Case Study

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905M56 CARE KENYA: MAKING SOCIAL ENTERPRISE SUSTAINABLE Tom Ewart prepared this case under the supervision of Professor Tima Bansal solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from CanCopy or any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 2005, Ivey Management Services Version: (A) 2007-04-13 On October 14, 2003, George Odo was finally asked the question he most feared: “What will happen to the farmers when CARE leaves?” George was the sector manager for Commercialization of Smallholder Agriculture for CARE Kenya. His vision had seeded the Rural Entrepreneurship and Agribusiness Promotion (REAP) project. By securing export contracts, financing and training farmers, REAP had successfully pulled farmers in Kibwezi, Kenya, over the poverty line. However, CARE financed the project with grants from Western governments, and George knew that CARE’s donors would ultimately withdraw their support. Without the subsidies, the farmers risked returning to their old lives. George had spent many long hours and sleepless nights dwelling on how CARE’s involvement in REAP could be commercially viable. George had to identify and implement a business model that was economically sustainable in order to prevent the farmers from falling back into poverty. KENYA, KIBWEZI AND POVERTY Although Kenya had the largest economy in East Africa, 55.4 per cent (17.1 million people) of the population lived below the extreme poverty line (US$1 per day) in 2001, up from 48.8 per cent in 1990. There were large income disparities between the country’s richest and poorest residents, and between rural and urban areas (see Exhibit 1). Life expectancy at birth was 45 years, the adult literacy rate

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was 84 per cent and gross domestic product (GDP) per head at purchasing power parity was US$1,020 per year. Kenya ranked 148th on the United Nations 2002 Human Development Index. By contrast, Canada ranked fourth with a life expectancy of more than 79 years, a 99 per cent adult literacy rate and a GDP of US$29,480 per year. Kibwezi was nearly three hours by road to the southeast of Nairobi. The Kibwezi region was particularly poor and vulnerable to economic and climate fluctuations. More than 70 per cent of the region’s 900,000 residents did not have secure access to food, compared to the national average of 56 per cent. Most people relied on assistance from government and development agencies. While many aspired for more, they lacked the economic means to climb out of poverty. Kibwezi could not attract major investments because of its lack of access roads, electricity and other infrastructure; low literacy rates; low access to rural services, such as banking and health; and poor rainfall patterns typical of arid and semi-arid areas. AGRICULTURE SECTOR The agriculture sector contributed 25 per cent to Kenyan GDP in 2003, and related agricultural services contributed another 25 per cent. More than 17 per cent of the labor force in the formal sector was employed in agriculture; however this figure understated the real value of agriculture in Kenya. More than 75 per cent of the total Kenyan labor force worked in the informal economy, outside of legal, regulatory and tax regimes. The Kenyan informal economy was almost totally based on agriculture. Most of the rural poor were smallholder farmers, who depended on subsistence agriculture and, failing that, on food safety nets. They had a poor resource base, were isolated due to poor infrastructure and had poor access to markets, technology, information, capital, and private and public sector services. As a result, the rural poor rarely participated in the formal economy. When Kenya gained independence from Great Britain in 1963, horticulture (the production of fruits, vegetables and flowers) represented 0.3 per cent of the country’s total export value.1 By 2003, this number had reached 26 per cent.2 This success has been attributed to Kenya’s comparative advantage in its year-round equatorial climate, competitive cost of labor, proximity to export markets in the European Union (EU) and Middle East, strong private sector, access to good air cargo facilities and simple export documentation procedures.3 The recent growth

1Neil McCulloch and Masako Ota, Export Horticulture and Poverty in Kenya, ISD Working Paper 174, Institute of Development Studies, University of Sussex, Brighton, U.K., 2002. 2Economist Intelligence Unit, Kenya Country Profile 2004, The Economist Intelligence Unit, London, U.K., 2004, p.68. 3U. Feldt, Sector Study of Horticultural Export Sector in Kenya, FKAB Feldt Consulting for USAID, 2001.

