IFC Leads Sustainable Investing in Emerging Markets

Two recent announcements from IFC (the World Bank Group member dedicated to private sector development in emerging markets) demonstrate continuing leadership in emerging market sustainable investing.

The IFC's inaugural green bond, a $200 Million, four year, fixed rate issue scheduled to close on April 26, will reserve all proceeds for investment in climate friendly projects in developing markets. This is the first time IFC will dedicate bond funds to a specific pool of loans. The green feature makes the bonds attractive to a growing audience of institutions charged with finding socially and environmentally responsible investments. “The Green Bond is yet another example of how IFC is creating innovative financial products that offer both development impact and good return for investors”, said Nina Shapiro, IFC Vice President and Treasurer.

IFC has also published a brief on it's ongoing sustainable finance mission in preparation for the Spring Meetings – the annual review of the joint IMF-World Bank Development Committee and the IMF International Monetary and Financial Committee held April 24 and 25 in Washington, DC. The plan is not just to invest IFC funds wisely, but to build investment infrastructure in developing countries while using IFC's track record to encourage and enable sustainable investment by global capital markets in those developing countries.

Three IFC focal points seem particularly exciting for the sustainable investment community:

• IFC is developing the necessary market infrastructure to support the growth of sustainable investment by funding the development of enhanced stock market indices, market research, and training; and by sharing IFC’s substantial experience in incorporating environmental and social issues when investing in emerging markets.
• With assets of over $20 trillion and long-term investment time horizons, pension funds are a potentially important source of investment capital for the hundreds of millions needed to combat climate change. IFC is working with pension funds to develop new financial instruments to help tackle climate change.
• Private Equity is an increasingly important source of capital for growing businesses in emerging economies. IFC is supporting private equity managers use of sustainability to identify new investment opportunities and drive improvement projects within their investments.

This work, along with projects like the Carbon Efficient Index, developed with S&P and Trucost and the Private Equity Toolkit, designed to bring a serious look at sustainability into private equity's investment decision process, show what IFC's mission is all about.

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Opportunities Inland: Growth for New Regions and Sectors in China

If you are not investing in China, you are missing out. Although some businessmen have been deterred by the country’s lopsided export-driven growth engine, international investors are finding an array of potential growth drivers appealing. While financiers sit tight for the expected revaluation of the yuan, strategists claim that China’s future growth will come from many new sectors and geographical locations. Investment opportunities exist hundreds of miles west of Shanghai and Beijing, in China’s lesser populated inland provinces.

China’s smaller cities are still in the early stages of industrialization and urbanization, in a huge domestic market and plenty of room to grow internationally. These regions have great demand for better infrastructure as well as residential and commercial real estate to support that growth.

Earlier this year investors feared that China’s economy was overheating and Chinese stocks slipped. But buyers are returning and confidence is increasing due to structural adjustments by the Chinese government to curb unhealthy liquidity which causes bubbles. China’s central bank moved to raise the reserve requirement ratio and slow exorbitant loan growth by banks. Internationally these were seen as smart moves and responsible growth management. Now the perception has changed and equity performance is cathching up. The MSCI China Free Index rose 2.2% so far in 2010, and almost 4% in April alone.

The next question is where exactly to invest. Chinese banks are announcing great returns, lower provisions for risky assets and higher fee-based income. Many analysts believe that China’s financial sector is likely to be very profitable in 2010. Another rapidly growing sector is China’s clean-tech industry. The world power reportedly spent $35 billion on renewable energy in 2009, including an international push into wind turbines. China’s low costs and relatively advanced technologies make it a fierce competitor in energy alternatives.

As second and third tier cities continue to growth robustly, plenty of new support infrastructure will be needed. China has openly been buying up natural resources, commodities, cement, and metals which are inputs for further development of public transportation systems. China still does not have a national railway or highway system. Finally, consumer services and leisure are a safe bet for solid long-term growth. As China develops, wages are rising and people have more to spend on vacations and fancy restaurants. Luxury goods and services will be big business.

Keep an eye on China’s growth and don’t be afraid to approach the beast. There are plenty of opportunities and partnerships abound.

