Impact Investment and International Development

Standing at the cross-roads - supporting the achievement of the United Nations Sustainable Development Goals      

AN OVERVIEW OF THE MARKET CHALLENGES AND THE OPPORTUNITIES

1. BACKGROUND

World leaders and the United Nations have committed to an ambitious program of social development and environmental reform, setting 17 Sustainable Development Goals (SDGs) to be achieved by 2030.

Without motivated leadership and significant capital contribution from the private sector, these goals will not be achieved.

Key to achieving the SDGs are the dual growth engines of developing market small to medium enterprises (SMEs) and sustainable infrastructure, leveraging private sector capital for impact investment.

The finance gap for infrastructure alone is estimated at USD 2-3 trillion per annum. Solutions for addressing this gap are being urgently trialled, strengthening the enabling environment through international development assistance and attracting far greater private sector investment through efforts by the multilateral development banks and development finance institutions, of which blended finance shows great promise.

Development finance institutions have been given the mandate and incentives to attract private capital at global and local levels by taking initiatives such as aligning global economic policies and financial systems; enhancing sustainable financing strategies and investments at the regional and country levels; and, seizing the potential of financial innovations, new technologies and digitalization to provide equitable access to finance.1 These objectives are being worked on as a matter of urgency with the key objective of addressing the large funding gap for SMEs and infrastructure programs in emerging economies.

Calls are being made by the World Bank, IFC and other global institutions and governments for business leaders to help facilitate the coordination of public and private sector finance in pursuit of the SDGs.

Private sector organisations that can effectively respond to this call, and mobilise capital, stand to be highly rewarded. They will share in the meaningful work of achieving the SDGs and the social, environmental and financial rewards that flow from this. An example being to participate in unlocking the projected US$12 trillion in market opportunities across four sectors of food and agriculture; cities; energy and material; and health and well-being,2 sectors which will grow 2-3 times faster than the average GDP over the next 10 years.

2.        THE CHALLENGE

While the last few decades have seen hundreds of millions of people lifted out of poverty, they have also led to unequal growth, increasing job insecurity, more debt and greater environmental risks. This mix has fuelled an anti-globalisation reaction in many countries, with business and financial interests often seen as central to the problem. This is undermining the long-term economic growth that the world needs.

In September 2015, leaders from around the world ratified the 2030 Agenda for Sustainable Development, setting out 17 SDGs - bold and transformative targets to shift the world onto a more sustainable and resilient path. Subsequent funding commitments have been made by governments to achieve these goals.

While the SDGs represent a new way forward, multilateral and bilateral institutions recognise that there is a significant gap between donor pledges and the funding required. In particular, SMEs in developing economies lack the access to the capital required to achieve their potential, and the infrastructure to underpin development lacks the necessary financial support. Development finance institutions are looking for ways to bridge this gap by partnering with private capital and business savvy entrepreneurs to find qualitative and quantitative solutions such as those offered by the emerging impact investment asset class.

3.        DEVELOPING ECONOMY SMEs

Access to finance is a common problem for business and it disproportionally affects new and smaller enterprises. Information asymmetries in the credit market, lack of collateral and fixed costs for banks in processing loan applications are some of the well-known problems. The 2008 global financial crisis compounded these problems, with so many banks now subject to new prudential regulations that can inhibit debt financing solutions.

While SME access to capital was ranked as the fourth most significant impediment to growth at the turn of the century, recent surveys now place it as the most significant3. A joint report by IFC and the SME Finance Forum found that 65 million enterprises, or 40 percent of formal micro, small and medium enterprises in developing countries have an unmet finance gap of $5.2 trillion a year4. The vast majority are domiciled in East Asia and the Pacific.

Enterprise finance is critical to economic growth in the developing world. Donors are working with emerging market governments to consider alternative country-specific strategies to boost SME access to capital. Where access to formal banking has been limited, banking sector reforms are being pursued. Options are also being developed to support new approaches to SME and entrepreneurship financing, such as asset-based finance, alternative debt finance, hybrid debt-equity instruments and equity instruments.

Alternative sources of finance can reduce debt exposure and have proven particularly useful to new and fast- growing firms at the core of productivity growth and job creation.

