CD Insight

21/02/2021
Read time: 13 min
  • Article

Annual CEO letter – Increasing investments in frontier markets 2021

Reflecting on 2020 and the pathway forward

With global economic systems disrupted due to the pandemic and many local financial markets severely affected, we have encountered many new learnings and challenges, but certainly also new opportunities for 2021. In our first Cardano Development Annual Letter, I reflect on the year gone by and write about the trends we see in frontier financial markets for 2021. We also look back at the inspiring work we have done in shaping local financial markets and why we think the risks we have taken and overcome have set us up well for future progress.

Pandemic?

There are still many unknowns about the effects of the COVID-19 pandemic on the economies in which we are working. There was a broad expectation of severe impacts on societies in developing countries, where the health systems are clearly unable to cope with a large-scale health crisis and social safety nets are non-existent. The impact on financial markets and debt portfolios of financial institutions in Africa and Asia, however, for now do not appear to be suffering from major financial stress.

Nevertheless, the economic effects are deep and disturbing. There is no question that at the Base of the Pyramid, economic distress has set back years of progress. The financial system can and does provide liquidity support to maintain value and employment for the real sector they service, but it appears that the pandemic has exacerbated pre-pandemic access to finance issues for the missing middle, especially in frontier markets. Now is a critical time for us all to double our efforts towards reducing unemployment for lower and middle-income households.

SMEs are suffering from a lack of economic momentum caused by macro-economic shocks, as well as tightening sources of capital as banks become more risk adverse. SMEs in frontier markets were already facing challenges to mobilise sufficient working capital and now the mainstream banks are more hesitant to invest in this segment. DFIs do not have the reach and the financial capacity to fully compensate for this trend, especially as this segment is traditionally hard to reach. We are therefore quite concerned about the potentially negative effects of COVID-19 on the inclusivity of the local financing systems in developing countries.

What are the trends we see as Cardano Development in financial market development for 2021?

Local currency finance – Now more important than ever

There is a great need for local currency financing in developing countries. The historic profiles of currency fluctuations in the past decades shows that FX crises affecting developing countries were relatively scarce in the period 1985 – 2005 but have since then occurred far more frequently.

Unfortunately, loans to borrowers in developing countries are still predominantly provided by international lenders and denominated in hard currency, which leaves borrowers exposed to exchange rate risk which can cause serious problems in the event of severe currency depreciation. With the economic disruption of COVID-19, developing country borrowers should be even more wary than normal to take on currency mismatches to avoid unmanageable debt levels.

According to the World Bank, sub- Saharan Africa’s public debt is projected to have increased to 63.1% of the GDP in 2020, from 58.5% of GDP recorded in 2019, rising further to 67.4% of GDP in 2021. In Q3 2020 alone there were USD 4 billion in Eurobonds issued. To avoid creating the next developing country debt crisis, more local currency options need to be offered and utilised.

All of our activities actively promote and prioritise the avoidance of currency mismatches in the provision of capital to target client sectors in developing countries. This is most visible in three of our existing mandates, TCX Fund, GuarantCo and The Water Finance Facility, who have the promotion of local currency finance at the core of their mission.

As donor agencies were adapting to reducing budgets and expanding ambitions, the concept of blended finance was established in the past decade. Rather than operate outside of the financial markets, using government-to-government grants to achieve development goals, donor agencies have learned to adapt their models to catalyse private investor interest by providing de-risking capital alongside investors. Simultaneously, more philanthropic investors with more diverse interests have emerged at some scale to enrich the financial marketplace.

The result is that currently, the opportunities abound to pursue meaningful business concepts with the support of patient capital that allows start-ups the time to achieve break-even before scaling up with more commercial funds.

Institutional investors are the largest potential pool of additional capital for the SDGs, with approximately USD220 trillion in assets under management (AUM). The potential is enormous, and the topics of ESG and impact investing are undoubtedly gaining momentum. The inconvenient truth is that a limited number of institutional investors have the appetite to invest in Emerging Markets Assets and remain on the fence regarding impact investing outside of home markets. We have seen over the past years with our work, that there is a clear mismatch between talk and practice, and we discern several reasons for this:

1 – Emerging Market listed debt, the benchmark for the asset class, is highly concentrated on sovereign and extractive industry issuers with high volatility and frequent defaults, leading to a high-risk perception with institutional investors.

2 – Emerging Market and Frontier Market private debt, as provided e.g. by the development banks, has a much better credit track record but publicly available data is lacking to prove its quality. While net yields on private debt are competitive, nominal gross yields appear unattractive.

3 – Investment volumes are too low and deal size is too small to compel institutional investors to invest time and effort in understanding the Emerging Market and Frontier Market private debt asset class.

