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26 October 2011

Inclusive Business Fund in Asias Mekong Region

A US$100 million Fund Promoted by ADB Investing in Businesses Serving the Poor and Low-Income Households in Cambodia, Laos, Thailand, and Viet Nam Concept Paper

STRICTLY CONFIDENTIAL

Executive Summary
The Asian Development Bank (ADB) plans to promote the South-East Asia Inclusive Business Fund for the Mekong region (the IB-Fund) in 2012, a targeted US$100 million vehicle deploying debt and equity in private companies in Vietnam, Cambodia, Laos and Thailand (the Region). The Fund will invest US$0.5 million to US$10 million in businesses that help to improve the livelihoods of people living at the base of the pyramid (BOP). It will target portfolio companies whose growth strategies and scalability are predicated on enhancing access to, and increasing the affordability of, innovative, poverty-reducing goods and services in key sectors such as agriculture, healthcare, sanitation, water, clean energy and financial services, among others. The IB-Fund differs from a traditional, sectorallyagnostic small and medium enterprise (SME) development funds by targeting innovative businesses which will generate commercially attractive returns and address pressing social challenges. Extensive due diligence undertaken by ADB in the Mekong region has highlighted the potential for SMEs to address pressing social (and environmental) challenges for the poor1 through inclusive business-orientated innovations and solutions. Indeed, the contribution of the SME sector to poverty alleviation could be far greater, yet its potential often remains unrealised because most SMEs struggle to access affordable, appropriate financing, above all risk capital. As a result, SMEs fail to benefit from the attendant value addition and expertise that accompany patient capital. In response to these challenges, ADB is seeking to partner with development finance institutions, donors, foundations and the emerging impact investment community to launch the Fund, the first of several vehicles planned for various Asian sub-regions between 2012 and 2015. The investment activities of the Fund will be tendered to a professional fund manager based in South-East Asia, following a request for proposals (RFP) to be issued by ADB and partner investors in January 2012. The purpose of this Concept Paper is to provide an overview of the Fund as currently envisaged by ADB and to serve as a basis for discussions with prospective partner institutions in November and December 2011. This consultation process will enable partners to provide feedback on the Fund design as it is finalised. In so doing, ADB is hopeful that by the time the RFP is issued, several institutions will have soft-circled commitments to the Fund and its accompanying technical assistance facility (TAF; see below), thereby enabling them to participate fully in the manager selection process.

Investment Opportunity and Fund Strategy

According to ADB analysis, approximately 82% of Asias population lived on less than US$4 per day in 2005, the latest year for which purchasing power parity (PPP) data are available. ADB estimates also indicate that 54% of the population lived on less than US$2 per day, the
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Thisreportdefinesthepoorinabroadercontextasthoselivingbelowthe$3perdayinternationalpoverty lineandbeingsociallyexcludedfromaccesstoservicesandincomeearningopportunities...

