BlueOrchard Brief: Set off on your impact journey in good company

05/05/2022 Blog

Investors have to ask themselves many questions at the beginning of their impact journey, e.g. what impact do I actually want to achieve? In which asset class and which region do I want to invest? One of the most important questions in this context is: Which is the appropriate investment vehicle for me? This question is especially important for “beginners” in the impact field due to the large variety of vehicles out there with different characteristics. In addition, we cannot underestimate the importance of how we design and structure investment vehicles, and the partners we choose to start the journey and make an impact.  In this article, Valerie Harrington, Associate Fund Manager at BlueOrchard, discusses blended finance vehicles and the role of development finance institutions.

What is special about blended finance?
One of the interesting type of vehicles are blended finance mechanisms. Simply put, blended finance refers to public funds provided as de-risking instruments to mobilize private capital. It allows parties with different objectives to invest side by side. Such vehicles offer investors a variety of unique features in which financial and social returns, risks, and protection against capital loss are adjusted to match the private investor’s particular risk/return positioning. development finance institutions (DFIs) are a key player in the blended finance ecosystem due to their high participation and investments volume in these types of transactions.

Taking a closer look at DFIs
As specialized development banks, DFIs are established to support private sector development in developing countries. However, there is a wide range of DFIs including both bilateral (such as KfW German Development Bank and the British Investment Corporation) and multilateral organizations (such as the International Finance Corporation and the InterAmerican Development Bank). Their strategic focus and operational capabilities vary depending on their mandate. For example, some focus on a specific country or region and/or development theme such as education, climate, or gender. DFIs generally engage in blended finance in two ways: Through so-called “catalytic capital” and through mixed concessional financing. Catalytic capital is meant to attract private capital by accepting a disproportionate risk/return profile therefore enabling third-party investments that would not occur otherwise. In other occasions, DFIs can provide financing at commercial terms while donors or other public organizations provide the concessional capital. To truly mobilize capital at scale for the grand challenges of our time, actors such as DFIs and private investors need to understand each other’s approaches and needs even better. In this context, the Catalytic Capital Consortium and Convergence recently published a research brief exploring the role of DFIs in providing catalytic capital.

Catalytic capital – the magic formula?
According to the study, DFIs use catalytic capital primarily for two purposes: building a track record and mobilizing additional investment. Another key finding is that DFIs tend to invest capital primarily in vehicles that can promote scaling and replication. In addition, DFIs focus on using catalytic capital to promote economic growth and climate finance. Not surprisingly, the majority of mobilized investors in these deals are private investors, including both traditional private investors (such as commercial banks) and impact investors. This is great news and is consistent with our experience in this space. We have managed more than USD 1 billion in blended finance mandates over the past 20 years, successfully mobilizing private capital. Over the years, we have worked hard to understand the needs of both groups of players, DFIs, and commercial investors, to figure out how to mobilize more private capital even more efficiently.

What do private investors need?
In our Blended Finance 2.0 study, we conducted a survey of our private investors to determine their basic motivations for participating in investment vehicles using blended finance. In terms of expectations for public investors, we found that the investors surveyed were looking for credit enhancements such as downside protection and 1st loss guarantees. These factors were seen as critical aspects for private investors to participate in these structures. Another key finding was that private investors are more willing to participate in blended finance funds once the investment has passed the proof-of-concept stage. This aligns well with the Convergence study findings that DFIs tend to invest capital primarily in vehicles that can foster scale and replication. One important aspect we noted is complexity. A significant number of investors surveyed wanted more simplicity in blended finance vehicles. For example, greater simplicity could be achieved through simpler liability structures, simpler operational aspects, and more private-sector management procedures.

Public and private players must move closer together
Studies like these help us to further improve the design of blended finance instruments so that public and private actors can work together toward the same impact objectives in an efficient and accountable way. We need to continue to improve our understanding of each other – DFIs, private investors, impact investors – to take a big step toward our social and environmental goals. In this way, we can be good company and partners for each other on our impact journey.

 

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