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was driven by U.K. supermarket chains, which purchased 53 per cent of Kenya’s fruits and vegetables. However, the Kenyan horticultural sector was facing considerable changes. First, the global trend towards market liberalization had increased competition for trade and finance. Second, the U.K. supermarkets –– which had driven much of the sector’s growth –– were demanding large investments in pre-packaging facilities and labeling programs. Third, rigid international accreditation standards and codes of practice (such as EurepGAP and Good Agricultural Practices) were threatening to increase farmers’ costs. These included sanitary and phytosanitary standards,4 maximum residue levels for pesticides, product labeling to track products from exporters to farmers, and higher environmental and ethical standards. As a result of these changes, exporters were contracting from large farmers rather than smallholders, who lacked the technical expertise and investment capital to meet these international standards. Smallholder farmers declined further into poverty because they were forced to sell to more accessible, less lucrative markets. Consequently, in recent years, the rural poor had started to migrate to urban areas where they often lived in slums. MUTULU MUTHOKA — A SMALLHOLDER FARMER Mutulu Muthoka (see Exhibit 2) was one of REAP’s most enterprising smallholder farmers. He worked in the Kwakyai Rural Sacco, a collective of more than 300 smallholders, 15 kilometres outside of Kibwezi. Mutulu lived with his wife and children in a small house made of intertwined branches and mud. His two acres of land produced sufficient food to feed his family. Before REAP, Mutulu planted two crops of maize every year during the two rainy seasons. He harvested and dried the maize to feed his family. When he was not working the fields, there was little to do. When the rains did not come, he relied on assistance from the government and non-governmental organizations (NGOs). In a good harvest, Mutulu was able to sell his surplus maize at the local market. With the proceeds, he was able to improve the efficiency of the farm. Before REAP, Mutulu was saving to buy a pump that would allow him to lease land near a perennial water source and produce three to four crops of maize every year. He hoped to grow different crops and sell them in different markets. Mutulu’s only sales channel was through brokers, who took advantage of him because he had no information on market prices, nor any alternative options. He did not trust his brokers, and yet had to rely on them because of his inconsistent product quality. Despite his entrepreneurial zeal, Mutulu made less than US$2 per day. 4The prefix phyto means “plant-based.” These standards were designed to protect the health of humans, plants and animals.

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His wife collected water, prepared food and raised the children. The children tended the family’s small animal stock, which consisted of a dozen or so goats and chickens. In 2003, primary school fees were eliminated, and since then, Mutulu’s children attended primary school when they were not helping with the harvest. CARE INTERNATIONAL CARE International (CARE) was a non-political, non-religious, global network of humanitarian organizations committed to fighting poverty. It was founded in 1946, in the wake of the Second World War. In 2005, the CARE network included 12 lead members –– including Canada –– and country offices in more than 60 developing countries. CARE’s mission was to serve individuals and families in the poorest communities in the world, promoting innovative solutions and lasting change by strengthening capacity for self-help, providing economic opportunity, delivering relief in emergencies, influencing policy decisions at all levels and addressing discrimination in all its forms. The CARE network employed more than 12,000 people, and managed 800 programs that assisted more than 45 million people every year. CARE Canada operated projects in 48 countries and was the lead member responsible for coordinating CARE’s work in Cameroon, Colombia, Cuba, East Timor, Indonesia, Jamaica, Kenya, the Russian Federation, Zambia and Zimbabwe. It had a budget of Cdn$179 million in 2003, most of which came from federal governments; multilateral institutions, such as the World Bank, the United Nations and the International Fund for Agriculture and Development (IFAD); and from other CARE lead country members. Since 1968, CARE had managed development and humanitarian projects in Kenya in the areas of primary health care, HIV/AIDS, small economic activity development, reproductive health, and agriculture and emergency response. CARE Kenya In 2004, CARE Kenya employed approximately 300 people and had a budget of nearly US$14 million. The agency attracted socially minded employees, who were often educated in social sciences. CARE staff had a reputation for excellent community engagement and mobilization. CARE staff was paid on a nonprofit compensation model, which rewarded process rather than profit –– staff was paid for fulfilling the mandate for aid, not trade.

