The growing supply and demand in respect of development financial institutions (“DFI”) has been an unusual success story in the current economic climate. In particular, the role of DFIs in the mining sector continues to grow. For commercial players, co-financing with DFIs opens up a range of opportunities in risky but lucrative developing countries. However, these countries – sometimes known as the “bottom of the pyramid” - are also where the vast majority of global poverty and inequality is found, with over four billion people who continue to live on less than US$2 per day. The project finance sector, together with its legal advisors, may unwittingly be in the business of development. It is becoming apparent that profit and poverty reduction are not, and arguably should not be, mutually exclusive. This article explores the opportunities for the commercial project finance sector to continue to partner with DFIs.
DFIs – who are they?
DFIs, although an increasingly significant player in the market, can be a relatively ambiguous term for many commercial professionals. It is a broad term that encompasses a growing range of alternative financing institutions, but all with a common mandate of providing finance to promote development and poverty reduction. The shareholders of DFIs are typically governments, although occasionally other financial institutions or organisations do hold shares. DFIs can be broadly categorised as multilateral, regional or bilateral.
- Multilateral development banks include the International Finance Corporation, a branch of the World Bank (“IFC”), the Asian Development Bank, the African Development Bank, the European Investment Bank (“EIB”) and the European Bank for Reconstruction and Development (“EBRD”). These institutions have very large memberships from both developed and developing countries. There are also a range of “multilateral financial institutions”, which are distinguished from multilateral development banks by a more limited membership and a speciality in certain forms of financing. Examples include the European Commission, Islamic Development Bank and Nordic Investment Bank.
- Regional development banks have a similar function to multilateral development banks or institutions, but with a regional focus. Shareholders usually consist of the regional countries, with additional major donor countries. Examples include the Caribbean Development Bank, the East African Development Bank and the Eurasian Development Bank.
- Bilateral development banks and agencies are set up by individual countries to finance overseas development projects, such as the CDC Group plc (UK) (“CDC”), Proparco (France), Norfund (Norway), Swedfund (Sweden) and Netherlands Development Finance Company (Netherlands).
It should be noted that there is a broader category of government backed financial institutions known as export credit agencies (“ECAs”) (for example the Export-Import Bank of the United States and the UK Export Credits Guarantee Department). ECAs are typically private or quasi governmental institutions that act as an intermediary between governments and exporters to issue export financing, frequently acting as underwriters on long term loans. ECAs provide significant funding for project finance in developing countries, which means the distinction between ECAs and DFIs can be blurred. However, ECAs have a broader mandate, namely to assist the national economy (of that ECA) by financing and insuring against loss in respect of foreign purchases of that country’s goods in circumstances where commercial lenders are unable or unwilling to accept the political or commercial risks. While this article focuses on commercial lenders’ engagement with DFIs, increasingly in emerging market deals, the involvement of an official government bank or export credit agency is becoming the norm rather than the exception.
Origins and structure
Development finance is a relatively new construct, with the World Bank established as one of the first DFIs in the 1940s in response to the financial aftermath of World War II. Most DFIs were incorporated during the late 1960s and 1970s. However, the trend has continued with the establishment of the EBRD in 1991 and Norfund in 1997. Typically, DFIs are funded by their shareholders and backed by government guarantees. With shareholders typically being sovereign states, dividends are not usually required to be paid on investments. As a result, DFIs can raise large amounts of capital with borrowings at low rates. DFIs are structured to be profit driven as the profits on investments are needed to fund ongoing engagements. For example, the CDC has not required new government funding for over 15 years, but has instead functioned on re-invested profits. Further, DFIs can be very profitable because they take higher levels of risk than commercial investors, often capitalising on the “first mover” advantage in the markets.
Types of financial products and services
Traditionally, DFIs provided relatively simple financial instruments such as grants or concessional loans (i.e. loans that are extended on terms substantially more generous than market loans, either by low interest rates or longer grace periods, or a combination of both). However, an appetite for more sophisticated products has grown rapidly and an innovative range of financial instruments are now being issued by DFIs, including equity and quasi equity instruments, guarantees and hedging instruments. In February 2013, the IFC partnered with Standard Chartered Bank as sole arranger to launch the first renminbi-denominated note. This note issuance was designed to increase the IFC’s opportunities to fund private sector development in emerging-market countries. Other alternative financial products, such as microfinance, social bonds or, on a smaller scale, peer to peer lending are on the rise. Whilst these alternative financial products may not present current opportunities for partnership with commercial lenders, they should be carefully watched by the commercial sector.
