CDC audit disclosure. How CDC has worked to drive implementation of the Investment Code. Working with fund managers on ESG management systems

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1 CDC Group plc 1 How CDC has worked to drive implementation of the Investment Code CDC is a Development Finance Institution (DFI), owned by the UK Government s Department for International Development (DfID). Our mission is to foster growth in sustainable businesses, helping to raise living standards in developing countries. CDC s Investment Code, which reflects and builds upon the World Bank IFC s best practice principles, outlines the environmental, social and governance (ESG) principles, objectives and policies to which CDC expects its investments to adhere. It is available on our website: uploads/cdcinvestmentcode.pdf Since 2004, CDC has operated principally as a private equity fund of funds (see PEVCExplained/features/WhatisPE ). This means that in order to implement our Investment Code, we have to work with the fund managers through whom CDC s money is invested in portfolio companies. Since most of these fund managers are based in the developing regions in which they invest, this enables us to encourage the growing private equity industries in those countries to develop with environmental, social and governance (ESG) considerations integrated into their systems from the very start. As we would like them to adopt these practices across all of their investments rather than just for investments they make on behalf of CDC, we focus our efforts on developing their understanding of why these issues are important and how to go about addressing them with companies in order to encourage improvements over time. We believe that this is more likely to generate long term sustainable change in the approach of fund managers and the industries they invest in, than a more penalty driven approach which is likely to be abandoned once CDC is no longer an investor. Economic growth, which is key to reducing poverty, is often limited in developing countries by the lack of investors willing to support new and growing businesses. Many commercial investors see the frontier markets of sub-saharan Africa, parts of South Asia and other low income countries as too risky and unknown. By supporting fund managers in those countries, both financially and with support to develop robust systems, CDC s investment in a fund can provide reassurance to other investors considering committing to the fund. Demonstrating that businesses in those countries can be profitable and responsible encourages other investors to follow CDC s lead. Fund managers that CDC invests with commit to adopting CDC s Investment Code, or substantially similar principles, through a legally binding agreement and to implementing them with the companies in which they invest. However, we recognise that we invest in some very difficult environments, in which standards are often not perfect. We therefore insist that fund managers report issues identified to us and agree action plans with investee companies to address them. Section five of CDC s Investment Code sets out the management systems we establish and maintain at CDC in order to drive implementation of the Investment Code across our investment portfolio. Our progress during 2010 is set out below. CDC s approach to managing these factors, as well as the range and type of investments it makes going forward is currently under review. DFID is currently undertaking an enquiry into CDC s business model. Depending on the outcomes of this enquiry and the evolution of international best practice, CDC may make amendments to its Investment Code during 2011 to ensure it continues to remain challenging and appropriate for the types of investments CDC makes. For example, CDC has recently reviewed its investment processes to ensure compliance with the UK Bribery Act. Working with fund managers on ESG management systems CDC continues to work with fund managers to establish and maintain ESG management systems throughout the investment lifecycle as illustrated below. In 2010, CDC launched its updated Toolkit on ESG for Fund managers, a comprehensive guidance document which sets out how ESG best practice can be applied at all stages of a fund manager s Investment Process. The Toolkit has since been translated into Chinese and French for additional accessibility for non-english speaking fund managers and their portfolio companies. CDC s ESG Toolkit was rolled out through internal sessions for CDC staff and a subsequent series of workshops for fund managers in eight cities across the regions in which CDC invests: Shanghai, Lagos, Sao Paulo, Bogota, London, Johannesburg, Mumbai and Washington DC. Over 100 people attended from 45 out of 71 fund managers. There were also several attendees from other DFIs and the World Bank. The Toolkit was very well received by fund managers attending the workshop.

2 CDC Group plc 2 All attendees who gave feedback rated the workshop as satisfactory or better and 34% rated the workshops as excellent. Fund managers found the sessions were also a very useful forum to discuss challenging issues and share best practice amongst themselves. Three topics in particular were discussed in greater detail across all these workshops due diligence and associated ESG risks; the business case for ESG and the link between financial returns and ESG initiatives; and ESG reporting, both on an annual basis and for serious incidents. In 2011 CDC will host further ESG workshops for fund managers, with at least one in Africa and one in Asia. These sessions will provide support for new fund managers and allow us to follow up with existing fund managers on improvements made over the past year, which tools they have found most useful and approaches to identifying and actually quantifying the business case for ESG in their portfolio companies. Monitoring the implementation of the Investment Code CDC s investment executives discuss ESG matters with fund managers both through informal telephone calls and at formal Advisory Committee meetings between the fund manager and investors, where high risk issues are covered. CDC s main channel to monitor implementation of the Investment Code more comprehensively is through annual ESG reports received from fund managers. In 2010, CDC received ESG reports for all funds from which an ESG report was expected (a total of 119 reports by the year end). During the year, CDC s ESG team also developed a framework to assess the quality of the ESG reports produced by fund managers and obtain a portfolio-wide view of trends. Where ESG reports do not meet CDC s minimum requirements, the ESG team is starting to discuss this with the Investment team and fund manager in order to set expectations for future improvements in reporting quality. These assessments, together with clear guidance in CDC s ESG Toolkit and the ESG workshops conducted in 2010, are bringing about a better understanding of, and increased capability for, ESG reporting among CDC s fund managers.