Photo Credit: Creative Commons

Gatekeepers – Halting Fraud, the Corporate Governance Breakdown

When should accountants, lawyers, etc. be held liable in order to deter their client's fraud?

It's confession time. First, “corporate governance breakdown” is search engine optimizationese for something that's usually called “securities fraud”. I know, I know, this is like using faux pas as a synonym for bank robbery. And why is “corporate governance” a hotter search term than “securities fraud” at a time when the SEC suit against Goldman and the bankruptcy examiner's report on Lehman Bros have securities fraud in the headlines? Who knows, but, like the heart, Google wants what Google wants. Second, any good ideas in this column are stolen from Multiple Gatekeepers, by Andrew Tuch, which will appear in the Va. L. Rev. Multiple Gatekeepers (MG for short, I like my law review articles in British racing green) is 77 pages long, with extensive footnotes. Some of these footnotes cite the works of professors who (literally) put me to sleep in law school – not including the ubiquitous Prof. Coffee, who arrived at Columbia long after I left and now seems to be cited repeatedly in every article, including MG, that has anything to do with corporate governance – perhaps “Coffee” is an optimal search term. This column is going to run considerably less than 77 pages, so we promise much oversimplification (sorry Prof. Tuch), for which we will compensate with frequent, obscure references that may be recognizable to a fortunate few as attempts at humor.

MG is not written on a blank slate. Many trees have given their lives to the discussion of topics like: who are gatekeepers – professionals (accountants, lawyers, investment bankers) who “rent their reputation” to assure investors of the quality of information provided by a corporation issuing securities or engaging in some other transaction requiring approval; when should gatekeepers be liable for the client's fraud – always (strict liability), when they fail to exercise due care (fault based liability) or never (since the client perpetrating the fraud is inevitably broke when caught, this answer is beloved only by, well, gatekeepers); and which of these answers will best protect society from the client's potential fraud – a question answered, at least in part, by the application of optimal deterrence theory. Optimal deterrence theory may sound like a branch of calculus used to site missile silos during the cold war, but fear not. Based on the application in MG it seems to be fairly basic game theory requiring only simple arithmetic, an understanding of expected value and an assumption that each gatekeeper will act with omniscience to maximize its utility.

MG's principal contribution is to note that transactions involve more than one gatekeeper, that these gatekeepers have an interdependent capacity to deter fraud, and that once this interdependence is recognized, optimal deterrence theory points to a fault model of gatekeeper liability as most effective in deterring client fraud. This contradicts other observers, who have argued for a strict liability approach based on the application of optimal deterrence theory to each gatekeeper independently. MG then reviews the existing legal bases for gatekeeper liability, noting the existing system is generally fault based, but prescribing greater clarity. As an aside, the 33 Act seems to have anticipated optimal deterrence theory with some prescience, while aiding and abetting liability under Rule 10b-5 lacks predictability. MG also prescribes formal procedures to enhance cooperation and coordination among gatekeepers.

Kudos, Prof. Tuch. All the right answers, for some of the right reasons. The participation of multiple gatekeepers in securities issuances and other major corporate transactions is an unassailable fact. Their interdependent capacity to deter fraud is correctly judged by Prof. Tuch, but with the emphasis on capacity, not practice. Real life gatekeepers often seek to avert liability by narrowing and clarifying the scope of their engagement rather than rooting out client fraud. Understandable, given the history, training, professional rules, fear of liability and desire to maintain a cordial relationship with the client, who is, after all, paying the bill – understandable, but not optimal deterrence. The result is gaps between the coverage of the gatekeepers, gaps through which the client bent upon fraud may creep.

Although I enjoyed the section applying optimal deterrence theory (family and friends claim I watch Star Trek, The Next Generation, but there is no admissible evidence), I did not find it persuasive. The gatekeepers don't seem to have enough information on the cost of liability and deterrence to undertake the calculations called for by the theory. Even if they did, the gatekeepers are driven by history, personal obligation, client loyalty and other factors not fully accounted for in the theory's approach to maximizing utility. Despite this, the conclusions and prescriptions match my own intuition based on experience. Right now the gatekeepers know the cost of liability is huge, even if not readily measurable in advance. They recognize they are already spending, tons, on deterring client fraud. They recognize that the approach of retreating to a narrowed engagement is losing the liability war, and most of the liability battles. Even if the gatekeepers don't have enough data to play Prof. Tuch's optimal deterrence theory game, they can still recognize that it's time to overcome history and follow his prescriptions.

