Blended finance: a solution to the SDG funding puzzle?

The capability of blended finance to mobilise additional finance from the private sector has been increasingly recognised by the international community as a way to help bridge the trillion dollar investment gap to achieve the Sustainable Development Goals (SDGs). The blended finance sector is large and growing but to successfully unlock private capital at scale MDBs and DFIs must meet the needs and expectations of private investors, most of all by increasing their transparency.

According to the UN, achieving the SDGs will require an annual investment across all sectors of around $5-7 trillion. Current levels of development financing are not sufficient, with an estimated $2.5 trillion funding gap per annum to realise the SDGs in developing countries alone.

To put this in perspective, In 2020, official development assistance (ODA) by member countries of the Development Assistance Committee (DAC) amounted to $161.2 billion - its highest level ever recorded. ODA continues to be a critically important source of finance for these countries, and at the same time, far below what is needed to scale development projects necessary to realise the SDGs and objectives of the Paris Agreement.

To achieve these goals a group of established MDBs devised the ‘Billions to trillions’ concept. This endeavours to use the “billions” in ODA and in available development resources to attract, leverage, and mobilise “trillions” in investments of all kinds: public and private, national and global, in both capital and capacity. A crucial instrument in this process is blended finance.

Blended finance is one of several tools to mitigate risk and facilitate financing for private sector-led projects. While there are multiple ways to structure a blended finance transaction, a distinguishing feature of blended finance is its ability to generate social benefits, as well as financial returns on investment. In this way blended finance can be a powerful tool in unlocking private investment in SDG linked projects.

The current state of blended finance

It is challenging to gauge the market size for blended finance due to the various definitions of what a blended finance vehicle actually is and the multiple ways it can be structured. However, The Blended Finance Taskforce, a Business & Sustainable Development Commission (BSDC) initiative launched in 2017, identified in a 2018 consultation paper that the market had reached a global value of more than $50 billion. It was also revealed that in the five years preceding 2018 the blended finance market doubled in size with the launch of more than 50 blended finance funds and facilities.

With specific reference to SDGs, The OECD's Development Assistance Committee (DAC) reports that blended finance has generated over $81 billion for development goals in four years, with 167 facilities launched between 2000 and 2016.

In total, OECD data shows that just over $205 billion was mobilised from the private sector by development finance interventions from 2012 to 2018. Guarantees mobilised the most private finance (39%), followed by syndicated loans and direct investment in companies (or special purpose vehicles), accounting for 18% of the total each.

Although increasing in volume, only 6% of private finance mobilised by development finance interventions between 2012 and 2018 was in the least developed countries (LDCs). In 2018 $3.8 billion was mobilised in LDCs, accounting for about 7.5% of the total, with Multilateral institutions mobilising the largest share of private finance in the 46 LDCs.

Why is private capital attracted to blending?

Private investors face two main investment barriers that blended finance can address - high perceived risk and poor returns for the risk relative to comparable investments. 

According to Manfred Schepers, the Founder of ILX Fund, a lack of clarity in the ability to allocate risk to assets in conventional development finance portfolios is a key reason why private capital is drawn to blended finance. Speaking to Uxolo, Schepers explains that in a developed financial system there's enough historical data to “slice a transaction in a way that the various tranches have formal ratings”. While the equity tranche of a securitisation doesn't have a rating, there's typically enough data to be able to assess the risk on that particular equity tranche. “And so on the one hand, it's to be able to create an asset that can be parked in a box. On the other hand, it's also a way of taking away the uncertainty of that risk,” siad Schepers. “Because if you don’t know the historical data, you can't assess what the real risk of that equity tranche is."

Blended finance is a useful tool when the real risk of an investment is unknown, either because there is no data or that data has not been shared. Blending thus helps mitigate investors' concerns, unlocking private capital to fill investment gaps.

An important part of a DFIs toolbox is the ability to provide the initial first loss, shielding private investors from extreme losses.

“We have seen an increased interest in DFIs that provide first loss, to have specific time bound first loss and a clear exit strategy,” said Valerie Harrington, associate fund manager at BlueOrchard finance, a provider of blended finance facilities. “Ideally, this would allow for first loss trenches to be transferred to different vehicles where it's needed the most at different points in time. For more developmental strategies, we have seen DFIs being able to provide grant funding to develop capacity building before starting to invest which is also very important to set the stage and to be able to create larger vehicles and achieve higher impact.”

First loss is only part of what development banks can offer. DFIs can also provide risk guarantees or insurance below market rates as well as technical assistance facilities - grant capital that is provided for capacity building purposes, for example, is highly regarded by the private sector.

