Final Report on the Prospects for Establishing Inclusive Business Facilities in Selected South-East Asian and South Asian

Markets
ADB Inclusive Business Fund Initiative

SUBMITTED BY NOAH BECKWITH ADB BOP INVESTMENT FUNDS INITIATIVE DATE: 19 JANUARY, 2013

Table of Contents
Section Introductory Remarks I. II. Cambodia Vietnam Page No. 3 8 25 43 54 60 84 94 101 107

III. Thailand IV. Laos V. India and Sri Lanka

VI. Indonesia VII. Philippines VIII. Bangladesh IX. Pakistan

Introductory Remarks and Broad Conclusions from IB Due Diligence

This report follows detailed due diligence undertaken between 2011-2012 in Cambodia, Vietnam, Laos, Thailand, India, Sri Lanka, Indonesia, the Philippines and Bangladesh, and an abbreviated desk study undertaken on Pakistan. The focus of due diligence was to evaluate the prospects for inclusive business (IB) in each of the markets, and to assess their suitability to the establishment of several IB Facilities to provide finance to private companies that do or might incorporate populations at the base of the economic pyramid (BOP) into their activates as consumers, suppliers, producers, distributors, or employees. The overriding conclusion of the due diligence exercise is that there is a critical role for private sector investment to play, accompanied by strategically-deployed technical assistance, in addressing issues of access to, and affordability, choice, availability, quality and price of key goods and services for the poor. Moreover, private sector investment could be harnessed in the target countries to incorporate the poor into supply chains in more sustainable ways thereby enabling them to accumulate wealth and reduce insecurity and vulnerability, and drawing them into production chains as producers and distributors. Finally, depending on the size of investments made, in certain countries, the Facilities would have the opportunity to affect the experience of BOP incumbents as employees by focusing on issues such as wages, and improving skills and mobility through training.

Whilst each market has its own particularities and unique set of challenges, several overarching themes and commonalities have emerged through the due diligence exercise, including:

1. A focus on the SME sector is required: Unsurprisingly, the lions share of economic activity in all of the markets surveyed is attributable to the small and medium-sized enterprise (SME) sector. This means that drawing SMEs into supply chains, and helping them to capture market share in the provision of key goods and services to lower income groups and the middle class alike must be a key component of an inclusive business strategy;

2. Access to finance is a persistent challenge: The micro- small and medium-sized enterprise (MSME) sector struggles to access finance from formal institutions in every geography investigated. This represents a significant bottleneck to their growth, which

hampers the ability of larger domestic companies and multinationals to draw SMEs and micro-enterprises if feasibleinto their supply chains. In order for ADB Facilities to be meaningful, to the extent that access to finance issues can be addressed through targeted lending to financial institutions, and complemented with concrete policy initiatives by other parts of the bank, the effectiveness of the initiative will be considerably enhanced;

3. Investing in financial institutions should be a prominent theme: A corollary of point 2. above is that although microfinance has made significant advances at the personal and, in some cases, micro-enterprise levels in most of the target countries, access to finance bottlenecks could be eased by helping financial institutions to develop pro-poor products that enable SMEs and small entrepreneurs to participate more effectively in the economy. Such products include agricultural finance, micro-insurance, micro-health insurance, working capital facilities and, more generally, the development of cash flowbased lending expertise as a means of liberating SMEs from the collateral trap which so often denies them finance;

4. Debt is preferable to equity: Given that financial and capital markets are in their infancy in many of the markets considered, and that entrepreneurs are generally not comfortable with opening their shareholding structures to external ownership, in a first iteration, it is advisable for the Facilities to focus on lending to businesses rather than deploying equity. This significantly reduces exit risk, and will help to mitigate currency risk (somewhat) in that there would at least be regular repayments back to the Facilities which could be transferred back into hard currency at the earliest moment possible. In some cases, as highlighted in the country analyses, there may be scope to consider equity investment, but it is not a sine qua non for any of the target geographies, and in some countries, such as India, it is debt rather than equity the entrepreneurs desperately require;

5. Technical assistance is vital: The strategic use of technical assistance funding will be critical to the success of the Facilities. Investee companies desperately need hands-on engagement from fund managers and technical and sectoral experts in the following key

areas, inter alia: corporate governance, management capacity-building, management information systems implementation, strategic planning, financial controls and accounting, preparation of information and reporting, human resource management, talent retention and incentivisation, marketing and customer-outreach. Technical assistance packages should be conceived ex ante, i.e., as part and parcel of the overall financial intervention in a company in order to ensure that fund managers do not gain a reputation for providing hand-outs. Additionally, recoverable grants and concessional loans should be considered in larger, more advanced investees to ensure that sponsors have skin in the game and do not view technical assistance as free money;

6. Facility sizes should not be the focus: Facilities need not be particularly large (i.e. greater than $100 million) in order to be effective or meaningful. What matters is the establishment of proof of concept, after which several things can transpire: additional investment instruments can be introduced, larger facilities can be raised, a broader range of investorsideally domesticcan be attracted and more sectors can be tackled;

7. Investment size is important: The Facilities must avoid the pitfall of trying to be all things to all people, or in other words, attempting to solve all access to finance and working capital issues in one initiative. For this reason, loans (and especially equity injections) below $500,000 should be avoided, because the risks and intensity of engagement increase vertiginously in such transactions. There is no question that the void between the upper echelons of micro-credit and the floor of the IB Facilities requires attention, but it must be acknowledged that that is beyond their purview;

8. Dissemination of learnings is vital: Linked to the above two points is the vital importance of disseminating learnings, especially across Asia. It is important to engage governments, corporates and the private sector more broadly in order for the concept of inclusive business to take hold market by market;

9. ADB is particularly well placed to convene/facilitate the IB Initiative: In all of the markets surveyed, ADB is perceived as a natural convener of key stakeholders

governments, banks, institutional investors and othersrequired to successfully launch inclusive business initiatives and, critically, to secure buy-in at the national, regional and local levels. This does not necessarily mean that ADB must provide the largest amount of capital in any of the Facilities; rather, that as the regions multilateral development bank, it is naturally positioned to champion the initiative. In addition, it is well placed to mobilise capital from development and donor partners based in strategically-important member countries such as China, Japan and Korea;

10. Partnerships with other multilaterals may be helpful: Some multilateral development institutions, such as the Inter-American Development Bank, the Corporacin Andina de Fomento and the International Finance Corporation, among others, have been promoting inclusive business for some time. Partnership with such institutions, leveraging their experiences and tailoring them to the Asian context may be enormously helpful in avoiding some of the inevitable pitfalls and teething problems;

11. Sub-regional Facilities are preferable: Due diligence revealed that, in contrast to Latin
America and Africa, there are no obvious fund managers focused on Asia that would be able successfully to invest one larger Facility across such a varied geography. In addition, investors would likely consider a continent-wide Facility to be unwieldy, and it would be extremely challenging to structure incentives across such a range of target countries where considerable variations in performance will inevitably emerge; and

12. Building fund manager capacity is vital: In addition to the above point, few fund
managers in the region, with the notable exception of India, have been focused on inclusive business. This provides ADB with the opportunity to achieve an additional development impact beyond that of the funds deployed in helping to build capacity among fund managers in the region so that they are better placed to invest to dual (financial and social) and triple (financial, social and environmental) purpose in future.

In conclusion, this compendium of due diligence reports presents a compelling case for promoting a series of inclusive business facilities in selected Asian countries. The Facilities would be well placed to demonstrate that private sector can be mobilised by ADB and harnessed by

domestic fund managers both to address pressing social challenges, whilst also providing attractive returns to investors. In the longer term, it is realistic to expect that this initiative would stimulate greater flows of private-sector capital into future IB vehicles as the concept becomes mainstreamed in the investor and asset management community.

I.

Cambodia

Political Landscape
Despite the notional presence of political opposition in Cambodia, the dominance of the Cambodian Peoples Party (CPP) effectively renders the country a one-party state and the prime minister, Hun Sen, continues to concentrate power in the executive branch of government unimpeded by any significant checks and balances. Notwithstanding, the global financial crisis and economic slowdown of 2009-2010, which led to factory closures and redundancies, clearly demonstrated that Cambodia is not immune to social tensions and unrest. On the one hand, this has encouraged Hun Sens authoritarian instincts, leading the CPP to propose legislation to further restrict organised labour. On the other hand, there is a growing realisation in government that a thriving, market-driven private sector is critical to maintaining rapid economic growth and, above all, to absorbing some, if not all, of the 300,000 young Cambodians who enter the workforce yearly.

Despite the likelihood that trade unions in the all-important garment sector will remain assertive and threaten strike action, emboldened by the redundancies in 2009-2010, and the fact that confidence in the judicial system will fail to improvethe courts have upheld numerous convictions against opposition figures in recent monthsfrom the perspective of the IB Facility, Cambodia offers a relatively stable, very business-friendly environment for investment. That said, three potential sources of political and social instability should be noted:

1. Commodity prices: Ordinary Cambodians, many of whom live at the base of the pyramid, are extremely vulnerable to commodity price volatility. Increases in the cost of living hit the poor rapidly and very hard, and renewed economic hardship could cause unrest and anti-CPP sentiment.

2. Land appropriations: Land grabs by large agricultural interests and property developers with close connections to senior CPP figures will continue. Many

Cambodians are resentful of involuntary resettlement, with de facto expulsions intermittently driving the poor from their homes and communities.

3. Cross-border tensions with Thailand: The dispute over the sovereignty of religious temples on the border with Thailand will continue. Some dismiss the issue as a political diversion from domestic challenges used by politicians on both sides of the border. Others argue that the dispute is more substantial, and could flare up in a significant way if left unchecked. Currently, there is little evidence that the issue has slowed thriving cross-border trade, both formal and informal, and Cambodias economic relationship with Thailand remains important. However, an escalation of hostilities cannot be ruled out, which would affect the Cambodian-Thai business corridor significantly.

Although it is important to note the key medium-term political and social risks above, it should be emphasized that the business climate and operating environment in Cambodia is extremely conducive to debt and equity investments as envisaged by the IB Facility. Certain sectors, such as rice, are politically sensitive because of their crucial contributions to GDP and social stability, but the government will look favourably upon any investments that strengthen them by boosting employment and exports.

Economic Policy and Performance

The Cambodian economy is extremely vulnerable to exogenous shocks: fluctuations in commodity prices, volatile international oil prices, external demand for its exports and deteriorations in its terms of trade more generally. The global economic crisis of 2009-2010 highlighted this vulnerabilitythe United States accounts for 40% of Cambodian garment exports, for exampleand it is unlikely that GDP growth will return to pre-crisis levels of 10% for some time. According to Economist Intelligence Unit (EIU) data, economic growth rates will hover in the range of 6-6.5% in 2011 and 2012, underpinned by an increase in manufacturing activity and strengthening demand for merchandise exports. Significant foreign direct investment (FDI) from China, Vietnam and several north Asian countries, such as Korea and Japan, will also drive GDP growth, and further increases in garment sales to European countries can be expected, helped by the Everything But Arms agreement which provides duty- and quota-free access to European Union markets for least-developed countries (LDCs). Significant

expansion is also forecast in the agriculture, footwear, tourism and construction sectors. Indeed, according to the World Bank, footwear exports increased by 57% in 2010, creating 18,000 new jobs between December 2009 and February 2011. Similarly, tourism posted a strong recovery in 2010, with a 16% increase in visitor arrivals on the previous year. From a socio-economic and BOP perspective, it will be critical to boost expansion, efficiency and value addition in the agriculture sector and, fortunately, government policy is supportive in this regard.

There are several notable structural weaknesses in the Cambodian economy which impede faster economic expansion and production efficiencies. It is important for the IB Facility to take account of these because there is an opportunity, through its investments in portfolio companies, to contribute to redressing them to some degree:

1. Diversification: The diversification of the production and export base is key. A supportive policy environment is critical in this area, as evidenced by the near trebling of milled rice exports following the governments policy to promote increased paddy rice production and exports. Other sectors require similarly conducive policy regimes to promote diversification and in order for Cambodian producers to capture greater value domestically and move up the value chain.

2. Import reliance: The high import content of exports makes the latter expensive, and augments producers vulnerability to price fluctuations of key factor inputs. Significant investment is required in domestic capacity and production of inputs, especially in the agriculture sector, to reduce import reliance and increase consistency and quality of supply.

3. Dollarisation: The Cambodian economy is highly dollarised, which undermines the effectiveness of monetary policy and leads to systemic asymmetries that disproportionately affect small producers.

4. Limited Revenue Generation: The combination of increased expenditure on defence and upward pressure on wages will keep the budget in deficit for the foreseeable future. This prevents the government from increasing spending on key social sectors.

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On a more positive note, unlike neighbouring Vietnam, inflation has largely been kept in check, and is well below double digits, hovering at 6%. The government appears cognisant of the potential impact of inflationary pressures on the economy from the Vietnamese experience, so it can be expected to maintain its policy of keeping inflation under control.

Operating Environment for the IB Facility

As stated above, despite the pervasive presence of the CPP and the politicisation of many business activities and relationships, especially in larger companies, the business climate in Cambodia is extremely conducive to the IB Facility as currently envisaged. Although the country remains heavily dependent on donor funding, the conversation in the private sector has become much more focused on entrepreneurship in recent years. Young Cambodians with graduate degrees and MBAs from foreign universities are returning to the country and infusing familyowned businesses with market-orientated strategies. As one observer stated, whereas the employer of choice among elite Cambodian graduates used to be the United Nations, there is now a strong preference for banking and finance, and many are starting their own businesses. Additionally, there is a realisation both within government and the private sector, that the country cannot rely on cost and wage arbitrage as a long-term guarantor of export competitiveness in the garment sector. Social instability and industrial action in China, coupled with inflationary pressures in Vietnam, have highlighted the need for Cambodian companies to move up the value chain asor ideally beforewages inevitably rise.

A salient challenge for Cambodian businessesand an area where the IB Facility can play a very active rolewill be their ability to create and capture more value within the country. Domestic value creation and capture are currently hampered by the modalities of available financing in Cambodia. The banking system is awash with liquidity, and not only do banks compete vigorously for opportunities to lend, but formal and informal loans from Chinese and Vietnamese traders are abundant. The problem in many instances is the quality, appropriateness and terms of the financing. In the case of Vietnamese liquidity, the government is directing their state-owned enterprises (SOEs) to lead the charge into Cambodia as a counter-weight to the fear of growing Chinese influence in the region. Private Vietnamese companies tend to follow SOEs thereafterpressured or of their own volitionbut the short-

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term and often expensive nature of the financing they offer impedes longer-term thinking in Cambodian businesses. Chinese lenders and traders are also rapacious, and see no value in building long-term relationships with Cambodian entrepreneurs and SMEs.

Another significant issue in the Cambodian context which, again, underscores a vital role for the IB Facility, is land acquisition and tenure. Land in Cambodia can be held under soft or hard title, the difference literally reflected in a paper (soft) or cardboard (hard) deed, respectively. Whereas few banks and lenders accept the former as collateral, the latter confers permanence of title and is a recognised asset. The government is slowly dealing with this highly-sensitive issue, but the disparity between espoused policy measures and concrete change on the ground will continue for a number of years. Hence the importance of financing mechanisms which consider cash flow-based lending and quasi-equity or equity as opposed to just collateral-based financing. The latter represents a de facto poverty penalty, because it is generally the poor who cannot afford to convert from soft to hard title if the opportunity arises, and assuming that they understand the arguments for and means of conversion. As mentioned earlier, forced expulsions and involuntary resettlement are also rife, particularly when land is required for commercial or industrial uses.

Debt and Equity Transactions in Cambodia: Prospects for the IB Facility

Despite excess liquidity in the banking sector, a vibrant semi-formal and informal financing community and the pervasive presence of Vietnamese and Chinese lenders, there is a very strong case for establishing an investment fund which provides debt and equity financing (where possible) to private businesses in Cambodia, for four main reasons:

1. Businesses require long-term partnership: Although Cambodian businesses are often under-geared, their reliance on debt and the lack of familiarity with equity perpetuates short-term thinking and poor strategic decision-making. Additionally, as competition intensifies within and beyond the region, the need for business development services (BDS), technology, know how, management information systems (MIS) and professional management is becoming ever clearer. Most banks and semi-formal lenders have neither the capacity nor the expertise to provide this value addition and mentorship to

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Cambodian businesses, which is central to the IB Facilitys relationship with its portfolio companies.

2. A growing recognition of the importance of value creation: Traditionally, Cambodian business-owners have focused on short-term cash generation and intermittent dividend issues to extract cash from their companies. In the case of family-owned businesses, beyond personal consumption, cash generation generally is directed towards repaying bank loans, which are perpetually rolled over. However, the economic downturn of 2009-2010 and the pre-crisis construction boom and subsequent bust have begun to shift this mind-set. During the construction boom of the mid-2000s, many businessmen and entrepreneurs were acquiring and flipping land primarily in the greater Phnom Penh area. Siem Reap, the gateway to the temples of Angkor Wat, was also vastly overbuilt, fuelled by heavy north Asian investment in hotel and other construction projects. Cambodian entrepreneurs have learned from the subsequent downturn that speculation is no substitute for generating long-term value in their core businesses.

3. The emergence of an equity culture: The forthcoming establishment of the Cambodian Stock Exchange (CSE) has gripped the business community. Whilst the CSE will likely remain nascent for many years, with few listings and limited trading volumes after its founding, curiously, it has provoked vibrant discussion of the benefits of listing and the modalities of external ownership. Following the bubble and fallout on the neighbouring stock exchanges in Hanoi and Ho Chi Minh City (HCMC), Cambodian entrepreneurs are beginning to consider the concept of underlying value in their businesses more carefully and, even if only in incipient and theoretical terms, the improvements that might be required if they were to list. The governments recent announcement that companies will be required to publish audited financial statements when they reach a certain size is also encouraging formalisation and professionalisation.

4. Collateral constraints: The Cambodian financing culture is predicated on collateral although, of course, in the subsistence, small-holder and SME sectors, informal and semi-formal financiers provide un- or semi-collateralised loans often at punitive monthly interest rates. Assuming that the government maintains its policy of diversification and

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export development, especially in the agriculture sector, Cambodian businesses will require appropriately-priced, medium- and long-term financing which provides them access to more than just money. Slowly, the absence of recognised collateral, counterbalanced by the need to invest and build critical mass to take advantage of export opportunities is forcing Cambodian business open.

