Blended Finance: Making the uninvestable investable

Early 2020 I was approached by the Royal Actuarial Society of the Netherlands and asked to contribute a short piece on blended finance, explaining it in "a way that even actuaries could understand it"! Obviously I was only too happy to oblige.

The original, in Dutch, can be found here, and I thought it was worth sharing my own English translation below (with a little bit of help from DeepL which would explain some of the odd syntax or terminology in places...).

Blended Finance: Making the uninvestable investable

It has likely not escaped the attention of the readers of this publication that in recent years there has been an increasing interest in sustainability, the consideration of ESG (environmental, social & governance) factors in investment decisions, and impact investment.

However, it is not always clear what investors’ precise motivations are to turn to ESG investments.

Sometimes it seems mostly to do with moral values - investors simply don't want their investments to be associated with weapons, tobacco or coal. Sometimes it's more about risk management - the best example is climate change, where investors fear that carbon-intensive companies and sectors will sooner or later be hit by government policies to combat climate change and want to prevent this from affecting returns. Finally, there is the category of do-gooders - investors who like to see their investments contribute to solving the major problems in the world: poverty, disease, hunger, inequality, plastic, and of course climate change; in short: “impact investment”. The United Nations has summarized these challenges very well in the 17 Sustainable Development Goals, or SDGs, that are often seen as a useful frame of reference in discussions about impact.

In the latter category, there has been a discussion recently about the effectiveness of these investments - to what extent does this “impact” actually exist, and how can we further promote it? - which may perhaps best be summarized under the header “labeling versus enabeling”.

Labeling

Of course, there are many investments that contribute to the SDGs somehow. First of all, there are the "slam dunks" such as wind farms and solar panels - it is clear that the global economy needs to transition away from fossil fuels if it is to combat climate change, and the faster the windmills and solar panels can be installed the better. The company's activity in these cases is the embodiment of the impact solution.

In addition, there are many companies that aim to contribute as much as possible to the SDGs as part of, or in addition to, their business operations. The increasing desire to define a company's "purpose" has gone hand in hand with growing interest in sustainability and impact. In general, it is not enough to set the goal of “aiming to be the best provider of office supplies” or “having the most satisfied customers” - the purpose is preferably linked to higher goals, for example one or more of the SDGs; well-known examples are Tony's Chocolonely and Triodos Bank. Another example: Unilever says it has enabled 55 million people to drink safe water (SDG 6).

Finally, there are examples of companies that have an 'accidental' impact - of course pharmaceutical companies play a role in promoting health (SDG 3), the agricultural sector has something to do with combating hunger (SDG 2), and probably every company has something to do with promoting employment and economic growth (SDG 8)

Analyzing the activities of companies and putting a tag, or 'label', on the sustainability goals that are (partly) served by the business activities allows investors aiming to improve the world through investments to select investments, or so it is thought.

Enabling?

It is not disputed that it is useful to get this information to the table. Investors and customers find it important to know and there are now several companies who perform this type of analysis. Of course there is a lot of grumbling about the quality of the data and the correlation between the findings of the various suppliers is low, but this will undoubtedly improve over time - the methodology and market standards are still developing, and these things take time.

A bigger question is whether it really helps, in the sense that it allows the financing of more solutions to global problems. In other words - "labeling" is useful, but is it also "enabling"?

This question is difficult to answer.

The investor who buys Unilever shares for 1000 euros undoubtedly likes the thought of being associated with a company that has made it possible for 55 million people to drink water without fear, but does this enable even more people to be reached? No. After all, the 1,000 euros will fall into the hands of the seller of the shares, not of Unilever.

Investors who consider it important to reach the next 55 million people would do better to look for the small businesses, universities or programs set up by the UN or WHO that develop water conservation techniques helping farmers in Africa or Central Asia to improve irrigation methods, influencing government policies in developing countries, improving water distribution infrastructure, etc.

Obviously this is just a random example on just one theme, but it shows that:

-??????The problem is often very complex and large listed companies, however well-intentioned are, are not usually equipped to solve these problems;

?-??????The scale of the problems across all SDGs is significant;

?-??????The necessary solutions often cannot (yet) be found in corporate activities, but in programs of governments, development banks or multilateral organizations such as the UN - in other words, they are not (yet) investable - the returns are too low (or there are is no return at all) or the risks are too great.

High expectations

At the same time, expectations of what investors can do to contribute to solving these kinds of problems are sky high.

Take the recently announced European Green Deal (officially: European Climate Law). For these ambitious plans - to be "climate neutral" by 2050 - Europe will need EUR 1 trillion (1,000,000,000,000) for the next 10 years. At the moment, a mere 7.5 billion of this has been allocated. The European Commission has indicated that it is also counting on the private sector.

Estimates for achieving the SDGs are much higher - 2.5 to 7 trillion per year - and here too it is assumed that the private sector will lend a hand.

Looking at the scale of the problem and the amounts needed, you cannot escape the conclusion that the world's major institutional investors will have to play a role - the pension funds, the insurers, and the sovereign wealth funds. However, these will generally have very stringent risk & return requirements based on their liabilities, which they will not easily deviate from, however important ESG and impact may be to them.

Cocktail

To overcome this problem, the concept of "blended finance" has been devised - actually new wine in old bottles, because this is nothing more than a public-private partnership, in which public funds are leveraged to attract private money.

The fact that the government or a development bank co-invests, or issues a guarantee, can significantly influence the risk-return assessment for the pension fund and can make the difference between investing and not investing. In 2016, The Economist compared blended finance to the mixing of cocktails, and estimated that there appears to be leverage ratio in blended finance: for every euro of public or philanthropic money, 1 to 20 euros of private money can be raised.

There are now many good examples of blended finance investment vehicles - Climate Fund Managers, co-founded by FMO, have set up the Climate Investor One fund, which has raised a total of 850 million from a mix of public and private sources; French development bank AFD has set up the Climate Finance Partnership with asset manager BlackRock to raise 500 million; large financial institutions such as Bank of America, Goldman Sachs, JP Morgan and the French Natixis have set up activities on a smaller scale.

The facts that these examples exist, and that financial institutions apparently see an investment rationale, are promising, but that does not alter the fact that we are still miles away from financing all solutions that are required to fix the world's problems.

What stands in the way of this is the complexity of blended finance solutions - there is not yet an international market for blended finance investments and they are therefore not easy to set up or trade. In addition, the parties required to mix the cocktails - governments, development banks, multilateral organizations, asset managers, investment banks - do not regularly meet, and often speak a different financial 'language', which makes structuring the blended finance vehicles even more difficult.

In other words, scaling up this market will is an uphill battle.

What would be an important facilitating factor here is the use of specialists in structuring financial transactions - portfolio managers, analysts, bankers, M&A lawyers and, of course, actuaries - who can use their expertise to promote the development of this market.

Because these hours will not be profitable for many of them at the moment, this will largely have to come from the desire to contribute to those lofty goals - purpose! However, the rapid development of this market seems almost inevitable, so there is a good chance that the pioneers in this field who are able to develop the right expertise and networks will be the specialists who are most in demand in just a few years time.