Pic Source: Convergence Finance
Blended Finance will play a critical role in achieving the target of Sustainable Development Goals (SDGs) by 2030. Going forward, there will be more synergies between Blended Finance and SDGs in the development sector. Blended Finance not to be confused with bending finance, is fast becoming an important and potent tool for bridging the yearly $2.5T gap to meet the UN Sustainable Development Goals (SDGs) target by 2030. Blended Finance is not a panacea for the global development crisis, but stills works as an innovative way to pool in commercial capital to aid risk-adjusted return for development projects.
OECD defines blended finance as the strategic use of development finance for the mobilization of 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 through public or private relationship gives a defining new policy perspective to blended finance.
The key objective of blended finance is to catalyze implementation of Sustainable Development Goals globally. Blended Finance works in offering 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. Although the field proposes a lot of promise, only $81B of blended finance has been raised for development work over the last four years according to OECD. Much of the capital is deployed for infrastructure and climate change with Africa attracting 30% of total contributions followed by Asia (15%). Various kinds of instruments are used to mobilize capital like Shares in CIVs, Guarantees, Syndicate loans, credit lines and direct investment in companies. Going forward let’s look in detail at how shares in CIVs (collective investment vehicles) work.
One of the major strategic use of blended finance is to enhance funds in the development sector especially in low and middle-income countries. In order to attract capital from the private sector especially institutional investors the idea of catalytic first loss capital evolved. Although blended capital can include both 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 blending capital for credit enhancement.
Guarantees work in covering the first set of losses while Grants might include first loss guarantee or deployment of capital without any repayment over a fixed time period. Grants also include money for technical assistance for completion of the project specifically to develop capacity and scale 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, and junior equity/ subordinate debt and collective investment vehicles are incorporated today.
To mitigate the risk of currency volatility in Africa, the currency exchange fund (TCX) launched a currency exchange to buffer volatility through swaps and forward agreements. Many development institutions invest in dollar or euro which is converted into the local currency in Africa and open to currency risk. TCX removes the risk though absorbing any loss of capital due to currency fluctuations which can be a huge 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 and are always next in line of cash flows to senior debt or common equity.
Collective Investment Vehicles include a structure which rewards cash flows in terms of seniority i.e. senior debt over subordinate debt or junior equity. Collective investment vehicles or funds 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. Collective investment vehicles pay back structure is loosely inspired by private equity funds. The structure blends multiple cash flows into tranches depending on the risk appetite of investors. The deal flows as a waterfall structure wherein senior debt or equity gets compensated before subordinate 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 which includes terms like preferred return, internal rate of return, carried interest and catch up (Look into them later). The structure could have mezzanine trance which is in the middle 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 with a cushion on first loss from the project cash flows. This structure helps in attracting 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 major development bank from Germany is a leader in utilizing blended finance for development space. KfW along with 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% of capital deployed by the private sector. The junior tranche is funded by BMZ while the mezzanine tranche funded 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 success of blended capital is Danish Climate Investment Fund (KIF) which invests in the renewable sector the sub-Saharan region in Africa.
The Kresge Foundation has funded Memphis Riverfront Development Corp to renovate and redevelop 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 bn of blended finance has been generated for development space in four years, a puny amount compared to $200 tr in global capital markets. A lot will depend on how the rules and regulations support emergence of innovation in 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. You can know SDGs implementation in India by clicking this link.
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.