1. Introduction
To close the investment gap for the SDGs and for the just energy transition – approximately $4.5 trillion annually – we need to drastically scale up private capital investment from the institutional investors that represent the deepest pockets in the world (asset owners: pension funds, insurance companies, sovereign wealth funds). And since SDG and climate problems do not always represent commercially viable solutions, this private capital will need to be ‘mobilized’. Fortunately, we have very good tools to achieve this – the financial structuring instruments that are now typically referred to as ‘blended finance’ – but there are certain barriers to scaling this up.
To analyze these barriers, we at Route17 have developed a framework labeled the Mobilizing Private Capital Equation. Building on the music analogy we used in our series of articles “Blended Finance is Like Music”, we liken the desired output – the amount of private capital mobilized – to music coming from an amplifier that has four dials, that can all be turned up or down. If one or more are turned to zero, no sound comes out at all. The more the four dials are turned up, the more sound comes out.
This can also be likened to a mathematical equation, where the outcome (the level of private capital flowing towards SDGs) is a function of four variables: (1) the supply of bankable projects, (2) the ‘mobilizing power’ of the risk mitigation capital that is used, (3) the linkages between the development banks (DFIs and MDBs) and private sector investors and, finally, (4) the orientation of private investors towards this kind of investing.
In this article, we will discuss each of these four barriers and reflect the most relevant observations and takeaways of a symposium in late 2023 on blended finance attended by approximately 60 representatives from a range of sectors – government, development banks, asset owners, asset managers, investment and commercial banks, academia and think tanks – and held under Chatham House rules.
2. Supply of bankable projects – “bankability”
This is the first barrier in our equation: if there are no projects to invest in, then logically no investment capital will flow. “Bankability” signifies, in short, that the project should generate, or have the potential to generate, some positive return. If there are no positive returns, banks or investors will not be interested in financing the project. The project sponsors may then still seek pure government or philanthropic funding. We focus primarily on projects in low- and middle-income countries – not because developed countries shouldn’t benefit from blended finance, but because the need for concessional funding is far greater in less developed regions. While these countries have the highest demand for capital investment, their cost of capital is often significantly higher, reflecting the perceived greater risks.
A key question to address is: “How can we increase the number of bankable projects at scale in low- and middle-income countries?”
Development banks (DFIs/MDBs) play a key role in sourcing bankable deals in developing and emerging economies– investment banks generally are not involved since origination is too costly. Indeed, most of the DFIs and MDBs have local presence in low- and middle-income countries and have dedicated resources and as such are well-positioned to play a similar role of rating agencies, providing a “stamp of approval” of sorts on bankability. In addition, development banks can build relationships with ‘clients’ whose projects have been financed, which can lead to a pipeline for the generation of further projects. it was observed that the shortage of supply of deals does not always mean that there are no projects, but that project managers (entrepreneurs, for example) don’t find their way to development banks. Development banks should be more proactive in identifying bankable projects, develop capabilities to identify non-bankable projects, and bring them to bankability levels in collaboration with external partners.
3. Risk mitigation capital used: “concessionality”
The supply of bankable projects, of course being “upstream” in our framework, can be a key bottleneck in ensuring that private capital can contribute more to addressing society’s challenges. Whether bankable projects can receive private capital funding depends largely on how effectively the risk-mitigating instruments are deployed by the public sector. The next section will therefore focus on the second dial in our framework: Risk Mitigation Capital Used, or “Concessionality”.
Key issues to be addressed are the barriers to increasing the ‘leverage ratio’: the multiplier of concessional capital, that is to say: how many private sector dollars can be mobilized for each dollar of public or philanthropic capital made available. The public sector is unlikely to materially increase the pie of concessional capital given the prevailing economic and fiscal pressures. Even more reason, therefore, to take a harder look at increasing the efficiency of the concessional capital that is available, and at what would motivate the providers of such concessional capital to do so.
Development banks were established and organized to efficiently raise large amounts of funds at competitive rates via capital markets, based on their high credit ratings derived from the paid-in and callable capital on the balance sheet coming from their sovereign shareholders. This is important blending and leverage in itself for sustainable development. But at a transaction level, development banks often achieve lower than average (less than 1) leverage in their private capital mobilization since they are primarily incentivized to deploy capital, and not to engage private sector capital. By incentivizing their staff differently, development banks could in a relatively simple manner mobilize a significantly higher amount of private capital to work for them.