Cambodia: Target Investment Sectors for the IB Facility

The Cambodian economy is not particularly diverse. It is heavily dependent on agriculture mostly subsistence and small-holdertourism and garment exports. Other than tourism, which is centred around Angkor Wat in Siem Reap, there is little depth to Cambodias economic base which, in turn, hampers commercial and export relationships because of inconsistency of supply and questions over quality and reliability. Although this is very gradually beginning to change as competition intensifies among Mekong countries, Cambodian businesses desperately require outside expertise and capital to professionalise and compete more effectively. From the perspective of the IB Facility, despite these challenges and the need to be cognisant of just how challenging the operating environment in Cambodia can be, due diligence confirmed encouraging prospects for investment in the following sectors and sub-sectors:

1. Agriculture Cambodian agriculture and aquaculture is diverse and a broad range of crops and raw materials are produced, including rice, cassava, pepper, cardamom, cashews, other nuts and spices, rubber, sugar and seafood, among many others. Because fertilizers, pesticides and herbicidesif and when availableare generally made from natural products, it is very easy to acquire organic status in Cambodia because most production is effectively organic to begin with. The main constraints to increasing crop yields and quality include: i. Lack of access to and/or inappropriate usage of key inputs, such as seeds, fertilizer and pesticides;

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ii. Absence of technology, know-how and in many cases, modern farming techniques; iii. Access to irrigation systems, especially secondary and tertiary channels, is largely random. As a result, most farmers only grow one crop per season and are dependent on favourable rainfall patterns; iv. Quality assurance and traceability mechanisms are generally nonexistent; v. Relationships with aggregators and processors are random, and there is little loyalty to purchasers among farmers. Crops are generally sold to the purchaser offering the highest price, whether an aggregator who purchased from a farmer the previous year, or an unexpected Chinese or Vietnamese trader. Consistency and quality of supply reaching domestic processors suffer as a result; and vi. Limited social organisation and co-operation among farmers, which compounds information asymmetries and un-level playing fields when it comes to pricing. Infrastructure constraints in Cambodia are also significant. There is no cold chain, storage facilities are poor, road and rail infrastructure are poor and no Cambodian port can handle ships carrying more than 20,000 tonnes of product. Although primary production in Cambodia is probably too rudimentary to be suitable for direct investment by the IB Facility and is politically sensitive for land-related reasons discussed above, any investment in agro-processing (see 2. below) will necessarily be confronted with these issues. Importantly, and in line with the IB Facilitys core objectives, supply chains will have to be strengthened in order for investment objectives in any aspect of Cambodian agriculture to be realised.

2. Agro-processing The long-term prospects for agro-processing in Cambodia are extremely bright, particularly in the rice sector (see below). The challenge is one of

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achieving scale: few processors have significant production capacity due to the absence of hardware and modern machinery, which means that investment is urgently required. The influence of Vietnamese investment and procurement is also significant, and generally value-destructive. In order to avoid domestic taxes and address supply shortages in Vietnam, traders simply buy up Cambodian crops and raw materials and smuggle them across the border for processing. At a formal level, Vietnamese enterprises pledged $1.3bn of investment in Cambodian agriculture in 2010it is difficult to know how much of this actually materialisedbut their true interest lies in input acquisition in Cambodia for processing and value addition in Vietnam. The Cambodian government and private sector will welcome any investment initiatives that help to counter this dynamic. Rice is the cornerstone of the agriculture sector, and the government has set an ambitious target of increasing rice exports to 1m tonnes by 2015. Given just 60,000 tonnes of rice were exported in 2010, the 1m tonne target is probably unrealistic. However, boosting rice output, improving processing and quality in order to compete within and beyond the region will remain high on the agenda. According to one source, there is US$700 million of investment pent up in the rice sector. Although some mills are state of the art and could do the colour grading and polishing demanded by international markets, poor paddy quality and supply impedes mill calibration for particular varieties. Massive investment is therefore needed in various areas: mills require better inputs, storage facilities, modernised production processes and, above all, they need help to adopt more entrepreneurial approaches to milling. This, in turn, opens the door for investment partners like the IB Facility, willing to support the professionalisation of their operations. As with other crops, consistency and quality of paddy supply to mills is problematic, because mills cannot compete with the price arbitrage of Vietnamese and Chinese traders. There is an opportunity, therefore, to invest in rice mills with a view to strengthening the supply chain not just

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through price-competitiveness, but mutual reliability: millers need to know that they can count on supply, and farmers need assistance in organising in order to bargain effectively, with loyalty clearly reflected in the prices they command. The BOP impact of engagement in the rice sector through portfolio companies could be significant, especially supporting cooperatisation among producers and millers. The IB Facility may find agro-processing opportunities in other sub-sectors such as cassava and sugar cane. Cassava has been booming recently, but there is little domestic processing capacity and cassava chips are generally exported to Vietnam.

3. Agricultural Inputs and Infrastructure Cambodian agriculture is desperately in need of good quality agricultural inputs, ideally produced domestically. Soil, fertilizer, pesticides, tools, tractors and the like are all in short supply and expensive to import. Chinese, Singaporean, Vietnamese and European investors in Cambodian agriculture have all spotted this opportunity and are investing aggressively. There will be opportunities for the IB Facility to invest in manufacturing, wholesale and distribution of agricultural inputs, whilst the Technical Assistance (TA) Facility can play a critical role in outreach, education of farmers and extension services. Access to water and irrigation schemes may also produce investment opportunities for the IB Facility. The government is responsible for primary and secondary channels, but tertiary channels can be provided by the private sector. Currently, irrigation schemes are haphazard and need upgrading and extension to vast areas without facilities. Distribution and logistics, with respect to both factor inputs and raw or semi-finished product, are desperately lacking. The absence of a cold chain compounds the problem, creating opportunities to invest in simply getting inputs to farmers and getting goods to market and export facilities.

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4. Financial Institutions and Access to Finance As discussed above, Cambodian entrepreneurs and SMEs, including some medium-sized enterprises of substance, struggle to access appropriate financing, either due to collateral constraints or because they are used to seeking the cheapest debt available. Vast segments of Cambodian society and, crucially, of the productive economy, remain under-banked or un-banked in this cash-dependent economy. Many communities have no formal banks or financial institutions at all. Although there is no shortage of microfinance institutions (MFIs) in Cambodia, the sector is unregulated and dominated by non-governmental organisations (NGOs). As regulation and transition to deposit-taking institutions inevitably take hold, there should be opportunities for the IB Facility to invest in MFIs and other financial institutions looking to provide access to finance to BOP populations in numerous ways: i. Agricultural finance, including factoring, reverse factoring,

commodity-based finance, warehouse finance; ii. Disaster and catastrophe insurance for small-holder farmers; iii. Micro-insurance, micro-health insurance and vulnerability schemes; iv. Mobile banking. Over-indebtedness has become a big issue in Cambodia, exacerbated by excess liquidity, lack of regulation, the governments openness to the establishment of any new financial institutions and an entrenched mentality among borrowers of perpetual refinancing. There is an opportunity, therefore, to help mould responsibly-managed financial institutions that are able significantly to undercut interest rates of 2-3% per month offered by traders and informal financiers and some MFIs by offering products tailored to borrowers at the BOP that take into account the challenges around land ownership and collateral.

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5. Clean Energy Bio-energy and renewable energy projects have begun to spring up in Cambodia. There are opportunities for gasification, or the use of rice husks, cassava husks or sugar cane by-products for conversion to energy, thereby reducing reliance on fossil fuels. Significant investment will be required in commercial approaches to wasteto-energy initiatives. Moreover, given that Cambodia lacks a national electricity grid, there is room for private sector energy generation. Agricultural waste conversion can therefore be used to power processing and milling plants and also be sold to local communities. Bio-gas production for domestic consumption and animal dung conversion for household energy are two other opportunities for the IB Facility to support. Technology and know-how are lacking, along with investment in capital goods needed for conversion.

6. Garments Although the garment sector is a critical contributor to the economy, and certainly involves the BOP from a production perspective, it would probably be best avoided by the IB Facility. Following large job losses 2009 and early 2010, the sector has begun to recover, but it is subject to aggressive and often unscrupulous investment from Taiwan, China and Hong Kong. Of the estimated 300 garment factories in Cambodia, only 15 are locally owned. Many foreign investors establish highly-mobile, under-invested operations in Cambodia to take advantage of cheap wages (wages are significantly lower than in Vietnam). The result is that many factories are literally little more than tin sheds that can be closed within days if necessary. Unless the IB Facility encounters local garment manufacturers with a longterm vision of establishing lasting relationships with foreign buyers predicated on a gradual move up the value chain, this sector is best avoided.

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7. Tourism As with the garment industry, the IB Facility will have to take a cautious approach to tourism investments. In recent years, Taiwanese, Korean and Chinese investment has been plentiful and unscrupulous, and overconstruction, particularly in Siem Reap, has caused a market glut. Land acquisition is complex, often with brutal consequences for the poor, so selection of partners would have to be carefully managed. Opportunities could nevertheless emerge in support services to tourism, such as catering, laundry, logistics and transportation. As visitor numbers increase, drawn initially by the Angkor Wat temples, but increasingly aware of stunning beaches and varied flora and fauna, eco-tourism is developing. Again, tourism is generally not a sector that lends itself to closed-ended investment funds because holding periods to realise value are often incompatible.

Cambodia: Proposed Fund Design

Based on due diligence, there is scope to deploy up to $15m in private Cambodian businesses, primarily in agro-processing, agricultural inputs and logistics, clean energy, distribution and logistics more generally and, possibly carefully-selected light manufacturing and tourism deals. The key features of the proposed Fund design for Cambodia are presented below:

Fund allocation to Cambodia: Due diligence suggests that it would be challenging to deploy more than $15m in Cambodia over a five-year investment period, and that a realistic figure lies somewhere in the range of $10m-$15m. The average transaction size is likely to be $2m, although if the IB Facility is able to gain exposure to rice milling opportunities, it should be possible to deploy $4m-$5m in one or possibly two transactions. It should be remembered that it may be possible to gain exposure in Cambodia indirectly, through Thai companies that are expanding or acquiring operations there, primarily in agriculture.

Transaction Profiles: As emphasized above, Cambodia is a cash-based economy. Individuals and entrepreneurs are familiar with debt from both formal and informal sources. They have little or no understanding of equity. The notion of opening up the ownership structure of a

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business to external participation is alien, and in many transactions, the financials will be neither comprehensive nor accurate enough to get a clear enough picture of the business on which to base a valuation. For this reason, most transactions in Cambodia will be time consuming and will likely involve debt, although, very slowly, quasi-equity and equity are gaining the attention of local businessmen seeking foreign partners. Cambodian deals will be growth plays, with financing largely used for working capital to boost output and achieve efficiencies. There is no management buy-out (MBO) culture in Cambodia, and rescues, restructurings and start-ups should be studiously avoided. They are far too risky. On a positive note, the government is very pro-business and hands-off when it comes to the modalities of foreign investment. Convertible loans, preference shares, preferred shares and redemption clauses are all permissible in Cambodia, not that they will be used very often. Other more complex equity structures will probably be similarly received when introduced. The key risk factor, however, is that no such deals have ever ended up in the courts, so enforceability in case of dispute remains an open question.

Risk Mitigation and Currency Issues: Cambodia is a highly dollarised economy and to a large extent, the US dollar remains the currency of choice for trade and investment. Denominating the IB Facility in US dollars makes sense in the Cambodian context, and indeed, the Cambodian riel is expected to appreciate marginally against the dollar in 2011. Where risk mitigation strategies are concerned, unfortunately it will not be possible to derisk investments through complex transaction structuring and strategic use of investment instruments. Cambodian sponsors will be intimidated by unfamiliar structures. A critical factor in Cambodian transactions will be for the IB Facility to work with competent local investment partners who are sufficiently connected to cross-reference prospective portfolio companies management teams. Undertaking know your client (KYC) checks is challenging because political connectedness abounds and larger businesses generally require strong links with the CPP in order to operate and grow. Two additional risks will need to be addressed in all Cambodian transactions. First, many will be family-owned businesses. Corporate governance arrangements are weak or non-existent, management is rudimentary, strategic planning is not systematic and often financials simply will not exist or will certainly fall far short of international standards. Faced with these risks, the opportunity for the IB Facility manager will be to persuade sponsors of the value of

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formalisation and transparency. If it is argued that this is a likely conduit to strong relationships with foreign partners and, possibly, an eventual listing, forward-looking Cambodian entrepreneurs have reached a point where such a message will resonate. The second risk is on the fiscal side. The relationship between most businesses and the tax authorities consists of creating a plausible scenario for turnover during the relevant period (generally vastly understated), and paying the tax representative the amount required to handle the situation. Most businessmen avoid making truthful declarations because, as they see it, it translates into a significant cost disadvantage vis--vis their competitors. Again, the IB Facility will have to persuade investee companies that the benefits of partnership and faster growth, and hence higher turnover, far outweigh the perceived short-term disadvantage of greater tax liabilities.

Exits: As discussed above, the advent of the CSE, soon to be launched, has changed the conversation significantly in Cambodia, and forward-looking businessmen are slowly focusing on building and realising long-term value in their businesses. That said, it is unrealistic to expect that trading volumes and the number of listings will be sufficient to provide a viable exit avenue for Fund portfolio companies. In other words, the IB Facility should avoid transactions where the exit thesis is predicated on listing, although of course, should the opportunity arise it will be a welcome boon. Most exits will take the form of strategic sales to regional or foreign buyers and company buy-backs, or redemptions. The fact that production and export from Cambodia, due to its LDC status, confers duty-free entry to many export markets increases the attractiveness of Cambodian acquisitions to foreign purchasersall the more so if, as a result of the IB Facilitys investment, the companies are well-run and have implemented proper corporate governance arrangements.

Fund Managers: Presently, there are only two independent fund managers in Cambodia: Emerging Markets Investments (EMI) and Leopard Capital. By their own admission, the two founding partners of EMI are new to private equity although they do have strong backgrounds in investment banking and corporate finance. EMI benefits from its strategic partnership with Aureos Capital, which has a seat on the investment committee and provides input on deal structuring. However, Aureos Capital does not have sufficient time or resources to take a very active role in the EMI portfolio. Leopard Capital was unavailable to

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meet during the due diligence exercise. Anecdotal feedback suggests that Leopard is not especially methodical in its transaction execution and, although more experienced than EMI, it is, on balance, the weaker of the two. See Section IV below for further discussion of fund management options.

BOP Impact: As one of the poorest countries in the world, it is difficult to see how the IB Facility will not have a significant impact on Cambodians living at the base of the pyramid. Any labourers employed by Fund portfolio companies will likely be earning $2-$3 dollars per day, if that, and farmers involved in the supply chain of agricultural processors and aggregators generally live at or below the poverty line. The main areas of BOP impact that the IB Facility could achieve in Cambodia include: Employment generation: Increasing job opportunities through portfolio company growth; Supply-chain strengthening: Building mutually-reinforcing relationships between farmers and processors is key to addressing the quality and consistency issues that hamper certainty and reduced volatility for the former, and the ability to boost output and secure more favourable trading relationships for the latter; Reduced income volatility: Smoothing income flows for poor farmers by helping them to form co-operatives and associations (where appropriate and possible) and strengthening their relationships with aggregators and processors; Reduced vulnerability: If the IB Facility can identify a well-placed, creative partner financial institution to invest in, it could build pro-poor financial products that may have an enormous impact on rural farmers and the rural poor; Access to finance: Far from any formal institutions, rural agriculturalists struggle to access appropriate financing that takes into account collateral constraints (land ownership), seasonality issues, limited access to inputs (or poor quality/inappropriate inputs when possible); Value-addition and value-capture: Particularly in the rice sector, but in fact in most transactions, the IB Facility can help Cambodian producers to move up the value chain and capture and retain more value in Cambodia;

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Business formalisation and professionalisation: Management capacity and corporate governance in Cambodian companies is rudimentary at best. The IB Facility can make a significant contribution, particularly through strategic deployment of TA Facility resources, by providing training and mentorship in this area. By leaving behind a cadre of well-run, well-managed businesses, the IB Facility can have a meaningful demonstration effect on non-portfolio companies. _____________________________________

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II.

Vietnam

Political Landscape
Although tensions and in-fighting have increased in recent months within the Communist Party of Vietnam (CPV), fuelled by the urgency of taming inflation and halting currency depreciation and contrasting approaches for doing so, spats between conservative hard-liners and more reformist elements will not undermine the partys grip on power. The government is more determined than ever to keep political opposition in check, so despite the increasing market orientation of the economy, the development of genuine democratic opposition will not be tolerated. The economic hardship in urban and rural Vietnam in the wake of the global economic slowdown and financial crisis of 2009-2010 has made the government nervous of social tensions and the possibility of uprisings or intermittent instability. In that context, the diplomatic row with China over the sovereignty of the Spratly and Paracel islands in the South China Sea has provided a useful pressure valve, and the government, unusually, has allowed anti-Chinese demonstrations to take place in Hanoi and HCMC. In the longer term, however, social unrest may re-ignite unless the government is able to tackle inflation and reverse escalating prices for staple foods. Resentment against the government is also caused by haphazard and forced land acquisition for factories and large infrastructure projects. Compensation is either woefully inadequate or simply not offered, and the rural, urban and periurban poor affected are left with few means to rebuild their livelihoods.

Such is the CPVs grip on power that the operating environment will likely remain relatively stable throughout the life of the IB Facility, though the modalities of achieving stability may be heavy-handed. The government has watched the industrial unrest and social upheavals in neighbouring China with trepidation. It will use all means to avoid similar confrontations in Vietnam, and from a strategic perspective, will seek to present Vietnam to investors and major export markets as a contrasting oasis of stability. Again, in order to achieve this, inflation must be brought well below double-digits as quickly as possible. Currency depreciation and the pressures of increasing dollarisation will also need to be dealt with effectively.

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Economic Policy and Performance

In this somewhat fragile political context, there is a question mark over policymakers willingness to implement the hard-hitting austerity measures required to stabilise the economy. The corporate sector has certainly felt the full force of tightened monetary policy and interest rate hikes, and the evidence suggests that it has been sufficient to quell the speculative activityboth corporate and personalwhich led to the boom and bust cycle of 2006-2009. Yet high oil prices have left the government little choice but to increase subsidised retail prices for fuel and electricity which, naturally, affect the poor most severely. A fundamental impediment to more effective policy making is the governments fixation on a perceived binary relationship between either achieving high growth rates or addressing fundamental structural and systemic imbalances in the economy. Party dogma that double-digit growth must be achieved at all costs and is critical to poverty alleviationnot, in itself, untruemeans that price and currency stability are foregone or not confronted vigorously enough. For example, domestic credit creation has slowed somewhat since the economic downturn, but the government has only reduced its target from 23% in 2010 to 20% in 2011, not nearly tight enough to quell inflationary pressures. Further inflationary pressures will be produced by consistent budget deficits in the region of 5% of GDP over the next three-to-five years, and although the return to near-double digit growth rates will boost government revenue, high oil prices and expenditure on social welfare programmes and infrastructure projects will keep the budget firmly in the red.

