Strategic Investment Funds

The past 15 years have seen the rapid proliferation of strategic, government-sponsored investment funds that, in addition to generating returns for their investors, are tasked with catalyzing capital flows to priority sectors of national and regional economies. Their role goes far beyond the provision of public capital. Wellmanaged strategic investment funds (SIFs) can create opportunities for attracting private investment, deepening domestic capital markets, and building the capacity of governments to act as professional longterm investors. At their best, SIFs bring highly specialized and sector-specific expertise to the structuring and financing of investment projects. Their presence as co-investors provides some degree of implicit political and regulatory risk insurance for private investors, particularly for infrastructure projects, which are generally more exposed to sovereign risk. 

However, a review of the existing literature suggests that the establishment and operation of SIFs is not without challenges. Efficient operation of these funds requires a high level of fund management capacity, independence, and transparency. To be successful, SIFs need to balance policy and commercial objectives, source investment opportunities well, and secure the right staff. Although SIFs have been around for a few decades, they have not until now been the object of analysis in the literature. 

Section 2 proposes a definition and classification of SIFs based on their investment strategy. Section 3 identifies factors that may explain their recent proliferation, while sections 4 to 7 focus on their structure, strategy, role, and operations. Section 8 identifies common challenges and proposes possible solutions based on the experience of a wide range of existing SIFs. Section 9 concludes.

Source: World Bank, https://openknowledge.worldbank.org/bitstream/handle/10986/25168/WPS7851.pdf?sequence=5&isAllowed=y
This work is licensed under a Creative Commons Attribution 3.0 IGO License.

This paper defines SIFs as special purpose investment funds that exhibit all of the following six characteristics. These funds: 

• Are sponsored and/or fully or partly capitalized by a government, by several governments, or by government-owned global or regional finance institutions; 
• Invest to achieve financial as well as economic returns, in accordance with a double bottom line; 
• Aim to crowd in private capital by co-investing at the fund and/or project level; 
• Operate as expert investors on behalf of their sponsors;
• Provide long-term patient capital, primarily as equity, and may also invest in quasi-equity or debt; and 
• Are established as investment funds or investment corporations.

Appendix A contains a non-exhaustive list of SIFs categorized according to their geographical scope. 

SIFs come in different flavors. Their investments tend to focus on infrastructure projects and/or funds, but may also include investments in private equity (PE) and venture capital (VC) funds for small and medium enterprises (SMEs). A useful categorization of SIFs can be derived from research carried out by Clark and Monk (2015) on sovereign development funds, which the authors define as publicly sponsored commercial investment funds that combine financial performance objectives with development objectives. The authors suggest four operational and not mutually exclusive strategies for sovereign development funds: (i) reinforcing, by reorganizing, professionalizing, and innovating state holdings (companies, infrastructure, or other real assets) so as to drive commercialization and higher returns; (ii) crowding in private capital, by acting as a cornerstone investor in key sectors or projects; (iii) catalyzing, by seeding new industries, thereby diversifying the economy away from industries that are no longer profitable or sustainable over the long term; and (iv) financializing, by deepening local financial markets, thereby underwriting the development process through the growth of the capital market and the emergence of new financial intermediaries and investors focused on opportunities in the region. Each of these strategies is situated along a double spectrum, from strategic to commercial in terms of investment objectives, and in tight or loose alignment with national endowments and advantages (figure 1).

Figure 1. Categorization of Strategic Development Funds

Because SIFs are first and foremost commercially oriented investors focused on leveraging public investment by crowding in new sources of funding from the private sector (either domestic or foreign), by definition they populate the upper-right quadrant in figure 1. Within this operating environment, SIFs could be categorized on the basis of their policy objectives as mainly catalytic, or reinforcing, or financializing. Figure 2 applies the proposed taxonomy to a subset of SIFs. The graph helps to visualize SIFs' strategic positioning, and suggests that financializing and reinforcing are the most common strategies for the SIFs observed in this paper, particularly in emerging markets and developing economies (EMDEs). On the other hand, SIFs that focus on climate financing appear to play a catalytic role independent of the country of operation. Examples include the Africa Renewable Energy Fund (AREF), the Renewable Energy Asia Fund (REAF), and the Global Energy Efficiency and Renewable Energy Fund (GEEREF).

Figure 2. The Strategic Positioning of Sovereign Investment Funds

As with sovereign wealth funds (SWFs), SIFs' sources of funding may include balance-of-payment surpluses, official foreign currency operations, the proceeds of privatization, pension reserve funds, fiscal surpluses, government (or government guaranteed) borrowing, and/or receipts resulting from commodity exports (IFSWF 2009). However, monetary authorities' foreign reserves held for balance-of-payment purposes, government employees' pension funds, traditional public enterprise operations, and assets managed for the benefit of individuals are not sources of funding for SWFs and SIFs. 

