Catalyzing Financial Innovation in Small Economies

April 22, 2022


Kigali International Financial Center (KIFC)

By Rob Henning, Technical Director, Finance and Investment, Palladium, and Aubrey Hruby, Transaction Lead, Finance and Investment, Palladium

Small can be beautiful in terms of financial innovation and major financial success. From the Netherlands and Portugal in the 17th century to Dubai and Singapore in the 20th century, small countries without a lot of natural resources have become significant players in global business. Thanks to their agility, dense networks between the public and private sectors, openness to trade and ability to specialize, small economies are uniquely positioned to become financial innovation hubs by creating best-in-class ecosystems where top talent, investors, and entrepreneurs can collaborate to drive economic and investment growth.

Yet, global corporate, equity and institutional investors typically ignore small economies (countries with a population of less than 15 million), dismissing them based on their smaller market size. Instead, they prefer to focus on the likes of Brazil, China, India, Indonesia, and Mexico. Countries such as Botswana, Georgia, Estonia, Kosovo, and Rwanda are perceived by some as lacking the scale needed to profitably build businesses and realize positive returns on investments. While some small countries have succeeded in delivering prosperity to their people, many remain underdeveloped. Nearly 8 percent of the world population lives in countries with fewer than 15 million people. Development partners can support and accelerate financial innovation in small countries by supporting capital mobilization externally, internally, and through the diaspora.

Attracting Global Capital

Small countries can seize a competitive advantage in the effort to attract global capital given their enhanced speed of reform and ability to digitize government services, as well as their densely networked political and business elite. Often more business-friendly than large jurisdictions, small countries have the potential to offer a good quality of life to attract the talent base that investors seek, especially important to those in global venture. Singapore, Israel, and Estonia lead the world in venture capital per capita. Estonia, in particular, has successfully marketed itself as a start-up hub after government-led digitization and the success of Skype and Bolt. A small domestic market combined with a workforce with strong IT skills allows for innovation and iteration. Latvia and Lithuania are now trying to replicate Estonia’s success with a special focus on the life sciences.

Inspired by Singapore, Rwanda has sought to attract investment by leveraging business-friendly tax, foreign exchange, ownership, and visa policies. Recently launching the Kigali International Financial Center, Rwanda has signed treaties eliminating double taxation and allows easy transition from a tourist visa to a work permit in order to advance a knowledge-based economic growth model.

Mobilizing Internal Capital

In the absence of significant global investor interest, small countries must work to leverage local capital pools for investment—be it through pension funds, insurance companies, or high-net-worth individuals. These pools of capital can be mobilized into debt and equity funds to help local companies grow. A notable example of local equity innovation is Georgia’s Synergy Capital, a homegrown private equity fund with $3 million in capital and comprised of 30 local high-net-worth individual limited partners. Although far below the average size of $25–30 million for a traditional small private equity fund, the lean management structure and unique insight into the local economy (stemming from its association with the leading strategy consulting firm in Georgia) have allowed it to pay a 10 percent dividend to its limited partners for the past three years.

Traditional private equity and venture capital funds shy away from small economies due to perceived limited deal flow and the lack of an in-country deal team. However, local sources of potential growth capital, such as pension funds and sovereign wealth funds, can help “crowd-in” equity financing by de-risking deals in the eyes of outside investors given their local in-country due diligence and stakeholder engagement capacity. Sometimes the local funds will need to work together creatively to create scale. For example, in Kenya, Palladium through the USAID-funded Kenya Investment Mechanism is supporting the Kenya Pension Fund Investment Consortium (KEPFIC). Launched in 2020, KEPFIC allows pension schemes to jointly invest in alternative assets and long-term infrastructure projects. Previously, individual pension funds were unable to invest in infrastructure projects because large ticket sizes exceeded their capital capacity. By pooling capital from individual funds, KEPFIC aims to mobilize more than $229 million over the next five years for infrastructure investment. In 2022, KEPFIC and Stanbic Bank announced that it raised $44 million through the Kenya Roads Annuity Lot 3 Project bond issuance, the first investment categorized under new guidelines allowing for pension funds to participate in infrastructure investment. The success of KEPFIC provides a template for other countries facing similar challenges of disaggregated internal capital sources.

In another example, the Government Institutions Pension Fund—the largest pension fund in Namibia—pioneered the use of an investment policy overseeing investments in private companies to establish 20 private equity funds managed by various fund managers with a total of 5 billion Namibian dollars ($340 million) committed. The fund creates co-investment opportunities for foreign financial institutions and other investors by establishing structures for direct investment. The strengthening of the private equity market in Namibia has allowed the government to curb the outflow of capital and provide access to capital for domestic investment opportunities.

Catalyzing Diaspora Investment

According to the World Bank, global remittances grew 7.3 percent in 2021 to $589 billion as post-COVID-19 economic recovery took hold in the United States and Western Europe. Many small economies are dependent on these flows with remittances reaching double digits of GDP in countries such as Georgia (13.3 percent), Kosovo (18.9 percent), and Lesotho (23.5 percent). These massive capital flows typically fuel consumption and ad hoc productive investment based on the diaspora’s deep personal connection to their countries of origin. Ireland, with a population of 5 million, is often overlooked as a small economy with a recent history of economic transformation. Founded in 2015, Digital Irish Angels is a group of U.S.-based accredited investors of Irish descent committed to providing angel and venture investment to Irish start-ups.  According to Pitchbook, the group has invested $16 million in three start-ups with in-country syndicate partners such as, Delta Partners, and the HBAN angel network.

Outside of coordinated angel networks, diaspora can invest directly through bonds and mutual funds. Blended finance solutions that combine public and private funds create opportunities to drive diaspora bonds that have allowed governments in Ethiopia and Ghana, among others, to raise cash by mobilizing diaspora communities through attractive terms. In private markets, Rwanda and others have launched mutual funds through which diaspora members can invest in sovereign portfolio funds. Blending public and private funds, in Germany seeks to connect entrepreneurs, diaspora groups, and external funders all at once. The program, launched in 2019, requires African small businesses to put in 25 percent of the investment, diaspora investors to match this, and the final 50 percent comes from the German government. The platform has found success in Cameroon and Ghana, countries with larger diasporas in Germany, for small €500 to €5,000 investments, but serves as a potential model for similarly constructed but purely private or venture schemes.

The Promise of Small Economies

The potential of small nations has been enhanced in the post-COVID-19 era. Work from home flexibility decentralizes talent and the shift to virtual collaboration platforms reduces logistical concerns and reinforces work-life balance considerations for employees. As labor markets become tighter and the competition for talent intensifies, small countries can leverage quality-of-life appeal to attract entrepreneurs and businesses. The success stories of Ireland, Israel, and Singapore serve as reminders that small countries can harness public and private sector innovation to become prosperous and redefine global best practices. Intermediaries that can marry growth capital from internal, external, and diaspora sources with the plethora of untapped business opportunities in these markets can transform smallness from a disadvantage to an advantage.