An Intro to Blended Finance
Part 1 of a mini-series on Blended Finance: covering definition, relevance, impact, and untapped potential...
This is part one of a mini-series exploring Blended Finance and its relevance for impact investments and Emerging Markets. Future topics will cover history, case studies, implementation, and opportunities in the space. Subscribe to be notified of future posts!
To VC or not VC?
There’s long been discussion on whether or not VC – which finds its origins and designs largely in Silicon Valley – is the right model for African tech. The answer to this obviously isn’t a clear yes or no. It’s nuanced and dependent on several variables – market, sub-sector, business model, expected time horizon for return, etc.
These factors affect the risk-return profile for any investment but are far more dynamic in Emerging Markets where questions of liquidity and market conditions can be susceptible to unique conditions. Rather than “Is VC the ‘right’ model for Emerging Markets” a better framing could be “When is VC the right structure” and “What are the broader range of financing instruments available?”
Both questions are equally dynamic and important. This intro will be a modest attempt starting to scratch the surface in answering them.
Most investment structures are notorious - equity, debt, convertibles, SAFEs, and grants – and are made available from angels, VCs, impact investors, foundations, and DFIs/multi-laterals. These are familiar to most people. However, beyond this are other options not as widely utilized. Some of these alternatives include revenue-sharing agreements, alternative underwriting, and more. However, beyond this, is an entirely separate structure and category: Blended Finance.
Every few years there are new impact and finance trends that rise in popularity.1 Blended Finance seems to be one of these, gaining attention and press similar to that of impact investments when it was first recognized as a category years back.
It’s been regarded as critical for addressing the estimated $2.5 trillion funding gap needed to attain the UNSDGs and a lynchpin to unlock developing markets scale and access commercial financing.
These are big claims. And there’s certainly room for a critical examination of them. However, Blended Finance deals have contributed over $213 billion to Emerging Markets in recent years. In light of this, understanding it would seem worthwhile.
Amidst the growing dialogue, there are two things I initially observed surrounding this topic that ended up giving way to this project.
The first is that there’s a lot of confusion about what Blended Finance actually is. I’ve heard it frequently referenced with interest but without a shared definition across conversations. Specifics on tactics and implementation tend to be even less common.
The second observation is that the bulk of blended finance transactions tend to lie in large dollar volumes of DFI and multi-lateral backed transactions. While smaller-scale use cases are theoretically feasible, there’s been less press and application here. More to come on this.
So, What is Blended Finance?
The working definition I generally hear is the use of non-dilutive, non-repayment financing in a capital structure (AKA grants).
This is a widely shared, but inaccurate definition.
Another working definition (which was my original thesis) was that blended finance was the blanket term for any kind of alternative or innovative finance structure that wasn’t either your typical debt, equity, SAFE, Convertible, or grant.
This is also not accurate.
Each of these are oft-used “working” definitions - but blended finance refers to something much more specific – both in structure and in purpose.
Structure: Functional Collaboration
The official definition provided by USAID is “the strategic use of development funds, such as those from government aid and philanthropic sources, to mobilize private capital for social and environmental results, such as improving infrastructure, education, agriculture, healthcare, and more.”
Said differently, Blended Finance is an investment structure that brings together at least two investors – or groups of investors – to collaborate on an investment. One is an impact/development financier (can be a donor or investor). The other is a private investor seeking market-rate returns.
True to the name - both groups come together to create a deal blending their respective contributions on separate terms.
The impact financier contributes with a concessionary agreement, which by definition means they’re participating at terms below the standard market rate. Specifics on this vary, but this is done to offset a level of intrinsic risk that then enables a market investor to then participate on a risk-adjusted basis. This second investor participates on terms expected to deliver market-rate returns that satisfy their commercial requirements.
What sets Blended Finance apart is this layer of concessionary capital. This could be given in the form of a grant, first-loss capital, technical support, etc. (more to come on structure in future posts) so long as it functionally addresses a level of intrinsic risk that would otherwise keep private investors from entering, boost the return profile, and allows the market investor to participate on risk-adjusted terms.
This is the basic structure.
Beyond this, the purpose of Blended Finance is equally important.
Purpose: Catalytic Capital without Market Distortion
The purpose of Blended Finance isn’t just to bring more capital into a deal but to catalyze a new market and do so without creating market distortions.
A catalyst - by definition - precipitates the formation of something new. With Blended Finance, the function and the litmus test is the launch of a new market that otherwise wouldn’t be possible.
This ‘market’ can be scoped as a dedicated country or market for a new technology. Regardless of how it’s defined, it should eventually be expected to sustain itself. This comes down to conditions that are favorable for doing business - or expected to be favorable by virtue of the investment - and also where there’s probability for follow-on capital.
The purpose of Blended Finance isn’t just to bring more capital into a deal but to catalyze the growth of a new market.
Beyond supporting the growth of these new markets, it should do so without giving way to any market distortion.
This is a pseudo-academic term, but market distortions are any kind of intervention that interferes with price or behavior within markets. The crowding out of investment capital that would naturally be attracted to a segment is one example. Another would be an unsustainable price point for a product or service. Now market distortions are created by foreign aid quite frequently and these examples are not exhaustive.
The TLDR is that Blended Finance should avoid this by investing with consideration for the elements that will either prohibit or create organic and sustained growth.
An untapped opportunity?
Finally - one of my earliest observations was that although the structure of Blended Finance has the potential to be widely applicable, deals tend to be most notoriously used by DFI’s and multilaterals, and most deal structures are quite large in volume. (The Median transaction size from 2010 - 2018 is $64-million.)2
There is a very good reason for this - namely, there’s always a trade-off between customization and more standardized offerings and transactions tend to be curated and tailored to the interests of backers. This can give way to more complex deal structures – which are innately labor-intensive and costly to implement.
Yet, while there’s little standardization in the space at present, I think there’s opportunity to creatively expand the scope to a broader subset of opportunities. The opportunity and challenges of this are part of what will be explored in future posts.
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For now - thanks for reading.
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Lis
I.e - microfinance that was acclaimed as a turn-key solution to end global poverty and years later has yielded mixed results.
Convergence is a great resource for historical data.