Scaling Up Risk Capital to Small and Medium-Sized ... · Challenges to investing in emerging-market...

Scaling Up Risk Capital to

Small and Medium-Sized Enterprises

in Emerging Markets

Global Conference 2009

Scaling Up Risk Capital to

Small and Medium-Sized Enterprises

in Emerging MarketsWednesday, April 29, 2009; 8:00 AM - 9:15 AM

Moderator:

Betsy Zeidman, Research Fellow and Director of the Center for Emerging Domestic Markets, Milken Institute

Speakers:

Matthew Gamser, Principal, Advisory Services, East Asia and Pacific Department, IFC

John Lyman, Program Manager, Google.org

Sucharita Mukherjee, Senior Vice President, IFMR Trust; CEO, IFMR Capital

Wayne Silby, Co-Chairman, Calvert Foundation; Founding Chair, Calvert Social Funds

John Simon, Visiting Fellow, Center for Global Development

Peter Tropper, Principal Fund Specialist, Private Equity Department, International Finance Corp.

Hubertus van der Vaart, Co-Founder and Executive Chairman, Small Enterprise Assistance Funds (SEAF)

Troy Wiseman, Chairman, CEO and Co-Founder, TriLinc Global

Problem definition

Small and medium-sized enterprises (SMEs) in

developing countries lack access to patient, non-asset-

based risk capital, particularly for amounts between

$100,000 and $1.5 million.

Challenges to investing inemerging-market SMEs

• Underdeveloped capital markets and a shortage of buyers

• Usually more time-intensive for the investor

• Need for technical assistance

• High risk and transaction costs

• Tendency for investors to move up-market

• Investments do not achieve fully risk-adjusted returns

Milken Institute Financial Innovations Lab February 3, 2009

• Investors in these markets discussed their expectations,motivations and objectives

• Participants explored two case studies:

– 1st party exit: Business Partners’ investment in Swift Micro Laboratories

– 3rd party exit: SEAF-Macedonia’s investment in On.net

• Fund managers discussed strategies for attracting capital to funds

• Participants brainstormed ways to increase scalable risk capital toemerging market SMEs

Best practices

• Plan exits from the outset

• Expand fund scale to reduce expenses

• Use structured finance to broaden the investor base

– Align interest transactions to increase IRRs

• Use local investor networks

• Create mechanisms to match investors and entrepreneurs

• Approach standardization

• Reduce information asymmetries

Potential capital solutions

Raising capital

• Regional funds or fund of funds

• Side-by-side technical assistance and investment funds

• Higher return tranches leveraged by PRIs/government funds

• Guarantee fund for local banks

• Public/private fund with high net-worth social investors

Exiting investments

• Royalty model

• OPIC exit finance facility

• Permanent capital vehicle (e.g., business development company)

• Map and match vectors /sectors– Clean-tech– Sustainable agriculture / food

processing– Health– Value chains

• Map and match– Market coverage– Investors / flows

• FDI• Multilateral / bilateral• Portfolio• Diaspora

Bridging information technology andfinancial technology asymmetries

• Map and match exit options

• Map and match deal flow (e.g.,BP)

• Map and match back office /overhead / marketing

Permanent capital

What would it look like?

Panelists’ slides

Matthew GamserPrincipal, Advisory Services

East Asia and Pacific Department

International Finance Corp.

12

Fiscal year 2008 highlights

• Investments: 372 new projects in 85 countries

• Advisory services: 299 new projects in 75 countries

• $16.2 billion in financing: $11.4 billion for IFC’s own account,$4.8 billion mobilized

• IDA countries accounted for 45 percent of IFC investments.Overall:

– $1.4 billion invested in Sub-Saharan Africa

– $1.4 billion invested in the Middle East and NorthAfrica

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18

$20

Net income and net worth

Net income (US$ millions) Net worth (US$ billions)

Net worth

Net income

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18

FY 2003 FY 2004 FY 2005 FY 2006 FY 2007 FY 2008

IFC financing

* “Mobilization” for 2006 and 2007 includes structured finance, loan participations, and parallel loans.

US$ billions

IFC’s ownaccount

Mobilization*

Loanparticipations

15

By offering to share risks on loan portfolios, IFC’s objectives are:

• To improve access to financing;

• To improve financing conditions;

• For banks: to support the growth of its lending activities to IFCpriority sectors and to improve the bank’s origination and monitoringcapabilities;

• For other clients: to support the growth of their business and totransfer the responsibility of managing the loans.

