Dialogue with Finnfund：An Innovative Pioneer that Combines Developmental and Commercial Goals

Mainly owned by the Finnish State, Finnfund is a development finance institution promoting sustainable development by investing in responsible and profitable businesses in developing countries. As of the end of 2019, Finnfund had a total asset portfolio value of 617 million Euros, and 75% of its new investment that year went to least developed countries or low- and middle-income countries. Finnfund provides businesses operating in Africa, Asia and Latin America with risk capital, long-term investment loans, mezzanine financing and expertise on investing in the developing markets.Finnfund puts special emphasis on sectors critical to sustainable development, namely clean energy, sustainable forestry, agriculture and financial institutions.

"Our long-term goal is that the impact performance generated by our investments and operating activities should be as rigorous and reliable as financial reports, and be independently and objectively verified. Impact cannot just be a good story. There are still different and non-standard ways of talking about impact in the industry, but everyone should at least have a common vision that impact should go beyond a good story. It is a strict, scientific and transparent process."

Q: Why did you join Finnfund in the first place and continue your work for 20 years? During these years, what major changes have occurred to Finnfund as a development finance institution?

A: Joining Finnfund may result from my experience of studying issues on both development as well as management and financing. I decided that I did not want to be a scholar, conducting academic research. I wanted to get involved in the real world, be innovative and get things done. I’ve been working for Finnfund for almost 20 years, and during this period, things have changed tremendously in our field. Our focus has shifted. Now we pay more attention to low-income countries and groups than in the past. We want to be an additional force to create a positive impact on what we do. There is much more funding available now, even in the poorer parts of the world. Commercial funds are much more involved in the society. Therefore, the European Development Finance Institution (EDFI) is also looking for self-improvement and ensuring the additionality of their movements.

I would argue that Finnfund was established as an impact investor 40 years ago, when the term “impact investor” did not exist. Our objective was not to make money but to have impact. At that time, our effort was named as contributing to economic and social development by investing in national and corporate projects, but in essence it was impact investment. The concept had a different appearance because the world looked different at that time and people then took another perspective.   Back then, capital constraint for development seemed to be the ultimate challenge for these low-income countries, and investments in fossil fuels rather than in renewable energy was not seen a problem.

When I joined Finnfund 20 years ago, the assumption in the industry was that we need to invest where there is a lack of capital. And we must be responsible and serve our clients in the same high-standard as is in the rich regions of the world, regardless of whether the local standards required it. At the same time, we drafted a list of negative industries for our investment, such as tobacco, alcohol, drugs, gambling, and guns. We would not invest in these industries, but would choose other legal industries. At that time, our investment activities were not called impact investments, but responsible or sustainable investments. It focused on environmental and social standards, and compliance with international standards, such as the International Finance Corporation (IFC) guidelines on environmental performance, the International Labor Organization (ILO) guidelines on social labor, and the United Nations Human Rights Guiding Principles.

Later, we began to add consultants on environmental and social issues to the team, or asked analysts and investment managers to do specific environmental assessments first. Then, we expanded to more environmental and social-related aspects in due diligence, and asked our clients to adopt relevant action plan. In the next few years, clients focused on seeking ways to establish a good management system. The premise of our funding included requiring them to invest resources to truly understand the relationship between themselves and environmental and social impacts, so as to be more serious on treating and managing related risks. Therefore, after the investment, our first step was (including the co-investors) to monitor the actual compliance of our clients with these requirements in accordance with the agreement standards. The second step was to gradually perceive impact in a more rigorous and logical way. We began to do all kinds of impact analysis, including the actual impact evaluation after investment withdrawal.

With the increasing experience, we have treated this process more and more rigorously, and even started to rank them according to the expected impact of the project, ask our clients to report their own impact expectations and compile some indexes with more detailed quantitative data. We now have a more international cooperation. We communicate and coordinate with other investors on things we are concerned about, including definitions and requirements for customer impact reporting. Participants in this type of investment transactions are usually large clients with multiple investors, and each investor has its own reporting requirements. Therefore, we will try to actively coordinate with them so that the investees can report in a standardized way, and avoid too much burden investors might place on the invested company.

Our long-term goal is that the impact performance generated by our investments and operating activities should be as rigorous and reliable as financial reports, and be independently and objectively verified. Impact cannot just be a good story. In addition, the impact we describe in the future should be comparable. It is based on a certain international standard with consensus. When talking about it among different investors and industries, we can all use the same vocabulary specifically with the same meaning. Investor’s description of the impact expectation requirements, the investee’s impact report, and even the third-party external verification methods should be consistent and standardized. Of course, we still have a long way to go. There are still different and non-standard ways of talking about impact in the industry, but everyone should at least have a common vision that impact should go beyond a good story. It is a strict, scientific and transparent process.

Q: Finnfund does impact investing with a very proactive and clearly articulated manner. Where does this motivation come from?

