Innovative finance can help rebuild Ukraine

GLOBAL BUSINESS DIGEST & MARKET ANALYSIS PAN Finance Magazine Q3 2022

Marcus Fedder

Marcus Fedder, a former director of the International Finance Facility for Immunization and a former treasurer of the European Bank for Reconstruction and Development, structured Brady bonds when he worked for the World Bank in 1990-91.

Innovative Finance Can Help Rebuild Ukraine

Ukraine will not be able to finance its huge postwar reconstruction needs on its own and should not count on reparations from Russia. But two innovative and recently proven mechanisms can help to bridge at least some of the funding gap.

ZURICH – Estimates of Ukraine’s postwar reconstruction costs vary widely. Ukrainian Prime Minister Denys Shmyhal recently put the likely bill at $750 billion, while European Investment Bank President Werner Hoyer thinks the country may need $1.1 trillion. Every day that the war continues, the figure increases.

Ukraine will need to rebuild power stations, electricity grids, and critical water, sanitation, and transport infrastructure. Industry will require investments, and houses will need to be rebuilt and repaired before the winter – although many cities, towns, and villages have been completely destroyed.

But Ukraine will not be able to finance such a massive investment program on its own and should not count on reparations from Russia. Financing must therefore also come from multilateral development institutions such as the World Bank, the European Investment Bank, and the European Bank for Reconstruction and Development. Western governments will have to contribute as well, as will the European Union. The biggest problem is that Ukraine will need the money as soon as the war is over. Because the country does not have sufficient reserves of its own, it will have to borrow. But its sovereign creditworthiness will be at rock bottom after the war, even though Fitch Ratings recently upgraded Ukraine from RD (restricted default) to CC.

Furthermore, Western governments will not be able simply to transfer an initial $100 billion overnight to Ukraine. Their finances are still reeling from fiscal measures to counter the effects of the COVID-19 pandemic and the newfound realization that they need to spend more on defense. Germany alone intends to invest an additional €100 billion ($101 billion) in its military.

But innovative financing mechanisms can help to bridge at least some of Ukraine’s massive funding gap. Policymakers should consider two recent precedents in particular.

One promising option is to set up an International Finance Facility for the Reconstruction of Ukraine (IFFRU). This would be modeled on the International Finance Facility for Immunization (IFFIm), which was established in 2006 by several donor governments under the leadership of the United Kingdom to provide up-front money to vaccinate children in the world’s poorest countries. The IFFIm received legally binding multiyear pledges totaling over $6 billion from highly rated governments, enabling it to obtain a AAA rating and start borrowing in international bond markets. The borrowed funds – the IFFIm’s first bond issue amounted to $1 billion – were sent to Gavi, the Vaccine Alliance to finance immediate large-scale immunizations.

The tax-exempt IFFRU would be based outside Ukraine and function in accordance with best-practice operational and governance standards. And rather than diverting huge sums of money out of their current budgets, many Western governments will be able to make legally binding commitments over 20 years. If correctly structured, the sums would be included in the respective government budgets only in the year they are due.

Depending on the donor countries’ credit ratings and the facility’s financial policies, the IFFRU could have a rating of AA or better.

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That would enable it to tap international bond markets and front-load financing for Ukraine, disbursing money as and when the country needs it. In this way, infrastructure and desperately needed housing for Ukraine’s displaced population can quickly be rebuilt.

A second possibility is for Ukraine to issue Brady bonds, following the example of some emerging markets – including several Latin American countries, Bulgaria, Morocco, Nigeria, Poland, and the Philippines – when they defaulted on commercial bank loans three decades ago. To resolve the crisis, the banks accepted a haircut, or certain loss, on the loans, and the remaining debt was converted into tradable sovereign bonds, with principal repayments collateralized and thus secured by specially issued government securities. In the case of dollar-denominated Brady bonds, the US Treasury issued special 30-year zero-coupon securities to provide such collateral, making the bonds attractive to investors.

Ukraine, whose CC rating will prevent it from tapping international debt markets on its own, could use a similar structure to kick-start its bond-issuance program. The government would be responsible for paying the interest on its Brady bonds – with the necessary foreign exchange coming from the country’s taxpayers – and the principal repayments would be collateralized or guaranteed by zero-coupon bonds issued by highly rated governments, the EU, or other entities. Ukraine would have to purchase these zero-coupon bonds, or governments wishing to support the country’s reconstruction could donate them.

Rising interest rates and tight government budgets mean that the large sums needed to rebuild Ukraine cannot be raised in one go. But creative financing mechanisms can help to reduce the strain and accelerate the country’s reconstruction.

GLOBAL BUSINESS DIGEST & MARKET ANALYSIS PAN Finance Magazine Q3 2022

Sébastien Mazella Di Bosco

Sébastien Mazella di Bosco is Co-Founder and Managing Partner of Px3 Partners.

