Herat mosque

Herat mosque
Herat mosque

29 June 2011

Kabul Intercontinental

Just in case we needed any reminder that risk is the principal obstacle to investment in Afghanistan, we spent yesterday evening having dinner to the sound of gunfire and explosions from the Intercontinental attack...

The human tragedy of the situation is just appalling; people are needlessly dead or injured today. The wider impact of such attacks is to destabilise an already fragile transition process.

What these attacks do for investor confidence remains to be seen, but for sure, it won't have reduced the Afghan risk premium.

24 June 2011

Design phase complete

Some personal reflections on the last day of the ABIF design phase...

It has been an intense and extremely interesting experience bringing ABIF from a few pages of draft terms of reference to a fully designed project ready to go in just 10 weeks. Since starting work at the end of March, we have come a long way in terms of developing and piecing together the DFID Business Case, the project strategy, the sector selection and market analysis, the investment strategy, the project operations, the marketing strategy, the monitoring and evaluation framework, a workplan and a budget. And on top of that, I think that we have come up with a new way to manage a challenge fund that could significantly enhance ABIF's success. No doubt we will learn and refine as we go along, but I think that we can be reasonably satisfied with what we have achieved so far.

The good news is that because of the clarity of the original objectives DFID set for this fund, we have been able to put together a project design where each element is logically aligned in order to achieve those objectives. When all is said and done, the core purpose of ABIF is very simple; we are here to incentivise investment that will make money for the project sponsors, change the way that people do business with one another and increase the incomes of poor people. A correspondingly straightforward project design around our core objective of contributing to accelerated and inclusive growth means that we have the solid foundations necessary for the implementation phase. The result (I hope) is elegant simplicity!

What has particularly surprised me during the design phase is the evident level of demand for ABIF. I guess that it is easy to get carried away, of course there is demand for grant funds. But even when we strip away investment projects that are just about making rich people richer, there is still a promising pipeline of ideas for projects that can deliver the kind of  market changes and benefits to the poor of Afghanistan that we have designed ABIF to achieve. With a bit of guidance and encouragement, these projects can get off the drawing board with the help of DFID funds used to offset the risk that stands in the way of investment.

It is always dangerous to make predictions, but I wouldn't be at all surprised if we are able to disburse the funds much faster and achieve much greater impact than anyone envisaged at the time that the initial project outline was developed.

I have lived and worked in Afghanistan for almost 5 years out of the last 10 years. Over that period I have seen many good things happen, but early optimisim often turned into disappointment as extravagant promises of progress were unfulfilled, claims of achievements did not chime with ordinary people, or money was invested in Dubai real estate rather than the future of the country.

With 2014 on the horizon, we are entering a particularly tricky period of significant change and uncertainty. Afghanistan remains largely unprepared for the future that is set out on paper; there are systemic weaknesses in almost every direction you look (economic, political and security). There has been tangible progress but it is fragile and could easily be reversed. Afghan colleagues are hopeful, but nervous about what the future holds. But what strikes me most is that despite the potential of the country and 10 years of reconstruction efforts, poverty remains widespread, particularly in rural areas. The reality is that millions of Afghans still live in the most desperate of circumstances for no good reason at all. This situation has to change.

Afghanistan is a complex environment and there is no single or easy solution, but I am absolutely convinced that ABIF can help to make some difference to the lives of poor people in Afghanistan. The implementation phase is going to be challenging and hopefully rewarding, I look forward to it very much.



If it is my place to do so, I would like to thank everyone who has been involved in the ABIF design phase; particularly the core team of Robert Smith (who worked on the challenge fund operations), Sarah Gray (who worked on sector selection and market analysis), Tamim Ahmadyar (who provided administrative support throughout) and Edriss Raha (who has introduced us to many of the project sponsors with whom we could be working in the future). Simon Foxwell and Frankie Whitwell from Landell Mills have been extremely supportive, providing constructive strategic advice and quality assurance. Additional significant contributions came from our consortium partners ITAD (M&E) and ARG (marketing). Finally, a big acknowledgement is due to the DFID Afghanistan team. Our primary contacts there were Elyas Hashemi and Doreen Broska; their feedback has been invaluable and it has been a personal and professional pleasure to work with them.

09 June 2011

Risk based approach to a challenge fund

We are now in the final stages of putting together the investment strategy for ABIF. Two of the biggest challenges facing us in defining the investment strategy for the fund were:
  1. How to ensure that we incentivise without subsidising; and
  2. How to ensure that we do not displace commercial finance providers.
I think that we have come up with a solution to both problems by applying some relatively simple tools from the world of private sector corporate finance.


Incentive or subsidy?
The operational objective of the fund is to incentivise commercially viable investment projects that will achieve our strategic objective of achieving market change that will accelerate inclusive economic growth. The incentive we offer is co-investment in the form of a grant to the private sector partner. Incentivising investment is all well and good, but in the absence of some rational mechanism to target and ration funds, a well meant grant can so easily become a market distorting and value destroying subsidy.