International, bilateral or multilateral financial institutions, domestic development banks, and some commercially focused development and climate finance institutions are not SIFs. Although these institutions may fulfill the four criteria proposed above, they differ from SIFs in their governance structure, and/or investment policy, deal sourcing, and staffing. In all these respects, they are more akin to government institutions than to SIFs, which – as discussed further in this paper – are nimbler structures that derive much of their modus operandi from the PE model. For example, South Africa's Public Investment Corporation is a state-owned asset manager that invests on behalf of the Government Employees Pension Fund (89 percent), Unemployment Insurance Fund (6 percent), and other public funds. Its main investment objective is to achieve strong long-term capital returns above the clients' benchmark while contributing to the broader social and economic development of South Africa and the rest of the African continent. The Public Investment Corporation lacks a formal double bottom line and, being a pension fund manager, is not an SWF, as defined by the International Monetary Fund (IMF) and the International Forum of Sovereign Wealth Funds (IFSWF). By the same line of reasoning, pension funds are not SIFs even when they align with responsible investment principles (consider, for example, the California Public Employees' Retirement System, CalPERS, which is the largest pension fund in the United States). 

Public pension funds derive at least part of their resources from contributions made by employees, and their fiduciary responsibility is toward their contributors. Specifically, for a defined contribution scheme, the fiduciary obligation is to maximize the replacement value of pensions provided to members upon their retirement. For this reason, pension funds' investments are entirely commercial and cannot be subject to a double bottom line – though they can and do invest in SIFs on commercial terms (for example, the South African Government Employee Pension Fund has invested in the Pan-African Infrastructure Development Fund). Unlike public pension funds, pension reserve funds are generally capitalized by budget transfers. Their objective is to hold precautionary savings for future government expenditures, which may include public pensions without having any contractual obligations to future pensioners (IMF 2008). Pension reserve funds function very much like other long-term government savings funds. Some pension reserve funds, such as Australia's Future Fund and the Ireland Strategic Investment Fund (ISIF), have combined commercial and developmental objectives. These particular reserve funds are SIFs. Others, such as the New Zealand Superannuation Fund, invest on purely commercial terms and are not SIFs. 

Government-owned investment funds that are fully capitalized by the government or a subnational entity to serve a politically defined purpose, and that do not seek private capital participation at the fund or project level, are also not SIFs. These funds represent pools of public capital destined for public investment, often in infrastructure, that could in principle be implemented through the normal budget process. They are fiscal funds: essentially, quasi-fiscal tools for governments. Like SIFs, fiscal funds provide increased functionality to public investment, since managerial and professional capacity is centralized in a specialized body. Their singular focus on policy objectives makes the attainment of these objectives more straightforward than for SIFs. But it also may cut them off from sources of private capital since profitability is a critical factor in attracting private investors. A notable example is the State Oil Fund of the Republic of Azerbaijan, which lists among its objectives "financing major national scale projects to support socioeconomic progress". 

SWFs may exhibit some of the characteristics of SIFs, particularly if their domestic investment strategy involves a double bottom line (for example, Malaysia's Kazanah Nasional Berhad, and the Nigeria Infrastructure Fund owned by the Nigeria Sovereign Investment Authority). However, unlike SIFs, SWFs' international investments are usually guided by commercial principles only. That said, an SWF with an exclusively domestic investment mandate may be considered an SIF if it exhibits the six characteristics listed in section 2 of this paper. 

SIFs support the development of local economies through direct investment that aims to generate a high level of private sector participation. To achieve their objectives, SIFs use different approaches: some domestically focused SIFs are owned by both the public and the private sector, while others are wholly owned by a government; some SIFs operate at a global or regional scale, and may be funded by several governments. For example, the Philippine Investment Alliance for Infrastructure (PINAI) is a 10-year closed SIF, managed by a specialized private investment manager – Macquarie Infrastructure Management (Asia) Pty Limited – that invests exclusively domestically in a broad range of infrastructure projects. The PINAI was created in 2012 by the Government of the Philippines with assistance from the Asian Development Bank (ADB), and has a domestic and a foreign pension fund as the two largest shareholders. Senegal's Fonds Souverain d'Investissements Stratégiques (FONSIS) also invests only domestically. It was established in 2013 to catalyze external investment supporting the development of a strong local economy and the creation of jobs. However, its capital structure is much simpler than the PINAI: it is wholly owned by the Government of Senegal, and operates as a private equity firm on the government's behalf. As a result, its investment strategy is closely guided by the government's national development plan. The European Fund for Strategic Investments (EFSI) is a regional SIF. It was established in 2015 and is funded through a €16 billion first-loss guarantee facility provided by the European Commission (EC) and by €5 billion capital provided by the European Investment Bank (EIB) – the European Union's long-term public lending institution. The fund is managed by the EIB and aims to generate additional investment of €60 billion by the EIB and by the European Investment Fund (EIF) and to unlock at least €315 billion in private sector investment over a three-year period.3 Box 1 outlines PINAI, FONSIS, and EFSI in more detail. 