These initiatives are making a difference. They however require greatly accelerated collaboration between public and private sector capital if the SDGs are to be achieved by 2030.

4.        SUSTAINABLE INFRASTRUCTURE INVESTMENT

There is no single type of investment of greater importance to the achievement of the SDGs than infrastructure. Sustainable infrastructure, as defined in a report by the New Climate Economy Commission, “includes all major energy, transport, telecoms, water and waste investments. It also covers the infrastructure required for effective land-use management. Infrastructure that meets key economic, social (inclusive) and environmental (low-carbon, resilient) criteria is deemed to be sustainable.”5 And of course, investment in transport, telecommunications and energy will be a key enabler of the SME growth required in developing countries that is so critical to meeting the SDGs.

The global economy needs an estimated US$6 trillion per annum to fund infrastructure development through to 2030. Based on current investment levels across public and private sources, this leaves a projected US$2–3 trillion gap per annum over the next 10 years. More than 70 percent of the projected investment needs will be in emerging and developing economies.

Developing economies are catching up with advanced economies due to technology diffusion and demographic transition, driven by a shift from agriculture to manufacturing and service-based jobs. One major aspect of structural transformation is the rapid urbanisation of the developing world. The global urban population will grow from approximately 3.5 billion today to around 6.5 billion in 2050, all in the developing world. To do so safely and sustainably, urban infrastructure including affordable housing; healthcare facilities; public transportation and low–carbon energy systems will need to be built. New initiatives such as the Mission Innovation and the Breakthrough Energy Coalition signal a greater willingness for countries and philanthropists to invest in and collaborate on technological research and development, which will help drive this shift.

All of these outcomes will require greater collaboration between public and private entities, from the institutional level to the project/enterprise level.

At the institutional (including regulatory framework) level, various donor support is focused on:

·     encouraging an increase in national government infrastructure spending, required to meet the approximately 6 per cent of GDP spend required at 5 per cent growth. This will require an increase in public finance through improved tax collection and increase in budget allocation to infrastructure. Various bilateral donor programs are working in this area, such as DFID and USAID;

·     increasing multilateral and national development bank lending, which recent analyses shows could provide an additional $1 trillion without affecting their credit status6, using mechanisms such as the IFC Managed Co-lending Portfolio Program, illustrated later in this paper: Towards a Solution;

·     Supporting project development and preparation, which requires a new architecture of financing and public policy intervention to structure projects so they are aligned with the needs of public and private investors. For example, the Asia-Pacific PPP Project Operations Facility launched through the ADB;

·     Creating an asset class around infrastructure to overcome the barrier of a lack of a liquidity for infrastructure projects. An asset class would require standardisation of project documents and regulations across geographies, such as some initiatives made in this area for the European Financial Services Roundtable and in Asia by the ADB.

Private sector investment institutions could complement and respond to these efforts by increasing private sector investment in infrastructure. The IMF estimates that more than US$100 trillion is held by pension funds, sovereign-wealth funds, mutual funds, and other institutional investors globally. This contrasts with total private investments in infrastructure in developing countries during 1990-2016 of only US$1.6 trillion, which equates to an investment over 27 years of less than that required annually to fill the $2-3 trillion gap.

5.        INSTITUTIONAL INVESTOR INCENTIVES AND IMPACT INVESTMENT

The retail customers of institutional investors are increasingly looking to achieve social and environmental impact with their investments, fuelling a growth in impact funds to over USD500 billion assets under management globally.7

There has been a common perception that achieving social and environmental impact requires a lower-than- market financial return on investment, or at best taking more risk to achieve market rates of return. This is not supported by the research. Studies that test the relationship between returns and ESG factors do have a range of results, but the bulk of analyses indicates that many ESG strategies boost returns and reduce risk or, at worst, do not have a negative impact.8 A recent study isolated those ESG factors with material impacts on profits from those without material impacts, and found that incorporating investments with material impacts led to significant portfolio outperformance.9 In essence, the study found that incorporating long-term non- financial risks in decision-making (such as climate risks), leads to long-term financial out-performance.

