DFI

Development finance institutions and private sector innovation

innovation development dfi

Post originally published on IDB’s Sustainable Business blog.

Development finance institutions (DFIs) can play an important role promoting innovation for increased competitiveness and sustained development in their client countries. Properly executed programs and projects can leverage private investment placement, develop local capital markets, improve resource allocation, as well as avoid moral hazard.

As laid out in the document “MDB Principles to Support Private Sector Operations,” endorsed by the heads of multilateral development development banks (MDBs), private sector operations should seek to include: (i) additionality; (ii) crowding-in; (iii) commercial sustainability; (iv) reinforcing – and avoiding distorting – markets; and (v) promoting high standards in governance and conduct. More details can be found here.

With this in mind, there are three types of interventions that work particularly well because of their intrinsic role in crowding-in private investments; providing additionality to high-impact businesses; and planting the seeds for continuous innovation.

1. Catalytic first-loss capital (CFLC)

This form of financing occurs when the financier takes on more risk than other investors by providing concessional equity, debt, grant or guarantees that lower the level of risk for other investors. This form of blended finance has been carried out by select DFIs since the late 1990s and has gained momentum in the past decade, especially with the growing presence of impact investors and large donors working with DFIs. One example is the Clean Technology Fund (CTF), which provides concessional funding for large low-carbon energy projects through multilaterals, including the IDB.

CFLC provides credit enhancement and mobilizes more risk-averse sources of capital. It supports innovation by financing projects otherwise difficult to finance and by leveraging complementary investments, typically at a rate of 4 times – often, significantly more. To illustrate this, $6.1 billion is allocated under the CTF for 134 projects and programs, expecting total co-financing of $51 billion from other sources. The approach supports projects of different sizes, from large geothermal plants to social entrepreneurship interventions.

CFLC adds the most value when it is part of a long-term strategy of continuous crowding-in of private investors – such as private equity funds and commercial banks – and phasing-out of the concessional funding. By supporting innovative (and often risky) projects, it generates significant demonstration effects, lessons learned, and promotes market development. Also, the very providers may participate in later rounds, directly benefiting from the initial risk taken. For example, a DFI may offer an early CFLC tranche, and then come back in a few years with a market-priced loan after the project has reached maturity and needs financing for additional growth.

2. Limited partnerships (LP) in select funds

Venture capital (VC) and private equity (PE) funds are key players in the creation of high-growth businesses and the dissemination of their innovations. In turn, impact investment funds are strategic supporters of innovations that bring about, not only financial returns, but also social and/or environmental benefits. Impact Assets showcases such funds.

Because these funds are specialized and typically operate locally, they know their markets, technologies, entrepreneurs and clients. They are better suited than DFIs to source deals and manage portfolios. Therefore, DFIs could spur innovation by increasing their presence as investors in these funds, providing technical assistance, coordination and cross-fertilization.

Understandably, DFIs worry about risk exposure and ratings. That said, efficient due diligence and strong diversification across markets, fund sizes and maturity, may well allow for a significant growth in DFI presence in this space within acceptable risks. Also, part of the funding may be mobilized through external donors, minimizing the impact on the DFI’s balance sheet.

3. Strategic support to incubators, accelerators, angels

Besides supporting larger projects and early stage businesses mature enough to receive VC/PE funding and CFLC, DFIs could pollinate the innovation ecosystem by spreading entrepreneurial seeds and fostering a change-making culture. One of the best ways to do this is to support the growth of business incubators and accelerators, as well as those who are most prone to invest in the ideas that come out of this fertile soil: angel investors.

Incubators and accelerators play an important role in the development of startups and their innovations, by providing office space, administrative support, mentorship, networking, access to capital, clients, among other advantages. Companies that are born in these platforms have much higher rates of success than lone-wolves. This type of support is especially important in developing markets, where information asymmetries and inefficiencies are high.

In this space, DFI support would come less in the form of financial resources and more in terms of technical cooperation, dissemination of knowledge and best practices and development of networks and systems. Institutions such as IDB’s Multilateral Investment Fund (MIF) and the World Bank’s infoDev work in this space.Finally, from the angel side, DFIs can promote a culture of early stage investing, for example, by supporting the creation of angel groups, business plan competitions with clear objectives, and even by providing matching grants to angel exposures (through donors, if need be).

Innovation is a broad and complex topic and one that should also involve discussions on policy, regulations, education, R&D, and the role of the public sector. That said, as far as private sector interventions go, the three described above, while by no means exhaustive, are bound to bring important progress from the bottom-up.

Andre A. is an economist and entrepreneur.

How international development organizations can help scale BOP businesses

dfi bop business

Most discussions regarding the scaling of base of the pyramid (BOP) models focus on financing the BOP companies themselves. While this is obviously very important and the way to go in the majority of cases, there are other ways development finance institutions (DFIs) could help BOP ventures scale.

My first company, PV Inova, was a BOP business in Brazil. It developed and patented a public GSM telephone that allowed low-income commuters to place cheap calls while on public transportation vehicles. We raised significant amounts of funding (equity, debt and grants) from different sources and closed partnerships with players such as Brasil Telecom, Oi Telecom, the Municipality of Porto Alegre, and Metro Rio. The venture received public support and media attention, and earned awards for social innovation and product development. However, ultimately the business did not thrive due to lack of large-scale financing. We then pivoted the company into a different business line, away from BOP.

What did I learn from this experience?

When you are in a capital intensive business (PV Inova for example demanded expensive hardware production), the conventional financing options do not necessarily work. Why? Because the BOP startup does not have the balance sheet to take on large amounts of financing, be it debt or equity. This is where there is a role for development finance institutions (DFIs).  DFIs could finance the large companies that are willing to purchase from or partner with BOP startups.

To illustrate this, I‘ll refer again to my own experience. After launching a pilot on 400 buses in partnership with Brasil Telecom in the city of Porto Alegre, PV Inova came back to the table with the telecom’s directors to negotiate the expansion of the business. Nevertheless, because margins were (by definition, as with most BOP businesses) thin and the project relatively small in the eyes of a large company, they ultimately decided not to continue to invest. They did however leave a door open in case we could come up with “interesting ways” to finance the scaling of the venture – which we couldn’t do at the time.

However, what would have happened if I had brought to the table a DFI willing to provide funding for Brasil Telecom to purchase the first large order of phones from us? This could have been the ultimate nudge, or tipping point, to make the transaction viable, representing the best of both worlds for all parties: (1) PV Inova would have been able to scale the business; (2) Brasil Telecom to finance the growth of a low-income targeted business and explore new market and branding opportunities; and (3) the DFI would have leveraged the expansion of an innovative BOP business while taking the lower risk of a large company’s balance sheet.

My experience negotiating with large companies from the “weak side” tells me that the involvement of a DFI could add real value to closing the deal. Also, risks for all parties could be manageable because, at the end of the day, the DFI should be paid back regardless of the success of the venture. Innovative and sustainable business models require innovative and sustainable financing solutions.

Andre Averbug is an entrepreneur and economist.

See also Copycat Businesses Can be Great. Photo: Reuters for The Telegraph