Exploring DFI Investments inSME Funds

Prepared by Henry Gonzalez and Senayit Mesfin

November 2012

Outline

• Background and Introduction

• Main Sectors and Regions

• Development Objectives and Indicators

• Fund Selection and Investment Decisions

• Performance and Exits

• Conclusion

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Background and Introduction

• Background: This research is a follow up to CGAP’s 2011 Small and Medium Enterprise (SME) funding scan, which identified more than 300 investment vehicles that focus on SMEs. The study estimated that public donors and investors committed at least $21.9 billion in support to small & medium enterprises as of December 2010. Some additional key conclusions included: The average SME Fund size is $42million SME Funds tend to be region specific and favor equity (26% equity only, 67% mixed

debt/equity, 7% debt only)

• Objective: The objective of this follow up study is to better understand the scope of DFIs investments into SME Funds with a focus on sector and regional exposure, investment process, performance, monitoring and impact. This study did not analyze DFI investments through financial institutions (e.g., banks or MFIs).

• Methodology and Key Resources: CGAP 2011 SME fund Database Desk research Eight in depth interviews with global and regional DFIs including: ADB, IADB-MIF, KfW,

CDC, FMO, IFC, Norfund.

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MAIN SECTORS AND REGIONS

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Region/Country Focus

• Based on the 2011 CGAP SME funding scan, almost half of the SME investments go into Sub-Saharan Africa and South Asia (See figure below)

• DFIs with larger SME portfolios that are active globally, mostly invest in matured SMEs based in larger countries such as China, South Africa, Nigeria, Kenya and Brazil. However, there are recent trends of SME funds being promoted in “frontier markets” like Ethiopia and Zimbabwe.

• Several DFIs are regionally constrained based on their nature (IADB, ADB); while other have niche strategies and limit their exposure to a few countries or regions:

Norfund: East/Southern Africa, Central America, Mekong countries (Vietnam, Laos, Cambodia) plus Bangladesh

CDC: South Asia and Africa 5

(24%)

(22%)(15%)

Key Sectors

• While investments are diversified, popular sectors include: simple manufacturing, services, financial institutions. New trends include agri-business and renewable energy.

“Popular sectors include: manufacturing and retail as well as agribusiness, forestry and some is being done in renewables too”.

• However, most public investors are “sector agnostic” conditional that there is commercial viability and development impact (e.g., women- owned SMEs, clean energy and production, as well as other areas within the so-called “Bottom of the Pyramid” (BoP)”).

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DEVELOPMENT OBJECTIVES AND INDICATORS

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Why do DFIs invest in SME Funds?

• The main objective for supporting SMEs cited by most DFIs was to accelerate growth, economic development and job creation.

• Some DFIs also mentioned the need to be “additional” beyond just providing capital, to facilitate the development of a private equity and venture capital industry.

“Our mandate is to develop a venture capital industry led by regional managers who invest in local companies, which can lead globally.”

“What is clear is that the DFI community is being challenged to justify our existence. We need to prove that we serve a role beyond the private capital, we should not shy away from frontier markets and we must be at the forefront of providing the risk capital needed. If this is not done, and DFIs behave pretty much as other private equity houses; then our existence will be rightly challenged.”

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How DFIs Assess Developmental Objectives

• SME Funds supported by DFIs do not collect and define impact indicators in a systematic way that would allow for suitable comparison.

• DFIs interviewed mentioned the following indicators as the most commonly tracked: job creation, women employment, rural clients coverage, annual sales, transfer of knowledge and technology, governance structures, diversification of source of capital, portfolio quality (NPL/PAR).

• Examples of tracking impact: IFC tracks development impact of SME investments through a formal system of reporting

such as ESG reports as well as a Development Matrix. ADB uses baseline indicators when they enter investments and they measure them after

exiting. They request annual reports from fund managers. CDC tracks impact at the portfolio company (jobs created, revenue, EBITDA) and at the

Fund level. CDC tracks funds at 5 years and again at 10 years looking at financial, economic, ESG and private sector development (PSD) indicators.

