Social investment

This "In depth" part is based on a dialogue between financial and social investors, during a Round Table organized by KIT on 7 September 2010

Stop Donating, Start Investing: investing in entrepreneurship in Africa

Views presented during a Round Table on 7 September 2010

1. Introduction
2. Vision of Dutch investors
3. Vision of (social) investment funds
4. Summary
5. Discussion points for a sequel debate on 10 November 2010

1. Introduction

• Investing in entrepreneurship in Africa

Africa badly needs capital for local investments. While large amounts of capital are circulating throughout the international financial world, most of it does not reach Africa. Why is there not more investment in Africa? What are the barriers to investing and how can they be overcome? What are the experiences of Dutch investors in Africa?
On 7 September 2010, the Royal Tropical Institute organized a round table discussion to address these questions. Representatives of established banks, pension funds, multinationals and pioneering investors within the Dutch financial sector debated the possibilities - and even the necessity - for Dutch investors to stimulate the African economy through profitable yet sustainable investments. The central idea was that shareholding and financial participation are a much better way than distributing aid. Africa has enormous potential in terms of labour, raw materials, agricultural products and business. In many African countries, despite the international financial crises, there is stable economic growth and a rapidly-growing middle class. Countless African entrepreneurs have noticed this growth and want to make the most of it, and there is a growing need for capital to make these investments happen. Chinese investors are already active. Dutch investment funds and multinationals also invest in African countries, but face a number of challenges, as explained below.

• Sizeable financial flows do not reach Africa

The international money flows are impressive. Globally, trade between banks amounts to approximately USD 800.000 billion. Of that amount, just USD 5-20 billion goes to African economies. A small part of that flow originates in the Netherlands. Dutch investment in Africa goes mainly to a few countries (e.g. Nigeria and South Africa) and a few sectors (e.g. mining and the oil industry). Increasingly, people are asking questions about the sustainability of these investments and their contribution to African economies. Many large Dutch investors such as pension funds (who together manage about €600 billion and are looking for long-term investment opportunities) have not yet invested in Africa. FMO, a public-private development bank in the Netherlands, is active in Africa and is starting to focus more on Africa's small and medium sized enterprises (SMEs), although only in some sectors.

• Two forms of Dutch investments

There are two ways in which capital flows from the Netherlands towards Africa:
• Multinational companies invest in local establishments in Africa with their own capital. This is accompanied by an introduction of their own management culture, with expatriate staff taking the lead,
• Social investment funds, especially the smaller funds, look for local entrepreneurs - people from SMEs with good entrepreneurial skills - whom they can support with venture capital.

The total amounts of global capital flowing to Africa are relatively small compared to the total capital that is invested in the world. Even if a small percentage of those global investment flows were directed towards Africa, it could mean an enormous increase in capital available to the African market.

2. Vision of Dutch investors

• A stable and sizeable market, good infrastructure and well-educated people

As mentioned above, Dutch investments in Africa can be roughly divided into two models. We will at first focus on the vision of the Dutch multinational companies that invest in local businesses with their own capital and introduce their own management culture. Public money is often used for social investments such as education and infrastructure that do not yield a profit.

During the round table discussion, Dutch private investors came up with a long list of suggestions for increasing financial flows and their impact. Those suggestions were summarized by chairman Herman Wijffels as either macro or micro in scale. Issues at the macro level are not always easy to influence, but are very important for a well-functioning African market and consequently for investors. The most important barrier to investment at macro level is the government of the country to be invested in, which is not always a reliable partner. Especially for long-term investments, such as those of the Dutch pension funds, long-term stability is important.

A stable, reliable government is also important for other macro-level issues. Conditions that provide for a stable and sizeable market, for good infrastructure and well-educated people, and for a reliable energy supply, water and waste management, are often created by a government who either delivers these services, or organizes them through the private sector. Although there is no tradition in Africa of government facilitating these services, these tasks need to be taken seriously.

