0 to 2.0 and then 3.0 as blended finance spreads well beyond infrastructure and mainstreams SDGs into markets.

Increasingly, blending is happening within the terms of a deal: capital stacks or creative financing structures are the talk of the day. Essentially donors put in risk-tolerant capital able to take the first loss, if a loss is made. This puts the deal within the boundaries of what is tolerable risk and return for more commercial investors to come in with larger money.

It was interesting to hear the latest trends in this. IFC is looking at how donors can buy down risk in IFC deals, by taking first loss. The EU’s DG DEVCO has around €70bn to spend on development, and so far around three, four, or five percent goes to the private sector. Of this, around 10% is for blended finance.

6. It’s not just about cash

Drawing on the experience of carbon finance, Richard Gledhill highlighted that creating impact with public money is about good structuring not just the volume of cash. Roberto Ridolfi emphasised that the EU is now a political actor, not just a financier, so influences where investment goes and how it is done in many ways. The role of the public sector as an actor and influencer, not just a financier, should not be underestimated.

7. Language barriers

The discussion was notable for several reasons, not least that we used the words ‘subsidise’ and ‘profit’ with relative ease, in a gathering that combined development people (majority) and private sector people (minority).

Differences in language used in development circles and business or investor circles emerged. Do donors ‘subsidise’ or ‘catalyse’ market development? Does their capital ‘buy down risk’ or ‘buy additional impact’. If an investment turns out to be successful, is this a ‘home run’ (core to the venture capital model) or ‘excess profits’ (with all the connotations of unfairness or inappropriateness of subsidy).

Do these differences matter? Different languages make it harder to build collaboration even where they can be translated into the same fundamental economic principles. The more substantive gap is probably around additionality. It is core to allocation of public resources. It’s not core to allocation of private resources and indeed doesn’t appear in Investopedia or other common investment glossaries. Investors focus on returns to their own financial contribution. If others are involved, that’s generally good as it suggests less risk and more chance to scale.

But speaking in multiple tongues can be useful. Sarona Asset Managemnet need to appeal to both commercial investors and donor types, so need the language of both. Ladipo Akoni highlighted that the biggest risk to the Babba Gona model is farmer default. So it’s essential not to tell farmers that the agricultural productivity programme is a ‘development project’

8. The challenges of answering the question

Why is the original question posed – value of subsidy vs value of additional impact – hard to answer? Several barriers were identified at the workshop:

• Additionality depends on ‘what would have happened otherwise’ which cannot be measured with most interventions into private sector development
• Dealing with contribution not attribution. Actions that change markets or business behaviour are never due to one intervention only. So any assessment has to be about identifying contribution not measuring attribution.
• The burden of measuring and quantifying development impact: even for a DFI, the burden can be unreasonable. As Luke Haggarty said, it would be easy to spend more on measuring impact than on the deal itself. For companies, there is a real risk of a reporting burden affecting comparativeness. As Alice Chapple asked, ‘how much information is enough’? We have not yet worked this out.
• Confidentiality- so often said (dare I say, ‘used’) to prevent information sharing and aggregation
• Apples and oranges- the types of development impact achieved by public subsidy are so varied, that comparison seems impossible. How can creating direct impact at scale be tallied against system change, particularly as one leads to the other and vice versa.

9. Inequality – the forgotten SDG

Who benefits and who gets left behind? This development-oriented audience, with the help of questions from Oxfam, SCF and others, focused on a topic that is not often aired. And based on panellist answers, it’s not one that is hugely explored. IFC do in-depth evaluations of a sample of projects which include this question– but would find it far too resource intensive to do them all. I could see a huge market opportunity for the Lean Data Initaitive being developed by Acumen, enabling light touch assessment of clients.

10. Shifting terms of the debate

This discussion reflects a transition that is happening. Donors and the development community are increasingly interested in the role of the private sector. DFIs and private sector players are getting more funds, but also more pressure to demonstrate development impact. This audience reflected on the shifting sands, noting that the terms of debate seem to have shifted from ’whether’ to ‘how much’ to use aid to support the private sector. The majority favoured deploying 1 to 10% of an aid budget for this – though there were a couple of notable exceptions holding out for zero %.

Given the shifting aid flows, clearer answers to ODI’s question will increasingly be needed. Even if we can’t answer the question now, it helps focus the mind on the even harder question, of where to best deploy aid funding in the absence of perfect information.

Further information

1. Watch the recording of the event online . The excellent panellists and audience covered a host of other issues too, on transparency, the principle of delegating decision-making to diverse investors, what is off limits, state aid regulations, the time scale for returns in conflict affected states, and issues of trust.
2. The context for the event includes a substantial increase in DFID spending on ‘development capital’ (as opposed to recurrent aid spending) including recent announcement of a £73 5mn replenishment of CDC, the UK development bank.
3. The CDC replenishment, and more generally evidence on the role of DFIs in creating growth and structural change. is covered by ODI’s Dirk Willem te Velde. See, e.g., his July 2015 blog, on the value of DFI investment in contributing to growth and jobs.
4. The Development Assistance Committee of the OECD has also recently changed rules how donor inputs to investment structures count as official development assistance, discussed in a blog by ODI’s Paddy Carter.
5. The emphasis on catalysing private investment into development solutions has been accelerated by the new Sustainable Development Goals and recognition of the inadequacy of public finance. The finance needed to achieve the SDGs is estimated by the UN at approximately £1.6 trillion every year, but current investment levels are less than half of that.
6. There is a growing literature on the social impacts of inclusive business (or social enterprise, or impact enterprise) and progress being made in assessment (summarised in my Christmas 2015 blog) but relatively less on the added impact created by donor input. A 2013 report explores impact of the Business Innovation Facility from a donor perspective. The Donor Committee on Enterprise Development recently published guidelines on assessment of additionality.
7. The EU Court of Auditors recently published a report on EU blended finance, warning it should only be used when the added value is clear, while noting it’s the next big thing in EU development policy funding.