Note 3 | April 2016 BLENDING PUBLIC AND PRIVATE FINANCE What Lessons Can be Learned from IFC’s Experience? Following international agreement on the Sustainable Development Goals, governments are now confronting the critical issue of funding the enormous investments—especially in infrastructure— required to meet those goals. Yet governments clearly lack the fiscal space to finance all the investments, as well as the skills needed to design and manage them. So the focus is on how to ‘crowd in’ private investment and private management. Since not enough private investment is flowing today, donor governments are exploring how to ‘blend’ public aid money with private finance to make aid spending go further and crowd in more private investment. As more public funds are applied to private sector projects, the term Before choosing to use blended finance to increase funding in a priority ‘blended finance’ has come to mean different things to different people. area, several questions must be addressed. First, are the fundamentals in In general, blended finance connotes a combination of public and place to produce financeable transactions? Blended finance will not private finance, which may or may not involve a form of subsidy. There make a financially unsustainable activity sustainable. Nor will it render are many shapes and forms in which public and private sector funds can unaffordable infrastructure suddenly affordable. All it will do is make be combined—or ‘blended’—within the scope of one project. When subsidies opaque and quite likely sub-optimal. applied indiscriminately, blended finance can subject projects and sectors to numerous pitfalls including market distortion and As Michael Klein has noted, on average power tariffs in emerging inappropriate risk allocation. markets cover 80 percent of cost, while water tariffs cover 20 percent. Private investment is not going to flow into power and water assets on The proper deployment of blended finance requires a careful this basis–it is simply not a viable investment. Governments can either understanding and navigation of these potential pitfalls. But the payoff transparently address this viability gap by closing it (raise prices and/or is worth it: When done well, blended finance has proved a highly cut costs) or by filling it with a subsidy. Either method is transparent effective catalyst to jump-start high-risk, nascent markets in developing and provides a basis for attracting private investment so long as the countries. solution is sustainable. Blended finance can sometimes be helpful to tip the balance in marginally profitable, risky projects toward attracting A DISCIPLINED APPROACH commercial investment, but it cannot alter the fundamental economics Blended finance approaches should not be attempted lightly. There are of an industry. To scale up finance, we need to build an investment not enough bankers, lawyers, and donor officials to run every climate and regulatory framework that generates robust project investment through a complex blended finance structure, and the structures on a replicable basis. Blended finance can help key incorrect application of blended finance can waste significant resources investments proceed, but should be seen as a stepping stone to more on dead-end projects while sending erroneous market signals. comprehensive reforms. Discipline and strategic deployment are crucial. MANAGING PROJECT RISK loan programs. But at the portfolio level, investors may soon fill their Where the fundamentals of project economics and investment climate appetites for certain risks (e.g. small countries, fragile states) while are in place, blended finance can make the difference in moving a many investment needs remain unmet. Blending public finance can play project forward. To do so, it is important to think carefully about how to an important role in expanding the risk appetite of private investors by mitigate project risk. Note that risk transference is not the same as risk partially guaranteeing their exposure or by helping rebalance their risk- mitigation. While it is possible to use public money for guarantees, reward expectations. At its simplest, a 50:50 risk sharing arrangement mezzanine tranches and other structures to buy down part of the project can double the exposure that an investor is willing to take in a certain risk, that approach does not make a project less risky, it merely transfers type of investment. But it can do more than that: By introducing exposure to that risk to the public sector contributor. In the long term it investors to new classes of risk that they have not previously had is preferable to pursue risk allocation structures which align risk exposure to, it can help them calibrate their risk perceptions—as their exposure to the ability to manage that risk—thus providing incentives to perception of risk comes down, the share of risk or the incentive support actually reduce the risk. Private investors do not mind taking risk, so which public finance needs to take or provide can also decline. long as they can diversify and hedge it, but they will want to be compensated for the risks they are taking—resulting in more costly, less Most investments, especially in infrastructure, generate revenues in affordable infrastructure. In contrast, structuring to reduce risk local currencies related to the performance of the local economy. So strengthens the economic fundamentals and makes infrastructure more financing these investments from local banks and capital markets can be affordable. a good way to remove currency risk. Governments and development finance institutions should look at ways to mobilize domestic savings Good project structuring allocates risks to parties best able to manage pools—which are increasing as populations age and more people save them, hence reducing overall project risk. Public institutions with a for retirement, and as growing middle classes save more and purchase relationship with the government, such as the Multilateral Development more insurance. These savings can be intermediated