Development finance institutions (DFIs) exist to contribute to development by supporting the growth of profitable private enterprises. When development finance institutions report profits, they are sometimes accused of putting profit before development. However, it is a fundamental misunderstanding to see profit and development as necessarily opposed. We would not help countries modernise their economies and eradicate poverty by losing money through investing in failed businesses.
Whilst this is important, it is not enough to really understand the relationship between financial returns – incorporating risk – and development impact. That requires understanding of how assets are priced, and how DFIs interact with private investment markets. It also involves thinking about how these relationships look at a portfolio level, and the difference between expected returns and expected impact, and realised returns and realised impact. A new paper Risk, return and impact digs into the detail.
The main points are:
- DFIs should be seen as pursuing a set of distinct investment strategies, that deliver impact in different ways. These strategies involve different combinations of impact, risk, and return.
- By pricing on commercial terms, DFIs can ensure that businesses who have no need of their support see no advantage in obtaining it. DFIs do not have an impact when they crowd-out private investors without adding anything, and pricing on commercial terms can help prevent that.
- DFIs can sometimes combine higher impact, higher risk, and lower financial returns by investing on concessional terms. But this must be done selectively, only when necessary and justified by potential impact.
- One of the ways in which DFIs generate impact is by having a higher tolerance for risk than purely commercial investors. But riskier assets are often priced to generate higher expected returns. Although DFIs often operate in market segments where risks are not fully compensated for by returns, high returns are sometimes the result of successful risk-taking.
The bottom line is that it is very difficult to infer anything about impact from a DFI’s reported financial returns. It all depends on where those profits came from. The relationship between risk, return and impact is complicated, and defies the idea of a simple trade-off.
To enable DFIs to construct portfolios that deliver the best combination of impact and financial returns, we would like to know what combinations of risk, return and impact investors have to choose from. That is not an easy question to answer, because we lack a universal yardstick with which to measure impact. British International Investment has recently introduced an Impact Scoring tool that assigns a score to investments, based on their alignment with our strategic impact objectives We hope to have a large enough sample to begin to analyse delivered impact alongside measures of financial risk and return by the end of this five-year strategy period. This note discusses these issues in principle, and how we might interpret data on impact and returns once it becomes available.