Yet momentum in favor of “investing with a purpose” in undoubtedly building with institutional investors in Europe and the US. Starting with the relatively unintrusive “ESG lens” investing, we have seen serious first-mover activity with pension funds and other institutional investors in the Netherlands, Scandinavia, and the UK that are developing mandates for emerging market impact investing, i.e. with prior intent of achieving positive change (e.g. climate or jobs). We expect this trend to gather pace and become a very meaningful contributor to the achievement of the SDG goals.

There is no doubt that in many (medium-sized) developing countries the local institutional investor communities (banks, pension funds, insurance companies and mutual funds) have undergone tremendous development in size and capacity. As local institutional savings undergo enhanced formalisation and institutions achieve size, the investor appetite to diversify away from sovereign bonds into the productive sectors such as infrastructure and corporates is gathering pace.

Local markets in developing countries come from a low base, still hampered by serious constraints (insufficient in scale, too expensive, too limited in reach and too short-dated) to support broad and sustainable economic growth and is a specific constraint on the delivery of the SDGs. Nevertheless, the time is ripe in many markets for catalyst interventions that assist and speed up the natural evolution taking place.

What is Cardano Development doing?

Cardano Development strengthens local financial markets in the developing world by designing and implementing innovative financial business concepts that make a difference. We use the best that donors, DFIs, international investors and domestic capital players can offer to create scaled innovative solutions for inclusive finance.

Our work in enhancing financial market development is designed to improve the inclusiveness of financial systems and to support economies against future shocks. Currently, developing countries are at serious risk of being left behind, with recent achievements in improved inclusive finance being overtaken by negative economic fall-out of reduced growth and, in certain sectors and countries, total meltdown that invariably hits the poorest the hardest.

We are therefore redoubling our efforts to contribute to growth and impact. Our existing business models have proven resilient and are poised to scale up in the efforts to regain ground in the coming year, where swift economic recovery at the Base of the Pyramid is needed to get companies and households back on track. Fortunately, neither our existing mandates nor our start-up projects are facing any threats to their continuity, some have even been presented with additional business opportunities. We are evolving as a group and addressing new investment and expansion opportunities as we innovate and grow.

Last year, Cardano Development produced its Theory of Change (ToC) which explains our pathway to shape and change financial markets through local currency financing. We strongly believe that finance is an essential ingredient to inclusive, sustainable and resilient economic growth.

Investing in more sustainable land use

Most banks perceive the risks associated with primary agricultural finance in developing countries to be too high to invest in and do not have sufficient long-term funding to provide long-term lending. Investing in good land practices and investments to counter deforestation have long repayment profiles that require extended tenors, beyond what can be supported by banks which are limited by ever-increasing stringent banking regulations.

Last year, the AGRI3 Fund was established by Rabobank and UNEP, together with partners IDH and FMO, as a blended finance vehicle to blend public and private funding and offer commercial banks long-term affordable capital which enables them to offer competitive terms to their clients who want to invest in better agricultural practices and enhance rural livelihoods. The fund is a classic blended finance vehicle with an innovative risk reduction structure and has recently completed its first transactions in Brazil and China. Cardano Development is one of AGRI3 Fund’s investment advisors, alongside FOUNT and Mirova.

We believe that AGRI3’s model is highly replicable by other banks and that using existing international financial structures and adapting them as appropriate in consideration of the commodity and country in question is an effective way to drive capital and knowledge (through technical assistance) to emerging markets. AGRI3 has USD 80 million in investable capital, provided 50/50 by the Dutch government (DGIS) and Rabobank. A further investment of USD 40 million is expected in 2021 by the Green Environment Fund, an entity of the World Bank.

Establishing a fintech for SME working capital

In 2020 Cardano Development established IMFact, a start-up to implement an innovative and highly risk-managed way to provide working capital to African SMEs. Its concept uses factoring, i.e. purchasing receivables from clients. However, in contrast to mainstream factoring practice, IMFact has designed the product’s specs to reduce risks (by using very conservative advance rates over a diversified pool of invoices) and thereby achieving (app-based) easy-to-access and very competitively priced funding for SMEs. In a second development phase, the product will be highly suitable as a fintech solution to reach deep down-market.

IMFact is starting in Kenya, working closely with the Medical Credit Fund, Total Impact Capital and FSD Africa Investments to provide financing for companies in the pharmaceutical value-chain. Healthcare is a particularly popular focus for donors, however, health-based transactions have become less frequent in recent years. They represent only 5% of annual transactions as reported by the CBF State of Blended Finance report. Even with these findings, I see an untapped potential for blended finance in advancing healthcare solutions, especially with the impact of COVID-19.

We intend IMFact to diversify to other SME value chains and other countries in the near future, unlocking its potential across the African continent. We have identified Morocco as the next country of operation where we intend to develop mainstream and sharia-compliant products in 2021.

