By Shanti Krishnan
The Development Funding Gap
Traditionally the domain of aid agencies, development finance institutions, and foundations (here we will call them collectively “public investors”), the landscape of development finance is changing rapidly. Public investors are increasingly engaging and investing alongside private investors to achieve their goals. These public-private partnerships, which come in multiple forms and structures, have the potential to provide a much-needed boost to the pool of available capital for development finance.
Estimates suggest that the emerging Sustainable Development Goals (SDGs) will require $4 trillion of annual investment. Current investment falls far short of these demands, leaving an annual investment gap of ~$2.6 trillion in critical areas such as health, education, food security, climate change, and infrastructure.
At the same time, private investors (e.g., private equity funds, pension funds, insurance companies) are increasingly looking to emerging and frontier markets for investment opportunities. In 2014, private equity investment in emerging and frontier markets totaled $33.8 billion, a 26 percent increase from the prior year. Moreover, an increasing share of these flows originate in other emerging and frontier markets. When directed properly, this influx of private capital into and between emerging and frontier markets can be a powerful force for global development by helping to support investments that generate social, economic, and environmental impact.
Yet despite this growing interest, significant barriers to private investment in emerging and frontier markets remain, including inefficient financial markets, weak institutions, and macroeconomic and political instability. These barriers contribute to a more risky, challenging, and uncertain environment for investors, particularly when compared to more developed markets.
The Blended Finance Opportunity
At the intersection of these two trends – the need for more development financing and private investor interest in emerging and frontier markets – is an enormous opportunity for public and private investors to join forces through blended finance.
According to the World Economic Forum’s ReDesigning Development Finance Initiative, blended finance refers to the deliberate use of public funds to attract private capital towards investments delivering development impact in emerging and frontier markets. Specifically, public investors strategically use their funds to mitigate investment risk and/or enhance returns for private investors. By supporting blended finance transactions, public investors can magnify the impact of their own resources; estimates suggest that public capital deployed through blended finance transactions can attract 1-10 times the initial amount in private investment.
For example, the DKK 1.2 billion (~$175 million) Danish Climate Investment Fund (KIF) provides risk capital to climate-related projects in emerging and frontier markets, while promoting the use of Danish climate technology. Backed by the Danish government, the fund has successfully catalyzed private capital from four Danish pension funds. The fund expects an annual 12 percent return, including a preferred return for private investors, and it will invest in projects that reduce greenhouse gases, such as renewable energy, energy efficiency, and transport schemes, as well as projects that help communities to improve their resilience against the effects of climate change, such as those related to coastal management and disaster preparation.
How Public Investors Can Participate in Blended Finance Transactions
While blended finance often involves innovative partnerships between public and private actors, it typically relies on traditional financing structures and instruments. Specifically, public investors can support blended finance transactions in three primary ways:
- Participate directly in a given investment opportunity: Public investors can participate in blended finance transactions by providing equity or debt financing at market rates and terms, and in many cases, below-market rates and/or terms to create a subsidy effect for private partners. Public investors may invest directly in a given opportunity or assets, or via investment in other funds that make direct investments. Providing financing, particularly on favorable terms, can make a prospective investment more attractive to private investors by reducing real or perceived risk and/or boosting investment returns. For example, the Africa Health Fund, which invests in healthcare enterprises serving the poor, was established with $57 million of funding from public investors, including the Bill and Melinda Gates Foundation, the African Development Bank (AfDB), International Finance Corporation (IFC), and DEG. Since inception, the fund has grown to over $100 million with support from additional public and private investors, and has invested in businesses like Nairobi Women’s Hospital and Ghana-based healthcare provider C&J Medicare.
- Issue products to mitigate investment risk: Public investors can also provide private investors with products that help manage specific types of investment risk, including credit, contractual, political, and systemic risk. Examples of these products include partial and full credit guarantees, political risk insurance, and currency swaps. By reducing the real and/or perceived risks associated with a given investment, these products can help boost private investor confidence and stimulate private investment in emerging and frontier markets. For example, the aid agency-backed Multilateral Investment Guarantee Agency’s (MIGA) Conflict-Affected and Fragile Economies Facility (CAFEF), established in 2013, provides political risk insurance to spur private investment in conflict-affected and fragile countries. By reducing the real and perceived risks of investing in these economies (which currently account for less than 5 percent of total investment in emerging and frontier markets), MIGA’s CAFEF is expected to facilitate $550 million of foreign direct investment and the creation of more than 5,000 jobs in target countries.
- Support efforts to identify or develop investment opportunities: Finally, public investors can help to identify and develop socially impactful investment opportunities in emerging and frontier markets, typically by providing grant funding or technical assistance. Pre-investment, public investors may fund feasibility studies or research to help identify and prove the case for investment opportunities in emerging and frontier markets, or to help with capacity building to increase a company’s investment-readiness. For example, the aid agency-backed Infrastructure Project Preparation Facility (IPPF) (managed by the AfDB) provides grants for infrastructure project preparation activities in Africa. By funding project preparation studies and technical advisory services, IPPF has helped to catalyze public and private financing for critical infrastructure development in energy, water, transport, and ICT.
Through each of these blended finance mechanisms, public investors can contribute to a more commercially viable investment climate for private investors, helping to direct private funding towards impactful opportunities in emerging and frontier markets.
The Future of Blended Finance
Blended finance has tremendous potential to transform development finance as we know it. Through blended finance transactions, public investors can leverage their funds and often higher risk appetites to direct billions of dollars of private capital towards advancing important development priorities. While not without its risks and challenges, scaling blended finance activity will be critical to meeting the world’s development financing needs, and to sustaining progress along critical economic, social, and environmental outcomes.