Scaling Blended Finance for Development

Commentary by Richard Crespin

Published November 21, 2024

Earlier this year, on the same day, I met with an impact investor focused on the United Nations' Sustainable Development Goals (SDGs) and with a team working on a new(ish) government-backed investment incubator. Both were working on essentially the same issues. Both wanted to invest in private companies that would have a scalable impact on improving the lives of people in emerging economies and positively impact the environment. Each wanted to "crowd in" investments from the other. When I suggested they meet and collaborate, both declined.

Bizarre? Unfortunately, no. This is very typical. Neither felt "ready" to meet with the other. To paraphrase one party, "We need to iron out all the details first." This is precisely the wrong approach. Instead, potential partners should work out the details and overcome the barriers together. Time and again, I've watched these "blended finance" deals-bringing together private, public, and philanthropic capital-fail to launch or scale because one party over-engineered the transaction or focused exclusively on its own needs. Interested parties end up incorporating terms and conditions that work for them but that inadvertently excludes the other.

This is not just an esoteric problem for wealthy donors, investment funds, or governments. The world, particularly emerging markets, faces a huge funding gap in ensuring clean water, air, and livable communities for its citizens. Convergence's 2024 State of Blended Finance report indicates a $2.5 trillion annual shortfall in the ability to address global challenges (enshrined in the United Nations' SDGs)-despite vast public and philanthropic commitments. On paper, blended finance would seem to offer the hope of closing this financing gap by crowding in money from governments, donors, philanthropists, and impact investors. Yet this "we have to figure it all out on our own" mentality continues to sabotage efforts to scale blended finance. Now, at the dawn of a new presidential administration, the U.S. government, and its partners in the philanthropic and private sectors, have the opportunity to take a new approach.

Barriers to Scaling Blended Finance

Although blended finance holds significant promise, it has not yet reached the scale needed to close the sustainable development financing gap. There are many reasons behind this, which can be categorized into three main barriers:

1. Misaligned interests and operations: Beyond differences in missions (e.g., businesses and investors prioritize profits while donors, impact investors, and governments prioritize social or environmental impact), the internal processes and procedures of institutions often actively impede collaboration. For example, commercial institutions want to react in days or weeks, while governments often take months or even years to make decisions. In addition, donors, especially the United States Agency for International Development (USAID), tend to favor cost-recovery grants where grantees get paid for costs incurred while investors want to link payments to results.
2. High (and unwarranted) perceived risk: There is oftentimes a mismatch between the actual and perceived risk of investors eyeing emerging markets. The surplus of potential investments in developed countries means that investment analysts spend most of their time and resources studying these opportunities, leaving emerging markets understudied. This, in turn, creates a greater perception of risk, with investors seeking higher risk premiums on their investments. Investing in an emerging or frontier market does warrant some risk premium, but not in every case or at the higher rates currently demanded.
3. The complex nature of blended finance transactions: Often, these transactions are not straightforward; they include investment subsidies like political risk insurance, first-loss guarantees, or in-kind contributions. While helpful, on the one hand, understanding the terms and conditions for these "sweeteners" requires research, expertise, and patience-which often runs short on the commercial side of the transaction, especially when coupled with the other two barriers (long-time horizons and higher perceived risk).

Put more simply, commercial investors are from Mars, while impact investors and donors are from Venus, and the engrained attitudes of each disincentivize these transactions. Having been at the table for multiple blended finance transactions, commercial investors often struggle to understand why someone would "just give away money," and philanthropic donors or governments often inherently distrust what they see as "greed" and, as a result, want to place so many strings on their money, they end up inhibiting either the financial performance or the ability of a commercial investor to understand the deal.

At the same time, an increasing number of philanthropic donors have come to realize that commercial businesses offer a more sustainable path to impact. They watched as nonprofits failed to achieve sustainable business models and ended up just coming back for more donations. If a company can operate profitably and achieve environmental or social goals (like those in the SDGs), this offers a more reliable and longer-lasting impact. Having a commercial investor involved also keeps the business focused on financial sustainability in addition to environmental or social sustainability.

How to Scale Blended Finance

To overcome those barriers and capitalize on the opportunities that blended finance brings, partners should follow seven principles linked to each barrier above.