IMFact is also the second of our initiatives that has a business model based on local management teams operating in a target country and predominantly targeting the use of local capital Water Finance Facility was the first, also in Kenya). Considering the fast rate of financial market growth in Africa and Asia, we realize that local intervention teams are more efficient in responding to market needs. We believe that this model makes optimal use of the positive developments in local financial markets, whilst the more direct link to the local real economy allows us to achieve more direct impact.

Our on-ground teams incorporate local talent, and we believe it’s essential that companies foster the mindset of diversity and inclusion when connecting with the local network to maintain a competitive edge.

Enhancing our corporate networking firepower

As everyone made a switch to remote work and international travel ground to a halt, the professional community has had to adapt to working without face-to-face contact, which can be challenging when dealing with hard negotiations and networking.

Human contact and networks with the outside world is vital for financial companies in developing countries, to stay in touch with innovations and capital options in order to grow. With our extensive networks both internationally and locally, we believe that we can play a meaningful role in continuing to connect domestic companies with the international community. During 2020, Cardano Development set up Financial Meetup events (in collaboration with our partner Footlight International), a match-making platforms to bring parties together to foster interaction and ultimately mobilise responsible investments and enable sustainable finance in emerging markets.

Small-ticket investors desiring societal impact is growing and the adoption of ESG principles is driving the ESG market, which is forecasted to reach USD 45 trillion in Assets under Management in 2020. Responding to the need to raise capital for our start-ups, Cardano Development intends to explore options to tap into this powerful development. As a first step, Cardano Development published a debt investment offering on the OnePlanetCrowd funding platform in December 2020. The target amount of EUR 500,000 was raised in under 48 hours. We were pleased with this success and are in process of extending this option to offer co-financing equity participations in the start-ups that we are developing.

In our continued efforts to reach new investors, last year we conducted preliminary research with the Young Advisory Group on developing partnerships with Family Offices which we expect will form part of our long-term investment strategy.

Concluding remarks

The state of many EMDC markets  is developing rapidly, now is the time to look out for opportunities. The key to our success is to be client-driven with our innovations, concentrate on meaningful and scalable options, be very aware of the needs of potential stakeholders and (blended) capital providers, and persevere, with driving innovative risk-management solutions to market.

One of the key elements of our innovation is the use of market data to properly assess risks and rewards. We would like 2021 to be the year that the financing community in the developing world comes together to gather, share and disseminate data on an ever-widening scale, urgently needed to unlock capital required for the exponential growth in investments needed to achieve the SGDs. We need pioneers with innovative business concepts and investors with the risk-appetite to forge frontier market development.

The main observation that I have in looking back on 2020 is the resilience and grit that is apparent in the societies in Africa and Asia in the face of the ultimate adversity that we saw this year. In the streets of Nairobi, Lagos, Dhaka and elsewhere, people are making do as best they can and have shown a superior ability to adjust to the new realities. This gives me hope that 2021 can show a swift recovery and a return to growth.

I am also very impressed with the continued determination and urgency that the teams in our company have demonstrated throughout this period. I have seen us adjust to new working practices and new ways of collaborating from a distance with resolve and good spirits, and I hope to see that we can maintain our positive drive to the conclusion of this pandemic and that we will all come out healthy and sound.

Our people and our businesses have risen to the challenge in 2020. I have no doubt that we are uniquely placed to benefit from the trends that are happening around us as I have noted in this letter, and I am looking forward to another successful year ahead for all our companies.

CD Insight

21/02/2021
Read time: 13 min

Annual CEO letter – Increasing investments in frontier markets 2021

Reflecting on 2020 and the pathway forward

With global economic systems disrupted due to the pandemic and many local financial markets severely affected, we have encountered many new learnings and challenges, but certainly also new opportunities for 2021. In our first Cardano Development Annual Letter, I reflect on the year gone by and write about the trends we see in frontier financial markets for 2021. We also look back at the inspiring work we have done in shaping local financial markets and why we think the risks we have taken and overcome have set us up well for future progress.

Pandemic?

There are still many unknowns about the effects of the COVID-19 pandemic on the economies in which we are working. There was a broad expectation of severe impacts on societies in developing countries, where the health systems are clearly unable to cope with a large-scale health crisis and social safety nets are non-existent. The impact on financial markets and debt portfolios of financial institutions in Africa and Asia, however, for now do not appear to be suffering from major financial stress.

Nevertheless, the economic effects are deep and disturbing. There is no question that at the Base of the Pyramid, economic distress has set back years of progress. The financial system can and does provide liquidity support to maintain value and employment for the real sector they service, but it appears that the pandemic has exacerbated pre-pandemic access to finance issues for the missing middle, especially in frontier markets. Now is a critical time for us all to double our efforts towards reducing unemployment for lower and middle-income households.

SMEs are suffering from a lack of economic momentum caused by macro-economic shocks, as well as tightening sources of capital as banks become more risk adverse. SMEs in frontier markets were already facing challenges to mobilise sufficient working capital and now the mainstream banks are more hesitant to invest in this segment. DFIs do not have the reach and the financial capacity to fully compensate for this trend, especially as this segment is traditionally hard to reach. We are therefore quite concerned about the potentially negative effects of COVID-19 on the inclusivity of the local financing systems in developing countries.

