Mobilising private capital for sustainable development
For there to be any possibility of achieving the ambitious SDGs by 2030, as much as US$2.5 trillion in private financing for related physical and social infrastructure alone is required per annum in emerging countries. How can development agencies and philanthropic funders effectively mobilise private capital for both financial returns and development impact?
Public and philanthropic donors increasingly engage with private investors in order to make their own limited financial resources go further and to increase the pool of funding available for development. But there are other reasons for growing interest by donors in working more closely with the private sector: they recognise the importance of private sector activity and finance as key drivers of growth and knowledge transfer in emerging countries. Compared to traditional grant funding, some donors also expect the private sector’s involvement to have a positive effect on the financial discipline of jointly funded projects, as donors hope to recycle their money and earn a financial return that can be reinvested in other development projects. On the other hand, private investors are interested in investing in emerging countries, attracted by high potential returns, portfolio diversification and exploration of new markets. However, they need help in overcoming a number of barriers. First, private investors are reluctant to invest in high impact funds, projects, and ventures in emerging markets because of perceived and actual high risk and low returns. Investment opportunities with the highest impact are also often small and segmented, increasing transaction costs and reducing attractiveness for large institutional investors, especially. Further, most developing and emerging countries lack the market infrastructure and regulatory framework that are needed to attract and direct private investment for development. In addition, each investor has their specific risk-return profile, asset allocation and investment strategy, and exit requirements, all of which determine how and where their capital is ultimately deployed.
There is no “one-size-fits-all” approach to mobilising and deploying private capital for sustainable development. In development finance, market-priced co-financing, matching facilities, and seed funding for pooled investment vehicles have been applied for some time in order to aggregate investment opportunities and to improve private sector financing in emerging markets. Development finance institutions (DFIs), both bilateral and multilateral, and, more recently, pioneering philanthropic organisations, increasingly employ blended finance strategies that strategically use concessional finance or guarantees to mitigate risk, enhance potential returns and thus unlock private investment for development. A study by OECD and the World Economic Forum identified more than 70 blended finance funds and vehicles accounting for US$25.4 billion in assets. Important tools in blended finance are structured funds, which typically divide the overall risk into different tranches, including a first-loss tranche, to make a fund investment opportunity viable. Furthermore, most structured funds mitigate capacity and sector risks using technical assistance facilities, financed by grant funding and user contributions for capacity building, project preparation, research or impact assessments. In that way, structured funds have the ability to meet the risk-return profiles of a variety of investors, such as development finance institutions, foundations, pension funds or banks. Figure 1 shows an example of such a structured fund: the Green for Growth Fund South East Europe, initiated and supported by the German government and the German Development Bank KfW. Other structured funds using a similar blended approach include the European Fund for South East Europe also led by German development institutions (€1 billion), the Essential Capital Consortium Fund managed by Deutsche Bank and supported with a credit enhancement by the Swedish development agency Sida (US$50 million), the African Agricultural Capital Fund with subordinated finance from various American foundations (US$25 million), and the Global Climate Partnership Fund, enhanced by Danida and the German Ministry of Environment via KfW (US$300 million). Figure 1. Typical structured fund (Green for Growth Fund) Source: Koenig, A. and E.T Jackson, 2016. Result-based financing mechanisms offer other means of mobilising private capital for development impact, by linking investors’ financial returns to agreed-upon and measurable impact. Examples here include development impact bonds (DIBs), and their most recent variations, Social Impact Incentives piloted by Roots of Impact with the support of the Inter-American Development Bank and the Swiss Development Agency, or the Social Success Notes developed by Yunus Social Business and supported by the Rockefeller Foundation. These and similar results-based instruments stimulate innovation and encourage providers of private capital to invest in impact-delivery organisations or provision of goods and services that would otherwise not be attractive to private investors that seek at least a minimum return. However, while a variety of pilot projects are now being implemented, these mechanisms are labour-intensive to design and implement, and have yet to reach scale in an emerging country context. Other financial tools that DFIs and governments worldwide have used are diaspora, infrastructure, and green bonds as a means to raise funds for developmental investments. Public and philanthropic donors can also use a number of supporting instruments to mitigate risk, enhance revenue potential and prepare the ground for developmental private investment. In the past, for example, they provided support to the acceleration and investment readiness of early stage entrepreneurs, provided capacity building to local financing institutions, strengthened the standardisation of impact measurement, helped build the capacity of new fund managers, commissioned research and data collection, and supported project preparation facilities. Public-sector donors, in particular, can leverage their roles as neutral brokers and trusted public entities by facilitating policy dialogue with host governments and providing technical assistance on policy reforms. Individual donors can also capitalise on their DFI’s investment experience in emerging countries. In one notable example, the Danish DFI IFU, working with the aid agency Danida, raised €175 million from four Danish pension funds for deployment in climate related investments in emerging countries without needing to resort to any concessional finance.
