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OVERCOMING THE ACCESS TO FINANCE PARADOX IN AFGHANISTAN EXPERIENCE FROM THE AFGHANISTAN BUSINESS INNOVATION FUND

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Summary

• The fundamental problem is the cost of commercial finance, rather than the availability of finance. Our experience has reinforced the belief that a fundamental obstacle to the growth of commercial finance in Afghanistan is the mismatch between the cumulatively high formal and informal costs of finance on the one hand, and the low risk-adjusted expected returns on investment on the other. The simple fact is that that commercial finance costs more than the returns investors can generate.

• Commercial finance is seen as risky (as banks are not trusted to look after deposits1, are often viewed as corrupt, with a risk of leaking information to criminal elements); with high costs (not only in terms of interest, but also the amount of collateral required, the time taken for the bank to release its claim over collateral, and the time taken to obtain a loan); and inappropriate terms (e.g. short-payment terms, not customised to meet SMEs’ needs). Informal finance on the other hand, through business and family associates, is considered less risky, due to the trust built up over many years, with lower transaction costs. Commercial banks have a difficult time competing with informal finance, of which there is a relatively high supply, and which, together with personal savings, is the main source of finance for SMEs.

• On the demand side, SMEs struggle to meet bank requirements due to the poor quality of business plans, the unrealistic nature of business plans in terms of forecasted revenue/growth, and the lack of strong administrative records by which banks can undertake due diligence2.

• New businesses, with a lack of business networks, find it difficult to obtain informal and formal finance.

• Grants, as used under ABIF, are an effective way to reduce the overall weighted average cost of capital in high risk environments. Grant finance does not necessarily crowd-out commercial finance if designed well. On the contrary, when used carefully, grants can be an incentive to secure and leverage additional commercial financing. So long as the cost of finance exceeds the returns that investment can generate, there is clearly no incentive to borrow. ABIF has shown that grants can tip the balance.

• Private equity represents an opportunity for business growth finance. In reality much of Afghan business is already financed by informal private equity. One avenue worth exploring is whether this informal PE market could be formalised outside of the banking system.

The Afghanistan Business Innovation Fund (ABIF), managed by Landell Mills Ltd from 2011-15 with funding from the UK Department for International Development (DFID) and the Australian Department of Foreign Affairs and Trade (DFAT), was a pilot project to incentivise private sector investment in innovative business models that would deliver wider development impact to drive inclusive growth.

In this learning brief we highlight a number of insights from ABIF’s experience of access to finance in Afghanistan.

These insights shed light on (i) how SMEs, including those which worked with ABIF, are able to access finance when surveys and literature point to access to finance as being a considerable constraint in Afghanistan; and (ii) why there is a discontent between Afghan SMEs who need financing but claim that they cannot borrow, and the lenders who have cash deposits but say that they cannot lend. The insights are many, but the principle ones are summarised as follows:

Note on terminologyCommercial finance refers to debt and equity finance provided by a financial institution whose business it is to provide such finance. Commercial finance may be traditional or Sharia-compliant.

Traditional finance refers to interest-bearing debt finance products.Informal finance refers to debt or equity finance provided by a third party (typically a family relative or a close business associate).

Working capital finance refers to short-term lending (typically in the form of an overdraft), while investment finance refers to longer-term debt or equity finance.

Serving customers at 786 Pharmacies

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at the heart of the problem. This issue laid at the heart of ABIF’s design, and our implementation experience backs up the validity of the project’s underlying logic.

Cost of finance > Return on investment = No borrowing, no investment

Reducing the market cost of finance (expressed in interest rates, which are driven by risk) is a long-term policy objective that depends on a multitude of external factors. In the meantime, open trade borders subject Afghan businesses to international market forces that limit their return on investment.

Afghanistan is currently caught in a “risk/return trap.” But even in this situation, ABIF has demonstrated that the access to finance problem can be overcome in the short-term with the right combination of circumstance and intervention. Despite initial concerns and misgivings, ABIF grantees have proved their ability to obtain commercial investment and working capital finance. Beyond that, one has even secured a private equity investment.

Introduction

This learning brief has been developed to illuminate lessons that can be drawn from the Afghanistan Business Innovation Fund (ABIF), particularly concerning access to finance for businesses.

The essential contributions made by small and medium enterprises (SMEs) and importance of commercial investment and working capital finance to private sector-led economic growth is widely recognised in Afghanistan. Improving access to finance for SMEs has long been high on the agenda for business membership organisations, government policy makers and donor agencies.

Nevertheless, Afghan SME owners continue to refer to challenges around access to commercial finance as a significant investment constraint. Most recently, a 2015 business climate survey conducted among 560 businesses in Kabul, Balkh, Nangarhar, Herat and Kandahar provinces found access to finance to be one of the most commonly cited constraints to investment, behind challenges such as poor security and market access3.

ABIF’s own investor confidence survey, conducted in 2012, indicated that successful investors relied almost exclusively on non-commercial finance when establishing or expanding their businesses. Our direct experience working with SMEs across Afghanistan has shown that significant, complex barriers – both real and perceived – to accessing commercial finance do constrain investment and business growth.

However, while there are numerous supply-side issues of commercial finance in Afghanistan, the availability of capital for lending is not the root problem. In discussions with the ABIF management team, officials from several leading Afghan banks explained that they would like to increase commercial lending to improve cash deposits-to-outstanding loans ratios4. The same point was made in a recent DFID scoping study which noted that Afghanistan’s banking sector is extremely liquid5. When pressed to identify specific obstacles to lending, bankers have told us that the main problem they face is with finding credible borrowers with bankable projects.

A variety of donor-funded projects have been implemented over the years to address apparent market failures in Afghanistan’s commercial finance market.

A small sample is outlined below.

Despite these efforts, as the business climate survey indicates, the access to finance problem appears to persist. So what is behind the continuing disconnect between Afghan SMEs who need financing but claim that they cannot borrow, and the lenders who have cash deposits but say that they cannot lend?

