Blended finance – the perfect blend?

Shyam Gharial

Senior Consultant

LCP clarity:

An investment structured using blended finance allows investors to contribute to sustainable impact projects which have been de-risked through the use of development finance.

LCP insight:

Reducing the systemic sustainability risks investors face requires a lot of capital. Blended finance attempts to create structures that attract more private capital to solve these issues. This article examines some of the methods used to sweeten the offering to private investors and provides examples of some of the positive impact investments available.

What does the “perfect blend” mean to you? To most, the phrase will remind you of coffee, or potentially a favourite brand of whisky. I’m not a huge fan of either, so to me it calls to mind the mixing of two beautifully made and complementary rave music records by a DJ who knows their way around a pair of decks.

I’ve recently become familiar with another contender in the investment world: blended finance. This is not an asset class and it is not an impact investment. Blended finance can take a great number of forms but it is ultimately a way of structuring an investment using two sources of capital to facilitate positive impact:

1. Private return-focused capital

2. Public / philanthropic impact-focused capital (often development finance)

The former will be seeking attractive risk-adjusted investment opportunities. The latter often seeks high "impact" sustainability outcomes first and is less concerned about maximising risk-adjusted returns – this is also referred to as “concessional” capital.

The “holy grail” of many development finance initiatives is how to get private capital working effectively alongside government capital (“unlocking private capital” being an oft-used cliché but one with some justification). Blended finance represents one credible way this could work. From a climate-perspective this approach appears to be critical. For mitigation but also for adaptation, which has received less attention but is becoming more urgent with every hour that passes without sufficiently radical mitigation action. The climate is changing rapidly and adapting to that change makes business/financial sense. An example of a climate adaptation investment would be South Pole’s Landscape Resilience Fund, which uses blended finance to invest in small businesses that train local farmers in areas where communities are most vulnerable to floods, droughts and other climate-related risks.

Enhanced positive impact using blended structures

Positive impact is often considered in terms of the UN Sustainable Development Goals (SDGs) – addressing social and environmental issues. To achieve the SDGs there is a vast funding gap of around $2.5 trillion pa. in developing countries. And impact investments make up a very small proportion of total investments. This is particularly due to the perceived risks of investing in developing nations, which can often be much greater than actual risks. Blended finance is seen as a way to close the financing deficit by crowding-in private capital.

Structures

A blended finance structure uses concessional capital to improve the expected risk-adjusted return profile for private investors – this helps increase the total amount invested in positive impact projects. It can do this through equity or debt positions in projects. Some of the main structures include (for the purposes of the accompanying diagrams, the “blended structure” is where the capital for investment sits):

First loss capital: the concessional capital is invested together with the private capital but the concessional capital absorbs a greater share of any losses than the private capital.

Results based finance: the concessional capital only pays into the structure once the impact they are seeking is delivered by the private capital investment.

Guarantees (or “contingent liabilities”): concessional capital is used as a guarantee and sits outside the investment structure. If there is a trigger event, such as a negative return, the concessional capital is paid to the private capital.

Technical assistance: only private capital sits inside the blended structure. Concessional capital improves the risk-adjusted return profile of the investments by improving the commercial viability of the investee – for example, through direct funding of training to empower local communities to run and manage their own sustainable development projects.

Concessional capital often sits outside the blended structure as it may not actually be permitted to take part in investing (for example, it may be explicitly mentioned in the rules of a foundation).

Examples of positive impacts through blended finance

A blended finance structure can be applied to individual projects but it can also be applied to a co-mingled fund. There are multiple funds set up using blended finance. Often, each has a differing area of focus. For example, there are agriculture funds, funds dedicated to the empowerment of women, and healthcare funds.

A well-known fund in this space is Mirova’s Althelia Sustainable Ocean Fund which was set up with a guarantee from the US Agency for International Development covering the first 50% of any losses. This 8-year fund creates impact by providing equity capital to companies involved with sustainable seafood, the circular economy and ocean conservation. Positive impact is measured in terms of climate change mitigation, land/seascape management, biodiversity conservation, gender equality, etc.

At project-level, an example of where concessional capital is used to increase the expected risk-adjusted returns for private capital is from the Global Climate Partnership Fund (GCPF) run by responsAbility. An investment made by the fund helped the financing of $43m of loans for energy efficiency and renewable energy in Costa Rica through Promerica Bank. Alongside this, GCPF also used a technical assistance facility to provide specialist sustainability advice.

Developed market transactions

Although blended finance focuses on providing capital to developing nations it is also used in developed markets. The UK Government-owned UK Infrastructure Bank is one such example which aims to drive regional and local economic growth focused on clean energy, transport, digital and water and waste projects.

What sort of returns can be expected?

Since funds that use blended finance structures are often private and invest in different parts of the capital structure of companies, and these companies have differing levels of risk, it is not straightforward to assign an expected return for private capital investors. The level of security provided by the concessional partner is also a factor in the target returns – for example target returns in blended finance structures that are highly guaranteed by G7 governments might be in the low single digits (a small premium over comparative government bonds). But double-digit returns can also be expected in some funds. Blended finance is gaining in prominence as a way of increasing the overall amount of money working towards sustainable development. There are still risks involved for private capital despite the presence of concessional capital (e.g. currency, credit, liquidity, etc). So, while nothing is perfect (apart from a top-quality music mix, of course), the use of blended finance allows private investors to access appealing risk-adjusted returns while contributing to the reduction in the urgent systemic sustainability-related risks all investors currently face.