Alternative Insight – April 2019

Do You DFI?


If you’re a private equity fund looking to attract DFI capital, here’s what you need to consider.

Development finance institutions (DFIs) are government-backed organisations which provide funding and, where necessary, technical assistance to private enterprise in emerging markets. They deploy capital through a variety of instruments, including long-term loans, direct equity and fund investments. The DFI sector has enjoyed spectacular growth – annual DFI commitments have risen from $12 billion (2000) to $87 billion (2017), according to a recent report from the Washington-based Center for Strategic and International Studies. So there is a lot of capital for which to compete.

Anchoring the market

DFIs are primarily tasked with funding projects that, because of their higher risk, commercial lenders and investors are unable or unwilling to back. DFIs often work together in consortia, sharing risks and information. They have a well-earned reputation for carrying out rigorous due diligence on funds and the management teams with whom they choose to place capital.

This means that DFIs often act as anchor investors for emerging market private equity funds. When they commit to a fund, it lends credibility to the management team and acts as a signal to the broader market, potentially unlocking additional capital commitments from commercial institutions. This is particularly helpful to first-time managers and for those focusing on higher risk regions like sub-Saharan Africa, who may otherwise struggle to raise money internationally.

Responsible investing

DFIs invest for profit, but they also want their investments to have a broader positive impact on host communities – for instance, creating local employment, growing supply chains, developing export industries, offering vocational training, increasing local infrastructure, facilitating technology transfer, improving corporate governance, preserving the environment, or providing goods and services that might not otherwise be readily accessible.

Infrastructure, telecoms, agriculture and financial services are longstanding target sectors for the DFI community. They are also increasing allocations to the water, sanitation, vocational education, affordable healthcare and renewable energy sectors, to better reflect human needs in their target regions, which have fast growing populations. Managers must also pay heed to DFIs’ exclusion lists: if the fund’s investment policy is broadly defined, then it will need to be married to more liberal excuse and drawstop rights for individual investors.

Think local

DFIs want to develop skills in the countries in which they invest, including in the field of investment management. GPs who can demonstrate genuine local commitment – either because they are headquartered in a target region (e.g., Africa) or have ‘boots on the ground’ (e.g., local employees in branch offices) – are likely to have a head start on firms which have neither.

The problem is not so much the unavailability of development capital, but the challenge of finding viable projects on a scale and in numbers sufficient to justify the enterprise. Many developing countries are hamstrung by informational asymmetries, shallow securities markets and deficiencies in public corporate financial reporting. This makes local knowledge and contacts integral to the search for investment opportunities.

Understand the investors

The ‘DFI’ nomenclature covers a diverse range of bodies, from multilaterals like the International Finance Corporation, to banks organised regionally (e.g., the African Development Bank) or nationally (e.g., China Development Bank), to state-owned investment firms (e.g., Britain’s CDC Group or Norfund of Norway), etc. In general, they are big institutions operating in complex, politically sensitive environments, navigating among governments, national interests, ministerial priorities and legislative scrutiny.

This has led many DFIs to foster prudential internal processes, with significant decisions requiring active due diligence, impact or compliance assessments, committee reviews and/or sign-off by senior officials. Elongated procedures of this sort can sometimes be frustrating for fund managers accustomed to turning on a dime. But to make their DFI relationships work, they will need to be patient, cooperative and understanding of the virtues of process.

ESG matters            

For most DFIs, environmental, social and governance (ESG) criteria are at the heart of sustainable, responsible investing – for example, general compliance with law, minimising environmental detriment, upholding high labour standards, and ensuring fair treatment of suppliers and other stakeholders.

The GP will be expected to adopt and implement an ESG policy that is consistent with the DFIs’ own – certainly at fund level, and (for funds which expect to acquire controlling stakes) at portfolio company level, too. It is accountable to investors on these matters and will be obliged to report back regularly and in detail on its and the portfolio companies’ ESG performance. The GP will also need to afford DFI representatives regular access to portfolio companies’ facilities, personnel and documentation so that they can inspect ESG implementation and judge any legal and reputational risks to the fund, e.g., from workplace accidents and environmental incidents.

Some big DFIs offer technical support to fund managers on these matters: for instance, CDC Group publishes a highly-regarded ESG toolkit on its website.

Oversight and control 

The nature of DFI investment mandates means that they will typically insist on a high degree of involvement in the fund to protect their interests. This means putting DFI investors on the fund’s LP advisory committee (LPAC) and arming the LPAC with teeth and a broader supervisory remit.

For example, the LPAC may be empowered to approve transactions in which management may have a conflict of interest, review fund expenses, authorise proposed deviations from the investment policy or concentration limits, approve replacement key persons, refer disputed asset valuations to an independent valuer, veto changes of control in the management company, and advise on ESG compliance. Investments which are high risk (from a political or ESG perspective) may need prior LPAC consent or additional ESG oversight (e.g., by external consultants).

Management can also expect to have comprehensive reporting and notification obligations, covering both the portfolio companies and the fund’s own affairs.