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Topical PaperComparative Institutional Review of ADB’s Private Sector Operations

NOTE

In this report, “$” refers to US dollars.

Director General

Officer-in-Charge

Team leader

Team members

V. Thomas, Independent Evaluation Department (IED)

V. Salze-Lozac’h, Independent Evaluation Division 2, IED

N. Subramaniam, Principal Evaluation Specialist, IED

N. Gamo, Senior Evaluation Officer, IED

I. Garganta, Associate Evaluation Analyst, IED

In preparing any evaluation report, or by making any designation of or reference to a particular

territory or geographic area in this document, the Independent Evaluation Department does not intend

to make any judgments as to the legal or other status of any territory or area.

The guidelines formally adopted by the Independent Evaluation Department (IED) on avoiding conflict

of interest in its independent evaluations were observed in the preparation of this report. To the

knowledge of the management of IED, there were no conflicts of interest of the persons preparing,

reviewing, or approving this report.

Attached is the executive summary of the report. The full main text is not presented for reasons of

confidentiality of the report.

Topical Paper

May 2016

Comparative Institutional Review of ADB’s Private Sector Operations

Independent Evaluation: TP-18

Acknowledgements

This topical paper was prepared by a team of staff members and consultants of the Independent Evaluation Department (IED) of the Asian Development Bank (ADB). The team included staff members Nathan Subramaniam (team leader), Noel Gamo, and Irene Garganta. Consultant team member Fredrik Korfker made valuable contributions to the formulation of this report. Consultant Marion Funtila contributed ADB data analysis and comparator analysis. As external peer reviewer, Marvin Taylor-Dormond, Director, IEG Financial Private Sector and Sustainable Development, World Bank Group, provided valuable comments that

improved the report. The report benefitted from feedback and discussions with staff of ADB, the EBRD and IFC. The report was prepared under the guidance of Vinod Thomas, Director General of Independent Evaluation Department, ADB, Véronique Salze-Lozac’h, Deputy Director General of Independent Evaluation Department, ADB and Walter Kolkma, Director of Division 1, Independent Evaluation Department, ADB.

Executive Summary Profit seeking and competition among private firms encourage innovation and economic development. The middle-income countries in the Asia and Pacific region need private sector knowledge and investment to help continue their rapid economic growth. Increasingly, governments in the region are seeking alternatives to public funding and looking to the private sector to help fill large infrastructure investment gaps and improve the efficiency of public service delivery. Strategy 2020, the long-term corporate strategy of the Asian Development Bank (ADB) approved in 2008, calls for ADB to expand its work with the private sector.

ADB’s private sector operations and supporting reforms for an enabling business environment have an important role to play in the region by creating jobs, building infrastructure, improving the access of small and medium enterprises (SMEs) to financial services, bridging the rural-urban divide, and providing efficient healthcare and education. ADB’s Private Sector Operations Department (PSOD) has made major strides in its development over the years. The department now processes both private and public sector projects in which ADB takes nonsovereign exposure risks, with infrastructure project finance and support through financial intermediaries being its main areas of focus. PSOD’s staff size has grown over the years, and was at 153 at the end of 2015. Private sector approvals have substantially expanded as well, exceeding$2.6 billion in 2015. PSOD has recently instituted changes to assess staff performance based on project commitments and disbursements and is working to streamline approval procedures. It has also been active in expanding its reach to Asia’s poorer countries, and is a key contributor to ADB cofinancing targets.

PSOD has also been a major contributor to ADB’s net income in the last few years and this contribution is deemed to grow. After the expansion of ADB’s balance sheet in 2017 and the resulting increase in its lending capacity, PSOD is expected to account for $3.5 billion to $4.0 billion of annual lending. This will entail a major expansion of both ADB’s private sector operations and in the organizational needs of these operations.

