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Due Diligence Report on Bangladesh and Pakistan for the ADB Inclusive Business Fund Initiative

Key Findings


Table of Contents
Section I. Introductory Remarks II. Bangladesh III. Pakistan Page No. 3 3 9


Introductory Remarks

This report follows abbreviated due diligence undertaken in Dhaka, Bangladesh in September 2012, and an abridged desk study undertaken on Pakistan to assess the viability of the Asian Development Bank (ADB) establishing a facility (the Facility) focused on improving peoples lives at the base of the pyramid (BOP) by investing in inclusive businesses. In summary, the challenges of making investments, whether debt or equity, of $500,000 to $10m in private businesses in Bangladesh are significant. Although there has been much focus on the role that access to finance can play in helping to improve the lives of poor people since the 1980s in Bangladesh, these initiatives have primarily concentrated on the microfinance sector. In a country still largely dominated by subsistence and small-holder farming, and with a high preponderance of small and medium-sized enterprises (SMEs), there is still significant dislocation in terms of the incorporation of the former into the supply chains of larger domestic and multinational companies. This is somewhat surprising, given that Bangladesh is now the worlds second-largest producer of garments, but beyond the garment sector, inclusion has been lacklustre. Where Pakistan is concerned, it has the advantage of a relatively sophisticated banking sector and, in pockets across many sectors, a highly-educated, well trained, adept workforce. That said, it remains a largely agrarian economy, and is vulnerable to adverse weather conditions which disrupt supply chains and wreak havoc at the individual, household and community levels and throughout the supply chain. The challenge for a Facility covering Pakistan is the extent to which investors would muster the appetite for exposure to such a risk-prone market. Domestic political uncertainty and the ever-present threat of terrorism, combined with the risk of natural disasters and adverse weather conditions only augment the risk. That said, there is a significant shortfall in patient capital, especially for the SME sector in Pakistan, and considerable pressure on donors and DFIs to channel more capital there.

II. Bangladesh
Macroeconomic and Political Landscape and Structural Challenges Bangladesh suffers from recurring, disruptive political instability which reflects the decades-long rivalry between the two main political parties, the Awami League and the Bangladeshi Nationalist Party (BNP). Unfortunately, this rivalry pervades all segments of the political economy, often translating into so-called hartals, or work-stoppages and protests, disrupting production and supply chains and culminating in violence. Corruption is endemic, and despite donors insisting for decades that future funds would depend on curbing official graft, little progress has been made. Where the

private sector is concerned, relatively low wages, combined with a productive and entrepreneurial workforce, have put Bangladesh on the radar screen of several international corporates, especially in the garment sector. Foreign direct investment (FDI) into SMEs, however, and even larger private firms has been muted compared to India, for example, because the operating environment is still seen as largely inimical, corruption is problematic, respect for foreign investor rights and returns is limited and exit strategies can be extremely challenging. In addition, Bangladesh can suffer from bouts of inflation and currency depreciation which generally reflect either periods of especially poor macroeconomic management and policy making, or adverse weather events and natural disasters that cause food prices to spike and import bills to soar. Notwithstanding the foregoing, Bangladesh has been surprisingly unaffected by the international financial and economic crisis which began in 2008. The knitwear sector has experienced unprecedented growth, and despite refugee-related issues, cross-border trade with Myanmar is rising significantly, which represents an unanticipated commercial opportunity. In summary, a Facility would encounter a vibrant domestic economy with various opportunities also to lend to export-orientated businesses.

The Structure of the Bangladeshi Economy: A Preponderance of SMEs The Bangladeshi economy is predominantly rural. Over 75 per cent of the population is in rural areas, of which over 40 per cent lives below the poverty line. Traditionally, the economy has been skewed towards agriculture and aquaculture, including production of rice, prawns and raw materials such as jute, but by 2004, more than half of rural income in Bangladesh was attributable to nonagricultural activity. This is an important development from the perspective of a Facility, because diversification will be perceived as an important risk-mitigating factor and natural hedge against the seasonality and weather-dependence of agricultural performance. Since the late 1990s, several new sectors have begun to take root in the country, including information technology (IT) and software development. Bangladesh has a competitive advantage in such areas vis--vis India, for example, because of the growing disparity in labour costs (software engineers are approximately 25% cheaper to employ in Dhaka than in Bangalore or Mumbai). Demand for private yet affordable healthcare and education has also increased vertiginously, with poorer segments of society still struggling to gain access. Where the middle class is concerned, as tastes change and more western behaviours take hold, demand for white goods, consumables and even processed foods, such as dairy products, has increased significantly. These trends signal the need for the emergence of a

deeper productive base in Bangladesh which, in turn, could provide significant opportunities to support inclusive business and BOP-engagement as a new modality of economic activity.