international vulnerability line, and 27% on less than US$1.25 per day, or in extreme poverty. Although relatively high GDP growth between 2005 and 2009 helped to lift more Asians out of poverty, the combination of the subsequent global economic slowdown, high energy and food prices, accelerating consumer price inflation, requires additional efforts to address vulnerability and poverty by making growth more inclusive. As many Asian governments struggle to allocate limited resources to key social sectors, ADB believes that risk capital and private sector disciplines need to be mobilised to support companies well-positioned to be powerful forces for poverty alleviation by achieving rapid, inclusive growth, generating employment opportunities, and providing key goods and services. Specific characteristics and recent developments which have led ADB to select the four target countries include the following: Vietnam: The financial crisis and economic slowdown in Vietnams key export markets, notably Europe and the United States, caused an unprecedented collapse of the capital markets in 2010, exacerbated by persistent double-digit inflation. Private companies are struggling to access finance, whether debt or equity, from any sources. With many companies now focused on domestic demand in order to reduce reliance on volatile export markets, there are compelling investment opportunities at reasonable valuations in BOP-relevant sectors, including agriculture, fisheries, healthcare, sanitation, education and clean energy, among others. It is anticipated that the Fund will invest up to US$50 million in 6-8 transactions in Vietnam. Cambodia: Although investing in Cambodia is challenging, due diligence has highlighted opportunities in several relevant sectors such as agro-processing and agricultural inputs, financial services and clean energy. Following the sharp decline in Cambodian exports since 2009, more looking Cambodian business owners are considering the benefits of partnership with foreign investors and the need to reduce reliance on punitive short-term debt financing. Deals will have to be carefully selected, and corruption is a formidable challenge, but the Fund will look to deploy up to US$15 million in 3 or 4 Cambodian companies. Laos: The least developed of the four target countries, Laos is nevertheless encouraging greater foreign investment and its regulatory environment is gradually improving. The Fund will take an opportunistic approach to investments in Laos, either investing directly or through Vietnamese and Thai businesses expanding into the country. There are interesting investment opportunities in agriculture, natural resources, clean energy, infrastructure, logistics and transport. The Fund could invest up to US$10m in 1-2 transactions in Laos. Thailand: A critical distinction must be drawn between the highly-developed economy and infrastructure of the greater Bangkok area, and much of the rest of Thailand. Poor infrastructure, limited access to, and poor quality of, key services, such as healthcare and education and important factor inputs for agriculture remain problematic for large swathes of the country. This presents investment opportunities in many of the sectors listed below. In addition to promoting investments in under-attended, poorer parts of Thailand, it should be noted that its inclusion in the Fund will provide an important counter-weight to more politically and economically volatile neighbours in the Mekong region. It is anticipated that up to US$25 million of investments will be made in Thailand, with a

4 particular focus on Northern provinces and the agricultural corridors that have begun to open with other Mekong countries.
Mekong Inclusive Business Fund: Investment Profiles total investment number of thematic focus and sample sectors (up to million USD) transactions 15.0 3-4 income generation and jobs (agro-processing) municipal services (financial services, clean energy) 10.0 1-3 income generation and jobs (agriculture, natural resources, logistics and transport), municipal services (clean energy) income generation and jobs (agricultural corridors) social protetcion (health care) income generation and jobs (agriculture, fisheries, education), municipal services (sanitation, clean energy) social protetcion (health care)

Cambodia

Lao PDR

Thailand - outside Bangkok (subregional cooperation areas; Northern provinces) Viet Nam

25.0

3-5

50.0

6-8

Total

100.0

13-20

In addition to standard financial performance, the development impact of the Fund will be assessed with regard to its sustainable and systemic contributions to poverty reduction and inclusive growth. To this end, ADB is developing an ex-ante impact assessment tool that will indentify and promote portfolio companies contribution to poverty reduction. The tool will also be used to assess the performance of the fund manager and will form part of the incentive structure.

ADB has identified the following thematic areas and sectors as particularly relevant to the Funds BOP investment thesis: 1. Employment generation and increased incomes for the poor: Agriculture: There are investment opportunities across the spectrum of agriculture in the target countries. Despite fertile soil, a broad range of crops and vast potential for organic farming, primary production requires technology, know-how and modernisation in order to scale. Yields are also hampered by poor co-operation among farmers, limited social organisation and infrastructure constraints. Agroprocessing, in turn, often suffers from erratic supply and quality not only due to value chain dislocations, but also because of volatile relationships between producers and aggregators. Additionally, there are severe shortages of key agricultural inputshigh quality seeds, fertilizer, pesticides, tools, machinery, tractors and so onoften because domestic producers cannot finance investment. Aquaculture: Despite strong demand for seafood and fish sauces, fisheries and fish processing are limited by scale and erratic supply. Investment is needed to expand and consolidate operations, particularly in Vietnam and Thailand. Light Manufacturing: Outsourcing to South-East Asian countries and production for domestic and export markets make manufacturing a clear focus for the Fund. The investment policy will, of course, be designed to ensure that only manufacturing opportunities relevant to the fund thesis are pursued, but it should be remembered that many factory employees tend to be BOP incumbents.

