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Four views on how development finance institutions must invest better

Expert Comment

Written by Alberto Lemma, Dirk Willem te Velde, Judith Tyson, Samantha Attridge

Hero image description: A Syrian refugee in Lebanon holds the money he will use to buy groceries Image credit:Medair/EU/ECHO/Kate Holt Image license:CC-BY-NC-ND

Our new report looks at development finance institution (DFI) investment, mobilisation and leverage from 2013 to 2018. Our research finds that green shoots are emerging, but that collective progress pre-Covid-19 had been slow and is far off the pace and scale as envisioned in the 2015 United Nations Addis Ababa Agenda for Action on Financing for Development.

Not only has Covid-19 exacerbated financing gaps, but it has also made the job of DFIs much more difficult. The international community and shareholders of these institutions are at a fundamental crossroads, and bold action is required to ensure a course correction.

Here, four of our experts reflect on the findings of the research and what this bold action could look like.

Samantha Attridge: new expectations but old models

The international community is becoming increasingly focused on mobilising private investment in support of the Sustainable Development Goals (SDGs). This has been accompanied by growing expectations on what DFIs should do. But there are inherent tensions within these, and DFI business models have been slow to adapt.

DFIs have been tasked to move beyond a narrow focus on job creation to focus on mobilising private investment at scale and/or making pioneering and transformative investment to create markets. At the same time, DFIs are expected to remain financially viable and profitable. But there are trade-offs. Mobilisation at scale may be at odds with securing higher development impact which may also involve the acceptance of higher risk to financial return. This could threaten DFI profitability. A clearer understanding of these tensions and balance between them is required.

DFI business models are adapting too slowly. Many DFIs are ‘market takers’. Their investment is often opportunistic and driven by individual deals. This approach may be consistent with the ‘old’ job creation and profitability objectives of DFIs, but there are limits to what this approach will achieve in terms of the ‘new’ objectives. DFIs must become ‘market makers’. Transformative investment, for example, requires significant risk-taking by DFIs and coordinated investment approaches.

Although this kind of investment has the highest development impact, it also has the highest risk of loss. The use of high-risk capital such as grants, equity, mezzanine finance and guarantees rather than senior debt – the current DFI default – is also needed. Mobilising investment at scale from institutional investors requires a shift to pooled portfolio approaches which aggregate projects and diversify risk. This may be at odds with their own account volume objectives where there is a limited deal flow, especially in the poorest countries.

DFIs are at an inflection point. New expectations have been set but this must be accompanied with business model change.

Dirk Willem te Velde: promoting a more active and targeted approach within the World Bank Group

ODI has been arguing that DFIs should take a more active role in tackling global challenges in addition to investing in financially sustainable projects for a decade. In 2015, the Addis Ababa Action Agenda recognised the importance of DFIs in promoting a transformative development agenda. But very few DFIs were present at the meeting, and ODI and the Center for Strategic and International Studies suggested bold changes in response. However, as ODI’s new research clarified, DFIs still have some way to go, though some are more advanced than others.

To inform International Development Association negotiations, we have been examining the need for a more proactive approach towards jobs and economic transformation at the World Bank Group over the last few years. Our analysis provided insights into the importance of aligning the work of development agencies and DFIs. Those on the inside of development agencies do not always view DFIs as supporters of broad-based development, but rather that they promote the interests of specific firms. On the other hand, DFIs do not always have full confidence in the efforts and effectiveness of development agencies in promoting the reforms necessary for financial closure of investments.

Our analysis and consultations revealed that a more active and collaborative approach to create markets is needed. This involves undertaking or building on diagnostics of binding constraints to investments in appropriate sectors relevant for economic transformation. This would lead to preliminary and explicit commitments by DFIs around which technical assistance can be structured. The building blocks already exist. It is just that incentives, culture and leadership need to promote a more focused approach.

The new International Finance Corporation Vice President, Makhtar Diop, could pilot this more active strategy. And given the importance of the World Bank Group in the development system, this new approach could also inform how development agencies and DFIs could work together more generally.

Judith Tyson: more securitisation and syndicated funds for institutional investors are needed

The mobilisation of private finance by DFIs and multilateral development banks (MDBs) remains slow at around $20 billion in 2018 annually. This figure is up from around $14 billion annually in 2013 for the 12 DFIs we sampled, which account for approximately 70% of private finance mobilised. This is an increase but is significantly below what is needed.

However, there has been notable success in the International Finance Corporation’s (IFC) Managed Co-lending Portfolio Program (MCCP). The MCCP create an underlying pool of diversified assets from the IFC’s portfolio. By the end of 2018, it had raised more than $7 billion from eight global investors including major institutional investors. The MCCP has been highly successful because it provides a diversified pool of assets with a reasonable return that matches the needs of such investors. It has also benefited from the management of the IFC which provides a ‘one stop shop’ investment vehicle. It also underpins investor confidence through the IFC’s competent and well-governed management in what can be a difficult investment environment.

However, one criticism of the MCCP is that it includes little or no assets from low-income countries (LICs). Even a small allocation of assets to LICs would increase development impact. This could be structured to also please investors by increasing the MCCP’s total yield for relatively little increases in risk.

Overall, the IFC’s success demonstrates the potential of pooled assets to meet the needs to institutional investors. Similar funds should be developed by other DFIs.

Alberto Lemma: alignment with national development plans

Should DFIs align their investment with national level development strategies? This is an important strategic question that we are currently examining in joint research with the Stockholm Environment Institute. It is especially vital given that economic reconstruction from Covid-19 will significantly influence national development plans for the next decade, at the least.

Although it makes sense logically for DFIs to align their investments with national development priorities, this is not the case in practice. Where there is alignment, it has not been due to a strategic decision made by DFIs, but rather, more of a fortuitous occurrence. To that end, DFIs should be more strategic and collaborative with governments and invest in decision-making processes.

However, it may not be such a simple proposition. Ultimately, DFIs are under no obligation to align their portfolios with national development priorities, even though such an act may have positive impacts on their licence to operate. It could also increase the willingness of governments to help resolve business constraints. In addition, some development strategies may not be realistic or there may not be feasible opportunities for commercial investments within them.

DFIs need to act as catalysts and first movers to have a significant impact on development. Taking a risk in a new strategic sector – if it is deemed commercially viable and meets development impact criteria – would allow DFIs to invest in strategic sectors, even if there is not an already mature market full of potential DFI investment opportunities.

DFIs should take care in analysing national development strategies and ascertain if there are potential overlaps, or if their investment portfolio could be guided towards national priority sectors. The simplest scenario is one where DFIs prioritise strategic sectors identified in national development strategies. More ambitious approaches would see DFIs collaborating with governments on their national development plans. A positive feedback loop between the national development strategy and DFI investments should also be established. Lastly, DFIs should advise governments on what sectors present feasible growth opportunities and help governments remove growth constraints within these.