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FUNDS SELECTION AND INVESTMENT DECISIONS

DFIs Have Similar Fund Selection Criteria

• Criteria for SME fund selection is shared by most DFIs, some key aspects include: Regulatory framework of the local market, corporate governance of the Fund, management

capacity, experience and track record of the General Partner, staffing and internal controls, strategic planning, SME area of focus, financial policies and procedures, governance and environmental aspects, risk management, monitoring, responsible finance, over-indebtedness, consumer lending, operations review, sources of finance, financial analysis, profitability.

• For most DFIs, the criteria for due diligence applies to any private equity (PE) transaction, SME related or not, and it includes assessments of: Skills of the team, relationship in their local markets and sectors, industry experience in

operating assets, especially if they take control or significant control, solid investment process, ability to exit deals, etc.

Policies related to transparency and integrity as well as ESG standards

• Examples: “When selecting Funds, we aim to play a catalytic role “typically investing in Funds that are

early stage and venture like.” “Our due diligence process includes a mix of profitability and non financial criteria linked to

development indicators such as job creation, gender, increase and improvement of living standards for SME owners and employees”.

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Different Investment Approaches

• Some DFIs prefer to concentrate in getting the best investment policy possible from the “start” and delegate decisions to fund managers.

• DFIs also sponsor the establishment of funds, capital mobilization, or provision of facilities for grants linked to Technical Assistance (TA).

Norfund runs a grant facility that can be used for TA assistance for Funds to use with their underlying investees.

• DFIs involved in setting up funds often have significant shareholder representation and tend to be more involved with strategy (as members of the board).

• Some DFIs participate in advisory committees with oversight roles. CDC is not sitting on boards or investment committees, but rather on advisory boards.

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Main Funding Instruments

• The split of debt vs. equity vary by type of DFI investments into SMEs (financial institutions vs. Funds) Examples: KfW: For financial institutions/banks they invest in both equity and debt; for the case of

funds they mainly invest equity ADB only does equity for funds, however when doing direct investing its mainly debt IFC does not tend to invest debt in their traditional SME funds, but do sometimes allow a

few creditors to come onboard with debt, but then converting them into equity holders.

• DFIs investing in funds could provide bridge loans that are linked to equity positions and are done for a short period of time.

• At the Fund level, those that target smaller companies mainly invest debt, and provide equity investments for larger firms.

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PERFORMANCE AND EXITSRETURNS & STRATEGIES

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Performance: Lack of Transparency on Return Information

• Most DFIs do not disclose transparent data on realized returns- often providing anecdotal examples.

• Initial findings reveal financial returns were not as optimistic as expected. However, figures vary by country, and by vintage within the same asset manager.

• There is a focus on meeting profitability targets, in addition to general development objectives.

• Several DFIs are currently carrying out external assessments on their portfolios (i.e. FMO and MIF/IADB).

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Exit Strategies Vary

• DFIs are mostly comfortable locking in their capital for 8-10 years with Funds and rely on Fund managers to decide exits as part of their autonomous investment strategy: Several DFIs prefer secondary transactions via strategic sales to other private

sector investors with same investment approach. Many DFIs have not had any exits yet since the funds are only between 5-7 years

and will be there for 8 or 10

• Initial conclusions indicate Funds took longer in deploying capital leading to extended investment periods than initially hoped.

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Conclusion

•DFIs role ranges from those investing in the smaller-side of the SME spectrum to those that favor the larger-end of the investment options closer to mainstream PE investors.

•Transparency and reporting on SME Fund performance lags behind.

•All DFIs have established indicators to track the impact of their investments; however, definitions and approaches vary widely making it difficult to have benchmarks.

•Some DFIs are revisiting their strategies, especially around their developmental role; exploring to focus more on early stage funds, frontier markets and on small and growing businesses.

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