Access to Finance As suggested above, although microfinance has made an enormous contribution to improving livelihoods in rural Bangladesh and, importantly, among women in particular, due diligence confirmed that SMEs still struggle to access finance from formal institutions. Despite vigorous competition among banksthere are more than 50 registered financial institutions in the country new, pro-poor products are desperately required, especially in the agriculture sector. Specifically, farmers and agro-processors require contract finance facilities, warehouse financing, factoring, reverse factoring, crop insurance and natural disaster insurance, among other products. Best practices in risk-sharing and population and cultivation area-based risk models are urgently required in order to help farmers boost yields and enhance livelihood security. Within and beyond the agriculture sector, lack of access to finance means that SMEs rely on retained earnings and household savings to expand, even for working capital needs. The positive corollary of this is that debt-to-asset ratios in the country are low, but growth is hampered considerably as a result. In response, the government has tried to increase credit, especially in rural areas, by promoting co-operatives, and providing re-financing facilities for agriculture. Such facilities are offered for crop cultivation (short-term loans of up to 12 months); livestock and poultry production, fisheries, nurseries, betel leaf and beef fattening and fruit gardening (medium-term loans of up to 5 years); and acquisition of equipment and heavy machinery (long-term loans of more than 5 years). However, banks urgently need to expand their focus in rural areas beyond agricultural activities and, across all sectors, reduce the time between loan applications and disbursals (according to World Bank research, it can take nearly 1.5 months for loans to be processed). Processing costs and interest rates are high, there are cumbersome documentation requirements and potential borrowers are often asked for documentation they do not have such as land titles and audited financial statements. Most alarmingly, over 80 per cent of SMEs recently surveyed by the World Bank indicate that they are unable to access the finance they require.

Lending Opportunities Emerging From Structural Issues in the Financial Sector Although Bangladesh has been largely insulated from the international financial and economic crisis since the late 2000s, a home-grown crisis has afflicted the banking sector since 2012. Ironically, this makes the timing of an IB Facility for Bangladesh propitious. From the mid-2000s, speculative activity on the stock exchange steadily increased, fuelled by loose monetary policy which enabled companies and individuals to use personal and corporate loans to take punts on the stock exchange. In consequence, several banks in the country have already failed and credit to all but the most familiar, secure borrowers has dried up. On the supply side, this structural crisis has been exacerbated by a scandal which has involved the syphoning of over $500 million from the banking system. The relevance to an IB Facility is that the absence of credit is making private companies that otherwise would be loath to consider financing from unfamiliar sources of debt or equity capital more willing to modify their pricing expectations and entry terms.

The Prospects for Inclusive Business in Bangladesh Ironically, although the challenging operating environment would suggest otherwise, the prospects for inclusive business are bright in Bangladesh for several reasons. First, from the BOP-as-employee perspective, given the consistent attention there has been on employee wages and conditions, large employers have realised that they can no longer avoid the scrutiny of national and international buyers, non-governmental organisations (NGOs) and other stakeholders and pressure groups. The factory fire in December 2012 in Dhaka in which over 100 people died has only heightened pressure on industrialists to improve conditions for low-wage workers. Second, as domestic capacity increases to meet increasing demand for consumables, processed foods, dairy products and manufactures, medium-sized enterprises in particular will be well placed to be drawn into domestic supply chains. Third, the concept of inclusive business has been embraced at the policy level, particularly as it dovetails conveniently with the recognised need to capture more value in the country, especially in raw materials and aquaculture. Finally, the government has signalled its support for showcasing IB initiatives which can then be scaled up and will hopefully attract foreign direct investment into the country. General improvements in access to investment opportunities should not be confused with greater willingness by sponsors to open ownership structures to outsiders. Relinquishing an ownership stake is still an alien concept to most Bangladeshi entrepreneurs, shareholder rights are not respected, and many view equity injections as free money. An IB Facility should therefore definitely focus on

debt, and must emphasise the value addition and knowledge transfer that would accompany funding, because business-owners may still be suspicious of borrowing from a new source. Nevertheless, the sweet spot for a Facility is arguably in the $250,000-$5 million range. At the smaller end of the spectrum, companies graduating from micro-credit are rarely picked up by the next level of financial institution and are left in a financing void. Although they often recognise the benefit of formalisation, it is very difficult for them to access loans above $250,000 that are reasonably-priced and not less than one-year in tenor.

