Blended Finance: Design & Implementation
Considerations, structure, and best-practices
Welcome back – Blended Finsights is a Substack dedicated to exploring alternative finance and growth strategies for startups in Emerging Markets. This article is a part of a mini-series on Blended Finance. Find other posts here – subscribe and share below!
So far, other posts in this series have been more high-level, explaining what Blended Finance is and the gaps it seeks to address.
This post, by contrast, is intended to be much more tacit – giving a distilled summary of what goes into implementation.
Disclaimer - there are few original insights in this post. Content is taken from interviews and resources on deal structuring with the intention of providing a cliff-notes summary for those who lack the time for independent research.
My goal is for this to lay the groundwork for future posts on opportunities and more subjective opinions.
Considerations
As previously stated, the blessing and the curse of Blended Finance is that it can be highly curated. The benefit of this is that it is tailored to the unique needs of investors and recipients. A downside is it creates limitations for replication and scale.
Temporarily setting aside these merits and challenges – there are several considerations that shape the rationale and structure of an investment. These are important to understand as we think about the potential to replicate blended finance or apply them across other projects.
Leverage
Leverage refers to the amount of commercial capital brought into a deal. It’s a ratio measuring commercial capital in proportion to concessionary capital. Generally speaking, higher leverage - that is, a higher ratio of commercial to impact capital - is positive.
In VC, it’s said of a company’s valuation that “valuation is as much an art as it is a science.” A similar concept applies to leverage.
Leverage is the most ubiquitous impact metric used for Blended Finance transactions. But, while it is important, it’s a simplistic measure because it doesn’t measure long-term outcomes and there’s no one-size-fits-all number that can be used to evaluate every investment.1 A leverage that is considered “too high” could indicate concessionary capital wasn’t needed. “Too low” a number could indicate inefficient use of concessionary capital.2
In VC, when determining a company’s valuation it’s said “valuation is as much an art as it is a science.” A similar concept applies to leverage. It’s a subjective assessment and there’s no “right” number, but a solid rationale is needed to justify the ratio - and consideration for risk, impact, and future commercial viability all should be factored into that calculus.
Impact
A second consideration in design is the unique impact focus of an investment or project – this could be solely market creation however frequently targeted impact areas also include climate, financial services, gender-based initiatives, agriculture, and low-income/fragile states. Given that many impact and development financers have dedicated mandates tied to their use of funds, this tends to be a non-negligible factor in scope and structure.
Risk & Returns
Return expectations will set the stage for working with commercial investors, and closely tied to this will be the type and level of risk tied to a particular investment. The amount of risk will inform the proportion of concessional capital that’s required. The type will inform the structure, as certain structures mitigate types of risk more effectively than others (i.e: guarantees reduce credit risk, Technical Assistance grants reduce project risk, etc.).
A note on regulation
Regulation is - in my observation - where transactions get dicey. The simplest way to minimize regulatory challenges is to home the investment in a recognized domicile (Delaware or Luxembourg are most common). However, there will always be outstanding factors specific to investor and investee markets. One example of this is the Basel requirements that International Banks adhere to determine the amount of reserve capital a bank must hold in proportion to their Risk-Weighted Assets (RWA). This means that even if an investment is derisked by other factors, a backer may still be required to have high-reserves to cover credit risk in a given geography. Another example is the treatment of grants, which vary across markets.
At the risk of stating the obvious, regulation is something to factor into investment design.
Actors
There are only a few critical actors needed in any given transaction. (Again - a more robust summary of these is given in this post.)
Concessionary Capital Provider (the “Impact Investor”)
This may be a development financer, impact investor, or donor. They will often be the originator of the deal and their funding will typically come with a set of impact goals that play a non-trivial role in investment design.
Private Capital Provider (“Traditional Investor”)
This is the private investor – or group of investors – bringing fresh capital into the investment. Their contributions should help position a project or market for commercial success by lending credibility and by setting the appropriate standards and expectations for working with traditional investors long term.
Investment Advisor / Deal Facilitator
This is an optional function but highly common. These are experts who understand the interests of both parties and are equipped to structure bespoke transactions. The most prominent names in the space include Convergence and CrossBoundary. There are several Boutique service providers as well. My last post speaks to the value of Deal Facilitators to align interests.
Legal & Finance
Beyond this, every deal will require a dedicated finance and legal function to ensure viability and compliance.
A Note on Actors Wearing Multiple Hats
It’s worth noting that the concessionary and private capital providers can in some instances be the same entity.
One example of this is DFIs which have concessionary capital allocations specifically earmarked for Blended Finance and separate balance sheets for profit-seeking capital. Another example is a traditional investor that will employ DAF or Foundation financing that can be used to create a first-loss investment alongside a profit-seeking investment. (Highly recommended solid legal counsel to ensure tax compliance!)