3 CDC Group plc 3 In 2011, CDC will continue to use this analysis to engage with fund managers who continue to submit ESG reports in which there are significant opportunities for improvements, or where CDC sees a decrease in quality from the previous year. CDC s twice yearly internal fund monitoring meetings are the key points at which a comprehensive assessment of the performance of all of CDC s funds is assessed, including ESG performance and related issues. The fund monitoring meetings highlight high risk portfolio companies, any incidents or issues during the past six months and the relevance of CDC site visits and verifications that the fund manager is adequately applying CDC s Investment Code. ESG-related discussions at recent monitoring meetings have included the follow-up to serious incidents and the quality of a fund manager s ESG reporting. In addition, ensuring ESG issues and risks remain well managed in light of team changes at fund managers is a further regular topic. A new systematic and proactive approach to assessing portfolio company risks and opportunities Through the annual ESG report, CDC requires fund managers to provide ratings for the ESG risk exposure and for the quality of the ESG management systems at each portfolio company. Recognising that not all fund managers provide a separate rating for each of the three Investment Code areas (environmental, social and governance) and that these ratings are not always consistent across fund managers as these areas are highly subjective, CDC carried out a desktop review of all companies in its portfolio. All ESG risk ratings and quality ratings for ESG management systems were reviewed and, where necessary, adjusted to provide a complete and comparable data set. CDC s portfolio-wide analysis identified 87 companies where ESG risk is high and management systems could be further improved. Of these 87 companies, 29 have been visited in the past three years and, where possible, the remaining companies will be included in a pro-active site visit calendar for CDC staff through monitoring and evaluation activities. In 2011 CDC aims to visit at least one third of the high risk portfolio companies to assess ESG performance and provide support on their specific challenges and opportunities. Where CDC is a co-investor with other DFIs, it is discussing options for sharing the delivery of these site visits, to maximise resources across institutions and reduce the burden on fund managers and companies. CDC will also use its portfolio-wide analysis to identify fund managers and companies with whom CDC can work proactively on developing specific ESG initiatives and pilot schemes. The first two areas being explored are potential carbon trading opportunities in Africa and working towards sustainable palm oil standards. Pilot schemes to drive improved performance on social matters in conjunction with another DFI are also being investigated; potential areas include enhanced health and safety training, general staff training programmes, management of HIV/AIDS matters and gender neutral/non-discriminatory hiring and staff management practices.

4 CDC Group plc 4 Focus on climate change In 2010, CDC published comprehensive guidance for fund managers on climate change, considering both the risks and opportunities it poses to portfolio companies. This document, as well as a brief summary piece, is available on CDC s website: climatechangeguidanceforfundmanagers.pdf Following initial investigation of the Clean Development Mechanism (CDM) and its potential for CDC s portfolio, CDC refined its portfolio analysis to identify companies likely to be high greenhouse gas emitters. It was noted that there are very few CDM projects in Africa which have successfully obtained carbon credits, and therefore in 2011 CDC is focusing on this region to identify opportunities within its portfolio. CDC will seek to engage with the fund managers and portfolio companies with highest potential, taking into consideration that the companies will need to a) have a sufficiently large turnover to be able to finance the upfront costs involved in getting CDM certification; b) have sufficiently large emissions for the effort to be worthwhile; and c) remain in CDC s fund of funds portfolio for a long enough period to allow for CDC support to the point where CDM certification has been obtained. From an investment perspective, CDC is actively addressing climate change not only through its existing funds, but also in selecting which new funds to commit to. As a result, CDC has invested in Berkeley Partners Renewable Energy Asia Fund in 2009 and the Interact Climate Change Facility in 2010, a pan-european DFI-backed facility that will invest in climate friendly private sector projects in poor countries. In 2011, CDC aims to strengthen its climate change activities by: + Investigate opportunities for carbon trading among portfolio companies in sub-saharan Africa and engage with fund managers as appropriate. + Work with a selection of fund managers and portfolio companies in energy intensive industries to reduce their energy consumption and adapt to the impacts of climate change. Focus on microfinance Microfinance is an increasingly large industry and important sector due to its large development impact potential and its reach into poorer and more rural regions, as well as individual small scale entrepreneurs who traditionally have had difficulties obtaining bank loans and credit. While microfinance holds great promise it also brings with it a range of challenges. In 2010 this led to tragic developments in several countries and regions, with developments in Andra Pradesh, in India, receiving extensive media coverage. Challenges and risks include occasionally very high effective interest rates, making it hard for borrowers to repay loans, the largely unregulated nature of the sector, the extent of cross-financing (numerous lenders giving loans to the same individuals) and poor oversight of borrowers, leading to challenges for both repayment and appropriate recovery processes. CDC is committed to eight microfinance investment vehicles and one fund which gives loans to local microfinance institutions (MFIs). CDC assessed if any of the funds it was invested in were impacted or involved in the situation in Andra Pradesh and received confirmation that the eight microfinance investment vehicles had already set out Client Protection Principles and Codes of Conduct for their operations. The fund that gives loans to MFIs did not because it is one step removed from the customers. CDC considers these principles, which set out standards for transparency, clear pricing and responsible debt collection practices to be essential for MFIs. CDC will update its requirements for future MFI funds to ensure they are required to sign up to best practice principles.