Another obstacle to investing, and one which the Dutch government and international institutions could have a role in mitigating, is the dumping of products on local markets. Dutch investors and African companies are both hampered by these practices. During the Round Table, it was commented that the Economic Partnerships Agreements (agreements that the European Union would like to sign with a number of African, Caribbean and Pacific countries) should be carefully reviewed. If only 20 percent of a country’s local production is allowed to be protected in the highly competitive global arena, local industries, including Dutch companies and joint ventures, will suffer. Free trade is not always beneficial, even for Dutch companies.

If a reliable and facilitating local government is absent, Dutch public money and private money should be invested in tasks that would normally be carried out by government. The managers present at the Round Table indicated that a large part of the investments needed for a well-functioning local economy cannot be made by the private sector alone. Better coordination of private and public investments would already be an important step. The positive role of funds from the Netherlands’ budget for development cooperation were emphasized, although viewed by some with scepticism. A suggestion was even made that the budget for funds to stimulate international trade with Dutch companies, which is now around 10%, should be increased to 20-25% as long as its use be clear and transparent.

According to a number of companies present, an interesting way to coordinate investments is to make them within a confined area. The possibility of an Export Processing Zone (EPZ) and other forms of ‘islands of economic stability’ are attractive to many businesses. These areas would ideally offer good infrastructure, information services, security and sufficiently qualified employees in a limited geographical area. This will reduce transaction, residential and establishment costs. In addition, under these circumstances knowledge can be more easily generated and managed and trainings within companies can be controlled and coordinated.

In order to estimate the positive impact of such ‘islands of stability,’ it would be necessary to look at the links that international or local companies establish with their surroundings. In some cases, raw materials are sourced locally to stimulate the economy, cut down on transportation costs, and guarantee a reliable supply of products. One Dutch company, for example, buys its agricultural raw materials locally in Sierra Leone, which gives a boost to the local economy. Often there is a social component in their business strategy in the form of corporate social responsibility. Social projects, often carried out in cooperation with local NGOs, support the good name that a company wants to build in these countries and among its consumer markets in the West. HIV/AIDS projects were mentioned in particular.

3. Vision of (social) investment funds

• It is mainly about local entrepreneurs

The second group of investors are the social investment funds. The smaller investment funds in particular are continually looking for local entrepreneurs, people from SMEs with good entrepreneurial skills, whom they can support with venture capital. Local markets in Africa are growing steadily, enterprises are focusing increasingly on national demand of the growing middle class, and there are growing opportunities for export companies that want to expand on to the international market.

These pioneering investors face hurdles similar to those of the bigger Dutch companies: lack of infrastructure, shortage of educated labourers, weak entrepreneurial skills and currency risks. Many of these problems are the responsibility of local or national government, and a reliable and service-oriented government is a key condition for making markets attractive for long-term investments. Infrastructure and logistics are also important to pioneering investors, but they need not be in the form of an Export Processing Zone as is the case for large Dutch companies.

Many SMEs have trouble finding appropriate financing: they are too big for microcredit loans but too small for large bank loans. ‘Upscaling’ to become a bigger and more profitable company is difficult. The development of local financial institutions, which would be able to provide adjusted supply, is still lagging behind. There are new institutions, but these are often young and still require support themselves, both in terms of finance and in terms of knowledge on financing. Often there is a need for advisors, not just for investors but also for entrepreneurs. In addition, local regulations can be an obstacle for microcredit institutions to upgrade to banks.

Shared visions

Looking at global investments, in some parts of the world benchmarks have been set artificially high. Rates of return are higher this way, but so are the risks related to these investments. The financial crisis is partly a result of those benchmarks. With respect to investments that have an artificially-high benchmark of 25% return on investment and higher, investments in Africa do not seem interesting. Only if the related risks are accounted for with these artificial benchmarks, a rate of return of 10-15% that can be realized in Africa is not bad at all, according to the investors present.

