DEVELOPMENT FINANCE INSTITUTIONS

Rhianydd Griffith and Matthew Evans

Reed Smith LLP

Legal Guide July 2012 July 2012 International Law, Debt and Finance, DFI

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This document provides general information and comments on the subject matter

covered and is not a comprehensive treatment of the subject. It is not intended to

provide legal advice. With respect to the subject matter, viewers should not rely on

this information, but seek specific legal advice before taking any legal action

Any opinions expressed in this document are those of the author and do not

necessarily reflect the position and/or opinions of A4ID

Advocates for International Development 2012

What is a Development Finance Institution (DFI)?

DFIs occupy the space between public aid and private investment. They are

financial institutions, which provide finance to the private sector for investments

that promote development. They focus on developing countries and regions where access to private sector funding is limited. They are usually owned or

backed by the governments of one or more developed countries.

What do they do?

DFIs provide finance:

to financial institutions that provide long-term capital and know-how to

local small and medium size businesses;

to private sector intermediaries (such as funds of funds) which invest in

underlying private enterprises involved in development projects;

directly to underlying private enterprises.

The finance is generally offered in the form of long-term loans (between 10 and 25

years), equity investment and credit risk guarantees.

As well as providing finance, DFIs often act in co-operation with governments and

other organisations in providing, (or financially contributing to/supporting),

management consultancy and technical assistance. This assistance can be

project specific, or general.

DFIs aim to promote best practices in business, governance and environmental

standards in the funds or companies in which they invest.

Why do they exist?

Private sector investment is strongly associated with economic growth, through

the creation of profits, jobs, government tax revenues as well as other benefits to

society.

The purpose of DFIs is to fill a gap in the financial market. Most low income

countries do not have sovereign credit ratings that are up to investment grade;

they do not have a rating between 'AAA' and 'BBB' awarded by an international

credit rating agency. This discourages private investors. It also makes it difficult and

expensive for entrepreneurs and companies to raise the finance they need in order

to develop, with small and medium sized enterprises in particular lacking access to finance.

DFIs invest in areas where, typically, commercial investors/banks would not.

For example in poorer countries and sectors, providing finance involves higher risk.

By taking on this risk, DFIs allow development projects to begin when they otherwise may not, or to continue when plans may have otherwise been

abandoned due to a lack of long-term financing and knowhow.

DFIs aim to invest on a sustainable basis by providing the means for developing

country governments to invest in projects that encourage socio-economic

development, thereby reducing the dependency on aid.

The finance provided by the DFI is also intended to act as a catalyst, which helps to attract

and mobilise the involvement of other private investors. Where a DFI is ultimately

crowded out of an investment, area, or sector by private investors, this is considered an indicator of the DFIs success.

What forms can they take?

Many DFIs have been established and are operated under specialist legislation.

Some are wholly owned by the public sector (i.e. governments and states).

Examples include CDC, which is owned by the UK Governments Department for

International Development (DfiD) and Norfund, which is owned by the

Norwegian Governments Ministry of Foreign Affairs.

Others have a mixed public and private ownership. Examples include COFIDES,

which is owned jointly by the Spanish Foreign Trade Institute and various Spanish

banks, and FMO, which is owned jointly by the Dutch government and commercial

banks.

DFIs can be bi-lateral (owned by one country to form partnerships with the private

sector) multilateral or regional (with multiple shareholders from various

countries). Examples of the latter include the Asian Development Bank, the

International Finance Corporation (IFC) which is part of the World Bank Group

and the European Bank for Reconstruction and Development (EBRD).

The IFC and EBRD are the biggest DFIs in terms of annual commitments to the

private sector.

How do they operate?

DFIs will usually be funded by their shareholders, including government funds,

and will be backed by government guarantees. As a result of their perceived

creditworthiness, DFIs can also raise large amounts of funds on the international

capital markets and borrow internationally at low rates. DFIs have higher levels of

liquidity than commercial banks because of their large levels of paid-in capital,

additional callable capital from a reliable source and exemptions from paying tax

on their income. Shareholders of a DFI will not usually require dividends to be paid

on their investment.

DFIs depend on profits from their investments to ensure they have the resources

for their ongoing engagements. CDC, for example, has received no government

funds for over 15 years. Instead, all profits are re-invested in the business

throughout its target emerging markets. DFIs can become very profitable because,

while they are required to take higher levels of risk than commercial investors, they often naturally find themselves with first-mover advantage in certain markets. A

well known example is the Celtel telecommunications company in Africa, in which

DFIs invested early and later found themselves with significant profits.