Structured finance andprivate finance mobilization

16

Borrower A

Risk

protection

Borrower B

Borrower C

Disburs

ements

Inte

rest &

princip

al

repaym

ent

The risk-sharing facility

17

• Loans to schools (Ghana, Kenya)

• Student loans (Indonesia, Chile)

• Loans to SMEs (IDA facilities in CAF)

• Loans for energy efficiency (CEU + CHUEE)

• Loans to health facilities (Nigeria – pending approval)

• Loans to agricultural supply chains (Cambodia, Indonesia, PNG)

• Loans for cellphone distributors (East Africa, Pacific)

IFC experience and plans with RSF

Debt

18

Structured fund (sector/region)for RSF and investments

RSF

FL

IFC, other DFIs

Donor funds

Investors (?)

Equity

Fund liabilities

Potential assets of fund

RSF

Mezz

Sucharita MukherjeeSenior Vice President, IFMR Trust

CEO, IFMR Capital

• Small industries in India contribute 40% of the country’s total industrialoutput

55% of the 12 million small enterprises in India are in rural areas

These enterprises are financially constrained by a lack of access to formalfinancial channels, working capital and the high cost of funds available

Growth is also hampered by lack of adequate infrastructure, limitededucation and access to networks

Interface to markets is weakened by remoteness of rural enterprises, smalland disaggregated nature of the sector, lack of standardized tools forevaluation, which results in high transaction costs

Small-scale industries (SSI) sector in India

• Provide rural enterprises with strong underlying businesses access todebt funding through securitizations

Pool together portfolios of assets generated by rural enterprises andissue securities providing investors access to a diversified range ofrural businesses

Rating methodologies for rural asset classes and structures with ratingagencies

Provide rural enterprises access to working capital financing

Use guarantees and credit enhancements to create high quality assetsand facilitate debt funding at a cheaper cost

Create a specialist institution that has expertise in this sector and canevaluate its risks and rewards

IFMR Capital’s strategy

Securitization Portfolio sale

MFI1 MFI2 MFI3 MFIn

•Ramp up risk portfolio

•Portfolio risk management via:

Risk pooling

Tailoring assets

Criteria and standards

Repackaging and subsequentsale of securities

IFMR Capital

Capitalmarkets

Banks

ORIGINATION

DISTRIBUTION

Pooled portfolio of loans to rural enterprises,infrastructure and micro-finance loans

EnE2E1

InfrastructureMicro-financeRural

enterprises

InI2I1

IFMR Capital’s strategy

Case study 1: Working capital financing

• Masuta is a producer company involved in the business of procurement, marketing and selling ofthe tasar (silk).

• The tasar is produced by a Mutual Benefiting Trust (MBT) that is comprised of women producers.

• The MBT requires financing for purchase of raw materials, and Masuta requires funding for itsworking capital requirements.

• IFMR Trust proposes to structure the loan as a commodity backed financing product under which:

• The cocoons will be stored in warehouses managed by Masuta

• Warehouse receipts will be issued by Masuta which certify the quantity and quality of thecommodity being held

• The loan will be extended to each woman MBT producer and is secured by the respective

collateral

• The warehousing of raw material and work in progress will be managed by Masuta, who will providea guarantee on the quality, quantity and storage of the collateral to the lender.

• The Loans will be pooled into portfolios (the “Warehouse Receipt Loan Portfolio”) and purchased bythe IFMR Trust at a mutually agreed price.

Repayment of loanfor raw materialpurchase

Loan

Repayment ofworking capital

loan

Working capitalloan

Case study 1: Working capital financing

• Servicer Company sets up water purification plants in rural India using its patentedtechnologies, gets into long term agreements with the village panchayat for access tosurface water and land.

• Panchayat makes a down payment of ~30% of the capital cost of the plant and the rest isfinanced through long term debt

• Panchayat owns the plant from day one but the company has rights to the user feesgenerated from water sales to cover debt service and operating expenses

• If user fees collected are insufficient for debt service, the company is liable for any shortfall

• If there is a surplus, it goes into a surplus account, where it stays for 8 years. At the end of8 years, the surplus is split between the panchayat, the company and the debt provider ona preagreed basis

• At the end of 8 years, the Panchayat gets complete rights to the user fees collected andcan choose to go with any operator for O&M from that point forward.