What are the trends we see as Cardano Development in financial market development for 2021?

Local currency finance – Now more important than ever

There is a great need for local currency financing in developing countries. The historic profiles of currency fluctuations in the past decades shows that FX crises affecting developing countries were relatively scarce in the period 1985 – 2005 but have since then occurred far more frequently.

Unfortunately, loans to borrowers in developing countries are still predominantly provided by international lenders and denominated in hard currency, which leaves borrowers exposed to exchange rate risk which can cause serious problems in the event of severe currency depreciation. With the economic disruption of COVID-19, developing country borrowers should be even more wary than normal to take on currency mismatches to avoid unmanageable debt levels.

According to the World Bank, sub- Saharan Africa’s public debt is projected to have increased to 63.1% of the GDP in 2020, from 58.5% of GDP recorded in 2019, rising further to 67.4% of GDP in 2021. In Q3 2020 alone there were USD 4 billion in Eurobonds issued. To avoid creating the next developing country debt crisis, more local currency options need to be offered and utilised.

All of our activities actively promote and prioritise the avoidance of currency mismatches in the provision of capital to target client sectors in developing countries. This is most visible in three of our existing mandates, TCX Fund, GuarantCo and The Water Finance Facility, who have the promotion of local currency finance at the core of their mission.

As donor agencies were adapting to reducing budgets and expanding ambitions, the concept of blended finance was established in the past decade. Rather than operate outside of the financial markets, using government-to-government grants to achieve development goals, donor agencies have learned to adapt their models to catalyse private investor interest by providing de-risking capital alongside investors. Simultaneously, more philanthropic investors with more diverse interests have emerged at some scale to enrich the financial marketplace.

The result is that currently, the opportunities abound to pursue meaningful business concepts with the support of patient capital that allows start-ups the time to achieve break-even before scaling up with more commercial funds.

Institutional investors are the largest potential pool of additional capital for the SDGs, with approximately USD220 trillion in assets under management (AUM). The potential is enormous, and the topics of ESG and impact investing are undoubtedly gaining momentum. The inconvenient truth is that a limited number of institutional investors have the appetite to invest in Emerging Markets Assets and remain on the fence regarding impact investing outside of home markets. We have seen over the past years with our work, that there is a clear mismatch between talk and practice, and we discern several reasons for this:

1 – Emerging Market listed debt, the benchmark for the asset class, is highly concentrated on sovereign and extractive industry issuers with high volatility and frequent defaults, leading to a high-risk perception with institutional investors.

2 – Emerging Market and Frontier Market private debt, as provided e.g. by the development banks, has a much better credit track record but publicly available data is lacking to prove its quality. While net yields on private debt are competitive, nominal gross yields appear unattractive.

3 – Investment volumes are too low and deal size is too small to compel institutional investors to invest time and effort in understanding the Emerging Market and Frontier Market private debt asset class.

Yet momentum in favor of “investing with a purpose” in undoubtedly building with institutional investors in Europe and the US. Starting with the relatively unintrusive “ESG lens” investing, we have seen serious first-mover activity with pension funds and other institutional investors in the Netherlands, Scandinavia, and the UK that are developing mandates for emerging market impact investing, i.e. with prior intent of achieving positive change (e.g. climate or jobs). We expect this trend to gather pace and become a very meaningful contributor to the achievement of the SDG goals.

There is no doubt that in many (medium-sized) developing countries the local institutional investor communities (banks, pension funds, insurance companies and mutual funds) have undergone tremendous development in size and capacity. As local institutional savings undergo enhanced formalisation and institutions achieve size, the investor appetite to diversify away from sovereign bonds into the productive sectors such as infrastructure and corporates is gathering pace.

Local markets in developing countries come from a low base, still hampered by serious constraints (insufficient in scale, too expensive, too limited in reach and too short-dated) to support broad and sustainable economic growth and is a specific constraint on the delivery of the SDGs. Nevertheless, the time is ripe in many markets for catalyst interventions that assist and speed up the natural evolution taking place.

What is Cardano Development doing?

Cardano Development strengthens local financial markets in the developing world by designing and implementing innovative financial business concepts that make a difference. We use the best that donors, DFIs, international investors and domestic capital players can offer to create scaled innovative solutions for inclusive finance.

Our work in enhancing financial market development is designed to improve the inclusiveness of financial systems and to support economies against future shocks. Currently, developing countries are at serious risk of being left behind, with recent achievements in improved inclusive finance being overtaken by negative economic fall-out of reduced growth and, in certain sectors and countries, total meltdown that invariably hits the poorest the hardest.

