Government owned development finance institutions provide project investment in poor countries – but they also earn surprisingly good returns in tax havens


Government owned development finance institutions provide project investment in poor countries – but they also earn surprisingly good returns in tax havens

On a map, the island of Mauritius is a tiny dot in the Indian Ocean. Nevertheless, because of its attractiveness to offshore financiers, it is officially the biggest foreign direct investor in India. The tax haven is responsible for a staggering 44% of the flows into that country. The US, by comparison, is the source of a mere 7%.

Now Mauritius is welcoming new investors: western governments, such as the UK and Norway. Strange as that may sound, their reason for investing in funds based there is stranger still. They are there to reduce poverty in developing countries.

Frustrated by the limitations of simply offering aid, western governments in recent years have turned to private equity funds to support economic growth in poor countries. These funds are largely based in tax havens, such as Mauritius.

Resources for these funds tend to come from government-owned development finance institutions (DFIs), which use taxpayers’ cash for investments in poor countries to stimulate economic growth and relieve poverty. But who benefits most from the activities of DFIs – the poor or the private investors – is open to question.

According to the original purpose of DFIs, the main beneficiaries of their investments should be the poor, especially those in the least-developed countries that commercial banks often perceive as being too risky and having too-low returns. Governments have established DFIs precisely to counter this problem: financing institutions that focus less on the bottom line and fill the gaps left by private finance.

Most DFIs have been established relatively recently – within the past 25 years – and are held at arm’s length from their government owners. Their existence acknowledges that many developing economies have scope for growth, but that sometimes investment assistance is needed to get it going.

The impact of DFIs should not be underestimated. European Development Finance Institutions (EDFI) is a Brussels-based representative organisation for the sector, counting 16 members. Jan Rixen, EDFI’s general manager, says that new commitments by members in 2008 totalled €5.2bn, spread across 941 projects in poor countries.

This money represents 10% on top of the official development assistance budgets of countries represented in EDFI. By the end of 2008, the total EDFI portfolio was worth €16.9bn, covering more than 4,200 investments.

EDFI’s oldest member, Britain’s CDC Group (formerly the Commonwealth Development Corporation) also emphasises the positive development effects of its investments. In CDC’s mid-July Development Impact Report, chief executive Richard Laing wrote: “We estimate that CDC’s 681 portfolio companies are supporting well over three million people – a major contribution to development in the poorest countries of the world.”

The darker side

But there is another side to DFIs, which has been exposed in the past few months, in particular by the UK’s Private Eye magazine. The revelations have suggested that the “major contribution” of DFIs has been to the enrichment of individuals such as Richard Laing.

In 2007, Laing’s remuneration was almost £1m. A House of Commons public accounts committee report, published in April this year, said this was “extraordinary … in a small publicly-owned organisation charged with fighting poverty”. CDC’s latest annual report shows that, following the fuss, Laing did not take a bonus in 2008 – but he was still paid £647,066, including a payment under a CDC “long-term incentive plan”.

One reason this has happened is that DFIs have been immensely profitable in recent years. This is the difference between government-to-government development aid and DFI investments. The latter is designed to earn a return – albeit on the basis that development benefits come first.

EDFI’s Jan Rixen admits that some DFIs have inverted this principle. “Some [EDFI] members looked more at returns than development effects,” he says. He adds that a “standard” return on investment for a DFI might be between 2% and 6%. However, as CDC highlights prominently in its 2008 annual report, its 2004-08 average annual return was 18%, leading to a cash mountain of £2.5bn. Investment in poor countries can be surprisingly good business.

Big profits

The big profits have also provoked criticism because DFIs make extensive use of tax havens. When the public accounts committee asked Laing how many of CDC’s 72 subsidiaries were registered in offshore centres, he replied: “It will be a few; it will be 12 to 20.” In fact, CDC later clarified, the true figure is 40.

DFIs commonly channel their resources through tax-haven-based equity funds, which do the daily work of selecting the right investments and overseeing the DFI stakes. Rixen admits that DFIs’ use of tax havens is “very, very common” but says this is “simply to avoid double taxation”, first on profits made in host countries, and second on the gains from those investments. DFI-owned companies in poorer countries do pay taxes on their profits, he emphasises. However, use of tax havens means development equity firms minimise their tax bills when they profitably sell a company in which they have invested.

The tax efficiency argument for tax havens is a moot point. Nicholas Bray of the Organisation for Economic Cooperation and Development says there might be legitimate reasons for using tax havens, but in general “they divert funds from governments that should be due to receive taxes”. But according to Rixen, without tax havens, many investors would pull out.

A Norwegian government report, published in June, considered these issues in depth. The report found that Norway’s DFI, Norfund, was channelling directly or indirectly about 80% of its investments through tax havens.

The tax haven identified by the Norwegian report as “the most popular location for funds in which Norfund participates” is Mauritius. This is also a favourite of CDC; of the 40 CDC subsidiaries based in tax havens, 18 are registered in Mauritius. CDC-backed investment funds located there include Africap, Aureos Capital, Avigo Capital, Business Partners, GroFin and I&P Capital.