Structure
With each of these factors – and actors – represented at a table, investors must then determine the right structure for a particular investment. Of all available options, there are a few core archetypes to address specific risks.3
Image from Convergence: ‘State of Blended Finance 2024’
Concessional Capital (debt or equity)
This is a transaction where the “blending” occurs in the financing capital stack. Concessional funding comes in the form of either subordinated/junior debt or equity. The impact investor provides first-loss capital on subordinated terms – ensuring losses are absorbed by their contributions first.
Guarantees & Insurance
These two instruments are distinct yet similar. A guarantee involves a commitment by a guarantor – likely tied to debt or equity - to pay part or the entire value owed to an investor in the event of non-payment or loss of value. Full guarantees can be a critical factor in addressing credit risk, particularly in instances where projects are penalized by an assigned Risk score tied to the credit rating of a particular country.
Insurance is used when a concessionary investor purchase insurances to hedge against known risks that could impact a particular investment and lead to financial loss (environmental, geo-political, etc.).
Grants
In Blended Finance, grants are normally issued in sidecar transactions and provide either technical assistance (business advisory or other capacity development services) and/or design-stage grants to cover the costs associated with designing a project and structuring the transaction.
Performance Grants
These are sidecar deals (i.e. social impact bonds) that ensure a development project will hit certain social or environmental goals. These can position a company to track and hit certain benchmarks or impact metrics that qualify for PRI or MRI capital.
Vehicles
Distinct from archetypes are Blended Finance vehicles, which are the means for distributing capital. Frequently used options are Funds, companies, projects, bonds/notes, Facilities, and/or Impact Bonds.
Given the cost to diligence and structure an investment is largely the same regardless of size, Funds are functionally the most efficient way to deploy large amounts of capital…
Across conversations with deal facilitators and DFIs, I was told that while many things vary across regions, unequivocally, Fund structures are the most common vehicle used for Blended Finance.
This is logical given they are a one-time vehicle to deploy capital across a broad base of smaller recipients. The following summarizes Blended Finance data gathered by Converge from 2014-2023.
Image from Convergence: www.convergence.finance/blended-finance
Funds are utilized most frequently, followed closely by project and company-based financing. Given the cost to diligence and structure an investment is largely the same regardless of size, Funds are functionally the most efficient way to deploy large amounts of capital, with one lump sum being allocated across a broader base of smaller investments.
Examples to Tie It All Together:
To pull it all together, here are a few examples taken from actual case studies:
A debt-fund has developed an underwriting model tailored to the unique needs of MSME’s in Emerging Markets. The fund targets the “missing middle” and is digitally enabled to help mitigate risk. However, it doesn’t come with traditional underwriting mechanisms and isn’t an easy sell to investors. To reach their close, they get an impact investor to contribute a partial guarantee of up to 20% of the total fund. This addresses credit risk and unlocks private investor commitments to launch the fund.
In this example – the guarantee is the structure and the debt fund is the vehicle.
A development financer wants to support the growth of entrepreneurship in an underdeveloped market. To help address capacity risk, they write a grant that provides technical assistance through an accelerator and they commit seed funding to the first wave of companies that go through the accelerator.
In this example – a Technical Assistance Grant4 is the structure. The accelerator is the programmatic vehicle, as well as potentially a fund structure if they use this to invest in companies.
A multilateral development bank (MDB) wants to finance a Wind Farm that will help reduce coal dependency in a developing country. To help address project-based risk, the MDB commits to “first-loss” equity shares for 15% of the total project financing. They then finance the rest of the project with a combination of commercial commitments and financing from their non-concessional balance sheet.
In this example – first-loss equity is the structure and the Wind Farm project is the vehicle.
Closing ‘Best Practices’
In each of my interviews, I asked investors and facilitators to share a best-practice to consider in structuring transactions. Here are two that came up with frequency in my research:
Have all actors present around the table from the beginning of the design process, as this establishes trust and clarity of interests from all players at the start.
It’s paramount to balance local context and private investor requirements in design. Local context ensures realistic considerations and constraints. Investor expectations ensure the transaction can catalyze a sustainable market.
Counter to this, I was told (anecdotally) that it can be common for the impact investor to most strongly influence structure and design because (1) they provide the concessionary capital enabling the investment (AKA - they can) and (2) they usually have mission-related requirements attached to its use.
I don’t have personal experience to validate this, but a takeaway from my discussions is that it’s important for impact investors to not allow programmatic mandates to dwarf the contextual and commercial requirements that will set a up project for success. This is key since recipients and future investors will bring any potential impact to-be-had to market.
Collaborating early is one way to ensure that realistic recipient and investor needs influence design more than any impact and program-related ideals.
More to come on principles and key takeaways in my next post.
In the meantime – thanks for reading. All shares, likes, comments, and questions are welcome to continue to elevate and improve the quality of this conversation.
As the conversation on Blended Finance continues to evolve, market growth over time has been elevated as a more appropriate measurement for impact. However, this is complicated to assess and takes time. Also, I have yet to speak to anyone actually measuring this (even if it is set as the ideal). By contrast, leverage is an immediate means of evaluation.
One interview I had did cite 5:1 as a minimum leverage target.
For more information on archetypes, this report has a great table that specifically gets into structures tied to targeted risk mitigation.