ABIF’s experience provides valuable insights and suggests solutions to this access to finance paradox.

Our experience has reinforced the belief that a fundamental obstacle to the growth of commercial finance in Afghanistan is the mismatch between the cumulatively high formal and informal costs of finance on the one hand, and the low risk-adjusted expected returns on investment on the other.

Through our interactions with SMEs and banks, we have also been able to identify a number of secondary supply and demand factors that combine in various ways to further limit access to commercial finance, but it is the simple fact that commercial finance costs more than the returns investors can generate that lies

Focus of project Project Principal project activities

Business enabling environment

World Bank Financial Sector Strengthening Collateral registry6

Supply side

USAID FAIDA and ACE/ADF Development of Islamic finance products

USAID Development Credit Authority and DEG Partial credit guarantees7

DFID Harakat, USAID FAIDA Capacity building for banks

Demand side USAID FAIDA, World Bank NMD

Preparing bankable business plans

Donor projects addressing access to finance in Afghanistan

Samimi Furniture Company

How ABIF works

ABIF’s objective, rationale and effects

The objective of ABIF was to incentivise private sector investment in innovative business models that would deliver wider development impact to drive inclusive growth. Without a doubt, ABIF succeeded to achieve this objective; grants were awarded through a competitive challenge fund mechanism and the vast majority of selected investment projects have completed successfully, resulting in positive economic benefits for over 280,000 Afghans.

Why were grants the right mechanism? The most powerful disincentive to private investment in Afghanistan is that few projects can generate returns sufficient to justify the cost of capital (which ABIF estimated at approximately 25% based on the investor confidence survey). Investments that would produce sufficient returns in many other developing counties simply are not viable in Afghanistan due to the high cost of capital.

The logic of ABIF’s response was simple – by blending a zero-cost grant with high-cost commercial and/or informal equity and debt, the weighted average cost of capital was reduced to match the anticipated return of each project8. By finding an investment’s “tipping point,” commercially viable business plans would become attractive propositions for investors.

While it is possible that some of the ABIF grantees may have proceeded with their projects without grants, we are convinced that ABIF grants shaped (in terms of market development impact) and accelerated successful private sector investment.

Additionally, ABIF grants delivered two positive side-effects that reduced the risk of project and/or business failure. First, the ABIF selection process included significant up-front business consultancy assistance that led to better designed investment projects more suited in scope and size to the applicant’s capacity. Secondly, under the terms of the grant agreements, grantees were required to secure adequate pre-financing to cover their investments in physical assets. The promise of a future grant payment made it viable (from a cost perspective) for grantees to obtain commercial finance. Also, when grant payments were disbursed, they provided vital working capital that reduced the likelihood and severity of cashflow crises.

Expected return from

project

Investment Financed by commercial

lending (20%*)

Financed by equity: savings or retained profits (25%)

Financed by grant

(0%)

Weighted average cost of capital (WACC)

Borrow and invest?

20%$1,000,000 $100,000 $900,000 $0 24.5% No

$1,000,000 $150,000 $650,000 $200,000 19.3% Yes

Using grants to reduce the cost of capital and encourage borrowing

When we designed the ABIF grant mechanism, the amount of the grant was predicated on an estimated weighted average cost of capital (WACC) – a combination of the costs of debt and equity finance – in Afghanistan this is in the region of 25%.

The positive “tipping point” effect of grant finance is illustrated in the table below, which shows how a hypothetical project requiring investment of $1,000,000 becomes viable when a small amount of grant finance is injected into the standard mix of debt and equity in a high risk environment.

It is a truth universally acknowledged that no rational investor will invest if the cost of capital exceeds the expected return on investment. Given that returns are constrained by Afghanistan’s relatively open market, and costs of capital reflect the high investment risk of a country at Afghanistan’s current stage of development (the “risk/return trap”), grants are one of the most effective ways of unlocking investment in the short term.

* Actual interest rates charged by banks may be lower than 20%, but this is a conservative estimate of the true formal and informal costs of a loan of this size.

Effect of grant financing on the weighted cost of capital and the decision to invest

Mili Medical Services

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Grantee total planned investment by sector

Pre-investment due diligence

As with any commercial partnership, the first step in the ABIF grant award process was extensive due diligence – examining both the credibility of the applicant and the viability of the investment and the business plan.

The informality that pervades the Afghan private sector – evidenced by lack of reliable financial records and statements, lack of credit history, etc. – is often cited as a major obstacle to commercial lending. ABIF faced the same problem, and had to find a way to work around this that would withstand external scrutiny and discharge the project’s fiduciary responsibility to DFID.

The first step was to undertake site visits to get a first-hand idea of the extent of each business’s current operations and to require proof of registration and ownership. Next, we reviewed tax clearance documents to ensure that applicants were in good standing with the government; these documents also provided some indication of the size (in dollar terms) of their current business activities.

After short-listing, we asked for bank statements, current contracts or other financial accounting documentation so we could get an idea of their cashflows9. We also required self-certification of applicants’ ability to finance the planned investments and working capital requirements. Finally, we took references from chambers of commerce or sector associations, suppliers and customers to ensure that applicants had established good business reputations in their respective sectors.

In the Afghan business environment, accessing this amount of commercially-sensitive information – at an early stage and before significant trust had been established with the applicant – was extremely challenging and time-consuming.

The headline numbersAfter two competitive rounds of business proposal solicitations conducted across Afghanistan, ABIF selected twenty-three SMEs with which to partner from a pool of more than 500 applicants.

Grant financing for investment was provided on a risk-sharing basis. Total grant commitments provided by ABIF totalled US$6.4million12 , around 35% of the total value of the planned cash investments of $18.1million.

Annual turnover of these businesses ranged from approximately $30,000 all the way up to $9 million, and with average expected investments of nearly $813,000 per grantee, access to finance for investment and working capital was a significant issue for many of these SMEs due to the size of their planned business ventures. Grantees’ planned investments, on a per-sector basis, are shown below.