In the context of the IB Facilitys focus on people living at the base of the pyramid, it is important to disaggregate Vietnamese inflation figures. They can be misleading. Ironically, high inflation has actually benefited rural farmers because their products are commanding much higher prices. The population segment that is being most affected by inflation are rural migrants who generally are forced to accept the lowest-paid factory jobs in peri-urban areas. With 41% of the Vietnamese inflation basket comprised of food, the proportion of this demographics expenditure on food once in conurbations is probably somewhere in the range of 40%-60%. In contrast, the rural poor and less-vulnerable urban poor, even with marginally higher incomes, are significantly less affected by high food prices.

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To a worrying extent, given the export-dependence of the Vietnamese economy and, further, the reliance on strong demand from two particular trading partnersChina and the United Statesthe medium and long-term GDP growth prospects are beyond the countrys control. Diplomatic sparring with China certainly does not help matters, although to date this has not significantly affected commercial and investment corridors. The salient question is whether there is a significant slowdown in the Chinese and American economies, which would rapidly reduce demand for Vietnamese exports. For this reason, it will be important for the IB Facilitys investment portfolio in Vietnam to be carefully balanced between domestic and external sources of demand.

Operating Environment for the IB Facility

Business sentiment in Vietnam is at an all-time low. The real estate market has fallen considerably and is expected to continue to do so, forcing some real estate players to issue bonds with ludicrous coupons to raise capital, in some cases 20% or higher. The speculative activity which caused the Ho Chi Minh Stock Exchange Index to sky-rocket from 250 to 600 in 2008 has ended, and the Index now hovers in the low 400s. It probably has further to fall. Worryingly, during the boom, both corporate and individual speculators were borrowing money from banks and interest rates of 10%-12% with a view to making 40%-60% returns in short periods on the stock exchange. Although the boom and bust cycle has been painful, four particular aspects of the fallout are critical and, ironically, positive from the IB Facilitys perspective:

1. An unprecedented focus on company value: Many businesses have collapsed and continue to do so in the wake of the crisis. For the first time, the government has allowed them to failincluding, importantly, bloated SOEs. This unprecedented willingness to tolerate bankruptcies has taught businessmen an essential lesson in the difference between underlying company value and short-term profit, a lesson not limited to public companies.

2. Recalibration of valuations: Historically, penetrating Vietnamese businesses has been challenging for external shareholders not just because of lack of transparency, but due to owners unrealistic valuation expectations fuelled by the boom years.

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The challenges of borrowing where once liquidity abounded have forced owners to reconsider valuations and restructure in order to attract much-needed capital.

3. Greater openness to equity: Vietnamese businesses have traditionally used debt to fund growth. Equity is not as unfamiliar as in Cambodia and Laos, but Vietnamese businesses owners are generally much more comfortable with debt. The fallout on the stock-exchange, combined with interest rate hikes and more stringent lending conditions, is forcing companies to consider equity participation where previously it would have been shunned. The IB Facility will therefore be well placed to invest in businesses using equity, quasi-equity and debt, which will provide a welcome counter-balance to debt-based transactions in Cambodia and, possibly, Laos.

4. The structure of post-crisis indebtedness is important: It is noteworthy that indebtedness levels are much higher in the corporate sector than in the personal sector. Speculative activity in the latter was, by and large, confined to business people in HCMC and Hanoi who had significant disposable income to bet on stocks. It will take a long time for banks to regain confidence in the financial viability of all but their largest clients. This, again, will help the IB Facility to access transactions which would have been almost impossible pre-crisis.

Another feature of the current business climate in Vietnam is also significant. The government is emphasising the importance of industrialisation both for job creation and to reduce the importcontent of exports, which remains stubbornly high (see below). Given the structure of the Vietnamese economy, successful industrialisation will necessarily require the inclusion of the SME and sector and non-SOE sector more generally into the supply chains of larger companies and public-sector projects. As the government has set about achieving this, the degree of weakness of commercial and infrastructural linkages between larger businesses and the SME sector, mirroring similarly fragile linkages between the two largest conurbations, HCMC and Hanoi, and rural areas, has been thrown into relief. As a result, there is a growing realisation in government and the private sector that supply chains, value chains and the interface between the SME sector and larger businesses, let alone export markets, needs urgent attention and strengthening. This dynamic is beneficial for the IB Facility because portfolio companies will be

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much more minded than before to invest time and resources into establishing robust supply chains and business relationships to improve consistency and quality of product.

Transactions in Vietnam: Prospects for the IB Facility

The extent to which the economic downturn of 2009-2010 has shaken Vietnams financial community, altered the financing landscape and affected the business mind-set cannot be overstated. Access to cheap debt, unbridled issuing of corporate bonds and their subsequent treatment as assets rather than liabilities all helped to fuel the unsustainable boom of the mid2000s. Unsurprisingly, along with sharp increases in interest rates, commercial banks have tightened lending policies, collateral requirements have become far more stringent and access to capital for the private sector is challenging for all but the strongest companies. It is important to distinguish between this dynamic and the SOE sector. Although the government has tolerated some SOE failures, there is no question that politically-directed lending to SOEs perceived to be strategic, regardless of their health, continues.

The salient point from the IB Facilitys perspective is that acute credit constriction and the inability to raise funds from speculative investors on the capital markets is forcing the creation of an equity culture in Vietnam. De-listings from the bloated stock exchanges are common, as companies seek to sell stakes at private equity-level valuations. The whole concept of company value is subject to re-evaluation, and in addition to being compelled to open their ownership structures to external partners, business owners have less power to resist the critical managerial and operational changes that the former introduce to increase transparency and drive efficiencies.

Unsurprisingly, it has become more difficult than ever for SMEs to access financing from formal financial institutions in the post-crisis environment, let alone larger companies.1

For the purposes of this report, the term SME is used for convenience. The reference is really to the medium-sized enterprises or lower mid-caps that the IB Facility will be targeting, or enterprise able to absorb $1m-$10m of debt, quasi-equity or equity.

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Collateral constraints: The smaller the company, the greater the struggle to provide acceptable collateral. Proof of land ownership can be especially challenging for small-holder farmers.

Poor accounting practices: Accounts are generally managed and presented so as to minimise tax liabilities. Sales are heavily discounted and costs are bloated to show little or no profit. It is difficult to gain an accurate financial picture of a business.

Non-banked cash flows: Many SMEs route cash flows outside of official bank accounts. Generally, a companys principal bank account is used to receive payments from customers, but not to deposit revenues or pay suppliers and staff. As a result, banks are even more reluctant to consider cash-flow based lending.

Lack of information: The pervasiveness of the debt culture means that SMEs are often unfamiliar with financial products and which might be appropriate for them.

Again, regardless of size, cash constraints are obliging companies to seek out financing partners for the longer term, requiring, in turn, greater openness and a willingness to professionalise.

Vietnam: Target Sectors for the IB Facility

Although the Vietnamese economy is largely export-driven, it is relatively diverse, and the near 90 million-strong population translates into robust and strengthening domestic consumption. As highlighted above, the salient challenge to achieve more consistent, rapid economic growth and, crucially, more balanced growthwill be to further unlock both the productive and consumption forces of the domestic economy. In many parts of the country, physical infrastructure still impedes access to inputs, markets, appropriate financing and information. These shortcomings need to be addressed in order for productive sectors as a whole to move up the value chain. Additionally, there is much reputation building to be done by Vietnamese companies domestically and internationally. Made in Vietnam is not synonymous with quality as a brand. Domestically, this often leads consumers to choose more expensive imports over Vietnamese product if they can afford to. Internationally, some producers and importers are wary of significant exposure to Vietnam because of poor reliability. That said, the backlash against certain Chinese goods, such as toys and dairy products, within and beyond China has been carefully watched by Vietnamese industry, and there is an awareness of the opportunity to

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exploit increasing disenchantment with Chinese producers and business relationships in some sectors. As the outline of target sectors demonstrates below, many of the investment opportunities for the IB Facility will be found in agriculture and light manufacturing, but there may be some interesting and very BOP-relevant opportunities in services, including healthcare and education:

1. Agriculture The base of agricultural products in Vietnam is much more diverse than in Cambodia, with crops and raw materials ranging from coffee, tea, cardamom, pepper, acacia, cassava, fresh fruits and vegetables, to fisheries, horticulture and floriculture. Indeed, as the worlds second-largest coffee producer, Vietnam is on the map as an agricultural player in a way that Cambodia is not. Nevertheless, significant challenges need to be overcome for the agriculture sector to achieve more rapid and consistent growth and, crucially, for smallholder farmers to capture more of value and income from their output. Given the likelihood of several Fund investments in agro-processing, working through portfolio companies will provide opportunities to address some key challenges to the sector, of which the following should be highlighted: i. Weak processing capacity: Resulting in many raw materials and unfinished products being shipped to Thailand for processing; ii. Value chain dislocations: Due to poor logistics, transportation and distribution networks. For example, avocados sell for $0.20/kilo at harvest points, but $2/kilo in Hanoi and HCMC, and often arrive spoiled; iii. Weak supply chains: Medium-sized producers and aggregators are realising the need to foster more consistent supply chains by building lasting relationships with individual farmers and co-operatives. Consistency and quality of supply are enormous challenges in Vietnam; iv. Contract enforceability: In order to achieve iii above, processors and aggregators must rely on relationships rather than contract enforcement. Farmers often have little or no understanding of contracts and they are certainly not enforceable through the courts. The only way of preventing farmers from selling to the highest bidder, regardless of

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signed contracts, is for purchasers to build trust, price competitively and offer security and reliability through repeat business; v. Poor co-operation among farmers: Top-down collectivisation and cooperatisation have generally been unsuccessful in Vietnam. This leaves individual small-holders more susceptible to predatory purchasers and lenders. If, however, bottom-up organisation is encouraged through Fund portfolio companies with a view to establishing equitable, lasting relationships, the chances of success could improve; vi. Rudimentary growing techniques: Most Vietnamese agriculture is unmechanised, seed quality is often poor, and hardware and machinery is lacking. Again, to strengthen supply chains, processors need to offer technology and know-how as part of their engagement with farmers; vii. Erratic land distribution: Land is distributed to farmers by the government, but is often random and, when deemed necessary for industrial plants or infrastructure projects, simply appropriated. Because land is the only asset most farmers holdand even that is tenuouspurchasing relationships are random, production is

inconsistent, crop timing is variable and pricing fluctuates considerably.

2. Agro-processing Not surprisingly, the demographics of Vietnam have fuelled demand for processed fruits, vegetables and, above all, fish sauces. Fish and agroprocessors have realised that in order to compete with imported products, which often sell for ten times more than domestic equivalents, they must improve quality, presentation and packaging. This, in turn, means addressing many of the challenges listed under 1. above. In order to move up the value chain, increase market share and develop export markets, agro-processors also need to invest in compliance and traceability systems, certifications and production best practices. Marketing, branding and packaging also need improvement. Opportunities to provide high-end niche and organic products have not gone unnoticed by

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Vietnamese producers, but they require know-how and, in some cases, technology. From a transaction and exit perspective, consolidation in agro-processing is slowly taking hold. Because of supply chain constraints, larger players are looking to purchase smaller players to increase market share. This is a significant proxy indicator for pent up demand for processed goods, suggesting enormous growth potential for the sector. Downstream from agro-processing, there will be opportunities for the IB Facility in fast moving consumer goods (FMCG) in two particular areas: repackaging and distribution for export and for the domestic market.

3. Agricultural inputs As in Cambodia, Vietnamese agriculture is hampered by poor quality inputs, including seeds, fertilizer, pesticides, tools and hardware. In some ways, the impact in Vietnam is more serious because farmers are often tricked by intermediaries into purchasing fake, adulterated or noxious products. Traditional herbal medicines for animals and pesticides for plants that are safe to use are in desperately short supply. The demand for quality factor inputs is vast, and there are opportunities for several players to aggressively grow companies who build reputations on high-quality, reliable and, above all, safe products. Again, this will require portfolio company engagement with farmers to establish relationships, and provide training on usage and best practices.

4. Fisheries There is significant potential for fisheries and fish-processing in Vietnam. Once again, however, consistency of supply and quality control are significant obstacles for local producers. Shrimp aggregators and processors tend to own their own farms, but output is rarely sufficient so they are forced to purchase from individual farmers and households.

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With burgeoning demand for seafood, fish products and sauces, there is an opportunity to work through investee companies to develop new models of aggregation and contract farming.

Moreover, the fact that two fish processors have gained pre-approval status from the US Food and Drug Administration (FDA), meaning that inspection is not required when product arrives in the United States, has highlighted to the sector the relationship between investment in technology and best practices, and the development of export markets.

5. Healthcare The Vietnamese are enormous consumers of healthcare and

pharmaceuticals, both in rural and urban areasindeed, Vietnam is the second-highest self-medicating country in the world. One of the main problems with the geography of healthcare in Vietnam is that the best care is concentrated in urban centres, particularly Hanoi and HCMC. There is burgeoning demand for better healthcare at lower socio-economic echelons and, of course, at the base of the pyramid. However, those reliant on free public healthcarethe vast majority of the populationhave little choice but to wait for attention, sometimes for day. The quality of the care they receive is highly variable. Recent analysis of the Vietnamese healthcare sector suggests that those in the upper segments of the BOP are willing and able to apportion some of their disposable income to quality healthcare. The three areas for which there is particularly strong demand include: i. Oncology consultancy and cancer treatment; ii. Maternal healthcare; and iii. Paediatric healthcare. Because the public healthcare system is strained, and medical professionals are not well paid, many doctors see patients privately as a way of increasing their incomes. Thriving groups of medical professionals have sprung up in urban areas that are fully private. There is, however, vast under-served, or entirely unattended, demand in the rural areas. Due diligence suggests that

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the IB Facility will be well-placed to help doctors and private clinics to formalise and develop hub-and-spoke structures through which to serve marginalised communities and the rural poor. Further, such investments would probably require $5m-$10m, providing a counterweight to smaller investments in the Vietnamese portfolio. The privatisation of primary healthcare as a strategy for alleviating pressure on public resources has become topical. In addition to hub-and-spoke approaches mentioned above, investment will be required in clinics serving mostly lower-income groups in secondary and tertiary towns and cities. As the healthcare conversation in Vietnam has started to focus on affordability, new models for financing and delivery of care have sprung up. Some financial institutions are realising that the market for pooled healthcare products and risk-adjusted models for coverage provision to lower-income groups could be a huge growth area. Tele-medicine and remote diagnostics models are also emerging. The IB Facility could well find opportunities to invest in financial institutions, most likely MFIs, that are specifically targeting access for the poor as their growth strategy. Professionalisation of hospital management and clinic administration, particularly childrens hospitals, may generate additional deal flow.

6. Education Demand for better quality education is burgeoning in Vietnam, and not just among middle and upper classes, nor only in urban centres. Particularly in the language school segment, there are many cowboy institutions offering appalling quality instruction, but the problem extends to primary and secondary education and professional education. The standard of instruction is especially poor in the social sciences, entrepreneurship and business education, with a dearth of well-trained graduates coming through the ranks. There are good prospects for the IB Facility to invest in education franchises and school chains at various levelsprimary, secondary, professionalin

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rural and urban areas alike. A hub-and-spoke approach may also prove effective in extending reach to rural areas and lower-income groups.

7. Sanitation The government is very focused on the urgent need to improve sanitation and waste-water management at the peri-urban and rural levels. Importantly, space is being created for the private sector to participate through outsourcing. Public-private partnerships (PPPs) would be complicated for the IB Facility, because the government tends to retain control of what it considers the most strategic or lucrative parts of operations, but once full outsourcing begins, there could be opportunities to invest up to $10m in this sector. State-of-the-art machinery and know how are in short supply.

8. Small Hydro and Clean Energy Whilst many small hydroelectricity opportunities will, in themselves, be too large for the IB Facility, there will likely be opportunities to deploy up to $10m, accompanied by project finance in a consortium. Some aggregators have begun to roll-up small hydro opportunities across communities. The build-operate-transfer (BOT) approach could well prove effective in this sector. The government needs additional capacity and supply which, realistically, can only come from the private sector. In addition to opportunities in waste-to-energy, there may be cleaner production plays possible in light manufacturing. An example cited during due diligence was a lighting company that needs $5m to modernise operations, introduce new technology and reduce reliance on fossil fuels to reduce costs.

9. Light Manufacturing The manufacturing sector has not fully recovered from the downturn of 2009-2010. Investment has dried up, competition with Chinese producers is

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vigorous and the high import-content of almost all manufactures makes the cost base very high. The closure of a Sony assembly plant in 2010 dealt a strong blow to the sector: the closure was not attributed to poor labour quality, rather high import costs vis--vis other South-East Asian countries. The opportunity in Vietnamese manufacturing is to invest in technology, know how, improve efficiency and productivity and, above all, to focus on quality and reliability. Domestic producers of components and parts are in desperately short supply. Over time, manufacturing will also need to move up the value chain in order to reduce import dependence. The retail exports that Vietnam has gained a reputation for may also provide prospects for the IB Facility, including clothing, shoes and other leather goods, furniture, wooden flooring and so on. Again, quality and reliability are the key to developing entrenched export relationships. There are some examples of Vietnamese exporters competing in South-East Asia and beyond in flooring, press-board, and wood composites such as MDF. However, establishing reliable supply chains from sustainably-managed forests is challenging, presenting an another opportunity for BOP-orientated Fund involvement. Manufacturing need not only be focused on export markets. Differentiation among local brands is increasing and consumers are becoming more discerning, causing local producers to move up the value chain in order to compete. Supply and service chains need strengthening, however, and particularly in the case of furniture, the potential BOP impact of investments could be significant as it relates to labour.

10. Packaging and Distribution The quality of processing, packaging, branding, presentation and marketing is very poor in Vietnam compared to many other Asian countries. This puts Vietnamese products at a disadvantage. As Vietnamese consumers become increasingly brand-conscious, demand for good packaging and distribution systems will increase. Companies can

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also achieve cost savings by not having to ship product abroad for packaging.

11. Garments The garment sector is clearly a significant contributor to GDP and a very labour-intensive industry. Owing to volatile demand in Vietnams main export market, the United States, it is a risky sector. That said, there may be selected opportunities to invest in garments. In a $4bn industry of which the import content accounts for $3.6bn, import substitution is badly needed to reduce costs and boost competitiveness. Moving up the value chain is also important in order to compete with China, which has abundant domestic supply of materials and accessories. The worst labour conditions and lowest wages in Vietnam are probably found in its garment factories. Unskilled and semi-skilled workers, many of whom migrate from rural areas, live in atrocious conditions in industrial zones, often with little or no access to affordable housing, clean water and nutritious food. On the IB Facilitys theme of improving peoples lives at the base of the pyramid, there is clearly a win-win to be achieved by changing the garment manufacturing model somewhat. One problem for manufacturers is that the work is so tedious that staff tend to move on after one year. If firms are serious about moving up the value chain, they need to invest in training and retain staff, which can translate into higher wages and better conditions. Again, investments in the Vietnamese garment sector are by no means straightforward, but the IB Facility should be on the lookout for opportunities to work with forward-looking, innovative management teams who come to recognise the relationship between loyal, well-treated labour and the ability to manufacture reliable, good-quality product.

