Systemic Impact of International Development Budget Cuts on Private Markets in Frontier and Emerging Economies

“Development finance institutions (DFIs) still play an important anchor investor role in the African private equity landscape and contribute a significant share of the funds raised.”     

- One of DEG’s (German Investment and Development Company) investment rationale for equity commitment to Adenia Partners V in 2023

In an attempt to build sustainable private sectors / capital markets, development money props up much of the private market ecosystem in many frontier and emerging economies. In 2015, DFIs and international aid organizations ramped up investment activities abroad in an attempt to mobilize private capital at scale to meet the ambitious goals included in the UN's 2030 Agenda for Sustainable Development. Adoption of this agenda acted as a catalyst, leading these organizations to increase investment of risk capital, largely on a non-commercial basis – through fund-of-fund investments, direct investing into businesses (in 2024, 58% of the disclosed transaction value in African private markets came from DFIs), and providing capital for risk sharing guarantees to local banks (who often then direct invest into companies and seed funds). As Western governments – from the United States to the UK, Germany, France, Netherlands, and Belgium – slash international aid financing between 25-40% and shift to more strategic priorities, the durability of this ecosystem will be tested. 

The potential implications of this are wide ranging. During our year of travel meeting with emerging market (EM) / frontier investors, we have repeatedly heard concerns from returns-oriented investors around a development-induced valuation bubble given the extent of development financing. A reduction in development capital may be the impetus for part of this bubble to burst. In addition to this valuation distortion, the extent of these activities may have also created a broader systemic risk which may be exposed by global cuts in development funding. In many markets, development capital is in a sense incestuous as funds too are seeded by this money. While we support the virtuous goal of strengthening private markets, we fear that these initiatives could have drastic unintended consequences given the global pullback on aid. 

In this article, we provide examples of transactions and funds (mainly in Africa where we believe this problem is most acute) that demonstrate the nature of the problem. We also discuss what we see as potential implications that funding cuts may cause.

Overview of DFI Involvement in the Private Investor Ecosystem 

In an effort to catalyze capital markets and bring long-term, self-sustaining economies to EM and frontier countries, DFIs and other government-funded development organizations have been providing capital (fund-of-funds) to local private investment funds, especially in Africa. When looking at transactions on the surface, one gets the impression that there is a developing independent sponsor network. However, once you dig into the LP base, one can see the dependency on development funding in this part of the ecosystem too. We would like to note that this dynamic is not only happening in Africa. We began noticing this trend in Nepal, the first country we took meetings in, however, we believe Africa is more relevant given the broader investment interest on the continent versus in more isolated frontier markets.

Looking at a few transactions, including the LP base of the sponsors involved, paints this picture clearer. In some instances, the seller and buyer (due to fund exposure) are the same, obscuring the DPI picture. This is where we believe the systemic risk really lies. While we acknowledge this dynamic occurs in more developed markets too (continuation vehicles, fund-of-funds, etc.), the lack of depth in EM / frontier markets makes this more troubling.

This dynamic can be demonstrated in AfricInvest’s, a leading Pan-African investment platform, acquisition of British International Investment’s (BII) stake in I&M, an Eastern African Banking Group. The acquisition was made via AfricInvest Fund IV, a $411m fund significantly supported by DFIs including BII which committed $50m, DEG ($30m), Proparco ($30m), IFC ($30m), DFC ($30m), FMO ($30m), and Finnfund ($20m) bringing the total commitment from development money to ~54%. While this may be a solid transaction, having development money so dually entrenched (aka buyer and seller) in non-robust markets may be a troubling sign for the times ahead given the current budgetary climate.

In 2024, Adenia Partners announced the sale of Ghana-based Cresta Paints to Uhuru Investment Partners. While Uhuru Investment Partners is technically an independent sponsor, ~50% of LP capital comes from DFIs with additional capital from AfricaGrow, a partnership between the German government and Allianz Global, and the European Investment Bank (EIB).