During the Round Table, optimism dominated within both groups of investors: there are many investment opportunities in Africa. Underdeveloped markets offer opportunities for those who dare to take risks. Underperforming markets have inefficiencies that can be resolved by innovations, such as buying shares or through direct investments in companies that bring these innovations on the market or use it in their businesses. For example, telecommunication in microfinance institutions reduced transaction costs in such a way that their services became available for large groups of clients who previously were not served. Through these innovations, microfinance companies became more profitable. Another example is innovative solutions for energy production. These innovations are an opportunity for Dutch investors who want to invest in local companies with money and knowledge. In this way, niche markets can be developed towards mainstream markets.

Tackling challenges can be seen as investment opportunities: setting up and offering education is a good investment, not only in people, but also financially. Examples were mentioned of successful and profitable investments in schools that could provide education for less-wealthy groups. According to the investors, common interest explains why public-private partnerships in the domain of education, training and other service-related industries can be successful. In this respect, Dutch companies would like to work together with NGOs, even though they viewed NGOs critically overall.

Solutions were mainly brought forward on the issue of spreading financial risks. Currency risks, for example, are difficult to cover for smaller funds. The costs of these risks that need to be covered are high.
When investing small amounts, costs are usually higher: this is caused by the fact that assessing and managing relatively small participations is more expensive. An integral approach, partnering with other actors on the markets, could be a solution.
A value chain approach was mentioned as one possible innovative step towards sustainable investments. Support of local financial institutions is an option in this case. Providing guarantee funds was mentioned as a successful approach used in the past by Dutch investors towards this problem.
The Dutch government and NGOs should make more of the strengths of private social investors, so that their interventions will have more beneficial results.

4. Summary

• Globally, there is an enormous amount of savings and investment capital that needs a rate of return. This capital could also go to Africa, so ‘money is not the problem’.

• Africa is in need of capital for economic development. African economies are growing steadily despite the global financial crisis. Africa is not yet integrated in the worldwide capital market, which is an advantage.

• Currently, most investment in Africa is concentrated in a few sectors (mining, mineral development) and a few countries (Nigeria, South Africa). China has become an important investor in Africa.

• Broadly speaking, Dutch investment is taking place in two ways: multinationals start subsidiaries through capital investments, with their own management and sometimes combined with public investments in infrastructure, logistics and education. A second group consists of social investors who are in search of local entrepreneurs and small and medium enterprises in which to invest.

• Transaction costs of investments in Africa are high for both groups of investors. Rates of return are around 10-15%.

• Multinationals are able to contribute significantly to economic development by buying local raw materials and supporting local production. This model can bring about sustainable economic development, which is not the case if companies simply export raw materials. To stimulate this further, multinationals favour so-called ‘hubs’ where infrastructure and logistics are supported with public investments.

• Small and medium enterprises in Africa are the motor of development and contribute directly to the existence of a growing middle class with purchasing power. Investors in SMEs can have significant impact on local economic development. This form of investment requires better financial institutions in particular and a class of better-educated entrepreneurs. The local SMEs also benefit when infrastructure and logistics are better organized, but they are not concentrated in ‘hubs’ and therefore other solutions need to be found.

• Both forms of investment need a better alignment between public and private interventions. The transition is from development cooperation towards international cooperation, where shared interests form the basis.

• Interventions of the Dutch government, but also of NGOs, need to take into account available investment capital and contribute to effective instruments, like investment guarantees and support for local financial sectors. Many of the current instruments are counterproductive or inefficient.

• Larger institutional investors will discover Africa, but rates of return have to be realistic. Investing in Africa concerns the ‘real economy’ and not all kinds of financial products that have come to prevail in the West. Investors are increasingly pleading that next to financial rates of return, other returns are also important, like positive social and ecological impacts. Investing in Africa can yield a good rate of return on social and ecological grounds.

5. Discussion points for a sequel debate on 10 November 2010

• How can investments in Africa be further stimulated?
What are the implications of the different models?

An important question regarding investing in Africa is whether the rates of return are attractive enough, compared to what investors are used to in the international financial world. Rates of return of 25% (with the accompanying risks) are not common on the African continent. Generally, rates of return there are 10-15%. The international financial crisis and increasing pressure from shareholders to not only focus on financial but also on economical, social and ecological returns, suggests that the international financial world should adjust its benchmark. Only if the benchmark goes down, will socially-important investments (which are more stable but have lower financial rates of return) in the South come within sight of the international financial world.

