Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
originally posted at: http://allaboutalpha.com/blog/2011/12/15/alpha-hunters-investing-in-global-development/
From our ‘developed world viewpoint‘ it is sometimes easy for us to forget that there was a time when the United States and Europe were (as we would classify them now) ‘developing’ economies- largely based around agriculture, with some limited trade, and huge income inequality. The industrial revolution changed everything, and began a series of events which brought massive opportunity for hundreds of millions. From our viewpoint, we also sometimes forget that during these revolutions- immense investments took place to finance the development of industry and infrastructure – while great philanthropists of the time provided social opportunity to lift people out of poverty.
“…The changes associated with the industrial revolution go far beyond the merely technical; they include population growth, large-scale and extensive industrial investment, and the remarkably pervasive effects of the application of science to industry, and have, in the past, led to a new system of social, industrial, legal and other relations, often described as modern industrial capitalism.” wrote Pollard in “The Economic History Review” (Vol. 11, No 2. 1958). He continued, “…In the present state of techniques, every important nation may sooner or later pass through that stage of economic development. Nevertheless, the technical similarities of the process of industrialization impose certain common features on each industrial revolution, of which the pressure on consumption, caused by massive simultaneous investment, is one of the most important. This pressure may in the future be obviated by large-scale foreign investment, or by new techniques beyond our present understanding. Without such help, one might venture to prophesy that the countries in the Soviet orbit will find it extremely difficult to ‘catch up’ on the consumption of the West… while the ‘underdeveloped’ countries in the rest of the world, as they come to the hurdle of their industrial revolution, will find it hard to maintain rigorous limitations on real wages and other incomes within a democratic framework…..“
While many see opportunities in the developing world solely as philanthropic, there are an increasing number of socially conscious investment funds who realise that alongside the work in alleviating poverty and dealing with extreme social-issues, there are clear needs (and opportunities) which exist for nations who are fighting hard to ‘catch up’ with the west.
William Foote is founder and CEO of Root Capital who, since their inception have provided $330 million in credit to 349 small and growing businesses in 30 countries, maintaining a 99% repayment rate from our borrowers and a 100% repayment rate to our investors. This year alone, they have supplied $120 million in credit to 250 businesses which represent (or aggregate) 220,000 small-scale producers. That investment will (at a conservative estimate) benefit the lives of over 1.1 million people. Mr. Foote began his career as a financial analyst in the Latin American Corporate Finance group at Lehman Brothers, and as a journalist in Mexico and Argentina. He was named an Ashoka Global Fellow in 2007 and a Young Global Leader by the World Economic Forum in 2008.
Q: What is the rationale behind root capital?
William Foote: We’re working at the nexus of two pretty powerful forces which, when combined, can have a profound impact on reducing global poverty. First, agriculture…. You’ve got around 2.6 billion people in the world who survive on less than $2 per day, 75% of them are rural and agriculture is their primary economic activity. Most are, however, mired in a form of subsistence farming that barely allows them to scrape-by. Increasingly there are farmers in Sub Saharan Africa and beyond who are finding they can get themselves out of poverty through agriculture if, and only if, they have reliable access to a well-paying market. The World Bank states that growth in agricultural sectors is twice as effective at reducing poverty than other sectors. The second force is the notion of small and growing businesses- who are the ones capturing the vast majority of new jobs in an economy. If you look for the next Steve Jobs or Richard Branson in developing economies, however, their businesses rarely make it out of the garage as they are missing three critical factors. They lack financial capital, qualified employees plus the knowledge and access to financial markets- those three things stop those businesses enjoying the kinds of prosperity we do in the northern hemisphere.
The “missing-middle” where it’s at in terms of Root Capital. How do you integrate and unleash these two powerful forces- agriculture and small and growing businesses. That’s when you fall into the trap of being too large for microfinance, and too small, remote or risky for the big banks. That’s the big opportunity we’ve been trying to address for a decade or more and hopefully this will catalyse a thriving financial market which will serve these businesses.
Q: What do you see as the opportunity for investors who want to enter this market?
William Foote: The opportunity for investors are mixed… low default rates… very much a capital preservation play… a diversified portfolio across thirty countries… and the fact that we are a conscious investment, an impact investment. We are not a high return proposition. We are unapologetically at the high-risk, low-return sweet-spot of agricultural finance. We choose to address geographies and sectors where there are real market failures or at least deep market imperfections. Specifically- we are trying to find those businesses that might aggregate a few hundred or a few thousand small scale farmers or producers (it could be coffee, cocoa, mangos etc) largely of sustainable export products where we have a stable market in common currencies with off-take agreements with a buyer like Starbucks, Marks & Spencers or more. We work with over 120 buyers.
These are early stage businesses that are poised for significant growth and therefore enormous social, economic and environmental impact if you can get them to grow. The reasons they don’t get finance are varied but, in the main, they may exist in areas without easy access to loan officers, they may be areas prone to conflict or geological events (such as landslides) and they may not have collateral. This last point is the one which, most frequently, breaks the camel’s back. The borrower may not have a registered land-title. Without that hard asset, most banks won’t even think about lending. In some cases, there is also perceived risks by banks in agriculture- and these customers are not networked.
