This post was written by Joan Larrea, CEO of Convergence, and originally appeared on ImpactAlpha.
When we look back from the year 2030 at the progress toward the UN’s Sustainable Development Goals, we are likely to see that the emergence of “blended finance” played a critical role.
Even in emerging markets investing, many people don’t quite know how to define this approach. A few months ago, I was one of them. Now, as the head of Convergence, the first platform focused exclusively on blended finance, I’m excited to see discussion of the concept from The Economist (“Trending: blending”) to Foreign Affairs (“The Innovative Finance Revolution”).
Blended finance combines funding from development institutions, philanthropic entities, and profit-seeking investors. Tweet This Quote
When I meet counterparts from development banks, philanthropic institutions, and the private sector, I find there’s still confusion about what exactly blended finance is. Where does it fit in the landscape of impact investing? How does it differ from the development finance that the World Bank Group and other multilateral institutions have been doing for decades?
Strategic Money
Boiled down, blended finance simply encourages more private sector investment by being strategic with the money already at work from official development assistance and philanthropic sources. Blended finance transactions combine funding from development institutions, philanthropic entities, and profit-seeking investors and put that capital to work in a way that is aligned with the UN’s Sustainable Development Goals (SDGs).
There are three signature markings of a blended financial deal:
- The transaction—whether a project, company, fund, or structured offering—is intended to yield a financial return.
- The venture or activity contributes toward meeting the SDGs in an emerging or frontier market. Not every investor in the transaction will have that intent; there may well be participants who are drawn instead by diversification, returns, or a strategic opportunity to enter a new market.
- The public and/or philanthropic parties at the table are catalytic, making a deal happen that would otherwise attract little or no interest from the private sector.
Blended finance opens a channel for the massive surge in private sector investment in emerging and frontier markets that will be critical between now and 2030 if there is any prospect for achieving the SDG targets. It is the private sector, after all, that grows economies, creates jobs, provides a tax base, and connects people with world markets. At the same time, these markets represent significant opportunity, as investors seek new high-growth opportunities.
The private sector grows economies, creates jobs, and connects people with world markets. Tweet This Quote
By blending different types of capital, these new structures can “crowd in” more private capital than would be available through traditional structures. Grant funding or “venture philanthropy” can give a transaction an early push to bankability. A technical assistance program funded in tandem with the transaction can benefit suppliers, end-users or other stakeholders, directly or indirectly.
And most consequentially, public funders or philanthropic investors can participate in the capital stack on less-than-market terms. They may provide first-loss capital to shore up the equity and debt layers, or provide unfunded support such as insurance or guarantees. Their participation, in whatever form it takes, may cover a specific downside risk or yield incremental upside to others.
At Convergence, we’re helping facilitate more blended finance dealflow in three main ways: first, our design funding provides grants to practitioners with early (perhaps radical) ideas for new financial instruments that, if proven, could become part of everyone’s toolkit for doing blended deals – think about the next green bond or microfinance CDO, for example.
Blended finance opens a channel for private sector investment in emerging markets. Tweet This Quote
Second, we offer knowledge resources such as deal data on past blended finance transactions and workshops for investors and officials who are putting deals together.
And, third, we’ve created the Investment Network, a community of accredited investors and deal sponsors connected via an online platform that puts interested capital in touch with deals in need of financing.
Special Blend
Our take on the term “blended finance” excludes most structures that involve only market-priced funding from a development finance institution (DFI) for a private sector entity. Why? Because the whole point of blended finance is to “grow the flow,” that is, to create more transactions with risk and reward characteristics that will attract investors from the sidelines. The blending is intended to induce them to make a sound bet on productive, positive ventures in difficult environments where they otherwise would have little interest.
What the DFIs have been doing for half a century remains of critical importance. But we focus on what is not yet happening enough.
The whole point of blended finance is to create more transactions that will attract investors from the sidelines. Tweet This Quote
Another term that often comes up in these discussions is “impact investing.” The Global Impact Investing Network, an authority in that space, defines impact investments as “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.” Impact investments can be made in both emerging and developed markets, and target a range of returns from below-market to market-rate, depending upon the circumstances.
Impact investors may be involved in blended finance, but there may well be others involved in the transaction who are focused first and foremost on their financial bottom line. An example of an impact investment that is not blended finance would be MCE Social Capital, because nowhere in its business model is there an expectation of financial return. MCE secures personal guarantees from individuals committed to an objective, and pools those guarantees to borrow funds that it then onlends at below-market rates to financial providers for underserved clients in emerging markets. Guarantors receive no financial return, but do contribute to poverty reduction in the developing world.
Blended finance will take us from the present-day billions to the requisite-future trillions that are needed to hit those SDGs. Tweet This Quote
Conversely, a blended finance transaction that would not require its limited partners to make an impact investment is Sarona Asset Management’s Frontier Markets Fund 2 (SFMF2). Its expected returns (post-blending) are of a caliber that would appeal to LPs with no impact lens. The fund has within its capital structure concessional financing from public funders, which improves its risk-adjusted returns, allowing it to catalyze more private capital. By amplifying the private capital available, concessional public financing has allowed Sarona to push into traditionally underserved markets, improving access to healthcare, financial services, and education in countries like Kenya, Haiti, and India. The fund’s private investors expect a market rate return; and SFMF2 plans to deliver, with a target net IRR of 15 percent.
So while the fund undoubtedly helps to reduce poverty—and incorporates rigorous ethical, social, and environmental screening and monitoring into its operations—it also is setting out with the intention to make its private investors money. This is the kind of additionality beyond the current flow of public and philanthropic dollars that is necessary to achieve the SDGs.
Keep it Simple
My least favorite term in the lexicon must be “innovative finance,” which is sometimes used in place of blended finance. We finance types are tinkerers and engineers at heart. But in most cases, innovative financing does not exhibit any financial innovation, as this report from the Global Development Incubator and Dalberg explains. Rather, it is an innovative application of an existing financial instrument or structure.
Anyone who has closed a deal knows that simplicity is precious. Tweet This Quote
Innovation is laudable when it achieves an objective otherwise out of reach, but what’s wrong with straight-up structures if they get to the same place? Anyone who has closed a deal knows that simplicity is precious, and that elaborate structures—including blended finance structures like development impact bonds—are what we do when simple just isn’t possible, or doesn’t get the right mix and volume of capital.
That brings us back to blended finance. Convergence is taking this moment to define the term in an effort to highlight the smart application of a finite pool of official aid and philanthropic money to take us from the present-day billions to the requisite-future trillions that are needed to hit those SDGs.
While blended finance may be young, all signs point to its prominent role as global investors seek new opportunities and global development challenges loom large.