2. Improving living conditions: By focusing on the provision of public goods, through the provision of municipal services, for example, the project will improve livelihoods and and achieve savings for poor households. Sample investments will include the following sectors: Clean Energy: The absence of national grids, inadequate energy generation and, in some regions, limited or no electrification, is producing investment opportunities in small hydro-electric facilities, waste-to-energy operations, bio-fuels and associated distribution and logistics, especially in Vietnam and Cambodia. Moreover, there are cross-cutting linkages with agriculture in cultivation of relevant crops (jatropha and corn), which has elicited investor interest in northern Thailand and southern Laos. Utilities: In several countries, regulatory regimes allow private provision of services such as sanitation, waste-water management, transport services, tertiary irrigation and electricity. Generally, it is poorer populations in both rural and urban contexts that suffer from intermittent or inadequate utilities or no supply at all. However, there is certainly no shortage of demand, providing significant investment opportunities for the Fund.

3. Social protection for the poor: Investments in health and financial services for social protection will make the poor more resilient against life, health, environmental and climate change, as well as economic risks. Healthcare: Public sector healthcare provision throughout the Region is stretched, inadequate and often of poor quality. With a population approaching 90 million in Vietnam alone, there are enormous opportunities for private hospitals, clinics and diagnostics centres to penetrate under-served or unattended provinces and serve the poor. There is also significant demand for distribution and retail of pharmaceuticals, medical consumables and hospital supplies, and manufactures of medical devices, furniture and equipment, all currently met through expensive exports. Financial Services: Although traditional microfinance is well established in Vietnam and Cambodia and, to a lesser extent, in poorer regions of Thailand, productive and social sectors require a broader range of tailored financial products, including: Agricultural finance: commodity-based finance such as warehousing, factoring and reverse factoring; Insurance: micro-health insurance, disaster and crop insurance, vulnerability schemes; and Leasing: especially for the agriculture sector, to address working capital constraints and the inability of many companies to undertake major capital expenditure.

While in poorer parts of the Region, especially Cambodia and Laos, millions of people still have no access to formal financial institutions, the Fund will not target consumer-orientated financial services. All financial services investments considered by the Fund will have to demonstrate clear social impact that supports inclusive growth and poverty reduction. This should principally be achieved through product innovation, outreach and depth of addressing systemic poverty problems.

Thematic focus: While all investments made by the Funds must, of course, be commercially viable and meet the Funds return criteria, it is important to highlight the crosscutting themes and opportunities which will also inform the investment policy, including: Last-mile solutions: Extending infrastructure, energy, utilities, communications and information technology to marginalised and excluded communities; Smallholder engagement: training and working with smallholders, from whom procurement is then possible on a reliable and consistent basis, boosting their incomes and reducing vulnerability to exogenous shocks; Affordable social services: making education, health, and social protection services at all levels accessible and affordable for low-income groups, especially youths and women; Promoting gender balance and social inclusion: Investment proposals that actively promote gender objectives and the inclusion of otherwise vulnerable groups (including children, youths and the elderly);

These themes also highlight the three main ways in which the Fund will conceive of the base of the pyramid in the investment context: 1. Producers: more effective inclusion of BOP producers in supply chains and value chains as an intrinsic dimension of portfolio company growth strategies; and 2. Employees: Improved working conditions, earning capacity, mobility, opportunity and security, and introduction of employee share ownership schemes (where appropriate and supported or championed by portfolio companies). 3. Distributors: Creating of new income opportunities for the poor by engaging them in the distribution networks that develop BOP markets with relevant, affordable and scalable goods and services 4. Consumers: Improved access to, and affordability, choice and quality of, public goods and services for poor (such as municipal services, clean energy, health care and social protection), disadvantaged, marginalised and/or excluded individuals and communities. The project will not finance business ventures where the main focus is to engage the poor as individual consumers of non-public goods.

The investment policy will be designed to ensure that investments are only made if they demonstrate clear impact in relevant thematic areas, such as those highlighted above, and that the manager is incentivised to maximise development impact by incorporating the above BOP engagement strategies into growth plans developed for, and in partnership with, portfolio companies.

