The evolving roles of DFIs
Development finance institutions (DFIs) may have been around for decades in some cases, but the past two years has shown their value as never before.
These organisations, which are owned by governments or groups of countries and invest in low and middle-income countries to stimulate economic development, were already growing in importance pre-pandemic. In 2017, they committed an aggregate US$67bn, up from US$12bn in 2000, according to the Center for Strategic and International Studies.
Further, a number of countries have either recently established DFIs or are looking at doing so – Canada created its DFI in 2018, and India is in the process of forming one. Meanwhile, the US boosted its own DFI, OPIC, by merging it with the Development Credit Authority and doubling its lending capacity to US$60bn to create the US International Development Finance Corporation in 2019.
Many DFIs jointly helped create private equity industries across emerging markets through fund investments. Backing first-time managers has been a particular focus for many of them as a means of broadening and deepening capital markets in developing economies and they have often been called on to support GPs through challenging periods when other investors have fled to safer havens. “There’s a high bar for attracting investment from DFIs such as the EBRD,” says Anne Fossemalle, Director, Private Equity Funds at the European Bank for Reconstruction and Development (EBRD). “But once we are LPs, we are not fair-weather friends. We continue to support GPs through crises. DFIs step up and help GPs through more difficult times.”
COVID-19 was clearly a crisis on an unprecedented scale, given that it was global and had an impact not just on portfolio company financials but across all aspects of operations for businesses and the firms backing them. DFIs were, on the whole, quick to respond. Early on, many collaborated with each other to share knowledge and pool resources to support specific sectors. The European Development Finance Institutions group, for example, formed COVID-19 working groups.
Individually, DFIs globally also provided much-needed practical help and capital to managers and portfolio companies. “When we found ourselves on the brink of the pandemic, our first reaction was to ensure that we could support existing fund managers in our portfolio,” says Alison Klein, Manager, FMO. “In some instances, that meant focusing on liquidity solutions and follow-on funding for managers.”
Liquidity generally was a massive issue in the early phases of the crisis. The International Finance Corporation created an US$8bn facility for use by banks to lend to existing companies, while the African Development Bank Group (AfDB) put together a US$10bn COVID response facility to support the private and public sectors.
Beyond the DFIs’ immediate responses to the crisis, they have continued to look to the longer term to back new talent. “The big issue - and we all agree on this - is that the industry needs to grow in our markets, with more fund managers, deals and exits,” says Lars Zimmerman, Vice President, DEG Impact. “It has been difficult for DFIs to back first-time funds through the crisis. However, we made a recent commitment to one in Nigeria.” DEG Impact is not alone. IFC, AfDB, FMO and EBRD among others all say they managed to make commitments to first-time funds last year at a time when many commercial investors have shied away from emerging markets generally and new managers especially.
“DFIs need to continue to support first-time managers to build up the industry,” says Marius Chirila, who covers private equity across emerging markets at the European Investment Bank. “We should continue to play a counter-cyclical role in emerging markets. And actually, we observed that some vintages where we have played a counter-cyclical role have generated robust returns. So clearly, being counter-cyclical does have its benefits. Incidentally, those vintages also show low participation levels from non-DFI investors.”
As some emerging markets have built momentum over the years, DFIs are also increasingly looking to frontier markets and focusing attention on nurturing markets that receive less investor attention. FMO, for example, invests in many of the smaller markets that are often overlooked by others. “In Latin America, FMO’s focus is on the Andean region and Central America, while Brazil or Mexico are largely excluded from our mandate,” says Martijn Woudstra, Investment Officer, Private Equity, at FMO. “Some people laugh when we say that, but we are confident about smaller markets, such as Colombia, Peru and Argentina – these are still sizable markets, where we see good opportunities at decent valuations.”
Clearly, sustainability is one of the central planks of DFI investing – both in terms of investing to create a positive impact and to create self-sustaining economies in the long run. On the former, DFI mandates mean they have always been impact investors, but the past decade or so has seen their remit broaden as environmental concerns have moved up the agenda. Indeed, DFIs are now considered instrumental in helping the world achieve many of the United Nations’ Sustainable Development Goals.