12. Access to finance As the lax, urban-centric lending which marked the boom has dried up postcrisis, financial institutions are being forced to innovate. They have begun to

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realise the value proposition of providing tailored to financial products domestically. The IB Facility could well find, or help to create, opportunities to invest in MFIs and other financial institutions looking to penetrate rural areas by developing the following products: Agricultural finance products, such as factoring, reverse-factoring, commodity-based finance, warehouse finance and so on; Crop insurance, disaster insurance and vulnerability schemes; Micro-health insurance; and Mobile banking and tele-banking.

Vietnam: Proposed Fund Design

Due diligence in Vietnam highlighted the profound impact which the economic slowdown of 2009-2010 has had on the business culture and financing landscape. Given the depth of the Vietnamese economy compared to Cambodia, the size of the population and extent to which domestic demand for basic goods and services is under-served or entirely unattended in many parts of the country, there is scope to deploy up to $50m in private Vietnamese companies in the sectors discussed above. From the perspective of risk diversification at the IB Facility level, it is fortuitous that openness to equity is increasing, given that transactions in Cambodia and, possibly Laos, will be almost entirely debt-based. The key features of suggested Fund design for Vietnam follow below:

Fund Allocation to Vietnam: The IB Facility will be able to consider a broad range of transaction sizes in Vietnamroughly between $1m and $10mwhich presents both an opportunity and a challenge. On the one hand, sound portfolio management across all of the IB Facilitys target countries would suggest several larger transactions of $5m-$10m should be made as a counterbalance to smaller, riskier deals in other Mekong countries. That said, the acute need for financing and partnership in the $1m-$5m range should not be overlooked. Clearly, the IB Facility manager should focus on the most financially viable and thematically-relevant transactions, so to some extent, the ultimate average deal size in the Vietnamese portfolio should only be pre-engineered up to a point. Caution will be

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required, however, to ensure that the portfolio does not become unwieldy with too many smaller transactions all requiring extensive engagement from the manager.

Transaction Profiles: The range of transaction types open to the IB Facility in Vietnam will be far greater than in Cambodia. Although Vietnam has never really had an MBO culture per se given its relatively recent free-market orientation, de-listings may generate MBO-style transactions or management buy-ins (MBIs), where existing management teams are replaced. The lions share of investments in Vietnam will be expansion plays and, depending on the sector, it probably makes sense to take majority positions. If majority stakes are not possible, strong rights must be built into shareholders agreements, with contractual access to cash flows and vetoes over key decisions at the board level. Smaller transactions in Vietnam are more likely to involve debt than equity. As in Cambodia, start-ups, restructurings and rescues should be carefully avoided.

Risk Mitigation and Currency Issues: Vietnam is struggling with the twin challenges of currency depreciation and rapid dollarisation. Currency hedging, if even available to the IB Facility, would be extremely expensive. Denominating the IB Facility in local currency would only amplify the currency-related impact for investors. The solution, which is predicated on the identification of a very solid fund management team, lies in several areas: Sound cash management: The IB Facility manager must practice just in time cash management, drawing down on committed capital to the IB Facility on an as-needed basis; Contractual rights to cash flows: Quasi-equity and mezzanine transactions must structure contractual rights to cash flows that begin as soon after deployment as possible. As cash flows back to the IB Facility, it must be converted into hard currency as soon as possible; Portfolio diversification: Clearly, one of the central currency-risk mitigants will be investing in a diverse portfolio which balances export-orientated companies which earn foreign currency with domestic companies; Tranched disbursals and follow-on investments: Where appropriate, disbursals should be made in tranches to investee companies. Additionally, some portfolio

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companies will hopefully require follow-on investment later in the investment period, which helps to space deployment periods. Although there is optimism that tighter monetary policy will help to arrest the slide of the Vietnamese dong in 2011-2012, currency depreciation will be a very real risk factor over the life of the IB Facility. This partly explains the rationale for including other Mekong countries in the IB Facility, but the importance of careful management of the Vietnamese portfolio cannot be overstated.

Exits: It will be a number of years before confidence in the Hanoi and Ho Chi Minh Stock Exchanges is sufficient to support listings as a viable exit strategy from Vietnamese transactions. That said, the divestment period of the IB Facility will not commence before 2016 at the earliest by which time much more stringent listing requirements and an improvement in the quality of companies on the bourses could make listing an option. Meanwhile, in addition to trade sales, management buy-backs and sales to strategic investors, two new exit avenues have recently emerged. First, a secondaries market has begun to develop in the $5m-$7m transaction range. Many fund managers see secondaries as a way of de-risking exposure to companies that still have significant growth potential and are moving up the value curve. Second, partial sell-downs are occurring, enabling investors to split their exposure between purchases from other shareholders and new share issues.

The demographics of Vietnam have fuelled interest from regional buyers, keen to get a foothold into the market. Beginning with minority stakes, trade buyers from the region have, in some cases, expanded their positions as they become more comfortable with their investments. In addition, according to several local fund managers, Deutsche Bank, Morgan Stanley and Citibank are all actively searching for mergers and acquisitions on behalf of operating clients.

Good exits will have to be engineered in Vietnam, principally through value addition and sound management. Prospective investors key complaints about Vietnamese businesses are that they are poorly-governed, poorly-managed, opaque and short-termist in outlook. In contrast, well-run businesses are few and far between because historically investors have not spent the time and resources needed to build relationships and create value.

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Fund Managers: Over 40 fund managers operate in Vietnam (or in the region with a Vietnam focus) investing in public and private equity, the majority on the listed equity side. There are only four private equity fund managers that could conceivably run the Vietnam portfolio: Dragon Capital, Mekong Capital, Anpha Capital and the Vietnam Investment Group. However, it should be they are all relatively amateur and sub-optimal, and would require significant mentoring and engagement. ____________________________________

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III.

Thailand

Economic Performance
Although the Thai economy was significantly affected by the global economic downturn and financial meltdown of 2009-2010, according to EIU data, real GDP growth in 2010 was extremely robust, at 7.8%, and is expected to hover around 4.5% between 2011 and 2015 (barring serious political instability and social unrest associated with the election result of 3 July, 2011, or at any point thereafter). Domestic demand has been fuelled by higher farm incomes and low interest rates and consumption of, and investment in, domestically-produced goods and services has expanded considerably. This growth was largely underpinned by strong household demand. Despite occasional adverse weather conditions and periodic bouts of political instability, the tourism sector has rebounded strongly with visitor arrivals are robust, reflecting the perception of Thailand as a value for money destination.

Thai manufacturing has been affected by high international oil prices, although some counterbalance has been offered by strong agricultural commodity prices, which have channelled robust cash flows into rural areas. Importantly, the government has managed to keep inflation in check at 3%-4% in recent years, but this has been attributable to subsidies for diesel, energy and transportation and price controls in some instances. The Bank of Thailand is cognisant that such subsidies are unsustainable, so it remains to be seen to what extent their causes upward pressure on prices.

The Thai economy has benefited from greater diversification since the mid-2000s, and the increasing breadth of the export base has, to some extent, helped Thailand to remain resilient in the face of unprecedented oil prices. The manufacturing sector includes textiles, garments, leather products, footwear and furniture, among other goods, supported by materials and accessories that can be sourced domestically. Agriculture, agro-processing, fisheries and fishprocessing are also vibrant sectors, and there is an increasingly important agricultural production corridor developing between northern Thailand and southern Laos. Thailand has established itself as an outsourcing centre in the automotive parts industry, with vibrant trade

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having developed with Japan and Korea since the early 2000s. Cement, base metal products and petrochemicals have also become increasingly important contributors to GDP.

Facility Investments in Thailand

The resilience of the Thai economy owes much to the legacy of the Asian Crisis and the wideranging reforms which had to follow in its aftermath. While the recovery process might have prevented Thailand from achieving the rapid growth rates of China and India in the mid-2000s, the consolidation of macroeconomic stability, largely due to sound policy making, left Thailand well positioned to weather the economic downturn of 2009-2010. The salient features of postcrisis Thailand which continue to underpin the countrys robust growth and attractive investment prospects , include: An effective reform programme: implemented from the late 1990s, which helped to address macroeconomic and systemic imbalances, currency volatility and uneven fiscal policies; Revitalised the balance sheets: of many Thai banks and, in turn, medium-sized companies, following regulatory reforms and tighter supervision of the banking sector, accompanied by significant consolidation and a steady reduction in non-performing loans (NPLs); Revived domestic lending: to both the corporate and personal sectors which, following a severe constriction, has been prudent. Engagement with the SME sector remains limited, however, and access to finance is a perennial challenge; Reasonable valuations: the severity of the Asian Crisis and recovery process in the early to mid-2000s meant that company valuations in Thailand never reached the unsustainable levels seen in many other emerging and developed markets in the mid2000s.

While Thailand has certainly not been impervious to the global economic downturn, its economy is relatively grounded and structurally sound, and offers an important counter-point of stability to other Mekong countries to be included in the IB Facility. The conclusion of abbreviated due diligence in Thailand is that it would prudent to include it in the IB Facility, for the following five reasons:

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1. Thailand offers a sound, stable operating environment, despite occasional bouts of political instability and social unrest;

2. Although a growing middle class has emerged in Thailand since the 1990s, much of the population lives at the base of the pyramid. Consumer demand, however, has increased across all segments, particularly as the agriculture sector has continued to deepen and expand, translating into commercial opportunities for domestic small and middle-market companies;

3. Despite excess liquidity in the banking system and vigorous competition to secure lending opportunities, most financial institutions are wary of engaging at or below the middle market. Access to financing, and especially risk capital, of amounts up to US$10 million continues to be very challenging for small and middle-market companies;

4. Owing to structural asymmetries in many productive sectors, which tend to have several large producers and a plethora of smaller players below, investment opportunities are emerging from increasing consolidation as marginal players are either absorbed or eliminated; and

5. Small and middle-market companies are increasingly focusing on value addition, having realised the importance of quality, reliability and responsiveness in challenging, competitive market conditions. Often more nimble than large companies, Thai mid-caps that recognise this opportunity and are well positioned to move up the value chain, increase and, when necessary, re-orientate production within and beyond their markets of origin. This trend should produce a combination of acquisition, consolidation and MBO out opportunities for the IB Facility.

Thailand: Target Sectors for the IB Facility

The IB Facility needs to take into account the duality of the Thai economy, in that the highlydeveloped industries in the greater Bangkok area are not representative of the whole country. Many parts of rural Thailand remain vastly under-developed with grinding poverty, and it is the economic sectors which have prospects, through rapid growth, of lifting people from poverty in

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these regions on which the IB Facility should focus. Additionally, as discussed in Manila in mid2011 and with prospective fund managers in Thailand, there is a strong argument for focusing on the northern provinces, due to developing cross-border linkages with Laos, Vietnam and Cambodia, especially in the agriculture sector.

Notwithstanding the foregoing, opportunities to invest in manufacturing companies which use large quantities of labouroften grossly underpaid and working in unacceptable conditions should not be overlooked. The reason for this is that such manufacturing companies will enable the IB Facility to achieve impact at the BOP from the employee perspective, by boosting employment, increasing wages, improving working conditions and focusing on collective bargaining and the right to organise.

Given the sophistication and diversification of the Thai economy relative to the rest of the Mekong region, ADB will have to stipulate exact investment parameters by sector with the selected fund manager. Assuming that the IB Facility will focus primarily on northern provinces, in keeping with its BOP focus, due diligence indicated that the following sectors would be of particular interest . 1. Agriculture Agriculture remains the backbone of the Thai economy, with approximately half of the population involved in the sector, ranging from subsistence through to mechanised farming and processing. The drive to comply with commitments under World Trade Organisation (WTO) organisation arrangements has seen agricultural exports flourish since the mid-1990s and, importantly, in contrast to Vietnam, without a corresponding increase in imports. The salient challenge in Thai agriculture, however, is that despite achieving food self-sufficiency quite some time ago, average yields of most crops remain low and production levels have languished. This is partly attributable to the fact that the geographical footprint of farming in the country is fairly dispersed, and in recent decades, more marginal and hilly land has been brought under cultivation, which has accelerated soil erosion.

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That said, it is the diversity of Thai agriculture which provides a broad range of investment opportunities. There are essentially four cropping systems in Thailand: i. ii. Rice-based: in low-lying areas with crop rotation; Upland cropping: which is good for sandy, loam soils but requires large plots and effective irrigation systems; iii. iv. Horticulture-based: smallholders operating mixed farming; and Integrated farming: including rice, fruit and tree crops, animal husbandry and aquaculture, with integration of at least two farm enterprises.

The diversity of Thai agriculture, especially since diversification became a central policy initiative in the mid-1970s, means that there is a large range of crops under production both for domestic consumption and export, including rubber, shrimp, rice, marine products, maize, cassava, soybeans, timber and wood products, fruits, pulp, and livestock and meat products, among many others. It is the higher value-added crops with direct linkages back to smallholder farmers which will be of greatest interest to the IB Facility.

Against this background, and given the need to increase productivity and efficiency in Thai agriculture, the IB Facility should focus on the following areas within the sector: i. Extension services: As in other Mekong countries, lack of education and understanding of the usages of key factor inputs such as fertilizer, pesticides and insecticides, have a negative impact on agricultural production. There may be opportunities for the IB Facility to invest in agricultural service and education providers able to work directly with farmers to improve yields and productivity. ii. Irrigation: Particularly in more challenging geographies of the country, such as hilly areas, irrigation facilities are woefully inadequate, and there is a reliance on rainfall, which has become increasingly erratic and, as in the case of the 2011 floods, occasionally severe. Secondary and tertiary irrigation systems are desperately required in many northern provinces.

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iii.

Value-added processing: Because the rural infrastructure of Thailand is vastly superioreven in the northern provincesto the other Mekong countries, the cost of value-added processing and of access to markets is lower. Additionally, aggregators, wholesalers and exporters have wellestablished links with key foreign markets, such as Japan, Korea, the EU and US. The challenge is to incorporate more distant farmers in northern provinces into these supply chains. There will be opportunities for the IB Facility to work on this issue from two angles: the smallholder farmers themselves, with a view to co-operatizing where possible, and the aggregators, who need assistance in developing strong relationships with rural producers based on generating consistent and high-quality supply.

iv.

Organic produce: With almost 30% of consumers in developed markets showing a preference for organic produce since the early 2000s, there is an enormous opportunity for Thai agriculture to satisfy this demand. Given the still rudimentary agricultural practices in many parts of the country, accreditation with organic status is often straightforward (compared to European farms, for example, which must demonstrate seven years of clean production before organic status is conferred). The opportunity in organics is also what is driving Thai processors and aggregators to seek opportunities for contract farming in southern Laos and Cambodia because, again, so much cultivation there is organic by definition. The challenge, as always, is to draw smallholders into these value chains and to help establish the linkages with buyer markets.

v.

Livestock: With consumption rising rapidly as more people join the middle classes in China, Vietnam and Thailand itself, meat processing and associated products will provide opportunities for the IB Facility.

At a structural level, there will be significant opportunities for the IB Facility to help address some of the issues which keep many Thai farmers in poverty. There is significant under- and unemployment in Thai farming associated with seasonality, especially in smallholder monocropping. Because of poor education levels, seasonally unemployed have no supplementary economic activities to

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engage in after the growing and harvesting cycle. Co-operatisation and better communication and organisation between farmers could help to alleviate this challenge. In addition, some farmers become marginalised by mechanisation and improved production techniques because they do not have the education to acquire knowledge and apply new techniques, and cannot afford machinery upgrades. One potential solution to this is co-operatisation through contract farming, which could provide a basis for previously unaffordable investment at the farm level.

2. Manufacturing According to UN data, SMEs account for around 70% of total manufacturing employment in Thailand and over 30% of manufacturing output. Although much manufacturing activity is centred on the greater Bangkok area, there are small industrial clusters around the northern hubs of Chiang Mai and Chiang Rai, among others. The key challenge is to help medium-sized producers to gain access to, and insert themselves in, national and international supply chains. This, in turn, will require managerial and technological upgrading, strengthening financial controls and management, and general professionalisation of operations. The IB Facility will be encouraged to pursue opportunities in light manufacturing beyond the greater Bangkok area, particularly where there are opportunities to work on increasing value addition and value capture within Thailand, and providing much-needed employment opportunities for local populations. Such opportunities might emerge in several of the following sub-sectors: machinery, flooring and panelling, spare parts, furniture, farm supplies and factor inputs related to agriculture. The relationship between energy efficiency and manufacturing may also produce opportunities for the IB Facility in Thailand. One example is an LED light manufacturing plant which requires US$3m of investment to produce nonmercury bulbs with a lifespan of 50,000 hours. Currently, incandescent bulbs using vast amounts of diesel for generators are used by fishermen to attract fish at night. A Thai company is looking to establish a manufacturing facility in

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Vietnam, which would sell directly to farmers, but also to municipalities for street lighting. With buoyant demand from a large market, there is a close correlation in a deal like this between the social and environmental benefits to the buyer, and the commercial rationale for expansion. 3. Education Although education levels are relatively high in the greater Bangkok area, they drop off vertiginously in more distant provinces, including the rural north. Private sector provision of primary and secondary education has begun to spring up in several provinces, along with nursery and day care franchises which enable households to boost incomes.

4. Access to Finance Following the Asian financial crisis of 1997-99, the Thai government promoted the SME sector as a pillar of the recovery, partly in recognition of its linkages to the rural, semi-formal and informal economies. The establishment of the SME Development Bank of Thailand in 2002 was a watershed moment in this regard. However, by the mid-2000s, critics argued that SME Bank and other state banks were using aggressive marketing campaigns and misleading public relations drives to force loans onto SMEs. Worse still, much of the lending was politically directed in that ambitious targets to pump money into SMEs were laid down by the Thaksin regime as part of its very public commitment to poverty alleviation and boosting rural incomes. As a result many SMEs have suffered high levels of indebtedness, and have failed to achieve productivity and efficiency gains because of the availability of cheap, inappropriate credit. Indeed, by 2007, it had emerged that SME Banks NPL ratio was 40%, and that almost three-quarters of outstanding loans were in liquidity difficulties. Worse still, one-quarter of companies had simply chosen not to repay their loans. Hence the opportunity for the IB Facility to consider investments in access to finance opportunities where it can be demonstrated that a financial institution, or a non-bank financial institution (NBFI) has identified a growth market for propoor, context-specific products such as agricultural finance, crop insurance,

50

disaster insurance (especially topical following the floods of 2011), microinsurance, micro-health insurance and so on.