A review of past experiences and close observation of the development of the impact investing field point to several trends and lessons:
While these and other trends and lessons are promising, the over-arching question facing practitioners and policymakers in this space is how rapidly such funds and mechanisms can now be scaled up to meet the implementation requirements of the 17 ambitious Sustainable Development Goals (SDGs). In particular, is there the political will for Northern donors and DFIs to exponentially scale structured, blended financing mechanisms? Or, if such political will is not there, what kind of a coalition will it take to build it? Much more is known now about how to mobilise and deploy private capital for sustainable development and that is an important advance. The imperative going forward is to ensure that the quantum of such capital is proportionate to the challenges we all face, that it is translated into SDG-compatible investments and that these investments make a meaningful difference to our common future. This article draws on research for a recent study: Koenig, A. and E.T. Jackson, Private Capital for Sustainable Development: Concepts, Issues and Options for Engagement in Impact Investing and Innovative Finance, Danida Evaluation Department, Denmark’s Ministry of Foreign Affairs, Copenhagen, 2016 http://um.dk/en/danida-en/results/eval/Eval_reports/publicationdisplaypage/?publicationID=E15693B2-6449-4AB1-A33A-BC8BE0067D42. References: Benn, J., C. Sangaré and S. Steensen, 2016, Measuring private finance mobilized for sustainable development, in OECD Development Co-operation Report 2016: The Sustainable Development Goals as Business Opportunities, OECD Publishing, Paris, 2016. http://dx.doi.org/10.1787/dcr-2016-11-en Koenig, A., 2016, Impact investing 2.0 – global drivers and trends, Berenberg Aspects, August 2016. http://www.socialimpactmarkets.org/#insights OECD and WEF, 2015, Blended Finance Vol. 1: A Primer for Development Finance and Philanthropic Funders. An overview of the strategic use of development finance and philanthropic funds to mobilize private capital for development. July 2015. https://www.weforum.org/projects/redesigning-development-finance OECD and WEF, 2016, Insights from Blended Finance Investment Vehicles and Facilities, January 2016. http://www3.weforum.org/docs/WEF_Blended_Finance_ Insights_Investments_Vehicles_Facilities_report_2016.pdf Wharton, 2016, Innovative Finance: Mobilizing Capital for Maximum Impact, August 2016. http://knowledge.wharton.upenn.edu Wilson, K. E., 2016, Investing for social impact in developing countries, in OECD Development Cooperation Report 2016: The Sustainable Development Goals as Business Opportunities, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/dcr-2016-11-en
About the authors Anja Koenig (left) is Founder and Director of Social Impact Markets and Lead, Finance for Change at the Impact Hub Berlin. Edward Jackson (right) is President of E.T. Jackson and Associates Ltd. and Senior Research Fellow, Carleton University.
This article was published in GREAT Insights Volume 5, Issue 5 (October/November 2016).