Participants of the Round Table suggested various conditions that are needed to stimulate investments in Africa. Pioneering investment funds are not intimidated by the risks they have to take, but would be better able to do their job if local entrepreneurship were more developed. The participants from the Round Table agreed this could be stimulated more. Remigration of knowledge migrants from the West could also contribute to this: with their knowledge and network, entrepreneurs that return home could make much of available opportunities.

There is always a need for a reliable local government, one that delivers services that businesses need. Good infrastructure, both for roads and communication, are important. Transaction costs need to go down significantly if African enterprises are to become more competitive. Having a pool of well-educated people is crucial. A stable political and economic environment is important because larger investments are long term. A pension fund has to be sure that its long-term investments will bring the promised rate of return and will not be lost to conflict, corruption or political battles. Although it has been said that most countries make good progress, we have seen conflicts in the last decade, such as in Nigeria, Ivory Coast and Kenya, where there is still a long way to go towards a stable political climate.

The Dutch government could help to control the risks of investment. However, the current measures that they offer are not flexible enough to respond to local and individual opportunities. Not all African countries are the same, there are many differences, and support by the Dutch government should be adjusted to those circumstances. The possibilities of using guarantees for investments in Africa need to be investigated. Public money should be invested in good education and training targeted towards the labor market, which can develop with the help of large private investments.

An important precondition for economic growth in Africa is the development of financial institutions. In the last decade, there has been a lot of attention for microcredit loans, but the regular financial institutions that finance SMEs are currently in need of more attention. NGOs that offer ‘soft capital’ have to stop competing with these local financial institutions. SMEs have capital needs that lie somewhere between microcredits and the bigger loans of regular banks: innovative forms of finance should be offered to fill that gap.

African governments can do a lot to improve the investment climate. And the Netherlands can contribute as well. The participants of the Round Table agreed that there is a need for better alignment between public and private parties. The Chinese approach, where political dialogue is followed by public investment with great private interests, seems to be popular in Africa. Europe has to find an answer to this trend. Public-private partnerships on a national scale could be the way to realizing new kinds of cooperation. Public investments in infrastructure and education should be accompanied by financial services and private investments. Alignment of investments, market knowledge and a value chain approach are necessary to getting this done. All of this requires a new form of development cooperation. Participants of the Round Table agreed unanimously that we have to move towards international cooperation, based on shared interests.

Sustainable development in Africa can contribute to solutions for different urgent global problems. Investments of Western pension funds that have a good rate of return in the long run could serve the growing demand for capital in Africa. Expectations for rates of return similar to those preceding the financial crisis need to be adjusted, however. Africa will not benefit from being part of a financial market characterized by excessive speculation and risky financial constructions. The fact that Africa is not yet integrated in this financial market is an advantage and brings opportunities for investors who are looking for capital investments with a genuine rate of return, ensuring stable investments as well as sustainable development.

• So what should change?

• Transition from development cooperation towards international cooperation,
• More harmonization and coordination of public and private investments,
• Attention to the development of local financial investments,
• Adjustment of expectations of rates of return that arose in the West before the financial crisis,
• Pension funds and other large institutional investors should show more interest in Africa. To do this they need involvement of private and public players.


• What questions remain?

• Long-term political and economic stability is needed for long-term investments. Is Africa also ready for this?
• Until now, investments have been too small in volume for the large pension funds: transaction costs stay high and push down the rate of return. How can large investments be coupled with lower transaction costs and contribute to sustainable economic development?
• Should Africa integrate into the global financial market or are reforms needed in the financial sector before this can happen? What should the West do differently to make sure Africa is not negatively affected?



References:

Gruber J. and Kamin, S. (2009) "Do differences in financial development explain the global pattern of current account imbalances?" In: Review of International Economics, 17(4), 667-688, 2009

Social Investment Forum (US) http://www.socialinvest.org/resources/sriguide/srifacts.cfm

The Open University http://www.open.ac.uk/oubs/socialinvestmentseminars/p2.shtml