However, it allowed ABIF to triangulate independent sources of information and to formulate sufficient understanding of our applicants’ financial positions and ability to effectively manage large amounts of money.

This process had two important outcomes. First, many applicants scaled back the size of their planned investment as they realised the working capital that would be required to finance their originally proposed expansion. Secondly, in the light of the due diligence findings, ABIF agreed with several shortlisted applicants that they were not ready to proceed with the application. In the end, awards were made, in part, according to the level of our confidence that these investments were realistic and able to be properly managed by the applicants.

The attrition rate from original application to shortlisting to selection to project completion suggests that this due diligence process was thorough and effective:

Number of applications received 520

Number of applications short-listed 46

Number of grants awarded 2310

Number of investment projects 2111

While ABIF demonstrated that financial due diligence is possible, despite prevailing levels of informality, commercial lenders in Afghanistan face additional regulatory requirements that push them towards demanding significant levels of collateral – oftentimes upwards of 150-200% of the amount of the loan. Collateral, which in the words of one bank CEO is “more for show than anything else – I keep the property deeds in my drawer, but cannot imagine ever collecting on collateral”, has therefore become a substitute for effective due diligence, which in any case, many Afghan banks lack the capacity to undertake.

Samimi Furniture Company

The structure of ABIF grant awards

The total grant award for each business was split into individual lump-sum milestone schedules13, which was a useful risk management strategy to ensure that financial risk was appropriately shared between the grantee and ABIF throughout the course of project implementation. Milestone schedules provided clear targets for grantees, and individual milestones were paid out as grantees achieved these pre-agreed targets, which were largely defined by their business plan projections14.

Each grantee’s milestone schedule was structured in three phases: an Investment Phase (IP), a Business Model (BM) phase and a Development Objective (DO) phase.

IP milestones were paid out when businesses achieved investment-related targets, which most often involved acquisition of capital assets to allow for expansion of their operations. In nearly all cases, the amount of each IP milestone was less than what was invested by the grantee, which ensured that grantees carried the bulk of the risk for their up-front investments.

BM milestones were paid according to satisfactory implementation of key components of the business model that would a) develop/support the business’s commercial sustainability or b) initiate a flow of economic benefits to ABIF’s target beneficiary populations.

DO milestones were paid as grantees provided sufficient evidence that a pre-defined number of ABIF’s target beneficiaries received the intended benefit through successful implementation of the business model. DO milestones always accounted for at least 20% of the total grant amount. This proportionally large percentage ensured that grantees were incentivised to fully complete their ABIF investment project and deliver expected benefits to target beneficiaries, rather than ‘drop out’ during the course of implementation15. DO milestones behaved as another layer of risk management for ABIF’s investment in pro-poor business models because they were not paid out until ABIF was satisfied that the overall goal of the investment had been achieved, thereby ensuring value-for-money for DFID16.

The example milestone structure below illustrates these operational principles17.

Milestone schedules provided clear targets for grantees, and individual milestones were paid out as grantees achieved these pre-agreed targets, which were largely defined by their business plan projections.

Milestones Description Milestone claim event % of IP completed

% of grant disbursed

Amount disbursed

(£)

IP1 Investment in machinery or equipment

Downpayment made according to contracts signed for purchase of X machines 10% 10% £19,991

IP2 Investment in land or buildings

Factory foundation construction complete, including preparation for waste management system and utility connection, and final payment made to the machinery supplier

30% 10% £19,991

IP3 Investment in machinery or equipment

Final payment made to supplier after X installed and tested, waste management system and utilities connected and operational

70% 25% £49,997

IP4 Investment in machinery or equipment

Final payment made to supplier after X installed and tested 100% 25% £49,997

BM1 Purchase of raw material inputs Raw material purchases from 2,000 farmers 5% £9,995

BM2 Production of finished goods 4,000 tonnes of finished goods produced 5% £9,995

DO Income to target beneficiaries $1,250,000 paid to contracted farmers and/or village representatives 20% £39,982

TOTAL £199,908

Worker at Sanaizada Edible Oil Production Company

Example milestone structure

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Disbursing grant payments

The formulation, monitoring and, in some cases, restructuring of milestone schedules during the course of project implementation was another critical component of ABIF’s success. ABIF management had to continually strike a balance between demanding results from businesses (i.e. milestone achievements) while not making milestone targets too stringent, which could result in unnecessary delays to overall project implementation and, ultimately, a reduction of benefits to target beneficiaries.

We needed to ensure that milestone payments, at each critical juncture of the overall investment project’s implementation, would appropriately stimulate the grantee toward successful implementation of the next phase of the investment while at the same time minimise ABIF’s risk.

In hindsight, the length of time that it took most SMEs to complete their IP milestones indicates that ABIF was largely successful with this adaptive model. Nearly all businesses took longer than expected – some substantially so – to move through their implementation phase and achieve the final Development Objective milestones. On average, businesses took 17 months to complete their IP milestones and nearly 9 months to complete their BM milestone18.

If ABIF had paid the full amount of each grant up front or in fewer-but-larger sums, it is likely that the SMEs could have completed their investments sooner, but from a payment-by-results perspective it would have been too risky for ABIF and we would have lost critical negotiation leverage during the course of our engagement with the grantees. In general, ABIF’s observation was that IP milestones were the most challenging for grantees to achieve for a variety of reasons19. However, once businesses had successfully procured capital assets and put them into productive use, the BM and DO milestones were relatively straightforward for them to achieve20.

Grant design and gaming the systemOne grantee’s plan to finance its capital investment fell through, which limited the business’s ability to achieve all its IP milestones. As a mitigation strategy, the company focused on achieving its BM milestones with the intention of using BM milestone payments to finance asset investment related to their remaining IP milestones. The grantee quickly realised, though, that ABIF had structured milestones in a way that they would never provide enough financing to fund the initial capital investment, so the project eventually stalled21.