Box 1. Examples of Strategic Investment Fund Strategies: PINAI, FONSIS, and EFSI

SIFs may also act as VC funds. The first state-sponsored VC fund programs were created by the U.S. and U.K. governments to improve financing for fast-growing young firms and foment post–World War II productivity. In the 1960s these funds represented the bulk of VC raised in the United States. Some of these programs are still functioning. For example, the Small Business Investment Company (SBIC) program, established in 1958, consists of federally guaranteed risk capital pools. State-sponsored VC programs are now seen in a growing number of EMDEs. In Senegal, Teranga Capital is an equity impact investment fund launched in 2016. The fund targets promising domestic SMEs, with financing needs between €75,000 and €300,000. In addition to long-term finance in the form of minority equity participation, Teranga Capital provides management coaching to support the growth and consolidation of the SMEs in its portfolio (sales and marketing; accounting; and environmental, social, and governance benchmarking). FONSIS invested in Teranga Capital as a limited partner alongside Investisseurs and Partenaires (the general partner and fund manager), Sonatel, Askia Assurances, and two private professional investors. Another SIF, the African Agricultural Capital Fund (AACF), provides growth financing to Africa's undercapitalized agriculture sector through SME investments in East Africa. The AACF was created in 2011 by the United States Agency for International Development (USAID) and another six investors. Managed by Pearl Capital Partners, the AACF aims to invest $25 million through equity investments to smallholder farmers with a target of around 15 percent annual compounded return. Successful VC industries have also been seeded by the governments of Israel and Brazil (box 2). 

Box 2. Venture Capital Funds in Israel and Brazil

SIFs may also be thematic investors. Particularly in clean-energy finance, several SIFs have been established with the objective of attracting private investment in wind, solar, and thermal energy infrastructure; and energy efficiency. Some climate-focused SIFs are funded by multilateral financial institutions, including Asia Climate Partners (established by the ADB) and the GEEREF (a hybrid fund with both private and public shareholding established by the EIB and several European governments) (box 3). Green SIFs are emerging at the national level, too. For example, Norway recently announced its intention to establish a domestically focused renewable energy investment fund, Fornybar AS, and the Government of China is considering the establishment of a national green investment fund.

Box 3. Examples of Green Strategic Investment Funds

Over the past 15 years, at least 26 SIFs have been established, and another 13 are planned (figure 3).6 Examples of existing SIFs include Bahrain's Mumtalakat (2006), Italy's Strategic Investment Fund (2011), Kazakhstan's Baiterek (2013), the GEEREF (2008), InfraCo Asia (2010), and the AREF (2014).

Figure 3. Growth in the Number of Strategic Investment Funds, 2000 onward

While there are undoubtedly many factors affecting the establishment of an SIF, the widening of the financing gap for long-term investment that followed the 2008 financial crisis is likely one of them. Indeed, 17 of the 26 SIFs presented in appendix A were established after 2008. SIFs like InfraCo Africa and the Indonesia Infrastructure Guarantee Fund were set up to crowd in private sector financing to infrastructure. Others, such as the Macquarie Mexico Infrastructure Fund and PINAI, funded by a combination of public and private capital, aim to improve government capacity to efficiently invest in public-private partnerships (PPPs). PPPs have historically been used to engage private capital in infrastructure projects that are too complex or too expensive to be financed by public capital alone. Global PPP investment in infrastructure reached $1.2 trillion in 2015. Although SIFs may be responsible for a significant portion of this investment, the lack of publicly available information on investment deals makes it difficult to estimate their contribution.

Governments have also established SIFs to support the domestic capital market. Particularly in EMDEs, local financial markets may lack the range of financial products or intermediaries required to sustain economic development, or the density of financial intermediaries may be too low to ensure effective competition between providers. As a government-sponsored financial intermediary, an SIF may offer financial services and products that are not yet being commercially provided, either for the economy as a whole or for certain sectors. The Indonesia Infrastructure Guarantee Fund is an example of this type of SIF.

In advanced economies and EMDEs alike, governments are increasingly preoccupied with enhancing the competitiveness of the local private sector, by nurturing the creation and growth of innovative SMEs. According to a recent Organisation for Economic Co-operation and Development (OECD) study, young SMEs are globally the primary source of net job creation. The disproportionate contribution of young firms to employment creation holds across all economies, sectors, and years considered. In countries with underdeveloped capital markets, SMEs frequently lack access to financing. Nonetheless, promising results such as those obtained in Israel and Brazil (box 2) could provide useful information for SIFs that invest as minority limited partners in hybrid PE and VC funds.

