How can Development Finance Institutions use research to inform their investment decisions? What is their role in supporting economic development and private investment?
Read more about the projects and investments of British International Investment on their website.
British International Investment (BII) is the Development Finance Institution of the UK government. In this episode of VoxDevTalks, Tim Phillips speaks to Chris Woodruff, a non-executive board member of BII, about how evidence and research is used in the strategic investment decisions of Development Finance Institutions.
What do Development Finance Institutions do? How does BII’s mission differ from other DFIs?
Development Finance Institutions (DFIs), including BII, generally operate with the aim of "doing good without losing money." This means they seek to achieve a modest return on investment that covers their operational costs while also prioritising additionality - investing in areas where private sector involvement is limited or absent and aiming to attract private investment alongside their efforts.
BII stands out from other DFIs in several ways. Firstly, while most DFIs may maintain a globally dispersed portfolio of investments, BII focuses on Africa and South Asia. Secondly, BII's sole shareholder is the UK Foreign, Commonwealth & Development Office (FCDO), which allows it to undertake higher-risk investments with significant potential for development impact. Notably, around 60% of BII's investments are in equity.
‘the great majority of what they [other DFIs] would do would be in debt, and we invest much more in equity that allows us to do some things that we might not be able to do with a pure debt book.’
What does the Board of BII do?
The Board at BII is responsible for setting the organisation's strategy and is composed of individuals from diverse backgrounds and countries. Among the board members, Chris Woodruff is the sole academic, bringing a unique perspective to the team.
BII employs a three-part development impact metric to assess its investments, focusing on productivity, sustainability and inclusivity. The inclusivity metric was specifically introduced to ensure that, even when investments meet the productivity and sustainability criteria, they also effectively reach and benefit the poorest and most disadvantaged communities.
‘Look, every metric that you use is going to be imperfect, but I do think that measuring at the investment level and at the portfolio level, measuring how well we're doing and finding investments that are productive, that is changing markets, generating growth, that are sustainable, that is low CO2 emission, low greenhouse gas emission investments and that are importantly reaching low income consumers and benefitting low income consumers, providing good jobs for low and medium skilled workers and so forth is a big part of the mission.’
Why is it important to study firms and the private sector?
When Chris Woodruff began working as an assistant professor 30 years ago research on firms was often classified under industrial organisation rather than development. This reflected the prevailing focus in the development field at the time, which prioritised areas like health and education.
‘The private sector is crucial to growth, and understanding what the constraints are to private sector growth and development…can help target investments towards the most effective way of increasing growth rates and reducing, as I say, poverty over the longer term.’
The majority of Chris Woodruff’s work has involved using randomised controlled trials (RCTs) and experiments, focusing predominantly on either very small firms or very large firms. Experiments typically require dividing a sample into treatment and control groups and to achieve sufficient statistical power, a sample size that is adequately large is necessary. Small firms are abundant in low- and middle-income countries, while large firms can be segmented into production units or lines, enabling the creation of sufficiently large sample sizes for robust analysis. RCTs however may not always be the appropriate method for answering some of the important questions.
What does the evidence currently tell us about investing for impact?
A substantial evidence base now exists on ways to increase the incomes of the self-employed or micro-enterprise owners, a crucial area of focus given that nearly half of those living in low- and middle-income countries (LMICs) are self-employed. While there is evidence that grants can effectively stimulate incomes, there is less robust evidence on fostering dynamic changes or driving sustained growth in microenterprises. Historically, loans have struggled to achieve the same income boosts as grants. However, the past decade has seen a surge in research on adapting loan structures to better support microenterprise income growth, such as introducing greater flexibility in the repayment process.
Loans are often considered more sustainable than grants, as they have the potential to reach a larger number of enterprises. This makes scaling up flexible loan structures an important priority. However, microfinance institutions (MFIs) are inherently conservative in their approaches, creating a need for further research on how to incentivise these institutions to adopt and expand innovative loan designs that drive greater impact.
Using research to inform business investment decisions
‘There are things, I think, where we need to know much more from research, external validity on the things that we have good, solid evidence in some places probably wouldn't be at the top of my list.’
Chris Woodruff highlights a number of reasons for this argument. Firstly, there exists a difference between academic standard or rigour and information needed for business makers to make a good decision.
‘I think that the evidence is useful in the discussions and guiding kind of how we think about investments, even when we don’t have perfect external validity.’
Secondly, for most major research questions, there is now a substantial evidence base that provides insights into why certain interventions may be more effective in some contexts than in others.
How does BII use research to make investment decisions?
Impact assessments are crucial, but research plays an equally important role in other areas. Specifically, given the scale of BII's portfolio, valued at $10 billion, careful and informed decision-making is essential to determine where to invest most effectively.
‘I think the surprise to me was that the real place that we need to use research is at the other end. It's at the front end of making investments... We know we really want to be quite careful about where we're investing and how we're investing, and the more we know about the particular levers that will really stimulate growth and development, the better off we're going to be in making investments.’
There is a significant role for all three types of financing, which can be thought of as existing along a continuum:
- Grant-based capital
- DFI-based capital, which is partly concessional due to its modest return expectations relative to the risk level
- Fully commercial capital
DFI-based capital serves a critical role in crowding in commercial investment. For large-scale challenges like decarbonising the economy, commercial investment is essential to achieve sustainable solutions. In such cases, highly concessional investments, or even initial grant financing, can help pave the way for future investments to become commercially viable. This approach ensures that development aid funds are not entirely consumed by these expenditures, preserving resources for other core development priorities.
Moreover, the inclusion of private finance introduces valuable market discipline. It incentivises firms to offer services that meet customer needs and to operate efficiently, fostering a sustainable and effective use of resources.
‘You layer in capital with different risk levels and different return expectations, starting from grants and leading up to commercial capital, and you use that combination to make an investment that wouldn't be possible with any one of those types of capital.’
DFIs can make use of these different types of finance and therefore helping to get many projects off the ground. BII in particular focuses on areas where there may be a missing market. For example, its subsidiary Gridworks specialises in facilitating private sector investments in power transmission infrastructure across Africa. These investments are crucial for improving access to electricity and supporting the transition to or increased use of renewable energy in the region. Part of the work of GridWorks is understanding how to crowd in the private investment and the reasons behind a lack of private sector investment. As Gridworks currently lacks a revenue stream, it is evident that this is an area where private investment alone would be unlikely to focus, highlighting the need for alternative or supportive financing mechanisms.
How does the approach of BII differ and where is more research needed?
RCTs and interventions typically concentrate on specific groups of recipients, often overlooking the broader effects on the wider economy - General Equilibrium effects. It is crucial to consider how an intervention or investment impacts the overall market, including those operating downstream or upstream. While new approaches in RCTs are beginning to address these broader effects, there is still significant progress to be made in fully capturing them.
Many DFIs emphasise job creation as a key goal. However, recipients of investments or interventions may, in some cases, displace others in the labour market. The overall effects on the economy can still be substantial and positive. Understanding these dynamics is essential for evaluating the true impact of investments and interventions on economic systems.
‘We need to be able to think about what are the investments that really change the incentives of the players in the market, so that those players become more innovative, more efficient, more productive, and generate growth because the investments themselves are not going to be enough if they're not levered into something that changes dynamics as you go forward.’