1.1. Finance Overview
The global development landscape is changing in profound ways. Huge pools of private capital - in developed and developing economies alike – have emerged and are looking for attractive investment opportunities.
While Official Development Assistance (ODA) has been flat in recent decades, private foreign direct investment has continued to grow. Even more remarkable is the growth in domestic private capital within developing economies (see graphic below). These resources have great potential to support economic development if directed towards suitable investments and opportunities, and mobilizing this abundant capital for development is emerging as a core element of strengthening countries’ ability to finance their development plans and strategies.
2 Sources: OECD, World Bank Remittances Data, International Monetary Fund (IMF) World Revenue Longitudinal Database (WoRLD), UNCTAD Stat and World Bank World Development Indicators (WDI), USAID analysis.
In addition to the growing abundance of private financial resources, other factors are prompting donors to shift their focus toward facilitating private investment, working to unlock market forces and transform private capital into investments that can advance development:
Finance is the process which gathers and pools unused or idle funds such as savings and retirement fund contributions, and then allocates those funds (the pooled funds within the financial system is often referred to as “capital”) to productive investment.
Productive investment results in income. Income received by the finance provider needs to be higher than the cost incurred for the funds they provide, thus rewarding the service they provide with a profit, or “return.”
Successful finance providers must be skilled at the art of assessing risk and the probability that the proposed loan or equity investment will succeed. In other words, that the loan will pay interest and repay debt, or the equity will produce a positive return. In the diagram to the right, we see the role of the financial markets in transforming financial assets into real assets. They do this through the processes described above – pooling unused funds and allocating them to investments in real assets that are expected to offer a suitable return. (Source: Mobilizing Private Finance for Development Textbook).
The term ‘equity’ has several different meanings, but for the purposes of this wiki, equity means ownership of an entire or part of a business. This can range from ownership of a stall in the market, to owning shares of stock in a company. When investors purchase equity, they pay funds to the previous business owners, who are thus able to invest those funds in real assets as described in the section titled “What is ‘Finance’?”
For equity investors such as mutual funds, their return comes in the form of dividends and an expected increase in the value of the investment.
|Pros of Equity for Business||Cons of Equity for Business|
“Patient Capital,” i.e. longer
|Higher expected return|
|Friendly to growth||Business must give up ownership control|
|Access to expertise and shared
interest (See angel investors)
Debt, alternatively, is basically raising money through a loan. Virtually every business has more debt than equity (See: Business Literacy Institute for a description of the debt-to-equity ratio).
In the case of banks and other debt providers, their return comes from the loan “spread,” or the difference between the cost of funds and interest rate charged, as well as any fees charged.
|Pros of Debt for Business||Cons of Debt for Business|
|Cheaper than equity||Collateral/Covenants|
|Doesn't involve ceding
|Often tax deductible
The common financing sources used in developing economies can be classified into four categories: Family and Friends, Equity Providers, Debt Providers and Institutional Investors.
Family and Friends: This source of financing is a popular primary source for many people and small businesses, especially in developing economies. The close familial/friendship relationships between lender and borrower tends to support a level of trust and risk tolerance that most start-ups are unable to secure from outside lenders. This financing is often ‘informal’ (i.e., without a formal contractual agreement) and the transaction sizes tend to be small. The terms and conditions tend to be flexible but relatively patient, reflecting the fact that this sort of financing usually supports start-up or rapidly growing businesses.
Debt Providers: These include commercial banks, microfinance institutions (MFIs), credit unions, and leasing companies, which bundle short-term funds and then extend them as loans or leases. Financial transactions here tend to be larger (with the exception of MFIs), and low-to-medium risk. Debt is an essential financial instrument because of the lower cost relative to equity. It has greater flexibility and does not require the borrower to cede control.
Equity Providers: These include “public collective investment vehicles” such as mutual (stock) funds and exchange traded funds, and private funds such a private equity funds. Such funds tend to be primarily ‘equity’ focused (taking ownership in business rather than a lending to businesses).
Equity providers are often aligned with commercial investors (or investment banks), which are primarily in the business of structuring and selling (often termed “placing”) equity investments to investors and providing financing advisory services to businesses. While investment funds are not prevalent in USAID presence and other developing countries, equity can benefit start-up and rapidly growing businesses by providing longer-term patient capital, and in some cases advisory services, while having a higher tolerance for risk. See Equity vs. Debt for more information related to the advantages and disadvantages of equity and debt, respectively.