Finally, the increasing number of SIFs may be indicative of their sponsors' growing confidence in the capacity of these funds to address market failures and economic externalities.7 SIFs' dual financial and economic objectives allow investments to be guided by market imperatives (measured in terms of internal rate of return) as well as higher-order policy imperatives (measured in terms of the economic rate of return, ERR, or other parameters) (see section 5). Externalities can cause the ERR to be higher or lower than the financial rate of return. For example, an infrastructure project might have positive economic externalities that are not fully captured by its financial return. A power plant, while paying for itself, can also improve access to electricity for local industry, and therefore strengthen domestic productivity. If the power plant is a wind farm, carbon emissions associated with a given level of energy production will be lower, generating a benefit (positive externality) that goes beyond the investment project itself. Over the past few years, SIFs such as GEEREF, Asia Climate Partners, and EFSI have emerged to address urgent investment needs in climate finance. SIFs' ability to crowd in private sector financing is of particular interest to climate finance, given the large estimates of the financing gap, and the limited resources available to the public sector.

The structure of SIFs vary along a broad spectrum, from the private management of public capital, via hybrid funds, to fully state-owned direct investment funds. In general terms, the choice of structure depends on the relative importance of market validation versus the policy objectives of the SIF. Private management of public capital occurs when the government invests in a private fund, on terms that reflect policy priorities, or when a public entity shares risk as a limited partner in a hybrid fund. In this model, investment decisions are made independently by the private sector general partner that manages the fund or by an independent investment committee that may include government representatives, while the overall investment policy is set by the fund's board, which is usually controlled by limited partners. The fund manager and general partner may be required to put up some share of the total capital. The PINAI is an example of this approach. 

In funds that are fully government owned and/or operated, market validation may come from constraints on the ownership share in each investment, limiting the SIFs' investments to minority participation of a certain size. Except for hybrid funds, fund management is frequently provided by a government-owned fund management entity operating at arm's length from the government (see appendix A). In general terms, the extent to which private capital participates in the fund's structure increases the market validation of investments (figure 4).

Figure 4. Strategic Investment Fund Structure, Market Validation, and Public Capital Multiplier

Although attaining a high level of private funding is a priority for SIFs, it is worth mentioning that a higher multiplier may translate into less control of policy objectives. In the fund-of-funds model, the public sponsor's control over an investee fund's investments may be limited to supervision of environmental, social, and governance reporting, while direct investment funds such as FONSIS can be expected to have a higher degree of control over policy objectives.

The Alberta Heritage Savings Trust Fund (AHSTF), while not an SIF, illustrates the importance of ensuring the market validation of investment projects (box 4). The AHSTF had a complex set of objectives, and a complex structure to go with it. The emphasis on public investment and the significant political influence over the fund's governance and investment decisions contributed to its poor results, and the funding of uneconomic projects resulted in many loans being written off.

Box 4. The Alberta Heritage Savings Trust Fund (AHSTF)

Other sovereign funds with a domestic investment mandate, such as Malaysia's Khazanah Nasional Berhad and Singapore's Temasek, appear better able to ensure market validation and generate financial returns while supporting their national economies. These funds' initial capital consisted of a portfolio of stateowned enterprises (SOEs) and other assets destined for full or partial privatization. As such, they acted as state-owned holding companies. Because these funds' role was to privatize state assets, their management and investment decision-making processes have, since the start, been exposed to and validated by market forces. The funds have since expanded into foreign assets while maintaining their public policy objectives. For example, Khazanah's foreign investments are to some extent driven by the purpose of strengthening sector and industry links that promise to benefit Malaysia's economy and Malaysian companies.

In principle, the policy objectives of an investment should be expressed in terms of its ERR estimated in accordance with one of several accepted methodologies (see appendix B). Although externalities can be hard to identify and objectively quantify, the ERR provides a single estimate of the social and economic impacts of an investment project. In practice, however, most SIFs use simpler, albeit less comprehensive measures. For example, the GEEREF measures its policy achievements in terms of the amount of clean power generated. The EFSI's main policy success benchmark is the amount of external investment unlocked by its guarantees for investment in the fund's defined priority sectors, with the aim to generate a 1:15 multiplier on its investments. The ISIF measures its policy objectives against the triple criteria of additionality, no displacement, and no deadweight, as illustrated in box 5.

Box 5. The Double Bottom Line of the Ireland Strategic Investment Fund

Publicly available data suggest that SIFs generate a wide range of public capital multipliers. Box 6 contains a brief description of the methodology used for calculating public capital multipliers and its application to a select number of SIFs for which data are publicly available. Although multipliers do not reflect the ability of SIFs to operate efficiently, or the wider social and economic impacts of their investments, they do provide a useful indication of a fund's ability to crowd in external capital. However, the following important caveats apply:

• Definition. Multipliers may refer to different dimensions (for example, different ratios, financing instruments, definitions of public and private capital, definitions of commitments or investment, and so on). For example, the external capital may come from other government institutions, or multilateral development institutions, instead of the private sector.
• Additionality. Private investment in a company or project may occur independent of public participation, particularly when the expected financial returns are attractive. In this case, estimated multipliers would be overstated.
• Projections. Multipliers may refer to expected rather than actual investment volumes. 
• Expectations. Multipliers can generate mechanistic or otherwise unrealistic expectations.