It’s a low-margin, lumpy cash-flow agriculture business that we’re financing but they’re absolutely growth oriented and generate enormous benefits from job-creation, economic growth, sustainable livelihoods, natural resource management and more. They become the economic engine for very large areas, but it’s low margin. That’s way we call it a capital preservation play.
Outside the Root Capital model, there is definitely a strong-focus on commercial agriculture- with a growing private equity market in Africa. These are players who are making bets on the growth of the agricultural market (which is also an inflation hedge).
Q: What are the risks in these markets, and how do you mitigate them?
William Foote: We manage risk by lending into the value-chain where we are able to leverage the non-financial-assets of the corporation that’s buying from these communities and agricultural businesses. By having off-take agreements, we have guaranteed demand for the underlying product and, therefore, bankable cash-flows. We have social and relationship capital wrapped up in these agreements too!
Due to the way we work with the value-chain, we are able to go to the buyer- get them to introduce us to their suppliers and use their global supply chain knowledge and geographic scope to work with the third party certifiers such as FairTrade, Organic or Rainforest Alliance (all of which have audit). We also go to the technical assistance providers which may be funded by DFID, the European Union, USAID or local-governments. They pump and prime local production. We also go directly to local loan officers and our staff on the ground. Through these ecosystems, we create a relatively efficient way to mitigate the political, economic and social risks.
Political [risk management] is partly about choosing the right country. We are actually lending into post-disaster and post-conflict markets like Haiti, DR Congo, Liberia and Ivory Coast but in general they are relatively low income but stable countries such as Tanzania, Rwanda and Latin America. Alongside this, we can also insure against political risk through organisations such as OPIC- and are also able to get some guarantees through the Development Credit Authority (DCA) where we are able to share-risk with the federal government on a deal by deal basis. On the economic side, it’s really the old fashioned methods. Know your clients… barefoot empirical due diligence on the businesses we finance… good old fashioned credit underwriting and management. On the social side, we face an interesting challenge. There’s a huge amount of corruption in some of these countries, but when you have traceability and transparency that’s been pushed through consumer and shareholder pressure into global value-chains, it can act as an antidote to the corruption which may exist in the market.
Q: How do you measure the impact of your investments?
William Foote: First, we think about what the outputs are…. For us, it’s capital and also financial management training (although that’s more akin to pure NGO work). The outcomes are growth- what is the year on year revenue growth, what is the payout to farmers for the products, and what might the delta be between that price and what they would have got at farmgate. Alongside this we compare against the numbers of farmers and producers selling through that export channel year on year- these are our fundamental KPI’s. Looking at impact this is measured at the household level…. and is somewhat complicated by the fact that you have to look at income attribution, other sources of income and so on… You can also look at this at the community level using measures of community cohesion, and by understanding whether infrastructure such as schools, maternity wards and so forth are being built. You also have to understand the economic impact at the regional level. That’s getting into ‘high cost scientific evaluation’ but we have to do a certain amount on a sample basis. Right now we have a study being done, funded in part by the Gates foundation, in Burkina Faso with regional producer associations that are selling through a Mango exporting company. A Burkinabe professor is working with masters student on the ground to produce an ethnographical, anthropological and economic study on what the impact is, at the household and sub-regional level, of the rapid growth of well-organised producer associations.
You have to have your standard financial credit-underwriting in place. You look under the hood of Root Capital and you will see a best-in-class small commercial lending operation where we really understand everything that can happen between farm-gate and the port. You can make that viral to the degree that anyone can do that evaluation. We also have a social obligor scorecard and an environmental obligor scorecard that our loan officers- with minimal training- are trained to use. It’s not a one-size-fits-all there’s a different scorecard for mango, shea-butter, coffee, mango and so forth. They’re not ‘deep’ but allow you to make sure you are making the right impact within your portfolio. Setting a high-bar on our standards is good-business and creating a model where, in addition to your financial due-diligence, you can check all-sorts of boxes on social and environmental business- gets a higher hit-rate of good sustainable businesses into a portfolio which a bank would need to scale
What does this mean for investors and risk managers?
Mr. Foote highlights ‘prejudices’ which exist in the investment and risk management markets. Firstly, relating to the ‘investability‘ of developing economies, and secondly the risk–profile. For ‘western‘ investors, the developing world offers the profound capital growth opportunities which were found over a hundred years ago when our nations were going through the same process- the difference? these nations are growing-up in a hugely well connected globalised economy, meaning that capital growth will occur in decades rather than centuries. For risk managers, there is also a need for changed consideration of the underlying. The truth is (a point proven by the overwhelming majority of people lending to these markets) – delinquencies and risk on loans into developing economies (in sectors such as agriculture) are often dramatically lower than their domestic counterparts. Even if those calls-to-action are not enough, I will conclude by reminding you that there are two billion consumers here, waiting to join the global-economy. Surely that- in itself- is reason enough for investors to no longer ignore the developing world.