Together with principal financing functions, DFIs can also act as management consultants and technical advisors, equipped to provide a whole package of services and consultancy skills in developing countries. In an ideal world, DFIs are designed to mobilise private investment with a long term business model to do itself out of business. However, the extent to which DFIs achieve these goals are heavily debated by their critics, as discussed further below.
Benefits of development finance
As a starting point, the business of development finance is not designed to compete with the commercial finance sector. For example, the EBRD states that its loans are designed to “complement, rather than displace” private sources of finance. As a result, loans are not subsidies and debt is deliberately priced at a mark-up level that reflects genuine country and project risk, including administration costs, commission fees, structuring fees, outside counsel fees and commitment fees at market rates. There are several advantages of co-financing with a DFI lender, for both the beneficiary and other commercial lenders.
- Risk guarantees - fundamentally, a DFI is mandated to facilitate investment in high risk, unstable and poor economies. As a result risk mitigation is one of the most significant benefits of co-financing with a DFI, usually provided in a form of guarantee. These guarantees can range from “all risk” guarantee against all defaults, regardless of the cause to “partial risk”, being specific contingent guarantees covering defaults arising from specified events (e.g. export credit agency or political risks). A DFI will consider the optimum level of risk, by balancing the costs of managing elevated levels of risk with their liquidity requirements, institutional credit ratings and the cost of borrowing. As a result, these guarantees encourage commercial lenders to invest in frontier markets and high risk sectors, which they otherwise could not.
- Longer maturity – significantly for beneficiaries, development finance loans are characterised with longer maturity periods than commercial loans (typically 10 to 15 years, rather than 3 to 5 years), which can be tailored to suit the individual project. Similarly, a beneficiary can benefit from longer grace periods. Typically loans will be structured in two tranches (A and B loans), where the DFI will fund a portion of the loan (with a longer tenure), and the remaining portion will be syndicated to commercial lenders. The flexibility provided by such loans allows all parties to maximise the sources of finance available and structure the finance appropriately.
- High level of liquidity – because the majority of funds are prepaid in stock, DFIs have the opportunity to offer additional callable capital, exemptions on dividends and corporation tax. DFIs are also able to borrow at sub-LIBOR rates due to high institutional credit ratings (usually AAA due to state guarantees and income from trading in borrowings).
The benefits from co-financing flow both ways. For the project and beneficiaries, it increases the amount of resources available for funding projects. For the DFI, it engages the international debt market in sustainable trade with developing markets. For the commercial lenders, it opens up opportunities in new economies with the protection of risk guarantees and support from the DFI.
Development finance is a relatively new concept and has faced considerable criticism. Most of the publicised criticism is focussed on the approaches adopted by DFIs when formulating their policies and the choice of investment projects. The conditions for lending imposed by DFIs are sometimes accused of overstepping the line of the private sector interfering with the local governance structure. Further, criticism has been directed at what is properly categorised as a development project or where a project does not promote development aims. As a result, some DFIs expressly list what sectors they cannot fund, for example finance for defence related activities, tobacco industry, some alcohol products or standalone gambling facilities. It has also been argued that DFIs widen the inequality gap in developing nations, by funding the elite portion of society, where little to no benefits are ultimately received by the majority of the population.
Nevertheless, such issues around this complex balancing act are common place when investing in any emerging market, and are not insurmountable by any means.
Working with DFIs can present different challenges. While all commercial institutions require a thorough documentation process, DFIs have different internal processes. For example many DFIs require extensive environmental provisions (often specific to each institution), including pre screening procedures, assessments and/or audits, the development of an environmental action plan, ongoing monitoring and evaluation of projects. For some projects, DFIs will require public consultations, which may add to the timeline. Typically a DFI loan will take at least six months from initiation to signing of the project documents. However, project finance deals (particularly in emerging markets) are notoriously document heavy, and these issues can, with proper management and planning, be effectively dealt with by the parties.
Co-financing with DFIs is an interesting space to watch for commercial parties operating in emerging markets. DFIs play an important role in being the “first to enter” a market and can act as a form of catalyst in opening up investment opportunities for the private sector, providing tailored risk coverage.