Why mobilising private capital for development makes sense
Public and philanthropic donors increasingly engage with private investors in order to make their own limited financial resources go further and to increase the pool of funding available for development. But there are other reasons for growing interest by donors in working more closely with the private sector: they recognise the importance of private sector activity and finance as key drivers of growth and knowledge transfer in emerging countries. Compared to traditional grant funding, some donors also expect the private sector’s involvement to have a positive effect on the financial discipline of jointly funded projects, as donors hope to recycle their money and earn a financial return that can be reinvested in other development projects. On the other hand, private investors are interested in investing in emerging countries, attracted by high potential returns, portfolio diversification and exploration of new markets. However, they need help in overcoming a number of barriers. First, private investors are reluctant to invest in high impact funds, projects, and ventures in emerging markets because of perceived and actual high risk and low returns. Investment opportunities with the highest impact are also often small and segmented, increasing transaction costs and reducing attractiveness for large institutional investors, especially. Further, most developing and emerging countries lack the market infrastructure and regulatory framework that are needed to attract and direct private investment for development. In addition, each investor has their specific risk-return profile, asset allocation and investment strategy, and exit requirements, all of which determine how and where their capital is ultimately deployed.
How private capital for development can be mobilised
There is no “one-size-fits-all” approach to mobilising and deploying private capital for sustainable development. In development finance, market-priced co-financing, matching facilities, and seed funding for pooled investment vehicles have been applied for some time in order to aggregate investment opportunities and to improve private sector financing in emerging markets. Development finance institutions (DFIs), both bilateral and multilateral, and, more recently, pioneering philanthropic organisations, increasingly employ blended finance strategies that strategically use concessional finance or guarantees to mitigate risk, enhance potential returns and thus unlock private investment for development. A study by OECD and the World Economic Forum identified more than 70 blended finance funds and vehicles accounting for US$25.4 billion in assets. Important tools in blended finance are structured funds, which typically divide the overall risk into different tranches, including a first-loss tranche, to make a fund investment opportunity viable. Furthermore, most structured funds mitigate capacity and sector risks using technical assistance facilities, financed by grant funding and user contributions for capacity building, project preparation, research or impact assessments. In that way, structured funds have the ability to meet the risk-return profiles of a variety of investors, such as development finance institutions, foundations, pension funds or banks. Figure 1 shows an example of such a structured fund: the Green for Growth Fund South East Europe, initiated and supported by the German government and the German Development Bank KfW. Other structured funds using a similar blended approach include the European Fund for South East Europe also led by German development institutions (€1 billion), the Essential Capital Consortium Fund managed by Deutsche Bank and supported with a credit enhancement by the Swedish development agency Sida (US$50 million), the African Agricultural Capital Fund with subordinated finance from various American foundations (US$25 million), and the Global Climate Partnership Fund, enhanced by Danida and the German Ministry of Environment via KfW (US$300 million). Figure 1. Typical structured fund (Green for Growth Fund) Source: Koenig, A. and E.T Jackson, 2016. Result-based financing mechanisms offer other means of mobilising private capital for development impact, by linking investors’ financial returns to agreed-upon and measurable impact. Examples here include development impact bonds (DIBs), and their most recent variations, Social Impact Incentives piloted by Roots of Impact with the support of the Inter-American Development Bank and the Swiss Development Agency, or the Social Success Notes developed by Yunus Social Business and supported by the Rockefeller Foundation. These and similar results-based instruments stimulate innovation and encourage providers of private capital to invest in impact-delivery organisations or provision of goods and services that would otherwise not be attractive to private investors that seek at least a minimum return. However, while a variety of pilot projects are now being implemented, these mechanisms are labour-intensive to design and implement, and have yet to reach scale in an emerging country context. Other financial tools that DFIs and governments worldwide have used are diaspora, infrastructure, and green bonds as a means to raise funds for developmental investments. Public and philanthropic donors can also use a number of supporting instruments to mitigate risk, enhance revenue potential and prepare the ground for developmental private investment. In the past, for example, they provided support to the acceleration and investment readiness of early stage entrepreneurs, provided capacity building to local financing institutions, strengthened the standardisation of impact measurement, helped build the capacity of new fund managers, commissioned research and data collection, and supported project preparation facilities. Public-sector donors, in particular, can leverage their roles as neutral brokers and trusted public entities by facilitating policy dialogue with host governments and providing technical assistance on policy reforms. Individual donors can also capitalise on their DFI’s investment experience in emerging countries. In one notable example, the Danish DFI IFU, working with the aid agency Danida, raised €175 million from four Danish pension funds for deployment in climate related investments in emerging countries without needing to resort to any concessional finance.