Photo Credit: Asakusa Temple Gatekeeper by Jim Epler

Emerging Markets Plugging In To Mother Earth

Imagine you are living far, far off the grid, in an emerging market rural outpost, say 100 miles Northwest of Moroto, Uganda near......well, you are pretty sure there's an outside world. You'd like a radio, maybe even a cellphone. You'd like to see at night without lighting candles and filling your home, and your baby's lungs, with soot and other dangerous combustion reaction products. If only you had an extension cord 100 miles long or better yet, if only you could just plug in to the dirt floor of your own home.

Soon you will be doing exactly that. Lebone Solutions, a team of six MIT students, has developed a battery powered by microbes living in dirt which can operate for months, charging LED lights, radios and cell phones. The device costs less than $20. It harnesses the energy from metabolic reactions of soil dwelling bacteria, an energy source that has been recognized for years but not utilized in a practical way. Lebone Solutions member Presser Aiden predicts 1,000 households will be using one by this summer. Although the dirt battery will be welcome in many emerging market areas, it was designed with sub-Saharan Africa in mind a region where some of the Lebone Solution members (along with 500 million other people) have lived without power.

The dirt battery was hailed by Popular Mechanics as one of the ten most brilliant innovations of 2009 and named one of the winners in this year's MIT IDEAS competition. It's also featured in a cover story on public service at MIT in this month's Spectrum (an MIT newsletter). The Spectrum story made me feel much better about many years of contributions - contributions to a wealthy institution that didn't always seem like it should be high on the list of neediest candidates for my limited funds.

The Spectrum public service story also reminds me of two trends I've been noticing lately. The first is a greater emphasis on relatively low tech solutions to problems like malaria, rural power or clean water. Solutions that combine solid engineering and cultural analysis without spending a fortune on new frontiers of basic science or expensive equipment that many emerging market populations can't afford. The second trend is the rapid advance of microfinance, with organizations like Kiva leading the way and tools like securitization steering microfinance in the direction of a socially beneficial investment that can compete with other interest bearing options. These trends are a powerful combination that might lead to a real take-off for impoverished rural areas a lot faster than expected.

Photo Credit: AnnaleeBlysse

Servicing Debt While Seeking Economic Growth

Across the world, governments are struggling with fiscal frugality. Government deficits are increasing at the same rate as during the second world war. The public debt is projected to rise to an estimated 110% of GDP by 2014, a rise of almost 40 percentage points from just 3 years ago. Without drastic changes by policy makers to curb and reallocate public spending, the financial trajectory for big powers looks bleak. But how can countries focus on economic growth while servicing their massive debts?

Some countries being forced to face their financial shortcomings before others. Portugal has plans to pay down its deficit from 9% to 3% over the next 3 years. Greece must cut its deficit from 12.7% of GDP in 2009 to3% by 2013. Britain’s upcoming election will be won based on economic growth and financial austerity. But the majority of the OECD members have no detailed strategy to service their debts while hitting their growth targets. The policy prescription they choose will have a huge impact on the stability and structure of their economy across all sectors.

Today’s deficits are leading to debt burdens that are simply unsustainable. A general rule of thumb regarding a reasonable level of public debt is 60% of GDP. That limit is outlined in the Maastrich Treaty, the guidelines for the euro. It is the figure that the IMF recommends as well. It asserts that the 35 percentage point raise in rich countries debt could raise borrowing costs by two percent. Sixty percent was also the average debt to GDP ratio among rich economies prior to the financial crisis.

If the world’s debt burdens are reduced to pre-crisis levels, the costs of the crisis will not be passed on to future generations. It would allow governments more fiscal leeway to deal with future recessions and would ensure that higher public debt does not hurt private investment, lowing future growth.

