Emerging markets can look like a scary place to fund managers. Only 17 percent of capital raised by private equity is invested in emerging markets.

And within this very broad category, the overwhelming majority of funding ends up in more developed regions, such as Asia-Pacific or Eastern Europe. Our recent LP Perspectives survey found that just 7 percent of LPs would consider investing in sub-Saharan Africa in the next 12 months.

This is a source of endless frustration for development professionals. Many insist that investors could make outsize returns by pouring capital into economies where there is massive potential for growth – and help the world meet the UN’s Sustainable Development Goals in the process. But for fund managers who have to look after their investors’ money, the risk is often too great.

“They struggle to find investable opportunities due to numerous transactional risks emanating from market volatility, political instability, illiquid markets and so on,” says Ladé Araba, managing director for Africa at Convergence, a network promoting investment in developing countries. “Limited exit options are particularly problematic for private equity investors.”

Blending opportunities

What if there was a way to change the risk-reward equation for emerging markets investors? Might this entice private sector capital into tapping the opportunities offered by the developing world and, in doing so, turbocharge the fight against poverty, climate change and a host of other ills?

That is the hope of those pushing the model of ‘blended finance’. The concept is relatively simple. While there are multiple ways to structure a blended finance fund, the basic element is that these funds aim to lower risks for private sector capital and offer more attractive returns. With blended finance, “private investors have much less to lose”, argues Cecilia Caio, a senior analyst at Development Initiatives, an NGO advocating for sustainable development.

Typically, development finance institutions or other donor bodies provide the initial first-loss capital on below-market terms, allowing private sector investors in the fund to benefit from higher rates of return. Alternatively, DFIs might offer risk guarantees or insurance for the fund, again on below-market terms. The fund is normally managed by a GP that specialises in impact investments.

“It’s really a private equity idea that you can create value by supporting your clients in building a pipeline of bankable projects”
Maria Teresa Zappia, BlueOrchard

Blended finance structures have most often been used for fixed-income vehicles. But Katrina Ngo, a senior manager at the Global Impact Investing Network, tells sister publication Private Equity International that similar structures can work well in the private equity sphere. “We’re hoping that private equity investors can see blended finance as a tool that allows them to invest in sectors or regions or themes that they might not have explored due to the risk profile of the investment.”

There is no doubt that the rewards are potentially lucrative for investors prepared to take the plunge into a blended finance structure. One fund manager tells us they expect a 12 percent return on a forestry investment in West Africa, compared with 3 or 4 percent that might be achieved with a comparable venture in Europe.

Many others agree that blended finance can unlock investment opportunities linked to issues such climate change. “Building climate resilience is about a new investment mindset, to ensure investment into future-oriented companies,” says Alejandro Litovsky, the CEO of Earth Security Group, a strategic intelligence consultancy. Litovsky cites the example of investments in sustainable rice production in sub-Saharan Africa and South Asia, which have vastly improved incomes and improved resilience to disasters.

Another key advantage of some blended finance structures – as opposed to a regular impact fund – is that the DFI does not behave as a typical LP after the initial investment, but instead uses its expertise to support the fund manager.

“Impact fund managers are often quite lean,” points out Yasemin Saltuk Lamy, deputy CIO for catalyst strategies at CDC Group. “So DFIs can use their wide-ranging resources in areas such as managing risk and measuring impact to support the fund.”

The DFI’s involvement often extends to providing technical assistance to strengthen the commercial viability of the fund’s investees. “We have realised that investment is one part of the story,” says Maria Teresa Zappia, CIO at BlueOrchard, an impact investment manager. “The other part of blended finance is having technical assistance facilities and capacity-building alongside investment vehicles.”

That, after all, is not so different to how a more conventional private equity fund works. “It’s really a private equity idea that you can create value by supporting your clients in building a pipeline of bankable projects,” Zappia adds.

‘The model works’

In some cases, institutional investors have committed to funds within months of DFIs providing the initial first-loss capital. He believes that “liquidity is pushing people even more into anything that yields”, but adds that “the interest in impact and in putting money to uses beyond just financial returns has grown immensely”.There are signs that blended finance could be ready to take off in private equity. Florian Meister, a managing director at Finance in Motion, a German impact asset manager, says that private sector investors are increasingly willing to make commitments at an early stage of a fund’s lifecycle.

Fundamentally, blended finance is attracting more interest because it has proven capable of offering both returns and impact. “The model works,” says Meister. Finance in Motion has raised seven funds, and many of its competitors manage funds that use a similar model. “They all work quite reliably.”