An important consideration is that not all concessional capital is created equally. In the pecking order of concessional capital, the most highly prized is the first-loss equity tranche. The more first-loss equity gets provided, the higher the leverage that can be accomplished: the more private capital that can be brought in. Also, more and more philanthropic capital is entering this space. But development banks often approach foundations to meet the banks’ own concessional capital needs, especially in climate and energy transition. Development banks do so even though they have access to concessional capital through ample sovereign donor funds entrusted to them.
Some private sector voices argued that foundations appear to have become the more sophisticated investors in blended finance compared to development banks, considering different incentives to make and move markets. Sometimes, different development banks can also undercut each other: with too few bankable deals going around, they all wish to pile into the same deals at the most favorable conditions. More coordination between development banks would therefore be desirable, and more work on creating their own bankable deals (as was also observed in our first break-out group).
Another observation was that development banks often “originate to hold”, versus “originate to distribute” which – while understandable based on how they are incentivized – is not conducive to bringing more private capital towards sustainable development projects. In other words, development banks should do more “moving” than “storage” of development financing.
Generally, the conclusion was that development banks are providing the most effective blending tools – with higher mobilizing power – least, and the least effective blending tools – with lower mobilizing power – most.
As argued above, reversing this requires updating incentives for staff. It also will require better education on deploying those more effective tools (which also tend to be more complex), and finally a clearer mandate from governments (development banks’ shareholders) to accept higher levels of risk on their balance sheets.
3.1. Filling the data gap: the Global Emerging Market Risk Database (GEMS)
Turning to the possible role of widely available risk data to increase the efficiency of scarce concessional capital, the public release of granular data on delinquency and default in emerging markets transactions, currently held for the benefit of development banks only in the GEMS risk database, would make a major difference for the private sector investors when they assess relevant risk factors and try to size concessional tranches efficiently.
Currently, the GEMS risk data that is published is not granular enough, and hence concessional tranches get sized conservatively (i.e., inefficiently) and based on mere rules of thumb. This Global Emerging Markets Risk Management database, managed by EIB and IFC, holds a treasure trove of several decades’ worth of comprehensive emerging markets risk data, by sector and market. It was, and continues to be, generally felt that GEMS is a public good that should have been made available to private sector investors a long time ago. Since then, the partial release of GEMS risk data in 2024 was disappointing to most market participants.
3.2. The role of guarantees
Lastly, on the topic of guarantees, according to OECD rules on Official Development Assistance (“ODA”), guarantees are counted as ODA when they are called upon and paid out, not when issued. This is a major disincentive for the public sector, including development banks, to use guarantees more often as they do not count towards a donor country’s ODA targets. The OECD Development Assistance Committee is reviewing these rules, but progress appears extremely slow. However, it was noted that certain government agencies (such as USAID and SIDA) form the proverbial exception to this rule. Global templated off-take guarantees have been designed but failed to gain traction or did not get implemented.
Consequently, guarantees, if and when issued, are usually highly bespoke, which is not efficient for the market as a whole and its participants. Foundations are often asked for guarantees, but because they are non-rated entities, they would have to be fully cash-collateralized which, again, is not efficient and therefore not used.
4. Links between DFIs/MDBs and the private sector: “marketplace”
The next section will focus on the third and fourth dials in our framework: Links between MDBs/DFIs and the Private Sector (“Marketplace”) and Private Investor Orientation (“Mobilization”).
The open questions under the “Marketplace” heading are how to improve the relationships between the public and private sectors, and how to design a global blended finance marketplace to allow for more effective involvement of private sector institutional capital. This proved to be one of the more vexing inquiries of the day.
4.1. Starting point and basic prerequisites
The philosophical starting point for this discussion is that markets arise when enough economic agents agree that the existence of an organized and orderly marketplace individually benefits them to conduct better, faster and more business. Sometimes these markets spring up amongst private sector actors without much of a nudge from governments, but often – as the history of marketplaces suggests – in fact such a “public nudge” is needed.
