Working in development finance, I often get asked what kind of “blended finance” solutions we have available for projects. According to the OECD, blended finance is the strategic use of development finance from multiple sources, including public and private sectors, to mobilize additional capital towards projects with social or environmental objectives in developing countries. It’s like mixing different ingredients to create a more potent solution.
Typically, blended finance involves combining concessional funds (often from governments, NGOs or foundations) with commercial capital (from private investors or financial institutions). The aim is to mitigate risks and attract private investment to projects that might otherwise be deemed too risky or financially unattractive. By leveraging public funds to catalyze private investment, blended finance can help address funding gaps and support sustainable development goals. It maximizes the impact of limited public resources and encourages private sector involvement in addressing global challenges.
In practice, people tend to think that blended finance is a magic wand, that can fund any project that does “good things” in society – irrespective of the project’s risk-return profile. For finance nerds, this means allocating capital to projects that are not on Robert Merton’s Efficient Frontier. For others it means investors accept inferior returns because the investment achieves a developmental goal. On paper this is indeed correct, but since the concessional finance component is the limited resource in this equation, there will always be heavy competition for the use of this magic wand.
So how do the custodians of concessional capital decide on the merits of allocating this scarce capital? I recently responded very intuitively to this question at a conference, and since the analogy seemed to resonate with the audience, it might also be useful here: Imagine that you are a first-time home buyer, and you have found the perfect house. The seller wants 100. The bank offers to lend you 80 and you have 10 in your piggy bank. Where will you find the remaining 10? The reality is that it would most likely have to be a relative, like an uncle, who would do it for one of two reasons: Firstly, the fact that he knows you personally and can judge the likelihood of you repaying the money. This would address the asymmetric information around your (perceived) credit risk, which moves this investment for the uncle back towards the efficient frontier. The alternative is, that he understands the (softer) benefits of you owning your own house, which motivates him to part with his money despite the likelihood that you might not be able to repay him. It is unlikely that he would do the same, even for your best friend. The result is that he uses 10 of concessional funding, to leverage another 90 from the private sector, so that you can buy the house.
Moving back to societal needs, the analogy demonstrates that project developers need to find their own “uncles”. Uncles who are motivated by the objective that their concessional capital would achieve, the main driver being the leverage that such concessional funding can achieve in the quest to address any specific sustainable development goal. And once project developers have found their uncle, they might have to do some of the “blending” themselves, just like when you buy your first house. Real magic wands in finance are very scarce, even though you might be lucky enough to find one from time to time.