With sufficient incentives on both sides: private investors to work towards social and environmental impact while achieving strong investment returns; and, public institutions to pursue social impact through engagement with partner and recipient governments at the institutional level, an innovative mechanism is required to combine efforts to unlock the US$2.5 trillion required to achieve the SDGs by 2030.

6.        TOWARDS A SOLUTION

Historically, there has been a sharp distinction between, on the one hand, public sector projects funded by governments, multilateral development banks and official development assistance, and on the other hand, private sector growth funded by commercial banks and private investors. A solution is to make greater use of the ability of development finance institutions, which include the multilateral development banks together with sovereign wealth funds, to mobilise private capital, including through blended finance. This emerging practice involves the strategic use of public capital to leverage private capital. Specifically, blended finance entails public funders using market-driven risk mitigation tools to mobilise multiples of additional private capital. The concept envisages converting billions of official development assistance into trillions of private capital supporting investment in developing countries.

The public or foundation finance component of blended finance, also known as ‘catalytic capital’, is structured to catalyse private capital to invest in areas/sectors/regions it would otherwise avoid. It can be structured in different ways to address a specific barrier inhibiting the flow of private capital for impact investing in developing countries:

·     Junior equity or guarantee: this capital takes the first loss on either an investment by investment basis (very strongly catalytic) or on a whole-fund basis (less catalytic). First loss capital has been recently  demonstrated to be very powerful in leveraging overall fund capital, by significantly reducing the commercial investors’ perceived risk;

·     Capped return: this capital gives up all or a portion of profit that would otherwise be earned. The more the profit that is given up, the more catalytic the impact. This does not change the risk profile, but improves the commercial investors’ risk-return equation;

·     J-Curve mitigation: This entails paying for all of the fund’s management fees and expenses during the early years of a fund’s life, with the possibility of recovery later in the fund’s life. Institutional investors dislike the ‘J-curve’ trajectory of private equity funds because some expenses are front loaded while value creation is back loaded. By covering fees/expenses early on, new sources of commercial capital can be mobilised for impact investing;

·     Early investment: Catalytic capital could be invested very early – well before a first commercial close – so that the fund manager can start creating a portfolio, thereby allowing commercial investors to invest into an existing portfolio rather than into a blind pool. This helps lower commercial investors’ risk of spending time and money on due diligence, only to find that the fund never gets off the ground.

Business leaders can support the revitalisation and re-orientation of development finance institutions. Their power to raise blended finance makes them a critical bridge between private investment and public projects.The IFC has now established a syndication platform, the Managed Co-lending Portfolio Program (US$7bn as of 2018), illustrated below; and, its own fund business to manage third-party and regional banks. Development finance institutions are moving in a similar direction. Recognizing the critical role of the private sector in achieving the SDGs, the three-yearly funding commitments made to the International Development Association (IDA) in December 2016 for the first time included a private sector window to promote blended financing of developmentprojects.

7.        CONCLUSION

The need for more blended finance mobilised by these institutions has never been greater: if executed well, it could be the single most important lever for delivering the SDGs.

A growing group of private investors, both millennials and then older demographic, is now benefitting from inter-generational wealth transfers and appears willing to pay more attention to the total returns of their investments, including measurable social and environmental returns alongside financial returns. This is expanding the potential for blended finance beyond infrastructure to new fields, such as sustainable agriculture, social housing, girls’ education, healthcare and off-grid clean energy provision. Leading global companies are also accessing development finance to improve the social and environmental performance of their supply chains and, in some cases, extending those supply chains into frontier countries and regions.

With such strong incentives, there are increasing opportunities to structure blended finance opportunities between development finance institutions, institutional investors and the right developing country infrastructure and/or SME opportunities.

The opportunity exists for organisations with the credibility, institutional knowledge and networks between both public and private institutions in developed and developing countries to make a real difference in achieving the SDGs, and in the process to share in the returns.

The 2030 United Nations Agenda is anticipated to create enormous opportunities for commercial finance and investment, potentially unlocking US$12 trillion in market opportunities growing 2-3 times faster than average GDP over the next 10 years, offering commensurate returns for those organisations engaged in this worthy challenge.