1. Increase and Improve Cocreation to Better Align Interests

Governments and impact investors do not spend enough time together. They wait too long to start collaborating, preferring to "work out all the details" before they engage the other parties, resulting in deals dying before they are ever really born. At the same time, the very bespoke nature of almost all blended finance transactions prevents scale, so we cannot expect governments and impact investors to cocreate everything. Instead, I suggest cocreating at a platform or portfolio level.

As an example, USAID has established what they call "blended finance platforms," including INVEST and the Climate Finance for Development Accelerator, among others. The next time USAID, the U.S. Development Finance Corporation, or an impact investor seeks to create a similar platform, instead of doing so in isolation, invite the types of institutions they would like to crowd in money from to cocreate the platform with them. This might include developing a common set of terms and conditions, methods for evaluating and trading off impact vs. return, and establishing a governance and decisionmaking structure for managing both individual transactions and decisions at the portfolio level.

1. Focus on Sustainable Economic Models to Align Interests and Manage Emerging Market Risk

Some donors focus overly on the corporate form, nonprofit vs. for-profit, and not enough on the underlying economic model. In fact, donor bylaws often prevent them from donating to for-profit companies. On the other hand, the nonprofit corporation form often scares away impact investors as they do not believe a nonprofit can produce a return on its investment. The term "nonprofit" should be a tax status, not a goal. Many nonprofits have very strong recurring revenues and can create both sustainable development impact and economic value. At the same time, most businesses are not composed of executives, just focused on the bottom line. In fact, most businesses solve a fundamental social problem by supplying relevant goods and services. Regardless of corporate organization, the economic model needs to create some way of sustaining itself without ongoing donations and repaying impact investors or lenders. Donors and investors need to be open to either corporate form. Making form follow function will better align interests among donors and investors as they design and fund these kinds of programs. It can also provide the kind of flexibility necessary to manage emerging market risk if donors/investors can agree on how to measure impact and if/how to tie payments to results. More on this below.

1. Agree on Measuring, If Not Specific Measurements

Much has already been written on the need for better measures and standardized development impact measurements, but, like standardized terms, I fear that this may be a bridge too far. Unlike financial performance, the types of impact that blended finance might create vary too much to lend itself to financial measurements akin to ROI (Return on Investment), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or ROE (Return On Equity). A more realistic approach might be aligning investment criteria by building off of the work the Rockefeller Foundation's Zero Gap Fund has already done. The fund puts forward financial products that meet the stringent investment criteria of institutional investors while complying with ESG standards. Even a small step, like standardizing the process by which impact measurements are agreed upon, documented, and assessed, would help attract institutional investors.

As an example, my firm, CollaborateUp, works with a family of donor-advised funds (DAFs) that have created a defined and repeatable process for setting and documenting SDG-related targets in all their investment agreements. The DAFs work with their prospective investment recipients to (a) agree on measurable SDG targets, (b) adopt a standard system to report data on the agreed-upon measures (paid for by the DAFs), and (c) an auditor to verify the targets are achieved (also paid for by the DAFs). They established this standard operating procedure across all their impact investments, regardless of topic. Other donors and impact investors might borrow from this operating procedure and blend it with Rockefeller's approach to investment criteria.

If donors, investors, and funding recipients cocreate their measurement approach, they will have taken a step toward better aligning their interests and addressing emerging market risks-especially if payments are linked to verifiable measures.

1. The Virtues of Fixed Price and Results-Based Finance.

Ultimately, the theory of blended finance relies on the ability of the organization receiving the funds to deliver a positive economic, social, and/or environmental result. Unfortunately, the pipeline of projects coming out of most philanthropic endeavors is ill-suited to results-based finance. To remedy this situation, USAID and other grant-makers should radically rethink how they award and measure grants. Right now, most grants rely on a cost recovery model, not results. Therefore, grantees spend an inordinate amount of time and money tracking costs, resulting in grantees becoming dependent on their grant-makers because they have built their entire business model on winning, managing, and reporting on their grants. All this focus on cost and administrative reporting might be better spent on achieving and measuring results.