through domestic Banks, are better placed to manage political risk than are private bond markets, through domestic financial institutions, and through investors. For example, Multilateral Investment Guarantee Agency domestic corporates that finance infrastructure and other investments (MIGA) offers affordable Political Risk Insurance because its member on-balance sheet through corporate finance. Of course this works better governments provide a counter-guarantee. Good risk allocation also in larger emerging markets where financial institutions and capital allocates risks based on the different risk appetites of different parties. markets are large enough to intermediate significant capital flows. For A key value addition of public finance is that it brings different risk smaller countries, regional financial institutions and capital markets can appetites and time horizons into the transaction. This offers play a similar role, but unless the region shares a common currency, opportunities for blending public and private finance in ways that some currency risk will remain. structure assets to meet private sector risk and time profiles. For example, public money may have a longer time horizon, and so can STREAMLINING PROJECT PREPARATION offer longer tenors or deferral features, allowing private investors to One-off deals are often too costly to appraise and offer too much risk take shorter term risk. Or the public sector can take the construction risk concentration. Aggregating assets allows for risk diversification and can (which it may be better able to monitor and manage) and then sell down create large enough ticket sizes to attract developed market pension assets to private investors post-construction when those risks are past. funds, insurance companies, sovereign wealth funds, and endowments. Before using subsidies, donors can consider what could be achieved Public finance can have a larger impact by participating in structured simply through patient capital. finance transactions for portfolios of assets rather than project-by- project financing. In smaller, frontier markets, donors are interested in Risk appetites are constrained by the size of balance sheets. Investors supporting ‘capacity building’, but more attention should be given to decide how much capital they want to put at risk for different risk streamlining origination—making it simpler to assemble projects, rather exposures. Hence, a constraint to getting large investments financed is than support complex processes. This means more attention to that the ticket size for each investor may exceed their risk limits, either standardization of deal terms and instruments, to common appraisal for that deal or for their total investment portfolio of that asset type. standards, and to debottlenecking government and regulatory approvals. Financial intermediaries can help by distributing assets across multiple IFC has effectively incorporated blended finance as part of its investors to reduce the risk exposure of each investor, as in syndicated investment procedures, allowing for its effective deployment in private environmental and social safeguards. IFC has also established a senior sector operations (see section on lessons from IFC’s experience below). committee to approve the use, structure, and terms of donor-funded concessional finance used as part of the overall blended financial IFC’S EXPERIENCE package provided to the client. In addition to strong governance and Over a decade, IFC has developed a targeted and disciplined blended transparency, IFC uses a targeted and disciplined approach for its finance approach that relies on non-grant instruments (loans both senior blended finance investments through the following: (i) Focusing on and mezzanine, equity, and guarantees) from donors to help the private projects where IFC financing alone is unable to make the project sector overcome the financing challenges endemic in many of the over happen; (ii) Minimizing concessionality to avoid market distortion; and 100 developing markets in which IFC operates. We have seen first-hand (iii) Supporting sectors that could achieve financial sustainability in the how often commercial banks have avoided investing in risky sectors, medium term. especially climate, in frontier markets. Regulatory, political, currency, and other risks, in addition to reputational risks stemming from complex Second, effective execution: Over the past decade, following the environment and social challenges, keep banks and investors from successful deployment of pilot projects, IFC has created a dedicated volunteering to be the first to jump into a market. blended finance product offering. This has enabled IFC to build a track record as a disciplined investor of concessional donor funds, employing Investors generally look for successful first-of-their-kind demonstration well defined procedures that encompass all stages of the project cycle, projects in a particular sector to ensure that a market segment has been from project due diligence/approval to monitoring and evaluation. IFC’s sufficiently de-risked before allocating large amounts of capital for blended finance operations allow IFC, as well as its donor partners, to follow-on projects. And for years, blended finance has provided exactly engage in new sectors, technologies, and countries sooner and/or at a that. larger scale than without blending. This approach has made donors comfortable with delegating authority to IFC for project approvals, Since 2009, IFC has blended $385 million in concessional investment maximizing efficiency in the support of impactful projects. capital to support 67 investment projects that have leveraged over $4 billion in third party financing. These investments have supported KEY FINDINGS pioneering projects including innovative energy efficiency financing in Blended finance is not a silver bullet and should be used only as part of Turkey and catalytic solar photovoltaic facilities in Thailand. a broader strategy that includes regulatory and pricing reforms. But overall, blended