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There is general agreement about the purpose of blended finance in impact investing.  Concessionary finance from the state or philanthropists is used to “allow”  (or entice) commercial investors to achieve a risk-adjusted return in social enterprises that they would usually avoid because the risks are perceived to be too high for the likely return.  Typically this will involve a junior lender that does not charge more for the higher risk, or some kind of ‘first loss” protection for the commercial investor, or the issuing of a guarantee that is not priced for the risk.  The idea is to mobilise the size of investments that only the capital markets can supply by gearing the concessional finance several times.  It is also possible that as an area of investment gets “de-risked” or commercial lenders come to understand that they have “mis-priced the risk”, that the gearing can improve, or (first prize) the commercial investors enter the space without support.

All of this makes sense, but I would like to raise these quibbles and caveats:

Risk adjusted, historical returns

It seems almost incontestable that the world economy is creating levels of inequality unknown for a century, if ever, and that this inequality is the source of many of the “problems” that impact investors would like to address. This is succinctly explained by Picketty (in his 1000 page book! Capital in the 21st Century) as being because the returns from capital grow faster than the economy.  These outsized returns (leading to inequality) are exactly what is captured in the notion of historical returns.   If we are to address the world’s most pressing problems, there is no doubt in my mind that these returns need to be tamped down.  They should certainly not be seen as an entitlement.

Yet what blended finance often does is use public (tax-payers) or philanthropic money to almost guarantee commercial investors the return that they consider themselves historically entitled to.  Surely that will not contribute to challenging and changing the “purpose of capital” as Jed Emerson calls it.(1)

The conservative influence of private investors

Anyone who has tried to negotiate a guarantee agreement or development bond or even a junior position in a capital structure with a bank or private equity investor has experienced the endless and repetitive attempts to maximise protection, minimise risk, and generally ensure  belt and braces for the commercial investor.  The risk is that the impact investors (because they are committed to the idea of blended finance) give too much away in order to get the deal done.  That is their choice when it involves taking on more risk.  But it also often involves changing the nature of the enterprise to reduce risk and keep the private investors on board. Then you have to ask: “What’s the point?”

Finally on this point I would note that in my experience, banks will try to take the guarantees or first loss investment and pass off their normal business as fitting the criteria laid down – lapping up the additional security with no real change in lending practices.

Complexity and cost

Even “ordinary” commercial investments where all actors are focussed on financial returns can be highly complex.  Throw in investors with different return expectations, and some focused almost exclusively on social returns and the negotiations, documentation and covenants can really stretch and dominate the process, leading to high legal costs.  In the case of impact bonds, the number of participants and consultants who may well not understand each other grows exponentially, as not only are the negotiations costly, but so too the costs of monitoring and reporting.

It should be remembered too that the enterprises which are the “beneficiaries” of such structuring often have limited management time and capacity to commit to such complicated structuring, and end up both giving ground and paying legal costs that compromise the purpose of the capital raise in the first place.  And where each investor has different due diligence and reporting requirements the burdens mount further.

Taking the market where it doesn’t belong

The COVID 19 pandemic has hopefully reminded us that some things cannot be left to the market, or the poor will get highly inferior services when their needs are in fact greater – most notably in public health and primary health care, and education – but arguably also in infrastructure, waste disposal and public transport.   Blended finance (particularly in the form of development bonds) seeks to conjour up a market solution where there is none, trying (at often high costs as described above) to enable commercial investors to make their “fortune at the bottom of the pyramid” requiring poor citizens to pay for services that should be provided by the state.  This is not to say that there is no scope for public private partnerships, but they should be managed by the state, not investors, and should define very clearly the services to be purchased from private suppliers and the quality standards required.  The more complicated the structure, the more likely it is to benefit the private funder, rather than the consumers of public services.

Defunding social justice initiatives

Three decades of insurgent market fundamentalism has led many to the belief that philanthropy is just a bottomless pit, and that markets and social enterprises could solve problems better (for which contention there is as yet precious little evidence). There is no doubt that this has led to both the diversion of funds from social justice initiatives and attempts to force those initiatives to become more “sustainable” by generating their own income.  It can be argued that often the problems in fact would be better addressed by making grants to support organisation and advocacy rather than cobbling together some kind of highly subsidised “market solution.” 

Crap detecting questions

I have no doubt that blended finance structures have a role to play. Before diving in it might help to ask these questions:

Is there really a market solution here, or are we just subsidizing private profit to pretend there is one?

Are you modifying in any way the behaviour and beliefs of the commercial partner?  If not, are you simply enabling the extension of a rapacious private sector into areas where it would not previously venture? Is that a good thing?

Is the investee company really benefiting from this, or is the deal driven by your love of complicated structures?

Is there a simpler solution (e.g. a standard public private partnership instead of a social impact bond)? Could you fill the funding gap by doubling down yourself, or attracting other “impact investors”?

The questions challenge the notion that it is a legitimate goal of impact investors to extend the reach the capital markets to every corner of the globe without challenging and fundamentally changing their behaviour on the way. 

Cedric de Beer: September 2020

(1) Emerson J:  The purpose of capital: Elements of Impact, Financial Flows and Natural Being. Available on line.