Blended Finance: Making Funding Work for Financing

In this second installment of a four-part series on impact investing and finance for development, Autumn Gorman from USAID's Private Sector Engagement Hub discusses blended finance. Read the series' first, third, and fourth installments.

We know that there is a global need for additional development dollars to achieve the Sustainable Development Goals. USAID and others know that Official Development Assistance (ODA) alone is not enough, so more is needed from the private and financial sectors. In blended finance, public funds are used strategically to catalyze private capital investments in sustainable development. But before we blend, it is important to understand the differences in how these types of funding behave. There is a clear distinction between providing funding — what donors and philanthropists do (the right of the spectrum), and providing financing — what investors, banks, and other “finance providers” do (the left of the spectrum). The terms "financing" and "investment" are often used interchangeably, even though banks don’t "invest" their loans in the way venture capitalists do. But both financing and investment seek financial returns.

However, funding is different and should not be conflated with financing — because they are profoundly different in terms of their overall objectives. The Golden Rule of Finance: Whenever money is invested, it should generate more value than what it costs. For funders, value is phrased in social and environmental outcomes, including economic growth benefiting societies. But for financiers or investors, the value is phrased in monetary terms — with financial benefits going to themselves. As noted in my last blog, impact investors consider both, seeking both economic returns as well as financial or monetary returns. But when the monetary return is unclear or non-existent, we should look at funding.

Case in point: Would development agencies be creating value by encouraging new loans to families with small businesses that have taken a large hit due to COVID-19? Perhaps not, if it isn’t clear that the new debt can be repaid with the businesses’ underlying cash flows. We could potentially make families worse off, should those loans be used to meet basic consumption needs and go into default. Clearly, feeding families in distress is a development priority, but in this scenario, financing (with a return expected for the finance provider) would create more harm than good. As such, they would be better served by being funded (through grants and donations) rather than being financed (with the obligation to repay that financing–plus some sort of return).

Blended Finance 

USAID does not provide financing. That is what the U.S. International Development Finance Corporation (DFC) and others do. However, USAID may provide funding to finance providers and support the formation of pools of capital to support development objectives — through what is called blended finance — using catalytic capital from public or philanthropic sources to mobilize additional private sector investment in sustainable development outcomes.

The idea behind blended finance is to reframe the math behind a risk-adjusted return by combining capital that expects no financial return (or even a loss, as a traditional grant), to meet the thresholds of private capital providers seeking competitive returns. However, this isn’t a simple thing to do. 

Would you invest $1,000 if you could have $1,200 in one year (20% annual return)? Maybe. You are probably thinking a lot about what ‘could’ means. What are the odds–or risks–of getting that 20% return vs. losing the entire $1,000? Well, if that is the only $1,000 you have saved, you may prefer it to go into a savings account where you have nearly zero risks of losing it, even though the return is much smaller. If it is money you would otherwise give to a charity that aligns with the same development outcomes of the investment, you may be willing to take significantly more risks, because you would be no worse off. A charitable gift is 100% loss. But if you could still achieve a similar impact and potentially have $1,200 to support something else in a year, the investment risk seems insignificant, even when it is relatively high.

In other words: context matters. For each investor, for each investment, there are potential risks and there are potential benefits.

Additionality and Leverage

When blending funds and finance, not only is it important to align stakeholder interests, but their risk profiles and expected rates of return as well. And to do this in a way that achieves the most additionality isn’t as straightforward as it may seem. 

There is almost certainly a point at which I could convince you to invest your only $1,000 that would otherwise go into a savings account. For example, if there was a donor that would guarantee 100% of your investment, leaving you only the potential upside of a 20% return (and opportunity costs of $10 — the amount you would get on a 1% savings account). Your $1,000 would certainly be additional — it wouldn’t have been invested without the guarantee — but would that be the best use of donor dollars? Probably not. In such scenarios, donors should instead look at other finance partners, or possibly even go back and look at whether more traditional funding might be more appropriate in achieving our objectives.

Now let’s look at additionality for another potential blended finance structure. Let’s say an investment fund manager is mobilizing a new $100 million fund, and seeks $1 million of donor capital, for potential leverage of 100:1. Good, right? We may think so, but is there any financial additionality? Going back to your $1,000, would your risk-return investment calculation fundamentally change if $10 of that investment was guaranteed, meaning you could still lose $990? Probably not. You would likely still choose the 1% savings account. Thus $1 million in a $100 million fund isn’t likely going to be financially additional either. In other words, the public funds being leveraged here aren’t really "unlocking" anything. Investors’ risk-return calculations aren’t going to fundamentally change. They are likely to make the same investment (or not) regardless of public/donor funding.

However, the 100:1 blend may be appropriate if the reason for doing so is more about ecosystem additionality: creating the market signals and removing systemic barriers to change the behavior of many. In other words, where the development outcomes occur across systems and/or sectors and are beyond and outside of any particular investment fund. For example, say an investor comes to USAID saying they would like to build a series of factories (>$1 billion), but there is an investor protection regulation that needs to be changed before they would be willing to make that move. USAID can combine its advocacy power with a ‘token’ amount of funding to indicate its support for the investment (e.g., $1 million, for >1000:1 leverage)–which might be all that is needed to provide necessary political cover for the government to make the regulatory change that not only results in this investment, but sets the stage for many others in all sectors, as well as possible benefits in strengthening government relations. The reason for supporting something like this has nothing to do with that one investor because the financial additionality is zero, but the ecosystem additionality is HUGE.

Blends that may look more like 1:1 may be appropriate in high-risk scenarios, such as in post-conflict areas, for seed-stage capital in frontier markets, and to pilot a new solution that directly addresses a critical gap in the financial markets. And they might have features that include either or both financial and ecosystem additionality. 

The point here is that using the funding to catalyze financing isn’t simple or straightforward. It is complex and nuanced. It should start by looking at the desired impact. Then start to think about how the different pools of capital could be blended in financial structures so they can invest together to achieve it. Leverage should never be the driver of such decisions. And always consider additionality — what would happen without donor support.

And don’t forget about the space between all or nothing (between receiving a return or 100% loss) for activities that can have a significant development impact, but may only ever be able to be partially self-sustaining. For example, we could include a feature so that part of a grant can be "recycled" or re-used to continue the program, and we can encourage philanthropy to deploy such approaches to stretch donor dollars. USAID’s PACE program deployed this approach with a grant that was used to support zero-interest, collateral-free loans for seed-stage companies in the Sahel. Repaid loans could then be recycled to support other aspiring entrepreneurs, and those that couldn’t be repaid due to illness or crises were forgiven. Thereby significantly reducing the risk of starting a new business. Just as we can nudge players on the left of the impact investing spectrum to move towards the right, we can nudge players on the right to move towards the left.

When addressing finance challenges, there are three concepts you should keep in mind: 1) the Golden Rule of Finance — which applies to both finance seekers and finance providers; 2) funding vs. financing, and their respective roles; and 3) Additionality — both financial and ecosystem. 

For more check out:

• This Guidance Note on Blending Finance for Additionality and Human Impact 
• Financial Leverage is Not a Good Measure of Impact. Here is What to Use Instead | Marketlinks
• Blended Finance - OECD
• Convergence - The Global Network for Blended Finance