A: I think there are three different (motivation) sources. First, creating impact is indeed our mission. Our major investor the Finnish government, and our stakeholders have always paid close attention to the development of impact. And they want us to publish reports on impact.

The second motivation comes from our peer groups of development finance institutions which share similar goals and considerations regarding impact, including many members of the European Development Finance Institutions (EDFI) Association, the World Bank Group, regional development banks and so on. In this group, we are discussing and trying to formulate standards, which as a result also creates some healthy peer pressure and motive innovation within the industry, making everyone get more serious about this issue. We also believe that the public sector has solved many basic social problems (such as children vaccinations, school accessibility, etc.). But there are also needs for improving living standards, such as food, transportation etc., where the private sector can play an important role. As a development finance institution that mainly invests in private sector, we see that there is an increasing need to tell everyone the way development institutions can engage in private sector investment activities, which is also a completely legitimate part of our mission. What we do has positive impacts in reality.

The third motivation comes from our own desire to seek dialogue with private sector capital and actively mobilize private funds for social development. Now there are many investors including individuals, families, and mainstream financial institutions who also desire that their investment can create more impacts. They need to get some guidance to ensure that their entire investment portfolios create a positive impact on social and environmental goals in addition to avoiding harm. Regardless of investors’ specific environmental or social goals and their mission, we all hope to enter the vision of these investors and actively get them involved in impact investment in accordance with our mission direction. This is why we recently (June 2020) launched an OP Finnfund Global Impact Fund with Finland's largest retail financial group OP. The first round of fundraising has already exceeded expectations.

Q: Will Finnfund seek more diversified financing source in the future?

A: Yes. In fact, 95% of the equity part of the funds comes from the Finnish national government. But apart from that, what sets us apart from other development finance institutions (DFIs) is that we are a leveraged business. We do borrow funds through banks to support our investment activities, and the government doesn’t provide guarantee for our loans, which I think is also our advantage.

An important difference between the way we cooperate with OP Group funds and the way we borrow from the commercial market and then invest is that the investor does not take our credit risk, but the risk of the invested project as our co-investor. Therefore, their exposure to risks has increased. Moreover, these investors invest specifically with us because of the "impact" appeal, and they want to see clearer content on this point. Therefore, we are under great pressure, and we must be able to answer these questions clearly in our work: What kind of impact do we hope to seek from each investment? How do we know that we have achieved the impacts? What are the specific commitments made by us and the invested company? What do we hope to achieve? And how should we report and explain, so as to be able to say that we have actually achieved the promised impact?

Q: Taking the impact fund cooprated with OP as an example, what requirments do LPs have the on financial return?

A: The specific return depends on the assets we invest in and the type of risk we take, but the overall goal is to obtain a mixed yield of about 10-12%, in which the expected return on equity investment is significantly higher, and some other investments in debts may be slightly lower.

Q: What is key to successs to convince institutional investors to join you in impact investing ?

A: I think a key part is that we need to convince institutional investors and family offices in our work professionalism, that our work in financial analysis, deal structuring, legal work and documentations are done professionally. We also need to make investors see that we assess social and environmental impacts properly, and have a system to manage relevant risks. Another key aspect is to show clearly where we anticipate to have impact, followed by impact reporting, monitoring and outcome validation - all of which are done properly and professionally. This successful fundraising with OP Fund is also an endorsement of our work in this field for many years. I think we have become a professional player and a credible partner too.

Q: We have seen that Finnfund mainly invests in poor and underdeveloped areas, but achieved good financial returns.   What is the secret for success?

A: One of our biggest interests over the years is innovation. We hope to go to the frontier of funds and seek to be ‘additional’. We believe that when you invest in places with lower incomes such as emerging markets, the risks will indeed be higher. However, if you adopt a diversified investment portfolio, the risks taken are properly compensated, and it is still possible to generate reasonable and substantial returns.

In addition, although there are still civil wars in some poor countries in which effective investments are difficult to be made for certain. Overall speaking, number of countries with civil war has reduced, and the number of countries implementing completely irrational economic policies has also reduced. For example, the economic environment for investing in Africa used to be very chaotic, unpredictable and extremely difficult, but now many African countries have greatly improved their economic policies. If you take half of the relatively better countries on this continent, their policies are quite reasonable, and it is entirely possible that investment in these countries will give relatively good returns. Of course, I’m not talking about every African country, but the better half - which is not necessarily the richer half. It is the half with a more reasonable policy environment. These markets provide reasonable options for making responsible investments.

On this basis, to successfully invest in these regions, an understanding of individual country markets is crucial. Investors need to know the differences between countries, and really study the country and industry they invest in, in order to successfully tap valuable investment opportunities.

Q: Does Finnfund still have active investments in China?