“[Technical assistance] has been demonstrated to be instrumental when it comes to markets where you need to set up the full stage, where there is need for specific products for end clients needs that are not there and that the financial institution is not ready, or they don't have the capacity themselves or the skills to develop those,” said  Alessandra Nibbio, Fund Manager at BlueOrchard Finance. “So in that case there is this capacity building capital kicking in that is absolutely crucial.”

Fundamentally, blended finance is attracting greater interest because it has proven capable of offering returns and impact, and crucially, for SDG related transactions.

Addressing the SDGs: Blended finance in practise

It's important to point out that blended finance can only address a subset of SDG targets that are investable. For example, blended finance is highly aligned with goals such as Goal 8 (Decent Work and Economic Growth), Goal 13 (Climate Action), and Goal 7 (Affordable and Clean Energy).  Energy projects, such as solar, wind, hydro and related battery technologies, are a particularly fertile ground for blended finance.

Last year, lithium-ion battery manufacturer Northvolt raised a $1.6 billion multi-sourced facility to finance its Northvolt Ett factory project in northern Sweden. The highly complicated blended finance transaction sourced capital from a range of private organisations including APG, BNP Paribas, Danske Bank, Danica Pension, IMI–Intesa Sanpaolo, ING, KfW IPEX-Bank, PFA Pension, SEB, Siemens Bank, SMBC, Societe Generale, Swedbank and  UniCredit.

Across the seven tranches these private capital providers took significant ticket sizes. In total, private capital accounted for just over $1.2 billion across four tranches, with tenors ranging from seven to 10 years. Euler Hermes ($525 million), NEXI ($150 million), Bpifrance ($75 million) and KEXIM ($455.7million) covered the loans in a ECA-backed buyer credit structure. The remaining $400 million was covered by EIB and NIB direct loans.

This deal demonstrated the willingness of ECAs, MDBs, DFIs and private capital to support large scale energy projects in Europe.

Indeed, MDBs and DFIs play a catalytic role in providing required credit enhancement to commercial investors by being fully subordinated to them in the fund capital structure. Through these blended finance mandates, driven by impact objectives, both in terms of climate finance and regional focus, scalable climate finance initiatives can increase financial flows and deploy investments at market rates in even the poorest countries.

The 370MW Sun Africa solar park project in Angola is a prime example where blended finance has successfully mobilised large amounts of private capital in an emerging economy. The structure of the project can also be viewed as a viable template for big-ticket renewable project finance deals in Sub-Saharan Africa.

The deal comprised two large projects and five smaller PV projects, with Angola’s Ministry of Finance (MoF) tapping a €640 million ECA-backed loan with two tranches: an 18-year €560 facility covered by EKN (100%) and put up by ING and SEK; and a 12-year EU 80 million tranche funded by the Development Bank of South Africa (DBSA).

In February this year, Angola’s MoF mimicked the success of this blended finance structure and raised another EKN/DBSA-backed loan with the same lenders and debt volume to fund the scheme. Both Angola solar deals included a development bank, an ECA, and a commercial bank, demonstrating DFI and ECA support is paramount to providing comfort to commercial banks on large-scale renewable financings on the continent.

But deals of this size remain few and far between

While these large transactions will be key to opening up “risky” regions of the world to private capital investments into SDG related projects, deals of this size remain few and far between. Blended finance transactions under $250 million scale make up the bulk of blended finance deals, at around 82% in 2018, according to non profit group Convergence.

Recent examples of these kinds of transactions include the Lotus wind power portfolio in Vietnam, which reached financial close last month in a $173 million blended finance deal. The financing was provided by MLA and bookrunner ADB, JICA and Australian ECA, Export Finance Australia (EFIC), alongside commercial banks from Hong Kong, France and the Netherlands. Pricing for this deal was between 300-500bp over Libor.

The 15-year facility comprises three tranches: a $35 million A loan put up by ADB; an $81 million facility funded by Bank of China (HK and Macau), Societe Generale, and Triodos Groenfonds; and a $57 million parallel loan funded by JICA ($25 million) and EFIC ($32 million).

Blended finance transactions range considerably in size, from a minimum of $110,000 to a maximum of $8 billion. The median blended finance transaction according to Convergence is $64 million, with most deals in the range of $50 million - $100 million.

Transactions of this size are supported by numerous facilities, including, but not limited to, the €114 million Finland-IFC Blended Finance for Climate Program (BFCP), the $200 million Canada-IFC Blended Climate Finance Program and the £105 million UK-IFC Market Accelerator for Green Construction. These facilities are bilateral partnerships between the governments of Canada, Finland and the UK with IFC to mobilise private capital for global climate action. The ticket sizes taken by private capital in projects supported by these partnerships are comparatively small.