5. Renewable Energy There will be opportunities for the IB Facility in bio-diesel in Thailand. Although there have been several high-profile failures in bio-diesel since the mid-2000s, significant resources have been put into research and development, particularly with regard to seed quality. Demand is expected to rise significantly as airlines are preparing to increase the amount of non-petroleum based fuels in their energy mix to comply with impending carbon restrictions and taxes. There are particular opportunities, therefore, for inter-cropping with jatropha. Additionally, much value addition is needed around the infrastructure and processing of oil seeds for extraction, which then require on-shipping to refineries. As a whole eco-system develops around renewable energy, there will be ancillary opportunities in transportation, warehousing, refining and logistics. Moreover, given that most cropping for bio-diesel is done on a contract farming basis, the IB Facility will be well-placed to pursue its social objectives within these commercial opportunities, especially in the areas of upgrading of techniques, education and co-operatisation, among others.

Thailand: Proposed Facility Design

Despite the relative sophistication of the Thai economy compared to other Mekong countries, the emphasis in this report has been on the disparity between the highly-developed greater Bangkok area and far less sophisticated rural provinces, especially those in the north. Given the logistical challenges of working across four countries, and the growing linkages between northern Thailand and its neighbours, it is recommended that the IB Facility pursue opportunities primarily in northern provinces. From the perspective of risk diversification in terms of the deal structures used by the IB Facility, there is a much greater chance that equity investments will emerge in Thailand than in Cambodia or Laos. This is particularly likely if investments are made in more centrally-located producers or aggregators with the specific purpose of boosting rural production. The key features of suggested Fund design for Thailand follow below:

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Fund Allocation to Thailand: Again, from a risk-diversification perspective, there will likely be opportunities to deploy $5m or more in several Thai businesses, which will offer an important counter-weight to smaller and riskier transactions in other Mekong countries. That said, transactions in rural Thailand are equally as challenging as in neighbouring countries. There are still enormous challenges around accounting, accuracy of financial information and record-keeping. Multiple sets of accounts are not uncommon. Furthermore, due to poor information and access to markets, often the business models of companies need reconfiguration. The problem is so acute that, according to the Institute for SMEs in Bangkok, over 50% of SMEs seeking investment fail to secure it because banks and other capital providers suspect that historical financialswhere availabledo not accurately reflect past performance and are an untrustworthy guide to future potential.

Transaction Profiles: Despite the foregoing, the range of transactions the IB Facility will likely be able to complete in Thailand will be broader than in neighbouring countries. Given the focus on northern Thailand, the IB Facility manager should be encouraged to pursue cross-border expansions, particularly as a risk-mitigated strategy for gaining exposure to Laos and Cambodia. In transactions that involve headquarters or holding companies in a major urban centre such as Bangkok, but whose operations are in rural areas (clearly an agriculture play), there may be opportunities to support management buy-outs, management buy-ins or de-listings. As in other countries, however, strong emphasis should be placed on securing contractual rights to cash flows as part of deal structures.

Risk Mitigation and Currency Issues: Since the Asian financial crisis of 1997-98, the Thai Baht has been relatively stable, and has actually appreciated against several key trading partners since the global economic slowdown and financial crisis of 2009-11. One of the reasons for including Thailand in the IB Facility is precisely as a counter-balance to the more volatile economic fundamentals in neighbouring countries. Political risk in Thailand is always a possibility; however, the impact on economic output and key indicators such as the currency and inflation tends to be limited, such is the integration of Thailand in global production chains.

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Exits: Thailand offers the most sophisticated market for exits in the Mekong region, and in the case of larger transactions, it is possible that one or two IPOs could be achieved. Trade sales, strategic sales and financial buyers are likely sources of divestments as well. Given the increasing engagement of multinational corporations and large industrial conglomerates with medium-sized enterprises in strategic sectors, such as manufacturing and agroprocessing, there are also prospects for large corporates acquiring smaller players that they believe are critical for their supply chains.

Fund Managers: A further reason for including Thailand in the IB Facility is that it has a far more developed and experienced fund management industry than its Mekong neighbours. It is anticipated that several fund managers based in Thailand will apply for the IB Facility mandate, and detailed discussions have already been held with one in particular. _____________________________________

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IV.

Laos

Economic Performance
Given that Laos has only just begun to emerge from years of economic isolation, it has been relatively unscathed by the global economic slowdown and financial crisis of 2008-11. It has benefitted from high international prices for agricultural produce and minerals, whilst strong investment in hydro-electricity projects has also helped to keep GDP growth buoyant. The central banks borrowing rate is relatively low for the region, at 5%, largely because it has been providing money at low rates for local infrastructure projects. In contrast, though, lending rates are punitive and have hovered in the low twenties since the mid-2000s. This stifles private sector investment and gross domestic capital formation, and hits the SME sector particularly hard, as collateral requirements are so stringent (approximately 3-times requested loan amounts). With inflationary pressures on the rise following increases in food prices, there is little likelihood that lending rates will come down in the near future.

From the perspective of the IB Facility, this is a favourable dynamic in that the availability of affordable loans to small private-sector companies is almost non-existent. Although the government has slowly embraced more market-orientated policies in recent years, this has not translated into a concerted effort to significantly lower lending rates such that businesses of all sizes are be able to borrow affordably. Unsurprisingly, in this environment, and given Laos predominantly socialist economic history, the notion of risk capital is virtually unknown in the country, and is only just beginning to be introduced, largely from transactions led from neighbouring Cambodia and Vietnam.

Operating Environment for the IB Facility

Laos is arguably one of the most challenging environments in which to deploy risk capital in Asia. Years of economic isolation, coupled with central planning, government interference and market distortions mean that investment vectors are skewed and only the largest companies of which there are fewplan for long term growth and profitability. The notion of partnership with risk capital providers is not familiar, let alone establishing and opening up a transparent

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shareholding structure in which an outsider might participate. SMEs tend to focus on cash generation with a view to providing for the needs of the owners and their extended families, and the notion of re-investment is rare. This said, there is an important distinction to be drawn between businesses in Vientiane and Luang Prabang and the rest of the country. Leaving the tourism industry to one side, which is mostly centred on the latter, some sizeable light manufacturing operations have emerged in recent years in the greater Vientiane area, especially as urbanisation has gathered momentum and a budding middle class has begun to form. It is the limited populationLaos has just 6.4 million inhabitants at latest count, according to EIU dataand resultant weak domestic demand that presents a formidable challenge to the IB Facility investments. Unless the IB Facility is looking at businesses with an export orientation, long-term growth prospects will likely be limited because domestic demand is simply not that strong. Furthermore, infrastructure deteriorates rapidly outside of Vientiane and Luan Prabang, meaning that access to markets is poor and supply and demand vectors interrupted.

Impact Potential of the IB Facility

As challenging as it may be to deploy capital in Laos, the potential to achieve impact at the base of the pyramid could not be greater. Poverty is endemic and in many cases severe. It ranges from food insecurity at the family and village level, to high vulnerability levels in urban and periurban areas due to low education levels and lack of permanent employment opportunities. In rural settings, vulnerability is exacerbated by uncertainty of land tenure and frequent flooding. Moreover, there is a clear relationship between poverty and lack of access to infrastructure. In rural areas, government analysis indicates that the poor are, on average, 13 kilometres from a road. Access to piped water and electricity is also a problem in many parts of the country.

Healthcare and education are also significant contributors to poverty in Laos. In most poor households, there is insufficient disposable income to be allocated to school fees for all family members, and many households are illiterate. Mortality and morbidity rates are high, especially among ethnic groups in mountainous areas, and communicable diseases such as malaria, dysentery, cholera and tuberculosis are still common. Against this backdrop, to the extent possible, the IB Facility should try to make investments that have the potential to achieve impact beyond the two large urban centres of Vientiane and Luang Prabang

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Transactions in Laos: Prospects for the IB Facility

The operating environment in Laos is the most rudimentary of all the Mekong countries, and is significantly more challenging than Cambodia in many respects. As mentioned earlier, the notion of long-term partnership and value creation with a foreign-provider of risk capital is not a familiar concept. Equity is virtually unknown. For this reason, the IB Facility will focus on identifying up to three debt transactions of $500,000-$3m. The challenges are familiar: Collateral constraints: Few Laotian companies can provide significant collateral, and in cases where they can, recourse is always questionable. The IB Facility can hopefully take a more cash flow-based approach to lending, in contrast to banks, whose collateral requirements are unachievable for almost all Laotian companies. The challenge, however, is that verification of the viability of future cash flows will be extremely difficult. Limited accounting: Many companies are too informal to produce accounts, or simply produce documents that will suffice for the tax man, who takes his own cut. To the extent that some larger companies produce something akin to formal financial statements, sales tend to be discounted and costs exaggerated to minimise profits. Accounting practices will have to be built in portfolio companies with significant education and training. A cash-driven economy: Laos remains a cash-dominated economy. Beyond the two main cities, and even within them, most trading takes place in cash and bank accounts are used for little more than receiving payments and paying suppliers, if that. Poor information: Unsurprisingly, it is extremely difficult to accurately assess the performance of a company due to poor information, or none at all.

Laos: Target Sectors for the IB Facility

To some extent, investment opportunities will have to be created rather than merely sought in Laos. In other words, prospective portfolio companies must be shown the potential of their businesses and educated as to the way in which risk capital and partnership can help them to grow. Significant amounts of training and support will be required in order to make businesses investible. Despite these challenges, there are four sectors in which investment opportunities could emerge for the IB Facility.:

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1. Agriculture Agriculture and forestry account for over half of GDP in Laos, and involve more than 80% of the economically active population. Subsistence farming is still very widespread, given limited use and understanding of fertilizer, poor quality seeds and lack of mechanisation. This, in turn, translates into low crop yield levels. According to official data, over 600,000 Laotian households depend on agriculture, of which nearly 80% comprise subsistence activities. Opportunities in agriculture include rice, fruits, vegetables, livestock, fisheries and non-timber forest products. There are significant opportunities in organic production, largely because so much agricultural land has never been subjected to use of chemicals. Spices, essences and balms also have strong growth prospects. Demand for quality seeds, farm-related inputs such as herbicides, pesticides, insecticides and fertilizer are increasing, although investments would need to be accompanied by significant technical assistance for education and training. There may be some opportunities to modernise and extend irrigation systems for sloping and lowland areas, although access and land tenure remain significant challenges. Contract farming and organic farming is just beginning to gain attention in Laos, driven by Thai, Japanese and Korean investment. The challenge will be to add and capture value in the country, which rarely happens currently.

2. Sustainable Forestry Laos has some of the richest timber resources in the Mekong region, and they are an important source of food, medicine and income for the rural poor, especially in mountainous areas. The salient challenge for the country will be to build a strong and diverse forestry sector whilst ensuring conservation. The wood processing industry is, however, an important contributor to manufacturing and accounts for 25% of all manufacturing jobs. Demand for high-quality wood and wood products from emerging middle classes in China, other Mekong countries, Korea and Japan has grown considerably in recent years. Once again, scale and domestic capacity are challenges. If they could be

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overcome, however, there may be opportunities for the IB Facility to invest in flooring, press-board, and furniture.

3. Aquaculture There is significant potential for freshwater fisheries in Laos. One of the challenges, however, is lack of understanding and techniques for integrating fish-paddy farming systems. Although aquaculture investments would necessarily be at the lower end of the IB Facilitys spectrum, demand for highprotein fish products is increasing.

4. Renewable Energy In addition to small hydro projects, there may be scope for the IB Facility to invest in renewable energy related crops in southern Laos, taking advantage of growing commercial relationships with Thai processors and aggregators. The IB Facility will have to be cautious, however, because forced land acquisitions and involuntary resettlement with no recourse have become major issues in the country.

5. Access to Finance Investing in financial institutions in Laos is not as straightforward as in Cambodia, where, arguably, the regulatory environment is too lax. However, several financial institutions based in neighbouring countries have spotted the extent to which rural and urban populations are either under- or unserved by financial institutions. One potential transaction for the IB Facility which emerged during due diligence is to inject capital in to a Phnom Penh-based financial institution which is looking to establish microfinance, micro-insurance and agricultural finance products in Laos. The government has committed to relaxing restrictions on foreign participation in the financial sector, and assuming that this transpires early in the investment period of the IB Facility, it should certainly form part of the investment strategy in Laos.

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IB Facility Investments in Laos

It is clear that opportunities for the IB Facility will be limited in Laos, but not impossible. Indeed, there is a strong catalytic role that the IB Facility could play in promoting risk capital in the country, either in direct investments or by investing in financial institutions that provide access to finance that is less collateral-intensive than current requirements. Demand for capital is strong, however. Given that all of the 23 commercial banks operating in the country require land and assets as collateral, most companies rely on friends and family for funds to grow their businesses. Many foreign companies that invest in Laos, especially from China, Korea and Japan, bring their financing with them, so this has not helped to develop local lending practices.

Despite these challenges, the IB Facility should target 1-3 investments in Laos. There is no question that some of the better-managed agricultural operations in the south of the country, along with selected light manufacturing or renewable energy companies could greatly benefit from capital injections of $500,000 to $3m. That said, it will be important for the IB Facility to be highly selective and to undertake thorough due diligence on sponsors. Indeed, in the event that the IB Facility is unable to get comfortable with any potential partners, as cross-border activity increases, it may well be possible to achieve exposure to Laos through Thai or Vietnamese companies expanding there.

Transactions in Laos will be exclusively debt based. Equity is unheard of. Self-liquidating structures will therefore be the means of exit, as there is little prospect of strategic or trade sales.

__________________________

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V.

India and Sri Lanka

The Need for an Inclusive Business Facility in India and Sri Lanka The creativity of the private sector in addressing urgent social and environmental challenges with inclusive business strategies in India and Sri Lanka generally has, unfortunately, not been matched with the availability of appropriate financing for growth. The preference of commercial banks and funds to finance larger, more established companies in both countries not only starves the SME sector of working capital (let alone equity), but it also hampers the ability of the private sector to develop innovative solutions to pressing problems which the public sector has neither the capacity nor the funding to confront effectively. The above observations are, however, general. They are contrasted with encouraging, important examples of businesses that are incorporating the poor into supply chains and demand segments as consumers, producers, suppliers and employees for two reasons: because it makes sound commercial sense and because they see profitable avenues for providing solutions to social challenges. The importance of the IB Facility (the Facility), therefore, is to provide such companies with working capital, the lifeblood they require to grow. For regulatory, fiscal, structural and cultural reasons, companies across South Asia struggle to access finance of up to US$10m. Similarly, microfinance institutions struggle to access debt from the wholesale markets even more so following over-indebtedness and suicides among several Indian borrowers which impedes innovation of inclusive, pro-poor products in key sectors, including agriculture, healthcare, clean energy and housing, among others. The strong conclusion of this Position Paper is that there is an opportunity for an IB Facility, seeded and sponsored by the Asian Development Bank, to make debt available to selected companies and financial institutions that are positioned to advance inclusive business initiatives in scalable and replicable ways. Moreover, ADB is uniquely positioned to harness internal expertise and bring financing mechanisms to bear which will enable it to foster

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interest in, and attract capital to, a modality of investment which could be genuinely transformative. In summary, initial due diligence suggests that there is a critical role for a US$100mUS$150m debt facility providing loans of US$1m-US$10m to selected businesses and financial institutions in India and Sri Lanka that are pursuing strategies to engage with the poor as consumers, suppliers, producers and distributors. There is no reason to suppose that, if well managed, a Facility of this nature could not generate double-digit returns for investors. Furthermore, if ADB and like-minded institutions are able to bring innovative instruments to bear, such as credit enhancements, a liquidity facility and foreign-exchange depreciation mitigation strategies, returns could be increased significantly.

India
General Observations 1. The Prospects for an Inclusive Business Facility in India Indias demographic composition and the incidence of poverty, coupled with burgeoning demand for basic goods and services, make inclusive business interventions not only timely, but critical. Population pressure and evolving consumption patterns mean that mass-market solutions are urgently required in healthcare, education, energy, transportation, water, housing, sanitation and agriculture, among many other sectors. Given that 53.7% of Indians were living below the poverty line in 2011, according to the Multi-Dimensional Poverty Index developed by the Oxford Poverty and Human Development Initiative, it could be argued that many investment initiatives will likely (or necessarily) affect base of the pyramid (BOP) incumbents in some way, either as consumers, producers, suppliers or employees. With such strong prospects for BOP engagement at many levels of economic activity, therefore, the question becomes the modality and conditions of engagement, and whether sustainable improvements in livelihoods can be achieved as a result.

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Initial due diligence as part of the ADB IB initiative suggests that focusing on three specific modalities of BOP engagement might be particularly effective for the Facility: incorporating BOP-owned/managed businesses, broadly within the small and medium-sized enterprise (SME) sector2, into the supply chains of larger companies; improving access to and quality, affordability, choice and availability of critical goods and services for the BOP; and engaging the BOP as distributors to reach under-served populations. There are various reasons for this dual focus articulated below, including the nature of obstacles to access to finance in India, the type of finance required, the role of the Indian banking sector, and the strategies and performance of existing non-bank purveyors of capital, among others.

Four additional conditions in the Indian context make an ADB IB Facility particularly fortuitous: first, the predominant focus of the banking sector on larger transactions (with some notable exceptions) due to the perceived lower risk; second, the resulting dearth of debt finance available to SMEs in the US$1m to US$10m range; third, regulatory constraints which make the deployment of debt by non-bank financial companies (NBFCs) very difficult in India; and fourth, the increasing interest among development finance institutions, family offices, high net-worth individuals (HNWIs) and foundations, among others, in supporting IB strategies.

2.

Determining a Strategy for the Facility in India Faced with Indias vast geography, poverty and urgent demographic challenges, it is important for the Facility to develop a focused strategy, recognising the impracticality of reaching all sectors, states and population segments through one intervention. Similarly, it must recognise that an attempt to engage with the BOP through all modalitiesi.e., as employees, consumers, producers, suppliers and distributorsis probably unrealistic and could adversely affect both the Facilitys financial performance and potential impact. Furthermore, it should be remembered that the medium of the Facility itself is investment, and that two of its central objectives are to achieve proof of concept and a demonstration effect encouraging replication thereafter. For these reasons, elaborated further below, it is

It is critical to note that the term SME in the India section of this Position Paper denotes companies that require up to US$10m of finance(in some cases even more)whether debt or equity. This is in sharp contrast to Sri Lanka. The different orders of magnitude must be borne in mind in order for the conclusions of the document to make sense.

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recommended that the Facility focus on business models that engage the BOP as consumers, suppliers and distributors.

1. BOP as consumers: Facilitating access to key goods and services for under-served populations will provide the Facility with a broad spectrum of investment opportunities whose commercial thesis is predicated on strengthening BOP engagement, and where technical assistance (TA) can help in that process. Investments of this kind can be subdivided into three themes:

i.

Overcoming consumer engagement obstacles: Working with businesses that have recognised the BOP as a viable, attractive market segment, but struggle to adapt pricing strategies and revenue models to the cash flow volatility of lower income groups, or to challenges such as physical remoteness, absent or limited availability of energy and technology and so on.

ii.

