DFIs are unlocking liquidity and mobilising private capital

We are increasingly seeing development finance institutions (DFIs) using secondary transactions – sale of existing fund interests – to address these situations in different ways.

Catalysing private capital

Whilst the mobilisation of private capital in developing market funds sometimes relies on blended finance arrangements, including first-loss positions, secondary transactions are proving to be a useful supplementary approach to encouraging more private investment.

A private investor buying an existing fund interest, including through a portfolio purchase, from a DFI can benefit from having greater visibility over the developing market fund’s portfolio, especially if most of that fund’s commitments have already been deployed. Such oversight allows the private investor to make a more reasoned evaluation on the fund’s projected performance than would have been the case if that private investor had been admitted to the fund during its initial fundraising period. As an additional benefit, a willing DFI seller might enable a developing market fund manager to develop a relationship with a private capital investor that might otherwise have been more challenging to establish.

Achieving exit

Developing market funds can take longer to achieve an exit due to the difficulty in either achieving an initial public offering (IPO) or as a result of there being a narrower pool of specialised buyers to choose from. Consequently, developing market funds are often required to extend their initial term to provide more time to realise their underlying assets.

Rather than waiting until the end of a fund’s life, DFIs can instead use secondary sales to realise capital and value from maturing funds and to redeploy these proceeds into new impact investments. Avoiding the wait for the eventual winding-up of a fund enables more efficient capital deployment and thereby amplifies the DFI's wider impact over time.

Developing secondary markets

Whilst the secondary market for funds interests in the US and Europe is already growing and maturing, secondary markets in developing countries are at a much earlier stage with fewer transactions and market participants.

Building up a secondary market in fund interests will not only provide existing investors with another exit option but could also potentially encourage new private investors to start investing in developing market funds.

Funds in developing countries can also benefit from the creditability conferred whenever reputable private investors make the decision to invest. Being able to demonstrate such market stimulation is being seen by DFIs as an increasingly important part of their capital mobilisation strategy.

DFI requirements

Prior to agreeing to secondary sale, DFIs must consider various important issues.

Pricing

Valuing private market interests can be challenging as a lack of comparable data affects price discovery but an increased volume in secondary transactions can help address this information gap and provide more predictable pricing. Like in almost any secondary transaction, DFIs may have to accept the need to transact at realistic prices, including discounts to NAV, buyers should also be aware that a DFI will still expect a competitive price for their fund interests so that the DFI can use these proceeds to enable future impact.

Continuing impact

Sometimes a DFI will only partially exit a fund and accordingly it may retain a significant stake. This ensures that the DFI’s more stringent environmental, social and integrity requirements continue to apply to a fund and the DFI will often remain actively engaged through monitoring and advisory roles. Should a DFI decide to exit fully from a fund then this may be either because the DFI has determined that its development aims have been largely met or it is comfortable that the private buyer shares the same impact commitments.

Deepening relationships

A secondary fund sale will often mean that DFIs will be introducing new private investors to a strong fund manager and that manager, or indeed the selling DFI, may also seek to “staple” a secondary acquisition to a broader commitment from the private investor to the fund manager’s next fund. The DFI can also choose to reinvest the sale proceeds to support the fund manager in new opportunities and thereby allow the DFI to continue and deepen its relationship with a successful fund manager.

Looking ahead

As funds in developing countries seek to bring in more private capital and to address the growing need for liquidity solutions, secondary transactions offer a mechanism not only to address liquidity challenges but also to encourage more incoming private capital into developing market funds.

As DFIs continue to refine their approach to secondary sales, we can expect to see more standardisation of the legal documentation to reflect DFI requirements and facilitate these arrangements. However, DFIs may wish to consider re-evaluating their own internal mandates so that these can be adapted as necessary to embrace further development of secondary markets, including the possible establishment of DFI-backed dedicated secondary platforms.