Box 6. The Public Capital Multiplier

All other things being equal, the size of the multiplier reflects the fund's structure. Intuitively, an SIF organized as a fund-of-funds should be able to achieve higher multipliers than an SIF that invests directly in specific projects alongside the private sector, although additionality is harder to establish at the fund-offunds level. In a fund-of-funds structure, such as that of GEEREF, the effect of the multiplier takes place at three levels, those of (i) the fund, by co-investing with other investors as a limited partner in a hybrid fund-of-funds; (ii) the invested funds, through the fund-of-fund's minority stakes; and (iii) individual investments, through the invested funds' minority equity or debt positions in individual companies or projects. In direct investment funds such as FONSIS, the multiplier effect occurs at the level of individual investment, in some cases through special purpose vehicles. For example, InfraCo Africa, Ghana CenPower, and the Kpone IPP gas project created Cenpower Generation Ltd. and were able to mobilize $903 million in financing from both African (70 percent) and other international (30 percent) investors. 

SIFs' investment strategy also affects the size of their public capital multipliers. Intuitively, SIFs that operate like publicly sponsored VC funds would be expected to display lower multipliers than SIFs that operate as more traditional investors in both equity and debt. This is due to the higher risk of equity investment, and the financial leverage. However, by participating in PE investments – either by coinvesting with the private sector or by investing in a private sector managed VC fund – SIFs can enhance their capacity to make complex and risky assessments of young companies with no credit or operating record, as well as reduce investment risk. Multipliers can also be estimated for credit enhancement and blended finance in general.

When policy imperatives prevail over commercial considerations, an SIF may find it difficult to attract private capital. Mechanisms to reduce risk or enhance returns, financed by the public share of the SIF's capital, may help to overcome this challenge. For example, if public finance within the fund is used to increase the risk-adjusted rate of return for private investors, an SIF may leverage private funds that invest in relatively high-risk regions or projects, yet need finance with low-risk premiums. Typical instruments for this are first-loss equity and capped return. First-loss equity means that the public sector investors take equity stakes in an SIF with a first-loss position, thereby increasing the number of projects within the SIF that can fail before the private sector investors lose money. In a capped-return arrangement, the government's return on the capital investment is capped, allowing co-investors access to higher upsides on their investments. The European Fund for Southeast Europe is an example of a first-loss arrangement (box 7). 

Box 7. A Strategic Investment Fund with a First-Loss Arrangement

An SIF could also seek to attract impact investors or commercially oriented financial institutions that identify with the policy objectives of the fund and often require a lower financial return than traditional investors (box 8). For example, AREF received financing from Sustainable Energy for Africa, a fund administered by the African Development Bank, at a rate of return capped at 4 percent.  

Box 8. Public Finance and Impact Investment

As outlined in section 2, governments finance their SIFs in various ways, including through equity investment or lending. In particular, a fund's public sponsor may undertake on-lending to the fund at the interest rate that the sponsor is eligible for. Countries that have a strong credit rating or borrow from international financial institutions (IFIs) may be able to secure a margin between borrowing costs and expected risk-adjusted returns on their sovereign fund's investments. An SIF capitalized with government borrowing will have the option of using the spread between the expected risk-adjusted return of the fund's investments and the cost of borrowing, to provide favorably priced credit or return enhancement to attract private investors, thereby increasing the multiplier.  Also, by carefully structuring the price and time profile of its on-lending, the government can de-couple its obligations to the original lender from the SIF's repayment schedule, allowing the SIF to manage its investment independent of the original debt repayment schedule. In accordance with the principles of good public finance management, equity investments and/or on-lending to the fund need to be channeled through the ministry of finance (representing the ownership of the fund), be included as liabilities in government accounts, and receive parliamentary approval.  

Like other financial institutions with government involvement, SIFs may have a comparative advantage over traditional financial institutions thanks to their privileged access to PPP investment opportunities, and a relationship of trust with public and private local investors. Clark and Monk (2015) suggest that this type of advantage may explain the remarkably high financial returns achieved by several SWFs with a domestic investment mandate in spite of their social and economic objectives. Examples include Singapore's Temasek (18 percent total shareholder return over 40 years), Malaysia's Khazanah Nasional Berhad (10year IRR of 13 percent), South Africa's Public Investment Corporation (10-year IRR of 16 percent), and the Palestine Investment Fund (10-year IRR of 10.3 percent). These funds, the authors observe, have taken on the role of wealth creators rather than wealth appreciators, acting like PE and VC investors by taking relatively large, direct stakes in projects and thereafter being actively involved in the operations of their investments. Furthermore, by being co-investors in PPP projects, SIFs allow governments to benefit if PPP projects turn out to be lucrative and provide comfort to the country's stakeholders that their interests are protected, thus reducing the likelihood of PPP contract renegotiation in the future.

Although SIFs are designed to achieve a wide range of policy objectives, some of which may be specific to a certain country or context, they face common challenges. These are discussed below.

