There has been growing attention on the strategic use of guarantees in blended finance to mobilize additional sources of commercial finance, following multiple reports that tout guarantees as the development instrument to unlock the greatest volume of financing (e.g., 2017 OECD Mobilisation Report).
Guarantees offer several distinct advantages, by (i) bridging the gap between perceived and actual risk (funds are only disbursed in event of payment default); (ii) allowing for capital efficiency for issuing public institutions (i.e., capital is only disbursed in the case of losses); and (iii) mobilizing local currency resources. At the same time, more evidence and clarity are needed around the effectiveness and efficiency of guarantees.
Convergence’s latest Data Brief reviews the use of guarantees in blended finance transactions to date. Guarantees have been the second most prevalent form of risk-taking by catalytic, concessional capital providers (after funded risk participations), present in more than one-third of all blended finance transactions captured in the Convergence database. These guarantees have been successful in mobilizing significant investments from commercial banks and corporates to SDG-focused projects.
However, our analysis also indicates guarantees have been concentrated in relatively more commercial projects and structures. Specifically, Convergence found that guarantees have been largely deployed in blended finance for:
Infrastructure projects: Approximately half of blended finance transactions with development guarantees have financed infrastructure projects, with a particular emphasis on renewable energy projects. While guarantees have been used to mobilize additional financing to social sectors like health, housing and education, this represents only a fraction of guarantees deployed to date.
Pooled investment vehicles: Guarantees have most commonly been used for funds, facilities, and bonds / notes – pooled investment vehicles where risk is also diversified across multiple projects and often countries. These pooled funds and facilities often also benefit from concessional debt or equity, in addition to a guarantee, either on the loan portfolio or a specific capital tranche (e.g., senior debt). Guarantees have been featured often in blended bonds / notes, which can be good vehicles for attracting local institutional investors as well as building local capital markets. However, bonds / notes remain a small minority of transactions captured in the Convergence database.
Large ticket sizes: Development guarantees have been used most frequently (20% of transactions) to mobilize additional private sector investment for transactions that are $100-$250 million in aggregate size. Compared to all blended finance transactions, transactions with a development guarantee have been much more likely to be larger than $250 million in total size and less likely to be smaller than $100 million. This may reflect the preference of commercial investors towards larger ticket sizes, but also begs the question about whether guarantees can be deployed to support smaller projects, which face the greatest financing gap.
- Commercial debt: Eighty-one percent of development guarantees captured have provided coverage on commercial debt into blended finance transactions, with another 12% providing coverage on both debt and equity (i.e., through mixed investment vehicles). While commercial debt provides critical financing to many projects, there is a continued need for more equity investments in developing countries.
Guarantees are undoubtedly one important instrument for mobilizing additional private sector financing for developing countries; but it is important to recognize that they are not a one-size-fits-all solution. We continue to need greater risk-taking and innovation to get guarantees, and blended finance more broadly, out of its “comfort zone”. Ultimately, the objective of blended finance is not to maximize the amount of additional financing, but to achieve measurable progress towards sustainable development.
By Justice Johnston, former Manager at Convergence