Sectoral Focus There is a relatively diverse range of sectors which an IB Facility could focus on in Bangladesh, including, but not limited to: Fisheries, agri-business and agro-processing: including dairy, fisheries (notably prawns), nuts, spices, tea, jute and rubber; Manufacturing: including light-manufacturing of consumables, white goods, intermediate goods and parts for industry; IT and software: in cases where it can be demonstrated that a Facility were supporting the development of new or high value-added segments that would lead to significant employment generation; Clean-energy: such as waste-to energy schemes, small hydro, bio-gas and solar energy; Utilities: including waste-water management, sanitation services, affordable energy and rural electrification, Education: primary and secondary education which is affordable and, ideally, lends itself to franchising; BOP-orientated higher education which is affordable and enables poor people to train in areas such as secretarial services, midwifery, nursing, technical support, mechanics and so on; Healthcare: medical consumables, diagnostic services, mobile healthcare and ambulance services, low-income group focused clinics; and Clean transportation: especially in secondary cities such as Khulna, Rajshai and Faridpur.

Facility Parameters In an environment such as Bangladesh, which is politically volatile and where sponsor risk is considerable, it would probably be prudent to begin with a relatively small Facility of, for example, $20-$30 million. Thereafter, once proof of concept is achieved, it would be much easier to raise more significant amounts of capital. Some of the main suggested parameters of a Bangladesh Facility include the following: Capital commitments: $20m-$30m, mostly from development finance institutions (DFIs) which, by and large, still have significant allocations available for Bangladesh (unlike India). Facility tenor: 8 years. Projected returns: 4-7%, not only because the Facility would make loans rather than invest equity, but also because currency risk is significant. Fund manager options: there are several small boutiques that have the capability to run a Facility. Additionally, as opportunities in the west for younger, educated Bangladeshis have decreased in the wake of the financial and economic crisis, many MBA graduates are returning from the United States and Europe, some with significant investment experience, and have been joining the investment houses in Bangladesh such as there are. Non-DFI Investors: Realistically, the Facility would largely be capitalised with DFI funds. However, there is a vibrant diaspora community in Europe and the United States, and it may be possible to attract investment from expatriates.




In many ways, the conditions for an inclusive business Facility in Pakistan are ideal: a highly-evolved financial sector, sophisticated business community, engaged Diaspora community, tradition of investment in private companies and so on. The challenge, of course, is the operating environment and the ability to compensate investors for the risk of investing in the country. Where the DFIs are concerned, this may not be as difficult, because building a vibrant private sector is seen as the eventual bedfellow of greater political stability and as part of a strategy to anchor the political economy of Pakistan. That said, the tensions between Pakistan and the United States in particular, and the way in which those tensions articulate themselves in terms of permissible financial transactions with the country, make the aggregation of a pool of capital for Pakistan difficult.

Economic Structure and Opportunities for Inclusive Business With a population of over 170 million inhabitants of which more than half the population is below the age of 23, the Pakistani economy is largely agricultural, although there is a sophisticated services sector and business community predominantly concentrated in the three main cities of Lahore, Islamabad and Karachi. Naturally, therefore, an inclusive business strategy would do well to focus on agri-business and agro-processing opportunities that focus on BOP-as-supplier models of engagement. As in Bangladesh, the challenge in Pakistan is to help farmers and rural aggregators to capture greater value at the rural level, not only by increasing yields and growing a greater variety crops, but also by mechanising and producing value-added, intermediate goods before on-selling. Sub-sectors related to agricultural production therefore also become relevant to the Facility, such as output of seeds, tools, light machinery, insecticides, pesticides, herbicides and so on. On the infrastructure side, secondary and tertiary irrigation, waste water management, clean and renewable energy and rural electrification are also areas that a Facility could consider. Unsurprisingly, as in the case of Bangladesh, the small and medium-sized enterprise sector accounts for over 75 per cent of economic activity in Pakistan but struggles to access finance from formal institutions. Although there are many aspects of access to finance that a Facility could focus on, an especially meaningful contribution could be in the intersection between finance and agriculture. Given that adverse weather events exacerbate considerably the vulnerability and insecurity of Pakistani farmers, with concomitant impacts along supply and production chains, the Facility could deploy capital in financial institutions with a focus on the following:

