The rise and importance of “catalytic” development finance

The term “catalytic capital” has generated considerable buzz in the impact investing and philanthropy communities in the last few years, largely due to a series of grants from the Catalytic Capital Consortium (C3), the organization that coined the term and that has subsequently worked to demonstrate and support use of the concept. ?

Yet the approach behind the term remains poorly understood—specifically, how it relates to other types of blended finance with philanthropic or donor support. C3 defines catalytic capital as “capital that accepts disproportionate risk or concessionary returns to generate positive impact and to enable third-party investment that otherwise would not be possible.” And although this makes catalytic capital sound akin to blended finance, the approaches differ in essence. ?

While all blended finance approaches use catalytic capital, not all uses of catalytic capital can be considered blended finance. Convergence, for example, the leading intelligence platform on blended finance, considers a transaction to be blended only when catalytic capital attracts private financing into the structure’s capital stack. Convergence also requires that catalytic capital financing be concessional in its pricing (e.g., with below-market rate returns). Convergence does not account for or consider other types of “catalytic” activities, however, such as demonstration effects or facilitating innovation.?

Using the C3 definition and looking at the Convergence database of historical blended finance deals, we see that use of catalytic capital has achieved an annual growth rate of 26 percent over the last twenty years (see below). In 2020, of the 54 blended finance deals, 72 percent included concessional debt, guarantees, or junior equity to facilitate and bring the deal to life.?

Another mistaken belief about catalytic capital is that it comes only from private foundations or donors looking to derisk others in the transaction. Few realize that a large share of catalytic capital also comes from development finance institutions (DFIs). In 2020 alone, $303 million (or 28 percent) of concessional financing was provided by DFIs to derisk or sweeten 24 deals for other investors (see figure below).?

So how do DFIs provide catalytic capital, and what might this mean for the future growth of its role in DFIs’ plans moving forward? Some quick insider research reveals three “archetypes” for DFI use of catalytic capital that I believe are worth sharing so others may learn from them and replicate their results: “demonstrate,” “derisk,” and “enhance impact.” Each is described below with examples.?

#1: “Demonstrate” the potential of a new investment thesis.

In 2016, Pomona Impact, a new impact investing fund with first-time fund manager, was created with a focus on investing in Guatemala and Central America. As a first-time fund manager, the founders had difficulty raising capital.?Pomona invested $1mm of friends and family money and was able to obtain a catalytic loan of $1mm from the IDB-Lab at favorable terms with concessionary rates.?The IDB Lab’s loan was instrumental to getting the pilot fund to critical mass (of $2mm) and provided Pomona the with the opportunity to demonstrate that it could make sustainable “impact investments” in the region.??

Two years later the pilot fund was considered a success, investing in organizations like EcoFiltro, Uncommon Cacao, and Yellow Pallet. Based on this demonstration effect that impact investing in Central America was feasible, the Pomona Impact team has now successfully raised and launched its first $20M fund, currently deploying capital into high-impact social enterprises across Central America with more than a dozen investors, including development financial institutions (DFIs) and private sources of capital.??

#2: “Derisk” to better serve the needs of difficult to serve social ventures.

Traditionally, due to perceived and real risks, agriculture has been considered a difficult segment to finance. Our own analysis shows that providing loans to ag-SMEs of below $1M is difficult to do profitably. We also know, however, that safe, reliable, environmentally sustainable food systems are critical to our shared prosperity. To respond to this urgent situation, Incofin, a fund manager based in Belgium, has introduced the Fairtrade Access Fund (FAF) to serve the financing needs of smallholder farmers and ag-SMEs by investing in Fairtrade-certified organizations and cooperatives in Latin America and Africa.?

To make the fund financially viable and to attract private investors like pension funds, commercial banks, and corporates, the FAF used an innovative blended structure with two share classes and the possibility of leveraging up to one time. These two share classes attract investors with differing profiles: Class A shares have a seven-year lock-up period, thus attracting investors with a long-term development focus (principally DFIs); Class B redeemable shares attract private investors.?

The FAF has been a big success, having now made $128M in disbursements and impacting more than 327K smallholder farmers’ livelihoods through 10 percent increases in productivity and $250 income increases per family. Without initial junior equity financing from the FMO, these investments—and thus these farmers’ livelihoods—might not have had access to those opportunities.

#3: “Enhance the impact” potential of investments with technical assistance.?

The Dutch Good Growth Fund (DGGF) is publicly funded by the Dutch Ministry of Foreign Affairs (MFA) and privately managed by Triple Jump and Price Waterhoose Coopers (PWC). Since 2014, DGGF has been providing a combination of catalytic capital, capacity building, and ecosystem development to bridge the financing gap for small- and medium-sized enterprises (SMEs) in emerging markets. DGGF provides catalytic capital via its Fund of Funds (FoF) to mezzanine, private equity, and venture capital vehicles, and concessional debt to upscaling micro finance institutions and digital lenders (to name a few examples) in a manner similar to that of many DFIs. Between 2015 and 2020, DGGF has committed EUR 324.8M via its FoF to 60+ local finance providers and EUR 37.6M committed by the seed capital and business development facility into 20 local finance providers and 10+ entrepreneur support organizations (ESOs).

The EUR 40M Seed Capital and Business Development (SC&BD) facility of the DGGF aims to strengthen the mission impact of the DGGF investment funds by providing technical assistance (feasibility and market studies) and enterprise support/business development services to the intermediaries in their portfolios. They also have built a knowledge and research team that helps to synthesize and share learnings across the portfolio on the use of catalytic capital. Combined, these additional services enhance and disseminate information on the impact of DGGF and its investments.

As these examples show, it is not only possible but critical that DFIs continue to provide catalytic capital. DFIs that invest concessionally and prioritize market building and innovation can achieve the greatest impact. If a DFI hesitates to take this route, one natural means of scaling up is to pair the activities of bilateral donor aid agencies with bilateral DFI support. One notable example is the USAID INVEST program, which has been working with the USDFC via Prosper Africa—but there are others.?Let’s hope the growth trend in DFIs’ use of catalytic capital continues.??

Kusi Hornberger co-leads Dalberg’s Finance & Investment practice based in Washington, DC. The views in this article are his own.?