While reducing debt burdens to pre-crisis levels makes sense, it will not be easy. A recent report in the Economist suggests that governments will need to improve their budget balances by an average of 8% by 2020 in order to reduce their debt ratios to 60% by 2030. Each strategy to balance the budget has its own pros and cons. Raising taxes, for example, may hurt growth more than living with a higher debt ratio. Most economists agree that fiscal adjustments via spending cuts are more sustainable and growth friendly than those that rely on tax hikes. Cutting public-sector wages is more effective than cutting public investment. Some cuts, like slashing farm subsidies or raising pension ages, have multiple benefits. They promote growth both by improving public finances and by augmenting efficient allocation of resources. The taxes that hurt growth the least are those on consumption or immobile assets like property. With the current global warming and pollution problems, green taxes are also an effective mechanism that will clean our economies and our environment. Only time will tell if governments will be able to fend off political pressures and take action to pay down their debts.

Photo Credit: Creative Commons

Intel's Sustainability Charter – What Really Happened?

Harrington Investments, Inc. a Napa, California-based socially responsible investment advisory firm wanted to establish a committee of the Intel Board of Directors that would be responsible for sustainability. To achieve this, Harrington intended to propose a by-law amendment for adoption by the Intel shareholders at the annual meeting, as it had in 2008.

Intel, like all big public companies, doesn't relish taking resolutions to the shareholders unless they are proposed by management. On the other hand, Intel is often recognized as an ES&G leader and seems to be proud of it – the Intel web site has extensive sections on social responsibility and environment. For Intel management, it was a Hobson's choice – look like you are saying no to sustainability, or endorse a by-law amendment that sets up a new committee with broad responsibility to pursue sustainability – an amendment that the Service Employees International union is endorsing as a means to address the problems of working families.

Instead of choosing, Intel found another path. On March 18, the Intel Board approved an amendment to the charter of the existing Corporate Governance and Nominating Committee to include the following:

“The Corporate Governance and Nominating Committee:

.......

Reviews and reports to the Board on a periodic basis with regards to matters of corporate responsibility and sustainability performance, including potential long and short term trends and impacts to our business of environmental, social and governance issues, including the company's public reporting on these topics.

......”

My speculation is that Harrington did not find this completely satisfactory. There is no committee dedicated to sustainability, and even the Governance and Nominating Committee has only the duty to report to the Board, not to strive for any particular goal or standard of sustainability achievement. Harrington's press release on the amendment notes that:

“Intel also had their outside legal counsel Gibson, Dunn & Crutcher LLP write a legal opinion specifically stating that pursuant to Delaware law, corporate responsibility and sustainability reporting based upon the committee's charter, was part of the fiduciary duty of company directors”

Intel's decision to seek the legal opinion may have been the final concession needed – Harrington did agree to withdraw the shareholder resolution proposing the by-law amendment and new committee.

Now that you have the facts, at least those that are publicly available, who won? Harrington is proclaiming the amendment to the committee charter and the legal opinion as a victory in its press release. Intel, a company that is normally not shy about trumpeting its ES&G achievements, is saying nothing. Intel has already been compiling annual CSR reports, but the formal involvement of the governance committee and its reports to the full board might add to the scope and rigor of Intel's efforts. Without seeing the text of the legal opinion it's hard to be sure, but based on the Harrington press release, the opinion may be circular - if the committee charter says it is to report to the board on sustainability matters then it is the fiduciary duty of the committee to so report – not exactly revolutionary. If the opinion stated that sustainability was more important than profitability it would be a hot potato (remember this is a public, for-profit corporation and the shareholders did not even get a vote on the sustainability amendment) but to opine that the directors can generate and consider reports on sustainability issues, issues which can and do effect profits, especially on a long term view, just does not seem like a stretch. So, Harrington gets something to crow about and Intel may actually get even more serious about its sustainability reporting – everybody wins, right?

Maybe. Intel dodged an unpleasant moment of conflict at its shareholders meeting, one that would surely have generated some negative publicity. In fact, Intel avoided going to the shareholders on this altogether. The Board can amend committee charters, and if the new language creates some unexpected problem, then the Board can further amend to fix it. Intel management can also stop worrying about a more broadly chartered sustainability committee like the one Harrington originally proposed, one that might add an extra dimension to future environmental or labor issues. Intel made some new reporting commitments, but only in an area where management was already a willing reporter. Harrington is issuing the press releases, but Intel management is silently smiling.