We are therefore redoubling our efforts to contribute to growth and impact. Our existing business models have proven resilient and are poised to scale up in the efforts to regain ground in the coming year, where swift economic recovery at the Base of the Pyramid is needed to get companies and households back on track. Fortunately, neither our existing mandates nor our start-up projects are facing any threats to their continuity, some have even been presented with additional business opportunities. We are evolving as a group and addressing new investment and expansion opportunities as we innovate and grow.

Last year, Cardano Development produced its Theory of Change (ToC) which explains our pathway to shape and change financial markets through local currency financing. We strongly believe that finance is an essential ingredient to inclusive, sustainable and resilient economic growth.

Investing in more sustainable land use

Most banks perceive the risks associated with primary agricultural finance in developing countries to be too high to invest in and do not have sufficient long-term funding to provide long-term lending. Investing in good land practices and investments to counter deforestation have long repayment profiles that require extended tenors, beyond what can be supported by banks which are limited by ever-increasing stringent banking regulations.

Last year, the AGRI3 Fund was established by Rabobank and UNEP, together with partners IDH and FMO, as a blended finance vehicle to blend public and private funding and offer commercial banks long-term affordable capital which enables them to offer competitive terms to their clients who want to invest in better agricultural practices and enhance rural livelihoods. The fund is a classic blended finance vehicle with an innovative risk reduction structure and has recently completed its first transactions in Brazil and China. Cardano Development is one of AGRI3 Fund’s investment advisors, alongside FOUNT and Mirova.

We believe that AGRI3’s model is highly replicable by other banks and that using existing international financial structures and adapting them as appropriate in consideration of the commodity and country in question is an effective way to drive capital and knowledge (through technical assistance) to emerging markets. AGRI3 has USD 80 million in investable capital, provided 50/50 by the Dutch government (DGIS) and Rabobank. A further investment of USD 40 million is expected in 2021 by the Green Environment Fund, an entity of the World Bank.

Establishing a fintech for SME working capital

In 2020 Cardano Development established IMFact, a start-up to implement an innovative and highly risk-managed way to provide working capital to African SMEs. Its concept uses factoring, i.e. purchasing receivables from clients. However, in contrast to mainstream factoring practice, IMFact has designed the product’s specs to reduce risks (by using very conservative advance rates over a diversified pool of invoices) and thereby achieving (app-based) easy-to-access and very competitively priced funding for SMEs. In a second development phase, the product will be highly suitable as a fintech solution to reach deep down-market.

IMFact is starting in Kenya, working closely with the Medical Credit Fund, Total Impact Capital and FSD Africa Investments to provide financing for companies in the pharmaceutical value-chain. Healthcare is a particularly popular focus for donors, however, health-based transactions have become less frequent in recent years. They represent only 5% of annual transactions as reported by the CBF State of Blended Finance report. Even with these findings, I see an untapped potential for blended finance in advancing healthcare solutions, especially with the impact of COVID-19.

We intend IMFact to diversify to other SME value chains and other countries in the near future, unlocking its potential across the African continent. We have identified Morocco as the next country of operation where we intend to develop mainstream and sharia-compliant products in 2021.

IMFact is also the second of our initiatives that has a business model based on local management teams operating in a target country and predominantly targeting the use of local capital Water Finance Facility was the first, also in Kenya). Considering the fast rate of financial market growth in Africa and Asia, we realize that local intervention teams are more efficient in responding to market needs. We believe that this model makes optimal use of the positive developments in local financial markets, whilst the more direct link to the local real economy allows us to achieve more direct impact.

Our on-ground teams incorporate local talent, and we believe it’s essential that companies foster the mindset of diversity and inclusion when connecting with the local network to maintain a competitive edge.

Enhancing our corporate networking firepower

As everyone made a switch to remote work and international travel ground to a halt, the professional community has had to adapt to working without face-to-face contact, which can be challenging when dealing with hard negotiations and networking.

Human contact and networks with the outside world is vital for financial companies in developing countries, to stay in touch with innovations and capital options in order to grow. With our extensive networks both internationally and locally, we believe that we can play a meaningful role in continuing to connect domestic companies with the international community. During 2020, Cardano Development set up Financial Meetup events (in collaboration with our partner Footlight International), a match-making platforms to bring parties together to foster interaction and ultimately mobilise responsible investments and enable sustainable finance in emerging markets.

Small-ticket investors desiring societal impact is growing and the adoption of ESG principles is driving the ESG market, which is forecasted to reach USD 45 trillion in Assets under Management in 2020. Responding to the need to raise capital for our start-ups, Cardano Development intends to explore options to tap into this powerful development. As a first step, Cardano Development published a debt investment offering on the OnePlanetCrowd funding platform in December 2020. The target amount of EUR 500,000 was raised in under 48 hours. We were pleased with this success and are in process of extending this option to offer co-financing equity participations in the start-ups that we are developing.