Samimi Furniture Company7

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Once the pre-grant due diligence activities were completed, ABIF generally left grantees to their own devices to raise necessary financing, apart from several key examples (discussed later). In nearly all cases, despite the problems that most anticipated, they were successful. By the end of the project, it was clear that access to finance was not as much a constraint as had originally been envisaged.

The ABIF grantees’ success suggests that when the overall cost of capital is reduced and with sufficient incentive and determination to invest, businesses can access commercial and non-commercial finance in Afghanistan. The important questions in the context of access to finance are therefore more focused on the origin of the grantees’ financing.

Financing investments

Amounts invested

As discussed, twenty-one ABIF-supported businesses planned investments of over $15 million in their business expansions.

The majority of this amount was allocated for productive assets (plant and machinery), and a much smaller proportion was intended to be spent on necessary infrastructure (primarily buildings) and intangible items directly related to implementation of the business model (marketing, advertisement, technical training, etc.).

Actual investment was slightly over $12 million, which is broken out in three general investment categories as shown below.

Investment categories

ABIF grantee reported investments

Capital assets $8,278,047

Infrastructure (specialised structures, facility upgrades, etc.)

$3,143,861

Others (marketing, advertisement, technical training, etc.)

$817,191

Total $12,239,099

Sources of investment finance

ABIF conducted a voluntary survey to elicit information about how grantees financed their investments. Nine of the twenty-one grantees agreed to participate, but the rest declined for commercial privacy and security-related reasons. Not surprisingly, as shown below, businesses sourced finance from several avenues including commercial lenders, business associates, friends, foreign private equity and other donor projects.

As the amount of money financed for assets and infrastructure in the table below is only a fraction of the $8.2 million actually spent, it is clear that substantially more financing was secured by those companies that did not participate in our survey. While we cannot be 100% certain, given the close nature of how ABIF worked with grantees during project implementation, we suspect that if these companies had received financing via formal commercial loans, we would have been informed earlier.

Therefore, we can reasonably assume that the bulk of other financing for assets and/or infrastructure – potentially up to $3-5 million –was likely sourced through informal arrangements with business associates or friends/family members. This was not unexpected as the ABIF investor confidence survey and other literature indicates that most business financing in Afghanistan comes from companies’ internal savings, business partners or friends/family22.

ABIF Grantee Investment Finance Summary (Assets and Infrastructure)

Grantee Source of Finance Amount Rate Status Used for

2 Afghan Growth Finance (AGF) $ 4,000,00023 Sharia loan (murabaha) In repayment Assets and infrastructure

3 Ghazanfar Bank $ 200,000 16% Repayment complete Capital assets

6 Afghanistan International Bank (AIB) $ 200,000 12% In repayment Capital assets

7 Foreign equity investor NA NA Under investment Equity

8 Personal friend $ 20,000 No interest Repayment complete Capital assets

9 Personal business associate $ 100,000 No interest In repayment Capital assets

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Traditional commercial finance

Two ABIF grantees sourced financing from traditional commercial lenders (i.e. not Islamic financing) for a total of $400,000, a very small proportion of the actual investment in assets and/or infrastructure. These loans’ interest rates were 16% and 12%, respectively. While these rates are within the normal range charged by banks in Afghanistan, ABIF grantees often indicated that high interest rates and relatively short-term payment terms significantly reduced their inclination to apply for traditional commercial financing.

Additionally, over the course of our work with grantees, some indicated distrust of banks and other commercial lenders because they feared their private financial information would a) attract undue attention from corrupt officials or b) that it could be leaked to criminal elements who could target them for kidnapping and extortion. At least two close relatives of ABIF grantees were kidnapped during their engagements with ABIF, so perhaps these concerns were potentially well-founded. The Kabul Bank case still resonates in the mind of some grantees as well; one requested that ABIF’s milestone payments not be routed through its New Kabul Bank account, but rather paid into another account that he deemed to be more secure.

Grantee #6 from the above table did not involve ABIF in securing finance from AIB, and the company did not seem to have any issues raising the capital. However, ABIF was substantially, though informally, involved with Grantee #3’s loan with Ghazanfar Bank. The grantee prepared and submitted the loan application, which was approved and the first $100,000 tranche was disbursed. Later, prior to disbursal of the second $100,000 tranche, the bank’s credit manager requested to meet with ABIF. We held a meeting (including the grantee) during which we discussed how ABIF worked, the amount and structure of our grant and the terms of the remaining milestone payments. This provided necessary assurance for the bank, and the final $100,000 tranche was then released to the grantee.

However, it is equally interesting to note that this company struggled to meet the terms of the loan. It was ultimately paid off, but the grantee continues to experience problems associated with the lender. As part of the due diligence process, government regulations require that the grantee and the financing bank each must pay an administrative fee for releasing the land title documents to be used for collateral. The grantee paid their part of the fee during the loan application process, but more than six months after paying off the loan, the bank has yet to pay their portion and legally return the title to the grantee.

For this reason, among others, the grantee recently indicated to ABIF that he would not likely pursue a commercial loan in the future; rather, he would deal with Sharia-compliant lenders or private business associates. Recently, the same grantee took on a large personal loan from a business associate as working capital for purchase of raw materials (shown in the table in the working capital section below). When asked about the difference between working with private lenders and commercial institutions, the grantee said, “Private loans are much easier. You can sit down with the lender, discuss terms and make an agreement in one day. It took way too long to work with the bank.”

Sharia compliant finance

ABIF’s survey revealed that only one grantee secured a loan from a sharia-compliant lender to finance capital investment (Grantee #2 with AGF). In ABIF’s experience, grantees expressed mixed opinions regarding cultural and religious issues around sharia-compliant financing.