Once the formation of a marketplace has occurred, we see markets thrive and scale after three prerequisites are met: standardization, transparency, and liquidity. A degree of standardization (e.g., underlying standard documentation, with only a limited number of variable terms) gives the product efficient tradability, which in turn allows demand and supply to come together in ever greater numbers. Transparency of price and other terms and conditions is vital for market participants to be able to rely on the integrity of the marketplace. Lastly, no market takes off without adequate liquidity in supply and demand, so that efficient and reliable price discovery can take place, and one can almost always find counterparties to easily trade in and out of positions thanks to available secondary liquidity, either directly or via a broker.
Examples of such thriving financial markets abound, from the broader equity, fixed income, and currency markets, to other equally highly functional markets such as the IPO market, global syndicated loan market or the ISDA swap markets. How does the global blended finance market compare against these benchmarks?
The global blended finance market scores badly against all the three market prerequisites – standardization, transparency, and liquidity. Blended finance deals come in many different forms, with different (combinations of) concessional inputs, structured in various possible ways, across a variety of different fund vehicles, projects, facilities, platforms, and bonds/notes, at different levels (project, funds, fund of funds, facility,) and in various stages across the full project lifecycle of longer-term investments, such as in sustainable infrastructure. The inherent flexible nature of the structuring approach is a compelling feature of blended finance and gives it potentially near-universal applications, but it also makes standardization extremely difficult to achieve. In other words, there is little standardization.
Nor is there much transparency in blended finance – the underlying risk factors, expected return, pricing, and relative position in the cash flow waterfall of various tranches in the capital structure are shrouded behind Non-Disclosure Agreements. Convergence (the global network for blended finance) has highlighted in its annual State of Blended Finance reporting that impact data are only reported by 60% of blended finance deals, and then mostly only to the investors in the deal, making it difficult for outsiders to assess how effective the transactions are in generating the desired impact.
A recent large, blended finance deal had some intricate tax and accounting considerations informing the deal structure, but we wouldn’t know this by looking from the outside in. No wonder deal makers in blended finance often feel they need to reinvent the wheel: this is nearly the opposite of the templated deals and transparency that would be required. To its credit, The Nature Conservancy decided to share the structure of its recent blended debt-for nature swaps (Belize, Barbados, and Gabon) on an open-source basis, and IFC provides annual disclosures on the subsidy element of blended finance transactions. Sadly, these are still exceptions that confirm the rule.
Lastly, global blended finance lacks the required liquidity of a marketplace. Sure, there are lots of pockets of concessional capital available if you know where to look. There are organizations up in the league tables doing blended finance deals every year. But getting one done, if you are not intimately familiar with or have solid entry points into this shortlist of institutions, is another story altogether. The process of demand meeting supply is at this time largely an informal one, driven largely by personal relationships. “Everybody is doing their own thing” was heard more than a few times at our symposium.
Besides the aspects of standardization, transparency and liquidity, this is of course also a key feature of marketplaces: relationships that bring a high degree of trust that underpins collaboration. Sadly, the different actors we’d like to see as active market participants – government agencies, development banks, philanthropic foundations, pension funds, and insurance companies in particular – largely operate in separate silos and have few relationships with the other silos. Where to go from here?
It is no surprise then that the global finance “market” is stuck at about $10-15 billion of deals per year. This is a substantial number in real terms, which demonstrates that this type of investing involving actors from different silos can in fact be done. But compared to what is needed, this is a drop in the ocean: the annual SDG funding gap is estimated at $4.5 trillion or more, while the sustainable infrastructure gap, as the sub-set of the SDG funding gap, that in principle should be investable for the private sector is estimated to be around $1 trillion per year. Blended finance does not appear to scale – for the time being.
While blended finance is technically perfectly capable of tailoring risk-return profiles to attractive levels for asset owners, many of them still think of blended finance as “too expensive, too complicated, too small.” It is not hard to see the potential attractiveness of blended finance because of the benefits of (i) portfolio diversification through largely uncorrelated emerging market exposure, (ii) exposure to higher-growth markets, (iii) tapping into 50% of the world’s GDP and (iv) exposure to the economic activity of 85% of the world’s population in those emerging markets. But asset owners do need to see a tangible pipeline of larger projects, to build diversified scalable portfolios. Institutional investors won’t commit capital or human resources if they don’t believe there will be scale.
