As we engage with our Cohort 1 participants and applications continue to come in for Cohort 2, we get a lot of questions on raising international capital. If you’ve been out attempting to raise capital or have already done so, you know there are a myriad of challenges you will face as an impact fund manager looking to secure capital from international investors. This is especially true for first time fund managers. Although each will have specific nuances, any foreign investor will take into account questions such as:
- Is foreign investment in a local financial services entity (fund) permitted?
- Is foreign investment in target sectors regulated?
- How well developed is the local legal system with respect to financial services and investment vehicles?
- Is there a robust and competitive private sector, not distorted by aid?
- Are government regulations capricious in their application to private entities and to foreign investors?
What does this mean for impact fund managers in frontier markets?
Impact fund managers should know the rank of their target investment geography on the World Bank’s annual Ease of Doing Business’ Report. LPs will know this information or they will have assumptions influenced by similar reports. It’s important context as when you’re out raising money it’s your job to convince a potential investor to go beyond the rank on the list and consider the opportunity you are presenting with your impact fund.
Since investors will likely not be experts in your regulatory environment, local fund managers should help them understand the nuances. A good start is to develop an internal “Frequently Asked Questions” document with the hardest questions you expect to hear or have heard from potential investors. Be proactive about highlighting your plans to address things that you already know have been raised as potential issues early in the investment process.
How Capria and others think about the diligence process
Below are a few of the broad areas we consider as part of a preliminary diligence exercise. We would recommend teams consider these areas as well as they approach international investors:
- Foreign Direct Investment (FDI) and exchange control issues: In order to secure international capital for your impact fund, you will need to know
if FDI is restricted in the target country or investment sectors. You’ll need to know the processes that need to be completed to make an investment enforceable. Depending on where the investment lies on the risk-return spectrum, the nature of the restriction on foreign investment could differ. For example, Zimbabwe caps foreign ownership of local companies and requires government approval for raising external loans above a certain threshold. Exchange control issues also need to be investigated to ensure investment proceeds can be fully repatriated, and to evaluate if any approvals are required for paying out investors. Using the Zimbabwe example again, a cap has been set on the margin (including interest, fees, etc.) that local companies can remit on external loans, shareholder loans and vendor financing loans on principal repayments.
- Tax issues: Where investment occurs through a regional fund that is not necessarily located in the investee company’s domicile as is the case for many fund structures, the potential tax issues multiply accordingly. To illustrate, investors in Germany invest in a fund in Mauritius that is making investments in companies in South Africa, Mozambique and Zambia. Some of the typical tax-related questions that fund managers can expect pertain to withholding tax on remittances and the presence of a Double Taxation Avoidance Agreements (DTAA) between the remitter’s country and the receiver’s country. Some non-typical tax issues that may arise are outlined below:
- Management fees: Separate withholding taxes are levied in some countries like Uganda on management fees or charges. Where the remitter’s country and the receiver’s country have entered into a DTAA, lower withholding rates may apply.
- Associated / related party transactions: Where the investment is being made through a combination of equity and quasi-equity, the investor may be considered an associated / related party of the investee company. In such a scenario, the parties will be required to comply with any transfer pricing regulations in the country where the transaction is being executed. Uganda, for example, requires ‘associates’ (defined broadly) entering into transactions that in aggregate equal to or exceed approximately USD $150,000 in a year, to maintain sufficient documentation verifying the arm’s length nature of such transactions.
- Branch / permanent establishment issues: We find that it is not only important to collect information on the fund’s domicile but to also enquire as to the nature of local presence proposed to be established by the fund managers in the target countries (where the fund is incorporated as an offshore fund). In some cases, local presence could incur separate branch corporate income taxes for fund managers, in addition to withholding taxes on revenues and fees. For this reason, many funds have only “advisors” operating in local countries with such establishment issues.
Other impact investors share information on their diligence process as well. For example, the Toniic e-guide on early stage global impact investing suggests a couple of key diligence steps that you will want to keep in mind as a fund manager looking to raise global capital such as:
- Checking if any sanctions imposed on the country prohibit or restrict the investment.
- Personal vetting will be conducted. As a manager, if there is anything that could be raised as a concern for any reason at all to an investor, it is best to be upfront about this as it will likely be uncovered by limited partners during DD.
- Vetting the necessary registrations / approvals required to be obtained by each of your entities and verifying your legal authority to enter into the proposed transaction.
- Ensuring that each of your entities comply with applicable anti-bribery and anti-money laundering laws.
As we progress through our engagement with and evaluation of Cohort 1 and future cohorts, we will refine this exercise even further. In the meantime, we hope that our analysis will be helpful to aspiring fund managers as potential international investors conduct due diligence. We welcome your thoughts and suggestions! Please feel free to contact us.