Alex Friedman

Alex Friedman, a former Chief Financial Officer of the Bill & Melinda Gates Foundation, is Co-Founder and CEO of Novata.

Private Equity’s ESG Generation

The private-equity industry is about to undergo an epochal shift, as the founders of many leading firms retire and a younger generation with a different view of capitalism takes over. Capital flowing through private markets can thus play the role it should in taking environmental, social, and governance criteria mainstream.

NEW YORK – When faced with a major threat, people have usually turned to religion or government for help. Today, the climate crisis is accelerating, part of Europe is at war, the United States is deeply polarized and beset by rising gun violence, COVID-19 is still with us, and developed economies are facing the prospect of a stagflationary recession. But while millions of people around the world are suffering economically and emotionally, religion has largely lost its moral authority and practical influence, and many governments are either hamstrung or controlled by autocrats.

The private sector cannot solve all these problems by itself, of course. But might the world at least be a better place if firms and investors consistently adhered to environmental, social, and governance criteria?

Not so fast, say some. The idea that business has an obligation to report on and discuss ESG metrics with the same rigor that it currently applies to its financial results is controversial. Some politicians have sought to make ESG considerations a partisan issue. Big investors claim that a surfeit of prescriptive ESG proposals in this year’s proxy season of annual shareholder meetings shows that the sustainable-investment movement has gone too far. Tesla CEO Elon Musk recently tweeted his opposition to the concept after the electric car manufacturer was removed from the S&P 500 ESG Index.

Nonetheless, capital can still be a critical lever for positive global change – but perhaps not in the way one might think. It is the capital flowing through the world’s private markets – not public stock exchanges – that can play the key role in taking ESG mainstream. After all, globally, nine out of ten people employed in the corporate sector work for a private firm. And for every publicly traded company, there are 200 private firms. Private businesses form the heart of capitalism. And the main artery through which the most important firms obtain resources to grow is private markets – and particularly private equity. To be sure, private equity has traditionally not been the first thing people think of when discussing how to improve the world. But though this industry has been around in its current form only since the 1980s, today it manages more than $9 trillion of assets and owns many of the companies we depend on for daily life. Moreover, it is about to undergo an epochal shift, as the founders of many leading private-equity firms retire and a younger generation takes the reins.

This cohort, now in their thirties and forties, is well aware of the failures of Gordon Gekko-inspired, baby-boomer investors and of the limitations of Milton Friedman’s view that business leaders’ only social responsibility is to maximize shareholder value. The new wave of private-equity leaders fundamentally believe that capitalism can produce shared and durable prosperity. They think that generating good financial returns requires recognizing that sustainability, the environment, and the dignity of workers are core to building enduring enterprises. Underscoring this view is the ideal of purpose: the belief that successful or-

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ganizations create a mutually positive dynamic between their owners, employees, customers, and suppliers, and the communities in which they operate.

In this environment of multidimensional returns, it is essential to develop key non-financial yet material metrics and establish benchmarks and standards of performance. The management guru Peter Drucker probably never said, “If you can’t measure it, you can’t manage it.” But that doesn’t make it any less true.

The choice of which ESG metrics to measure may vary, depending on the region, industry, company size, and owners’ goals. But this is no reason to give up on establishing standards. There are many important indicators that every business can regularly measure in order to make good on talk about doing the right thing.

For example, all companies should track their freshwater use, waste generation, and direct and indirect emissions, and monitor whether any of their activities are causing soil sealing. Other key metrics include the diversity of the management team and the board of directors, employee attrition, work-related injuries, and data breaches.

There is no one-size-fits-all approach to capturing ESG data, but there is a minimum that does fit all. We applaud the work of the ESG Data Convergence Initiative to develop baseline reporting metrics, as well as efforts by the International Sustainability Standards Board to update and globalize industry-based standards.

This information needs to be tracked now. Globally, there are over 8,000 private market investment firms, and the vast majority have not yet embraced ESG criteria. That needs to change. Regulators will soon demand it, as rules and standards such as the Sustainable Finance Disclosure Regulation and those recommended by the Task Force on Climate-Related Financial Disclosures come into effect. Investors will demand it, too – and already are, as the significant rise in the number of climate-related proposals in this year’s proxy season shows. And society needs investors to pay greater attention to ESG factors in the face of heightened social tensions and unprecedented environmental instability. Put simply, we must move from “trust me” to “show me.”

Almost 90 years ago in the US, Congress created the Securities and Exchange Commission, and the accounting industry established Generally Accepted Accounting Principles. Businesses whose financial disclosures had been uneven and spotty began reporting regularly and transparently. In turn, capital markets were bolstered by broader investor participation and the advent of shareholder democracy.

We now need to do the same for ESG reporting and stakeholder democracy. And a new generation of private-market players can lead the way.