Is a marketplace for blended finance a lost cause, and with it, the scaling of blended finance? A consensus is emerging that this is not the case. Exchanges operators have considerable technology and expertise in developing new markets and scaling them, in complex products such as derivatives, and it would be useful to get them on the case. Similarly, engaging rating agencies to assess the different tranches of transactions and aiming for standardized documentation wherever possible could serve as potential accelerators.
4.2 The promising role of intermediaries
Chances are that the global blended finance marketplace may evolve into something more like the global M&A marketplace. In that case, there is no formally organized marketplace or exchange, but there are very active intermediaries (investment bankers and brokers) who constantly look for mandates to buy or sell and bring together parties with the right alignment of interest. It’s the intermediaries that make this market a highly functional one, with no less than USD 2.9 trillion of deals done in 2023 (a down-year no less, amidst lots of macro-economic headwinds).
If this model does have any predictive value for blended finance, there may well be an interesting opportunity for independent advisory firms, boutique merchant banks, and investment banks to become the blended finance intermediaries of the future. Now that some forward-looking asset owners are starting to look beyond ESG and disclosure-based approaches that often come with little “additionality,” and into actually financing sustainability, the next few years may well see an upturn in intermediary activity, and with it, blended finance deal numbers and volumes.
Our planet is certainly demanding more urgently every day that we act, and in the knowledge that we have the financing tools as well as the different actors who can deploy them, it is the lack of an efficient marketplace that keeps us from bringing all this together and rising to the challenge.
5. Private Investor Orientation: “Mobilization”
This final section covers the last dial: the orientation of private investors towards blended finance (“Mobilization”).
5.1. From sustainable finance to financing sustainability
Many have had high expectations of what sustainable finance (ESG) practices would do to generate “impact” – in other words, contributing to the financing of sustainability initiatives. We also argue that many sustainable finance practices don’t, in fact, generate impact. ESG integration is a good example of this. While integrating ESG factors into investment decision-making can have benefits, and has merits as a risk management framework, enabling real-world positive social outcomes that otherwise would not happen doesn’t appear to be one of them.
As academics, regulators, clients, and investors reach similar conclusions about sustainable finance, more investors are embracing established financing methods like blended finance. While these approaches may be complex and involve collaboration with public or philanthropic entities, they often lead to tangible impact.
We refer to this shift in orientation as “Sustainable/ESG Finance to Financing Sustainability” which is fully aligned with the concept of Transition Investment as described elsewhere in this report. We believe this shift needs to happen across the financial sector, with asset owners in particular, for investors to play a more active role in the blended finance marketplace and contribute larger amounts of capital to transactions that generate real, additional impact. And we do see the shift happening.
So, if this shift is, in fact, happening, why is this dial in our framework — the orientation of private investors towards financing sustainability — still considered a barrier?
Well, because the shift is not happening fast enough, certain dynamics are keeping the brakes on.
5.2. Technical issues…
There are many technical issues that need to be addressed in considering blended finance investments and that could be dealbreakers in many situations. Given the scope of this article, we just highlight three important technical issues below:
Pricing/benchmarking: information on how deals are priced and lack of clarity on what asset class returns or benchmarks they should be compared to (e.g., infrastructure).
Ratings: many institutional investors require a rating from e.g., S&P or Moody’s, but blended finance transactions don’t usually come with ratings. Some institutional investors consider internally generated ratings, but developing these is hard work. Often, the minimum rating required is BBB- but many blended finance deals fall below this if they have an (internal) rating.
Risk information: the best source of information on risk aspects of blended finance transactions, such as default and recovery rates, is the GEMs database (kept by the Global Emerging Markets Risk Database Consortium), most of which was not accessible to institutional investors until recently. This should help assess the risks more precisely and remove some of the ‘perceived risk’ that many in the group believed to be a barrier.