Good governance. For an SIF to be an attractive investment target or co-investor for private investors, it needs to be first and foremost a credible investor. For many investors, corporate governance has become one of the key factors in the investment decision‐making process. For example, 1Malaysia Development Berhad (1MDB), an SIF set up in 2009 to turn Kuala Lumpur into a financial hub, started to attract national attention in early 2015, when it missed payments of $11 billion (£7.1 billion; €9.9 billion) that it owed to banks and bondholders. A series of probes and investigations exposed its weak corporate governance. These findings crippled the SIF's credibility and its ability to attract investors. From the perspective of an SIF, it is therefore very important to incorporate solid corporate governance mechanisms in legislation that establishes an SIF, as well as in the SIF's bylaws and other policy and procedural documents – and to make such documentation available to investors. Sound corporate governance arrangements define clear mandates and objectives, provide incentives for the SIF's board and management to pursue shareholders' objectives, and facilitate the monitoring of performance by shareholders and owners. This is particularly important for SIFs and other state-sponsored institutions where clear policies and mechanisms are required to deal with complex mandates combining financial and public policy objectives. Strong corporate governance – in particular, clear separation between the ownership role of the government or other sponsors, the oversight role of the fund's board, and the fund manager's independent role in decisions on investment and exit – help to ensure efficiency and accountability. Transparent and timely reporting of accounting information, and strong external audit systems, help increase the market credibility of an SIF, particularly when the fund engages in PPPs.  

SIF structure. Hybrid SIFs – that is, SIFs that are funded by both public and private capital – provide a high degree of market validation, and are likely to generate a high overall multiplier. Since private sector participation occurs at the fund level, hybrid SIFs are likely to exhibit competitive financial returns. The PINAI, the AREF, and the REAF are examples of the hybrid model.  However, an external manager may not have a natural incentive to pursue high multiplier effects at the project level, since this is likely to result in more complex and time-consuming transactions that will not necessarily correspond to a higher return to the SIF's own share of project capital. Linking the external manager's remuneration to the achievement of a multiplier benchmark may mitigate this risk. For fully state-owned and/or managed SIFs, limiting the SIFs' investment to minority participation can provide market validation of projects and enhance the integrity of investment decisions. In this way, due diligence by private sector co-investors can confirm the profitability of investee projects or companies.  

Domiciliation. The jurisdiction in which the fund is domiciled may affect investors' perception or assessment of the integrity of a fund's activities, since such integrity is in part determined by regulatory quality, rule of law, and overall institutional quality in the country of domiciliation. Recognized international financial centers with strong legal, regulatory, and supervisory standards for fund operations may help to enhance investors' confidence. International SIFs, such as AREF, GEEREF, or Asia Climate Partners, tend to be domiciled in known jurisdictions with attractive and cost-efficient regulatory frameworks, such as Luxembourg, Mauritius, and Singapore. Tax optimization is another key factor deciding domiciliation.  

SIFs that invest exclusively in the domestic market are normally domiciled in the country of operations, independent of their shareholding structure. This is likely related to these SIFs' need to attract domestic institutional investors as well as taxation, and the home governments' desire for a certain level of control over the funds. Where appropriate, dual registration could be considered, for example, to provide some degree of insulation against undue political interference in investment decisions – the biggest threat for any SOE – and in the resolution of investment disputes.

Project preparation. Many EMDEs lack the capacity to transform investible projects into actual transactions, which is a hindrance to PPP finance even where capital may otherwise be available. Empirical evidence in Asia and Africa shows that project preparation facilities are not effective in transforming investible projects into actual transactions. To accelerate the generation of project pipelines and the preparation and closure of PPP transactions, several EMDE governments are establishing infrastructure PPP project venture funds. For example, by identifying and working with financial and technical partners, Senegal's FONSIS is able to develop and structure strategic projects from initial sourcing through transaction close. The underlying aim is for the fund to be responsible for managing all stages of the preparation of PPP transactions until financial close. A PPP project venture fund may, after originating and structuring a project, be entitled to take an equity and/or mezzanine stake in the project's special purpose vehicle, representing the government's participation. The PPP venture fund would then have a direct incentive to generate viable and profitable projects. Such a fund can be set up either as a fully state-owned SIF, as a public-private (or hybrid) SIF, or even as a subfund or fund compartment within an SIF. FONSIS is an example of a fully state-owned SIF that includes a PPP venture fund function. The inclusion of the venture-financing function in a single fund (as opposed to a separate compartment) enables the government to capitalize on project preparation costs that the SIF at financial close converts into equity stakes, or into a cost refund or a success fee. 

