Blended Finance Overview
Blended finance is a strategy that combines capital with different levels of risk in order to catalyze risk-adjusted market-rate-seeking financing into impact investments. The providers of the risk-tolerant, “catalytic” capital in blended finance structures aim to increase their social and/or environmental impact by accessing larger, more diverse pools of capital from commercial investors. The utilization of blended finance structures and catalytic capital is increasingly relevant within the impact investment ecosystem, particularly in how they can help address some of the world’s critical challenges.
Why is Blended Finance Important?
While the impact investment industry has grown remarkably over the past few years, accounting for more than USD 228 billion invested, the challenges impact investors seek to address remain daunting. Mobilizing additional capital is a crucial need for the industry.
This is especially true in terms of achieving the United Nations’ Sustainable Development Goals (SDGs). It is estimated that the SDGs face an annual funding gap between USD 5 to 7 trillion. Capital deployed through blended finance structures can help address this gap by enabling the entry of more conventional capital flows into products, companies, and funds which incorporate impact objectives.
Despite its potential, blended finance remains underutilized. Key challenges include difficulty in structuring blended finance vehicles due to their complex and bespoke nature; issues with aligning expectations among various stakeholders; and lack of available risk capital. On top of this, the challenge of shifting mindsets remains. The misconception that impact first investing, and patient capital, can be utilized in limited investment areas, such as official development assistance, or by development agencies, continues to be a barrier for expansion of private investment in these initiatives.
The opportunity for innovative blended finance structures to expand the reach and scale of impact investing is encouraging. Particular objectives such as increasing access to Healthcare and Affordable Housing, or supporting Community Development, can be supported more effectively by these approaches. The GIIN is committed to continue to work with the investor community to build guidance and thought leadership around these tools.
Blended Finance Characteristics
As previously referenced above, the core characteristic of blended finance approaches is that they allow two, or more, investors to invest alongside each other while simultaneously targeting their own objectives. One investor can pursue market rate returns, while the other can provide sub-market rate returns in exchange for social or environmental impact. Frequently these groups will be referred to as “Private Capital”, targeting market-rate or near market-rate returns, and “Public/Philanthropic Capital”, targeting concessional, or more flexible/patient, capital returns.
A unique offering of blended finance structures is their ability to expand the definition of what constitutes a feasible investment. Certain investors may deem a particular investment unsuitable based on risk-adjusted returns. Restructuring this same investment opportunity in a blended finance vehicle provides a lower-cost layer of capital, which can enable the more risk-averse investors to reassess the opportunity as a good investment. This is an example of creating a “blended pool,” so that impact-focused investors can invest alongside a more diverse group of investors.
The Blended Finance Working Group identified a number of challenges that arise in structuring blended finance investments. Since these investments often involve a variety of stakeholders, the Working Group found that difficulties frequently occurred during negotiations over the design and specific terms of the investment vehicle. Specific issues included opposing expectations between risk capital providers and market-rate providers, as well as a lack of common language among the stakeholder group. At best, these issues led to a lengthy negotiation process; at worst, they caused deals to fall apart. To address these challenges, the Working Group has created a suite of resource documents for stakeholders who have decided to utilize a blended finance structure that leverages one of five catalytic tools.
Download the Blended Finance Resource here.
Motivation to use Blended Finance
In terms of deciding if and when to use blended finance, investors’ motivations are varied and driven by a variety of factors such as risk-return preferences, impact targets, and fiduciary responsibilities.
Below are examples of situations that trigger blended finance conversations:
- An investor wants to build a certain size or type of fund but does not have sufficient capital available via conventional structuring without adjusting the risk profile of the fund.
- An investor has access to a certain amount of grant and/or public money and wants to use this funding to leverage private capital.
- An investor’s investment structure is dependent on a combination of public and private capital, e.g., a social impact bond.
In the scenarios above, catalytic capital is utilized to address risks (perceived or real) facing market-rate investors and preventing them from entering into an investment. These risks could be associated with the piloting of a new business model or entrance into an unfamiliar market.
Catalytic Capital - A Bridge to Mobilize Greater Impact
While only a portion of the blended finance relationship, catalytic capital can play an outsized role in addressing significant challenges, such as climate change, sustainability in the renewable energy industry, and international development assistance. A variety of investor types are actively utilizing catalytic strategies, but due to the requirements tied to this approach, certain groups and institutions are more likely to be active in this space. Organizations like the IFC and World Bank, multilateral and development banks, Development Finance Institutions (DFIs), and Institutional Investors are prime examples of asset owners who are exploring catalytic innovations. Another organization helping drive the growth of catalytic capital is the John D. and Catherine T. MacArthur Foundation. Partnering with a group including other foundations, impact investors, and nonprofits the John D. and Catherine T. MacArthur Foundation has launched the Catalytic Capital Consortium, C3, which, “aims to demonstrate the power of this form of investment to extend and deepen the reach of the impact investing field.”
Catalytic capital can also be used in priming early stage investments. If an investment may not yet be ready to attract risk-averse, market rate investors, catalytic capital can be used to help build the financial capacity so that overtime additional investors can be brought in. This can be especially useful in enabling investments to scale up in developing or emerging markets, where the current state of the market may limit the entry of traditional private investors. In this sense we can see catalytic capital as a tool for international development.
Investors who consciously assess financial returns alongside social and environmental impact frequently have a wider definition of an acceptable investment than those who solely measure results on financial returns. This being said, some impact opportunities may struggle to gain traction, particularly in the early stage. A variety of factors can cause this, such as high upfront costs or uncertain return potential. In such instances, the strategic use of catalytic capital can be the key to unlocking this impact. By accepting disproportionate risk and/or concessionary returns, catalytic investors can bridge the gap between grants and traditional impact investments.
Current GIIN Activities on Blended Finance and Catalytic Capital
In 2021 GIIN Members have the opportunity to participate in the Blended Finance Knowledge Hub Series. The Blended Finance Knowledge Hub aims to transfer practitioners’ know-how and enable members to become engaged in blending capital for positive impact. Building directly on the resources, findings, and success of the Blended Finance Working Group, the Knowledge Hub serves and connects all GIIN members, regardless of their prior level of engagement with Blended Finance workstreams and working groups.
Additionally, the GIIN’s Product Development Platform, which connects fund managers who have in-development investment products with diverse sets of asset owners, frequently showcases products utilizing blended capital.
Outside of these ongoing series, the GIIN frequently partners with its members to organize bespoke, informal discussions related to shared areas of interest for Blended Finance and Catalytic Capital focused investors.
Sign-up for our workshop and webinars newsletter here to learn about upcoming workshops and webinars on gender lens investing, or reach out to us via email to the Member Engagement Team. To more deeply engage with the GIIN’s expertise on blended finance and catalytic Capital, consider GIIN membership.