Other technical constraints (that we won’t elaborate on here) would include currency risk, cost and time involved in doing blended finance deals, ticket sizes available, legal and regulatory considerations, limited availability of ESG data and exclusions for emerging market investments, and lock-up related liquidity considerations.
…and behavioral constraints
Our discussion also pointed out several constraints that are more organizational or behavioral and, therefore, tend to be less visible than the technical constraints listed above. Again, we list four of the most important behavioral constraints below.
Misalignment: many institutional investors commit to impact investing, e.g., to contribute to SDGs or Paris goals, which implies a substantial focus on EM, private markets, and blended finance. However, too few follow up on their commitments by aligning goals and organization, ensuring their staff have the connections, capabilities, and mandates to make EM and blended finance investments.
Mandate: because of the previous point, it is also often unclear within asset owner or asset manager organizations which team should take on potential blended finance deals.
Focus on “impact” or “finance”? Some in the group felt there should be more emphasis on the impact, or ‘additionality,’ of blended finance investments, as this would allow investors to see that making these investments would go a long way in meeting their impact commitments. Others felt that emphasis should be mostly on the financial or technical requirements; the thinking was that we should simply try to harness global capital flows by creating investments that meet institutional investment requirements. In this context, there was also the recommendation to do more ‘blind audition’ investing, in other words, to remove references to EM, impact, or SDGs; the thinking was that institutional investors would be more likely to consider them like any other investment and that we avoid preconceptions about (perceived) risk or sub-par returns in EM or blended finance investments.
ESG staff tied up elsewhere: ESG staff within asset owner or asset manager organizations are often considered the logical entry point for blended finance investment opportunities or even as potential advocates and initiators of this kind of investing within their organization. In reality, it was observed that ESG staff spend most of their time doing TCFD reporting, collecting data on CO2 emissions, or taking care of SFDR disclosures. “If I told my boss I’d like to spend one day a week on this kind of investment, that would be very difficult”; “for ESG people it’s a ‘nice to do,’ not a ‘must do’”; “the reporting burden is so vast and doesn’t leave time to engage with development banks, even if our leadership would probably be interested in blended finance”; were some of the comments made.
6. Key takeaways
Reflecting on the feedback received from our group of stakeholders, we can’t deny that the challenges to mobilizing more private capital towards the SDGs are daunting. Also, there are no simple solutions to many of the identified constraints.
At the same time, we feel confident that we have managed to both reaffirm the strong case for blended finance as well as confirm that our Route17 Mobilizing Private Capital Equation framework identifies and analyzes the knobs we need to turn to dial up the flow of capital.
It effectively also validates an earlier series of articles authored by Route17, “Blended Finance is Like Music.” In these six articles, we discuss what Governments, Asset Owners, Foundations, Development Banks, ESG Professionals, and Asset Managers can do to overcome the barriers to blended finance identified in this symposium.
While we emphasize in these articles that all these actors should move proactively and not play the waiting game, we also firmly believe that government’s role here is crucial: they are the only actors on our list that can put their finger on the scale for each of the four dials in our framework – they can increase the availability of investable projects; as shareholders, they can direct development banks to use the blending toolbox more and more effectively; they have awesome convening power to bring together parties and help build a marketplace; and they can rethink sustainable finance regulations to accelerate the shift from “Sustainable Finance to Financing Sustainability.” By extension, there is also a special role for Sovereign Wealth Funds as government-sponsored institutions of all stripes in advancing this agenda. Indeed, strategic investment funds with a developmental agenda can provide first-loss equity tranches in local investment opportunities, and mitigate country level risk factors by providing managerial oversight and industry expertise. Large intergenerational savings sovereign wealth funds can instead out their long-term capital at work to garner the future benefits of sustainable development.
But this is certainly not letting the finance and investment sectors off the hook. So, we’d like to end this series by quoting Bill Gates in his 2022 book How to Avoid a Climate Disaster: “The amount of money invested in getting to net zero … will need to ramp up dramatically and for the long haul. To me, this means that governments and multilateral banks will need to find much better ways to tap private capital. … It’ll be tricky to mix public and private money on such a large scale, but it’s essential. We need our best minds in finance working on this problem.”