When the Economics Don’t Work: Realigning Capital Markets with Development Impact
We sat around the conference room table, as we’d been doing every six months for the previous five years, stealing furtive glances. Poker faces. Finally, someone broke the silence: “We’re not making any money – is anyone else?”
Collective exhale. One after another we went around the room, competitors finally acknowledging the shared challenges that confronted us all in trying to lend in nascent markets. From one seasoned impact investor: “We thought agriculture would be just like microfinance – three or four years to learn the sector and then solid returns and impact.” From another: “Forget decent returns – our board is pushing hard for us to reach break-even. The only way to do that is by going upmarket. We wish we could lend farther on the market frontier and achieve more impact but the economics just don’t work.”
The Challenge of Lending to Agricultural SMEs
The impact investors in that room had gathered in May 2017 for a meeting of the Council on Smallholder Agricultural Finance (CSAF), an industry alliance of 16 pioneering lenders that come together to share learning and promote best practices for lending to small- and medium-enterprises (SMEs) in the agriculture sector. CSAF includes several of the most successful impact investors in microfinance and renewable energy, many of which have been financing agricultural SMEs for over a decade. Collectively, CSAF members lend US $700 million to hundreds of agricultural SMEs each year.
These SMEs – from Fair Trade-certified coffee cooperatives aggregating smallholder farmers to cashew nut processors offering hundreds of mostly women employees their first regular paycheck – often supply some of the world’s largest food companies. In Africa, agricultural SMEs have the potential to create pathways out of poverty for thousands of farmers and low-skill workers. But this potential remains unrealized due to an estimated $65 billion annual financing gap, which translates to roughly three in four agricultural SMEs lacking the finance they need to grow.
What explains this financing gap? Simply put, the economics of serving agricultural SMEs are not attractive to lenders. These businesses are located in remote areas, have few assets to offer as loan collateral, and possess limited management capacity to navigate volatile markets and a changing climate. These factors, among others, mean that the revenue generated from loans to agricultural SMEs typically do not compensate for the risks or costs to serve them, and enterprises operating with thin margins are not able to pay the much higher interest rates lenders would need to charge to cover their costs.
As a result, lenders face a direct tradeoff between their impact objectives to expand access to finance for businesses serving marginalized rural communities in low-income countries, and the financial return requirements of their investors — most of whom identify as “impact investors” and are willing to accept higher risk and below-market returns.
This tension between impact objectives and financial sustainability is not unique to lending for agricultural SMEs, or even to development-focused investment approaches more broadly. It helps to explain the financing gap to achieve the UN Sustainable Development Goals that was estimated at $2.5 trillion annually even before COVID-19 exacerbated poverty levels and reduced the risk-appetite of capital providers. Unless capital markets can close this financing gap, the economic recovery from COVID-19 will be slow, with long-term human suffering and planetary stress far exceeding the immediate impacts felt today.
Current blended finance approaches are not enough
Back to the CSAF conference room, where the catharsis from sharing common challenges segued into heated discussions of potential solutions. Facing a trade-off between mission and financial sustainability, CSAF members decided to join forces in pursuing a third option: creating a mechanism to align impact with return.
So-called “blended finance” approaches in which public or philanthropic capital take a higher risk or lower return in order to crowd in commercial capital are increasingly common, at the level of an individual deal or in the capital structure of an investment fund. But we wanted to go a step further by aligning impact and financial sustainability for capital providers across an entire marketplace.
To that end, this September we launched Aceli Africa: a market incentive facility designed to align capital supply and demand. Aceli’s solution is simple in concept: use subsidy – smartly – to reward lenders for the impact they generate. To varying degrees of effectiveness, this is what every industrialized country around the world does to stimulate investment in strategic sectors of its economy. Aceli believes that the development community – including impact investors, development finance institutions and policymakers — needs to stop pretending that financing for the most marginalized sector in low-income countries is somehow going to become commercially viable within a few years. By drawing upon donor funding to offer lenders targeted financial incentives tied to specific objectives (e.g., food security or economic opportunities for women), Aceli aims to mobilize private capital for impact today – and generate competition that will reduce the amount required to incentivize new loans in the future.
While CSAF members birthed the idea, Aceli Africa is now housed at the Global Development Incubator and includes a diverse mix of lenders: Two-thirds of the 25 participating lenders are banks or non-bank lenders domiciled in East Africa, where Aceli is initially focusing. This geographic choice is strategic: Around 65% of the population in the region depends on agriculture as their primary source of livelihood, but only about 5% of commercial bank lending goes to the sector. Closing this gap is one of the keys to inclusive agricultural growth that creates employment for millions and improves food security across the region.
The journey to design Aceli Africa has been guided by three questions: 1) How much subsidy is required to catalyze a functioning capital market? 2) How can that subsidy be targeted to align market growth with social and environmental impact? And 3) Can we build a robust evidence base demonstrating that the benefits on livelihoods, food security and economic growth more than outweigh the upfront costs – and can we partner with African governments to adopt policies that expand and sustain these approaches?
The answers to these questions will have implications well beyond the agriculture sector. As COVID-19 threatens to erode decades of global progress against poverty, and as capital markets retreat in the wake of heightened risk and depressed returns, blended finance solutions at marketplace scale are needed now more than ever.
Part two of this series will focus on the data-driven approach to designing Aceli Africa’s solutions for building a thriving and inclusive marketplace. Part three will focus on how this approach could be applied to other sectors and geographies.
Photo courtesy of Budiey.