5 CDC Group plc 5 Evaluations: deep-diving into fund managers and portfolio companies CDC conducts qualitative and quantitative evaluations of each of its funds. These evaluations fulfill several purposes, including: + assessing progress and performance against expectations; + identifying areas for potential improvements to be discussed with the fund manager; + distilling best practice for sharing with other fund managers to improve overall portfolio performance; and + gathering insights to inform and improve CDC s future screening, due diligence and investment practices. Assessing ESG performance is one of the six key elements in CDC s evaluation framework, which is explained in further detail in our Evaluation Methodology document, available on CDC s website ( ). Evaluations are carried out at the mid-point and at the final stage of a fund s life. The mid-point evaluation typically takes place approximately five years after the fund was set up. This point is the end of the investment period, that is, when it is expected that all capital will have been invested in companies. At this stage CDC is able to gain an understanding of how the fund manager is working with its portfolio companies to drive business improvements, of which ESG can be a key contributor. The final evaluation takes place at the end of the fund s life, usually five to six years after the midpoint evaluation. At this point it is expected that most companies will have been sold from the fund and it is possible to get a view of how the fund performed overall and key lessons for future investments. In 2010, 15 evaluations of CDC funds took place, of which 10 were mid-point and five were final. These evaluations included interviews with the fund manager, desk-based research and site visits to a selection of companies (except for some end of life evaluations, especially of legacy funds). Nine of these 15 evaluations were carried out by an independent third party consultant. As in 2009, the aggregate evaluation results for 2010 showed that the evaluations conducted by independent third parties produced higher evaluation ratings than the evaluations conducted by CDC staff. This provides some reassurance to CDC that the qualitative and subjective aspects of a fund evaluation are being assessed fairly by CDC staff. Aggregated results of evaluations in 2010 can be seen in CDC s 2010 Annual Review. CDC s evaluations also produce revealing examples of both ESG success cases as well as examples where CDC s fund manager has run into difficulties. In 2010 for instance, one evaluation report demonstrated how an Africa-focused real estate fund manager has estimated that over 1,000 indirect jobs have been created in the supply chain of its real estate projects. In another example, a packaging company in South Asia has implemented sector leading social policies including residential facilities for employees, as well as subsidised meals and travel facilities. More problematic ESG examples at portfolio companies are also discussed in evaluations. In one instance, a forestry company that rigorously follows sustainable management practices has been unable to achieve industry leading Forestry Stewardship Council (FSC) certification as it was originally established on forested land. The company was founded in 1992 before this principle became a requirement of FSC certification. As a consequence, finding a buyer for the company became more difficult, demonstrating the continuing importance of sustainability considerations in the forestry sector. In 2011, 19 development impact evaluations are due, including the final evaluation of all remaining legacy assets that are deemed to be useful or informative. Over half of CDC s fund evaluations will again be completed by a third party to obtain an independent view and point of comparison to evaluations carried out by CDC staff. CDC s approach to serious incidents and safety Since 2009, CDC has required fund managers to monitor and report all serious incidents and to promote appropriate corrective actions with portfolio companies. CDC defines serious incidents as incidents involving portfolio companies which result in loss of life, material effect on the environment or material breach of law. This reporting is essential for CDC to be able to assist its fund managers and for them in turn to assist the portfolio companies in understanding and managing risks and improving performance over time in this regard.

