Three Ways to get Better Outcomes from Blended Finance
This piece originally appeared on Impact Alpha. It was authored by Lala Faiz, USAID INVEST, Serena Guarnaschelli, KOIS, and Vanessa Holcomb Mann, USAID INVEST.
Blended finance continues to gain traction, and for good reason. For investors, it can shift the balance between risk and return in frontier and emerging markets, opening up new opportunities for investment. For providers of foreign aid, it can close gaps in development financing and ease some of the toughest global challenges we face. Used properly, blended finance channels private capital into areas where it can have a positive impact while generating solid returns. It develops markets and builds local capacity.
However, blended finance is far from meeting its full potential. Estimates vary, but a recent study by the U.K.’s Overseas Development Institute found that each dollar of public funding from Multilateral Development Banks and Development Finance Institutions leverages 75 cents of private investment on average and only 37 cents in low-income countries. While leverage is an imperfect measurement of success, this statistic asks us to take a hard look at the state of blended finance – to ask when and how blended finance should be deployed and how we can get the best results.
In 2017, The U.S. Agency for International Development launched the INVEST initiative to facilitate work between USAID and the investment community. INVEST is actively supporting 19 transactions, in companies, infrastructure deals, and financing instruments or funds in Haiti, Ghana, Tunisia, India and a half dozen other countries. Partnering with specialized investment firms like KOIS Invest enables USAID to effectively mobilize private capital to achieve positive social and environmental impact.
As more development partners like USAID use blended finance as a tool, lessons are emerging on how to use it more effectively and get better outcomes with the funding it crowds in – ultimately, allowing it to reach its potential. Here are a few things we have learned.
When designing initiatives, it can be tempting to leap too quickly to one particular financial solution – either one that is very familiar like an investment fund, or one that is nascent and exciting like a development impact bond. It’s important to avoid both of these temptations. Just because a solution performed well in one context does not mean that it’s well-suited to another.
A systematic approach is the best defense. Rather than starting from a solution, start from the issue and build up from there. First, identify the root causes of the problem you are trying to solve, with an eye toward the underlying financing issues. Then determine whether blended finance is truly the best tool to solve them. If it is, pay close attention to the local context to make sure the solution is aligned to the maturity of the sector and the depth of local financial systems.
The U.S. Agency for International Development’s INVEST initiative, which mobilizes private capital for development impact, grappled with this challenge when beginning work in Haiti and the Democratic Republic of Congo. At first glance, the most tempting solution was to structure funds to channel private capital into these markets. But after surveying the available investment opportunities and intermediaries, INVEST recognized that a fund might not be the right first step. These markets did not yet have deep benches of talented fund managers to draw from or strong pipelines of investable deals, both of which would be necessary to attract investors.
Instead, INVEST focused on setting up investment facilitation platforms. These platforms serve as neutral intermediaries that can identify deals of various sizes, use transaction advisors to connect firms to qualified investors, and provide the support needed to bring deals to financial close. USAID’s experience with investment facilitation in Kenya and Mali, working in partnership with investment advisory firms such as CrossBoundary, demonstrates the value in building a track record for investment -- it not only raises awareness of investment opportunities but decreases perceived risk for future investors. In East Africa, USAID deployed an investment facilitation team to accelerate private investment into 30 transactions. To date, 15 transactions have reached financial close, mobilizing over $96 million in investment.
The investment facilitation approach provides flexibility to leverage different types of capital and support a wider range of transactions. It simultaneously strengthens the intermediary ecosystem and creates a track record of success, thereby laying the groundwork for the establishment of future investment funds. This is all part of USAID’s broader strategy to mobilize private capital for development and advance countries on their journey to self-reliance.
Keep it simple
The global environmental and social challenges we face are complex, but that doesn’t mean that the solution should be. Our recommendation is to use the simplest possible financial structure that addresses the problem – and only add features or partners when they are truly needed. For example, development impact bonds (DIBs) can foster innovation, produce better results, and offer more transparency. But at times the complexity of DIBs may make them a poor fit for the market or problem at hand. Difficulty attributing impact can also make DIBs less attractive than simpler tools.
There is a wide range of approaches that can be used to crowd in private capital. However, more complex approaches come with heavier management burdens and costs, which may not always provide the best value. In fact, some of the simplest tools that development partners like USAID have – like grants and deliverable-based contracts – can be very effective at reducing risk for investors and crowding in private capital.
For example, development partners can subsidize a fund’s due diligence costs through provision of technical expertise to its investees. They can provide grant capital to help mitigate real and perceived risk. Or, they can use deliverable-based contracts that pay once a fund successfully closes a financing round as a way to attract additional private investment, as USAID recently did with Women’s World Banking Asset Management’s Blended Finance Fund. The fund focuses on financial inclusion for low-income women especially through digital financial services, to break the poverty cycle and promote self-reliance. These approaches aren’t flashy, but they are effective and fairly easy to implement, and that’s what really matters.
Development partners are rarely alone in trying to address an urgent challenge. That’s why it is so important to understand the landscape of existing efforts. Many companies already invest in the communities where they operate, strengthening their supply chains and financing early-stage entrepreneurs. Rather than building parallel programs, donors can support and scale these investments by removing specific obstacles. It can be more powerful and more effective to partner and fill a crucial gap in an existing initiative than to try to build an end-to-end solution all by yourself.
For example, Solvay sells guar derivatives to cosmetics companies as a thickening agent in lotions and other products. In 2015, Solvay launched the Sustainable Guar Initiative (SGI) with L’Oreal and Hichem, a guar gum manufacturer. The initiative was designed to empower and educate farmers in climate-resilient agricultural practices, thereby ensuring a stronger supply chain. By 2017 it had demonstrated a good track record, reaching 3,000 farmers in Rajasthan, India. It was then that Solvay brought in Henkel, which also uses guar gum in its supply chain, to double the farmers reached. Current plans to significantly scale up the project’s reach create an opportunity to attract additional donor and investor capital, particularly to generate the start-up funding needed for cooperatives to become self-sustainable.
This type of approach is part of a bigger trend. The interests of corporations, investors, and providers of foreign aid are more aligned than ever before. More and more they are joining together in corporate investment partnerships that combine their strengths and divide up risks. Companies gain partners that help them address threats to their businesses and ensure their future viability. Investors reduce risk, get access to new investment opportunities, and diversify their portfolios. And donors crowd in additional resources and get a better return on their limited capital.
Blended finance holds a lot of promise, but the devil is in the details. The operational lessons we are learning are critical. We must match the solutions we design carefully to the problems we need to solve, and then execute them well. And we must work together keeping in mind not only our risk/return expectations but the strengths and limitations of our institutions. Only then will blended finance have the chance to live up to our high expectations and hopes.
About USAID INVEST and KOIS
USAID leads international development and humanitarian efforts to save lives, reduce poverty, strengthen democratic governance, and help countries advance on their journey to self-reliance.
KOIS is a firm specialized in impact investing. It deploys capital in impact businesses and funds that generate a competitive financial return, as well as a positive impact on society and the environment. For more information visit www.koisinvest.com.