Zappia is similarly optimistic. She acknowledges that at present, private equity blended finance funds are normally quite small – in the range of $50 million-$100 million. Institutional investors might currently prefer the safer option of putting their money into fixed-income blended finance vehicles.

But these can have an investment period that is as long as in private equity. “At least from a liability perspective, there is not such a huge difference between fixed income and private equity vehicles in blended finance,” Zappia says.

Not so fast …

In practice, blended finance still accounts for only a tiny fraction of the funds allocated by DFIs, alongside development banks and donor institutions. The dream of using blended finance to “turn billions into trillions” remains precisely that – a dream.

Convergence collects data on blended finance transactions. Its latest annual report shows a steady growth trend in blended finance activities, although the market appears to have stagnated since around 2016 and capital commitments remain below $20 billion annually.

And the most enthusiastic adopters of blended finance in recent years have been commercial banks. They accounted for 46 percent of the commitments from commercial investors to blended finance transactions between 2016 and 2018.

The share of commitments made by private equity, venture capital and institutional investors has been steadily declining since 2010.

Clearly, both fund managers and investors will take some convincing on blended finance – and indeed on impact investing more broadly. Saltuk Lamy warns that “it takes quite a cultural shift for commercial investors to engage with impact investors”.

“The interest in impact and in putting money to uses beyond just financial returns has grown immensely”
Florian Meister, Finance in Motion

Put another way, much of the private equity community simply does not need the hassle of dealing with the complications that come with impact investing, especially when reliable returns are readily available in developed markets.

While some blended finance vehicles have seen increasing interest from private sector investors, firms establishing a fund with a niche objective are likely to face challenges in raising capital.

Zappia says that BlueOrchard’s climate adaptation fund “has been music to the ears of a lot of investors, but it has certainly taken more time than with other mandates to attract funding”. She adds that “because what we’re trying to do is innovative and new, it takes time in a due diligence process to convince investors”.

And there is not a large pool of GPs capable of managing a blended finance fund. The market is dominated by specialist impact investors, along with some larger firms that can invest resources in acquiring the expertise to engage in impact investing. For others, operating a blended finance vehicle – even with the assistance of a DFI – would be outside the scope of their capabilities.

There is no way around the reality that managing a blended finance fund in emerging markets is, almost inevitably, a high-maintenance undertaking.

“A huge amount of effort and expertise goes into the preliminary stages of project and managing development risks,” says Saltuk Lamy.

Meister argues that fund managers must have a physical presence close to their assets in order to manage risks and keep track of investees. “If you do it from a desktop in New York or Singapore, you’re not going to hear the problems – these are very illiquid markets and you won’t have time to react.”

If fund managers take the wrong approach, the damage can be long-lasting. “The catch is that not all the impact funds that are being quickly put together are genuinely creating an impact,” warns Litovsky. “This is a risk, which we have seen sour relationships.”

Indeed, investors have long complained that they need standardised metrics to measure funds’ ESG performance. With impact investing – including when blended finance structures are used – the problem is even more acute. These funds generally have specific objectives – some of which are very niche – meaning there is no obvious way to compare impact performance across funds.

Katrina Ngo from GIIN agrees that there is fragmentation in the metrics being used. But she is still hopeful that “if people start using the same metrics then you can get to that comparability that we’re seeing in other forms of responsible investing”.

So, while blended finance clearly has a role to play in allowing investors to generate impressive returns and, at the same time, address development challenges, not everyone is ready to embrace the model.

This won’t discourage DFIs like the CDC Group from believing in the value of using public sector capital to facilitate private sector investment.

The key, says Saltuk Lamy, is for DFIs to be flexible in how they approach the challenge.

She argues that in some contexts, DFIs can tackle the early stages of shaping the markets – before they seek private sector involvement.

“We believe that DFIs can come in at the initial stage and invite other investors to join us over time,” she says.

Giving private equity a chance

As institutional investors grow more comfortable with the blended finance approach, they may be more willing to give private equity a chance.

“If we were to leap forward 10 years, as private equity blended finance builds a longer track record, we will see vehicles increase in size,” says Maria Teresa Zappia, CIO at BlueOrchard. “And the volumes that can be mobilised from commercial investors will increase.”

Alejandro Litovsky, the CEO of Earth Security Group, also believes that a golden age for blended finance in private equity could be around the corner. “Blended finance not only represents a way of engineering public-private financing deals,” he says. “It also embodies a spirit of co-venturing and co-investing, of going at it together to unlock the potential for growth of vast regions of the world that are developing fast.”