Route17 (III/IV): the mobilizing private capital equation

This is part three of a four-part series on mobilizing private capital. You can find part one here, part two here, and part four here.

Links between DFIs/MDBs and the private sector: “marketplace”

This is the third in a series of articles we are writing about the takeaways from a symposium that Route17 and Dimensional Fund Advisors hosted in September 2023: an invite-only group of approximately 60 representatives from a range of sectors – government, development banks, asset owners, asset managers, investment and commercial banks, academia and think tanks – to discuss blended finance.

In the first article, we discussed the “why” of blended finance – closing the $4.2 trillion annual funding gap for SDGs and climate – and we introduced the “Mobilizing Private Capital Equation”, the analytical framework that Route17 developed to frame the day’s discussions.

Building on the music analogy we used in our series of articles Blended Finance is Like Music, we liken the desired output – the amount of private capital mobilized – to music coming from an amplifier that has four dials, that can all be turned up or down. If one or more are turned to zero, no sound comes out at all. The more the four dials are turned up, the more sound comes out.

The mechanism can also be likened to a mathematical equation, where the outcome (the level of private capital flowing towards SDGs) is a function of four variables: (1) the supply of bankable projects, (2) the risk mitigation capital that is used, (3) the links between the development banks (DFIs and MDBs) and the private sector investors and, finally, (4) the orientation of private investors towards this type of investment.

Each of the four break-out groups in the symposium discussed one of the barriers. The first article referenced above described the take-aways from the discussion in the first group, focused on Supply of Bankable Projects: “Bankability,” while the second article covered the conclusions from the second group, on Risk Mitigation Capital Used, or in other words, “Concessionality”.

This third article discusses the third barrier (“Marketplace”), while the fourth and final article will cover the last barrier (“Mobilization”), to be published in the next few weeks.

The conversation in the “Marketplace” group focused on how to improve the relationships between the public and private sectors, and how to design a global blended finance marketplace to allow for more effective involvement of private sector institutional capital. This proved to be one of the more vexing inquiries of the day.

Starting point and basic prerequisites

The philosophical starting point for this discussion was that markets form when a sufficient number of market actors agree that the existence of an organized and orderly marketplace individually benefits them to conduct better, faster and more business. Sometimes these markets spring up amongst private sector actors without much of a nudge from governments, but often – as the history of marketplaces suggests – in fact such a “public nudge” is needed. 

Once the formation of a marketplace has occurred, we see markets thrive and scale after three prerequisites are met: standardization, transparency, and liquidity. A degree of standardization (e.g., underlying standard documentation, with only a limited number of variable terms) gives the product efficient tradability, which in turn allows demand and supply to come together in ever greater numbers. Transparency of price and other terms and conditions is vital for market participants to be able to rely on the integrity of the marketplace. Lastly, no market takes off without adequate liquidity in supply and demand, so that efficient and reliable price discovery can take place, and one can almost always find counterparties to easily trade in and out of positions thanks to available secondary liquidity, either directly or via a broker.

Examples of such thriving financial markets abound, from the broader equity, fixed income, and currency markets, to other equally highly functional markets such as the IPO market, global syndicated loan market or the ISDA swap markets.

How does the global blended finance market compare against these ideas?

Evaluating the global blended finance market against these three market prerequisites – standardization, transparency, and liquidity – we see that blended finance does not meet any of them. Blended finance deals come in many different forms, with different (combinations of) concessional inputs, structured in various possible ways, across a variety of different fund vehicles, projects, facilities, platforms, and bonds/notes, at different levels (project, funds, fund of funds, facility,) and in various stages across the full project lifecycle of longer-term investments, such as in sustainable infrastructure. The inherent flexible nature of the structuring approach is in itself a compelling feature of blended finance and gives it potentially near-universal applications, but it also makes standardization extremely difficult to achieve. In other words, there is little standardization.