Micro-insurance: Few individuals in low-income groups in Pakistan are able to obtain insurance against illness and injury, and for property and productive assets. This is especially relevant in rural communities, where direct or indirect dependence on agriculture is high. Individual households, the local entrepreneurs serving them and others in the supply chain face covariant risk stemming from war, illnesses such as HIV/AIDS and malaria, catastrophic natural events (tsunamis, earthquakes), adverse weather conditions (drought, floods), insect infestations, and fluctuations in the quality of inputs and market prices for produce.

The usual response of Pakistans low-income groups to risk events is to use available savings, borrow from informal sources or informal group resources, sell assets and/or default on loans. This risk has seen the emergence of a new financial service, micro-insurance for lowincome groups, and has taken advantage of advances in communications, IT and the development of appropriate insurance carrier/agent business models. Moreover, the growth prospects for micro-insurance in Pakistan are vast, as only 10-15 million people are estimated to be covered at present. Risk management is key to effective micro-insurance, and policies must be designed to deal with limited and variable cash flows and unstable economic conditions in Pakistan. Coverage for the poor must therefore incorporate appropriate delivery channels, low premiums, low administrative costs and simplified administrative procedures. Premium rates must cover the provision of reasonable benefits as well as administrative, product servicing and delivery costs. Many MFIs chose to offer micro-insurance on a mandatory group basis by linking coverage to a loan product. This approach may be cost effective, but does not minimise downside risks. In addition, many MFIs lack technical expertise, institutional capacity, and systems support, as well as protections provided to licensed insurers through legal and regulatory frameworks. Under partnership arrangements between licensed insurers and MFIs, important benefits can accrue to both institutions. By actively working in low-income areas, MFIs are known to and trusted by local communities and are well-positioned to develop volume and outreach. In addition, they can educate and advise individual clients who may be unfamiliar with insurance plans, and have developed efficient mechanisms to obtain information and handle financial transactions. The insurance provider is able to minimise overheads, gain access to reinsurance and take advantage applications using advanced IT mechanisms. Among the more innovative and successful micro-insurance products relevant to Pakistan are:

Area-based Index (ABI) Insurance: Designed to address correlated risk for loss from a single, widespread event, ABI insurance is written against specific hazardsdrought, floods, yield loss, animal mortality ratesdefined and recorded at regional levels. Individual policies are based on the value or level of protection sought, with purchasers paying the same rate of premium throughout a region. In the event of a risk event, each policy holder is awarded the same indemnity per unit of insurance as the amount of units initially purchased. By abolishing individual contracts, inspections and assessments requirements, administration costs are minimised.

ABI insurance can be bundled with other financial services and the premium can incorporated into the loan total. In such cases, the policy insures both borrower and intermediary against default due to the occurrence of specified risk events. In some cases, the policy itself can be used as collateral. Policies can be sold to individuals, groups and organisations through formal and semi-formal financial institutions. ABI insurance has a variety of applications for all types of organisations. For example, to prefinance some emergency operations in certain African countries, the World Food Programme and the World Bank have developed and purchased a rainfall index insurance scheme from AXA Re, the global reinsurer.

Health Micro-insurance: In order to minimise adverse selection, administrative and delivery costs and to maximise outreach and efficient premium collection, microinsurance schemes have generally aimed at groups rather than individuals, with preference given to pre-existing groups formed for purposes other than obtaining health insurance. The households of primary members of the group are covered. Various service delivery models have been tested successfully in other parts of South Asia and in Africa which could be relevant to Pakistan, including: Community-based models: local communities form groups that capitalise and manage a risk pool for their members; Provider models: hospitals and clinics create pre-paid, risk pooling coverage for using their facilities; Full-service models: downsized insurance services tailored to the low income market are offered by regulated mainstream insurers; and

Social protection models: health careas well as crop, livestock and covariant catastrophic riskis underwritten by national governments.

