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IFC: An Expanded Role for Venture Capital

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1967
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David Grenier

WITHIN THE FAMILY of institutions known as the World Bank Group, a notable feature in recent years has been the expansion of the International Finance Corporation (IFC). This development is evident in a number of areas: the rising level of IFC’s investment operations, the increase in its capital resources, and the growth of its responsibilities within the Group. The very fact of the existence of an institution such as IFC indicates an unusual consensus on the part of some 83 member governments concerning the need to encourage private enterprise and private investment in the developing areas. The growth of IFC indicates how this broad objective can be furthered by an intergovernmental organization which provides risk financing on terms related to the going rate for private capital.

When IFC was established in July 1956 as an affiliate of the World Bank, its role was conceived as a distinct one. To supplement the work of the Bank, IFC was intended to help finance private enterprises, in association with private investors and management; to assist in developing local capital markets; and to encourage the international flow of private capital. Unlike the Bank, IFC was set up to deal exclusively with the private sector and to operate without any kind of government guarantee. Unlike the Bank, too, the most significant yardsticks of IFC’s operations were to be the extent to which it could act as a catalyst in stimulating other investment as well as its ability to revolve its own funds by selling off parts of its investments to other investors.

Nevertheless, IFC came into existence with two major handicaps. Its own share capital resources were comparatively limited. In addition, under its original Articles of Agreement, IFC was restricted from providing equity financing, even though it was expected to make loans with equity features, such as the right to participate in the profits of an enterprise. Experience showed that these restrictions limited IFC’s ability to meet the needs of private enterprises in the developing countries. As a result, IFC’s Articles have twice been amended: in 1961 to permit the Corporation to invest in equities, and in 1965 to permit IFC to supplement its own share capital of approximately $100 million by borrowing from the Bank. These changes have been reflected in the scope of IFC’s operations. It has emerged as the investment banking arm of the Bank Group. It takes minority equity participations, carries out stand-by and underwriting arrangements, and develops the kind of continuing relationship with clients characteristic of a private investment banker. It has also become the main point of contact between the Bank Group and private enterprise in the fields of industry, mining, and development finance companies. In each of these areas, IFC is responsible for appraising and supervising all projects submitted to the Group, irrespective of which member of the Group is to provide the financing.

Greater Flexibility

Over a period of time, IFC has become more flexible in the kinds and amounts of financing it will provide as well as in the range of enterprises it is prepared to finance. So far, the Corporation has confined its attention almost exclusively to the manufacturing industry: the bulk of the commitments of more than $200 million made to date by IFC have been to iron and steel, pulp and paper, textile, cement, and fertilizer companies. Recently, however, IFC has helped to finance ventures as diverse as an electricity utility company, a tourism project, and enterprises related directly to agriculture in the form of grain storage and livestock raising. In all, IFC has now made investments in enterprises located in 36 countries. While Latin America remains the region where IFC has made by far its largest over-all commitment—reflecting the range of private investment opportunities available in such countries as Brazil, Colombia, and Mexico—the Corporation has more recently extended its interests in Africa and Asia.

Since the removal of the charter restriction on equity investment, the normal method of IFC financing has become a blend of equity and long-term loan funds or, alternatively, straight equity. Less frequently, IFC may undertake financing through the purchase of convertible debentures or through a loan with a stock option attached. Only in two exceptional cases has IFC provided loan financing without equity or an equity feature.

The size and type of investment originally made by IFC were dictated not only by the limited availability of suitable projects but also by the limited size of its own resources. This position has changed now that substantially larger resources are available to IFC in the form of World Bank funds. Following the completion of amendments to the Articles of Agreement of the Bank and IFC in late 1965, the Corporation is at present permitted to supplement its own share capital and reserve of approximately $130 million by borrowing up to $400 million from the Bank. An initial Bank loan of $100 million to IFC was in fact approved last October, for use by IFC in the lending part of its investment operations. As a consequence, the upper limit on the size of the individual commitment IFC is prepared to make has been raised. Up to last year, the largest single commitment undertaken by IFC was of the order of $6 million. The maximum amount which IFC would ordinarily consider committing on its own account to a single enterprise is now $20 million. Reflecting the increased resources available from the Bank, IFC has in recent months made commitments of about $10-12 million, and others of similar size are now in prospect.

A Distinctive Role

IFC’s position within the Bank Group is a distinctive one. Unlike the Bank and the International Development Association, which are mainly concerned with major infrastructure projects in the public sector, IFC’s operations are concerned exclusively with the private sector, chiefly in industry. While the Bank and IDA are lending agencies, IFC is in a position to provide risk financing in the form of equity as well as long-term loan capital. In contrast to the Bank’s conventional lending rate and the “soft” terms of IDA credits, the terms of IFC financing are intended to be in line as far as possible with the expectations of private investors and designed specifically to attract their participation in IFC investments.

