One of the things I learnt when writing the paper Risk, Return and Impact was how private equity investors think about required returns. I come from an economics background so presumed that equity investors would think in terms of “expected returns” — which are the product of potential outcomes and their respective probabilities (when you roll a dice the expected value is 3.5). If you were writing down an economic model of investment, that is what decisions would be based on.
It turns out that private equity investors often price deals by primarily looking at returns under a baseline scenario. I say “primarily” because they may also consider upside and downside scenarios, and discuss their likelihood, but they tend not to assign probabilities and compute an expected return.
This is rather like the interest rate on a loan, which is also what lenders receive if things go to plan (although debt is low risk and things go wrong far less often). But equity investors cannot “require” returns in the same way as lenders can, by specifying interest payments. What they can do is price equity — which amounts to valuing a business — so that if things go to plan, they will get the return they are looking for. But if things do not go to plan, that’s their tough luck. They cannot place a company in default and start legal proceedings, like a lender can.
This gap between “required” and “expected” returns is at its most extreme for venture capitalists, who might price deals to at least treble their money under whatever they consider a reasonable success scenario to look like, but then they may also expect three-quarters of their investments to fail and return nothing.
I think this misunderstanding (muddling up expected and required returns) — which I laboured under myself — really matters for how we think about private finance for development.
Imagine that you have $100 to invest and you want your money back. You have two options — Safeville, where you get your money back for sure, and Riskland, where half the time the project blows up, and you get nothing. That means if projects in Riskland return $200 when they succeed, the expected return in both places is $100. But you are “requiring” returns that will double your money in Riskland when things go to plan. Now if we observe that Riskland is not attracting much investment, is the problem here that private investors have unreasonably high “required” return expectations, or is the problem that projects blow up half the time? If you knew the private sector minimum return expectation was to double their money in Riskland, which would imply “required” returns of $400, that would be a completely different story — and a reason to blame low investment on high private risk premia — which is why this distinction matters.
Here is a table from the Finance for Climate Action report by the Independent High-Level Expert Group on Climate Finance, published at COP.
I presume this table is mislabelled and these are not required returns on solar projects, which are mostly financed by debt with much lower interest rates, but are rather the required returns of the equity investors in solar projects. If you want convincing on that point, try putting a 20% plus cost of capital into a “levelized cost of electricity” calculator and see how close you can get to the low single digit cent tariffs per kilowatt hour that are now routine in solar PV auctions (things have moved on since then, but the Kom Ombo solar project in Egypt hit a tariff of 2.5 cents/kWh).
Equity is the risk-bearing portion of solar project finance. When regulatory problems delay operations, it comes out of equity returns. Or when construction costs are higher than anticipated, or currency depreciation and FX shortage result in the project going into arrears, and so forth. I think these required returns numbers will reflect how projects are priced based on some reasonable base case scenario. I don’t think are expected returns. If you really think that you can make a 20% plus return on average from putting equity into solar PV in Africa, I suggest you pick up the phone to your pension fund manager [1]. As the authors of the Finance for Climate Action reports are at pains to point out, the main problem here is how often projects run into trouble, not unreasonable returns expectations.
What does this mean about the choice between public and private finance? If you are a government, in the absence of externalities, you also should not be putting $100 into projects that blow up half the time, unless they return $200 when they succeed [2]. The public sector expected return on investment need not be exactly the same as private — the risk premium should arguably be lower, for example. But the basic point remains — projects that fail are bad news when financed publicly too, and a higher return when things go to plan should be required from things that often fail.
If the argument is that a reliance on private finance is resulting in too few investments going ahead in risky countries because private required return hurdle rates are too high, the first point is that they are not as high as they appear (if they are “required” returns for equity) and the second point is, I think, that public sector required return hurdle rates ought to be high in those place too [3].
If there are positive externalities and the social returns on investment are higher than financial returns, then you have a case for subsidising the investment, and investing even if expected financial returns are negative. But that case for a subsidy is there whether the project is publicly or privately financed. Whether public or private finance is the most efficient choice is a complicated question that depends on a lot of factors — one of them could be unreasonable risk premia required by private investors. But you must look at expected returns to see risk premia, not returns required under a baseline scenario. High “required” returns from equity investors in risky environments are not enough to conclude that public investment would be the better choice, because public investment should also require more from riskier projects. If you want to subsidise green investments in low-income countries and think that cheap sovereign debt from multilateral banks for publicly financed projects is a more promising way to go about that than putting concessional blended finance into private projects, that’s a legitimate but different argument. The risks that are made visible in market required returns do not go away when publicly financed, and the costs of project failure must be paid either way.
[1] The IMF report Private Finance for Development: wishful thinking or thinking out of the box? (pp 26–29) reports that average realised returns in African private equity funds and returns on equity reported by firms in Africa, in most recent years, have been close to 5%.
[2] There is a whole set of interesting questions here about how the choice of structure (public or private finance, ownership and operation) affects how often projects blow up and what happens when they do … which are going to have to wait for another day.
[3] I am betraying my ignorance of how publicly financed projects are structured here, but I don’t imagine that public investment necessarily portions project finance into a risk-bearing equity-like component with a different return hurdle to a lower risk debt component. So the return financial hurdle on a public project may look more like the “weighted average cost of capital” (i.e. the combination of debt and equity) in a private project.