finance has proved an effective element of the Blended finance was the ideal tool to help support these high-impact, development finance toolkit and will continue to be going forward. transformational projects in sectors that were unable to attract commercial financing, but had the potential to become commercially Blended finance investment solutions capitalize on partnerships among viable over time. By blending public sector funds in the form of co- a multitude of development and private sector partners: international investments in private sector projects, IFC not only directly enabled organizations, donor agencies, and private enterprise. For this multi- these important projects, but also helped demonstrate to private stakeholder partnership to have the desired development impact, public developers and financiers that these sectors were in fact profitable, institutional expertise and emerging-market knowledge are essential to stimulating a series of follow-on investments. identify and structure projects that can demonstrate market and sector sustainability in the long run.  LESSONS FROM IFC’S EXPERIENCE In IFC’s own blended finance operations, we have identified two elements that are critically important to effectively apply blended Neil Gregory, Head, Thought Leadership, Office of the Chief finance in frontier markets. First, strong governance: IFC has a mature Economist (Ngregory@ifc.org); Kruskaia Sierra-Escalante, Head, and well established set of board-endorsed principles for governing its Blended Climate Finance (KSierraescalante@ifc.org). blending operations. At the individual project level, IFC applies the same standards when investing on behalf of donor partners as it does with respect to the administration and management of IFC’s own affairs, including the application of integrity due diligence and BLENDED FINANCE IN PRACTICE Global Agriculture & Food Security Program (GAFSP) GAFSP’s Private Sector Window (PrSW) is managed by IFC and provides innovative financing to enhance the commercial potential of smallholder farmers and medium and small enterprises. Among its approaches is a blended finance mechanism to crowd-in private sector investment funding by enhancing the risk and return profile of projects that might not otherwise attract commercial funding. GAFSP funding is co-invested alongside IFC funding, with concessional funds allowing investments to target market failures and invest in early-stage, risky projects with sound business plans and a high degree of development impact. Every one dollar of PrSW funding leverages eight dollars of private sector funding, and since 2015 this has seen the deployment of $174.8 million in funding to support 26 investment projects with a total size of $930 million. Blended finance for climate change mitigation and adaptation IFC’s Blended Climate Finance (BCF) unit manages roughly $700 million in concessional donor funds, to be deployed in conjunct ion with IFC’s commercial funds, to catalyze climate-smart investments with high development impact that would not occur under normal market conditions. Using concessional financial instruments such as soft senior or mezzanine loans, direct equity investments or private equity funds investments, and guarantees, IFC addresses market barriers in order to facilitate pioneering projects that combat climate change and provide powerful demonstration effects. Since 2010, the BCF unit has committed $281 million in donor finance to mobilize $1.1 billion in IFC financing and $3.7 billion in private sector investment. In South Africa, the BCF unit invested $41.5 million in two concentrated solar power plants that will avoid 442,000 MTCO2 emissions per year, the first of its kind in Sub-Saharan Africa. Global SME Finance Facility Small and medium enterprises in emerging markets face a trillion-dollar financing gap. While banks in some markets are beginning to move into SME lending there are segments that remain almost totally underserved. This includes SMEs in fragile and conflict-affected markets, women-owned businesses, education and healthcare SMEs, and firms in rural markets. This Facility helps increase the access to finance for such SMEs by providing financial intermediaries with dedicated SME lending windows and guaranteeing loans made to SMEs using blended finance. The Facility also shares best SME lending practices and provides advice to enhance banks’ SME operations in areas su ch as product development and risk management. This alleviates the real or perceived risks that prevent commercial financing of projects in a sector. Expected Impact by March 2021:  Improve SME’s access to finance by facilitating the disbursement of $8 billion in loans to at least 200,000 SMEs (of which 50,000 are women-owned businesses).  Support the creation of one million jobs. IFC - Goldman Sachs’ Women Entrepreneurs Opportunity Facility (10,000 Women) Blended finance investment solutions capitalize on partnerships among diverse actors, including international organizations, development co- operation agencies, and private enterprise. An example of such a partnership is the Women Entrepreneurs Opportunity Facility, launched in March 2014 by the International Finance Corporation and Goldman Sachs’ 10,000 Women. This is a first -of-its-kind global facility dedicated to expanding access to capital for women-owned small and medium enterprises. Through the facility, IFC aims to invest up to $600 million in financial institutions that are committed to expanding their financial services to small and medium enterprises owned by women in emerging markets. It also aims to signal the relevance of this asset class to the broader investor market. The funding for the facility includes $50 million of blended finance from Goldman Sachs’ 10,000 Women to create performance incentives for financial institutions to boost their lending to this segment, and to support capacity building among financial institutions and women borrowers. Michael Klein (2015) ‘Public-Private Partnerships: Promise and Hype’ World Bank Policy Research Working Paper