The involvement of DFIs in emerging markets means that many fund managers have a strong advantage over those in more developed markets as environmental, social and governance issues (ESG) become increasingly important for mainstream LPs. “All emerging markets funds will have at least one DFI as an LP – if not more,” says Fossemalle. “They therefore have ESG ingrained in their organisations – it’s part of how the add value to companies rather than an add-on.”
Thomas Walenta, Senior Investment Officer, Asian Infrastructure Investment Bank, agrees. “Part of our remit is to invest around sustainability because our region is already impacted by climate change,” he says. “Sustainability and ESG integration are the new normal for managers in our markets – they are part and parcel of their fiduciary duty as managers.”
And when it comes to creating self-sustaining economies, DFIs place a strong emphasis on attracting capital from private sources. Some of this effort is directed at helping capital from more developed markets target emerging markets. DEG Impact, for example, is a new advisory arm built out of German DFI DEG. “Our first mandate is AfricaGrow, a fund of funds we have established with Allianz to help it manage investments in Africa,” says Zimmerman. “It’s a serious, commercial fund that makes fund and direct investments to generate both returns and high impact.” The initiative has €200m, including €70m from Allianz, to invest across African small and medium-sized enterprises and private equity and venture capital funds.
Yet one of the major issues in many emerging markets is a lack of domestic investment – something many DFIs are working hard to address. “The primary role of DFIs is to de-risk investments and crowd in other investors,” says Arun Kumar, Principal Investment Officer at the African Development Bank Group. “An important part of this is mobilising local capital from pension funds and insurance companies.”
It’s a view shared by José Cabrita, Head of CEE – Lower Mid-Market Investments, at the European Investment Fund. “DFIs are doing a lot to support first-time funds and build the industry,” he says. “But we also need to work with local institutional investors and their regulators to help mobilise capital into private equity and venture capital to put the industry on a sustainable footing.”
New niches
To successfully attract further private capital, both locally and internationally, there is increasingly a need to develop features of the private markets that we have seen emerge strongly in developed markets. Co-investments, for example, can help both GPs unable to raise large enough funds as well as LPs that need to deploy larger sums of capital or want to get to know managers better. “We see a lot of managers that can’t raise enough capital to pursue their chosen strategy,” says Menno Derks, Partner and Managing Director of Fund Investments at Sarona Asset Management. “Co-investments allow them to do this. We look at co-investments on their own merits, but they can be a great way of assessing a manager before making a fund investment or of building a stronger relationship with an existing manager.”
Liquidity in emerging markets can be a particular issue – and one that may be exacerbated following the pandemic as exits may have been delayed. Developing secondary markets could therefore offer comfort to LPs that they have options should they need or desire liquidity.
“We see far fewer secondaries than we’d like to,” says Derks. “My hope is that DFIs will see the development of the secondaries market as an important area to focus on if private equity and venture capital markets are to grow further in emerging markets. In the past, this has been frowned upon because it wasn’t seen as creating a development impact. Yet there is a strong argument to say that secondaries can help deepen capital markets – more capital will flow to emerging markets if there is an active secondaries market.”
It may be that Derks does not have too long to wait. CDC, for example, recently suggested it was supportive of moves to encourage secondaries deals to create more liquidity in the markets it targets. And there is a real push among some DFIs to remove obstacles in the way of private capital investment. The IFC is clearly one of them. “IFC is really focused on creating markets,” says Colin Curvey, Fund Head at IFC Asset Management Company, an IFC-owned GP that raises third-party capital.
“If there are potential markets where there are sticking points or where regulatory change would lead to more investment, improved efficiency and positive impact, we’d encourage people to reach out to the IFC. IFC want to work with regulators and governments to find ways of attracting more capital to emerging markets and we’re prepared to put capital and resources behind this.”