Case study 2: Credit enhancement unlocks value

An infrastructure case study

SPV

IFMR Trust

FundsFunds

Portfolio ofclean drinkingwater plants

Securities

Assignment and monitoringof portfolio rating

Guarantee/creditenhancement

InvestorsServicer CompanyServicer Company

IFMR Trust

Servicer Company Investors

IFMR Capital

Rating Agency

Servicer company

Financing structure

Case study 2: Credit enhancementunlocks value

Originate to distribute model for MFIs

• Releases capital and improves liquidity

• Access to the capital market for unrated entities

• New avenues to raise funds

– Lenders will have tools to evaluate risk of loan pools and risk manage exposures

– Second loss enables larger exposures

• Brings down the cost of capital

• Reduces dependence on a few lending agencies

• Incentives to improve transparency, quality and efficiency of operations

EquitasMicro Finance

Rating Agency

Case study: Equitas Microloansecuritization structure

Rs. 16 crores

Portfolio ofmicrofinance

loans

Securities withperiodic

principal andinterest payments

Assigns andmaintains rating forthe portfolio

Rs. 16 crores

Credit enhancementSenior note• Cash collateral by the MFI• Junior note fully subscribed by IFMR Capital• Excess interest spreadJunior note• Cash collateral by Equitas

SpecialPurposeVehicle

Cash Collateral(First-loss by

Equitas: 11.7% )

AA Senior Notes(80%)

Banks, mutualfunds

BBB Junior Notes (20%)

Fully subscribed by IFMR Capital

How the risks are mitigated

John SimonVisiting Fellow

Center for Global Development

Consortium of SME funders

SME#1

SME#2

SME#3

SME#4

SME#5

DFI/OPIC financing= 90%

First loss = 10%

DFI/OPIC

Senior debtto facility

Foundation SME venture fund Social investment fund

Payback of initialinvestment

Capitalization of consortium –fraction of investment in SMEs

Consortium contribution to exit facility

SME exit facility

Loans to SMEs based on potential of businesses to service debt

Hubertus van der VaartCo-Founder and Executive Chairman

Small Enterprise Assistance Funds (SEAF)

Established 1989 as a subsidiary of CARE

• Separated in 1995 to pursue a more commercial development strategy

• Today manages $480 million in 19 funds

• 285 investments, with an average size of a litte over $1 million

SEAF

• Small Industries Development Bank of India• State Secretariat for Economic Affairs,Switzerland• Swedfund International AB• United States Agency for InternationalDevelopment

Commercial investors• Kotak Mahindra Bank• Life Insurance Corporation of India• New York Life International• Pound Capital

• Seguros Suramericana

Socially responsibleinvestors

• Calvert Social Investment Fund• Calvert World Values International Equity Fund

•

Development financeinstitutions

• Belgian Investment Office• Black Sea Trade and DevelopmentBank• Deutsche Investions- undEntwicklungsgesellschaft

• European Bank for Reconstruction andDevelopment• FMO• Finnish Fund Industrial Cooperation• International Finance Corporation• Kazakh National Innovation Fund• Millennium Challenge Georgia Fund(MCG)• Norwegian International Fund for

Developing Countries• Overseas Private InvestmentCorporation (OPIC)• Polish Cooperation Fund

Pension funds• AFP Prima

• AFP Integra• Proteccion

• Provenir• Colfondos• Evangelische Kirche in Hesse andNassau

Foundations• Ford Foundation

• Foundation for the Development ofPolish Agriculture

Total committed capitalapproximately $480 million

Representative investors

Full cycle experience Nuevos Fondos SEAF vs. PIB Mercados Emergentes (1989-2008)

Exit experience of SEAF with SMEs

Exit experience of SEAF with SMEs

Fund name Realizations Mult. of cap. inv. Gross IRRAfghanistan 2 1.9x 37%

BSEF 22 2.2x 21%

SEAF-Croatia Fund 20 1.6x 12%SEAF-Macedonia Fund 14 2.2x 25%

Caresbac Poland - Developmental 24 0.3x -27%

Caresbac Poland - Commercial 23 3.1x 21%

Caresbac Bulgaria 23 0.9x -3%Central Asia 1 1.2x 7%Colombia 2 1.3x 26%TBF Bulgaria Fund 6 2.1x 16%TBF Romania Fund 10 2.4x 39%Sichuan 1 1.8x 10%Russia 7 1.0x -5%TOTAL 158 1.8x 13.0%

Exits from all SEAF investment funds

Highlights include:

