This op-ed was originally published on Devex.
Co-authored by Joan Larrea, CEO, Convergence and Kusi Hornberger, Partner, Dalberg.
We are far short of achieving the Sustainable Development Goals by 2030. Public and philanthropic institutions alone cannot fill the current $7 trillion annual financing gap — the private sector must step up. But what will incentivize the sector to do so, and how can the development sector ensure the funds are targeted to meet the SDGs?
Development finance institutions, or DFIs, can answer these questions — if they recognize how their potential to contribute has changed. Here are four ways DFIs can strengthen their ability to promote catalytic investment.
1. Increase blended finance windows to catalyze investments
Concessional funds from donors are scarce and thus must be used fully and strategically to crowd in other types of capital. Currently, blended finance windows (i.e., money donors set aside for blended finance) are woefully underused — losing opportunities to draw in third-party capital to fill development needs.
In 2020, 1.6%, or approximately $1.6 billion, of all participating DFI private financing was at concessional or submarket rates. This is a huge missed opportunity to catalyze investments; in fact, in a typical blended finance fund, each dollar of concessional capital leverages $4 of commercial capital, of which less than half is private sector investment capital.
Yet, according to Convergence’s database of historical blended finance transactions, DFIs are putting forward the concessional capital in less than a tenth of blended finance transactions. If scaling mobilization is the goal, donor governments must push DFIs to do more, guiding them away from acting like risk-averse investment banks and encouraging them to provide more risk-tolerant catalytic capital in many more blended finance transactions.
DFIs must be incentivized to proactively seek deals in social infrastructure, climate adaptation, and other projects. And further, take subordinated debt positions in these blended finance structures to best catalyze private capital and achieve development impact and financial return.
2. Seek ecosystem additionality and not just financial leverage
DFIs should broaden their definition of “additionality” to “ecosystem additionality” — and recognize the broader impact they bring beyond financial leverage — which can create market signals and remove systemic barriers that change behaviors. For instance, learnings from a blended finance transaction can bring benefits broader than the transaction itself.
Being driven by ecosystem additionality may mean not only selecting transactions that, in the first instance, promise to deliver higher leverage or draw in larger investors, but also supporting smaller blended finance transactions that may have greater potential to transform markets.
One example is IDB Lab’s $1 million loan, deployed in 2016, to Pomona Impact, then a new impact fund with a first-time manager investing in risky markets in Central America. IDB Lab’s loan was catalytic, with concessionary rates, allowing Pomona to achieve success in only two years with investments in organizations like EcoFiltro, Uncommon Cacao, and Yellow Pallet.
omona demonstrated that impact investing in Central America was feasible, raising and launching its first $20 million fund. Currently it deploys capital into high-impact social enterprises across Central America with more than a dozen private and public investors.
Many new impact funds, having observed Pomona Impact’s success, are entering or considering investments in the region — investments that might not otherwise have been made.
3. Interact and collaborate more with private catalytic investors
DFIs can increase and strengthen their catalytic investments by intentionally seeking out and collaborating with other catalytic investors, rather than partnering by chance or on a transaction-by-transaction basis.
DFIs should seek ways to both co-invest and share learnings that strengthen catalytic investments and outcomes. To clarify, we do not suggest DFIs collaborate with other catalytic investors to mitigate their own risk, but instead share lessons learned, tools, and specialized expertise.
Greg Neichin, managing director of the family office Ceniarth LLC, suggests matching catalytic investors systematically through a “DFI capital gap dashboard” that provides both DFIs and catalytic capital investors with ways to efficiently source deals to their mutual benefit.
Such an intentional partnership was recently announced between the International Finance Corporation and The Rockefeller Foundation. The Rockefeller Foundation has committed $150 million in catalytic capital to mobilize up to $2 billion in private investments to de-risk private investments in distributed renewable energy solutions across sub-Saharan Africa. The demonstration effects of this effort will illustrate the potential unlocked when catalytic investors choose to work together.
4. Report better on blended finance use and impact
Publish What You Fund’s 2023 DFI Transparency Index indicates that DFIs generally are insufficiently transparent. Most do not publish evidence of impact, financing flow data, or proof of accountability to the communities they invest in.
Data reporting is crucial to understanding typical deal terms, the rationale for using concessional funds, and disaggregated information on types of capital used. Increased reporting reduces information asymmetries that prevent private investors from accurately assessing investment and project risks, lead to mispricing of risk and, ultimately, a higher cost of capital in the countries that most need it.
IFC was ranked the most transparent nonsovereign DFI in the assessment, highlighting their robust environmental, social and governance, or ESG, reporting, accountability mechanisms, and disclosure of high-risk financial intermediary, or FI, subinvestments. For example, in 2020 IFC launched the green equity approach that precludes equity investments in FIs that do not have a plan to phase out coal investments by 2030. In addition, IFC is the only major DFI that shares the percent of project cost that is covered by concessional terms in their project-level data reporting. Any DFI can adopt and benefit from these practices that help mitigate perceived investment risk and ensure that all investments align with their values and mandates.
DFIs must act now. The SDGs' environmental, social, and economic outcomes cannot be achieved unless DFIs use catalytic financing to push the boundaries of where markets can work. DFIs must rethink how they will provide capital to fulfill their mandate to foster private sector activity where it is most needed, and the four recommendations here are a good place to start.