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Art of Blended Finance and SDGs

 

Blended Finance will play a critical role in achieving Sustainable Development Goals (SDGs) by 2030. There will be more synergies between Blended Finance and SDGs in the development sector as we advance. Blended finance, not to be confused with bending financeis fast becoming an essential and potent tool for bridging the yearly $2.5 trillion gap to meet the UN Sustainable Development Goals (SDGs) target by 2030. Blended finance is not a panacea for the global development crisis. Still, it works as an innovative way to pool commercial capital to aid risk-adjusted return for development projects.

The OECD defines blended finance as the strategic use of development finance to mobilize additional finance towards sustainable development in developing countries.

This is a defining change in the scope of blended finance from its work as various financial structuring instruments to its strategic use as a form of finance to eradicate social inequity. The means to attract additional capital for implementation of SDGs through governments, foundations, development finance institutions through concessional (soft loans with lower interest rates and/or longer repayment duration) or non-concessional resources or public or private relationships gives a defining new policy perspective to blended finance. The key objective of blended finance is to catalyze the implementation of Sustainable Development Goals globally. Blended finance offers private investors a first loss guarantee, mezzanine, or senior debt to cushion against potential losses with actors from development space, i.e., donors, multilateral development banks, and development finance institutions taking equity first loss. According to OECD, although the field proposes a lot of promise, only $81 billion of blended finance has been raised for development work over the last four years. Much of the capital is deployed for infrastructure and climate change, with Africa attracting 30 percent of total contributions, followed by Asia (15 percent). Various instruments are used to mobilize capital like Shares in CIVs, Guarantees, Syndicate loans, credit lines, and direct investment in companies. In the future, let’s look in detail at how shares in CIVs (collective investment vehicles) work. One of the critical strategic use of blended finance is to enhance funds in the development sector, especially in low and middle-income countries. The idea of catalytic first-loss capital evolved to attract capital from the private sector, especially institutional investors. Although blended capital can include concessional and non-concessional Finance, IFC deployed about $560 million of concessional development funds between 2010 and 2016 to support more than 100 projects in 50 countries. This signifies the skew towards concessional finance as part of blending. Development Finance Providers take the first loss capital through guarantees, grants, insurance working as different ways of integrating capital for credit enhancement. Guarantees work in covering the first set of losses, while Grants might include a first loss guarantee or deployment of capital without any repayment over a fixed period. Grants also have money for technical assistance to complete the project, explicitly developing capacity and scaling up the business model. While guarantees are the most widely used in blending capital, especially in infrastructure projects, more instruments, including pay for success (social and development bonds among others), securitization, hedging, junior equity/ subordinated debt, and collective investment vehicles incorporated today. The currency exchange fund (TCX) launched a currency exchange to buffer volatility through swaps and forward agreements to mitigate the risk of currency volatility in Africa. Many development institutions invest in the dollar or euro, which is converted into the local currency in Africa and open to currency risk. TCX removes the risk by absorbing any capital loss due to currency fluctuations, a massive deterrent for investors investing in Africa. Subordinate debt or junior equity is the first loss capital cushion, i.e., in case of adversity, they incur the losses. They are always next in line of cash flows to senior debt or common equity.

Collective Investment Vehicles include a structure that rewards cash flows in seniority, i.e., senior debt over subordinate debt or junior equity. Collective Investment Vehicles are designed as special purpose vehicles to attract the pool of capital from different actors, including development finance providers, foundations, endowment funds, high net worth people, and institutional investors, including pension and asset managers.  Private equity funds loosely inspire collective investment vehicles’ payback structure. The structure blends multiple cash flows into tranches depending on investors’ risk appetite. The deal flows like a waterfall structure wherein senior debt or equity gets compensated before subordinated debt or junior equity. Coming to the waterfall, this structure is widely used in private equity in rewarding cash flows to investors, i.e., general partners and limited partners, including terms like preferred return, internal rate of return, carried interest, and catch up (Look into them later). The structure could have a mezzanine trance between senior trance and subordinate trance and has the second line to cash flows from the project. Senior tranche has an investment-grade rating for attracting institutional investors. This structure does not follow the usual risk-adjusted return compensation since private investors have the higher return cushion on first loss from the project cash flows. This structure helps attract more capital through a preferred return to investors so development providers can diversify to more projects in low or middle-income countries.

Another example of Blended Capital and SDGs convergence is MIFA. Microfinance Initiative for Asia (MIFA), which exclusively targets financial inclusion in Asia, a key Sustainable Development Goal. KfW, a significant development bank from Germany, utilizes blended finance for development space. KfW, IFC, and asset manager Blue Orchard launched a fund to offer senior and subordinate funding to financial intermediaries in local currency. The fund has blended public and private capital through a series of senior and mezzanine tranches with 50 percent of money deployed by the private sector. BMZ funds the junior tranche, the mezzanine tranche sponsored by Blue Orchard, KfW, and IFC. The senior tranche includes private investors. The fund has successfully disbursed 133 loans amounting to $285 million in Asia. Another successful blended capital is the Danish Climate Investment Fund (KIF) which invests in the renewable sector of the sub-Saharan region in Africa. The Kresge Foundation has funded Memphis Riverfront Development Corp to renovate and redevelop the Memphis riverfront for the betterment of citizens. This is one of the many ongoing projects in different cities in the United States of America. However, still, a lot must be done in attracting private capital. According to OECD, only $81 billion of blended finance has been generated for development space in four years, a small amount compared to $200 trillion in global capital markets. A lot will depend on how the rules and regulations support innovation in the development space backed by political goodwill. A comprehensive and transparent monitoring and evaluation system for measuring key performance indicators, including a set of regulatory frameworks encompassing Blended Finance 2, will aid in evidence-based accountability.

References

  • Making Blended Finance Work for the Sustainable Development Goals (SDGs), Better Finance Better World, Blended Finance— A Stepping Stone to Creating Markets, Blended Finance 2: Giving Voice to the private sector, River of Dreams: Sprucing up the Front Porch of Downtown Memphis.

 
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