Armenia's first solar power plant is a typical example of how these facilities are deployed. Fotowatio Renewable Ventures, which is developing the 55MW plant, will receive a $35.4 million debt financing package consisting of two $17.7 million long-term loans, one each from IFC and the EBRD. The IFC package includes an $8.9 million loan from its own account and an $8.9 million loan from the Finland-IFC Blended Finance for Climate Program. The project will also receive a €3 million investment grant from the European Union, mobilised by the EBRD.

Without a blended finance facility many of these projects may not have proceeded. However, much work is needed to scale up the million dollar transactions and multiply the billion dollar ones to achieve the trillion dollar objectives.

Scaling up private capital mobilisation -  What can DFIs do?

In practise, blended finance accounts for a tiny fraction of the funds allocated by DFIs, meaning the dream of using blended finance to turn billions into trillions remains, for the moment, just a dream. The trillion dollar question is how can DFIs and MDBs attract the private investors, who are more used to the reliable returns of developed markets?

For Schepers It's imperative that development institutions share their data and decades of experience of challenging and risky markets, so that private investors can see, and also compare, both financial returns and non-financial impacts.

“There is no risk return data in relation to Infrastructure Finance in Africa, or Middle East or Korea or in emerging markets generally,” said Schepers. “In the capital markets, we've got an abundance of data, within the development of the finance there's a total dearth of data. So it's a total pie in the sky that there will be growth and mobilisation without further understanding of the risk and returns that the private sector investments in those asset classes can generate.”

Indeed, as these assets being eyed up in blended finance deals have historically not been rated, the rating agencies don't have historical data. As a result, much of the “risk”, as understood from the private sector, may actually be perceived risk. In fact, it may be the case that a transaction may not not require a first loss facility or a guarantee, but without the data it’s difficult to know.

“The public sector needs to make and do its utmost to make the data available on what are the projects? What is the history? And yes, there will be certain sectors where there is just no data, where the risk judgments are just too big,” added Schepers.

The desire for transparency and standardised reporting is echoed by BlueOrchard. “From our side, we strongly believe that transparency and reporting that is comparable as much as possible, and is aligned with best practices, is an important key,” said Nibbio. “What we have seen from a more private, institutional investor perspective, is that it's not only the first loss that they are looking at, it's more the strategy ,and the strategy per se, of the vehicle. So they look at the financials overall, the impact strategy overall, because these days investors are really overwhelmed by investment opportunities. So it's difficult for them to pick and choose and compare what they see in the market in terms of opportunity.”

The Uxolo perspective - transparency is essential

The scarcity of readily available, standardised and transparent high-quality data on investment projects in emerging markets has the potential to lead to skewed risk perceptions and therefore suboptimal investment decisions. Indeed, perfect information creates incredibly deep markets and incredibly efficient allocation of capital. For this reason over the past years Reuters, Bloomberg, S&P and Moody's have all grown to support capital markets.

There is a risk that without the relevant and correct data blended finance may be engaged when it is not needed, and worse still, blended finance may be deployed in an investment that is genuinely risky, potentially causing huge losses to the public sector. A greater sharing of large scale, well diversified data can help investors build an accurate picture of risk, and help in the building of a homogeneous development finance asset class, comparable in nature to assets private investors are more used to, such as high yield and emerging market corporate bonds.

Data does exist - the Global Emerging Markets (GEMs) Risk database, which was envisioned as a way to allow the development banks themselves to better manage their own credit portfolios. GEMs is the world’s largest default and loss database for the emerging markets business of International Financial Institutions (IFIs). It pools data on credit default rates from customers funded by the contributing IFIs, their rating migration and the recovery rates of defaulted projects. However, in a rather on the nose illustration of the transparency problem, this database is not free and open which is significantly holding back the provision of private capital.

Blended finance clearly has a role to play in allowing investors to generate healthy returns, and at the same time, address development and climate challenges, but without available, contrastable data, the goal of turning billions into trillions will remain in doubt.

Uxolo is building a database of global project data from MDBs and DFIs, including blended finance transactions. If you wish to gain access to the free beta version please register here.

Uxolo has also just launched its inaugural survey mapping out the MDB / DFI space and their collaboration with private capital, which you can take here. This survey has been designed for DFI’s, MBD’s as well as a range of private capital providers to take part and should take you no longer than 10 minutes to complete.