Sourcing projects from national budgets. Since SIFs are partly or fully state owned, they have an opportunity to align their investment strategy with the identified economic development priorities of their country of operations, subject to project viability. The close relationship with the government makes it easier for SIFs to source their projects from national infrastructure master plans, line ministries of relevant sectors, PPP units, SOEs and public utilities, PPP studies performed by the government and development banks, other SIFs and SWFs, in addition to private developers (unsolicited proposals), commercial banks, and PE infrastructure venture funds. FONSIS is an example of this model. Sourcing projects from national development plans and other government-related project pipelines must not inhibit the ability of the SIF's manager to make fully independent viable investment decisions that will enable the SIF to attract private capital. An SIF established as an independent entity by an act of parliament may help to address this problem, as was the case for FONSIS. Legal independence of the SIF may also address an important challenge often faced by public investment units that are part of national treasuries. For these units, it may be difficult to offer staff benefit packages beyond those available through standard public sector salary regimes, as is necessary to attract and retain highly skilled investment managers from the private sector. 

Investment objectives. Successful achievement of an SIF's double bottom line requires that fund managers invest in projects that achieve competitive financial returns sufficient to attract investors across the risk spectrum, as well as economic policy objectives and associated economic returns. As discussed in section 6, when policy imperatives prevail over commercial considerations, SIFs may find it difficult to attract private capital even when they have good corporate governance. On the other hand, a fund that defines its policy objectives too loosely, focusing only on the maximization of returns, may end up making investments that would have taken place anyway, crowding out instead of crowding in private sector capital, resulting in a negative multiplier at the level of the overall economy. 

Performance metrics. The ERR is a comprehensive measure of the economic and social impacts of an investment project on society as a whole, and has been widely used by the public sector and the donor community as part of their economic analyses.  The tools used in the economic analysis of a project go beyond an ERR estimation, and can be used to answer broader questions about the impact of the project on the entity undertaking it, on society, and on various stakeholders. Economic analysis can also help to identify project risks and assess sustainability. However, none of the SIFs referred to in this paper use the ERR to assess investment opportunities, and none applies an explicit trade-off between financial and economic objectives. In practice, SIFs use a simplified approach: they assess investment opportunities that satisfy a financial return benchmark, against an economic benchmark frequently expressed as a proxy measure of the project's economic and induced impacts, such as employment creation, the stimulation of new firms, the reduction of carbon emissions, and other proxy variables of their policy objectives. For example, ISIF measures the social and economic contribution of the investment it undertakes through a variety of proxy variables, including employment, value addition at the enterprise level, and underlying investee turnover (see box 5), and publishes data on its economic impact every six months.  

SIFs often operate within a confined investment universe, that is, they invest only in certain sectors, themes, or asset classes predefined by their owners (for example, ISIF, AREF, GEEREF). A confined investment universe would, in principle, include the sectors and themes that are expected to contribute the most to the achievement of the SIF's policy objectives (that is, sectors that are expected to exhibit high ERRs). Beyond its simplicity, this approach has multiple advantages: it allows an SIF to tailor its organization (staffing and business processes) around a few, well-defined areas of expertise, and it facilitates the identification of meaningful and easy-to-understand proxy variables of economic impact.  

The use of proxy variables as substitutes for the ERR, although a common practice among SIFs, provides only a partial assessment of a project's socioeconomic impacts, and may be more open to selection bias than a more comprehensive economic analysis. Using the single measure of the ERR, albeit not perfect, may also facilitate the assessment of the relative desirability of projects with the same IRR and cash profile. For example, of two projects with the same IRR and cash profile, it would be difficult to choose whether to invest in the one that generates more exports or the one that reduces greenhouse gas (GHG) emissions. By estimating the ERR when possible and appropriate, an SIF could more easily compare alternatives with wide-ranging expected outcomes, and optimize the economic impact of its investment portfolio. This is particularly important when the number of investable projects is greater than the resources available to the SIF. Other indicators that capture unquantifiable impacts should also be considered.  

Economic analysis is an integral part of the investment decision-making process in public sector organizations and for IFIs. The experiences of these organizations could offer useful guidance to SIFs in designing ways to measure their double bottom line while preserving their private sector vocation.

Human capital. The role of human capital as a key factor to explain firms' performance has been highlighted by researchers working on developing a resource-based theory of competitive advantage. The theory argues that the heterogeneous distribution of valuable resources among firms – such as human capital – explains performance differences. Researchers generally concur that the knowledge embedded in human capital is a firm's most universally valuable resource, and it is hard to imitate. High returns and risk diversifications have traditionally been the main focus of the PE, VC, and investment industry at large. A vast number of research papers have been published on the growing importance of human capital in the economic world, but very few are specific to the investment industry. While it is undeniable that an investment fund's performance is driven by many external factors – such as favorable markets, and a stable or growing economic environment – in an increasingly globalized economy the underlying internal driver of success is the quality of an organization's human capital.  

Critical skills. The staff of the best investment companies, at all levels, share common characteristics: they have (i) knowledge and skills about generating value, and an ability to read and interpret trends within the target markets, that is, financial awareness; (ii) the ability to quickly implement the right investment approach, that is, commercial awareness; and (iii) access to extensive networks of contacts and the ability to interact with a wide array of people and interests, that is, people skills.  