Some emerging trends and lessons
A review of past experiences and close observation of the development of the impact investing field point to several trends and lessons:
- New investors: Currently, only a tiny, but increasing, fraction of global assets under management is targeted at investments that advance sustainable development. However, a growing number of new prospective investors especially in the Global North but also in the Global South, are exploring opportunities to invest for both financial returns and impact in emerging countries. These include foundations or family offices divesting from fossil fuels and looking for reinvestment targets, faith-based organisations encouraged by the Vatican’s strong interest in impact investing, corporate and institutional investors seeking new market opportunities and diversification of risks, and individual citizens engaging through crowdfunding platforms and retail products offered by pioneering financial-service providers.
- Increased dialogue and matchmaking: At the global level, there is a wider variety of dialogue platforms and matching mechanisms than ever before aiming at facilitating cross-sectoral exchanges of experience, collaboration, co-investments and innovative finance. This includes recent facilities such as the Canada-based Convergence platform or the Global Innovation Lab for Climate Finance, as well as industry associations, like the European Venture Philanthropy Association and the Global Impact Investing Network, that increasingly facilitate interaction between the development finance community and existing as well as prospective impact investors. The Organisation for Economic Cooperation and Development (OECD) has recommended the use of public funds to establish additional platforms in developing countries to facilitate knowledge exchange among key actors. It has been argued, however, that more skilled brokers and dealmakers - with both investment and developmental experience who are able to support matchmaking between investors and investees and to create and structure transactions - are needed.
- Financial performance: Recent research on the financial performance of blended finance funds and vehicles indicates that such investment can yield competitive market returns, at least for some investor categories and where development agencies ideally bear some or all of the preparation and administrative costs. Questions remain with regard to the eligibility of concessional development finance and more specifically on the definition, measurement and reporting in international development assistance statistics on funds leveraged, rather than on public funds committed, under the new TOSSD (Total Official Support for Sustainable Development) framework recently published for consultation by OECD.
- Market infrastructure: In the Global South, market infrastructure on the ground is developing quickly in some regional hubs, such as Kenya, India or Brazil, but is still inadequate in most countries. More has to be done to strengthen the pipelines of investible deals, to scale pre-investment services as well as to support affordable, high-quality impact investment education and enhance cross-sectoral leadership skills amongst all market players. A larger number of bigger, locally owned impact funds, as well as the talents of local fund managers, must be nurtured. The role of the public and philanthropic sectors in supporting the development of such market infrastructure is essential, as is the development by governments of conducive regulatory frameworks for private capital mobilisation, in both the Global North and Global South.
- Impact: In co-financing and blended finance structures, the alignment of impact expectations among different kinds of investors is particularly important. However, measurement and evidence for impact, as well as comparability across sectors and geographies, remains challenging. This is due to the diversity of measurement approaches in use, methodological challenges, the lack of transparency influenced by the confidentiality concerns of the private sector, lack of voice of the intended beneficiaries of the investment, as well as the costs of impact measurement.