While these are just two examples, there are many more transactions with a similar dynamic. For example, Adenia’s sale of OMOA Group, an African payments player, to SPE Capital (specifically SPE PEF III, LP). In 2024, SPE PEF III announced a first close of $140m with commitments coming from FMO ($20m), Swiss DFI SIFEM ($15m), IFC ($30m), and the European Bank for Reconstruction and Development ($40m) equating to 75% of funds raised to date. The list goes on. 

Ironically, some funds market themselves as a means to ween off development funding dependency; however, they are heavily funded by development money themselves. For example, look at Equator, a $55 million climate-tech VC focused on Sub-Saharan Africa. The fund’s Managing Partner Nijhan Jamal noted “We are needed more than ever to invest in technology and scalable ventures tackling fundamental climate challenges. These investments will help reduce dependence on aid and instead bring more global private capital into the region.”  While this is in part true – looking at its LP base reveals their dependency on the development/aid community too. Key investors include BII (~$15m), IFC ($5m), Proparco ($5m), the Global Energy Alliance for People and Planet (recipient of government aid dollars), and DOEN (financed by the Dutch postcode lottery). Note that BII, IFC, and Proparco alone account for 45% of the fund. 

A high number of  private equity and VC funds in EM and frontier markets have a capital base funded 20-60%+ by DFIs. For example, Adenia V, one of the largest Pan African funds at $470m, has an LP base consisting of ~49% DFI capital. In the fund closing press release they note “About 60% of the funds raised for Adenia Capital V come from long-standing investors, including the EIB, IFC, Proparco, and DEG... The remaining 40% of the commitments are from development finance institutions investing in an Adenia-launched fund for the first time, such as Findev Canada and the US International Development Finance Corporation”. Africa Development Partners III Fund (ADP III), a $900m 2021 vintage fund received ~29% of capital from DFIs. This list continues as well with some funds being nearly entirely development money - i.e. Nepal-based Dolma Impact Fund II which is entirely funded by DFIs.

Overview of Capital Injections and Impending Funding Cuts

DFIs are purportedly “self-sustaining” institutions however many receive annual capital injections from the governments that are shareholders in the DFIs. For example, in the 2024/2025 budget - BII is allocated £0.9 billion from the official development assistance (ODA) budget (keep in mind the entire BII portfolio is £7.3 billion as of 2023). See below for a chart showing the capital injections at BII as discussed in an ODI article found here. In addition to BII, other DFIs are dependent on annual capital injections. AFD, of which Proparco is a subsidiary, receives ~€2.0 billion per year. FMO requires ~€1.0 to 2.0 billion per year (funded in public markets and through private placements). Norfund and Swedfund receive hundreds of millions per year as well.

It is stated that these capital injections are made to fuel further growth. A problem may arise if and when these injections cease to continue given these DFIs are key investors in sponsors that are becoming more important in enabling exits from earlier investments. Note that some DFIs are funded in part by bond issuances and not solely from government budgets, however, most are still reliant on capital injections from ODA in the budget.

Source: CDC/FCDO annual reviews

The above sentiment is echoed in a December 2022 working paper “An Exploration of Bilateral Development Finance Institutions’ Business Models”. The authors state “...while the DFIs have been able to grow their portfolios during the period under study (2017 - 2020), this may not continue without them making better use of their balance sheets, also given that annual net incomes have been low to negative. Dependence on funding from countries and controlling entities may not be sustainable..”. 

On top of the cuts and restructuring in the United States, many of the largest European donor countries have announced substantial ODA cuts (25%+, often phased over a series of years). Countries that have announced cuts of this magnitude include the UK, the Netherlands, France, Finland, Belgium, and Germany. The EU and member states provided 42% of global ODA in recent years (2022-2023) – this funding, including capital injections to DFIs, will certainly be impacted by the stated budget cuts.

Like America’s shift in industry spend to more strategic sectors, European nations have stated intention of doing the same, so regardless of the magnitude of cuts to capital – there will certainly be a shift in recipients of capital.