This paper was prepared at the request of ADB’s Development Effectiveness Committee to assess PSOD’s strategic positioning, and identify opportunities to enhance the department’s development effectiveness. ADB’s Independent Evaluation Department reviewed PSOD’s strategic positioning, the key issues and constraints faced in its operations, organization and staffing, the profitability of operations, the sector coverage of its portfolio, and operational efficiencies. The review provides elements of comparisons with peer multilateral development banks. The review benefitted from stakeholder discussions with ADB staff and management and staff of the European Bank for Reconstruction and Development (EBRD) and International Finance Corporation (IFC). Based on this study, the report offers some options that would need to be further investigated to arrive at a detailed operational plan, accommodating various ADB wide institutional constraints. The report does not intend to imply that ADB should systematically adopt the same models as the EBRD and IFC, but rather to highlight good practices that can then be adapted to the specific situation and needs of ADB. Moreover, some of the options would require gradual implementation, in line with the expected growth of PSOD.

As stated in the approach paper for the study, the report focuses on comparisons with the EBRD and IFC. Both have large overlaps in operations with ADB in geographic regions served, unlike the Inter-American Development Bank and the African Development Bank. Also, EBRD and IFC have benefitted from many more years of experience in private sector operations and have advanced systems and procedures that PSOD could benefit from as it expands its operations. Another source of information was the mid-term review of ADB’s Strategy 2020 and the subsequent action plan, which touched on PSOD-related issues. This paper is expected to feed into the PSOD’s expansion plans, and to help inform private sector operations in the context of ADB’s Strategy 2030 in addressing the financing

iv Comparative Institutional Review of ADB’s Private Sector Operations

needs of countries in the region. The summary below links findings in various areas to suggestions for solutions and improvements.

Commit to Development Impact and Value Addition. A major aim of ADB’s private sector operations is to contribute to development outcomes and to align with overall ADB objectives. These operations should act as a catalyst for investments and not displace the private sector. Achieving development impact and investment profitability are not mutually exclusive. The evidence from large data sets of operations at IFC and ADB show that development impact and investment profitability can have a direct positive relationship. One does not need to come at the expense of the other. ADB private sector operations should be able to pursue and achieve a double bottom line of both development impact and investment profitability. ADB should continue to pursue private sector projects that will deliver both and it could do more of this by increasing private sector operations in riskier countries.

In a One ADB, there are considerable gains to coupling PSOD transactions with economic, sector and policy work of the organization. A case in point is the investment approval process seeking advice from the economic research and regional cooperation department (ERCD). Currently, PSOD uses its own staff economists to review transactions. This paper would like ADB to consider institutionalizing the review of significant transactions by an ERCD economist who could independently make a quick assessment of the economic returns of the project at this stage, and provide feedback to improve the design of operations and enhance their development effectiveness. The ERCD economist could also check for and comment on ADB additionality. The approach in IFC is to ask questions on the choice of clients and the MDB and the financial and nonfinancial additionality of the MDB's participation in the operation. Investment officers could discuss value addition in consultation with economists and present indicators for tracking and reporting on value addition in the project approval document. This contribution should be planned so as to avoid delays in the approval process.

Especially in a growth environment, it is important that safeguards continue to be implemented with an adequate degree of independence or arms distance from transactions such that private gains do not eclipse social damages. PSOD has its own environment and social safeguards division that reviews transactions, which is good. Looking at PSOD's expansion, however, ADB needs to ensure that safeguards staff can with a degree of objectivity and independence weigh in with investment staff to make the right calls. ADB could consider how PSOD's safeguards intervention can be positioned to exercise the needed degree of independence from the drive for delivering transactions for mitigating environment and social risks.