Institutional Investors: These include pension funds and insurance companies with large amounts of cash inflows that typically need to be invested over the long-term. Institutional investors are important because of their size and huge appetite for debt and equity. While institutional capital in developing countries remains relatively small, it is growing rapidly and is generating interest as to how it can be unlocked to support development.
Finance and the financial markets play a critical role in the market economy by allocating capital to productive investment, creating a virtuous circle of wealth which drives economic growth. Beyond pooling savings into capital and allocating that as investment, a well-functioning and sophisticated financial marketplace also does the following:
- Provides liquidity, i.e. the ability to rapidly access cash: Many businesses have seasonal changes in their cash needs, for example, retail during major holidays, or agriculture during harvesting season. Liquidity also provides investors confidence that they can sell their financial asset for cash if needed or desired.
- Facilitates price discovery, i.e. the act of determining the proper price of a security, commodity, or good or service through the competitive market forces of supply and demand: This allows prices to efficiently signal the most productive use of financial resources.
- Allows for the sharing and management of risk via the diversification of investments as well as by matching the risk appetite of individual investors to the risk profile of different investments.
According to UNHCR, the graduation approach is “a sequenced, multi-sector intervention that supports the poorest and most vulnerable households to achieve sustained income and move out of extreme poverty within a specified period. Graduation programs provide a comprehensive package that includes consumption assistance to meet basic needs, skills training, seed capital or employment opportunities to jump-start an economic activity, financial education and access to savings, and mentoring to build confidence and reinforce skills” (See: UNHCR Graduation Approach).
A graduation approach is unique from other financing methods in that it explicitly targets the poorest households and provides them with resources to “graduate” into eventually developing a small to medium-sized enterprise.
The approach can be summarized by the following steps:
- Address immediate consumption needs. The poorest households are often consumed with day-to-day survival, therefore eliminating the possibility of saving, investing or dedicating time to building new skills.
- Once basic needs are met, aid providers can begin to provide training relating to saving money, transferring assets (such as livestock), life skills, and technology.
- Foundational training, along with consistent counseling, opens up opportunities to consult other financial methods and institutions to continue to improve a household’s livelihood.
See A Technical Guide to the Graduation Approach for a more detailed overview of the graduation approach in finance.
Medium- and long-term financing is hard to come by for all but the more established, larger enterprises. While the expansion of microfinance has begun to serve low-income households and microenterprises, the very poor continue to be underserved. Smaller and medium-sized enterprises (SMEs) tend to be too large to be served by microfinance institutions and yet too small and high-risk to be attractive to the formal banking sector, resulting in what has been termed the “missing middle.”
This has significant development consequences because the majority of economic growth, and employment is created by small and medium enterprises. Thus, their difficulty in accessing finance constrains overall economic growth.
An ‘investment catalyst’ in this context encourages, facilitates, and sometimes provides direct financial investment to an enterprise or individual entrepreneur in a developing economy. USAID is considered an investment catalyst because it assists SMEs acquire financing.
As investment catalysts, there are several things development agencies such as USAID can do to facilitate financial transactions that may achieve specific development goals but fall short of the ability to obtain financing. Each works by making the transaction more attractive in some manner, for example:
- By reducing or offsetting cost and risk (i.e., “squeezing the pricing stack”); or
- By increasing the financial return.
According to the International Center for Research on Women (ICRW):
“Gender-Smart Finance involves learning how to better integrate gender into investment processes to make smarter investments that enhance returns, gender equality and women’s economic empowerment.
In the world of work, gender-related risks and opportunities crosscut all industries. However, gender itself is constructed based on a dynamic set of relations between women and men in different contexts.
Investors must therefore ask different questions based on the sector, business model, region, and their own investment thesis” (Source: ICRW Resource Hub for Gender Smart Investing).
For more information on gender-smart finance broken down by sector, visit ICRW’s gender-smart homepage to explore gender-smart financing in agriculture, off-grid energy, power infrastructure and healthcare: ICRW Resource Hub for Gender Smart Investing.
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