Access to Finance and Private Equity in South-East Asia

ADB considers that the Fund also responds to formal financial institutions reticence to service SMEs in the Region. Simply stated, financial exclusion still represents a significant constraint to growth and private sector development. Stringent collateral thresholds in the

form of land and fixed assets, unrealistic requirements for audited historical financials and the absence of cash flow-based lending all exclude many businesses from access to finance. Moreover, risk capital of up to US$10 million, especially in the form of equity and quasi-equity, is rarely available in Vietnam, difficult for Thai companies to access beyond the greater Bangkok area and virtually non-existent in Cambodia and Laos. The Fund will contribute to alleviating this chronic constraint by providing risk capital to businesses that otherwise turn to predatory semi-formal or informal sources of funding, often at punitive interest rates and with financial products not necessarily designed to help the poor in a sustainable and systemic way. In addition, Fund investments in financial institutions will help to address access to finance issues by specifically targeting those seeking to develop pro-poor products and extending them to under- and un-banked population segments.

Development Impact at the Base of the Pyramid

The ADB has engaged a recognised expert to create a pragmatic tool for assessing the potential development impact of portfolio companies ex-ante, and a monitoring and evaluation (M&E) framework which will be used to assess the development impact of Fund as a whole. Additionally, drawing on best practices from existing impact investment vehicles, the Funds social objectives will be embedded in the investment policy, and will be incorporated into the remuneration structures used to incentivise the manager. In summary, the greater the impact achieved by the managerthe impact itself deriving from growth and scale based on enhanced access, quality and affordabilitythe more upside available to the manager in the form of carried interest. ADB believes that the Fund should adopt a broad definition of poverty when considering development impact, and in this context, the World Banks definition of pronounced deprivation in well-being is instructive. The Fund will support ADBs strategic focus on poverty reduction through the promotion of inclusive growth, i.e. a development process and outcome that creates more economic and social opportunities for low-income groups.2 The M&E framework will therefore select social and socio-economic indicators relevant to each sector and sub-sector and complement them with more qualitative analysis that assesses issues such as opportunity, vulnerability, empowerment, security and mobility, among others. In addition, the M&E framework will focus on the following important themes: Supply-chain strengthening: Building mutually-reinforcing relationships between producers and aggregators to address quality and consistency issues that dislocate supply chains and impede income growth for the poor; Reduced income volatility: Smoothing income flows for poor producersespecially in the agriculture sectorby helping them to form co-operatives and associations (where appropriate and possible) and strengthening their relationships with aggregators and processors;

ADBs inclusive growth concept does not focus specifically on the very poor (i.e. the $1.25 a day international poverty line at purchasing power parity rates of 2006) and broadens this to the $2 poor and socially excluded groups. For this project the targeted beneficiaries are mainly the vulnerable children, women and men in Asia with income up to $3 a day. For more information on ADBs Inclusive growth approach and how to operationalize it see http://www.adb.org/poverty/inclusivegrowth.asp

8 Social capital formation: enhancing, through improved access to relevant goods and services, what the World Bank defines as the institutions, relationships, attitudes and values that govern interactions among people and contribute to economic and social development; Value-addition and value-capture: Especially in poorer countries such as Cambodia and Laos, moving up the value chain to capture and retain more value domestically, thereby boosting local incomes, increasing market share and enhancing competitiveness; and Business formalisation and professionalization: Improving management capacity and corporate governance in the portfolio so that a cadre of well-managed businesses remains long after the Fund exits.

Acknowledging that few fund managers incorporate social objectives into their investment processes to the extent envisaged for this Fund, ADB will provide significant support and mentoring in this domain. In addition to making technical assistance funding available (see below), guidance will be provided through the Fund Advisory Board, which will benefit from the participation recognised experts in the area,including from ADB, its partners, and further afield. In this regard, the teams willingness and ability to co-operate closely with Advisory Board members will be carefully assessed in the manager selection process.