• Every $1 invested generates $12 inlocal community benefits

• 66% economic rate of return oninvestments

• 26% rate of employment growth;25% wage growth

• 72% of new jobs go to semi- andunskilled workers

• SMEs train employees andincrease benefits

SME Financ ie rs

Emplo ye e s

Lo c al Co mmunity

Financ ial Institutio ns

Similar Pro duc e rs

Custo me rs

Supplie rs

Lo c al Go ve rnme nt

Co mpe tito rs

SEAF’S development impact record Original research for our development impact report

26% average annual employmentgrowth

84% of the jobs at the surveyedcompanies go to unskilled and semi-skilled employees

Skill breakdown of employees at surveyed companies, Dec 2005

Semi-skilled29%

Skilled 16%

Unskilled55%

Impact on lives of employees

• Wages – 25% compoundedannual wage growth (in US dollarterms)

• Training – 85% of the SMEsprovide formal or informal trainingto their employees

• Promotions – almost 10% ofemployees promoted in 2005

• Benefits – 83% of employeesreceived health and pensionbenefits in 2005

Representative wage growth at

surveyed firms

Intitial Year (Average of

2002)

Year 2005

25% compound annual growth rate

in wages in US dollar terms, presented

over the average number of years

invested of 2.67

Impact on lives of employees

19.2%

10.9%

2.1%2.4%

1.6%3.0%Carried interest Cash management

Fund expensesPCDEs

Fund managementexpenses

39.1%

Gross IRRto fund

Net IRR to members

TBF Romania Breakdown of IRR performance

32.3%

2.9%0.7%

4.1%Carried interest

Fund expensesFund management expenses

40.0%

Gross IRRto fund

Net IRR to members

SEAF Global Fund = USD 90 million Breakdown of IRR performance

Investors want:

• Professional reporting and transparency, double bottom line

• Liquidity

• (Some) current returns

SMEs need:

* Patient capital (as long as they are are growing)

* Follow-on investment when needed

* On-the-ground monitoring but global benchmarks and advice/marketaccess

Scaling up is necessary, but how?

• SEAF and OPIC--$30 million global debt facility

• Need matching equity line

• Gradually building to an invested PCV of at least $500million

• Blended instruments

• Likely annual returns of 10-15%

Toward a permanent capital vehicle

Troy WisemanChairman, CEO and Co-Founder

TriLinc Global

• SME growth, especially in emerging markets, can provide the best risk-adjustedinvestment returns and create the most significant sustainable social andenvironmental impacts.

• The key to economic growth and environmental sustainability is a thriving middleclass and that the critical driver of a successful middle class is growth in SMEs.

• Providing attractive financial returns with high social and environmental impact is thekey to attracting enough scalable risk capital to bring about meaningful sustainablechange.

• Transparency is critical, not only in financial reporting but, also in social andenvironmental impact reporting.

• Investing in companies that have strong ESG (Environmental, Social and

Governance) policies will outperform their counterparts

and create the best long term value.

TriLinc Global Our beliefs

Individual Investors are seeking:• Predictable, income-generating investments• Social impact investments that meet or beat traditional risk-adjusted returns (do well by doing good)• Evidence that their social impact capital generates quantifiable social and environmental impact

SME Intermediaries are seeking:• Access to a dependable and predictable private capital partner• Increased capital to leverage existing cost base required to serve the SME space• Assistance with the T.A. needs of the high-impact entrepreneur• MBO exit financing• Ability to re-circulate committed capital

SMEs are seeking:• Access to appropriate and affordable capital• Access to more technical assistance to help improve the performance of their company• Ability to “buy back” their company equity with mezzanine debt

Scalable SME risk capital challenges

Support and

impact costs

First-loss

guarantees andhedges

$

Financial

Returns; social and environmental

impact reporting

Social and environmental impact

Buy

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edic

tabl

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Portfolio investments

TriLinc Global SME Social Impact Fund

Low-interestleverage

Analysis, Structuring & PortfolioMonitoring

AggregatedLoans

$

Latin Americaspecial purpose

vehicle

Eastern Europespecial purpose

vehicle

Africa specialpurpose vehicle

TriLinc CapitalManagement

New private capital through intermediaries to SMEhigh-impact entrepreneurs

Scalable SME risk capital solution

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Sr. &

MezzanineDebt

Tranches:

High-Yield

Tranche:

LocalInstitutional

Investors

ForeignInstitutionalInvestors

TLG orThird-PartyInvestors

Bonds

$

Bonds

$

SOCIAL IMPACT BONDS