Photo Credit: xcaballe

Arrrgh! Pirate Finance – Emerging Market Success?

The piracy finance model excerpted (with minor edits) below appeared in early March in a UN report, and has gained interest through more recent republications, first in UN Dispatch, then Alphaville. The model is fascinating – so is what it tells us about Somalia, an area that, right now, can only aspire to be an emerging market:

The success and expansion of pirate militias requires new organizational arrangements and practices. Although leadership of pirate networks remains anchored in Puntland and central Somalia, participation in maritime militias and investment in pirate operations is open to a broad cross-section of Somali society. The refined finance model guarantees every participant in the operation, if successful, a well-defined percentage or share of the ransom money.

A basic piracy operation requires a minimum eight to twelve militia prepared to stay at sea for extended periods of time, in the hopes of hijacking a passing vessel. Each team requires a minimum of two attack skiffs, weapons, equipment, provisions, fuel and preferably a supply boat. The costs of the operation are usually borne by investors, some of whom may also be pirates.

A would-be pirate should already possess a firearm. For this contribution, plus, his services, he receives a class A share. Pirates who provide a skiff or a heavier firearm, like an RPG or a general purpose machine gun, may be entitled to an additional A-share. The first pirate to board a vessel may also be entitled to an extra A-share.

At least 12 others are recruited as militiamen to provide protection on land if a ship is hijacked., In addition, each member of the pirate team may bring a partner or relative to be part of this land-based force. Militiamen must possess their own weapon. Each receives a ‘class B’ share — usually a fixed amount equivalent to approximately US$15,000.

If a ship is successfully hijacked and brought to anchor, the pirates and the militiamen require food, drink, fresh clothes, cell phones, air time, etc. The captured crew must also be cared for. In most cases, these services are provided by one or more suppliers, who advance the costs in anticipation of reimbursement, with a significant margin of profit, when ransom is eventually paid.

When ransom is received, fixed costs are the first to be paid out. These are typically:

• Reimbursement of supplier(s)
• Financier(s) and/or investor(s): 30% of the ransom
• Local elders: 5 to 10 %of the ransom (anchoring rights)
• Class B shares (approx. $15,000 each): militiamen, interpreters etc.

The remaining sum - the profit,- is divided between class- A shareholders

Wow. The model has sophistication, with four classes of securities: 1) investors get a super share that splits 30% of the gross; 2) suppliers essentially get a subordinated preferred – payment is contingent on a successful hijack and ransom but return is a fixed percent of value supplied; 3) land based militia also get a lesser preferred, with a fixed sum contingent on success; 4) marine pirates get common.

The model assumes compliance with the deal terms by pirates, not generally known as a law abiding group. Is this driven by fear of retribution, the need to preserve reputation so that future missions can be staffed and financed or some other force, such as clan relationships? Really the model assumes more than just compliance. Since the supplier has limited upside, the supplier's investment probably makes sense only if the supplier can count on investing in multiple operations, with some chance to recover in the event the failure rate is high on the first few operations in which the supplier participates.

Finally, the model has some pieces missing. Who is the organizer and how are they compensated? Is it the primary investor? If so, does the lead get a share of that 30% that exceeds the pro rata share attributable to his investment?. Is the captain of the ship the organizer? If so, isn't this worth a couple of extra Class A shares? Who, in general, are the financiers? What percentage of Somalia's can afford to be venture capitalists?

In an emerging market with no consistently functioning educational or judicial systems, the pirates are pulling off some fairly sophisticated financing. Aside from how to be a pirate, what's the lesson? The pirate model probably tells us something about the capability and resiliency of the Somalians, if this lawless territory could somehow turn itself back into a nation and offer legitimate opportunities that would attract the same ingenuity. It may even tell us something about the prospects for investment and assistance for the Somali private sector from the outside world. Apparently, Somali's can run a business, but the outsider who is not viewed as part of the crew may end up walking the plank.

Photo credit: darkpatator