Coverage under health micro-insurance schemes varies to meet the needs and payment capacity of policy-holders as well as the management capacity of providers. For example, hospitalisation only coverage plans may range from only limited emergency services to coverage for surgical, medical and maternity services. Hospitalisation and outpatient coverage schemes range from basic to fully comprehensive cover, including chronic illnesses. Premiums vary according to coverage levels. Limited outpatient and community health service plans may be less expensive but are usually limited to locally-available services only.

Collateralised commodity lending: This form of lending would expand opportunities for post-harvest financing for Pakistani producers, traders and processors in agri-business. With traditional lending schemes, underlying collateral such as commodities, represents a second payment source to be mobilised in case of loan default. Under collateralised commodity lending mechanisms, the commodities become the first source of repayment. By retaining the right to sell off the asset in case of loan default, the lender shifts the risk from the willingness of the borrower to repay the loan, to the ability of the borrower to produce and conclude the underlying commodity transaction. In effect, collateralised commodity lending changes the lenders risk structure. Within collateralised commodity lending, there are two important types of financing:

Warehouse receipt financing: This is a lending mechanism that uses commodities as loan security. A receipt, issued by the licensed warehouse storing the commodity, serves as the basis for the loan transaction. Risk is thereby transferred from the borrower to a liquid asset which may be immediately sold off in case of loan default. Physical production is thus leveraged to access finance, there is no lien on the borrowers fixed assets and the lenders administration costs are reduced.

Export receivables financing: Under this scheme, the lender pays funds to an exporter on the basis of assigned import contracts from an importer. The lender

thereby finances the working capital needs of the exporter, with the importer paying the lender first and the lender paying down the loan and passing any remaining funds to the exporter.

Factoring: Factoring has become an increasingly important funding mechanism for unbanked SMEs in some parts of South Asia seeking to finance production cycles when buyers are given 30-to-90-day payment terms. Factoring is a form of supplier financing and not a loan per se, as it does not involve debt repayment or increase the sellers liabilities. Factoring provides sellers with immediate access to working capital finance. In addition, many factors offer credit and collection services in addition to funding the receivables. This is particularly important in environments where commercial laws, enforcement and bankruptcy systems are not well established. In developing countries, some intermediaries engage in reverse factoring to reduce the risk of fraud due to non-existent receivables and/or buyers and poor credit information. In this scenario, the factor purchases the accounts payable from large, transparent accredited firms only. In this way the factors credit risk is equal to the default risk of a high quality buyer rather than an SME.

In addition to a strong focus on access to finance, a Facility for Pakistan could play a meaningful role in BOP-as-consumer IB engagement models. Services that are accessible and affordable to the poor in areas such as education and healthcare are desperately required, especially in more remote parts of the country. Similarly, availability of key medical consumables, medicines and diagnostic equipment is lacking.

Facility Implementation in Pakistan Unlike several other countries examined as part of the ADB IB Facility, Pakistan has a relatively vibrant private equity industry, which means that there are a number of players that could be considered to implement the Facility. Technical skills in evaluating transactions, whether debt or equity, are well developed, so there would significantly less implementation risk than in some other countries, and the need for technical assistance focused on deal-doing would be lower than in Bangladesh, for example. Where TA would be required is at the investee company level, concentrated in areas such as corporate governance, building management capacity, financial

controls, management information systems and so on. Although respect for shareholders or lenders rights is somewhat greater in Pakistan than in Bangladesh, the Facility would have to emphasise the importance of long-term partnership with sponsors in order to get into the undergrowth of companies and strengthen internal processes and systems. Self-liquidating instruments would, of course, be critical, because the Facility would not want to incur high exit risk in the form of having to identify external buyers of stakes in businesses.

Conclusion ADB is probably best advised to take an opportunistic approach to establishing an IB Facility in Pakistan. For logistical and political reasons, it would not be feasible to have a window for Pakistan added to an India-focused Facility, so realistically, it is probably best combined with Bangladesh (note that investor appetite for exposure to that particular combination of countries would need to be explored). If it were possible to aggregate domestic capital alongside DFI commitments, a Facility of $30-$40 million is not unrealistic for Pakistan, and the indications are that deal flow would be vibrant in the $500,000-$7 million range.