economic development

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.

Economics as if people mattered

schumacher small is beautiful

What took me so long to read “Small is Beautiful: Economics as if People Mattered”, by E. F. Schumacher? This 1973 classic was never introduced to me during my education in economics, but I finally got to it. While undeniably but delightfully utopian, very few books go so deep in the attempt to completely reformulate the way economics is studied and practiced.

Some of the most current issues in the economic debate, especially since the 2008 crisis, such as the status of the economic “science” and its quantitative methods, the treatment of the environment, and the questioning of the “homo-econonomicus”, were eloquently raised by Schumacher over 40 years ago. Other issues, in fact, are even more fundamental in nature, and may only be discussed today in places like the New School or the Institute for New Economic Thinking.

My original intent was to dismember the book and develop linkages to current economic theory and practice. However, I’ll step back and let the man speak for himself and the reader be the judge. Below, I list my favorite Schumacher quotes:

The ownership and the consumption of goods is a means to an end […] Modern economics, on the other hand, considers consumption to be the sole end and purpose of all economic activity, taking the factors of production—labor and capital—as the means. [Instead of] maximize human satisfactions by the optimal pattern of consumption, [it] tries to maximize consumption by the optimal pattern of productive effort.

The modern economist […] is used to measuring the “standard of living” by the amount of annual consumption, assuming all the time that a man who consumes more is “better off” than a man who consumes less. A Buddhist economist would consider this approach excessively irrational: since consumption is merely a means to human well-being, the aim should be to obtain the maximum of well-being with the minimum of consumption.

Economic development is something much wider and deeper than economics, let alone econometrics. Its roots lie outside the economic sphere, in education, organization, discipline and, beyond that, in political independence and a national consciousness of self-reliance.

An ounce of practice is generally worth more than a ton of theory.

It is doubly chimerical to build peace on economic foundations which, in turn, rest on the systematic cultivation of greed and envy, the very forces which drive men into conflict.

The cultivation and expansion of needs is the antithesis of wisdom. It is also the antithesis of freedom and peace. Every increase of needs tends to increase one’s dependence on outside forces over which one cannot have control, and therefore increases existential fear. Only by a reduction of needs can one promote a genuine reduction in those tensions which are the ultimate causes of strife and war.

Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius — and a lot of courage — to move in the opposite direction.

From the point of view of the employer, [work] is in any case simply an item of cost, to be reduced to a minimum if it cannot be eliminated altogether, say, by automation. From the point of view of the workman, it is a ‘disutility’; to work is to make a sacrifice of one’s leisure and comfort, and wages are a kind of compensation for the sacrifice. From a Buddhist point of view, this is standing the truth on its head by considering goods as more important than people and consumption as more important than creative activity. It means shifting the emphasis from the worker to the product of work, that is, from the human to the sub-human, surrender to the forces of evil. […] The function of work [should] be at least threefold: “to give a man a chance to utilize and develop his faculties; to enable him to overcome his egocentredness by joining with other people in a common task; and to bring forth the goods and services needed for a becoming existence.

That soul-destroying, meaningless, mechanical, monotonous, moronic work is an insult to human nature which must necessarily and inevitable produce either escapism or aggression, and that no amount of “bread and circuses” can compensate for the damage done—these are facts which are neither denied nor acknowledged but are met with an unbreakable conspiracy of silence—because to deny them would be too obviously absurd and to acknowledge them would condemn the central preoccupation of modern society.

Ever bigger machines, entailing ever bigger concentrations of economic power and exerting ever greater violence against the environment, do not represent progress: they are a denial of wisdom. Wisdom demands a new orientation of science and technology towards the organic, the gentle, the non-violent, the elegant and beautiful.

Education which fails to clarify our central convictions is mere training or indulgence. For it is our central convictions that are in disorder, and, as long as the present anti-metaphysical temper persists, the disorder will grow worse. Education, far from ranking as man’s greatest resource, will then be an agent of destruction.

Modern man does not experience himself as a part of nature but as an outside force destined to dominate and conquer it. He even talks of a battle with nature, forgetting that, if he won the battle, he would find himself on the losing side.