A recent report noted “a phenomenon of self-exclusion for many Afghan SMEs from formal financial services given the major reservations against borrowing on interest from banks or microfinance institutions on religious grounds.”24 The report went on to note prevalent “cultural and religious unease with debt and interest products in vast segments of the Afghanistan business community.”25

And a few of ABIF’s grantees did feel strongly about the issue, in line with these statements. However, for others, business-related considerations took precedence over religious concerns. They indicated openness to either Islamic or traditional finance depending on what better suited their particular needs. One grantee noted, “`No one prefers commercial loans, but it depends on the business. Traditional, small businesses will close their operations before taking a conventional loan [due to religious convictions], but larger, more developed businesses tend to be more flexible. They will choose a loan that works best for them.”

Of course, context for each grantee mattered tremendously and ABIF’s sample is small, so overarching conclusions cannot be drawn on this issue.

In ABIF’s experience, grantees expressed mixed opinions regarding cultural and religious issues around sharia-compliant financing.

Above: Naab Interiors. Below: Sahrai Brothers

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Private equity

One ABIF grantee accomplished a significant achievement in Afghanistan’s current economic context by securing a private equity (PE) investment from a UK-based PE firm. To ABIF’s knowledge, this was the first such investment of its kind in Afghanistan outside of the oil, gas and mining sector. The PE firm focuses on frontier investments in conflict/post-conflict zones, and as they began visiting Afghanistan, they reached out to ABIF for companies who were good candidates for PE investments. After reviewing our portfolio of companies, and speaking with several of our business owners, they found one company that satisfactorily fit their investment model.

After an extended negotiation process, an equity deal was signed in early 2015, and initial tranches of PE funding have been released. Subsequent ABIF post-grant support subsidised some costs to support scaling of the business model, which is already having results in increased sales, much stronger decision-making and management, more-developed business administration systems and longer-term strategy for continued growth.

ABIF played an important role in supporting this investment. The head of the PE firm noted, “We faced a variety of challenges in structuring this investment in an environment where gathering reliable financial information is difficult and regulations are complex and often obstructive. The initial introduction to the business came from ABIF who increased our comfort level to work with the business through their close relationship with the entrepreneur. ABIF also provided invaluable assistance through post-grant support, without which we would not have been able to make the investment.”

The model of mixing grants with private equity is something very innovative in Afghanistan, and it is far from a proven model. The investment is in its very early stages so its true impact will only become visible once the investment is fully completed to the point where the PE firm considers an exit. The firm did embed an employee within the business as part of its investment strategy, and from ABIF’s perspective, this had a tremendous impact. The grantee business’s management, organisation and professionalism increased substantially through the PE firm’s engagement, so it would appear that the investment is headed in the right direction.

Other donors

In order to partially offset the cost of their capital investments or, in several cases, augment them with additional complementary assets, a number of grantees turned to other donor projects such as the USAID-funded Assistance in Building Afghanistan by Developing Enterprises (ABADE) and the World Bank-funded New Market Development (NMD).

Grantee #7, the same firm that secured the private equity investment, submitted an application to ABADE to offset the costs of establishing new pharmacies. This was driven primarily by the PE firm who obviously saw benefit in the potential for additional donor funds to scale up and expand pharmacy coverage in Kabul. At the time of writing, the application was under USAID’s review process.

Grantee #6 both offset a portion of their investment costs and acquired additional assets by signing a Public Private Alliance (PPA) with ABADE who assisted the company in identifying adequate machinery for their factory production line and funded a portion of the total cost. It is notable, however, that ABADE’s support further leveraged the total amount of the grantee’s investment in their ABIF project, even when taking ABADE’s financial contribution into account. This example was clearly a win-win for ABIF, ABADE and the grantee, though ABADE’s long approval and procurement process did impact the timeline of ABIF’s expected engagement with the grantee. The length of time it took to procure and install the machinery meant that less impact was achieved under ABIF implementation, but long-term impact will likely be enhanced.

Grantee #1 augmented ABIF-related assets by working with ABADE to purchase a commercial truck scale and install a small cold storage facility in their production factory. The company also worked with NMD to offset costs of packing materials and hire short-term technical assistance to support installation of their ABIF-related factory machinery and increase efficiency of factory operations. These efforts enabled the grantee to lower its operating costs, improve production efficiency and produce higher quality finished goods.

A grantee who declined to participate in the survey worked with ABADE to substantially scale its ABIF investment. Under ABIF, the grantee invested in 300 low-tech production tools, and when the business model proved to be successful, the company worked with

ABIF increased our comfort level to work with the business through their close relationship with the entrepreneur and provided invaluable assistance through post-grant support, without which we would not have been able to make the investment.

ABADE to purchase an additional 400 tools. Under ABIF, this grantee installed a large-scale manufacturing unit in their factory. Now that it is fully operational, the company is pursuing a much larger PPA with ABADE for investment in new machinery to facilitate a venture into textiles production.

Finally, Grantee #4 worked with NMD to offset costs of packing materials and website development.

Based on these examples, it was clearly not uncommon for businesses to engage more than one donor project to finance separate parts of the same investment project or to increase the scope of the project through additional investment in complementary assets. This option for reducing the costs of investment, alongside perhaps somewhat less-intrusive due diligence than a commercial institution, is clearly attractive for many SMEs.

Prior to grant award, ABIF required applicants to be forthcoming about funding from other donor projects. In most cases, grantees applied to ABIF first and then to other donor projects after implementation of their ABIF project was well underway. From an operational standpoint, though ABIF and ABADE had somewhat different mechanisms, we cooperated very closely to ensure that we were not ‘double-funding’ grantees for the same assets or other items. This system worked well and increased transparency between ABIF, ABADE and the grantee on a number of occasions.