Technical Assistance Facility

It is evident from the Investment Strategy that significant technical assistance will be needed for the Fund to achieve its financial and social objectives for three reasons. First, the commercial viability of many transactions will require deep engagement not only with portfolio companies, but with their suppliers and many other stakeholdersthat considerably exceeds usual interaction levels between fund managers and portfolio companies. Second, the fund manager will require training and support in integrating social criteria into the investment process. Whilst it will, of course, be crucial to select a fund manager that is committed to the social and financial objectives of the Fund, investors should be mindful that few fund managers in the region have significant experience in impact investing. Third, most Fund portfolio companies will be rudimentary insofar as management, governance, accounting and reporting are concerned. Additional resources will be needed to help businesses professionalise.

In ADBs view, the technical assistance facility (TAF) should be capitalised at 3-5% of the total commitments of the Fund. While the TAF may be implemented independently from the fund manager, part of its resources will be made available to the manager in support of the social and commercial objectives of the Fund, specifically focusing on the following activities: Fund manager training in promoting social impact: Social interventions and non-financial value addition strategies; Poverty assessment and BOP analysis;

9 Development impact assessment and application of the M&E framework.

Portfolio company training: Development of inclusive business strategies; Value chain development and supply chain management; Management capacity building and corporate governance strengthening; Accounting, financial management and controls; Marketing, stakeholder engagement and customer outreach; Management information systems and ICT development.

Supply chain engagement: Outreach, training, extension services and education (agriculture/fisheries); Producer organisation, co-operation, collective bargaining; Manufacturing and production training and best practices; Environmental and social management, health and safety.

In addition the TAF will support sector focussed capacity building engagement with the governments to ease the business environment for Bop ventures. The TAF will have its own transparent corporate governance structure and will be run by a technical assistance committee comprised of contributing investors, one member of the investment team and an independent social impact specialist. The TAF will not support the day-to-day operations of the Fund, such as due diligence. Particular attention will be paid to ensure that TA Facility resources are not used to support or subsidise day to day operations of portfolio companies, nor for capital expenditure. Applications for technical assistance will be submitted to the TA committee by the managing director of the Fund and will require unanimous approval.

Fund Manager Selection, Fund Terms and Timetable

Given the limited number of experienced fund managers in the Mekong region, ADB will solicit responses to the RFP from asset managers throughout South-East Asia including countries such as Malaysia and Singapore. The challenges associated with investing successfully in the target countries should not be underestimated, and therefore investment acumen and transaction experience must be at the forefront of manager selection criteria, in addition to experience in impact investing. Managers not located in Mekong countries will have to demonstrate extensive experience and engagement in the Region, and that they have, or are committed to establishing, deep partnerships with local investment professionals. ADB believes that it is important for the target return of the Fund to reflect the challenging nature of the geography and the dual investment thesis. Extensive due diligence in the region suggests that a net internal rate of return (IRR) of 10% is realistic for a fund of this nature, however the manager will of course be encouraged to exceed this (within the contours of the investment policy).

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The principal terms which ADB will propose to fund managers are presented below, subject to discussion and input from fellow investors in the Fund. With specific reference to carried interest, ADB believes that an additional 5% of carried interest beyond the traditional 20% should be made available to the manager if exceptional performance against BOP targets can be demonstrated.

Target Fund Size Minimum Commitment Target IRR Preferred Return Carried Interest Organisational Fee Fund Management Fee Fund Managers Commitment

US$ 100 million US$ 5 million 10%, net of carried interest, fees and expenses 6% 20% to the General Partner, with an additional 5% available for exceptional poverty reduction and inclusive growth outcomes Up to 1% of total capital commitments 2.5% 0.5% of total capital commitments

Following discussions with prospective partner institutions, ADB plans to issue an RFP in January 2012, with a view to interviewing prospective managers starting in late-February. Ideally, ADB would like fellow investors to participate in the manager selection process and, of course, negotiations with the successful candidate thereafter. The intention will be for the Fund to be operational the fourth quarter of 2012.