The original design for ABIF suggested that we should limit the ABIF grant by fixing a maximum grant level of 50% of the total investment project when co-investing with individual companies and 70% when co-investing with business associations, and then rely on competition between potential grantees to maximise leverage of donor funds. This strategy was intended to limit the risk of subsidy and has the advantages (from the donor project's point of view) of being the established way that challenge funds operate (so it is the "safe option") and administratively simple (so it is easy to understand).

However, it is a very blunt instrument, which fails to take into account the market circumstances in which the fund is operating and could exclude high risk/high impact projects from applying to the fund.

First, where do the pre-determined numbers 50% or 70% (or any other number that different challenge funds use) come from, why not 25% or 75% or anything in between? Answer, any number pre-determined in this way would be completely arbitrary. Secondly, why should funding two identical projects in different places and different times impose the same limit? Answer, none at all.

In the imperfect market of donor funding (where gaming is rife), there is just as much risk of subsidising a project by giving a 30% grant as there is a 50% grant or a 70% grant if you don't understand the investment risk associated with the investment project. The riskier the location (for ABIF, places like Helmand), the higher the grant has to be to offset that risk and incentivise investment that will impact some of our least accessible target beneficiaries. The riskier the innovation (say a business model completely untried in Afghanistan), the higher the grant has to be to offset the risk and accelerate the introduction of new products or services that will impact the incomes of our target beneficiaries. And of course, the converse is true, the less risky the location and the less risky the innovation, the lower our grant should be. Thus the risk based approach is a vital value for money tool for donors.

Adopting a risk-variable investment strategy not only provides a basis for opening up the competition to more risky investment projects and for comparing projects on a like-for-like basis, it also provides a mechanism to avoid subsidy. However imperfect the challenge fund competition may be, by having a risk benchmark for each project will allow us to identify the level of grant that would cross the line from incentive into subsidy and negotiate the ABIF contribution accordingly.


Avoiding displacement
Afghanistan has a very limited commercial investment finance market. Bank corporate lending is minimal and there are very few investment finance products available on the market. However, there is something, however inadequate, going on. The last thing that a donor funded grant fund should do is to nip the market in the bud by blundering in and distributing grants to private sector investors. The danger of displacement is very real.

To try to avoid displacement, the original ABIF design had as an eligibility criteria that the investment project should have failed to attract commercial finance. In other words, the fund would only provide a grant if the banks wouldn't touch the investment project. Sounds sensible at first glance, but two issues:
  1. Another blunt instrument; why shouldn't ABIF support projects that banks would fund, but because of high interest rates (about 20% in Afghanistan) the investment is non-viable?
  2. The risk of gaming is obvious; get a letter from a bank declining a loan, and go to ABIF where you can get free money!
Again, the risk based investment strategy provides an answer. By understanding the investment project risk and the cashflows associated with the project, it is relatively straightforward to arrive at a weighted average cost of capital (WACC) that turns a commercially viable project into a viable investment opportunity. In any country, the WACC would be derived from the cost of equity and debt to the investor. The justification for ABIF providing grants is that the WACC for Afghan investors is so high that investment doesn't pay, the returns are simply not high enough to cover the cost of the finance.

ABIF cannot change the risk that determines the cost of capital, and it cannot change the future investment project cashflows, but it can reduce the size of the original investment to achieve those cashflows. So ABIF provides an investor with a third financing option; in addition to equity and debt, the investor can apply for a grant. We know the cost of debt (about 20%), we know the cost of grant (0%) and if we can find out the cost of equity (in Afghanistan, retained earnings), we can calculate the appropriate level of grant that would avoid displacement of other sources of finance. Knowing this number would allow us to provide a complimentary source of finance, rather than a competing source of finance. ABIF will be able to offer grants at a level that fits into the realities of the commercial finance market.

The way forward
Having designed and agreed the principles of this risk based investment strategy, the next step is to work out the details and put it into practice. So far as we are aware, this is the first time that a challenge fund has tried to bring this degree of rigour to its grant giving so there is no model to follow from the world of private sector development.

Our plan is to conduct a kind of business confidence survey. By speaking with business leaders around Afghanistan, we can understand their perceptions of risk and therefore their implied cost of equity. This survey will need careful planning and design, but we do think that the results will allow us to:
  1. Arrive at an estimate of the implied cost of equity; and
  2. Uunderstand varying risk perceptions around Afghanistan.
Armed with this understanding, the next step will be to interpret the survey findings and incorporate them into the detailed investment modelling tools. Given that applicants have to demonstrate the commercial viability of their proposals (one essential tool being a cashflow forecast), we should have the necessary data to complete the calculations.

It will be extremely interesting to see how this works in practice, but it is particularly pleasing that we now have an investment strategy that will ensure that the project is as rigorous about controlling its inputs as it is about measuring its results.