Introducing technology: Some businesses that recognise the BOP as an attractive segment are unfamiliar with technology that can facilitate new, propoor engagement models such as remote tele-sales, mobile distribution, subscription-based purchases, tele-medicine and so on. The Facility will find opportunities to invest in companies in which the application of technology could open up new demand segments to be serviced.

iii.

Access to finance: Although the regulatory environment makes investing in Indian financial institutions complex, the Facility will have opportunities to work with NBFCs to develop products that enable the poor to access key goods and services both in the personal and productive sectors. With regard to the former, access to clean energy and solar power is a particularly prominent theme, along with micro-housing. Where the productive sector is concerned, there are numerous opportunities, including micro-venture capital, micro-insurance, crop/disaster insurance and input financing.

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2. BOP as suppliers: Engaging the BOP as suppliers is arguably the domain in which most progress has been made in the development of IB strategies by larger Indian businesses. Most prominently in agriculture, some aggregators have recognised the tangible and intangible returns on investment that derive from facilitating farmers access to inputs, information and finance, for example, or from training them in best practices. Similarly, variations on contract financing models have emerged where aggregators arrange access to funds which enable poor suppliers to cover the cost of goods sold, thereby enabling them to be integrated into the supply chains of the former. This not only fosters loyalty, but also it improves quality and productivity, and over time, suppliers can outgrow the need for this interim financing mechanism.

3. BOP as distributors: Successes in developing micro-entrepreneurs with local knowledge and networks have been well documented in Latin America, Africa and India, especially in the area of solar lighting solutions. Where the Facility could have a particular impact in India, however, is working with traditional financial institutions and NBFCs to develop financing solutions whilst also helping distributors develop delivery models that are tailored to vastly-differing states and even regions within them. Moreover, the incentive mechanisms which have been key to the effective design of BOP-led distribution models mean that there is dual engagement of the poor: as distributors and as employees.

It is suggested that Facility not focus explicitly on BOP as employee investment opportunities for two reasons. First, companies of the size that require finance which will enable them to hire significant numbers of poor peoplefor instance, in manufacturing or retailwould likely have other sources of debt or equity available to them. Second, other than improving environmental, social and governance (ESG) practices within large investments of this kind(note that ESG improvements will, anyway, be required by investors in all Facility portfolio companies)increasing the quantum and quality of employment opportunities will be an objective common to all Facility investments.

With regard to investment size, there is a clear, urgent need for debt finance in India in the US$1m-US$10m range discussed extensively below. This implies a focus on lower middle market opportunities with strong growth prospects which, to a large extent, have remained

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unrealised due to lack of access to finance, above all working capital. Attempting to deploy capital below the US$1m level in the so-called unorganised sector would be ill-advised (note, importantly, that in BOP as supplier investments, some Facility portfolio companies will themselves incorporate this segment in their supply chains)as would trying to invest significantly larger amounts. This is because there is fierce competition for larger transactions, requiring a different skill set.

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Access to Finance: Unattended Demand and Supply-side Challenges 3. Access to finance remains a key constraint to inclusive microeconomic growth Access to financeboth debt and equityremains a fundamental constraint on faster, more broad-based SME growth in India, and it should be noted that the challenge pertains to companies that require US$10m as much as it does to those that need US$500,000 or US$1m. In other words, it refers not only to the mom and pop and so-called unorganised segment, but also to lower-middle market companies, especially in Indias Low Income States (LISs). The literature on access to finance in India is extensive, and this Position Paper does not set out to summarise it. However, the following key dimensions of the access to finance problem should be highlighted in the context of the Facility: Supply-side bottlenecks: Although Indian banks are obliged to lend a certain percentage of assets to priority sectors including micro- small and medium-sized enterprises and agriculture, they do so largely under duress. Moreover, with few exceptions, they approach the SME sector with a corporate lens and erect insurmountable barriers to finance in the form of unrealistic collateral requirements, submission of at least three years detailed financials and long, bureaucratic form-filling exercises. Banks urgently require training in appraisal, monitoring and evaluation SME loans. Currently, they gravitate towards the M segment because it is more familiar and viewed as less risky.

Where public sector involvement is concerned, significant debt finance is theoretically available to Indian SMEs through the Small Industries Development Bank of India (SIBDI). Moreover, guarantees and credit enhancements are also, theoretically, available. In practice, however, many potential borrowers lack of awareness of SIDBI products, combined with labyrinthine bureaucracy make the debt almost impossible to access. Worse still, the application process is so cumbersome and time consuming that banks administering the SIDBI funds increase loan prices accordingly. The result is that what was intended as a concessional product ends up being prohibitively expensive.

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At a more general level, lending has been constricted by the absorption of vast amounts of credit in the infrastructure and real estate sectors during the boom, much of which was for projects requiring government approval which has since been delayed indefinitely or withheld. Banking sector assets have been depleted through this over-exposure.

Demand-side constraints: In consequence, SME growth is hindered as owners often resort to taking personal loans at monthly interest rates of 2%-5% to try to inject working capital into their businesses. Further pressures on SMEs result from the following factors, among others: The frequent mismatch between loan terms and supplier and customer payment terms if SMEs do manage to access formal finance; An inability to invest in research and development and technologies that would improve efficiencies; The absence of information technology (IT) and management information systems (MIS) that would enable improved supply chain and inventory management; An inability to develop effective marketing strategies resulting in limited visibility to vendors and customers; and Failure to attract fresh talent.

4.

Breaking the deadlock: making debt available to SMEs The demand for debt in India clearly far outstrips supply across sectors, company sizes and geography, and it is the strong conclusion of the due diligence exercise that the Facility should focus on providing debt rather than equity (see below). More specifically, the Facility should take three aspects of the problem with access to debt into consideration, including affordability, security and tenor of debt:

i.

Affordability: Demand for working capital from Indian SMEs is fuelled as much by the lack of affordability of debt from formal financial institutions as scarcity. Affordability, it should be noted, refers not just to loan price, but also to repayment

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terms, which often fail to accommodate revenue seasonality and cash flow volatility. The Facility must therefore ensure that it provides debt at affordable rates and that it accommodates the volatilities highlighted above.

ii.

Security: Few SMEs are able to meet banks rigid collateral requirements. Providing security and personal guarantees can be a struggle, and traditional sources of collateral such as land often fail to provide anywhere near the amount of coverage needed. Training in cash flow-based lending must be provided to intermediaries administering Facility funds, otherwise collateral constraints will once again prevent many companies from accessing them.

iii.

Loan tenor: When SMEs do manage to access debt from formal sources, the tenor is often inappropriate. Many businesses require what are effectively working capital facilities which are both long term (if not open-ended) and take into account fluctuations in monthly revenues. To the extent that the Facility can incorporate patience and flexibility into the tenor of its loans, the contribution that it will make to the financing landscape and, critically, the demonstration effect it will have on other financial institutions will be significantly enhanced.3

5.

The Facilitys modality of finance: debt versus equity Whilst many Indian companies struggle to access finance of all kinds, there are several compelling reasons why the Facility should avoid providing equity: Unfamiliarity with equity: Not only do many businesses in the Facilitys target size range have opaque ownership structures and informal or non-existent governance arrangements, few owners are open to dilution. This is even more prominently the case in LISs and remote areas. Additionally, the absence of the repayment discipline of debt, which is immediate, can foster an approach to equity as free money, especially among family-owned and less sophisticated businesses.

The question naturally arises whether loans on such terms would distort the market. However, given that most banks focus on larger commercial opportunities, the opportunity cost of the distortion that might transpire is outweighed by the demonstration effect the Facility could have in alerting banks to the viability and, ultimately, profitability of financing the missing middle.

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Unrealistic valuation expectations: Although there has been a significant correction in the market since early 2011 and many large private equity funds are either under water or may, at best, return capital to investors, business owners valuation expectations remain unrealistic. This is particularly the case in the SME sector, where owners lack a thorough understanding of the drivers of excessive valuations in the mid-to-late 2000s.

Absence of transactional infrastructure: With the exception of large transactions (US$20m and above) undertaken by large private equity houses, India does not have the intermediaries, knowledge or transactional infrastructure that facilitate equity deals. This becomes an even more significant obstacle in transactions and is more acute in remote areas and LISs.

Inability to accompany equity with debt: Under current regulations, the ability of funds to deploy debt alongside equity is limited, cumbersome and expensive. Although the regulations can be circumvented (to a degree) by using mezzanine structures such as convertible debt and preference shares, it is rumoured that SIDBI may close such loopholes. Given that it is usually more working capital that companies appropriate for Facility funding lack (and are positioned/structured to absorb) rather than equity, debt is the more logical modality than equity.

In addition, the performance of private equity funds, especially those of 2004-2007 vintage years, is trending towards mediocre at best to disastrous at worst. Entry prices were justified by inflating growth assumptions, and a mutually-reinforcing vicious circle developed whereby owners came to expect exaggerated valuations and funds failed to attract investors unless they promised commensurate returns.

By contrast, the advantages of debt are significant, including; Risk profile: The discipline of immediate and regular repayments, which provides insight into businesses cash flow positions, coupled with the exit realisation inherent in debt significantly reduces the risk profile of a Facility. Return profile: This need not, however, imply that the higher returns generally attributed to equity must be foregone (and they are certainly not being achieved at

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present!). Indeed, significant upside generated from sales multiples are not likely,4 but medium and long-term debt at annual interest rates of 16%-18% would be highly competitive and attractive to many target companies. Moreover, the ability to return cash to investors frequently, whilst recycling proceeds from interest payments, will help to counteract the impact of currency depreciation on the Facility. Need for working capital: Even larger, more sophisticated companies that manage to secure equity investment from private equity funds or other sources still need access to working capital, and indeed often end up using the equity in this way, which is very costly and inefficient in the long run. Opportunity to stimulate complementary lending: Banking in India is relationship based, particularly at the SME level. Relationships are especially important in LISs and remote areas (when there is access to formal financial institutions). As highlighted above, given that many business owners have to take out personal loans to fund working capital requirements, the Facility should help to mobilise complementary lending from banks that take comfort from its willingness to lend to sponsors they already know (but may have rejected for business loans) from personal banking relationships. The presence of the Facility should, therefore, act as a catalyst for breaking down such barriers between personal and commercial lending, and strategic use of TA funds could be critical in this regard (see below).

Proposed Focus and Structure of the ADB IB Facility for India 6. Inclusive business: where access to finance and impact intersect The conclusion of initial due diligence in India is that the timing for an IB debt Facility is favourable. In fact, it is arguably urgent owing to several features of the Indian financing landscapesome long-standing, some more recentwhich are exacerbating the impact of financial exclusion. These include:

Note that it may be possible to deploy mezzanine structures in some cases to capture upside for investors, however, this should not be relied upon as regulatory arrangements are subject to change.

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Turmoil in the microfinance sector: Following the scandals in various microfinance institutions (MFIs) in Andhra Pradeshover-indebtedness leading, in some cases, to suicidesmicrofinance has, to some extent, become a dirty word in India. The relevance of this to the Facility is that, although most MFIs had been focused on aggressive growth of their loan books, a few were focused on the development of new, inclusive products and mobile payment methods especially targeting women and the illiterate. Innovation has since all but ceased due to MFIs difficulty in accessing debt from the wholesale markets and because of restrictive new legislation introduced by the Reserve Bank of India (RBI, the central bank). In addition to forcing many micro-entrepreneurs to seek finance from money lenders, pawn shops and gold tradersdepending on their proximity to innovative MFIs, they might have been able to access small business loansMFIs are struggling to upscale with and for their clients because of nervousness in the sector. It should be noted that, particularly in agriculture, this was a significant source of finance (again, depending on location) for some BOP suppliers and producers.

Debt funds are a relatively new phenomenon: The emergence of debt funds is recent, and is being led by two formidable players in international finance: KKR and a breakaway team from Citibank. Unsurprisingly, they are seeking to raise large funds that will be focusing on substantial transactions. Whilst other fund managers may follow suit, there is no evidence to suggest that there will be a focus on lower middle market companiesi.e., deals of below US$20mlet alone SMEs as more traditionally defined.

The start-up space is relatively robust: In contrast, seed capital, even for social enterprises, has remained relatively robust in India, although admittedly it is more difficult to access in LISs and remote areas. There is little indication that there has been a significant decline in the availability of such finance in the wake of the international economic slowdown and financial crisis of 2008-2011.

In essence, therefore, the orientation of equity towards large transactions, combined with the relative accessibility of venture capital and the limited availability of innovative, inclusive

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financial products from MFIs that had been venturing down this path, creates a compelling role for the Facility to focus on the unattended segment of broadly US$1m-US$10m debt transactions.5

Furthermore, given the relative costliness of bank finance in India, and the difficulty of accessing it post-crisis, many companies that require amounts in excess of US$10m are able to fund their needs through substantial cash accruals. Focusing on such companies would likely be a distraction, as there would be no compelling reason for them to pursue Facility financing (unless, of course, they needed to complement equity with debt financing that they were unable to source).

7.

Suggested parameters for the ADB IB Facility in India With the above discussion in mind, this section proposes some parameters and objectives for the IB Facility in India, and attempts to highlight areas where it could make a highly significant contribution through innovation and flexibility:

i.

Geography: An exclusive LIS focus is neither necessary nor prudent for several reasons. First, the quality of deal flow in LISs is generally poor. Second, with the exception of Pragati, there are few competent fund managers focussed on LISs. Third, in order to achieve a balanced portfolio from a risk perspective, it is advisable to combine an opportunistic effort to reach LISs and remote areas with transactions in other states. Recommendation: If the Facility is apportioned among several managers, a significant allocation to Pragati (subject, of course, to full due diligence) would be an effective strategy for ensuring LIS coverage.

The issue of geography should also be considered from the perspective of rural and urban settings. Given the raid, unplanned, widespread urbanisation throughout India, urban and peri-urban poverty have become as urgent as rural poverty. This suggests

Note that the Facility would also have opportunities to lend to MFIs to support innovation of new, inclusive products. It would be important, however, to ensure that such activities did not replicate, overlap or confuse activities associated with the US$400m line of credit that ADB has extended to SIDBI.

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that a focus on basic infrastructurewater, sanitation, housingin secondary and tertiary cities could be as impactful as a rural focus per se.

ii.

Sectors: If the above-suggested orientation for the Facility is acceptedtargeting the BOP as consumers, suppliers and distributorsseveral target sectors naturally stand out, including:

i.

Agriculture: With a particular focus on value capture and value addition through supply chain development. For example, bringing technology and TA to bear to introduce or improve pre-cooling, dehydration, resin and enzyme extraction, steam sterilisation and so on. Some large aggregators have attractive growth prospects and steady cash flows reflecting steady contracts, but struggle to fulfil orders because SMEs in the supply chain cannot access finance to boost capacity. Another area within agriculture which has a disproportionate impact on the BOP is infrastructure, such as food chain and cold chain strengthing (or introduction where absent).

ii.

Access to finance: Working with selected NBFCs and MFIs on new product development, including crop insurance, disaster insurance, micro-health insurance, micro-venture capital, access to clean energy and so on (see footnote 4 above, however). Access to finance opportunities could also be pursued by lending to SME financing companies that provide finance of $500-$15,000 to SMEs. The opportunity in such companies would be to help them to enhance credit and risk analysis, and to support development of new products that assist them in retaining and growing with their clients.

iii.

Distribution: Distribution of solutions that are vital to, and affordable for, the poor, such as solar lighting, clean cooking solutions, clean water, sanitation, secondary and tertiary irrigation, and so on. (Note the dual BOP engagement here: BOP as distributors (i.e., employees, in a sense) and the impact on endusers.

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iv.

Housing: Affordable housing for the poor, although initially launched by some companies such as Mahindra as a corporate social responsibility (CSR) initiative, has proven to be profitable in parts of India whilst, of course, being desperately required.

v.

Education: With a focus on last mile solutions, i.e., focusing on cost-reduction and hence affordability of vocational, primary and remedial education (note that investment in K-12 is restricted by the Indian government).

vi.

Healthcare: Owing to poor quality and a general mistrust of public healthcare, there is a tradition of paying for private care, even among lower income groups in India. This makes investments in healthcare delivery and last mile solutions more viable.

iii.

Innovation: There are three areas in which, if innovative, the ADB Facility could make an enormous contribution to the financing of IB initiatives in India.

a. Incorporation of a liquidity facility: Especially post-crisis, investors react negatively to lock-ups or gate provisions, and tend to prefer funds which provide redemption facilities (at least quarterly) at the prevailing net asset value (NAV). Given the mismatch between the tenor and liquidity of assets and liabilities, illiquid instruments are difficult to sell down in order to meet redemptions. Recommendation: A liquidity facility (LF), provided by a counterparty with an AAA rating such as ADB, could be used to meet redemptions to the extent that asset sales are infeasible at any given time. All or part of ADBs commitment would remain un-drawn to meet liquidity requirements to fund draw-downs or redemptions. In case of drawdowns, they would happen at NAV. Meanwhile, the un-drawn portion of the LF would generate returns for ADB on an un-funded basis on the committed portion of the Facility. Further upside would be available to ADB by capturing the bid-offer spread in case of redemptions.

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b. Credit enhancement: Foreign investors neither understand nor recognise Indian rating agencies methodologies and rating scales. Not only do investors have concerns about the ability of the former to assess the credit-worthiness of investee companies, but they are also worried about Indias debt rating as a sovereign. Recommendation: Providing protection on principal commitments (at the portfolio level, not the individual credit level) could mitigate such concerns of private-sector investors that might otherwise not participate in the Facility.

c. Currency hedging: Given the considerable depreciation of the Indian rupee in 2012, many private-sector investors prefer to hold their investments in hard currency, and may even be willing to forego upside in order to minimise currency exposure. Furthermore, the Indian rupee has become extremely expensive to hedge, and is rarely available beyond a one-year time horizon. Recommendation: Leverage the expertise of ADBs capital markets department to provide the operating currency to those investors who may otherwise not participatei.e., non-DFIsin a cost-effective manner at the Facility level.

In summary the table below provides sample terms for an ADB IB Facility in India: US$150,000,000 DFIs, foundations, HNWIs, local and international banks 1-3 depending on due diligence 7 years 4 years 36 months 14-18% per annum US$5 million 2% per annum 20% above a hurdle rate of 8%

ADB IB Debt Facility Investors Fund managers Facility life Investment period Lending term Target return Minimum commitment Management fee Carried interest

If a key objective of the Facility is not only to enhance awareness of inclusive business as a tool for achieving social outcomes and producing attractive returns, but also to attract private-sector players into the space, then the incorporation of the innovations listed above, combined with the attractive returns that could be generated, would enable ADB to make a critical contribution and to move the market.

