Opinion: Here's how private equity investment can work for development

As we prepared for last week’s U.K.-Africa Investment Summit, we discovered something: CDC, the U.K.’s development finance institution, accounts for about 10% of the money raised by private equity funds for investment in Africa, according to data from AVCA. We think that makes us the largest private equity investor on the continent.

It is something we are very proud of. Not everybody feels the same way. Some development campaigners would stop the CDC from investing through private equity funds because, they argue, it’s not good for development. Who’s right?

In rich countries, there are fears that the financial sector has grown too large. Private equity funds are known for leveraged buyouts and other practices of debatable social value. The presidential race in the United States has raised the profile of such concerns, with Sen. Elizabeth Warren’s Stop Wall Street Looting Act responding to high-profile cases such as the demise of retailer Toys R Us, in which the fund managers profited despite the business collapsing.

The investment funds that CDC supports are a world away from that. What we do, and what the funds that we invest through do, is provide funds for growth. It’s not about buying out existing shareholders and loading businesses with debt. It’s about putting fresh money into companies to finance new investments in the real economy. One caveat is that CDC and the fund managers we support will sometimes make acquisitions. But we want to create value through growing businesses, not extract value through financial engineering.

The reason that we delegate investment to external fund managers rather than only invest directly is that we can reach more small businesses in a more cost-effective manner by supporting local teams of investors than we could by trying to do that centrally.

That segment of the market is especially important for development. Inequality is very high in many of the countries where we invest, and markets are often dominated by a small number of companies with too much market power. That is a recipe for high prices and low growth. Competition from new entrants can improve that situation. New entrants need patient investors willing to tolerate risk.

Other reasons that equity is an especially important form of development finance might be less widely appreciated. Many people worry about capital flows into lower-income countries creating the risk of a financial crisis. But equity brings stability, not fragility. When a business runs into bad times, it can stop paying dividends to equity investors, but lenders still want their money and will sometimes wind up a business to get it. Crises happen when short-term lenders try to take their money and run, but the only way an equity investor can exit is by finding someone who wants to buy.

Equity is also risk-absorbing, so it allows companies to pursue riskier, higher-growth strategies. Microfinance has not resulted in borrowers growing their businesses to the extent that people once hoped because — among other reasons — if you must start making loan repayments almost immediately, you cannot take a punt on longer-term investments that might not pay off. The same goes for larger businesses. The importance of the venture capital industry for enabling higher-risk investments is well-documented, although much of the evidence comes from rich countries where researchers can access more data.

More subtle mechanisms could be at work, too. For example, the economist Alessandra Peter has found that countries more reliant on debt tend to have higher inequality. Peter suggests that when outside equity is harder to find, bank-financed family dynasties are more common. Access to equity, meanwhile, allows entrepreneurs to sell down their holdings and diversifies ownership. In less-developed countries, more liquid stock markets are associated with lower inequality and poverty.

The data even suggests that countries with more equity finance have lower carbon emissions. Equity markets seem to reallocate capital toward greener activities, and credit markets toward dirtier. The authors of that study suggest that equity is more suitable for riskier green investments and that equity investors take a longer-term view than lenders, which makes them more concerned with sustainability.

So there are lots of reasons why people who care about development ought to care about equity. Admittedly, it is hard to provide empirical evidence that directly connects private equity investments to poverty reduction. One may show that the two tend to go together, but disentangling correlation from causation among a small sample of countries where many things are occurring simultaneously is terrifically difficult.

A final reason why we invest through funds is that we are trying to nurture a responsible local financial sector so that domestic savings — pension funds and sovereign wealth funds — can be invested to benefit domestic economies. We support first-time fund managers until they have established a track record and can raise funds without us.

So hopefully, rather than celebrating how important we are to the African private equity industry, we will one day be celebrating the opposite.