A: Now we are not investing in China. But in the 1990s, the China was actually our single most important investment area. At the turn of the century, there were a lot of positive innovations in the market, and to some extent, capital constraints. Looking at China now, liquidity in the market is ample, and competition among capital is fierce. Officially, China is still listed as a middle-income developing country by the OECD, which, in principle also belongs to our investment universe. But we have not made investments in China for a number of years - I think that might remain so in the future. Russia is a similar example, where we have withdrawn from although it is also part of our investment universe in principle. The main reason is that we are really concerned therefore focused on places where there is still insufficient funds and the capital needs for development have not been satisfied yet.

Q: Do you adopt any facilities to mitigate risks arising from investing in frontier markets?

A: We know that many development finance institutions or other impact investors do have some risk mitigation tools, or growth preparation facilities, and there are some "soft" funds or grants that can be used for project preparation. But we have none of these. Although this may be a handicap compared with other development finance institutions, that also focuses our mind strongly on finding good commercial players. To some extent, we are not chasing the problem, but chasing the solutions of the problem. And the teams that have the solutions.

In addition, because we are in relatively small scale compared to many other development finance institutions, we often invest in companies in their early stage. In a sense, our funds are to help these companies become bankable or investible in the eyes of larger commercial investors, so that they have a good start. While many larger investors may complain about lack of investible projects in the impact market, we are part of the solutions here. Thanks to our early investment, these companies can become potential credible investment opportunities for larger investors that join at a later stage.

Q: How is Finnfund’s development mission reflected through making early-stage investments?

A: We believe that Finnfund can truly fulfill its own development mandate, using part of the funds to take certain risks early on and back founders and teams who are on something potentially big . This could help achieve our development goals rather than hurt.

An example of how DFIs can indeed achieve development goals in this way is, at the beginning of 2000, mobile phone operators in Africa were mostly funded by DFIs. At that time, commercial investors were not fully convinced of the commercial potential in this sector. They thought: Will Africans who don’t even have shoes need to use mobile phones? Later, similar stories also happened in the field of renewable energy. For example, the solar power sector today has become far more competitive, but DFIs were also on the forefront there before. Now, we are actively looking at some new fields, such as agriculture sector. In our investment areas, many countries are developing rapidly, and cities are getting bigger. But at the same time they are very fragile in food supply chain and are highly dependent on imports. In our opinion, this sector is a very interesting one with both commercial opportunities and significant developmental impact.

Q: How does Finnfund consider in exiting an investment project?

A: The starting point in any of our investment is to have some ideas on how to exit before we invest any penny. In other words, without understanding and thinking about exit, no investment will be made. Of course, the time scale of exiting different projects will differ.

Especially in low-income countries, investors need to be more patient. Many private equity companies have a 10-year fund lives. In practice, this usually means that the actual investment period for each investment is 4 to 6 years, which is very short. 4-6 years may or may not be enough. I think that there is a high risk. Therefore, in general, capital needs patience - of course, different industries will be different. As far as agriculture or forestry area that we are interested in, longer investment horizon is needed. If there are larger players who want to enter these industries and buy the platform we helped develop - this is very lucky. But we can’t just count on this.   And we still need to be patient and be prepared for long-term investment.

From another perspective, if a company is managed in a highly responsible way, for example, everything it does is based on high international standards. Then chances are higher that larger international investors are interested in this type of companies when they look for investment opportunities. The possibility of being acquired will be higher, because the last thing such investors want to see is companies that may embarrass them in the future (such as certain operational scandals). So far, some of our best exit have been cases where what we have been investing in are seen as a sort of platform for an international player to come and make much bigger things. And they are regarded as credible acquisition targets. We are also willing to exit from the projects and enterprise platforms we have built for international players, who will do bigger things faster and   more effectively thanks to their resources and manpower. For these big players, they need acquisition targets to be completely clean, such as no corruption or environmental pollution issues. As a DFI, we have spent a lot of energy investing and managing in a responsible manner, which obviously has added value to the investees. We have turned them into good companies that large investment institutions can trust.

Q: How can government and public sector engage in impact investing effectively?

A: At present, I think that the private sector approach in development has been relatively successful, and more and more governments have decided that supporting private sector development is actually the way to go for achieving impact. While traditionally almost all public sector organizations have involved in private sector investment for a long time, I don’t think they have been particularly successful. Direct investing in the private sector is fundamentally different from supporting it.

I would argue that it is a better way for the public sector to leverage on for example, impact-oriented financial institutions with a development angle or policy angle (such as policy banks, who have a mandate of "not losing money"). From the perspective of Finnfund and some innovative institutions similar to us, the biggest problem for most public sector institutions is to think that it is easy to find reasonable investment opportunities in the private sector. In fact, the risk come from outside the system. There is greater risk to get carried away and end up investing in well-meaning but not commercially viable ideas. Therefore, for public sector, it is a good starting point to invest with a "no-loss" mindset with adopting commercial thinking.