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George Odo George Odo (see Exhibit 2) was the senior manager in charge of CARE Kenya’s commercial sector development projects. He hadn’t always worked in the development sector. After his education in finance and accounting, he had worked in the private sector and as a financial accountant for the Office of the President. George’s grandfather was a subsistence farmer, who had been determined to educate his children and allow them to escape the poverty of smallholder farming. In 1999, while consulting for a large, commercial export farm, George began to question conventional wisdom that only large farms could compete for foreign contracts. George joined CARE Kenya in 2000 to manage the REAP project, and had strong opinions about development:

The best way to help smallholders achieve their development agenda is to help them get access to markets because doing so will increase their incomes, which then impacts their lives.

Development Strategy CARE’s development strategy had evolved over time. In what CARE called the First Wave of international development, CARE and its overseas volunteers undertook small-scale projects, such as building schools. These projects were largely funded by individual charitable donations. While they were often very successful, they were not sufficient to address the multitude and magnitude of problems of the world’s poor. As well, direct subsidies could make recipients dependent on development agencies. The Second Wave consisted of large-scale, poverty-reduction projects funded by governmental and multilateral organizations. These projects provided much needed infrastructure, for example large irrigation systems, and had significant macroeconomic impact. However, grants (as the principal form of financing) did not often lead to self-sustaining delivery models, and they were susceptible to bureaucratic barriers and shifting donor priorities. The micro-finance revolution began what CARE called the Third Wave, a market- based approach to development. Micro-financing proved that poverty-eradication projects could be sustainable and could operate on commercial principles. Micro- financing involved lending small amounts of money, typically to small groups of poor entrepreneurs –– a market that the large financial institutions deemed too risky. Lending to groups, often women, lowered the default ratio. Beyond micro- financing, the Third Wave sought to address structural problems that suffocated entrepreneurship in economically developing countries. These barriers to entrepreneurship included no access to credit, burdensome regulatory

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environments and negative market conditions (such as local monopolies). These barriers inhibited poor residents from entering the formal economy, which reduced tax revenues and weakened the government, giving rise to what CARE called the “missing middle” –– a relative absence of the small- and medium-sized enterprises that often fuel economic growth through innovation and high rates of employment. THE RURAL ENTERPRISE AND AGRIBUSINESS PROMOTION (REAP) PROJECT Through education and through infrastructure development, CARE’s agricultural projects in Kenya had previously helped smallholders improve crop yield and efficiency by addressing the mix of inputs into their horticultural processes. George explained:

This was a good development model, but not a good commercial one because it would have collapsed when donor preferences shifted and the project had to close.

In the late 1990’s, approaches to rural development began to change. Development agencies, such as CARE, were unused to philosophies like “markets” or the “private sector.” However, CARE began to analyse the markets for cash crops to determine why subsistence farmers were not able to take advantage of them. It concluded that numerous structural barriers impeded farmers from entering the formal economy and selling their goods. In late 1999, with funding from the International Fund for Agricultural Development (IFAD), CARE USA, and the Canadian International Development Agency (CIDA), CARE started REAP –– a market-driven horticultural project targeting smallholder irrigation farmers living below the poverty line in Kibwezi, Kenya. The project intended to answer the question: can a market-driven, smallholder agriculture model be commercially viable (i.e. not be subsidized by CARE) and demonstrate development impact (i.e. increase farmers’ incomes)? CARE took a multi-step approach. First, CARE established a small consultancy, which it called the Central Management Unit (CMU). The CMU engaged the farming communities and learned that private sector exporters were often frustrated working with smallholders because of the poor and inconsistent quality of their products. The CMU gave farmers credit to lease blocks of land of at least 30 acres, close to water and that had not been primarily used for agriculture. Then the CMU assigned groups of 20 to 30 farmers to parcels of land, called Production Units (PUs). Farmers then paid for the legal incorporation of the PUs and obtained share certificates as either limited liability corporations or co-operatives. It was important to legally recognize the PUs in order to give the private sector confidence in doing business with them, as the PUs would be subject to a legal and

