What more private investment means for UK aid

The National Cement Share Company in Ethiopia built a new factory with the help of U.K. development investments through the Commonwealth Development Corp. Photo by: Gavin Houtheusen / DfID / CC BY

Parliament will vote in early January on whether to pave the way for quadrupling the budget of the U.K. government’s development finance institution, formerly known as the Commonwealth Development Corp.

While development experts and economists generally support the move, many are raising concerns as to whether CDC, which already saw a 100 percent budget increase only last year, will be able to manage more cash.

The new legislation would increase the amount of money the U.K. Department for International Development can invest in the CDC from 1.5 billion pounds ($1.87 billion) to 6 billion pounds. It would also allow DfID to increase the ceiling again to 12 billion pounds at a later date without another vote in Parliament.

The strategy aligns with recent pledges in DfID’s recent bilateral and multilateral aid reviews to make greater use of the CDC and to more broadly use aid to enhance trade outcomes.

The move fits a broader trend among major donors shifting official development assistance to their private investment arms, many of which have expanded their development finance institutions on a much larger scale than the proposed increase from DfID.

On average, instruments such as the U.S.’s Overseas Private Investment Corp. and the World Bank’s International Finance Corp. provide a return on their investments, allowing governments to more easily make a case for their operations.

In this case, however, the funds would come from DfID’s existing budget, leaving some in the aid community worried that new CDC investments will mean a temporary but potentially destructive cut to DfID’s current development operations.

Questions are also emerging about how an institution that saw its budget doubled only last year can shoulder the funds. The U.K.’s National Audit Office has previously criticized the CDC for failing to demonstrate concrete impact with its investments within typical development timeframes.

The CDC, however, says it is ready — and that investment will only come as quickly as credible projects emerge, and after a thorough business case is made its sole shareholder, DfID. CDC will release its investment strategy for 2017-2020 early next year, Lynsay Taffe, spokesperson for the CDC told Devex. The document is under pressure from MPs to address concerns about CDC’s plans to improve accountability.

“There’s no discussion going on between us and government going, for example, ‘so we’re going to get 4.5 billion in the next spending round,’ I can’t say that won’t happen, but it’s the same chance of us getting zero,” Taffe told Devex. “But we are aware government is keen for us to play a greater role in its economic development plans.”

Leveraging the market

DfID’s recapitalization last year came with a few strings: CDC narrowed its remit to sub-Saharan Africa and South Asia in the hopes of engaging more at-risk markets and creating this highest impact in the poorest places through its equity and debt financing.

DfID allocates funding to CDC in tranches, releasing funds when investment plans and targeted investees are approved by the donor. The budget increase would therefore be the equivalent of raising the institution’s credit limit.

Taffe compared the recapitalization to a mortgage: It gives the buyer an idea of how much she can spend on a house, allow her to go out and have conversations, but the money isn’t in hand until she chooses the right property.

Even if the CDC receives a new capitalization in the current spending round, “it was always clear, both through CDC and [DfID] that no new money would come through CDC without a full business case,” she told Devex.

The idea of a more powerful CDC emerged in 2012, when CDC increased its appetite for risk by reducing the target return on investment. CDC also incorporated new instruments, such as equity and debt financing. DfID was “satisfied” with the reforms, Taffe said, and so the agency invested in the CDC for the first time in 20 years to the tune of 735 million pounds’ worth of equity, maxing out the CDC’s previous cap of 1.5 billion pounds.

“In our discussions with government since 2012 when we set the new strategy, the government was saying, if this goes well, and this strategy works in the way we want it to, there is a chance we’d want to invest more in CDC,” Taffe told Devex.

Aware the government was considering further investments, she said CDC “did lots of scenario forecasting on things like, what’s the demand for investments in the geographies we invest in? Are the skills and expertise and the value that CDC brings wanted where we invest? And is CDC set up well enough to deliver the development priorities for the government?”

Gaming out how much CDC could spend with its current administrative and staff capacity, Taffe said they found an upper limit: by their estimations, CDC could handle up to 4.5 billion pounds more than their current 1.5 billion pound cap. DfID then drew up the legislation, which will receive its third and final reading on Jan. 10.

If the bill passes, CDC has been given no guarantees about how much, if any, money it will receive, according to Taffe. CDC can only access funds by submitting an investment plan to DfID, who then offers input on proposed investments. Only when DfID approves can CDC can begin the investment process.

The process can take a while. For example, CDC was only able to withdraw the first funds from last year’s 735 million pound investment “a couple of weeks ago, so we haven’t actually spent it yet.” Taffe told Devex.

Particularly with equity investments, in which the CDC buys part of the company, “the process of finding the right investment can take up to two years,” she said, “because you have to know them, you’re going into business with these people.”

Par for the course

Many criticize the proposed bump to the CDC precisely for the care it and other DFIs must take when seeking out investments.

In order to invest, DFIs must choose businesses that meet a range of criteria, most notably a balanced level of risk: high enough across the portfolio to create impact and reduce poverty in regions many other investors would avoid and yet low enough to ensure an overall return on investment. CDC’s portfolio of investments averages a 7.5 percent return

Longer investment cycles mean impact takes longer to measure. CDC’s investment model also moves through a series of funds, rendering the money more difficult to track than typical aid interventions.

“I’m worried if they have the capacity to absorb that kind of money, and how will they make sure that they use it well, because that’s a huge growth projection for any organization to go through.” Amy Dodd, head of the U.K. Aid Network told Devex.

Even if all the money is made available to the CDC at once, Taffe said there are currently no plans to increase the CDC’s current 220 staff, except for “maybe some additional people in-country,” Taffe said.