“All the programmes we fund must contribute directly to our own interests: promoting trade, enhancing security and reducing migration…The goal is not merely to reduce development aid, but to make it better. We will make clear choices, doing only what we do best and working wherever possible with Dutch businesses.” 

- Reinette Klever, the Dutch Minister of Foreign Trade and Development Cooperation

Additionally, we cannot rule out further funding cuts impacting multilateral organizations such as the World Bank / IFC from some of their largest funders (US is the IFC’s largest shareholder, over the last ten years the US has committed $16.4 billion) given rhetoric to date. 

Implications 

When the coffers are open and capital infusions are occurring, this system seems to work. But what happens when the taps run drier? That is what we may be about to figure out. 

It is not clear exactly which organizations will be impacted by the announced cuts and to what extent. Regardless, we believe preliminarily that reductions / shifts to this funding system could have the below impacts.

1. Asset Pricing Capitulation / Valuation Reset 

The ultimate goal of development-financed investments in private markets is to create sustainable investment ecosystems in countries with challenged capital markets - to create an environment in which businesses / projects can attract capital to grow and private players can generate necessary returns. Ironically, the development capital itself has created an environment that is generally unattractive for returns-oriented investors to enter due to inflated valuations. For many years, there has been too much capital chasing too few quality assets – creating an inefficient, distorted market. From what we have heard in the field from the few investors we spoke with that received no development funds (think family offices / HNWI fund managers – we first mentioned this concept in our Nepal PE report here), this bubble has been a problem for some time. The development capital blocked out returns-oriented investors, especially in certain sectors, due to the high valuations created from non-commercial investment activity. 

This valuation bubble may come to a head given the coming funding void driven by development budget cuts – and the insinuation that private investors should work to fill that void. At these inflated valuations, truly market-driven investors are unlikely to be willing to invest in assets at current pricing levels. We believe there will need to be a valuation reset, particularly in certain sectors. Especially, if capital is harder to come by, pricing capitulation may be down the road.

We believe that sophisticated investors in frontier markets may be positioned to take advantage of this reset. 

2. Where is the Opportunity - Players Serving Western Strategic Interests

While cuts in funding will cloud the entirety of the ecosystem, new opportunities will come from this shift. Companies and funds which can support the strategic priorities of Western governments will feel the benefit. 

3. Bubble Burst for ESG / Climate-Oriented Companies and Funds

The specifics of the change in aid funding / strategy are still being determined. One thing that has been made clear is that investment focus areas will shift to more strategic sectors (critical minerals, infrastructure / logistics, and security). Net investment dollars could possibly still increase (over increases in grants, etc.), but the dollars will be allocated differently and chase new priorities.

Historically, dollars have been allocated to businesses and funds focused on supporting green energy infrastructure, female founders, and SMEs in general. As governments hone in on strategic investment, funds and businesses operating in less strategic sectors will be exposed to this shift in capital allocation.

4. Tougher Exit Path

The constant supply of development money created the illusion of a robust exit environment. The creation of a sponsor universe through fund seeding enabled sponsor-to-sponsor exits. 

We believe that the restricted financing environment will make new fundraising (for new and existing funds) more challenging, and in turn, create a less certain exit environment for existing and future investments.

5. Only the Strongest Companies / Funds Will Survive 

We see a scenario in which certain businesses and funds will wind down or seek financing at a discount. Only businesses and funds that are truly sustainable will continue to exist. 

6. Some Ecosystems May Collapse Resulting in Long-Term Distrust of Capital Markets 

Finally, in a worst case scenario, the bubble truly bursts in several markets and trust in the capital markets deteriorates in economies the West is trying to build. During our travels, we have encountered many countries which have experienced market failure before. Unfortunately, it results in years, and potentially permanent, lack of trust – from business owners, investors, banks, and beyond – in the power of private markets.   

Parting Thoughts

The implications of a systemic contraction in foreign development spending are unknown at this point as specifics of reform have yet to be released. Given the extent select EM and frontier capital markets rely on international development money, this situation needs to be monitored. 

Is there a backstop here or is the backstop perpetually more money? We may soon find out.