Opinion: Private capital for development requires new business models

Despite the widespread disappointment with the “billions to trillions” agenda, there has been plenty of innovation by multilateral development banks and development finance institutions demonstrating the potential to mobilize larger amounts of private capital for development. The most promising involves bringing private capital into the capital base of the institution and sharing the risk on multiasset portfolios with private investors. But these innovations have not been widely adopted and scaled up. MDBs and DFIs persist with outdated “originate to hold” business models — where a financial institution originates an asset with the intention of holding it on its balance sheet as a long-term investment — by using public shareholder capital to invest for their own account. Too much effort goes into structuring bespoke investments, including those which blend in concessional finance, and mobilizing private capital one transaction at a time. This approach is appropriate for first-time investments in difficult contexts but is not scalable for private capital mobilization in less risky countries and sectors. As a result, private capital mobilization volumes remain low at around $20 billion a year. To achieve a step change in their mobilization activity, MDBs and DFIs can do two things. The first is to bring private capital onto the balance sheet, thus expanding their own account lending capacity. The second is to adopt an “originate to share” business model, where financial assets are created with the intention of sharing the exposure with private investors. This can coexist alongside an “originate to hold” model that continues to invest in high-risk, frontier investments to be kept on the balance sheet, as those assets will not be attractive to private investors. MDBs have over many years shown that the most effective way to mobilize private capital for development is by issuing bonds to multiply the financing they can deploy based on their shareholder capital. Some bilateral DFIs, including the German Investment Corporation DEG and the Dutch Entrepreneurial Development Bank, FMO, have done the same, but most rely entirely on shareholder capital, with no debt leverage. Several DFIs, including FMO and Proparco, have also shown that it is possible to bring in minority shares from private investors who share the DFI’s mission. While the equity returns that MDBs and DFIs make may not excite commercial investors, there may be investors who want to share in the development impact by taking minority equity or hybrid capital stakes. MDBs and DFIs can also reduce the public capital backing required for lending by taking out credit insurance. This effectively mobilizes the private capital on insurance company balance sheets to underwrite the credit risk in place of public shareholder capital, enabling the MDB/DFI to lend more. In 2022, the Asian Development Bank insured $1 billion of financial sector loans, while the International Finance Corporation has raised more than $3.5 billion from 13 insurers through unfunded versions of its Managed Co-Lending Portfolio Program. Findev and FMO aim to insure half of the credit risk in all transactions. To scale up mobilization at the transaction level, MDBs and DFIs should assemble risk-diversified, multiasset portfolios which can be invested in by insurance companies, pension funds, sovereign wealth funds, and the like. These can be packaged as funds or programs managed by the MDB or DFI, or by a private fund manager. IFC-managed funds have raised $8 billion from 55 private institutions since 2009, while its MCPP program has raised more than $10 billion from 11 private institutions. Smaller MDBs and DFIs may need to pool assets across institutions to create portfolios large enough and risk-diversified enough to attract institutional investors. ILX Fund recently raised $1 billion from three Dutch pension funds for a multi-institution asset pool of this type. In the same way that standard residential mortgage loans enabled securitization of mortgage portfolios, it would be easier to attract private capital into such multiasset portfolios if MDBs and DFIs adopted standard loan terms, legal documentation, and credit ratings. This could build on IFC’s Master Cooperation Agreement, which provides for shared due diligence and legal documentation among two MDBs, 14 DFIs, and 19 private financial institutions. More than $10 billion has been committed in transactions using the MCA. A key next step would be to adopt a common credit rating methodology, aligned to private market standards so that investors can more easily compare the risk profile of portfolios of MDB and DFI loans. So what is holding MDBs and DFIs back from mainstreaming these approaches to mobilization? First, business processes to generate new assets are not oriented toward generating large volumes of assets to share with private investors. MDBs and DFIs need to scale up business development and transaction processing to handle larger volumes than the institutions can finance from their own account. Second, existing revenue models and risk management may not be financially sustainable under an “originate to share” strategy. MDBs and DFIs need to recover more origination costs upfront and accept that the residual own account portfolio will be riskier than the assets that can be shared with private investors. They may also need to upgrade their data management and reporting to meet private investor requirements. Scaling up mobilization of private capital is possible, based simply on approaches that have already been successfully deployed. Now is the time to retool the business models of MDBs and DFIs so that these approaches are mainstreamed into their businesses.