Unlocking pension fund capital for the SDGs and climate in emerging markets
Emerging markets face a $4.2 trillion annual funding gap for SDGs and climate goals. Multilateral development banks and development finance institutions are well equipped to address this gap, and initiatives such as ILX can help pension funds overcome barriers and unlock scalable, risk-adjusted investments, driving impactful and diversified returns.
The annual funding gap for emerging markets (EMs) to achieve the Sustainable Development Goals (SDGs) and address climate challenges has reached an estimated $4.2 trillion annually. Bridging this shortfall is beyond the capacity of the public sector alone and needs stronger collaboration with the private sector as well as greater efforts from the latter to mobilise capital into these markets. Encouragingly, pension funds and other institutional investors have already significantly increased their sustainability-focused investments in recent years. However, these initiatives have yet to reach the scale required.
For pension funds, emerging markets offer unique opportunities for growth, portfolio diversification and contributions to closing the development financing gap. Yet, several barriers continue to prevent the flow of this much-needed capital. A key challenge is the perceived risk of investing in EMs, often driven by the limited availability of reliable risk information. Initiatives such as the release of the Global Emerging Markets Risk Database Consortium (GEMs) last year, which provides detailed insights into recovery and default rates in EMs, are essential in bridging the gap between perceived and actual risks.
Investors often lack the on-the-ground knowledge and networks needed to navigate complex regulatory landscapes and effectively manage uncertainties.
Another significant barrier is the lack of experience and presence in emerging markets. Investors often lack the on-the-ground knowledge and networks needed to navigate complex regulatory landscapes and effectively manage uncertainties. This absence of local expertise undermines their confidence when investing in these markets. Additionally, institutional investors have historically prioritised more well-established asset classes such as private equity, public equities or bonds, and thus often struggle to fit the development finance asset class within their existing mandates.
In response to these challenges, ILX Management B.V., with incubation support from the German, Dutch and UK governments, launched ILX Fund I in early 2022. This $1.05 billion SDG-focused private debt fund targets EMs and co-invests alongside multilateral development banks (MDBs) and development finance institutions (DFIs) on behalf of leading Dutch pension funds, with the belief that investors will benefit from the MDBs’ and DFIs’ emerging markets investment track records. After a successful deployment and with over 45 investments in 20+ emerging markets, ILX launched ILX Fund II, using its own resources, with commitments from Danish pension fund investors – demonstrating the scalability of the model and its relevance at the European level. The increased commitments brought the total assets under management to $1.7 billion.
MDBs and DFIs are well-equipped to address SDG- and climate-related challenges at scale. With their years of experience in EM investments and robust environmental and social safeguards in place, they are experts in managing credit, country, sector, and environmental, social and governance (ESG)-related risks. In addition, their local presence and knowledge make them trusted partners for institutional investors looking to invest in these markets.
Despite the challenges, MDBs and DFIs have shown strong returns, low losses, and high recovery rates – as proven in the recovery and default data from GEMS. They are multifaceted experts in this field, with the ability to tailor their products to different investors’ classes and with flexibility in terms of commercial appetite. Their commitment to fiduciary duty and safeguarding capital further strengthens their role as partners when driving sustainable impact in emerging markets, ensuring that investors can achieve both impact and returns.
Investing in emerging markets at scale, alongside MDBs and DFIs, allows pension funds to diversify their portfolios and invest across regions and sectors while expanding away from traditional EM debt markets.
Investing in emerging markets at scale, alongside MDBs and DFIs, allows pension funds to diversify their portfolios and invest across regions and sectors while expanding away from traditional EM debt markets. It also offers them an opportunity to complement their existing portfolios with investments that cannot be sourced via public markets. The returns on these loans are market equivalent and risk-adjusted, as well as proven largely uncorrelated with public market volatility.
Pension funds are the ideal investor to co-invest alongside MBDs and DFIs. They have long-term investment strategies and risk profiles that align closely with those of these institutions. MDBs and DFIs need to take centre stage in mobilising this private capital and originating large scalable deals that enable pension funds to invest in impact projects in EMs without compromising on results. By taking collective action, MDBs and DFIs will be able to guide large pension funds’ investments towards closing the financing gap for the SDGs. Pension funds, in turn, require a shift in strategic asset allocation to fit the development finance asset class into their mandates.
Large-scale fund strategies such as ILX are a good example of how these partnerships can happen. However, further efforts are needed to underscore the significance of efficient, scalable approaches to mobilising private capital without relying on additional guarantees or concessionality. Such approaches are essential to minimise the misuse of blended finance vehicles, which should only be reserved for high-risk scenarios.
Sofía Vega Núñez is the communicaiton analyst at ILX Management B.V..
The views are those of the author and not necessarily those of ECDPM.