One baby step USAID and other grant-makers might make would be to introduce more fixed-price grants, linking payments to the achievement of milestones. This would start to acclimatize more organizations to align their business models around reporting impact, which would, in turn, attract impact-oriented investors. USAID can also play a critical role in helping train organizations on results-based finance and helping them create transparent yet robust measurement systems. Again, this will both better align interests and address emerging market risks as donors/investors no longer bear all the execution risk and will only pay for the actual results achieved. The incoming Trump administration could use this moment to reinvigorate the programs it started during its last administration, including the New Partners Initiative and Effective Partnership and Procurement Reform, to inject this results- and impact-based model into more of U.S. foreign assistance.

1. Aggregate and Standardize

Reducing complexity through standardization helps achieve scale and reduce cost. The bespoke nature of blended finance transactions today essentially locks in high transaction costs and prevents scale. The development finance field needs to come together to develop common frameworks, terms, and conditions for blended finance. This could lead to the creation of standardized financial products, which could, in turn, create the conditions for securitization (see Recommendation 7), deepening the pool of capital while diversifying the risk for investors. For example, the International Development Finance Club and the European Investment Bank have already taken steps toward standardized green bonds and other products. The transparency and comparability that standardization would allow would attract more interest from institutional investors.

At the same time, we must stay realistic about what can and cannot be standardized. Given the vast differences between different development projects, we cannot expect to achieve standardization on the level of a corporate bond. Instead, we should focus on standardization at the platform or portfolio level. We could aspire to create a standard set of disclosures, akin to an American HUD-1 that sets a minimum standard for the data elements to disclose or standard methods for categorizing types of investment (e.g., what constitutes a green energy investment vs. a global health investment). Standardization at this level would contribute to our ability to then aggregate investments into pools that could be syndicated (see Recommendation 6) and/or securitized (see Recommendation 7).

1. Syndicate Debt

Syndication offers another path to less complexity while also reducing emerging market risk perception. Loan syndication allows for standardization, scale, and diversification of risk. In a syndicated loan, multiple lenders agree to offer the same terms and conditions to one or more borrowers. This allows the lenders to pool their expertise and lending capacity. As an example, one lender might know how to value green energy projects, while others might not, but knowing they can rely on the lender with expertise to properly assess the lending risk, the less experienced lenders become more willing to lend.

Syndicated bonds, especially those paired with credit enhancements from development finance institutions (DFIs)-including first loss guarantees, political risk insurance, or below-market lending rates-can attract less risk-prone investors. The very nature of a bond promotes scale because it comes with clear terms, predictable returns, and liquidity (the ability to buy and sell them more easily). Thematic bonds, such as green bonds or social impact bonds, look especially promising because they may appeal to both public and private capital. Taken together, syndicated loans and bonds offer a path to greater scale both in number and size of transactions as well as scale of impact at more manageable levels of risk.

1. Securitize

Securitization-the process of pooling multiple contractual loans, including mortgages, business loans, or bonds, and selling marketable shares in the resulting pool-has created the ability to better diversify risk while expanding the capital available to lend. Loans to small and medium-sized businesses or even microloans from microfinance institutions could be pooled and securitized. DFIs might step in to improve the creditworthiness of these pools by providing enhancements, including subordinated debt tranches, which would absorb losses before more senior tranches, then making the overall pool and resulting shares more secure and attractive to institutional or other conventional investors. Pooling blended finance instruments and then securitizing them would offer a path to greater scale by tapping into larger and more diverse groups of investors and sources of capital while also aligning financial incentives with achieving development results.

Conclusion

As I mentioned in my opening anecdote, earlier this year I tried, but failed, to get impact investors and government donors to work together to design blended financial instruments. In the coming year, I hope we can instead crowd in more of these kinds of institutions to work together to cocreate better, more flexible, and more broadly attractive blended finance approaches and transactions. If the people actively working on blended finance deals, including the incoming Trump administration, come together to develop standardized models and terms, grow a pipeline of project owners adept at results-based finance, and deploy more sophisticated financial innovations, we can make a significant dent in the sustainable financing gap.

Richard Crespin is a senior associate (non-resident) with the Project on Prosperity and Development at the Center for Strategic and International Studies in Washington, D.C.

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