'Leveraging' private sector finance How does it work and what are the risks?
Report||18 April 2012|
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1. Purpose of this paper
The notion that public investments should be used to ‘leverage’ additional investments from private actors is increasingly used in a variety of development finance forums, including aid, development finance, agriculture and, in particular, climate finance. The World Bank has become one of the leading proponents of this concept, though nowhere has it spelled out clearly what it means by ‘leverage’ or how it should be measured.
This briefing (a) helps explain the existing ways in which the World Bank Group (WBG) attempts to use its investments to leverage additional investment from private actors, and (b) briefly lays out some key risks associated with doing this. Though the term is also used by other bilateral and multilateral institutions, the focus on the Bank is because of its central role in this debate, and because it already practices most of the methods associated with leverage.
This paper is divided into the following sections:
What is leverage? Sets out how the term is being used in development finance debates, how it is measured, and points out that this discussion is similar to the longstanding debate over ‘additionality’ at the Bank. It also argues that use of the term leverage should not be extended to cover political influence, donor pooling, or catalytic public investments. In this section, and the next, the focus is on financial leverage – the use of public funds and institutions to mobilise private lending.
Methods of leverage: Identifies the three main forms of financing that might be regarded as leverage at the WBG: loans, equity investments and risk management products. There are various types of each form, which are detailed. This section argues that measuring financial leverage is not really possible or sensible for equity investments or risk management products.
Ten problems with leverage: sets out succinctly ten reasons why arguments in favour of leverage should be treated with scepticism.
2. What is leverage?
Before we examine the use of the term in the context of the above debate, we should avoid confusion by noting that there are two more commonly used meanings for the term:
In development finance debates, the term is rarely used consistently by the World Bank or others, but the WBG defines the basic concept as:
This financial leverage of private capital is the focus of this paper, and is how the term ought to be generally understood. However, the Bank often uses the term in a general sense to mean any large overall impact of a smaller amount of Bank investment or advisory input. The International Finance Corporation (IFC), the Bank’s private sector arm, also uses the term in both a loose and tight definition, and often calls it ‘mobilisation’. In fact, the IFC has a more strict definition:
It sometimes refers to other activities that may encourage or support private sector investment, such as advisory services, as ‘catalytic mobilisation’. This distinction is important – this paper only focuses on the first part, which the IFC calls core mobilisation, but which is more commonly thought of as financial leverage. To be crystal clear in this paper, we will not use the term in the following three ways, and encourage others to also not use it in these contexts:
(a) Catalytic investments are not financial leverage – for example the World Bank-coordinated paper for the G20 on climate finance unhelpfully bundled all public investments “that encourage much more widespread climate-friendly changes in behaviour by private firms across the whole economy” as leverage. This makes the term essentially meaningless, as (a) most public investments are intended to induce changes in behaviour of private actors, and (b) it is very difficult to quantify the direct impacts on private sector actors of such public investments. For example, the Bank suggests that “carefully designed and scaled public investments in demonstration projects to pilot and debug new technologies and institutions can have a major impact in promoting learning and the diffusion of new ideas.” In each individual case this may be true – or may fail – but the aim is to change markets and behaviours on a more fundamental scale, not to directly leverage additional resources.
(b) Pooled financing is not financial leverage – the World Bank, through its trust funds, has promoted the pooling of donor, multilateral development bank (MDB) or other public financing to tackle certain issues. However, it has also caused confusion by sometimes calling this leverage. For example, the most recent Clean Technology Fund (CTF) semi-annual report claims its investments are “expected to leverage $9.874 billion in co-financing from governments, MDBs, private sector, and other sources.” The donor and other public funding in this example is only leverage from the CTF’s perspective – the other public bodies might just as well have claimed to have leveraged the CTF money!
(c) Inducing policy reform is not financial leverage – the use of international financial institution (IFI) or donor influence to push, cajole or advise developing countries to change their policy positions is sometimes described as leverage. It would be better thought of as political influence, and is highly problematic. It normally undermines domestic democratic space, may promote the wrong approaches, can degrade government capacity, and rarely works as intended – as previous campaigns against policy conditionality have shown. The use of technical assistance (TA) is a grey area – many argue that this is often attached to a particular policy agenda that is being promoted, and in general terms, TA has a very poor track record, particularly when it is donor driven.
