Multilateral Development Banks (most commonly referred to as MDBs) were created around 70 years ago to spur the sustainable development of their member countries.
Their business model remained relatively stable throughout the years. They raised capital resources from their ownership group and capital markets to fund projects in member countries. Their top-notch credit rating – AAA for all of them, including the African Development Bank (AfDB) – enables them to raise very competitive but limited resources from capital markets. This business model reaches its limit in a world where the Sustainable Development Goal (SDG) needs, evaluated at $3.9tn, dwarf the combined balance sheets of all MDBs and Development Finance Institutions alike.
For Africa alone, the SDG needs are estimated at $600bn, while the AfDB’s lending volume in 2017 was $8.7bn. Hence, the G20 call to MDBs to leverage the ‘billions’ of Official Development Assistance resources into ‘trillions’ of investments. MDB shareholders also urged them to explore innovative ways to optimise their balance sheets. The AfDB is at the centre of Africa’s transformation process. In response to the call for action, it devised a multi-pronged resourcing strategy including the optimisation of the Bank’s balance sheet.
For its sovereign portfolio, the most notable balance sheet optimisation transaction to date is the 2015 MDB exposure exchange, whereby the AfDB, the International Bank for Reconstruction and Development (IBRD) and the Inter-American Development Bank (IDB) reallocated their exposures from borrowing countries in which one of the participating MDBs is concentrated, to countries to which that MDB has no or low exposure. The exposure exchange reduced country concentrations and created an estimated $10bn additional lending headroom for the AfDB.
For its private sector portfolio, the AfDB, similarly to its peers, usually funds projects at inception stage, when the risks of implementation are highest. However, after ‘construction’, these projects are significantly de-risked and routinely attract private investors’ interest. This is the reason underlying the synthetic securitisation of a $1bn portfolio of approximately 50 loans from the Bank’s non-sovereign lending book, including power, transportation, financial sector, and manufacturing assets. The portfolio spans the entire continent, with exposure to borrowers in North Africa, West Africa, Central Africa, East Africa, and Southern Africa.
The transaction involves slicing the portfolio into different sequential tranches which determine the distribution of losses. The AfDB as originator of the transaction will retain the junior ‘first loss’ tranche; investors will take the second loss tranche; the European Commission (EC) will cover the third loss tranche, while the AfDB will also keep the senior tranche. This means that the losses on the portfolio will be covered first by the AfDB until the first loss tranche is fully depleted. Then losses will be allocated to the second tranche, the third loss tranche and, finally, to the senior tranche.
It is very standard for issuers to retain the first losses on a reference portfolio (the covered loans), as this aligns the interests of the AfDB and the investors and mitigates moral hazard on portfolio monitoring and recovery. As a result of this cascading structure, the senior tranche retained by the Bank consumes less capital and the structure will generate over $650m in additional lending headroom.
First of its kind
This transaction is the first of its kind among MDBs, but it is a relatively standard operation for commercial banks. We are using here a well-tested technology of the commercial banking world, but its transposition into the MDB world was everything except seamless. The AfDB is grateful to the investors’ group – namely Mariner and Africa50 – for their patience, while the rating agencies were evaluating the impact of the capital reduction of this technology on a non-granular, emerging market portfolio. We are also thankful to the European Commission whose senior mezzanine guarantee made the transaction commercially viable.
This vehicle will enable institutional investors, including pension funds (from the US, Canada, the United Kingdom, Switzerland and Africa), charitable organisations, corporations, state and municipal government entities, foundations, endowments, insurance and re-insurance companies and private family offices, to participate in the financing of infrastructure projects in Africa. We hope that this first ‘toe in the pond’ – so to speak – will embolden similar institutions to invest more on the continent in the future.
Is this a new world for MDBs where instruments such as securitisation will relieve these institutions from recurrent calls to shareholders for additional capital? It is a very early stage to assess the real impact of such transactions on MDBs’ balance sheets, their impact on MDBs’ preferred creditor’s status and rating assessment, and above all, market appetite for these transactions.
What is clear is these instruments will buy time between capital increase operations, enabling MDBs to operate longer with the same amount of capital. Using the ‘engine analogy’, these transactions improve the ‘fuel economy’ by lightening the load that MDBs carry on their balance sheet. This will enable them to carry forward longer; but the time will come when they will still have to stop by the ‘fuel station’ for a capital increase. n