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Personal networks

ABIF increasingly realised through the course of project implementation that grantees’ financial decisions were far more nuanced than straightforward “bottom line” considerations. As in other countries, Afghanistan’s business activities largely reflect social and cultural norms. Businesses that do survive are highly resilient and dependent on maintaining strong relationships with business associates along their value chains. An Afghan business’s ability to build and maintain trust with a circle of business associates is of utmost importance for success. By working only with established businesses, ABIF noticed that nearly all had already developed strong business networks meaning that they likely had access to informal credit26. Those companies that were established, but somewhat younger, appeared to have more problems in accessing credit of any kind.

Patronage networks, common in all echelons of Afghan society, seep into standard business practices, and ABIF witnessed examples of this on many occasions during implementation. Grantees nearly always kept as much of their business as possible “within the family,” in both literal and figurative senses. Grantees maintained trusted close-knit business associates and were generally reticent to engage with external actors, even when it was potentially commercially profitable to do so. On a number of occasions, ABIF tried to facilitate natural business connections between grantees27, but they did not share our interest in working outside of their established connections even when it was clear that it could be mutually beneficial. Based on the amount of informal financing that occurred within ABIF’s portfolio, these networks clearly can offer adequate options, which are preferable to formal lenders for a variety of reasons.

These economic relationships can be self-reinforcing to the exclusion of formal lenders. A USAID report on financing within Afghanistan’s agricultural sectors makes a succinct point:

The most important variable in informal finance provision and use is the business relationship. Business relationships that have been developed over years, decades or generations create trust and commitments that significantly reduce credit risks and transactions costs. Afghanistan’s informal finance system is sustainable as it has made Afghanistan’s value chains work for decades, if not centuries, under very adverse circumstances.28

This quote can be applied to many business environments, but considering the additional risks that Afghan SMEs face, it is no surprise that informal finance functions as well as it does to the exclusion of commercial finance. If financing can be accessed for potentially less cost and with fewer requirements from informal sources – and if business trust and influence can be strengthened by working within trusted informal networks – why should a business engage with a potentially risky and “over-bearing” formal lending entity that potentially presents opportunities for corrupt behaviour?

Given these considerations, formal institutions may simply have a difficult time competing effectively with informal financing. The fact that commercial banks are finding ways to diversify revenue streams through a variety of fees and other services decreases their incentive to better compete with informal financing. They charge a lot from donor projects (monthly fees, transaction costs, payroll fees, online fees, etc), have donor credit guarantees for the loans they can provide and charge high interest rates, so there is little downward pressure to offer products that will better compete with informal financing.

Herati Cashmere and Skins

ABIF Grantee Investment Finance Summary (Working Capital)

Grantee Source of Finance Amount $ Rate Status Used for

1 Agriculture Development Fund (ADF) 1,000,000 Islamic loan (wakalah) In repayment Raw materials

2 Agriculture Development Fund (ADF) 500,000 Islamic loan (murabaha) In repayment Raw materials

3 Personal business associate 500,000 50% of net profit In repayment Raw materials

4 Agriculture Development Fund (ADF) 250,000 Islamic loan (wakalah) In repayment Raw materials

5 Azizi Bank 3,000,000 NA Repayment complete Raw materials

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Sources of working capital finance

While Islamic financing was not the preferred method reported for acquisition of assets and infrastructure, our survey revealed this option to be more common for working capital financing, as indicated below.

These working capital loans were not included as part of the actual $12.2 million investment from ABIF grantees, but clearly, their investment projects generated substantial working capital needs. This is especially true of those businesses working in the agricultural and cashmere processing sectors.

Based on financial data reported from grantees, the dollar value of raw materials purchased from Afghan suppliers exceeded $15.3 million, which was substantially more than the total amount invested for project-related assets, infrastructure and non-tangibles. As only $5,250,000 of working capital was recorded from our survey, this means that an additional $10 million was spent on purchasing raw materials from Afghan suppliers. Presumably, a significant proportion of this was financed in some way as that amount of money is unlikely to be retained by most of ABIF’s grantees.

ABIF was only marginally involved in one of the working capital loans. After fully upgrading its factory under an ABIF investment, one agricultural processing grantee required financing to procure substantial amounts of raw material to process throughout the year.

As part of its engagement with ABIF, the company underwent a large expansion of its supplier network, and farmers who had previously not worked with the company were reluctant to join the network without early-stage financial benefits (as opposed to selling on credit, which is extremely common in much of Afghanistan’s agricultural/horticultural sectors).

Like several other companies included in our survey, this grantee turned to the Agricultural Development Fund (ADF), a lending entity established by USAID to facilitate investment in Afghanistan’s agriculture sector. The company submitted a loan application, but ran into several deficiencies with its paperwork and collateral requirements. ABIF stepped in on an informal basis, explained our partnership with the grantee, and the loan was ultimately approved when the issues were clarified, which allowed the grantee to provide up-front financial incentives to his network of farmers and purchase a substantial amount of their crops. After a very successful first production year, the company recently indicated to ABIF that the new farmers in its network were now confident in the business model and were more willing to provide raw materials up-front with fewer incentives. As such, the business expects that it will be able to finance its own working capital needs for this upcoming harvest and production season.

Sanaizada Edible Oli Production Company

Post-grant support investment

In 2015, ABIF and DFID decided to use the remaining programme budget to spur additional grantee investment into their ABIF projects in the form of post-grant support (PGS). These funds were to be allocated on the premise that additional investments could be made on a cost-share basis to a) support a scale up of each business’s current operations to increase its development impact (and DFID’s value-for-money), and/or b) increase the business’s technical or administrative capacity to facilitate stronger competitiveness of their market development-oriented business strategies.

ABIF worked with willing grantees to identify areas for PGS support and then, based on other donor projects which had conducted similar schemes, required grantees to contribute between 25% and 35% of the total cost of the support. While PGS activities were still ongoing at the time of writing, ABIF expects to incentivise an additional $200,000 from grantees to implement PGS activities through this cost-share mechanism.