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Depending on due diligence, the Facility could either be administered by one manager, or divided among several. There are advantages and disadvantages to both approaches. Working with a single manager simplifies logistics and communications and would enable ADB to develop a very close working relationship through which it could get a very granular sense of lessons learned. Disadvantages of this approach would include single-manager exposure risk.

It is suggested, therefore, that ADB adopt an agnostic approach on this issue and, at the appropriate time, evaluate all potential managers (of which there are not many) on their merits. If there is a positive relationship between the ability to cover multiple sectors and geographies and deploying capital with several managers, then it probably makes sense to work with several.

Regarding time to market, there is significant pressure on many DFIs to restrict engagement with India to LISs or activities which will have a clear impact on the poor. For this reason, a Facility which explicitly targets inclusive business as a means of achieving pro-poor outcomes is extremely timely and would likely be well received by various DFIs, notably CDC, Proparco, Sifem, DEG and FMO.

Strategic use of TA has also already proven to be of interest to various donors in conjunction with the Facility (see below for a discussion of technical assistance).

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Sri Lanka
General Observations 1. Overview of the Current Financing Landscape The salient feature of the Sri Lankan economy in the context of the Facility is that approximately 91% of its 18,000 firms are SMEs, according to World Bank data. Since the global economic slowdown and financial crisis, SMEs have suffered disproportionately in terms of access to finance, for two reasons. First, commercial lending rates soared to 2530% in 2008-2009; and second, banks re-directed their lending activity to larger, safer corporate clients.

Worse still, the non-performing loan (NPL) ratios of some Sri Lankan banks peaked at 10% (some data indicate they may have reached 12.5% in some cases), augmenting aversion to lend to the sector. With borrowing requirements of larger firms likely to accelerate as the economic recovery gains momentum and credit constriction slowly eases, capital will be directed to large companies rather than SMEs. Indeed, the World Bank estimates that unmet credit demand between 2010 and 2012 could be as high as US$1.5bn in the country. With banks constrained by the global credit crunch and reticent with uncertainty, lending volumes have fallen significantly, and demand for government securities has sky-rocketed.

Meanwhile, there have been on-going efforts to persuade commercial banks to downscale to supply credit to SMEs, however, it appears that associations of risk with the segment are so strong that very significant credit enhancements would be required in order to persuade them to divert even a small fraction of resources in this direction. The flight to treasury bills and all but the largest corporate clients is a trend that will abate at a glacial pace, and there is little reason to suppose that banks nervousness about the relative informality of the SME sector will subside soon.

2.

Opportunities for the IB Facility Given the inimical view of banks on smaller businesses in Sri Lanka, opportunities for the IB Facility lie in the SME space, and arguably should be approached from two routes: provision

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of debt finance of up to US$2m to lower-middle market companies that themselves have established linkages into the supply chain; and provision of finance to MFIs with the specific objective of developing inclusive financial products:

i.

SME lending: Unlike India, there is little equity culture in Sri Lanka and, with the exception of Aureos Capital, which is focussed on much larger transactions (US$10m and above), there is no dedicated private equity fund in the country (note that one fund sponsored by LR Global, is attempting to raise US$30m for US$1m-US$5m equity deals and is approaching a first close). Transactions above US$2-US$4m are difficult to come by, and business owners are hesitant to open their ownership structures to external shareholders. As highlighted above on the lending side there is, conversely, a chronic shortage of debt available to SMEs. Even when banks are willing engage with SME clientsand this assumes that they have well-prepared financials, suitable governance structures, sufficient collateral and a strong operating historyit is generally not below interest rates of 20% or more. Furthermore, bank capacity for assessing opportunities in the SME segment is weak, and varies significantly between branches and regions (beyond Western Province and the greater Colombo area, it drops off vertiginously). Thus, few banks are equipped to recognise attractive commercial opportunities in the SME segment and reject potential clients outright.

There is therefore a critical gap to be filled with debt, both in the upper echelons of the SME space, and in the transitional space between the largest loan sizes that MFIs can provide and more traditional small-scale banking. It is important to clarify the implications of this for the Facility: because of the dearth of small-scale finance in the countrybroadly speaking, loans of US$10,000-US$250,000many small business-owners take out multiple loans from MFIs but use them for so-called income generating activities. So the opportunity for the Facility becomes a twopronged strategy: addressing both the absence of small-scale finance and facilitating innovation in the microfinance sector (see below) in order to help foster a continuum of finance for SMEs.

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ii.

Promoting innovation in MFIs: Microfinance has a long, established history in Sri Lanka and emerged from the non-governmental organisation (NGO) and donordriven model of the 1980s and 1990s. Largely focused on the group lending model, geographical coverage of microfinance is impressively high and is being extended to areas that were impenetrable during the civil war. That microfinance is a priority for the government is evidenced by legislation pending in parliament which, from 2013, will enable MFIs to take deposits, mobilise savings and will facilitate the creation of a credit bureau by forcing all microfinance practitioners to register with a central authority. (This particular development will be key to reducing the incidence of multiple loans).

This background is critical because the new legislation will pave the way for muchneeded innovation in microfinance, and it is in this domain that the Facility can play a vital role. More specifically, there are 5 sub-sectors which urgently require the development of inclusive, pro-poor financial products that the Facility can support:

a. Agriculture: There is burgeoning demand among subsistence and smallholder farmers for: Insurance products, covering disease (crop and livestock), and natural disasters such as floods and drought; Access to inputs, such as seeds, pesticides, insecticides, herbicides, fertilizer and so on; and So-called cultivation loans, which allow farmers flexible repayment terms (i.e., not monthly), removing the asymmetry between harvests and payment schedules.

b. Value-chain clustering and reverse investment: LOLC Microcredit, for example, has developed an innovative co-operative investment product, whereby it takes a stake in a farming co-operative and provides finance to farmers for purchasing inputs. A pool of permanent working capital is created, whilst TA funding supports the administration of the entity. Farmer incomes increase as the co-operative, with the support of LOLC, cuts out

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middlemen by establishing fair-trade contracts and developing new export opportunities. The scheme has been successfully piloted with 800 cinnamon farmers, and requires significant additional capital.

c. Micro-health insurance: The vulnerability of household livelihoods to illness, especially in the agriculture sector, is extreme. There is scope to introduce products that have proven very successful in Sub-Saharan Africa which apply new modelling techniques to at-risk groups. The result is a winwin for communities and MFIs, where effective yet profitable coverage is provided.

d. Small-scale renewable energy: One MFI has experimented with small-scale biogas projects, whereby 25 families pool animal and crop waste to create clean energy for cooking needs. A fertiliser by-product is also produced. The MFI provides the finance for design and implementation, resulting in a sustainable energy solution and attractive return on investment.

e. Micro-housing: Some MFIs have been experimenting with micro-housing loans, whereby clients with strong track records of multiple loans with the MFI are able to borrow up to US$10,000 to construct small homes. The MFIs have recognised an opportunity to leverage long-standing client relationships, and need additional capital to expand the programme.

3.

Recommendations for the IB Facility in Sri Lanka It is recommended that approximately US$20m of the IB Facility be deployed in Sri Lanka, apportioned in the following way:

i.

Loans to MFIs for product development: Progress on integrating the poor further into supply chains in inclusive ways that enable them to both capture greater value and increase incomes depends on two developments. First, engaging with aggregators and influencing their procurement policies and willingness to engage with suppliers. And second, developing financial products that help the poor to

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improve yields and increase output whilst enhancing their resilience to exogenous shocks.

The MFIs interviewed during due diligence emphasized the need for technical assistance funding and infusion of expertise from other markets in the development of inclusive products. They specifically highlighted the importance of gaining access to some of the risk assessment and modelling techniques that have proven effective in agricultural insurance and micro-health products in Sub-Saharan Africa.

ii.

Debt finance for SMEs: There is a dearth of debt available for SMEs in the range of US$50,000 to US$2m. There are several intermediaries which the Facility could consider to administer loans to SMEs, whilst supporting them in the areas of credit analysis and risk assessment, cash flow-based lending and so on. By the same token, the Facility could opt to work with one or several commercial banks, were there a genuine commitment to developing expertise in SME lending in the long term.

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Key Additional Considerations for India and Sri Lanka

The Importance of Technical Assistance 1. The need for multi-dimensional engagement: finance plus technical assistance All constituents interviewed as part of the due diligence exercise in India and Sri Lanka multilateral development institutions, DFIs, commercial banks, donors, fund managers NGOsemphasized the importance of providing technical assistance alongside finance if meaningful progress is to be made in solidifying the inclusive business concept in the region.

There are several areas or themes which would be crucial for TA to cover:

i.

Engagement with aggregators: In the BOP as suppliers model, awareness needs to be built among aggregators in several areas. First, some still struggle to distinguish between CSR and inclusive business strategies. In other words, the long-term value of developing supply chains by engaging with producers with expertise and/or finance is still not widely recognised. Second, few aggregators have expertise in working with local financial institutions to encourage them to provide products to their suppliers that would ease production bottlenecks.

ii.

Development of service provision models: Whilst a company may recognise an opportunity to provide goods and services to BOP populations in ways that enhance access and affordability, they may struggle to develop effective implementation models to do so. In both India and Sri Lanka, companies struggle to understand sales, distribution and consumption patterns and need assistance with developing outreach and market development models. Similarly, the development of risksensitive products and modalities of engagement with poor and remote distributors and suppliers require training. In many relevant sectorshealthcare, agriculture, education, for exampleinteresting breakthroughs and important failures and lessons learned from other geographies, notably Africa, can be brought to bear through TA in order to replicate best practices.

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iii.

Training of local bank staff: Banks incentivise staff to mitigate risk and minimise losses. This risk aversion underlies their reticence to engage with the SME sector. TA would be critical to train partner financial institutions in credit appraisal, cash flowbased lending and, more generally, the ability to identify diamonds in the rough i.e., SMEs which, despite poorly prepared financials, ad hoc or absent governance arrangements and loose financial controls, would clearly thrive and become solid clients were they given access to finance and TA to address such weaknesses;

iv.

Technology upgrading: SMEs in both India and Sri Lanka of all sizes need technology upgrades covering many areas, including: Accounting systems, management information systems and financial controls; Procurement and inventory management; Supply-chain tracking and management; In agriculture, clean energy production (small biogas, for example), cooling, storage, transportation;

v.

Training: In numerous areas, including: Management capacity and corporate governance; Human resource management, retention, training and incentivisation; Financial controls and accounting; Fiscal management and effective tax planning; Stakeholder engagement: producers, consumers, suppliers, local,

provincial/state government and so on; and Export development, marketing and new market penetration.

vi.

Investor-readiness or investibility: Although the use of TA to prepare companies for investment is controversial6, it might be used to work with companies considered and initially rejected by the Facility, but which have a strong chance of

Many donors have concerns around free rides and sponsors with take the money and run attitudes. Additional concerns include the effectiveness of the so-called machine gun approach, whereby TA is sprayed at many potential investees in the hope that some prove worthy of investment.

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securing finance if they meet certain key targets and milestones. For example, a fund manager might advise a company that, provided proper corporate governance arrangements are implementeda board of directors with three external directors, for examplethey will qualify for a loan. TA could then be used for training on board composition and effectiveness, and could even be structured as a re-payable grant once the target becomes a portfolio company.

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VI.

Indonesia

Macroeconomic and Political Landscape and Structural Challenges Despite intermittent bouts of terrorist activity which continue to concern investors, Indonesia has made significant inroads in modifying the image of the country as a more stable environment in which to do business, with relatively sound macro-economic fundamentals. Although currency depreciation remains a significant concernimportant in the context of the ADB initiative because of the impact on returns, whether debt repayments or realisation of equity stakesthe elevation of the countrys sovereign credit rating to investment grade by two of the three biggest international rating agencies in 2012 was a significant cross-roads. To some extent, this reflects the emergence, within the burgeoning population of over 200 million people, of more and more incumbents of the middle class, all with aspirational demand tastes that are driving consumption and the development of deeper domestic production markets. With specific regard to the ADBs inclusive business (IB) initiative, one of the biggest challenges posed by the structure of the Indonesian economy is the vast gap between quasi-oligopolistic large corporates and parastatal companies on the one handand not simply in the energy sectorand the vast swath of SMEs on the other, with little in between. The groundwork for these structural imbalances was laid in the 1960s, when the so-called new order, or more modern approach to economic development, was initiated. Decades later, the lasting impact is that it is very difficult and unusual for SMEs to be drawn into the supply chains of larger corporates in a meaningful way that enables the former to increase their value added activities. These structural asymmetries are further exacerbated by the fact that the Indonesian economy is heavily intermediated by small-scale traders and distributors. In some ways, it could be argued that this is a proxy for the lack of conducive physical infrastructure (with the exception of the greater Jakarta and Surabaya areas) and the inherent challenges of moving goods and services around such a vast archipelago. Be that as it may, however, from the perspective of inclusive business, the salient point is that it affects the way in which goods are procured from the SME sector by larger companies, and partially explains why few SMEs are successful at developing export markets for themselves. There are some exceptions to this, where buyer-driven trade networks have developed in sectors such as furniture and garments in Jakarta, and garments and carved wooden furniture in Bali, but given that the SME sector accounts for over 90 per cent

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of employment in the country and that its rapid growth will therefore be critical to any lasting poverty alleviation, more concerted efforts are required to address these structural challenges.

The Financial Landscape and Inclusive Business In recent years, the central bank of Indonesia has strengthened the regulatory framework and supervisory arrangements for the banking sector, which has increased confidence significantly since the Asian financial and economic crisis of 1997-1998. The focus, more recently, has turned to further development of the financial markets and new investment vectors and disciplines, such as venture capital, private equity, microfinance and angel investing. Importantly, the ministry of finance is looking to strengthen entry regulations for non-bank financial institutions (NBFIs), their transition to regulated entities, licensing arrangements more generally, and capital requirements for all actors in the financial sector. This is important to the ADBs IB initiative because SMEs pervasive inability to access finance from formal financial institutions means that they are often left at the mercy of predatory, unregulated, semi-formal purveyors of finance that charge punitive rates for loans. Also significant from the inclusive business perspective is the governments decision to grant venture capital firms tax exemptions for investing in certain sectors. Although there are concerns that this could distort the allocation of capital and promote rent-seeking behaviour among some players, the overarching recognition that alternatives to bank finance from heavily collateral-focussed institutions for SMEs and the non-corporate sector more generally is critical to more broad-based growth in the country.

An Inclusive Business Facility in Indonesia: A Natural Focus on the SME Sector The ADBs IB initiative in Indonesia will, naturally, have a significant focus on the SME sector. With the exception of the oil and gas sector, over 90 per cent of all firms in the country are SMEs, providing livelihoods for more than 90 per cent of the population. Moreover, the SME sector accounts for nearly all new employment creation in the country, according to the Organisation for Economic Co-operation and Development (OECD). With regard to the crucial agriculture sector, according to data published by the Ministry of Co-operatives and SMEs, 87% of output is attributable to micro-, small and medium-sized enterprises. It is therefore clear that in order for the strategy of an IB initiative in Indonesia to be meaningful, it must have a

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significant focus on the agriculture sector and an emphasis on strengthening the linkages between small producers and larger aggregators and processors. The challenges to improving the competitiveness and dynamism of Indonesias SME sector are familiar in the South-East Asian context. SMEs tend to have relatively high production costs, low levels of efficiency, and struggle to invest consistently and meaningfully in human resources, technology, machinery and other vital fixed assets. As a result, their ability to capture greater value by producing more semi-finished and finished goods is compromised which, in turn, often keeps incomes relatively low. Part of an IB strategy for Indonesia must therefore concentrate not just on the more effective incorporation of SMEs into supply chains, but creating opportunities for them to add and retain value themselves. The Indonesian government has recognised the importance of incentivising larger companies to reach into the supply chain and incorporate SMEs, especially in the non-oil and gas sectors. Indeed, there have been some important policy initiatives around incentivising larger companies to create clusters of SME producers and suppliers since the late 2000s. By the same token, however, some small firms are protected under Indonesian law through the reservation of certain industries for them. This, in turn, requires larger companies, especially foreign ones, to partner with them in order to gain access to foreign direct investment (FDI) opportunities. The concern, nevertheless, is that this could discourage FDI inflows to sectors which are particularly SME-intensive because SMEs are unfamiliar with and vulnerable to exploitation by larger companies. Constraints to Growth in and Inclusion of the SME Sector In addition to access to finance (see below), there are several important constraints to faster growth in the SME sector which are critical to note in the context of the IB initiative. This is because their hampered growth is, to a large extent, the result of their lack of inclusion. First, SMEs ability to invest and grow organically is impeded by price fluctuations for raw materials, marketing challenges, transportation and distribution difficulties, high energy prices and supply interruptions and often high labour costs. Given that all of these challenges, in the aggregate, signify a relatively high expense-base in which to operate, savings are often made by avoiding formalisation. Whilst on the one hand this enables them to remain below the radar of tax authorities, on the other hand it damages them in the long term because it makes them harder for larger companies to identify, engage with and draw into their supply chains. Second, this

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naturally limits export development opportunities and translates into poor export performance. Indeed, the OECD notes that Indonesian SMEs are among the least likely in South-East Asia to export directly to buyers; i.e., to the extent that there are linkages forged with SME markets abroad (and even domestically), these tend to be brokered through intermediaries such as traders or trading companies. Third, productivity levels remain low because turnover and profit does not increase sufficiently to enable business owners to afford new machinery, modern tools, information, technology and other inputs. Ironically, some of these structural and systemic challenges have been obscured by the steady depreciation of the rupiah, which flatters the performance of the SME sector in local currency terms. However, in the long run, the inflationary impacts of depreciation far outweigh the benefits which SMEs might perceive in nominal local currency. Improved Access to Finance: The Key to Inclusive Business in Indonesia Bearing in mind the contribution of the SME sector to Indonesias economic output and the fact that many of Indonesias poor are, by definition, engaged in micro- or small enterprise, then in can be argued that rapid growth in the SME sector is vital to poverty alleviation. This, in turn, could be accelerated by greater inclusion of the SME sector in economic activity, but only if SMEs ability to access finance is vastly improved. There is an enormous opportunity, therefore, for ADBs IB initiative to work with financial institutions to create, or further develop, products offered by financial institutions that help to alleviate bottlenecks in access to finance. Before considering the nature of such products, it is important to highlight the main factors which, inter alia, impede SMEs access to finance in Indonesia: Insufficient collateral: Like many South-East Asian countries, and particularly since the Asian Crisis of 1997-98, Indonesian banks are most comfortable with collateral-based lending, which proves a high hurdle for most SMEs (especially in frequent cases of inability to use individual or communally-owned land);

Incomplete or sub-standard financial records: Banks generally require at least three years historical financial information from prospective borrowers. SMEs often lack the financial and accountancy training to prepare this information to standard;

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Reticence to consider cash flow-based lending: Given the high concentration of SMEs in the agriculture sector, the combination of exogenous risk factors such as weather fluctuations and risk of natural disaster with seasonality and volatility of earnings makes banks very nervous about lending against future cash flows; and

Inflexible repayment terms: Similarly, most banks are unwilling to consider accommodating the irregular cash flows of prospective SME clients in repayment schedules, again excluding them from the formal financial system.