An attitude to life which seeks fulfillment in the single-minded pursuit of wealth – in short, materialism – does not fit into this world, because it contains within itself no limiting principle, while the environment in which it is placed is strictly limited.

Don’t you feel like changing the world right now?

Andre A. is an economist and entrepreneur. Photograph: www.schumachercollege.org.uk

Entrepreneurship, Innovation and Prosperity

entrepreneurship innovation prosperity economic growth

Entrepreneurship and economic development

What is the common ground between the economic prosperity of the Netherlands in the XVII-XVIII centuries, nineteenth century England, twentieth century U.S. and, more recently, countries such as South Korea, Singapore and Israel? Although the question could be answered from different angles, fundamentally it can be inferred: in their own time, these countries promoted economic systems where resources were efficiently channeled to the most competent entrepreneurs and endeavors.

Canadian economist Reuven Brenner summed it up perfectly: “Prosperity is the result of matching talent with capital and holding both sides accountable”. The “capital” can come from one or more sources: capital markets, government, savings or inheritance. The “talent” may be fostered internally – through education, incentives for innovation and entrepreneurship, development of a risk-taking culture – and/or imported, with the opening of borders to skilled and entrepreneurial immigrants. Finally, “accountability” is constructed through solid institutions (political, economic, regulatory, legal, social) that promote a stable business environment, where contracts are honored and a long-term perspective is installed.

Back in time, on entrepreneurship and prosperity

In the XVII-XVIII centuries, the Netherlands had the most developed capital market in the world. It operated the forefront of financial instruments, both debt and equity, which enabled people and companies with good business ideas to grow their ventures. Therefore, at a time when most societies were divided essentially into castes – with royalty, nobility and aristocracy keeping their wealth generation after generation – the Dutch popularized the access to capital and implemented a socioeconomic system that was (by the time’s standards) more democratic and meritocratic. Moreover, in addition to having effective institutions, it opened its doors to immigrants from diverse backgrounds, welcoming for example Spanish Jews and French Huguenots, who brought innovations from their countries and who, by definition, were mostly entrepreneurs (what is more enterprising than venturing oneself into a new country?)

A century later, England became the engine of the Industrial Revolution within the same logic: capital-talent-institutions. Innovations, both technological (e.g., steam engines) and of process (e.g., revolutionary management techniques) were only possible due to an economic system where risk was properly rewarded and the process of trial and error was stimulated. In the second half of the twentieth century, the United States, in turn, established itself as the major economic superpower based on: capital (Wall Street, Silicon Valley and its angel investors and VC/PE funds, R&D subsidies); talent (Americans and immigrants educated in universities such as Stanford, Harvard and MIT); and institutional climate (pro-business laws, efficient legal system, overall social fabric etc.)

Immigration was especially important in the U.S. As proof, 40% of Fortune 500 companies were founded by immigrants or their children, including giants such as Intel, Google, eBay, Apple and GE. Furthermore, ¾ of patents developed in American universities had the participation of immigrants. It is no wonder that immigration reform is constantly brought up within the debate for promoting American competitiveness and sustained economic growth.

Recently, the most successful cases of economic development were the Asian Tigers. The political, economic and institutional reforms that occurred in these countries, combined with investment in education and the development of capital markets, enabled a flurry of investments and skilled immigration, driving the growth and development of these countries. Another interesting case is Israel, a nation created just over half a century ago, in the middle of the desert, and that thrives due to skilled immigration and education, dynamic access to capital (private and public), a culture conducive to risk taking, and solid institutions.

Traditionally, the quest for prosperity has been driven by top-down policies, often based on unrealistic economic models. Looking at economies through the lenses of “capital-talent-accountability” gives us a clearer view of the issues at hand, from the bottom up. It provides better grounds for understanding the underlying factors that build an economy and allows for more factual and entrepreneurship-friendly policy making.

Andre Averbug is an entrepreneur and economist.

See also An Idea Is Just That – Not Yet An InnovationImage: source unknown (anyone?)

What’s your opinion about the link between entrepreneurship and prosperity? Leave us a comment!