Improve Operational Efficiency. PSOD management has instituted changes to make staff more accountable and increase efficiencies. It is important for ADB and PSOD to promote a culture focused on disbursement and commitments, and to move away from the focus on approvals. The staff incentive structure needs to reflect this change. Even though PSOD approval targets are regularly met, cancellations at PSOD averaged about 37% for all NSO from 2006 to 2012. Over 68% of these were full cancellations, of which over 75% happened before the projects were signed. The corresponding net disbursement ratio—the amount disbursed as a proportion of approvals—for 2006 to 2012 was 51%. During the same period, cancellation rates amounted to about 35% for energy and 77% for transport sectors. PSOD needs to investigate the reasons for these high cancellation rates, which are a drag on operational efficiency and development effectiveness. Some changes to address this may be underway. The 2015 Annual Portfolio Performance Report (APPR) also flags high cancellations as an issue but notes a marked improvement in the proportion of projects that get signed within 12 months of approval in the last 2 years.

Proportionate to financing volumes, PSOD processes fewer deals than its peers. The EBRD and IFC are much larger and, proportionally they process many more deals. At the EBRD, 352 deals were processed in 2015 compared to 26 at ADB, 13 times the number of deals processed at the EBRD compared to ADB, even though the EBRD approval amounts for 2015 at $8.6 billion were only 3.3 times larger. In 2015, IFC processed 15 times the number of deals than ADB for an approval amount that was about 4 times larger. PSOD investments comprise relatively large transactions in sectors like

Executive Summary v

energy which end up using large approval amounts for a few transactions. To reach smaller countries and more diverse sectors, PSOD should move toward smaller transactions and more deals. Clearly, ADB NSOs need to add more investment staff to achieve more deals and to reach similar average deal size as the EBRD and IFC.

To realize more number of deals and smaller average deal size efficiently, approval procedures need further streamlining—PSOD processes are more onerous than at the EBRD and IFC. ADB’s private sector operational procedures need to be different from those of its public sector operations. In particular, they need to be market-oriented and flexible enough to meet market demands. ADB and PSOD need to review the NSO approval process to reduce the number of hand-offs during the approval process. The document requirements for concept approval and report and recommendation of the President (RRP) approval need to be further streamlined to make the process simple and straightforward. Projects need to be tiered based on risk (by Office of Risk Management) as is the case at IFC, and the lower risk projects need to be delegated to PSOD management for approval. Approval frameworks need to be established and approved by the board, so that projects falling within the approved framework can be approved by PSOD management with only notice to the Board. An initial decision of starting the process of concept clearance needs to be communicated to the client in about a week’s time after a request for financing, subject to concept Investment Committee approval.

Approach to Risk-Taking. Related to the approval processes is ADB’s approach to risk-taking. The nonperforming loans (NPL) ratio by itself is not a full proxy for the right levels of risk. But over the last five years, ADB’s NPL ratio is much lower than that of EBRD and IFC. Even so, PSOD investment volumes have increased significantly in the past 5 years relative to earlier periods, and the risk profile of new investment activity is assuming higher levels of risk. What is important is to allow for the right levels of risk taking while balancing it with prudential financial management. This can be furthered by promoting a collaborative culture between risk and the investment teams by establishing an appropriate incentive structure for risk staff to provide innovative solutions to enhance operations. The credit staff at IFC are usually much more senior than the investment officers and this promotes a culture of respect for risk management staff among the investment officers. At IFC, this is further facilitated by using highly experienced veteran industry specialists for key sectors in the operating department to mentor and give guidance to investment officers. ADB also has senior credit staff and benefits from industry specialists’ expertise on an ad-hoc basis.

As NSOs are growing in volume and number, ADB could consider making more systemic use of some of these industry specialist staff from regional departments or thematic sector advisory groups and have them play a role in mitigating country, sector and theme specific risks. Such specialists could also be recruited from outside ADB if not available internally. With increased numbers and volumes of NSO, there is a need for improved risk management and to further develop and strengthen the existing work out group within Office of Risk Management (ORM) to handle difficult credits. To be clear, reconsideration of risk appetite or relaxation of approval procedures cannot be at the expense of rigorous risk analysis or at the expense of appropriate safeguard measures.