Nor is there much transparency in blended finance – the underlying risk factors, expected return, pricing, and relative position in the cash flow waterfall of various tranches in the capital structure are shrouded behind Non-Disclosure Agreements. Convergence (the global network for blended finance) has highlighted in its research that impact data are only reported by 60% of blended finance deals, and then mostly only to the investors in the deal, making it difficult for outsiders to assess how effective the transactions are in generating the desired impact. A recent large blended finance deal had some intricate tax and accounting considerations informing the deal structure, but we wouldn’t know this by looking from the outside in. No wonder deal makers in blended finance often feel they need to reinvent the wheel: this is nearly the opposite of the templated deals and transparency that would be required. To its credit, The Nature Conservancy decided to share the structure of its recent blended debt-for nature swaps (Belize, Barbados, and Gabon) on an open-source basis, and IFC provides annual disclosures on the subsidy element of blended finance transactions. Sadly, these are still exceptions that confirm the rule.

Lastly, global blended finance lacks the required liquidity of a marketplace. Sure, there are lots of pockets of concessional capital available if you know where to look. There are organizations up in the league tables doing blended finance deals every year. But getting one done, if you are not intimately familiar with or have solid entry points into this shortlist of institutions, is another story altogether. The process of demand meeting supply is at this time largely an informal one, driven largely by personal relationships. “Everybody is doing their own thing” was heard more than a few times at our symposium.

Besides the aspects of standardization, transparency and liquidity, this is of course also a key feature of marketplaces: relationships that bring a high degree of trust that underpins collaboration. The participants in our third discussion group agreed that, sadly, the different actors we'd like to see as active market participants – government agencies, development banks, philanthropic foundations, pension funds, and insurance companies in particular – largely operate in separate silos and have few relationships with the other silos.

Where to go from here?

It is no surprise then that the global finance “market” is stuck at around $9 billion of deals per year or less, for several years in a row now. This is a substantial number in real terms, which demonstrates that this type of investing involving actors from different silos can in fact be done. But compared to what is needed, this is a drop in the ocean: the annual SDG funding gap is estimated at $4 trillion or more. Blended finance does not appear to scale – for the time being.

While blended finance is perfectly capable of tailoring risk-return profiles to attractive levels for asset owners, many of them still think of blended finance as “too expensive, too complicated, too small.” It is not hard to see the potential attractiveness of blended finance as a result of the benefits of (i) portfolio diversification through largely uncorrelated emerging market exposure, (ii) exposure to higher-growth markets, (iii) tapping into 50% of the world’s GDP and (iv) exposure to the economic activity of 85% of the world’s population in those emerging markets. But asset owners do need to see a tangible pipeline of larger projects, to build diversified scalable portfolios. Institutional investors won’t commit capital or human resources if they don’t believe there will be scale.

Is a marketplace for blended finance a lost cause, and with it, the scaling of blended finance? The group discussing this did not think so. Operators of exchanges have considerable technology and expertise in developing new markets and scaling them, in complex products such as derivatives, and it would be useful to get them on the case. Getting rating agencies to rate the various tranches of transactions and aiming for standardization of documentation wherever possible were also mentioned as potential accelerators. 

The promising role of intermediaries

Our discussants believed that the global blended finance marketplace may evolve into something more like the global M&A marketplace. In that case, there is no formally organized marketplace or exchange, but there are very active intermediaries (investment bankers and brokers) who constantly look for mandates to buy or sell and bring together parties with the right alignment of interest. It’s the intermediaries that make this market a highly functional one, with no less than USD 2.9 trillion of deals done in 2023 (a down-year no less, amidst lots of macro-economic headwinds). If this model does have any predictive value for blended finance, there may well be an interesting opportunity for independent advisory firms, boutique merchant banks, and investment banks to become the blended finance intermediaries of the future. Now that some forward-looking asset owners are starting to look beyond ESG and disclosure-based approaches that often come with little “additionality,” and into actually financing sustainability, the next few years may well see an upturn in intermediary activity, and with it, blended finance deal numbers and volumes.

Our planet is certainly demanding more urgently every day that we act, and in the knowledge that we have the financing tools as well as the different actors who can deploy them, it is the lack of an efficient marketplace that keeps us from bringing all of this together and rising up to the challenge.

But there is one final bottleneck, and our last article in this series will therefore focus on the fourth dial in our framework: Private Investor Orientation (“Mobilization”).

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