By Alberto Bernardini, Sustainable Finance Director, GreenWave
This blog is part of a series on tackling COVID-19 in developing countries. Visit the OECD dedicated page to access the OECD’s data, analysis and recommendations on the health, economic, financial and societal impacts of COVID-19 worldwide.
Private investment in sustainable development has been on the rise in recent years. Impact investments differ from traditional investments as they aim to generate positive, measurable impacts on society and on the environment, in addition to being financially profitable. According to the Global Impact Investing Network’s (GIIN) annual impact investor survey, close to 300 impact investors worldwide collectively managed USD 404 billion of impact investment assets in 2019. This is almost double the USD 228 billion worth of assets under management by 200 impact investors in 2017. Moreover, the rapidly growing impact investment market could provide the capital needed to address the world’s most pressing challenges in areas like sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services such as housing, healthcare, and education.
Developing countries needs in these areas were high before the pandemic. In 2019, 690 million people were undernourished; 789 million people did not have access to electricity and 5.3 million children died before reaching the age of five. The pandemic has increased and accelerated these needs: according to the World Bank, COVID-19 could generate 176 million additional poor people surviving on $3.20 a day and an additional 177 million people on $5.50 a day. Additionally, many services like micro credit, access to electricity and access to education have suffered due to the inability of low-income people to afford them. Every industry has suffered differently, with transportation and tourism affected the most in terms of future recovery prospects. Logistics is another industry in need of deep transformation. Kenya’s flower exporters, heavily dependent on foreign demand, sell 70 percent of their flowers to Europe, which represents 1% of the country’s GDP. With restrictions on international flights and on gatherings such as weddings, demand for flowers has fallen dramatically. Companies in this sector have had to re-invent themselves by pushing delivery services and sales to grocery stores, cutting salaries, lowering prices and purchasing fertilizer in advance. In this context, impact investment is vital to help companies retain jobs and shift their business models.
Challenges to the private sector have been alleviated, at least temporarily, through public recovery packages in support of firms and workers. However, public support has varied in magnitude across countries, the EU launched a €750 billion recovery plan and the US matched it with a $1 trillion recovery plan. Developing countries also launched their own plans, for example the Coronavirus Alleviation Programme in Ghana, providing soft loans to micro, small and medium enterprises and paying all Ghanaians’ water bills over 3 months. Although these programmes are critical and represent large shares of government budgets, they are less substantial and inclusive compared to those of developed regions. Impact investment can also play a role here in closing the gap in areas where investment and support is still needed.
Even though investment needs are growing, most impact funds have interrupted investing in new companies and are focused on supporting their current portfolio. The main financial support tools that impact funds have provided their investees are follow-up investments by matching requirements with financial instruments, and debt payment holidays for companies running low on liquidity. In general, the companies most in need of financial support are small companies and start-ups with limited cash runway to keep operations running and limited revenue streams. New initiatives have been launched to support companies at risk of disappearing. Examples include Acumen’s energy relief fund that supports energy access companies, and a new financing initiative launched by ResponsAbility and eight other impact funds to support microfinance and small medium enterprise finance institutions. Non-financial support provided by investors has taken the form of assistance in internal reporting activities, governance – by providing strategy direction – and through introductions to new investors (including soft money) and potential commercial partners to diversify revenue streams.
According to the International Finance Corporation, the average fund size in a developed market is of $472 million and an average fund size focusing on Africa is of $142 million. Smaller fund sizes lead to a series of issues that prevent impact investors from providing the patient capital that the business environment requires and that could ultimately serve the lowest income populations. Private investments in developing regions also require fund managers to step out of their conventional role and act as business consultants, closely accompanying companies’ growth. The smaller size of these funds, and the fact that most have their physical headquarters in developed countries, also mean the following:
· Lower management fees and therefore limited liquidity
· Smaller teams and hiring of less experienced fund managers
· Limited number of investments
· Less risk taken and investments in the “usual suspects”
Close to half of smaller funds are based in the U.S. Geographical concentration of these funds also has its shortcomings:
· Inability to make the best informed decisions
· Inability to easily shift a funds’ strategy
· Missing out on local opportunities
· Limited liquidity for follow-up or new investments
The total assets of private impact funds in 2019 were $415 billion of which 30% targeted emerging markets. This is still far from the $2.5 trillion annual spending required for developing countries to reach the sustainable development goals. It also means that existing investments target the lowest hanging apples. With impact investments increasingly going to developing countries, and if most funds continue to base themselves abroad, competition will rise for the same investment opportunities. This will pull market returns and in turn financial instrument pricing, even further below the market rate, losing all attractiveness.
This crisis will eventually set the more resilient business ventures apart from the rest. This also means the actual value of businesses will be better reflected as a result of the pandemic. The crisis has highlighted a number of learning points that could help both policy makers and private investors take several courses of action to improve impact investment directed at developing regions. From a managerial perspective, the way investments will be made and managed will differ: investees’ cash management will become more important, potentially requiring cash reserves; investments will be made more diligently and selectively, with further emphasis on inclusivity and how they benefit local communities; and there will be more focus on board composition. From a structural perspective, funds need to establish themselves locally and regionally to better identify investment opportunities; bigger funds with longer mandates and more funds providing blended finance solutions are needed; and overall they need to increase their alignment with country priorities.
In short, to exit the current crisis and respond to the rising pressures of climate and green finance, business ventures need to become more resilient and impact funds more effective. Liquidity is an issue for both sides and is leading to further emphasis on cash management and stricter due diligence. Lockdowns have highlighted why geographical proximity is critical and should not be an issue of convenience but a question of strategic and business rationale.