In our continued efforts to reach new investors, last year we conducted preliminary research with the Young Advisory Group on developing partnerships with Family Offices which we expect will form part of our long-term investment strategy.

Concluding remarks

The state of many EMDC markets  is developing rapidly, now is the time to look out for opportunities. The key to our success is to be client-driven with our innovations, concentrate on meaningful and scalable options, be very aware of the needs of potential stakeholders and (blended) capital providers, and persevere, with driving innovative risk-management solutions to market.

One of the key elements of our innovation is the use of market data to properly assess risks and rewards. We would like 2021 to be the year that the financing community in the developing world comes together to gather, share and disseminate data on an ever-widening scale, urgently needed to unlock capital required for the exponential growth in investments needed to achieve the SGDs. We need pioneers with innovative business concepts and investors with the risk-appetite to forge frontier market development.

The main observation that I have in looking back on 2020 is the resilience and grit that is apparent in the societies in Africa and Asia in the face of the ultimate adversity that we saw this year. In the streets of Nairobi, Lagos, Dhaka and elsewhere, people are making do as best they can and have shown a superior ability to adjust to the new realities. This gives me hope that 2021 can show a swift recovery and a return to growth.

I am also very impressed with the continued determination and urgency that the teams in our company have demonstrated throughout this period. I have seen us adjust to new working practices and new ways of collaborating from a distance with resolve and good spirits, and I hope to see that we can maintain our positive drive to the conclusion of this pandemic and that we will all come out healthy and sound.

Our people and our businesses have risen to the challenge in 2020. I have no doubt that we are uniquely placed to benefit from the trends that are happening around us as I have noted in this letter, and I am looking forward to another successful year ahead for all our companies.

CD Insight 21/02/2021

Read time: 13 min

Annual CEO letter – Increasing investments in frontier markets 2021

Reflecting on 2020 and the pathway forward

With global economic systems disrupted due to the pandemic and many local financial markets severely affected, we have encountered many new learnings and challenges, but certainly also new opportunities for 2021. In our first Cardano Development Annual Letter, I reflect on the year gone by and write about the trends we see in frontier financial markets for 2021. We also look back at the inspiring work we have done in shaping local financial markets and why we think the risks we have taken and overcome have set us up well for future progress.

Pandemic?

There are still many unknowns about the effects of the COVID-19 pandemic on the economies in which we are working. There was a broad expectation of severe impacts on societies in developing countries, where the health systems are clearly unable to cope with a large-scale health crisis and social safety nets are non-existent. The impact on financial markets and debt portfolios of financial institutions in Africa and Asia, however, for now do not appear to be suffering from major financial stress.

Nevertheless, the economic effects are deep and disturbing. There is no question that at the Base of the Pyramid, economic distress has set back years of progress. The financial system can and does provide liquidity support to maintain value and employment for the real sector they service, but it appears that the pandemic has exacerbated pre-pandemic access to finance issues for the missing middle, especially in frontier markets. Now is a critical time for us all to double our efforts towards reducing unemployment for lower and middle-income households.

SMEs are suffering from a lack of economic momentum caused by macro-economic shocks, as well as tightening sources of capital as banks become more risk adverse. SMEs in frontier markets were already facing challenges to mobilise sufficient working capital and now the mainstream banks are more hesitant to invest in this segment. DFIs do not have the reach and the financial capacity to fully compensate for this trend, especially as this segment is traditionally hard to reach. We are therefore quite concerned about the potentially negative effects of COVID-19 on the inclusivity of the local financing systems in developing countries.

What are the trends we see as Cardano Development in financial market development for 2021?

Local currency finance – Now more important than ever

There is a great need for local currency financing in developing countries. The historic profiles of currency fluctuations in the past decades shows that FX crises affecting developing countries were relatively scarce in the period 1985 – 2005 but have since then occurred far more frequently.

Unfortunately, loans to borrowers in developing countries are still predominantly provided by international lenders and denominated in hard currency, which leaves borrowers exposed to exchange rate risk which can cause serious problems in the event of severe currency depreciation. With the economic disruption of COVID-19, developing country borrowers should be even more wary than normal to take on currency mismatches to avoid unmanageable debt levels.

According to the World Bank, sub- Saharan Africa’s public debt is projected to have increased to 63.1% of the GDP in 2020, from 58.5% of GDP recorded in 2019, rising further to 67.4% of GDP in 2021. In Q3 2020 alone there were USD 4 billion in Eurobonds issued. To avoid creating the next developing country debt crisis, more local currency options need to be offered and utilised.

All of our activities actively promote and prioritise the avoidance of currency mismatches in the provision of capital to target client sectors in developing countries. This is most visible in three of our existing mandates, TCX Fund, GuarantCo and The Water Finance Facility, who have the promotion of local currency finance at the core of their mission.