Some confusion occurs because sometimes donors (though not as far as we are aware, the World Bank), use the ratio to refer to:
Leverage and additionality
It makes sense to work with the most common definition of leverage (or financial leverage) given above, but we must be careful not to take assumptions about the relationship it implies – that public investment causes the additional ‘leveraged’ private investment – at face value. The debate here is essentially the same as the longstanding issue of whether the IFC achieves ‘financial additionality’. There are two judgements that have to be made:
As Box 1 shows, this is a contested area, and even the best designed public interventions are likely to fail on one of these criteria occasionally.
In addition to the issue of whether it is possible to use public money to provide financial additionality or leverage, there is also the question of whether the nature of that private investment – or the nature of the private investors – can be altered when public funds are used to leverage private funds. The evidence on IFC additionality (see Box 1) suggests that this is much harder to achieve. This is a critically important question, but it is not the focus of this paper.
Box 1: We have been here before: leverage = ‘additionality’
Estimating leverage is extremely similar to the longstanding debate over whether the IFC provides additionality – additional development benefits over private investment with no IFC involvement. The most recent study by the Bank’s arms-length evaluation body, the Independent Evaluation Group (IEG), provided a terminology, which can be adapted for leverage.
The IEG’s results should be treated with caution, as they rely primarily on validating a sample of the IFC’s own internal evaluations. However, “using a highly inclusive definition of additionality” the IEG found that “at least one form of financial additionality was apparent in 85 per cent of evaluated investment operations”. Bearing in mind that this was based on the IFC’s results and used a broad definition of additionality, this suggests that a reasonable proportion of IFC lending is duplicating – or possibly supplanting – private investment.
Perhaps more worryingly, the IEG found that “at least one form of operational or institutional additionality was identifiable in about one-third of the cases.” So the argument that the engagement of IFIs in private sector projects is likely to improve the projects and companies should be treated with scepticism.
Another category of additionality is often also identified:
This is an issue that the IFC has been struggling with, and is currently trying to adapt its internal systems to deal with. For example, the IEG’s 2011 evaluation, Assessing IFC’s poverty focus and results, found that: “fewer than half the projects reviewed included evidence of poverty and distributional aspects in project objectives, targeting of interventions, characteristics of intended beneficiaries, or tracking of impacts.” More shockingly, only “13 per cent of projects had objectives with an explicit focus on poor people”, while just “6 per cent of projects explicitly identified gender issues in project design and only 3 per cent analysed a project’s potential effects on women’s assets, capacities, and decision making.”
3. Methods of leverage
The different types of financial leverage are largely already in use at the World Bank Group. They can be divided into three types: loans, equity investments, and risk management products. We will examine each below, describing how they operate, and evaluating how easy it is to assess the scale of financial leverage , before moving in the next section to other risks associated with leveraging private investment.
There are four main types of loans at the IFC: investment loans; syndicated loans; financial intermediary loans; and concessional loans.
The above kinds of loans are publicly-backed loans – there does not need to be any grant element to them.
III. Risk management products / securitised finance
There are a number of risk management products that the World Bank Group sells to companies. These are a bit like insurance: in each case the company pays the Bank a fee and the Bank only pays the company should the risk materialise.
For all of these risk products, three points are worth noting:
It is very hard to assess financial leverage – the existence of the guarantees may be an important part of obtaining finance for a particular project, but it is: (a) difficult to know if it was critical; (b) difficult to assess what the financial input of the public institution will be – they only pay out if things go wrong; and (c) possible in the case of many risk management products for a similar product to have been bought from a bank or other private sector provider. The IFC also argues that its products can allow companies issuing bonds to get higher credit ratings, reducing their borrowing costs. It may be possible to measure this, but the IFC has not yet attempted to do it.
Risks are involved for the World Bank Group – the Bank Group is ultimately liable for payouts far in excess of their income for these products. In normal circumstances this need not be a problem, but during global crises which may affect all their investments, it can cause problems for the Bank (and potentially for the governments that back it). However, this has so far not presented problems for MIGA or the IFC.
Ten problems with leverage
As leverage is often presented by the Bank and others as an incontrovertibly good idea, this short section is intended to highlight the main criticisms of leverage. It is not an in-depth critique, but intended to clarify some of the risks and problems involved.
