What is blended finance?

IMPACT 101: What exactly is being blended in blended finance? Why do we need this strategy – and what are the challenges of making it work? Catch up in our explainer with Dalberg's Marcos Paya.

What is blended finance? What exactly is being “blended”?

Marcos-Paya_DalbergMarcos Paya: Blended finance is an umbrella category encompassing the many ways in which diverse sources of capital and knowledge combine in a transaction to generate positive impact.

Some existing definitions, like Convergence’s, point to the fact that blended finance can mean combining private capital with public and philanthropic funding. The OECD points to the fact that it is used for “sustainable development in developing countries”. And others, like the Global Impact Investing Network, point to the different kinds of risk and investing instruments that come together with different incentives and different terms.

All of these definitions concur around the fact that ‘blending’ or being ‘blended’ is a strategy of sorts – an intentional decision to use money and knowledge in some kind of innovative combination because traditional approaches have not worked or not been tried before.

‘Blending’ is an intentional decision to use money and knowledge in some kind of innovative combination because traditional approaches have not worked

And while three criteria need to be met for a transaction to be considered ‘blended’ – the transaction overall contributes to impact; the transaction overall looks to achieve a return; and some participants in the transaction are ‘catalytic’ – I’d argue that these established definitions may no longer be fully fit for purpose. 

Blended finance is starting to emerge as a practice in diversified economies with mature capital markets; it doesn’t always need to be exclusively about financing (it can be defined by the convergence of capital and technical assistance, for example); and doesn’t always need to feature a party that’s willing to make a loss (several return-seekers can come together, for example, under different terms and often differing levels of risk). 

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So blended finance brings capital and knowledge together in different ways to make an impact – but why do we need it?

MP: We need it because critical challenges faced by both people and planet are underfunded, because many fundable solutions are out of reach for fiscally-strained governments whose role it may be to provide public goods, and because the traditional market-based economic model that much of the world operates under does not sufficiently prioritise, account for, or value positive social and environmental impact. Blended finance can play an important part in introducing innovation and positive intentions into market systems that over time have produced and perpetuated unacceptable levels of inequity and inequality.

 

How does blended finance compare with catalytic capital?

MP: These are not either/or – catalytic capital can be part of a blended finance deal.

As defined by the Catalytic Capital Consortium (C3), catalytic capital is investment capital that is “patient, risk-tolerant, concessionary, and flexible”. Catalytic capital can be a component within a blended structure and is often critical to achieve the right balance of risk for the multiple parties involved.

 

How significant is blended finance? How much of it is there out there? 

MP: According to Convergence, the platform for blended finance that we at Dalberg helped initially give shape to: 

  • Blended finance, under Convergence’s definition, has mobilised approximately US$180bn in capital towards sustainable development in developing countries to date;
  • Blended finance transactions range considerably in size, from a minimum of US$110,000 to a maximum of US$8bn;
  • Funds (eg equity funds, debt funds and funds-of-funds) have consistently accounted for the largest share of blended finance transactions; and
  • Concessional debt or equity has been the most common archetype of a blended transaction, including first-loss debt or equity, investment-stage grants, and debt or equity that bears risk at below-market financial returns to mobilise private sector investment.

What is most significant is how much blended finance can continue to grow and scale. As highlighted in the 2022 State of Blended Finance report, the opportunity for enhancing flows of blended finance to achieve globally established climate and environment targets remains massive – the World Bank estimates that “low-carbon and climate-resilient infrastructure in low- and middle-income countries could require investments of around US$1.6tn annually from now to 2030, or 4.5% of their GDP”, with much of this demanding a blended approach in order to effectively meet both private and social returns.

 

What are the typical challenges with making it work? In what cases does it not work?

MP: Challenge #1: Blended finance is too often perceived or understood as an ‘end’, rather than as a ‘means’. Actors seeking to put together a blended finance transaction may see near-term value in making the deal possible –  in raising the capital, in calibrating the risk across parties in a way that ultimately allows for financial close – but if it all of that has not led to some kind of positive impact, then the ultimate value of that blended transaction is arguably moot.

At Dalberg, we worked with USAID and INVEST on laying out an approach that sequences the flow of impact in blended finance – this can be a starting point to ensure indirect impact is more adequately conceptualised and of course measured.

Blended finance is too often perceived as an ‘end’, rather than as a ‘means’... if it has not led to some kind of positive impact, then the ultimate value of is arguably moot

Challenge #2: The spillover impact of blended finance is often overlooked and undervalued, especially as a decision-making criterion for whether or not to ‘blend’. A very interesting recent essay by IDB Invest’s blended finance team points out that more and more blended finance decision-makers could aim for even greater social good even beyond the linear direct and indirect impact of a single transaction; that blended finance has the potential (under certain conditions) to generate spillover knowledge that can improve how market systems operate, and also ‘fix weak links’ in intertwined networks of economic activity.

This is valuable to think about – in addition to the question of ‘would this investment have taken place without a blended finance structure?’ – when deciding whether or not to ‘blend’.

Challenge #3: There’s not enough evidence on the failure of blended transactions, which limits the field and practice of blended finance from improving and evolving. While there has been good progress on aggregating transaction data and defining guiding principles for blended finance in practice (eg on the degree to which a donor or investor should ‘concede’ returns), poor measurement and uneven disclosure lead to limited clarity on when blended finance risks generating market distortions. The Global Emerging Markets risk database is a step in the right direction for key blended finance institutions to learn from each other on deal performance but more evidence of its kind needs to be made public for the blended finance space to continue to mature. Private investors and key intermediaries like ratings agencies could benefit tremendously from more data on risk calibration in data-scarce investment environments.

 

What’s an interesting example of how blended finance is evolving?

MP: Development finance and donor institutions have been doing some interesting work that continues to expand the definition of blended finance, primarily through broadening the range of (both capital and geographic) markets in which blended finance is undertaken. 

For example, the ‘Mobilising Institutional Capital Through Listed Product Structures’ (MOBILIST) programme has used catalytic donor funding to accelerate capital formation in listed markets, ie, make it easier to pool and move capital in and out of structures like stock exchanges. Efforts under MOBILIST can help evolve the piecemeal, deal-by-deal nature that has defined blended finance to date.

Secondly, through its INVEST program, USAID supported the global issuance of a housing bond in West Africa that brought together development finance institutions like the US DFC, and allocators like Bank of America Securities, Brean Capital, The Bank of New York Mellon and others. Beyond the immediate impact of making a first-of-its-kind transaction possible, the deal will mobilise at-scale private capital for the development of housing solutions, and facilitate a new way of investing in West African capital markets.

Lastly, innovative transactions like the debt-for-nature swap in Belize were made possible through blended finance structures that combined a nature-based bond instrument issued by a commercial bank with insurance (political risk cover) provided by a development finance institution. 



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