Blending or still just mixing?
Although several Millennium Development Goals (MDGs) have been reached, there is still a huge financing gap (approximately US$ 2,500bn per year), which is needed to meet the new Sustainable Development Goals (SDGs) for post-2015 development. There is, therefore, more interest in cooperation between the public and private sector to fill this gap, both sides. At the same time, the attention to efficiency and effectiveness of donor funds is increasing. Blending and innovative financing can help to achieve these goals.
Blending is the strategic use of donor funds to mobilize financing from official development banks and the private sector. It combines grants (which can be used for e.g. technical assistance, investment grants, interest rate and insurance premium subsidies, guarantees and risk capital, such as equity) with financing (such as loans, equity and guarantees) from official development banks and private finance for development projects.
Innovative financing for development
There are two ways to look at innovative development financing: first, as a new way to mobilise funds from new sources, in addition to public funds, NGOs and foundations. Second, as a new way to use funds in a manner which makes projects viable, for example through distribution of risks. Through innovation, new products can be developed, new markets entered and new participants attracted for development projects. Innovation will add value by mobilizing additional resources, creating an efficient financial intermediary system, and focusing on results. Until now the innovative financing market mainly consisted of thematic (e.g. green or impact) bonds, micro-finance and result-based financing.
Increased use of established instruments by new participants, the development of new instruments and their application in new and existing markets, are expected to increase this market substantially in the coming years.
There are, however, a number of barriers, which limit the growth of innovative finance. Basically, a structured market for supply and demand of innovative development finance does not exist, yet.
On the supply side, there are potentially relevant and interested, but different, groups of private funders for blending, each of them characterised by specific objectives, risk/return profiles, location and operating conditions. Examples are domestic and international banks and companies, financial investors (such as pension funds, asset managers and private equity), insurers, and social investors, such as NGOs, impact investors, foundations and philanthropists. Many of them are not familiar with development finance and have institutional constraints, e.g. limited staff resources and very strict regulatory requirements for such investments, which are mostly seen as too risky.
On the demand side, not enough funds are earmarked to design new instruments and test them in new markets. Developing them can be costly and takes time; an example is microfinance, which took decades to get off the ground. And there is not much of an intermediate structure: lack of data, standards, metrics and liquidity limit transparency and the development of a market. As for the existing innovative finance mechanisms, they often do not take into account the business environment and the investment constraints of the private sector, and low-risk products such as bonds and public sector guarantees, are most frequent.
Way forward – and the role of blending
In order to stimulate innovative financing, the public and private sector will have to work together. Exchange of information and coordination of actions will be required to build up the innovative financing market. Institutions that can mediate between public and private donors, private funders and beneficiary governments can play a useful role.
The private sector (e.g. banks, impact and institutional investors) will have to be willing to invest in existing and promising new ventures (which have been designed by financial intermediaries) that produce development and financial returns.
From its side, the public sector will have to ensure that the institutional, legal and regulatory environment allow for innovative financing and search for opportunities to deploy innovative financing mechanisms, e.g. for the ‘Bottom of the Pyramid’, the informal sector, in rural and urban areas, and in fragile states. Such actions can be financed out of technical assistance components of blending projects.
At project level, risk cushions provided by grants, e.g. in the form of guarantees or an equity contribution to a project company, can reduce the risks for public and private sector funders to an acceptable level and attract sizeable amounts of additional resources. Often projects can only start with donor support through risk capital, and other funders, both public and private, will only provide senior debt and enter with risk capital in a next stage, when the project has matured and become less risky. This applies to all kinds of projects, from micro finance to big infrastructure.
In conclusion, the combination of private sector approaches and development goals will allow for increased opportunities to alleviate poverty, fight climate change, and deal with other sustainable development challenges. Blending can be a useful tool in unlocking additional (private and public) project funds and increase innovative development financing.
Sander Winckel is an independent expert on blending and innovative finance.
The views expressed here are those of the author and not necessarily those of ECDPM.