The World Bank recently highlighted SMEs inability to access finance regularly and in meaningful amounts as among the top impediments to more rapid, broad-based growth and private-sector development in Indonesia. The reason for this is that SMEs must rely on either retained earnings, finance from family and friends, or loans at punitive interest rates from money lenders, loan sharks or other highly informal sources to fund basic working capital needs. As a result, professionalisation, up-skilling, human resource-development, improving technology and gaining access to new technology, product development, more effective marketing strategies and other key business needs suffer. Additionally, the chances of SMEs being drawn into larger, deeper, more lucrative supply chains are reduced. The short-circuiting of SMEs access to finance also limits their ability to develop export opportunities. Unlike some other South-East Asian countries, for instance Vietnam and Thailand, there is a notable lack of direct contact between Indonesias SME sector and foreign buyers with the exception of some sectors such as wood products, garments and textilesmeaning that the export sector as a whole is dominated by larger players. As highlighted above, marketing linkages tend to be forged between SMEs and trading houses, distributors and other local intermediaries, with the result that income-growth and employment-generation potential is muted at the SME level. In addition, SMEs lack the information and expertise to penetrate export markets, are unable to adapt to rapid changes in foreign market conditions or tastes and, above all, struggle to accommodate time lags in payments often due to long shipment times. There is some evidence that rising internet connectivity is helping current and prospective exporters to access information on sales opportunities, inputs, raw materials, new technologies and machinery, but given Indonesias vast geography and significant disparities in connectivity and literacy across the archipelago, improvements are patchy.

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Another important factor which impedes more consistent export development among SMEs is that, since the financial crisis of 2008-2011, exporters are no longer able to collect payments by showing a bill of lading to their bank. Due to tighter regulations, banks are forcing them to await remittance of payments by the issuing banks into their accounts before releasing funds. Not only does this represent a significant time lag for cash flow-sensitive SMEs, but also, the slow turnover in cash means that they are unable to plan and initiate other activitiesfor example, servicing future orders in adjacent or even independent business linesuntil payment has been received.

Opportunities for the ADB IB Facility Whilst the litany of inefficiencies and structural and systemic imbalances highlighted above may appear to indicate that Indonesia is not suitable to an IB Facility, in fact, due diligence suggests that significant opportunities would present themselves for a vehicle, particularly if focused on debt (see Section IV below). Before briefly presenting them below, it should be mentioned, however, that it would be advisable for Facility interventions in Indonesia to take the form of debt rather than equity, although it may be possible to deploy equity in some specific cases. This is for two main reasons: first, because it is arguably on the SME sector that an IB initiative should focus; and second, because SMEs, by and large, have little familiarity with equity and are loath to allow external shareholders into their ownership structures. Furthermore, may are not sufficiently sophisticated to even have shareholding structures, which significantly augments the risk for external investors. Due diligence revealed that the following sectors, inter alia, would be particularly well positioned for debt allocations by an IB Facility: Financial Services: Although access to financial services has improved significantly in Indonesia at the individual credit level in recent years, primarily through the medium of microfinance provided by institutions such as Bank Rakyat Indonesia (BRI), as discussed above, all but the largest corporates and parastatals struggle to get access finance from formal institutions. The IB Facility could, therefore, work with financial institutions to develop products which are inclusive in the sense of enabling BOP incumbents to participate more fully in production and supply chains. Such products might include:

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Agricultural finance: including contract finance, warehouse finance, factoring, reverse factoring and products that facilitate access to improved inputs such as seeds, fertilizers, herbicides, pesticides, insecticides, machinery and so on;

Access to energy and clean energy more generally: including solar lighting, waste to energy initiatives, small-hydro, bio-gas etc.;

Cash flow-based products: At the more sectorally agnostic level, there is an opportunity to help financial institutions to create cash flow-based lending windows which would enable vast numbers of SMEs, currently excluded due to a lack of collateral, to get access to credit. With strategically-deployed technical assistance for training and implementation of risk management systems, financial institutions could begin to provide unsecured lending products admittedly, probably more to medium-sized than to small businesses in the first instancethe idea being that, over time, the institutions gain comfort with cash flow-based lending and credit risk assessment more generally.

Agri-business and agro-processing: In light of the dominance of the agriculture sector, and the vast potential for local producers to be drawn into domestic supply chainslet alone to develop export opportunitiesthere will be enormous opportunities in agribusiness and agro-processing. As more Indonesians enter the middle class, tastes are changing, meaning that demand for processed vegetable-based foods and dairy products has increased significantly. This presents opportunities for the IB Facility from two angles. First, it could look to lend at the medium-sized, and in some cases small business level. But second, it could look to lend to larger producers based in or near cities like Jakarta and Surabaya, that understand the long-term benefits of engaging with the SME sector in order to strengthen local supply chains and, in some cases, begin to go organic;

Value-added niche agriculture and aquaculture: Given the enormity of the Indonesian archipelago and its varied topography, small-scale producers of niche products such as spices, balms, essential oils, extracts and the like need to be connected not only with

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aggregators in urban centres, but also larger international producers of foods, cosmetics, medicines and luxury products. In many cases, such companies require urgent investment and technical assistance in branding, marketing, certification and so on. They also need to be connected with international purchasers;

Wood products: There is a clear opportunity in Indonesia to contribute to the development of sustainable use of timber resources by helping craft makers, furniture manufacturers and providers of flooring, wood panelling and other wood to procure raw materials from sustainable sources. A more sophisticated IB approach, additionally, would also help such businesses to work with local communities so that the latter are engaged in a more consistent way in supply chains, thereby improving the consistency and quality of supply to IB investees, whilst translating into increased incomes for local households;

Utilities: SMEs in many rural and peri-urban areas desperately lack consistent, quality utilities such as water, sanitation and energy. This provides an opportunity to lend to secondary and tertiary irrigation developers, waste water management companies, small-hydro and bio-gas companies and the like;

Manufacturing: Since the 1990s, Indonesia has successfully and prominently inserted itself into global supply chains of automotive parts and other components manufactures. This dynamic has been accelerated by off-shoring and out-sourcing from North Asian companies located in Japan and Korea, and even China, more recently, which have seen domestic manufacturing costs rise considerably. The opportunity for the IB Facility is twofold: supply-chain focused BOP engagement models looking to incorporate smaller producers of specific, often high-value added components into their supply chains; and employee-based BOP engagement models where there is an opportunity to influence the lives of significant numbers of workers; and

Transportation and Infrastructure: Although it might be assumed that transport and infrastructure investments would be too large for the Facility, given the geography of Indonesia and the need for highly-localised solutions, there may be opportunities to

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invest in smaller, transportation companies and infrastructure developers that are focused on areas that will significantly improve physical access for the poor, both in the personal and economic capacities. (See Section IV below for a discussion of the suggested size and key characteristics of an IB Facility for Indonesia, including returns, size, tenor and so on).

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VII.

Philippines

Macroeconomic and Political Landscape and Structural Challenges Although the election of Benigno Aquino III has been welcomed by many as a watershed moment in macroeconomic management and, crucially, the tackling of corruption in the Philippines, the country remains somewhat of a laggard compared to other members of the Association of South-East Asian Nations (ASEAN)-6 region. Not unlike Indonesia, this can partly be attributed to geographical challenges posed by an archipelago comprised of thousands of islandsthe cost of transportation and logistics in Philippines is exorbitant, for example however, independent economic analysts and ratings agencies concur that the outlook for the country is increasingly bright. The combination of a relatively well-educated population, much of which, in the service sector, speaks excellent English, has helped to make services exports a thriving sector in recent decades. Additionally, the Philippines has been able to make inroads in the development of a distinctive tourism destination brand, helped by security concerns in Indonesia and intermittent political instability in Thailand, its two major competitors. The agribusiness sector is also well-placed to capitalise not just on burgeoning domestic demand and increasingly sophisticated tastes and desire for processed foods, reflecting growing upward movement into the middle class, but also, greater regional demand (China is a notable source) for both raw and processed agricultural products. Importantly, at the structural level, the government has been successful in taming inflation, which is now well in single digits, and rapid currency depreciation is no longer a problem. On the contrary, the consistent appreciation of the peso since the late 2000s has eroded some of the artificial competitiveness which Philippine exports have traditionally relied upon. The longerterm advantage of this, however, is that it is forcing Philippine exporters to focus on productivity and efficiency gains, opportunities to move up the value chain and improve quality as a means of safeguarding existing export markets and creating new ones.

Structural Issues Affecting the SME Sector Given the preponderance of micro-, small and medium-sized enterprises (MSMEs) in the Philippines, and a significantly more populated middle ground between MSMEs and large corporatesthis is important with regard to the prospects for drawing the former into supply

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chainsthe prospects for an IB Facility are broadly favourable. The challenge, however, is that of the 761,000 enterprises registered in 2008, nearly 92% of them were micro-enterprises. This implies a degree of informality and lack of critical mass which makes it very challenging for formal institutions and larger companies to work with. In recognition of this, from the 1970s the government began to focus on providing access to finance and technology transfer to SMEs, and on improving information flowing to them. Few formal institutions would touch the sector, however, because of the perceived risk levels, even though the government had implemented protectionist measures to stimulate it. By the 1980s and 1990s economic policy focused on trade liberalisation, promoting competition among SMEs and helping them to gain market access. The focus on creating sub-contracting linkages with larger companies and the provision of financing and guarantees to exporting SMEs did begin to achieve more rapid and lasting growth rates in the sector, along with improvements in physical infrastructure (although patchy, depending on location), which facilitated access to markets. Despite the foregoing, the Philippine Development Plan (PDP) of 2011-2016 plainly acknowledges that the country has fallen short of its targets both for the SME sector as a whole, and inclusive growth more generally. Importantly, it recognises access to finance as one of the key obstacles to SMEs being able to play a more robust role in the economy and insert themselves into production chains more consistently. Whilst recognising that programmes such as the SME Unified Lending Opportunities for Growth, established in the early 2000s, which funds export finance initiatives and provides short-term working capital loans to SMEsmore than $600m of loans have been approved since 2003the PDP also acknowledges that all of the accompanying hand holding and value addition that SMEs desperately require, especially in the area of financial management and strategic planning, has been absent. Access to Finance Unsurprisingly, at the heart of the stunted growth record of SMEs lies the challenge of access to finance. Disappointingly, despite the many initiatives launched since the 1990s and 2000s, the volume of financing has proven too small, it has been skewed by the mandatory nature of credit allocation stipulated by various policy directives, and chiefly, has failed because a large proportion of government funds goes to livelihood, small-holder and micro-enterprise projects that often fail to achieve critical mass. Additionally, the Small Business Corporation (SBC) established by the government has relatively limited geographical coverage, and applicants

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complain of lengthy proposal evaluation times, general bureaucracy and an unwillingness to consider early-stage or start-up companies. At the same time, the banking sector has broadly complied with mandatory lending directives focused on the SME sector. The problem, however, is that much of the funding gravitates towards larger small enterprises and medium-sized enterprises, many of which are actually large enterprises that deliberately under-state their assets in order to qualify for funding. The general structure of the banking sector also exacerbates access to finance challenges. Banks in the Philippines are divided into commercial, rural and thrift banks, the idea being that this helps to ensure that credit does not flow only to large borrowers. From their establishment, thrift and rural banks were incentivised to lend to SMEs through mechanisms like lower capital and reserve requirements and access to re-discount facilities from the central bank. The problem is that even they are far too exigent vis--vis SMEs: familiar requirements of three years historical financials, lengthy business plans, cumbersome additional documentation requirements and so on. Banks also complain of the very high transaction costs associated with servicing the SME sector, choosing to focus instead on larger, safer clients. The governments MSME plan for 2010-2016 has once again highlighted access to finance as a key obstacle to faster growth in the SME sector and, encouragingly, mentions the importance of promoting inclusiveness as part of the MSME development and modernisation strategy. It points out that MSMEs are unable to meet the stringent and voluminous requirements of banks, that funds for start-ups are unavailable, and that interest rates still remain on the high side for many. It also highlights the fact that, theoretically, there should be sufficient funds in the banking system to meet the needs of SMEs, given that banks are mandated by law to allocate 8% of their loan books to SMEs.

Opportunities for an IB Facility in Philippines As in the case of Indonesia, the inimical operating environment and structural challenges that SMEs face in the Philippines creates opportunities for an inclusive business Facility. Perhaps even more than in Indonesia, however, significant technical assistance will be required in the Philippines to address issues such as sub-standard or non-existent financial record-keeping, poor or absent business plans, weak financial management, lack of understanding of sound cash flow management, poor marketing and client-outreach strategies and so on. The opportunities for IB in Philippines are not, however, limited to the SME sector. The linkages between larger

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corporates and aggregators are far more robust that in Indonesia, especially in the greater Manila area and in other major conurbations. In summary, this would enable to IB Facility to engage with the BOP through almost all recognised models. They are presented below, along with the sectors that might be categorised under them, although naturally, there will be crossover in many cases: BOP as employee models: Partly because of the preponderance of good English speakers, and also because of the service-orientated culture, Philippines has developed a prowess in call centres and related information services. This has provided the opportunity for many incumbents of upper echelons of the BOP to gain access to employment opportunities. Not only could the IB Facility look to invest in new labourintensive facilities, especially those beyond metro-Manila, but also, it could explore opportunities in:

transcription services: including the medical sector, legal profession, accounting, banking and so on. Some medium-sized firms are emerging (in contract to much larger call-centres) that are servicing regional and international (mostly US) corporates and financial and medical institutions. Such firms tend to be relatively labour intensive.

BOP as supplier models: Given the importance of agriculture and aquaculture to the Philippine economy, the IB Facility should definitely focus on incorporating small and medium-sized players into the supply chains of aggregators and producers. But the BOP as supplier model can incorporate other sectors in Philippines, notably the electronics and similarly semi-sophisticated manufacturing sectors (not to overlook more opportunities in more traditional manufacturing). As the trend of North Asian companies out-sourcing and off-shoring production of items such as chip boards and semi-conductors has intensified, Philippines has emerged as a major producer of semifinished or interim goods that lie below the high-tech prowess of Japan, Singapore and Korea. Such businesses tend to involve significant up-skilling of labour which, in turn, enables workers to command higher wages and preserves retention rates.

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BOP as consumer models: The delivery of key goods and services for the poor remains a challenge throughout much of non-urban Philippines. Given the geography of the country, franchise models are particularly relevant in segments such as primary and secondary education and healthcare. Similarly, demand for nutritional foods and beverages has sky-rocketed in the country, and not just among the middle classes, creating opportunities for more domestic production. Due diligence also revealed opportunities in the provision of essential utilities, such as energy (small hydro, wasteto-energy projects, solar), irrigation, waste-water management and so on.

BOP as distributor models: Again, in light of the geography of the country, franchising and devolved, localised distribution models are essential in order for companies to achieve scale domestically. The Facility will be well-placed to explore opportunities in key pro-poor market segments such as provision of solar lighting, remote medical diagnostics, e-learning and the like.

Access to finance: A cross-cutting theme opportunity which would provide significant investment opportunities in the Philippines is providing debt to financial institutions to develop new, inclusive financial products for BOP incumbents. The characteristics of such products are no different to those highlighted in Section II above.

IV. Key Issues and Recommendations Due diligence revealed a compelling case for establishing an ADB inclusive business Facility in Indonesia and the Philippines. Given that so many SMEs still struggle to access finance from formal institutions, and that larger, more forward-looking companies are becoming more familiar, even if gradually, with the concept of inclusive business, there is scope to establish a Facility of up to $100 million with the following key features: Focus on debt finance: Especially at the SME level, but also in many larger companies, there is an unfamiliarity with equity and an unwillingness to open shareholding structures to outsiders. Debt is a much more familiar modality, and from the Facilitys perspective, especially where smaller borrowers are concerned, it is important to establish the discipline of regular repayment;

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Prudent currency-risk management: Although the Philippine peso has appreciated significantly for the last four years, this will not necessarily be the case over the life of a facility, and the Indonesian rupiah certainly tends to depreciate fairly consistently. For this reason, the advantage of a debt-focused Facility is that cash flows will accrue throughout its life, meaning that they can be translated back into hard currency at the earliest possible juncture. This will not eradicate the impact of currency depreciation, but will help to reduce the effect on overall returns. This, in turn, is important from the perspective of replicability and scalability of future facilities;

Loans of $500,000-$10 million: Part of the rationale for incorporating Indonesia and the Philippines into a wider South-East Asian initiative is that both countries have the critical mass to provide larger opportunities that counter-balance smaller, and arguably riskier transactions in the Mekong region. It is even possible to conceive of larger loans beyond $10 million in the case of consumer and employee-orientated BOP plays in both Indonesia and the Philippines;

Fund management options: Neither country has a particularly well-developed private equity fund management sector. Many of the large, international houses do undertake transactions in both countries, but they tend to focus on deals that are far beyond the scope of the Facility. Due diligence has, however, identified managers based in Singapore and Thailand with deep relationships in both countries and expertise in completing transactions there. A prudent strategy for the Facility might therefore be to stipulate that such managers either establish a small, local presence in Indonesia and the Philippines, or enter into partnership with investment boutiques in which capacity can be built in inclusive business and undertaking relevant transactions.

Returns: Given that the Facility would likely have a debt orientation, with equity possibly to be used in a few, limited cases, it is likely that returns would be in the region of 4-7% per annum. In the event that quasi-equity instruments are used where some sort of equity kicker is possible, slightly higher returns might be feasible.

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Potential Investors: To some extent Indonesia and the Philippines fall between two stools. On the one hand, development finance institutions (DFIs) are experiencing unprecedented pressure on budgets, along with pressure from sovereigns to prove that they are investing in the poorest countries. On the other, there is certainly increasing interest in both countries among more traditional investors who are looking beyond the BRICs (Brazil, Russia, India and China) given the challenges experienced in the latter since the late 2000s. The trick will be to persuade the DFIs that including both countries into a greater Mekong Facility provides a welcome counter-balance to the Mekong countries, and that this stability will enable them to access investments more effectively via a pooled vehicle focused on broader developing South-East Asia. ________________________

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VIII.

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

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attributable to non-agricultural 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 countrynew, 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

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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 (longterm 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

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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 dove-tails 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;

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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.

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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.

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IX.

Pakistan

In many ways, the conditions for an inclusive business Facility in Pakistan are ideal: a highlyevolved 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-assupplier 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

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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, microinsurance for low-income 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

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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 hazards drought, 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 pre-finance 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:

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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

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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 nonexistent 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.

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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. _______________________________________

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