As donor agencies were adapting to reducing budgets and expanding ambitions, the concept of blended finance was established in the past decade. Rather than operate outside of the financial markets, using government-to-government grants to achieve development goals, donor agencies have learned to adapt their models to catalyse private investor interest by providing de-risking capital alongside investors. Simultaneously, more philanthropic investors with more diverse interests have emerged at some scale to enrich the financial marketplace.

The result is that currently, the opportunities abound to pursue meaningful business concepts with the support of patient capital that allows start-ups the time to achieve break-even before scaling up with more commercial funds.

Institutional investors are the largest potential pool of additional capital for the SDGs, with approximately USD220 trillion in assets under management (AUM). The potential is enormous, and the topics of ESG and impact investing are undoubtedly gaining momentum. The inconvenient truth is that a limited number of institutional investors have the appetite to invest in Emerging Markets Assets and remain on the fence regarding impact investing outside of home markets. We have seen over the past years with our work, that there is a clear mismatch between talk and practice, and we discern several reasons for this:

1 – Emerging Market listed debt, the benchmark for the asset class, is highly concentrated on sovereign and extractive industry issuers with high volatility and frequent defaults, leading to a high-risk perception with institutional investors.

2 – Emerging Market and Frontier Market private debt, as provided e.g. by the development banks, has a much better credit track record but publicly available data is lacking to prove its quality. While net yields on private debt are competitive, nominal gross yields appear unattractive.

3 – Investment volumes are too low and deal size is too small to compel institutional investors to invest time and effort in understanding the Emerging Market and Frontier Market private debt asset class.

Yet momentum in favor of “investing with a purpose” in undoubtedly building with institutional investors in Europe and the US. Starting with the relatively unintrusive “ESG lens” investing, we have seen serious first-mover activity with pension funds and other institutional investors in the Netherlands, Scandinavia, and the UK that are developing mandates for emerging market impact investing, i.e. with prior intent of achieving positive change (e.g. climate or jobs). We expect this trend to gather pace and become a very meaningful contributor to the achievement of the SDG goals.

There is no doubt that in many (medium-sized) developing countries the local institutional investor communities (banks, pension funds, insurance companies and mutual funds) have undergone tremendous development in size and capacity. As local institutional savings undergo enhanced formalisation and institutions achieve size, the investor appetite to diversify away from sovereign bonds into the productive sectors such as infrastructure and corporates is gathering pace.

Local markets in developing countries come from a low base, still hampered by serious constraints (insufficient in scale, too expensive, too limited in reach and too short-dated) to support broad and sustainable economic growth and is a specific constraint on the delivery of the SDGs. Nevertheless, the time is ripe in many markets for catalyst interventions that assist and speed up the natural evolution taking place.

What is Cardano Development doing?

Cardano Development strengthens local financial markets in the developing world by designing and implementing innovative financial business concepts that make a difference. We use the best that donors, DFIs, international investors and domestic capital players can offer to create scaled innovative solutions for inclusive finance.

Our work in enhancing financial market development is designed to improve the inclusiveness of financial systems and to support economies against future shocks. Currently, developing countries are at serious risk of being left behind, with recent achievements in improved inclusive finance being overtaken by negative economic fall-out of reduced growth and, in certain sectors and countries, total meltdown that invariably hits the poorest the hardest.

We are therefore redoubling our efforts to contribute to growth and impact. Our existing business models have proven resilient and are poised to scale up in the efforts to regain ground in the coming year, where swift economic recovery at the Base of the Pyramid is needed to get companies and households back on track. Fortunately, neither our existing mandates nor our start-up projects are facing any threats to their continuity, some have even been presented with additional business opportunities. We are evolving as a group and addressing new investment and expansion opportunities as we innovate and grow.

Last year, Cardano Development produced its Theory of Change (ToC) which explains our pathway to shape and change financial markets through local currency financing. We strongly believe that finance is an essential ingredient to inclusive, sustainable and resilient economic growth.

Investing in more sustainable land use

Most banks perceive the risks associated with primary agricultural finance in developing countries to be too high to invest in and do not have sufficient long-term funding to provide long-term lending. Investing in good land practices and investments to counter deforestation have long repayment profiles that require extended tenors, beyond what can be supported by banks which are limited by ever-increasing stringent banking regulations.

Last year, the AGRI3 Fund was established by Rabobank and UNEP, together with partners IDH and FMO, as a blended finance vehicle to blend public and private funding and offer commercial banks long-term affordable capital which enables them to offer competitive terms to their clients who want to invest in better agricultural practices and enhance rural livelihoods. The fund is a classic blended finance vehicle with an innovative risk reduction structure and has recently completed its first transactions in Brazil and China. Cardano Development is one of AGRI3 Fund’s investment advisors, alongside FOUNT and Mirova.

