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17 Aug 21

Five critiques of blended finance – and five responses from Convergence

Five critiques of blended finance – and five responses from Convergence

The opportunity to blend private capital with philanthropic and public funding has been heralded by financial heavyweights from Blackrock to the billionaire-backed Breakthrough Energy as a way to advance investments aligned with the U.N. Sustainable Development Goals.

Over the last few years, blended finance has grown from a niche field to a central topic at major conferences and boardrooms around the world. The conversation has moved beyond whether blended finance is a part of the solution to closing the $2.5 trillion SDG investment gap, to determining how it can be best deployed.

A quick refresher: blended finance is the use of catalytic capital from public or philanthropic sources to increase private sector investment in sustainable development. Convergence is the global network for blended finance. According to our data, blended finance has mobilized nearly $160 billion to-date towards sustainable development.

As blended finance becomes more prosaic and widespread, it also attracts more skeptics, and for good reason. Private sector involvement in development should always warrant close scrutiny, and the complex structures and financial jargon that accompany blended finance transactions can make them opaque and difficult to comprehend.

At Convergence, we don’t see blended finance as a silver bullet that will solve every development challenge. However, we know that traditional development aid will not meet the volumes required to achieve the SDGs by 2030. To do that, we’ll need the private sector, and to get the private sector, we’ll need blended finance. The money’s there; $2.5 trillion represents less than 1% of global finance markets.

To provide a bit more clarity on the role of blended finance in sustainable development, we’ve put together some responses to common critiques of blended finance that we come across.

__Critique #1: Blended finance doesn’t support low-income countries __

Most blended finance deals invest in lower-middle income countries rather than in low-income countries (as noted in our 2020 State of Blended Finance report, 56% of blended finance transactions have targeted lower-middle income countries, while 26% have targeted low-income countries). That’s because it should only be used for transactions where there are underlying revenues. This is reflected in the blended finance market; blended finance has most commonly been applied to commercially oriented sectors, such as financial services and energy (i.e. renewable and clean energy projects, not extractives).

We believe that most Official Development Assistance (ODA) should be distributed traditionally; that is, to support basic needs such as health and education, especially for those in Least Developed Countries and fragile and conflict affected states. However, in places that still need development aid but have the potential to attract investment, using a small allocation of ODA to draw in that investment frees up more ODA to be used (in pure grant form) in the places that really need it.

As blended finance becomes more prominent, there’s a misperception that a huge amount of traditional ODA is being diverted towards it. However, ODA being channeled towards blended finance and private sector instruments was only $3.4 billion in 2019 – a fraction (~1.9%) of the $158 billion in total ODA provided by member countries of the Development Assistance Committee (DAC) that year. We hope to get this number to 5%. This additional funding going into blended finance, if used strategically, could then draw in many times that amount in private capital, which could mean hundreds of billions dollars more towards the SDGs.

Critique #2: Blended finance initiatives lack transparency and accountability

There is widespread recognition in the industry of the importance of data sharing, simplifying structures and boosting transparency and impact reporting (particularly ex-post) to increase understanding and achieve scale.

However, the lack of transparency on impact outcomes reflects a larger issue in the official development community. For example, the Aid Transparency Index 2020 report, by the Publish What You Fund campaign, found that only a small minority of donors published the results of their projects, and even fewer published project reviews and evaluations.

To improve transparency and accountability, it is critical that donors demand accountability when deploying their capital. That accountability comes in the form of metrics and reporting on financial and impact outcomes.

Critique #3: There is no proof of effectiveness or impact

We disagree. The goal of blended finance is to increase funding towards the SDGs and all blended finance transactions involve the presence of development actors, whether it be a government or a philanthropic foundation. Blended finance transactions are therefore subject to the same rigorous approval processes and due diligence practices, including those used to assess impact, as other development projects, including those funded by ODA. No donor, whether public or philanthropic, places scarce resources into private-sector-led financial constructs without asking hard questions about value for money. Ultimately, this brings us back to the answer above, there simply isn’t enough transparency around effectiveness and impact in the larger development community.

Finally, at Convergence we like to think of blended finance impact on two levels: the impact related to the underlying activities financed (e.g., improving the resilience of smallholder farmers), and the impact of the blended finance approach itself (e.g., mobilization of additional capital for the SDGs, demonstrating the viability of new markets and new business models to private investors).

__Critique #4: Blended finance can distort markets __

All ODA and philanthropic funding, whether operating via traditional channels or used in blended finance, carries the risk of market distortion, since non-market-priced capital is entering the market.

To reduce market distortion, blended finance must adhere to the principles of minimal concessionality and additionality. What this means is that concessional financing should only be used in cases where a transaction is outside the risk / return mandate of private investors, and where concessional financing can bring in additional dollars that would not otherwise be invested (i.e. additionality).

Organizations such as the OECD have determined principles on minimum concessionality to help donors assess the appropriateness of blended finance and concessional financing.

Critique #5: The complex governance of blending erodes local ownership and accountability

Except for regional development banks, the most common funders in blended finance are development organizations in North America and Europe. This reflects their outsized role in the development finance space more generally. At the same time, most commercial investors in blended finance are also from developed countries. That’s because the scale of the private sector in developed economies is significant and the money is looking for places to go.

However, local participation of funders and stakeholders is imperative to ensure that blended structures are appropriate for the given market, and thus improve blended finance’s overall effectiveness and efficiency. As blended finance funds economic activities that help grow domestic economies and as governments in the developing world increasingly embrace private sector mobilization as a key component of their development targets, our expectation is that more local investors will start participating in blended finance deals. In addition, organizations like Convergence are supporting capacity building and education in boosting local participation in blended finance.

The point of blended finance is to mobilize private capital, whether that’s domestic resource mobilization or cross-border mobilization. Examples of blended structures that have attracted local financing include the Acorn Holdings Corporate Bond launched in 2020 to finance the construction of student housing in Kenya, and achieved a dual listing on the International Securities of the London Stock Exchange (LSE). The bond received a guarantee from GuarantCo, an intermediary whose mandate is to provide catalytic guarantees that attract local currency financing, to adjust the risk-return profile for private investors. Blended structures such as these promote participation from local investors and support the development of local capital markets.

Originally published on ImpactAlpha, access here

About the Author
Joan M. Larrea

Joan M. Larrea is an expert in catalyzing investment in places that need it most and brings with her close to 30 years of experience in emerging markets investing. Joan has led Convergence since its inception, establishing it as the leading independent authority on blended finance. She serves on the Global Environment Facility Advisory Group for Non-Grant Instruments, the Advisory Council for FinDev Canada, and the Advisory Council for the U.S. Millennium Challenge Corporation. Prior to joining Convergence, she led the U.S. Overseas Private Investment Corporation's (OPIC) efforts to partner with philanthropic and private investors to increase capital flows to OPIC's target markets. While there, she also directed a pilot program to finance smaller, high impact, and innovative funds, many of which drew on blended finance structures. Previously, Joan served as a managing director on the emerging markets team at Global Environment Fund, an asset manager dedicated to the energy, environmental, and natural resource sectors. She began her career as an investment officer at International Finance Corporation, the private sector arm of the World Bank Group, where she concluded pioneering transactions in a variety of infrastructure and manufacturing sectors across Asia.