For some EMDEs, the establishment and operation of SIFs have been greatly helped by the increasing availability of highly qualified investment professionals both domestically and among their diaspora. For example, Nigeria and Senegal have been able to staff their respective SIFs with diaspora members that have extensive international experience in the financial sector. 

Cross-fertilization. Since SIFs are generally established to crowd in private investors, co-financing with the private sector is likely to enhance market validation and at the same time provide additional expertise to enhance the quality of investment decisions and fast-track their staff's learning curve. This model works best when there is a general alignment of interest among investment partners. The combination of private and public sources of funding in a hybrid SIF's capital structure helps to keep the limited and general partners' interest aligned, and may also be well suited to addressing issues related to limited partners' inadequate human capital. However, even as a limited partner, an SIF needs to acquire and retain sufficient capacity for project selection and assessment, and for the oversight of the general partner's activities.

Staff remuneration policy. An SIF's ability to offer staff benefits packages beyond those available through standard public sector salary regimes is also critical to attract and retain highly skilled investment managers. This may require special legislation. For example, FONSIS benefits from legislation that sets it apart from other SOEs, and allows it to operate as an independent PE firm on behalf of the Senegalese government. The fund offers salaries and benefits that are relatively competitive to attract and retain highly specialized staff from the private financial sector. During recruitment, applicants' experience and education are screened by a professional recruitment firm, and candidates take financial aptitude tests as part of the selection process. In low- or middle-income countries, where high salaries for SIF professionals may be politically contentious, donor organizations could help remunerate specialist SIF staff via technical assistance facilities, as deemed adequate for the successful operation of the SIFs.

The number of government-sponsored SIFs has grown rapidly over the past 15 years, opening new opportunities to crowd in private capital to infrastructure PPP projects/funds and SME funds. SIFs are designed to achieve a wide range of policy objectives, some of which may be country and context specific. Some SIFs invest only domestically and are owned by both the public and the private sector, whereas others are wholly owned by a government. Some SIFs operate at the global or regional level, and may be funded by several governments.  

Notwithstanding their diversity, all SIFs aim to crowd in private capital. This is achieved at the fund level by engaging as a limited partner in hybrid funds, by investing in other funds, or at the project level through co-investment and/or the use of various return-enhancing and de-risking instruments. Investing with the private sector allows the public sector to generate a multiplier effect, which can range from 1:12 for a typical SIF's direct investment to 1:70 for a hybrid fund-of-funds. The size of an SIF's capital multiplier does not reflect its ability to operate efficiently, or the wider social economic impacts of its investment. But it does provide a measure of market validation, which is a critical success factor. 

SIFs' sources of funding may include balance-of-payment surpluses, official foreign currency operations, the proceeds of privatization, pension reserve funds, receipts resulting from commodity exports, and also contributions from IFIs and private sector actors. Partners that have a high credit rating or that borrow from IFIs can on-lend to an SIF at low cost. In this case the SIF can, when necessary and justified by policy objectives, take advantage of the margin between low-cost loans and the expected risk-adjusted returns on its investments to enhance returns for private investors or de-risk their investments.

SIFs face common challenges. Whatever their country of operations or area of investment, they all need to reconcile (and appropriately measure) policy and commercial objectives by achieving attractive returns on their investments while delivering meaningful social and economic impacts. Based on publicly available information on the objectives, strategies, and operations of a sample of SIFs, this paper has identified some of the challenges that are implicit in the SIFs' dual objectives, and has outlined ways in which SIFs have addressed them.  

When policy imperatives prevail over commercial considerations, SIFs may find it difficult to attract private capital even when they apply good corporate governance principles, and are domiciled in a country having good regulatory quality, rule of law, and overall institutional quality. Sourcing investable projects may also be difficult, particularly where lack of capacity and information asymmetry hinder the preparation of a welldocumented pipeline of bankable projects. Sourcing projects from the national budget may provide the opportunity to align the SIF strategy to the development priorities of the country of operations. SIFs' close relationship with government makes it easier for these funds to source their projects from the national development plan, and other government-related project pipelines must not hinder the ability of the SIF to make fully independent viable investment decisions.  

To be able to operate as expert investors, SIFs need to secure and retain professional staff with knowledge and skills on generating value, the ability to read and interpret market trends and quickly act on them, and access to an extensive network of contacts. Co-investing with experienced private sector investors can provide an SIF with both market validation and additional expertise, to enhance the quality of investment decisions and fast-track its staff's learning curve. An SIF's ability to offer staff benefit packages beyond those available through standard public sector salary regimes is also critical to attract and retain highly skilled investment managers.  

Notwithstanding their growing number and relevance to policy making, SIFs have not yet been the subject of in-depth analysis in the literature. This paper has made a first attempt at recognizing their unique features, categorizing them on the basis of their investment strategies, and identifying common challenges to their success – as well as ways to address these challenges.