Investment decisions of the DFI will be overseen by a supervisory and

management board. The make up of the supervisory board varies from DFI to DFI

and will not always include representatives of the government by which the DFI is

owned. For example, the supervisory board of the FMO does not include representatives of the Dutch government.

Which investments are made on a day to day basis will generally be governed by

one or more of the following:

shareholder targets with respect to countries or instruments1;

the economic and social impact of the relevant sector2;

lack of capital/market failure in specific sectors;

the comparative advantage of the DFI in certain sectors, countries or

instruments3; and

the commercial interest of home country firms4.

Assessing impact

DFIs take account of the financial returns to the investment, the economic

contribution through employment and taxes, the social impact on beneficiaries

and compliance with social and environmental standards.

Various monitoring and measurement models have been established to measure

the impact of DFI investments,5 some of which are based on developing standard

1 In 2009, approximately 45% of CDCs portfolio was invested in sub-Saharan Africa due to the low income status of its various countries 2 FMO specialises in housing, energy and finance, on the basis that investments in these sectors make a real impact 3 A perceived comparative advantage in selecting good fund managers may lead to a decision to favour funds of funds as an investment mechanism 4 Sectors may be chosen by a bilateral DFI on the basis of its home countrys perceived comparative advantage in those areas.

indicators that can be reported on by investees, or the progress of which can be

tracked using readily available data. These models, or variants on them, are used

by the majority of DFIs. Over the past decade, the evidence suggests that sectors

such as agriculture, infrastructure, financial sector and manufacturing produce strong development impacts.

Despite a growing literature assessing the effects of individual investments and

projects on development, there are gaps in the research on the macro impact of

DFI investments. For one, most impact systems focus on micro-level impact of the

relevant investment and secondly, systems for monitoring any wider development

impacts can be demanding, meaning smaller institutions with lesser volume lack

the capacity to match the scope, reporting and review frequencies that the system

demands.

DFIs provide two types of evidence of their catalytic effects: (i) descriptions of

where their presence may have been catalytic and (ii) leverage ratios (i.e. how

much the private sector or other DFI input has invested alongside). For example,

CDC estimates that every dollar of CDC investment coincides with $5 of third party

investment.

DFIs do not tend to report development impacts by financial instrument (e.g.

equity or credit) so it is not possible to analyse which type of instrument delivers

the highest development impact.

Risks and challenges

DFIs must take care to avoid crowding out private sector investors through their

subsidised pricing structure, as their access to cheap funds allows them to provide

cheaper downstream finance. There has been particular discussion recently about

DFIs crowding out private funding for microfinance, as well as a concern that DFIs have a tendency to lend to the most creditworthy Microfinance Institutions (MFIs),

forcing private microfinance investment vehicles to invest in smaller and riskier

institutions. Some DFIs, like CDC, invest through intermediaries in an attempt to

minimise the risks of direct competition.

Pursuing a double bottom line of both profit and development can prove

difficult as the two often contradict each other. On the one hand, DFIs must invest

shrewdly and generate returns yet on the other they must facilitate the economic

development of the countries they invest in. Along similar lines, it has been argued

that DFIs strict social and environmental sustainability policies are a constraint

on their flexibility and capacity to close deals.

During the global financial crisis, international commercial banks pulled away

from the perceived risks of long-term debt finance and in some cases DFIs filled the

5 For example: IFCs Development Outcome Tracking System (DOTS), the German Investment Corporation

(DEG)s Corporate-Policy Project Rating and EBRDs Transition Impact Monitoring System (TIMS).

space being the first to enter or the last to leave a troubled sector. However, not all

DFIs were able to play a countercyclical or additional role; commitments and

investment fell in a number of DFIs in 2008-2009, including CDC, DEG and IFC.

DFIs have been criticised for using tax havens as the location for intermediate

holding companies when making investments and for participating in third party

funds domiciled in those locations. Certain DFIs have justified the use of such

entities on the grounds that they accommodate the requirements of institutional

investors who may invest alongside the DFI, whereas others have made it their policy not to continue this practice.

The Future

DFIs should not lose sight of their responsibility to expand access to financing

through consistently searching out under-invested countries and sectors, while

working to maximise the social outcomes of their projects.

Improving the monitoring of impact on a macro scale is something various DFIs are

working on which should also allow us to undertake a broader evaluation of their

overall role in global development.

Primary Sources

Development Finance Institutions: Profitability Promoting Development*

Thomas Dickinson

CDCs position in the wider DFI architecture Christian Kingombe, Isabella

Massa and Dirk Willem te Velde, Overseas Development Institute, 17

January 2011

The Growing Role of the Development Finance Institutions in International

Development Policy Published by Dalberg Global Development Advisors Copenhagen 2010