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regulatory framework. The farmers had owned their land before, but had never shared ownership of a company. Next, CARE negotiated contracts with private sector exporters that sold primarily to U.K. markets. The contracts specified the buyers’ expectations for type, quality and quantity of produce needed. Subsequently, CARE prepared production and business plans with the farmers to show them the link between their production and the market. Farmers’ profits were based on their ability to grow quality produce as specified in the contract and control their costs, of which a large portion went to REAP through loans for labor, seeds, fertilizer and chemicals. CARE’s CMU offered farmers micro-credit and working capital loans for inputs, term financing for irrigation equipment, market access and technical training in agronomy. The farmers paid a fee of 10 per cent of their gross profit for these support services. The CMU provided farmers with inputs within two weeks of ordering, and paid them every month, once paperwork had been signed in Nairobi. George had expected that the interest from the loans and the management fees would cover the expenses of the CMU and, thus, the REAP project. CARE had planned that once REAP was profitable, it would be left to operate as a self- sustaining unit. Private Sector Exporters CARE had arranged for the smallholders to sell their produce to five horticulture exporters, all privately owned, in Kenya: East African Growers, Vegpro Kenya Ltd., Kenya Horticultural Exporters, Frigoken and Mbogatuu. East African Growers was the dominant player in the industry with annual sales of approximately US$50 million. Vegpro Kenya Ltd. had sales of approximately US$40 million. Kenya Horticultural Exporters and Frigoken were similar in size to Vegpro Kenya Ltd. Mbogatuu was the smallest company of the five. The major exporters often procured their produce from two sources: large-scale commercial farms that they owned and operated, and out-growers (independent contractors), many of whom were smallholders. The large commercial farms had extensive agronomic expertise. They focused their operations on high-margin products, such as cut flowers, in specific geographies, which created gaps in the supply of certain products, such as baby corn, okra, ravaya and karella. These gaps were filled by out-growers. Many smallholders operated in locations that favored some crops, resulting in high yields. Despite this interdependence, the out-growers did not generally have reliable relationships with the exporters. Buyers would often show up sporadically and buy only the crop they wanted and negotiate low prices.

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Competition was tight among the exporters because there was very little upward movement in prices and yet costs increased every year. The exporters constantly struggled to achieve high yields and hold costs flat on their large-scale commercial farms and through the out-growers. Export companies began competing for the privilege of working with CARE on the REAP project because farmers who worked with CARE had better quality produce and were more reliable than those who didn’t. REAP’s biggest private- sector partner was Vegpro Kenya Ltd. Vegpro Kenya Ltd. Vegpro Kenya Ltd. (Vegpro) was founded in 1979 and had since grown into one of the largest horticultural buying and growing companies in Eastern Africa. Vegpro grew 80 per cent of its production on its large, wholly owned, commercial farms and sourced the rest from smallholders. Vegpro relied on smallholders for specialized crops, but demanded that they be of consistent high quality and available in sufficient quantities through the year. The company had sales of US$40 million in 2003, selling primarily to supermarkets in the United Kingdom. From 2003 to 2004, Vegpro had contracts with REAP smallholders worth more than KSh63 million (Kenyan Schillings).5 Much of Vegpro’s growth was attributed to its ability to meet changing customer needs, including the increasing demand for more value-added products, such as pre-packaged vegetables. Vegpro worked closely with customers to develop new products and presentation formats that suited their needs. Vegpro had dedicated agronomic personnel in production units and in a central technical department. They oversaw product testing, grower audits, EurepGAP accreditation, pest management and environmental management programs. Without these technical experts, contracts with the demanding European markets would have been lost. Vegpro processed all products in modern, air-conditioned facilities located in the cargo area of Jomo Kenyatta International Airport in Nairobi. Without the facilities, Vegpro would not have been able to maintain a continuous cool chain to control the quality of the delivered product. Every day, more than 60 tonnes of pre- packaged and prepared vegetables were flown to European markets. Vegpro valued staff welfare and environmental protection. It worked with the Ethical Trading Initiative to ensure staff welfare standards, and developed environmental codes of conduct. The company provided all staff with free