- Additionality: The challenges in structuring blended finance vehicles remain significant as well. These include, first, identifying those projects where blending should be applied and determining the kind and extent of concessionality that is needed and, second, ensuring that the concessional element can be phased out in a reasonable time period, limiting any market distortions and wastage of public resources and promoting financial sustainability in the long term. In this context, some observers have criticised the lack of evidence regarding the additionality of public donor interventions, that is, credible evidence that, without donor intervention, the private investors would not have engaged at all, or would only have engaged much later, and that the intervention involving private investors significantly increased the development impact of an investment. Indeed, proponents of blended finance vehicles must achieve a fine balance in ensuring accountability for public resources and realising development impact in return for providing concessions to the private sector and respecting the confidentiality needs of private partners.
- High risk-high impact: Important gaps remain in mobilising private capital for high risk–high impact investment strategies, that is, investments that target fragile and low-income countries, for businesses that serve the base of the pyramid or for innovative entrepreneurs that seek early stage funding. While there are more examples such as the Impact Fund of the UK’s Department for International Development, the Global Innovation Fund, and the ACP-Impact Financing Envelope managed by the European Investment Bank, they are still insufficient.
The imperative of the Global Goals
While these and other trends and lessons are promising, the over-arching question facing practitioners and policymakers in this space is how rapidly such funds and mechanisms can now be scaled up to meet the implementation requirements of the 17 ambitious Sustainable Development Goals (SDGs). In particular, is there the political will for Northern donors and DFIs to exponentially scale structured, blended financing mechanisms? Or, if such political will is not there, what kind of a coalition will it take to build it? Much more is known now about how to mobilise and deploy private capital for sustainable development and that is an important advance. The imperative going forward is to ensure that the quantum of such capital is proportionate to the challenges we all face, that it is translated into SDG-compatible investments and that these investments make a meaningful difference to our common future. This article draws on research for a recent study: Koenig, A. and E.T. Jackson, Private Capital for Sustainable Development: Concepts, Issues and Options for Engagement in Impact Investing and Innovative Finance, Danida Evaluation Department, Denmark’s Ministry of Foreign Affairs, Copenhagen, 2016 http://um.dk/en/danida-en/results/eval/Eval_reports/publicationdisplaypage/?publicationID=E15693B2-6449-4AB1-A33A-BC8BE0067D42. References: Benn, J., C. Sangaré and S. Steensen, 2016, Measuring private finance mobilized for sustainable development, in OECD Development Co-operation Report 2016: The Sustainable Development Goals as Business Opportunities, OECD Publishing, Paris, 2016. http://dx.doi.org/10.1787/dcr-2016-11-en Koenig, A., 2016, Impact investing 2.0 – global drivers and trends, Berenberg Aspects, August 2016. http://www.socialimpactmarkets.org/#insights OECD and WEF, 2015, Blended Finance Vol. 1: A Primer for Development Finance and Philanthropic Funders. An overview of the strategic use of development finance and philanthropic funds to mobilize private capital for development. July 2015. https://www.weforum.org/projects/redesigning-development-finance OECD and WEF, 2016, Insights from Blended Finance Investment Vehicles and Facilities, January 2016. http://www3.weforum.org/docs/WEF_Blended_Finance_ Insights_Investments_Vehicles_Facilities_report_2016.pdf Wharton, 2016, Innovative Finance: Mobilizing Capital for Maximum Impact, August 2016. http://knowledge.wharton.upenn.edu Wilson, K. E., 2016, Investing for social impact in developing countries, in OECD Development Cooperation Report 2016: The Sustainable Development Goals as Business Opportunities, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/dcr-2016-11-en
About the authors Anja Koenig (left) is Founder and Director of Social Impact Markets and Lead, Finance for Change at the Impact Hub Berlin. Edward Jackson (right) is President of E.T. Jackson and Associates Ltd. and Senior Research Fellow, Carleton University.
This article was published in GREAT Insights Volume 5, Issue 5 (October/November 2016).
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