Follow the money

Companies registered in Mauritius are not required to produce annual reports, pay no capital gains tax, and pay minimal corporate tax – only on profits earned in Mauritius. Antonio Tricarico of Counter Balance, an NGO network that in July published a report on European Investment Bank (EIB) lending to companies based in tax havens, says the use of locations such as Mauritius is part of the “financialisation” or “privatisation” of development.

Certainly the managers of the funds that invest cash on behalf of DFIs can benefit very handsomely. Shorecap, a Caymen Islands registered fund, which manages CDC money, boasted in its 2007 annual report of a 23% rate of return – a not uncommon level. Fund managers take a share of this, as well as earning fees of 1.5% to 2% on the money they invest.

According to Counter Balance, large international institutions such as EIB actively support such practices, despite recent pronouncements from political leaders about cracking down on tax havens. The same investment funds that are backed by CDC and Norfund can raise capital at low cost from EIB, and put it to use earning high, tax-free returns. EIB officials even sit on the boards of some equity firms, so the bank can hardly claim ignorance of their tax haven status.

Rainer Schlitt of EIB says the bank’s policy on tax havens is under review, in particular because the issue has become a focus for the Group of 20 nations, which met in London in April. He adds that EIB will not disclose information on the interest rates charged to tax-haven-based funds investing in development projects, but says: “Due to our AAA rating we are able to refinance ourselves at excellent conditions on the markets and to pass that advantage on to our clients.”

EDFI’s Rixen also says that the outcome of future G20 meetings is crucial for future DFI strategy. Tax issues are “very high on the agenda”, he says, and DFIs are waiting “to see what is coming”.

Wind of change

DFI profit seeking has led organisations such as CDC to move out of traditional but low-yield sectors such as agriculture, and into sectors such as pharmaceuticals and telecommunications, with investment often directed to fast-growing emerging economies such as China and India, rather than to the poorest countries.

CDC’s 2008 annual report notes that while agriculture now makes up only 5% of its portfolio, consumer-facing businesses make up 17% and financial services 19%. The report highlights investments in a shopping mall in Accra, capital of Ghana, and an Indian drug manufacturer that supplies global multinationals such as Pfizer.

There is nothing wrong with these investments per se, but is it necessary for DFIs to back them, when they are profitable and could attract finance from commercial banks?

Rixen says EDFI members are becoming more circumspect. While the initial focus has been on profits, now there is “increasing focus on additionality”, meaning that projects should be supported only if they cannot attract commercial finance. “We need profits but we need to look very much at development effects,” he says.

The British government has certainly ordered a change of direction for CDC. From the start of this year it must make 75% of new investments in countries with income per capita of $905 or less. Half of investments must be targeted to sub-Saharan Africa.

Meanwhile, the Norwegian government has told Norfund not to make new investments in tax havens. A wind of change is blowing, according to Rixen, though this is also a result of the economic crisis, which has seen “international banks pull out of developing countries”.

Governments now want DFIs to focus strictly on development impacts and to work harder. “We have been told that our owners are willing to take lower returns,” Rixen says. “Governments are asking for more focus on agriculture, renewable energy and infrastructure in general.”

If this happens, it will be welcomed by development NGOs. Marta Ruiz of the European Network on Debt and Development says there is no “dogmatic position against private equity”, but the objective of generating 20-30% returns may contradict development aims. DFIs need to get back to their core focus, Ruiz says, which should be investments leading to “long-term, sustainable benefits for the societies where they are investing”.

CDC – key facts

CDC Group is owned by the UK Department for International Development, which is its sole shareholder.

The group does not pay a dividend, is exempt from UK corporation tax, and has received no government capital for a decade.

CDC is a fund of funds, working with more than 20 fund managers with expertise in emerging markets to make equity investments in companies.

  • Since 2005, CDC has committed almost $3.5bn in new investment, attracting $21.1bn from other investors.
  • In 2008, CDC invested a record £436m in 681 companies via 127 funds.
  • $2.2bn of tax revenues were generated by the 390 companies that reported tax data.
  • 40 of CDC’s 127 subsidiaries are registered in tax havens; 18 of these are based in Mauritius.
  • 676,000 people were employed in the 514 portfolio companies that reported employment data to CDC in 2008.
  • According to the 2008 evaluation, 86% of the 96 portfolio companies investigated made improvements in environmental, social and governance practices.


Responsible investment

In May 2009, all 16 European development finance institutions pledged to follow responsible investment principles when financing projects.

The organisations will ensure that fund managers, through whom they channel development finance, account for the social and environmental impacts of their investments.

At the end of 2008, the total investment portfolio of EDFI members was €17bn.

EDFI members are: AWS, Austria; Bio, Belgium; CDC, UK; Cofides, Spain; DEG, Germany; Finnfund, Finland; FMO, Holland; IFU/IØ, Denmark; Norfund, Norway; OeEB, Austria; Proparco, France; SBI/BMI, Belgium; Sifem, Switzerland; Simest, Italy; Sofid, Portugal; Swedfund, Sweden.

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