Some CDC projects — shopping centers and luxury condominiums — also don’t create impact in the way aid professionals are used to seeing it.

Compared with traditional development projects, CDC investments are “not intended to directly benefit a well-defined group, in a fashion that would be relatively straightforward to estimate,” Willem te Velde and Paddy Carter from the Overseas Development Institute write in their evidence submission to Parliament. Impacts are instead “felt across an economy, and may emerge slowly and in a nonlinear fashion.”

The pair favor gradually scaling up any new investments in the CDC, unless it’s able to identify “large-scale transformational projects.”

“If CDC is put under pressure to take large sums,” they said, “that will raise the risk of making investments that are not merited on developmental grounds or may lead to idle funds.”

A risky investment

Any increase to the CDC will come from the UK aid budget. Whether DfID gives the CDC 4.5 billion in this spending round or metes it out over the four years left in the current Parliament, DfID must divert money from current aid programs in order to increase its investment in the CDC. Critics are divided about which scenario is better for sustainable development: a one-off deposit, cutting the current 13 billion pound aid portfolio almost in half for one year, or a sustained four-year cut of 1.2 billion pounds per year.

That cut to traditional aid is alarming to some advocates. CDC funds come with an “opportunity cost,” Dodd said. “We can do other things with that money. So we have to be able to show with the CDC that it not only produces results, that it produces equal or better results in the long-term or the short-term or whatever than some of the more traditional aid.”

Owen Barder, Europe director at the Center for Global Development, suggested a one-off increase in the aid budget to compensate for the investment.

“The apparent trade-off between investing in CDC and spending on other forms of ODA is entirely self-inflicted,” he wrote in his evidence submission to Parliament. He explained that an investment in CDC “in the long run is likely to improve the nation’s balance sheet (because CDC obtains a positive overall return on its investments),” so he argued that the Treasury should allow an “exceptional increase in ODA in the year such an investment is made, so that other ODA programs do not have to be temporarily lower to finance the investment.”

His proposal, however, would be a hard sell; national media frequently lampoons aid spending and makes perennial calls for repealing the U.K. government’s commitment to spend 0.7 percent of gross national income on aid.

A taxing enterprise

After its release “early next year,” MPs will be scouring CDC’s investment strategy for evidence that the facility can achieve DfID’s goals of reducing poverty while upholding the agency’s standards for transparency and value for money.

Critics of the CDC and other DFIs will look for plans to expand impact evaluation and clarify the CDC’s use of intermediary funds and institutions.

“Based on my discussions with CDC, I know they’re in the process of developing a task risk assessment tool,” Matti Kohonen, principal adviser on the private sector for Christian Aid told Devex. “They’re trying to make more out of this area, but they’re really not the frontrunner [among DFIs].”

One of the ways the CDC measures impact is by the amount of tax paid by its investees, “but they’re not doing proactive risk assessment or proactive impact assessment on their portfolio, which I would see as a higher standard,” Kohonen told Devex.

Tax havens are another hot button issue. CDC currently uses financial jurisdictions such as Mauritius and the British Virgin Islands to handle financial transactions, encouraging investees with growing businesses to do the same, in order to bypass potentially less secure institutions in the investees’ country or region.

The CDC says that the contexts in which it works simply cannot offer the financial stability needed for its level of investment. Giving independent testimony during an evidence session, economist Sir Paul Collier told MPs the use of overseas tax jurisdictions “has a triple function: sometimes it is a tax haven, which is bad; sometimes it is a secrecy haven for banking, which is worse; and sometimes it is a neutral administrative centre for a lot of third-party investments,” he said, suggesting the CDC falls into the latter, ostensibly less nefarious category.

“If a company from the Middle East wants to invest, along with a company from India and a company from Singapore, along with CDC, they try to find a neutral territory.”

Kohonen and other critics, however, argue that the CDC’s geographic focus on South Asia and sub-Saharan Africa provide an opportunity to work on improving in-country financial institutions, rather than using and encouraging its investees to use offshore jurisdictions.

Small comforts

A fully scaled-up CDC could, if only temporarily, mean a loss of business for DfID’s traditional development partners as ODA is converted into CDC’s capital. But Taffe and others said that growth at the CDC could in the longer term create more space for the DFI to partner with traditional aid players on impact evaluation, social and environmental standard-setting, technical assistance and advocacy.

CDC already works with some NGOs in-country on these issues, and collaboration “is something we might look to do more of,” Taffe said. “We are trying to look at other ways we can deliver investments into those countries and looking at other partners,” she said.

Asked how she envisioned development partners engaging with CDC in its increased capacity, Dodd said she doesn’t expect to see much of a role for traditional aid organizations. “I see the role more as, particularly with the huge amount of money going in, accountability and scrutiny, both here and in-country.”

Still, the growth of DFIs means a shift in the traditional development landscape may be inevitable. Finland, Spain, Belgium, Switzerland, France and others all recapitalized their DFIs in 2015, some spurred by the calls from the U.N. to leverage aid into private sector investment in order to reach the more than $2.5 trillion needed to achieve the Sustainable Development Goals.

Increasingly, sustainable development craves a return on its investment.

For more U.K. news, views and analysis visit the Future of DfID series page, follow @devex on Twitter and tweet using the hashtag #FutureofDfID.

About the author

  • Molly Anders

    Molly Anders is a former U.K. correspondent for Devex. Based in London, she reports on development finance trends with a focus on British and European institutions. She is especially interested in evidence-based development and women’s economic empowerment, as well as innovative financing for the protection of migrants and refugees. Molly is a former Fulbright Scholar and studied Arabic in Syria, Jordan, Egypt and Morocco.