5 US$1 = KSh79

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transport, basic medical treatment and free lunches, and environmental management plans were in place for each production site. By 2002, REAP’s smallholders produced approximately 50 per cent of Vegpro’s Asian vegetables, although this quantity made up less than five per cent of Vegpro’s total sales. REAP’S SUCCESSES AND CHALLENGES The REAP project had been a success but had also faced challenges. On the upside, REAP demonstrated that very poor farmers, organized as limited liability companies, could enter the supply chain; establish contracts with, and gain credit from, the private sector; and that they could build their agronomic and managerial capacities to grow sophisticated vegetables, all of which pointed to successful economic development. By 2003, 137 participating households earned an average of US$100 per month, and 413 households earned US$40 per month, up from US$12 per month before REAP. Farmers could afford to school their children, buy medicines and re-invest in personal assets, thereby breaking the cycle of extreme poverty. However, REAP had failed to be commercially viable. It had been unable to choose the right clients and staff, or to modify its bureaucratic systems to be more like a business and less like a non-governmental organization (NGO). A business entity could focus operations on efficiency rather than just effectiveness. From the smallholders’ perspective, REAP was successful because it increased farmers’ earnings by linking them to markets that they would otherwise have been unable to access. Mutulu expressed his gains in spiritual and physical terms: “When REAP started we thought mana [meaning help from above] had come.” He stood up with a chuckle and displayed his impressive round gut. “And look at my belly now!” On the downside, while most of the PUs were making money, the CMU had never been profitable. The CMU costs were subsidized by donor funding, which would eventually come to an end. The CMU needed to be financially sustainable for it to continue providing services to the farmers. Some smallholders were not showing up for work, and there was occasional infighting. Contracts with exporters were not always fulfilled. For example, from October 2002 to September 2003, REAP farmers supplied only 30 per cent to 40 per cent of their contracted volumes. The CMU’s losses were absorbed by REAP through debt for which CARE was liable. REAP faced challenging performance-related issues when farmers didn’t meet their targets. Some farmers faced various barriers to being successful

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entrepreneurs. While the competitive horticulture industry would have cut them out of the game, REAP could not easily abandon its clients. CARE had a propensity for funding projects through grants. As such, REAP’s relatively loose lending criteria had resulted in loans that exceeded their clients’ ability to repay. Not only did over-lending increase CMU’s bad debts, it also lowered farmer productivity. Two upcoming issues especially concerned George. First, he knew that in its current structure, REAP would require continuous external fundraising and that donors would become increasingly difficult to secure. As such, CARE’s involvement in REAP would have to be scaled back in the near future. Second, George recognized that EurepGAP agricultural standards would be extended and intensified at the end of 2005. While the large export companies were already certified, no smallholder would be able to afford costly integrated pest management and tracking systems. For REAP to continue beyond 2005 in its current structure, it would need a huge injection of capital. IMPROVING REAP George Odo was determined to solve these problems and make REAP sustainable.

We are continuously meeting in CARE, including annual review forums for projects. Through these meetings, it was becoming clear that REAP had problems. Against our donor contracts, we were achieving our targets. But against our market contracts, our performance was below par.

