Tackling the Risk or ‘Perceived Risk’ of Inclusive Business Investments
When risk mitigation processes are put in place, inclusive business deals are no more risky than other investments – it’s is just a different kind of risk.
Earlier this year, inclusive business pioneers and thought leaders from across Asia came together to share ideas, experience and knowledge at ADB’s 2nd Inclusive Business Forum for Asia in Manila. The result was four days of lively discussion, collaboration and questioning on the state of inclusive business in the region and where it is heading.
A new report, entitled A Gathering of Pioneers, takes an in-depth look at the key themes discussed and the implications for Asia.
The risk associated with investing in inclusive business as opposed to mainstream business is a common topic amongst those engaged in inclusive business and is often cited as being a major deterrent for investors. Risk was a key topic of discussion at the Forum as well and while investors expressed the need for caution, they agreed that by putting risk mitigation processes in place, inclusive business deals are no more risky than other investments, it is just a different kind of risk.
Jorim Schraven from FMO, the Dutch development bank) admitted that formerly as Chair of the FMO Investment Committee he had ‘looked unfavorably’ at inclusive business deals. Risk, particularly operational risk, tends to cascade through the inclusive business deal. Uncertainty about base of the pyramid (BoP) consumer behavior underpins operational risk. But the complex structures that create layers of risk in inclusive business deals also help to share and thus mitigate risk.
In the opening session, Lito Camacho from Credit Suisse explained that inclusive business investments can generate as good a return as other deals and it is an advantage that inclusive business deals have risks that are unrelated to other risks that Credit Suisse takes as an institution.
More or less risky?
Why inclusive business may be more risky:
- Business model is unproven. Scalability is unproven.
- BoP market is unfamiliar and information is lacking.
- Multiple players add to complexity.
- Inclusive business models such as Lifespring Hospitals are asset-light, lack collateral.
Why inclusive business may be less risky:
- It involves multiple stakeholders and disperses risk.
- Understanding of the poor reduces risk.
- Takes a long-term view
- Doesn’t just look at quarterly profits.
- Risks are weakly correlated to other investment risks (so may be counter-cyclical).
A wide range of suggestions for how to clarify and mitigate risk emerged, falling into 3 broad categories:
1. Sharing financial risk
- Financing arrangements that include first loss guarantees and other forms of risk-sharing amongst investors.
- Deal structures such as milestone-based investments, convertible notes, put options, syndications; inclusion of performance payments in the model as incentives.
- Integrating output-based payments and subsidies, tapping into government programs and grants.
2. Tightening the business model to reduce operational risk
- Invest where there is strong demand growth at the BoP.
- Understand the consumer and affordability, and invest in consumer capacity or community development.
- Pay huge attention to cost structures, use technology for scale at low cost.
- Coordinate value chain players to blend skills and build buy-in.
3. Good risk management processes include:
- Due diligence – deploy usual high standards of social, environmental and ESG risk screening to inclusive business deals.
- Reality check – visit on site to understand things on the ground and credibility of the partners.
IFC’s approach combining risk mitigation tools
Since 2005, IFC has invested $12.5 billion in more than 450 companies in 90 countries, reaching more than 250 million beneficiaries to date. A variety of risk mitigation tools are used, including first loss guarantees and incorporation of subsidies, attention to cost structures in the business model, and investing in the BoP consumer base.
For example, in the Manila Water investment, output-based aid was integrated, along with subsidized connection fees for poorer households, reducing the risk for investors. Investment in community development ensured that communities would decide on cost-sharing and police against non-metered water use.
Beneficiaries of the water meters grew successfully from 300,000 to 1.8 million in 2002-2014. First loss guarantees were seen as better than subsidy because they reduce the price of capital but market principles still apply to the business. The costs of structuring deals are high, particularly the first time, due to the discovery process.
Mitigating risk through financing structures and engagement with BoP clients
In an ADB investment in Pakistani dairy supply, it was more important to focus negotiations on how to mitigate risk than on rates of return. DFID agreed to provide first loss cover of up to 20%. The dairy company agreed to take 10% second loss, ADB and the local bank agreed to cover 70% as third loss. Due to this structure, it was possible to offer credit to farmers at lower rates (15-20% below MFI rates for a 5-year loan) thus enhancing the social impact and scalability of the business. Arrangements with the dairy farmers further reduce default risk: as they get paid by the dairy weekly, so repayments were arranged weekly. Good repayment performance leads to eligibility for further loans, acting as further incentive. Finally, support from a veterinary team further reduces non-payment risk.
Another example of careful engagement with consumers to reduce risks came from 8890. In the Philippines, 8890 sells low-cost housing ($9,000 – 20,000). A proactive collection platform focuses on educating consumers, providing financial literacy training and modifying their behavior. This has led to 96% collection efficiency and exponential growth.
Malik Rashid, a Risk Management Specialist with ADB, emphasized the importance of risk culture of the investor: “Being able to structure a transaction properly is important. But willingness to be able to close on a highly structured innovative or unprecedented transaction is determined by the risk culture in your organization.”