Improve Sector Diversification and Product Mix. ADB’s share of financial sector operations has varied widely in the last few years. The needs of many countries with higher local liquidity are in the development of the financial sector rather than in infrastructure, for which they might be able to find local financing. Repeat transactions with existing clients with development potential need to be encouraged especially for financial intermediary transactions. To diversify its sector mix and to better serve the market, ADB should consider lightening up on the energy sector and supporting the industrial, commerce, manufacturing and agriculture sector more. This will better align with many of the national strategies that are increasingly focusing on building their manufacturing sector as a major source of employment. In 2015, EBRD’s portfolio share of industrial, commerce and manufacturing (including agribusiness) sector projects was about 21.8% of total approval amounts representing 117 transactions and was even slightly higher at IFC at 23.6%, and the corresponding figure for ADB was 0.1%. ADB NSO share of transport approvals in 2015 was zero; a more strategic

vi Comparative Institutional Review of ADB’s Private Sector Operations

approach to sector and geographic planning could help maintain appropriate levels of investment in key sectors.

In infrastructure, bankable deals are getting harder to find. To counter this, IFC is going upstream by asking staff to spend up to a third of their time in developing transactions; a lot of this work is done at the country level. Many infrastructure projects are viable economically but not financially, which often inhibits building a pipeline of bankable projects. To increase the share of bankable infrastructure projects, the use of innovative tools need to be encouraged (along with, in some cases, subsidized lending and guarantees funded by third party donors to bridge viability gaps). PSOD could have different windows for donor-funded subsidized lending (subordinated debt for example) alongside commercial terms based lending for the same project. Further collaboration with IFC in deal sourcing would be beneficial to both institutions.

PSOD needs to adjust its product mix to address market needs and to help meet mobilization targets. ADB should consider providing complete financing solutions for large projects. Like EBRD and IFC, ADB could syndicate portions of the financing that it cannot finance itself. This will not only provide added certainty to project developers in their financing thereby reducing chances that the developer replaces ADB financing with another lender, but also generate new revenue streams for ADB. Currently, the guarantees business represents only a small portion of ADB’s private sector business. But guarantee and syndication products could be a valuable mobilization tool for PSOD, and they could be used to attract new investors to ADB projects. For meeting mobilization targets, ADB should differentiate trade finance short term guarantees from long term guarantees, and report on these separately.

ADB should consider addressing the local currency financing needs of private businesses by providing innovative product solutions. Asset management should also be further pursued as a mechanism to mobilize additional capital and stabilize private sector revenues.

Develop a Private Sector Strategy. The most recent PSOD strategy was developed in 2006. ADB private sector operations have expanded a great deal since then, and a number of corporate quantitative targets have been introduced. However, given the market focused nature of private sector operations and the wide geographies covered, PSOD needs to update and refine its strategies on a more continual basis to remain relevant to countries’ needs and ADB goals. As is the case at the EBRD and IFC, PSOD could develop a 3-year rolling strategy aligned with ADB’s overall strategy, and provide an operational plan for the first year of the 3-year rolling strategy. The plan for the next year could include targets for commitments, disbursements, and sector, and geographic allocations for operations. This should be translated as a performance scorecard for PSOD with geographic and sector targets, which can be tracked by the Board and Management. PSOD collaborates with the regional departments in the country programming strategy process. Further alignment with regional department country strategies could enable the sequencing of important policy reform in countries ahead of or in parallel with private sector operations.

Reduce Earnings Volatility. Like the EBRD and IFC, ADB equity earnings represent a large share of overall income from private sector operations. In 2014 and 2013, the equity share of ADB’s private sector income was more than two times the share of income from loan operations. In 2015, the net ADB equity share of earnings fell off to almost nothing. To better manage overall income of private sector operations, and stabilize its contributions to ADB balance sheet, the institution needs to stabilize its equity income. The share of income from loans would likely increase over time, as the disbursed private sector portfolio increases. Importantly, the share of ADB equity approvals needs to increase from current levels. In 2015, the share of equity investment approvals was only 5% at ADB, compared to 16% at the EBRD and 30% at IFC. Unless equity investments are seeded over time, and developed by adding value, there will not be a stream of good divestments to make in the coming years. Also, ADB could consider fee business such as asset management to smooth out earnings, as IFC has done.