George started by analysing REAP’s financial statements and projections. Most of the PUs were profitable after their first year of operation. Exhibit 3 shows the Profit and Loss Statement for the Wololo Wa Thange PU. However, the CMU had lost KSh12.5 million in 2002 and was only projected to make its first, modest profit of just over KSh1 million in 2006 (see Exhibit 4). Stepping back, George wondered if a completely different approach would be necessary to make REAP commercially viable, without compromising its development agenda. He was confident that a market-based approach to development was necessary in order to address the severe poverty problem in rural Kenya.

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Exhibit 1

INCOME DISTRIBUTION IN KENYA

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Urban Rural

% o

f K en

ya ‘s

T ot

al In

co m

e

Richest 20% Middle 60% Poorest 20%

Source: Economist Intelligence Unit.

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Exhibit 2

PHOTOS OF SELECTED REAP STAKEHOLDERS Source: Casewriter and CARE Employee, Jesse Moore.

Mutulu Mathoka George Odo

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Exhibit 3

WOLOLO WA THANGE PRODUCTION UNIT Profit and Loss Statements

(for the 12 months ended June 30, 2002 and 15 months ended September 30, 2003) (in KSh)

Hist 2003 Hist 2002

Turnover 2,290,871 917,436 Less: Cost of Sales 844,713 545,961 Gross profit/(loss) for the year 1,446,158 371,475

Less: Expenses Depreciation 414,650 118,638 Operational Costs 441,401 438,776 Management Fees 144,616 – Total 1,000,667 557,413

Profit (Loss) before Finance Costs 445,491 (185,938)

Finance Costs 501,162 308,035 Adjustment to Loans (608,854) – Profit (Loss) after Finance Costs 553,183 (493,973)

Taxation 553,183 (493,973) Dividends Paid 232,000 202,000 Profit/(Loss) 321,183 (695,973)

Source: Company files.

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Exhibit 4

PROFIT AND LOSS STATEMENT FOR THE CENTRAL MANAGEMENT UNIT (in KSh)

Hist Hist Proj Proj Proj 2002 2003 2004 2005 2006

Revenues Interest 1,237,564 2,970,847 3,507,132 3,605,000 3,408,000 Management fees – 42,158 243,144 3,799,677 5,085,808 Total 1,237,565 3,013,006 3,750,277 7,404,677 8,493,808

Staff costs (direct costs) Salaries 5,218,351 4,188,318 Employee benefits 982,465 770,516 Employee allowances 520,120 420,837 Consultants 1,049,178 709,576 Total 7,770,114 6,089,247 7,839,417 6,664,210 5,096,285

Gross Profit (6,532,549) (3,076,241) (4,089,140) 740,468 3,397,523

Administrative costs Office supplies 572,723 329,480 – – – Overhead apportionment – CARE 525,460 49 – – – Communications 110,143 205,968 – – – Audit fees 420,000 318,600 – – – Facilities – rent 223,135 12,756 – – – Total 1,851,461 866,853 517,735 518,327 424,690

Operational costs Repairs & maintenance 384,511 161,952 – – – Vehicle running 640,393 548,365 – – – Vehicle repairs & main. 686,376 243,900 – – – Insurance 93,508 58,583 – – – Travel & lodging 1,206,460 2,265,964 – – – Training 91,221 528,458 – – – Sundry 468,675 744,036 – – – Total 3,571,144 4,551,258 1,466,783 1,480,935 1,274,071

Total costs 13,192,719 11,507,358 9,823,935 8,663,472 6,795,047 EBITDA (11,955,154) (8,494,352) (6,073,658) (1,258,795) 1,698,762

588,141 719,708 1,391,104 529,005 606,815 EBT (12,543,295) (9,214,060) (7,464,762) (1,787,800) 1,091,947 Taxes – – – – – Net Income (loss) (12,543,295) (9,214,060) (7,464,762) (1,787,800) 1,091,947

Source: Company files.

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