By Jean-Philippe de Schrevel, Founder and Managing Partner of Bamboo Capital Partners
This blog is part of the upcoming OECD Private Finance for Sustainable Development Conference that will take place on 29 January 2020
We now have just 10 years to achieve the Sustainable Development Goals (SDGs). To date, the SDGs have been underfinanced. The annual financing gap to achieve the SDGs by 2030 currently sits at USD 2.5 trillion. The current approach is not working. Historically, financial institutions have focused on financing one or two SDGs in isolation, and this funding is often directed towards relatively low-risk investments. Collectively, we need to reconsider how we can realistically finance the SDGs by 2030, and this is where blended finance impact investment vehicles have an opportunity to shine.
Blended finance offers a simple and exciting way forward for two main reasons. On one hand, because of the different layers of risks and returns that make up its structure. With a “first loss layer” and then “senior layers” on top, all layers share the same investment portfolio. However, if there is a loss, the first loss layer is the first to bear it, thereby protecting the senior layers of investors. On the other, because of the types of investors attracted to the different layers. The first loss layer appeals to traditional donors, charities and philanthropic organisations. Instead of investing a dollar in a cause they support, they can now invest in the first loss layer of an impact fund targeting the same cause. If the investment manager has done a proper job, this initial dollar may not be lost and could even generate a return, meaning the donor can invest it again. This is efficient philanthropy.
Blended finance’s catalytic effect
Just as importantly, blended finance has a catalytic effect and helps overcome major barriers in at least two ways.
First, by attracting much needed institutional capital thanks to its first loss layer. The first loss layer helps overcome a major barrier to investment by institutional and other investors with strict fiduciary responsibilities who would generally consider expected financial returns to be too low for the perceived risk. The initial investment attracts institutional investors, such as pension funds and sovereign wealth funds to the senior layers of the fund. Traditionally, they have not expected the same level of financial returns from an impact fund. However, because they are protected by the first loss layer, the lower returns generated by the investment portfolio meet their risk-return requirements. This way, traditional donors can grow the overall resource for the cause they support.
Blended finance structures can be applied to different sectors, asset classes and fund horizons. For instance, Bamboo Capital Partners launched an open-ended fixed income fund focusing on smallholder farmers in Africa last year. The first loss of the fund has initially been provided by the European Union, the government of Luxembourg and the NGO AGRA, for a total of USD 50 million. Private investors are now looking at investing in the senior and mezzanine tranches of the fund. Another example is a closed ended “tech for impact” venture capital fund that we are launching this year and will target early stage African technology companies with high potential to offer essential services to a large underserved population. A groundbreaking particularity of the fund is that African governments themselves will provide its first loss tranche.
Second, blended finance enables the investment manager to take a higher risk approach when dealing with its portfolio target companies. This means, for instance, that investors may be willing to invest in enterprises which are at an earlier stage of development or which are more innovative and use technology to benefit low-income populations. The fueling of digital innovation is critical, as new technologies have the potential to help entire countries leapfrog decades of economic development, which developed economies, have followed in the past. Businesses built on new technology have real potential to transform the world’s least developed economies. For example, blockchain’s characteristics of security and transparency could be conducive to the creation of digital identities. This would help more people enter the formal economy in these countries and in turn, contribute to a number of the SDGs. However, businesses employing new technologies like blockchain in emerging and frontier markets are inherently risky investments.
The challenges of blended finance
Blended finance funds have the potential to attract more private capital towards financing the SDGs than ever before. However, they bring their own challenges.
One of them is the on-going management of the size of a blended finance fund’s different tranches. Some degree of liquidity needs to be offered to investors coming in the senior tranches of the fund, while some proportionality between tranche sizes has to be maintained in order to keep the risk return profile of each tranche.
Another challenge is for investors into senior tranches to apprehend the necessary level of protection given by the first loss tranche, as the impact investing space still lacks reliable aggregated performance data on similar past investment portfolios. Ideally, reliable default statistics over a long period will enable us to provide senior tranches of blended finance funds with an investment rating. This would ease decision-making and portfolio construction for private investors.
In conclusion, blended finance impact funds are a valuable piece of the puzzle. They are able to invest significantly in riskier markets because the first loss tranche of funding catalyzes investment from traditional financial institutions. Impact funds structured using blended finance are able to invest in businesses and markets which have previously been overlooked and yet have the potential to unlock major transformative growth. This will make a significant contribution to the SDG financing gap, but more importantly, transform the lives of people who live in these markets.