In examining investment proposals, IFC takes into account such factors as economic priority and potential profitability and tries to ensure that the presence of IFC is likely to make a constructive contribution. There are other factors to consider. The kinds of situations in which IFC is prepared to act are those where new money is needed; where sufficient private capital is not available on reasonable terms; where the sponsors, together with other investors, are prepared to make a meaningful contribution to the risk capital requirements; and where there is room for participation by local investors. It is through its attention to such criteria that IFC establishes its function as a development financing agency. At the same time, the Corporation takes much the same kind of position as would a private investor, in terms of attempting to determine the technical soundness of a project, the availability of markets for the company’s product or products, the competence and experience of the management, and the adequacy of the financial plan.

In the broadest possible sense, IFC tends to be involved in projects which, but for its catalytic role, might not go ahead. This in turn reflects the fact that IFC is in business to be more venturesome and take somewhat larger risks, whether business or political, than the market would be prepared to absorb. Since no two IFC investments are identical, the exact terms of IFC’s participation in a project vary considerably. In some instances, IFC may be needed to put up part of the “first money”, to get a project going and to give confidence to the private investors taking part; in other situations, IFC may be required to put up the “last money” needed to fill a gap in a financial plan.

Often, IFC may also be needed to provide financial entrepreneurship not available from other sources. This may involve putting together the kind of investment package available to the entrepreneur in the industrialized countries from specialists who can provide technical know-how, mobilize equity and long-term loan funds, recommend marketing and distribution arrangements, and establish effective management. IFC is in a position to provide some of these services but it does not provide or participate in management and is not a know-how partner, so that the actual sponsorship and technology for a project must come from private investors. Many of the enterprises in which IFC has invested are in fact joint ventures between local and foreign investors, with the foreign partner providing technical, managerial, and administrative skills and the local partner contributing knowledge of local market conditions and experience in handling relations with labor and government. In this kind of situation, IFC can sometimes act as a third party in helping to bring prospective partners together.

Developing Capital Markets

The greater emphasis today on IFC’s role in developing local capital markets and mobilizing local resources is seen in its activities as an underwriter of public offerings of securities. In this way, IFC can help to obtain some degree of public participation in the ownership of family-held or closely-held enterprises, which tend to be the norm in developing countries. The underwriting technique can also be used to help expand the ownership base of larger enterprises needing additional equity in order to increase their borrowing capacity. IFC has now made stand-by or underwriting commitments totaling $25 million to enterprises in some 10 countries, most notably Mexico, where the Corporation has on three occasions helped to underwrite securities offered by the largest shareholder-owned steel company in the country, Compania Fundidora de Fierro y Acero de Monterrey S.A. IFC’s partner in each of these operations was the subsidiary of a leading Mexican bank, with financial institutions in the United States and Europe acting as subunderwriters for a substantial part of the IFC commitment.

IFC’s function as an underwriter can be traced through its relationship with Fundidora. The initial IFC commitment, made in 1962, involved participation in a $4 million stock offering, together with a direct subscription to shares of the company. The capacity of the Mexican market to absorb the offering was limited, and only about 60 per cent of the issue was placed with shareholders during the underwriting period, the remainder being sold over the course of the following months. In 1964, IFC took part in a much larger transaction, involving the underwriting of a $12.2 million stock offering, this time with increased participation on the Mexican side. Despite the size of the offering, the largest ever to be made by a private enterprise in Mexico, the issue was nearly 100 per cent subscribed. Last year, IFC took part in a further underwriting of stock in the amount of $7.2 million, this time in conjunction with a private placement of $6 million of convertible debentures, denominated in U.S. dollars, the first paper of this kind to be issued by the company. Since 1962, these underwriting operations have helped to broaden the capacity of the Mexican capital market. The ownership of the company has increased from some 700 shareholders in 1962 to over 2,000 shareholders today. Finally, the recent private placement of convertible debentures will facilitate the company’s recourse to raising funds outside Mexico.

Development Finance Companies

Within the last five years, one of the major extensions of IFC’s operations has been in respect to development finance companies. These are institutions controlled by private shareholders, both domestic and foreign, and able to act as a focal point for growth of the private sector. They provide equity and medium and long-term loan capital to industry and other private enterprise, carry out underwriting operations, help to promote and finance new enterprises, and otherwise assist in developing capital markets. The Bank Group has been an important external source of funds for some 25 development finance companies of this kind in 21 countries, providing a total of over $560 million in capital resources. In turn, the development finance companies have represented a useful channel for providing finance for smaller or medium-sized enterprises to which the Group could not give effective direct assistance. Since 1962, IFC has become a shareholder in 17 development finance companies in 15 countries, involving commitments totaling nearly $19 million. On a number of occasions, IFC has joined with development finance companies in financing projects which required more capital than the companies alone could provide.