1. Assessing financial additionality is difficult and headline figures are not reliable
The discussion in the previous sections highlights the fact that additionality – and hence leverage – cannot be assumed just because public institutions are co-investors with private funds. The following issues often arise:
2. The higher the leverage ratio, the stronger the private sector influence and the lower the likely financial additionality
In all forms of leverage where private investors put forward most of the capital, they will have the predominant influence in the design and implementation of the investment. Their goal is to make money, not to promote development, and there will be trade-offs between their objectives and those of the public institution. The greater the leverage ratio, the smaller the overall contribution of the public body, and hence the lower its power and influence in the design and implementation of the investment.
Also, as noted above, higher leverage ratios imply that the project is more likely to have been funded without any public sector involvement.
3. National strategies and policies should be paramount – but may be ignored or overridden in the quest to achieve leverage
It is widely acknowledged that the effectiveness of private investments, in terms of reducing poverty and contributing to sustainable development, is dependent on the political and policy context at international and national levels. In international climate change discussions, the World Bank-led paper for the G20 was repeating accepted wisdom when it said: “private investment in climate mitigation and adaptation remains limited compared to its potential and is hampered by market, institutional and policy failures or barriers.” In the aid effectiveness debate, the primary importance of ‘country ownership’ of policies and programmes for effective interventions by international donors is recognised in the Paris Declaration, the Accra Agenda for Action, and was reaffirmed in Busan in 2011.
While international institutions, other countries and the global economic environment affect all countries, the overwhelming experience of successful developing countries is that private sector investment needs to be directed and influenced by a national strategy – to ensure sufficient investment in areas which will increase productivity, employment and sustainable poverty-reducing growth.
Therefore attempts to leverage private sector finance should be directed by national strategies and institutions and take place at the national level. However, most existing models and institutions operate through global funds or international financial institutions that are not always well linked to national plans.
4. Many existing World Bank methods promote foreign investment as if it were an end in itself: it is not and entails risks as well as rewards
Foreign direct investment (FDI) can help developing economies by providing jobs, creating demand for domestic products and upgrading skills and technologies. However, there are a number of problems that can be caused by foreign private investment that need to be carefully considered and managed by developing countries, including:
5. Leverage means increasing debt and often involves linking poor countries more closely to volatile global financial markets
Leveraged finance is not aid; it is lending to companies, usually at market rates, which must be repaid. Often developing countries or particular sectors do suffer from lack of access to credit, but this cannot be assumed. Though the links to global financial markets through traditional lending models described above are weak, they are becoming far stronger in the new models promoted by the AMC and others. This may make greater credit available, but also means borrowers are more directly connected to global financial markets, which can be highly volatile.
6. There are opportunity costs when using limited public investment to leverage private investment
Using public resources to try to leverage private sector investment means those resources cannot be used elsewhere. These opportunity costs may be particularly important in certain countries or sectors where the need for straightforward public investment – for example in climate adaptation, healthcare, education, infrastructure or environmental protection – may be very high.
7. Many of the current methods used mean both actual and potential transfer of risk to public institutions – implying moral hazard
In addition to explicit guarantees, private investors may assume that the IFC is unlikely to allow the investment to fail and may end up bailing it out – or persuading the government to do so. Sometimes, private investors may assume an IFC-backed investment will receive special privileges, for example, being less likely to fall foul of governmental interference, or benefiting from special treatment from the government. This means moral hazard is a significant issue – investors taking greater risks because they assume they will not have to bear the full costs should investments turn sour.
8. Transparency and accountability are currently very low for publicly-backed private investment in developing countries
The new IFC access to information policy, for example, is far weaker than its counterpart at the public lending arms of the World Bank Group (the International Bank for Reconstruction and Development, which is the World Bank’s middle-income country arm, and the International Development Association, the Bank’s low-income country arm). The use of financial intermediaries entails further loss of transparency and accountability, including the potential for weakened application of environmental and social standards.
9. Leverage may open the door to undue political influence in developing countries by IFIs and donors
It is important to remember that the World Bank and other international institutions are major influencers of policy in many developing countries through norm and standard setting, research, and influence over how they frame the overall discourse. This emphasis on the importance of private investors and capital markets can be seen as the culmination of a longstanding position, pushed vigorously over the past 30 years, that developing countries should orient their economies and policies to attract foreign investment.
10. Positive developmental impacts may be absent
Developmental impacts are not the objective of most of the private actors involved in the above mechanisms, and it is dangerous to assume – as the IFC often does – that any private investment is good for growth and poverty reduction, for the reasons set out above.
This text may be freely used providing the source is credited.
Published: 18 April 2012 , last edited: 18 April 2012
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