Some grantees found PGS support very useful and valuable, while others have not taken advantage for a variety of reasons. Generally, Afghan SMEs exhibit enormous preference toward investments in physical assets as these are less risky than investment in skills development training for their staff. However, once ABIF grant milestones were achieved and assets were installed and operational, ABIF noticed a shift in grantee interest with regard to development of their staff. Specifically, several grantees used PGS support to increase the professionalism of their business accounting and internal management systems, which should improve their ability to access commercial finance in the future, if they so desire29.

...once ABIF grant milestones were achieved and assets were installed and operational, ABIF noticed a shift in grantee interest with regard to development of their staff. Specifically, several grantees used PGS support to increase the professionalism of their business accounting and internal management systems.

Sanaizada Edible Oil Production Company

Naab Interiors.

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As outlined throughout this learning brief, ABIF witnessed a variety of approaches to financing throughout its 3.5 years of work with twenty-one Afghan SMEs. Perhaps the most significant lesson to be gained from this experience concerning access to finance is that thanks to the injection of grant finance, SMEs did invest in innovative business models, and nearly all of those grantees who needed substantial external financing for investments were able to access it.

Though the sample size is small, this lesson indicates that access to finance constraints in Afghanistan are not fully understood by many donor-funded projects, perhaps the only exception being ADF, which has chosen to reduce the costs of borrowing in direct competition with commercial lenders.

From a macro perspective, we recognise the substantial market failures in Afghanistan’s commercial capital market, despite high bank liquidity and their expressed desires to increase lending. However, it is also clear that commercial financing is often neither competitive nor the preferred option in the eyes of many SMEs. ABIF’s grantees provided a wide range of reasons for this.

At a micro-level, there is clearly a lot going on behind the reported problems associated with accessing commercial finance. In this brief, we have tried to extract some of the main issues based on our experience of working with an admittedly small – but in our view, representative – sample of SMEs.

The fundamental problem is the cost of commercial finance, rather than the availability of finance. While there is a focus on high interest rates attached to traditional lending, it should be remembered that although Sharia-compliant loans do not carry interest, they do nevertheless carry a cost to the borrower. It is almost impossible based on available information to calculate the costs of Islamic and traditional finance on a comparable basis, but given that both traditional and Sharia-compliant lenders operate in the same risk environment (in fact, Sharia-compliant lenders’ risk is sometimes higher due to the nature of the products offered), it is reasonable to assume that the effective costs of both are fairly similar.

Poor loan product design was also discussed as something preventing commercial capital from flowing to Afghan businesses. Loan terms are a frequently mentioned problem. Investment generates returns over several years, whereas bank lending products in Afghanistan are typically much shorter-term. One grantee noted that banks do not offer loan products that are customised enough to meet SME needs, especially medium-sized businesses. He said that microbusinesses can access support and large businesses can find ways to raise financing, but those in the middle are the most in need of help.

This echoes financing gaps in many developing countries where the “missing middle” is often referenced. Most ABIF SMEs would fall into this category.

But the problem is not just on the supply side. Our experience of working with grant applicants over the six-month application period revealed first a generally poor quality of business planning (at least in a format that allows an external funder to take a rational lending decision) and the unrealistic nature of many business plans promoted by sponsors (in terms of forecasted revenue/growth). Notwithstanding regulatory requirements, in these circumstances, it

is not surprising that commercial lenders require significant collateral.

On top of these simple supply and demand constraints, other factors militate against businesses accessing commercial finance:

• Trust and cultural traditions: Afghan businesses are typically family affairs, and there is a marked reluctance to step outside of the immediate family circle to access finance. Lack of trust in banks is a big obstacle, one grantee noted that banks may be “more professional with financial information. Individuals might not be.” Commercial privacy is clearly a major consideration for Afghan businesses.

• Fear of negative consequences of engaging with banks: With some justification, Afghan business owners are anxious about the unintended negative consequences of borrowing from commercial lenders. They worry about exploitation or being reported to the tax authorities. Recently, ABIF has even witnessed concerns about the safety of bank deposits, perhaps resulting from the Kabul Bank fraud.

• Hidden transaction costs: The costs of borrowing from commercial lenders are informal as well as formal; businesses have to navigate unclear and time-consuming bureaucratic requirements, cope with uncertainties about disbursement of loans and face problems with closing loans. All of these challenges add to the effective cost of borrowing.

• Ready availability of informal finance: Afghanistan is not short of cash; it is just that much of it is outside of the formal banking system. In developed countries, banks act as intermediaries between depositors and borrowers, but in a country where neither really trust the banking system, those with money to lend rely on informal connections to find those who want to borrow.

Finally, some donor-funded projects have contributed to the problem by unwittingly creating disincentives to, or competing with, commercial lending and borrowing. Over the last decade, there has been a succession of projects that have offered grant finance for business investment. For whatever reasons, many of these grant schemes have been seen as a “soft touch”30 – encouraging business owners to focus on gaming donor systems to their personal advantage and invest in assets for the sake of investing, rather than investing for sustainable business growth. One grantee noted that donor-supported lenders (particularly the ADF) can be more flexible than commercial providers, which is most certainly a large part of the institution’s continued success.

Concluding observations

Sahrai Brothers

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ABIF, as a project to incentivise private sector investment in innovative business models, has been successful. There are four important lessons for donors in designing future projects designed to address access to finance for business investment:

• Intervene to reduce the costs of borrowing: In the longer-term this will happen as investment risk reduces. But in the meantime, grants are an effective way to reduce the overall weighted average cost of capital in high risk environments. Grant finance does not necessarily crowd-out commercial finance – although this is what has happened in practice due to poorly designed grant programmes. On the contrary, when used carefully, grants can be an incentive to secure and leverage additional commercial financing. So long as the cost of finance exceeds the returns that investment can generate, there is clearly no incentive to borrow. ABIF has shown that grants can tip the balance.