Apart from supplying share capital, IFC has assisted development finance companies in a variety of ways. In several countries, the Corporation has taken the lead in helping to reorganize and expand existing institutions, as in Finland, Morocco, Malaysia, Nigeria, and Thailand. The most recent example of this type of operation was in Tunisia, where IFC was responsible for helping to reorganize an existing government-owned institution, the Société Nationale d’Investissement (SNI). As a result of these arrangements, the World Bank last year agreed to make SNI a loan of $5 million, with IFC making an accompanying share investment. In addition, IFC was instrumental in securing the participation of French, German, Italian, and Swedish financial institutions as shareholders of SNI. As a consequence of the reorganization, SNI is now under private control.

IFC has also been prepared to assist in establishing new development finance companies where gaps in the local capital market have indicated a substantial need for a shareholder-owned institution, where the volume of business available has offered the prospect of profitable operation and where the government has been prepared to provide support. Examples of IFC’s operations in this respect include institutions established in the Philippines and Venezuela. Experience over the years has indicated that while development finance companies of the kind associated with the Bank Group can operate profitably in the larger countries and are an effective medium for assisting medium-scale industry, they are not as well suited to meeting the needs of smaller countries where the potential market is smaller, nor are they a suitable medium for financing small-scale industry or handicrafts.

Assessing IFC’s Operation

In making an interim assessment of IFC’s operations, a number of criteria can be applied. One is IFC’s function in rounding out more substantial investments by others. So far, IFC has taken part in financing industrial projects involving a total capital cost of approximately $895 million. IFC’s exposure in these projects (net of cancellations, terminations, and participations by private investors in the original commitments) amounted to $150 million, indicating that on average every $1 committed by IFC has been matched by commitments of $5 by other investors. Another measure of IFC’s operations is the fact that the Corporation has been able to turn over a total of approximately $57 million of its investment and underwriting commitments to other investors, or over one-fourth of total IFC commitments. This reflects in large part the extent to which IFC has been able to sell parts of its investments to a wide range of financial institutions in North America, Europe, and the Middle East. Finally, of the 23 IFC investments closed out so far, 21 have been closed out at a profit. Taking into account losses incurred in two instances, the average annual return on these investments has been approximately 12.15 per cent.

Much of the growth of IFC’s operations is recent. This is reflected in results for the fiscal year ended June 30, 1966, during which the Corporation’s commitments of $35.6 million were more than 40 per cent greater than in any previous year. This figure is likely to be exceeded during the current fiscal year: in the first nine months alone, commitments announced amounted to $32.3 million. These results indicate the major changes now taking place in IFC operations, not only in terms of the number of commitments but also the kind and size of commitments. Several factors are involved. Some, such as tight money conditions in the major capital markets of the world, are not likely to continue indefinitely. Of greater long-term relevance are the growth of IFC’s own experience and capability, a larger flow of projects, reflecting greater interest on the part of outside investors in the prospects for the manufacturing industries in the developing countries; and the growing sophistication of the industrial structure of many of the larger countries in the developing areas, as evidenced by the establishment of new, capital intensive industries.

With these factors at work, the initial World Bank loan of $100 million to IFC will make it possible for the Corporation to sustain and expand its present level of operations and make larger individual commitments at a time when its own uncommitted funds have been virtually exhausted. Examples of the new dimension of operations open to IFC are the recent $12 million equity and loan financing of Manila Electric Company (MERALCO), the leading private electric power utility in the Philippines, and the $10.7 million financing of Ultrafertil S.A., a new company formed as a joint venture by U.S. and Brazilian investors to establish a $70 million fertilizer manufacturing and distribution complex in Brazil. Illustrating the trend toward greater diversification in IFC’s operations is its first commitment in the field of tourism. The IFC participation is in a $6.7 million program to finance an internationalclass hotel in Nairobi, the capital city of Kenya, and new tourist facilities in the national game parks, which are Kenya’s chief tourist attraction. Here the guiding considerations included the economic priority of tourism as the country’s second largest source of foreign exchange; the prospects of investing in an enterprise with experienced sponsorship and management; and the knowledge that the construction of new tourist facilities which IFC is assisting will be supported by investment by others in related infrastructure, for example, all-weather access roads in the national parks.

The Prospects

The prospects before IFC are in many ways more attractive than at any time in the past. Of necessity, much will depend on a continuing flow of projects suitable for IFC financing and, more generally, on continued growth of private sector activity and private capital flows to the developing countries. The need for substantial investment in manufacturing and other industry is apparent in a number of areas: most urgently, perhaps, in the expansion of fertilizer production, an area in which IFC has taken the lead on behalf of the Bank Group in discussions with private investors. Nevertheless, there are strong and continuing social, political, and emotional issues involved in the role of private enterprise and private capital in economic development. On the one hand, there are real doubts on the part of many private investors as to whether the risks incurred in the developing countries are in line with the potential returns, in terms of market penetration and growth or actual return on capital. On the other hand, there are strong differences of opinion in some developing countries regarding the priority to be accorded the private sector. These differences of opinion are compounded by fears of foreign ownership of resources, concern about the balance of payments impact of repatriating dividends and interest, and other factors. Despite the progress of the last decade, there clearly remains a wide gap to bridge in reconciling the expectations of the private foreign investor with the aspirations of the host country.

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