6 CDC Group plc 6 CDC takes safety of employees at work very seriously and considers a safe working environment to be a defining characteristic of responsible, well run companies. As part of the engagement processes that fund managers use to implement CDC s Investment Code with companies, where appropriate companies are encouraged to develop systems, such as training for staff or improved procedures, to ensure they are working towards improved health and safety standards. The management of the business must be a willing and active partner in bringing about the changes to reduce and manage risk. The process is not an instant fix, although there are often immediate steps that can be taken which have a significant effect. Time, patience and a shared determination to achieve higher standards are necessary. The long term results are a better and safer working environment and increased value in the company. Serious incident reporting was introduced as a requirement in legal agreements with funds invested since For funds invested prior to then, legal agreements cannot be amended but CDC makes the importance of full and complete reporting on serious incidents very clear in its verbal and written communications, its ESG Toolkit and its ESG workshops. This includes an expectation that fund managers report within a few working days of any serious incident and that they provide a detailed report at a later stage with an analysis of the cause of the incident as well as measures to be taken to avoid recurrences. CDC in turn reports to its Board in every Board meeting and to its shareholder DFID every quarter with respect to the development impact of CDC s portfolio, including serious incidents and how they have been addressed. In 2010 two environmental and four governance serious incidents across CDC s portfolio of 930 companies were reported to CDC. Also 68 fatalities were reported, of which 44 were members of the public and 24 were either employees or contractors. Further details of serious incidents which occurred across CDC s portfolio in 2008, 2009 and 2010 can be viewed on CDC s website ( com/serious-incidents.aspx ). Keeping up to date with best practice and cross-industry working A key area of focus for CDC is to work with other DFIs to align requirements and expectations on reporting, ESG management and development impact measures. This is important to CDC as it not only allows CDC to stay at the forefront of international best practice, but also because it reduces the burden on fund managers, making them more willing to engage positively with the issues. Since 2009, CDC has been involved with a European DFI (EDFI) Working Group on Development Effects. As part of the group s remit, CDC is chairing a sub-working group to harmonise development impact indicators and evaluation processes and during 2011, will establish common indicators and develop draft guidelines for evaluations of funds in which two or more DFIs invest. CDC is active in the responsible investment community in order to stay informed of and foster the development and implementation of best practice. In particular in 2010, CDC worked with various thought partners and spoke at international conferences. Highlights have included: + hosting the EDFI working group on ESG and development impact, which in May 2010 took place at CDC s offices in London; + UNPRI membership and participation in the Private Equity and Emerging Markets working groups; + presenting the business case for ESG performance at an investor conference arranged in Sao Paulo, Brazil by Private Equity International (PEI) on 18 October 2010; + participating in panels at the Triple Bottom Line Investing (TBLI) London conference on 11 November - CDC s Toolkit on ESG and the business case for ESG performance were both discussed; and + providing input to the revision of IFC Performance Standards. In 2011, CDC will continue to monitor opportunities to contribute to best practice on ESG issues. Some of the forums in which CDC will participate include: + consultation rounds with IFC and European DFIs on updates to the IFC Performance Standards;

7 CDC Group plc 7 + meetings with EDFI Environment and Social Working Group to drive harmonization and alignment of environmental and social (E & S) reporting templates, indicators, exclusion lists and other matters + written contributions to the PEI Media publication The Guide to Responsible Investment, produced in March 2011; + participation in EDFI/Interact Working Group on Corporate Governance and chairing sub-working group to estimate financial returns from good corporate governance; + participation in the International Finance Institutions Working Group on Legal matters and chairing of sub-working group on ESG templates and requirements; + participation and speaker/panel in European Venture Capital Association events; + participation and speaker/panel in TBLI events; and engagement with industry on UK Stewardship Code on fiduciary and other duties in equity in the UK and abroad. Targets for 2011 Working with Fund Managers + Host further ESG workshops for fund managers, with at least one in Africa and one in Asia. + Engage with all fund managers submitting an ESG report quality rated as 50% or less, and those where a marked decrease in quality is observed from the previous year. + Carry out 19 development impact fund evaluations, with at least half of these carried out by an independent contractor. Working with Portfolio Companies + Visit at least one third of the visitable high risk portfolio companies to assess ESG performance and provide support on their specific challenges and opportunities (visit to be delivered by CDC staff or contractor, or a co-investing DFI). For 2011, the target is at least 20 companies. + Investigate opportunities for carbon trading among portfolio companies in sub-saharan Africa and engage with fund managers as appropriate. + Work with a selection of fund managers and portfolio companies in energy intensive industries to reduce their energy consumption and adapt to the impacts of climate change. Updating CDC s Policies and Practices + Update CDC s standard requirements for future MFI funds to ensure they are required to sign up to best practice Client Protection Principles and Codes of Conduct. + Implement any necessary changes to CDC s Investment Code and requirements to fund managers in light of the UK Bribery Act and other new, relevant best practice standards. Contributing to Best Practice Development + Work with other EDFIs towards establishing common indicators and draft guidelines for evaluations of funds with multiple EDFI investors, by chairing EDFI sub-working group. N.B. CDC s investment model and approach to measuring its development impact is currently under review by DFID. These targets may therefore be reviewed or replaced as part of that process.