Executive Summary vii

Decentralize and Reorganize Staff. ADB’s private sector operations are primarily located at the headquarters. The lack of proximity to clients represents a problem for ADB in various aspects of its NSO—in origination (not being able to generate sufficient number of deals in a proactive fashion), in deal execution (not being able to be responsive enough) and in monitoring (not being able to address client needs, add value to portfolio and provide remedial measures to address problem portfolios). This is in stark contrast to the EBRD and IFC, which are far more decentralized. At ADB only 7% of the PSOD staff was located in field offices in 2015, compared to 30% at the EBRD and 58% at IFC. ADB can address this by increasing its presence in the major countries of operations. Given that India and the People’s Republic of China are the major operational areas, ADB needs to base a proportional share of the staff at these locations in the form of hubs. In addition, a small financial hub (either in Singapore or Hong Kong, China) would help manage financial sector operations.

Headquarters product teams needs to be organized along sector lines in the long run. ADB could appoint sector directors, to build expertise in their specific areas and to liaise better with regional hub teams. The professional staff at the country level needs to be senior relationship managers (with support staff, analysts and junior bankers hired locally) with the ability to maintain high level relationships with major clients and generate a healthy pipeline. Hiring staff locally makes sense from a cost standpoint (local staff are generally cheaper than headquarters staff), as well as from a business point of view (local staff are usually much closer to the market and hence, understand it better). At the EBRD, about 80% of the 373 field office professional staff is locally hired. Decentralization of operations at ADB will likely have cost implications for the first few years, with revenue offsets only expected to materialize with a time lag. This is an important consideration in planning for decentralization.

Develop the information technology System. PSOD does not currently have a comprehensive information technology (IT) system for deal origination, execution, monitoring, and risk management. In the past, due to PSOD’s small number of transactions, not having a full scale IT system might have made sense from a cost standpoint. But as the portfolio and number of approvals expand, not having a comprehensive IT system will be a key operational risk for ADB that needs to be addressed immediately. IFC recently finished developing a new IT system, and during meetings it was noted that senior investment staff were required to contribute and guide the development of the new IT system, alongside IT staff. Lack of IT systems and communication networks with regional offices at ADB will constrain any decentralization efforts.

Pursue One ADB rigorously. For the ADB private sector operations to benefit from the public sector operations there needs to be a unity of purpose between the public and private side of ADB. However, ADB needs to carefully balance this objective against the uniqueness of approach needed for private sector operations. The One ADB culture will be promoted by closer and more institutionalized collaboration to seek inputs from regional departments and country teams during early stages of private sector approvals, to better link the NSO strategy with country strategies, and to make systemic the soliciting of advice from a select group of highly experienced industry specialists from ADB regional departments to help mitigate project risks. The Office of Public-Private Partnership (OPPP) can form an important source of deal pipeline for regional departments and PSOD. Both regional department and PSOD operations could benefit from sharing of expertise and information with OPPP to develop infrastructure in the region.

ADB’s 2015 APPR raises many of the same issues as in this paper, including high cancellation rates, the need to replenish equity investments to enhance future profitability, and the need to build an IT system. The suggested options to be considered in the context of PSOD expansion plans are presented in Chapter 5 on Conclusions and Suggested Options. These suggestions are presented under the subcategories of Operational efficiency and deal approvals, Development effectiveness and PSOD Strategy, One ADB and procedural improvements, and Decentralization and organizational changes. These suggestions need to be considered as part of a more holistic approach to reorganize ADB’s private sector operations, rather than in a piece meal fashion.