Blended finance: How setting up a financial intermediary can accelerate sustainable development

With the world facing major challenges such as climate change, inequality and hunger, we need sustainable development now more than ever – but it needs adequate financing.

Blended finance is the strategic use of public finance for the mobilization of additional private finance towards sustainable development in developing countries.

The most significant value of blended finance transactions is the ability to unlock funding for investments in areas that are not well funded. These investment segments are typically seen as 'too risky' for low-risk-seeking investors, or returns are not commensurate with risk for risk-seeking investors.

Despite the obvious benefits of blended finance strategies, the market for such deals has globally grown at a tepid rate. As tracked by Convergence, a global network for blended finance, since 2010, the aggregate blended finance flows touched close to $180 billion as of 2022, with annual capital flows averaging approximately $9 billion since 2015.

This is significantly low considering the amount of capital required to meet sustainable development goals (SDG) – estimated at about $4.2 trillion annually in developing countries.

Several challenges constrain the adoption of blended finance, including the small size of projects, high search, due diligence and transaction costs.

In addition, private investors who may ideally be interested in investing in sustainable projects find it difficult to participate in blended finance as they may not have accessible networks, connections or the time to engage in structuring.

On the other end, several small companies or projects that require the finances do not have the resources to structure deals or do not have the necessary capacity and knowledge to conduct extensive due diligence that investors need.

Multilateral development banks (MDBs) and development finance institutions (DFIs) are well-positioned to do financial intermediation to lead blended finance deals.

However, they primarily originate blended finance deals for investing their proprietary capital; hence the potential for mobilizing private capital has not been realized.

This is illustrated by DFI Working Group's Joint Reports on Blended Concessional Finance of 2021, which suggests that MDBs deployed $1.4 billion in concessional funding, which catalyzed $5.1 billion from their own account and only $3.1 billion from the private sector.

The lack of an accessible intermediation platform for sustainability projects makes it hard for private financiers to participate in blended financing.

Accordingly, enhancing and opening up channels where private investors can easily interact with concessional capital providers can facilitate a greater flow of capital toward the development sector.

A promising solution is to build a green specialized financial intermediary, the role of which would involve:

The financial intermediary can develop its domain expertise and build a strong network in the industry to identify suitable investment opportunities for blended financing transactions. This domain knowledge and network can help the intermediary pool together various developers, companies and projects that seek debt and equity capital.

The intermediary will also have to play the role of an aggregating agency where in investment requirements of multiple smaller companies are brought together to make a sizable investment opportunity.

Feedback from investors highlights that the development community should push for deals above $500 million through aggregation platforms to unlock private capital at scale. The agency can create a place for varied types of investors – small, medium and large – to come together for investments.

The financial intermediary will also have to be familiar with the regulatory and financial landscape of the country and the international investors to develop tax-efficient structures. Over time, building standardized templates for deals rather than bespoke transactions can reduce transaction costs significantly, which will help small-size deals in particular.

Another integral value addition from the intermediary will be in conducting due diligence on at least the basic financial and legal parameters that can reduce investors' searching and transaction costs.

Conducting the diligence at scale will help bring down overall transaction costs. Smaller private investors can leverage the diligence done by the intermediary to avoid duplication of resources to diligence the same investment opportunity.

Making a case for the positive 'additionality' is created by using public/ philanthropic money at a lower than the market rate of return is a fundamental requirement of blended finance deals.

However, often the baseline and post-project implementation impact data are either not tracked or easily available or are sitting in silos. In effect, the financial intermediary can take the lead in creating an open-source repository of detailed data on the impact of the projects.

It will serve as evidence for attracting a greater flow of public capital as there would be evidence of the creation of additionality. Besides, private capital providers can better understand how this transaction structure can offer market-rate returns, thereby accelerating private capital flows.

Multilateral development banks and development finance institutions can very well continue to play the role of a financial intermediary to develop the blended finance market, but would be required to make amends to their operations and business model.

This could include increasing the targets for MDBs to augment the share of private capital mobilized in blended finance transactions and making mobilization targets a core performance indicator.

Another useful strategy would be to shift the operations of MDBs and DFIs to take positions in transactions that attract private investors rather than focus on their funds’ deployment. An example of this would be the investment of MDB/DFI as second-tier capital instead of a primary capital provider in a blended finance structure.

Additionally, providers of finance to the MDBs and DFIs, such as the OECD Development Assistance Committee members, can allocate greater money towards mobilizing private finance. Currently, only 2% of overseas development assistance is used to mobilize private capital.

In a nutshell, a financial intermediary can accelerate blended finance adoption to mobilize capital for sustainable development.

It would need to fill in the missing gaps in the current market and is primarily responsible for coming up with new ways of attracting private capital flows to the development sector.

The traditional financial institutions, the MDBs, and DFIs who have done this work so far can play a major role by re-aligning themselves to pave the way for private financiers in blended finance transactions.

The views expressed in this paper are solely those of the author(s).