We believe that AGRI3’s model is highly replicable by other banks and that using existing international financial structures and adapting them as appropriate in consideration of the commodity and country in question is an effective way to drive capital and knowledge (through technical assistance) to emerging markets. AGRI3 has USD 80 million in investable capital, provided 50/50 by the Dutch government (DGIS) and Rabobank. A further investment of USD 40 million is expected in 2021 by the Green Environment Fund, an entity of the World Bank.

Establishing a fintech for SME working capital

In 2020 Cardano Development established IMFact, a start-up to implement an innovative and highly risk-managed way to provide working capital to African SMEs. Its concept uses factoring, i.e. purchasing receivables from clients. However, in contrast to mainstream factoring practice, IMFact has designed the product’s specs to reduce risks (by using very conservative advance rates over a diversified pool of invoices) and thereby achieving (app-based) easy-to-access and very competitively priced funding for SMEs. In a second development phase, the product will be highly suitable as a fintech solution to reach deep down-market.

IMFact is starting in Kenya, working closely with the Medical Credit Fund, Total Impact Capital and FSD Africa Investments to provide financing for companies in the pharmaceutical value-chain. Healthcare is a particularly popular focus for donors, however, health-based transactions have become less frequent in recent years. They represent only 5% of annual transactions as reported by the CBF State of Blended Finance report. Even with these findings, I see an untapped potential for blended finance in advancing healthcare solutions, especially with the impact of COVID-19.

We intend IMFact to diversify to other SME value chains and other countries in the near future, unlocking its potential across the African continent. We have identified Morocco as the next country of operation where we intend to develop mainstream and sharia-compliant products in 2021.

IMFact is also the second of our initiatives that has a business model based on local management teams operating in a target country and predominantly targeting the use of local capital Water Finance Facility was the first, also in Kenya). Considering the fast rate of financial market growth in Africa and Asia, we realize that local intervention teams are more efficient in responding to market needs. We believe that this model makes optimal use of the positive developments in local financial markets, whilst the more direct link to the local real economy allows us to achieve more direct impact.

Our on-ground teams incorporate local talent, and we believe it’s essential that companies foster the mindset of diversity and inclusion when connecting with the local network to maintain a competitive edge.

Enhancing our corporate networking firepower

As everyone made a switch to remote work and international travel ground to a halt, the professional community has had to adapt to working without face-to-face contact, which can be challenging when dealing with hard negotiations and networking.

Human contact and networks with the outside world is vital for financial companies in developing countries, to stay in touch with innovations and capital options in order to grow. With our extensive networks both internationally and locally, we believe that we can play a meaningful role in continuing to connect domestic companies with the international community. During 2020, Cardano Development set up Financial Meetup events (in collaboration with our partner Footlight International), a match-making platforms to bring parties together to foster interaction and ultimately mobilise responsible investments and enable sustainable finance in emerging markets.

Small-ticket investors desiring societal impact is growing and the adoption of ESG principles is driving the ESG market, which is forecasted to reach USD 45 trillion in Assets under Management in 2020. Responding to the need to raise capital for our start-ups, Cardano Development intends to explore options to tap into this powerful development. As a first step, Cardano Development published a debt investment offering on the OnePlanetCrowd funding platform in December 2020. The target amount of EUR 500,000 was raised in under 48 hours. We were pleased with this success and are in process of extending this option to offer co-financing equity participations in the start-ups that we are developing.

In our continued efforts to reach new investors, last year we conducted preliminary research with the Young Advisory Group on developing partnerships with Family Offices which we expect will form part of our long-term investment strategy.

Concluding remarks

The state of many EMDC markets  is developing rapidly, now is the time to look out for opportunities. The key to our success is to be client-driven with our innovations, concentrate on meaningful and scalable options, be very aware of the needs of potential stakeholders and (blended) capital providers, and persevere, with driving innovative risk-management solutions to market.

One of the key elements of our innovation is the use of market data to properly assess risks and rewards. We would like 2021 to be the year that the financing community in the developing world comes together to gather, share and disseminate data on an ever-widening scale, urgently needed to unlock capital required for the exponential growth in investments needed to achieve the SGDs. We need pioneers with innovative business concepts and investors with the risk-appetite to forge frontier market development.

The main observation that I have in looking back on 2020 is the resilience and grit that is apparent in the societies in Africa and Asia in the face of the ultimate adversity that we saw this year. In the streets of Nairobi, Lagos, Dhaka and elsewhere, people are making do as best they can and have shown a superior ability to adjust to the new realities. This gives me hope that 2021 can show a swift recovery and a return to growth.

I am also very impressed with the continued determination and urgency that the teams in our company have demonstrated throughout this period. I have seen us adjust to new working practices and new ways of collaborating from a distance with resolve and good spirits, and I hope to see that we can maintain our positive drive to the conclusion of this pandemic and that we will all come out healthy and sound.

Our people and our businesses have risen to the challenge in 2020. I have no doubt that we are uniquely placed to benefit from the trends that are happening around us as I have noted in this letter, and I am looking forward to another successful year ahead for all our companies.

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