• Support mechanisms that increase returns on investment: Private equity, which is much more interventionist in nature (providing management support as well as finance) than bank lending, represents an unexpected opportunity for business growth finance. PE investors achieve their desired return through dividends and exit, whereas banks rely on interest rates. In reality much of Afghan business is already financed by informal private equity (even loans are in effect equity investments). One avenue worth exploring is whether this informal PE market could be formalised outside of the banking system.

• Encourage experience and learning through practice: There is no “silver bullet” that will achieve systemic change in the finance market; improving access to finance will be a gradual process of encouraging businesses to borrow and banks to lend. Through experience and adaptation, lending expertise will develop and loan products suitable to the local market will emerge. The access to finance challenge for donors is how to start and nurture this process, rather than finding “the solution”.

• Have in mind that lending regulation is of secondary importance: Banking regulation is clearly important for many reasons (protecting depositors, avoiding abuse by shareholders etc.), but it is not the key to the access to finance problem. Most Afghan businesses are informal and regardless of regulation, few trust the banks to operate as honest brokers.

Above: Naab Interiors Middle: Herat Ice Cream Below: Ayra Mellat Corrugated Box Production Company

Azimian Food Products.

1616786 Pharmacies

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1 In light of the Kabul Bank scandal.

2 Which is partly the reason for the high levels of collateral required, due to the inability of banks to undertake sufficient due diligence.

3 ACCI, Business Tendency Survey Report, June 2015, http://www.acci.org.af/media/7th%20ACCI%20Business%20Climate%20Monitor%20Survery%20%28English%29_%20June%202015.pdf

4 ABIF discussion with a senior bank official in one of Afghanistan’s major banks

5 Coffey, 2014, pg 75

6 Da Afghanistan Bank, 2014, http://dab.gov.af/en/news/da-afghanistan-bank-has-successfully-launched-the-modern-and-fully-electronic-movable-collateral-registry-2

7 USAID, 2015, https://www.usaid.gov/news-information/fact-sheets/development-credit-authority-dca_old

8 For more detailed explanation of ABIF’s design, see http://www.capacity.org/capacity/opencms/en/topics/gender-and-social-inclusion/risk-compensating-grants-in-afghanistan.html as well as the knowledge brief titled ‘Challenge Funds in Fragile States: Experience from the Afghanistan Business Innovation Fund’

9 This presented some challenges as some grantees have multiple bank accounts or have significant amounts of cash in the Hawala system, but it was only one of several data points used to take funding recommendation decisions.

10 After award, two grants were eventually cancelled for non-performance.

11 Of these 20 investment projects were completed. The one not completed was in the mining sector. Of the 20 completed, 18 received full payment based on evidence that the business models had been achieved as envisaged and that there was a development outcome (benefits to target beneficiaries). The two that could not fully achieve this were also in the mining sector.

12 Actual commitments of £3,758,050

13 Each grant had between three and eight individual milestones, depending on the size of the business and the investment project being implemented. The most effective milestone schedules, for ABIF’s purposes, had between 4 and 6 milestones.

14 We initially had concerns that businesses would try to achieve milestones out of a logical sequence presented in their agreed business plans (i.e. do the “easiest” milestones first). However, because our structure forced grantees to secure necessary financing to kick-start their project, this issue was largely averted.

15 We suspect that this model also increases the likelihood of subsequent changes in the market system. Once businesses have seen that their models work, they (or others) will be more likely to scale their model in the future.

16 In one case, the business was commercially successful, but it could not show that the pro-poor aspect of its business model worked so ABIF did not pay out BM or DO milestones.

17 Though some of the milestone language has been changed to protect commercial information, this particular milestone schedule belonged to a business that invested over $800,000 in new assets and infrastructure.

18 As of the time of writing, this sample included 17 businesses that had completed their IP milestones and 11 businesses that had completed both their IP and BM milestones.

19 Financing was indeed a barrier for many grantees, and it sometimes took time to secure funding, but most grantees were confident in their ability to secure it well before embarking on their investment projects. The main reasons for delays were instead due to the procurement of capital assets which took a very long time for most grantees. Some were not 100% sure of the specifications of necessary equipment, others had a difficult time finding suppliers, some had customs-related delays, and then it took some time for grantees to put the assets into productive use.

20 This is very interesting because often the BM milestones required substantial working capital. Given this, it would appear that most of the ‘risk’ of grantees investments related to acquisition of assets and putting them into use. In comparison, the sales side of their

businesses (except in the mining services sector) did not appear to be major constraints.

21 The grantee was in the mining services sector. In a strong market, it could have theoretically been possible to achieve one or two small BM milestones to provide seed funding for business start-up and initial revenue generation of fund capital assets, but in a stagnant sector – like mining services turned out to be – it was not feasible.

22 The World Bank Afghanistan Enterprise Survey-Afghanistan, 2014, pg 11 and The Center for International Private Enterprise, 2010, pg 14-15

23 Approximately $2.2 million of this was directly associated with the ABIF project; the remaining $1.8 million was for business expansion that was complementary to, but outside of, ABIF’s purview. However, we thought it helpful to give context of overall investment.

24 Coffey, 2014, pg ii

25 Coffey, 2014, pg 22

26 One of ABIF’s criteria for ensuring that the business model could be scaled was a strong network.

27 For instance, we attempted to connect two grantees in the cotton sector. One had access to a strong network of cotton suppliers (from which it sourced cotton seeds for oil production). The other needed cotton fibre and did not have an established network of suppliers. Additionally, we tried to connect a cardboard box manufacturer to an ice cream distributor who uses tens of thousands of boxes/year. In both cases, grantees did not express interest in connecting with each other.

28 USAID, Afghanistan Agricultural Finance Market Research, 2010

29 For a variety of reasons, many legitimate Afghan businesses do not keep strong administrative records. This is one factor that substantially contributes to SME’s inability to access commercial finance.

30 ABIF grantees have consistently reported that the ABIF application process was significantly more demanding than other donor funded schemes.

Endnotes

Asia Pharma

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