It is an intoxicating message for those who see a breakthrough in financing development. There is a pool of money out there so large that just a small fraction of it could go a long way in filling the multi trillion-dollar annual investment gap required to achieve the Sustainable Development Goals.
The conversation on private finance for development has evolved significantly over the past few years — raising new questions and challenges.
Practitioners in development often repeat the slogan “billions to trillions” to articulate the promise of what has been termed blended finance, the layering of public concessional funds to turn a risky development project into an investment-worthy opportunity for investors focused on a commercial return. So far, the results have been underwhelming.
A 2018 Convergence study identified more than $100 billion in blended finance transactions in aggregate deals value since 2005. It highlights that development finance institutions and multilateral development banks made up nearly half of the proportional investment, while commercial banks, asset managers, and insurance companies amounted to only 11 percent of the total.
When contrasting this to a 2016 McKinsey & Company estimate of $120 trillion in assets managed by institutional investors, it becomes clear new approaches and innovations will be necessary to fulfill the promise of blended finance.
This should not signal a failure. Meaningful progress has already been made with several recent innovative examples.
The International Finance Corporation’s Managed Co-lending Portfolio Platform creates a scalable lending platform for institutional investors to invest in infrastructure projects. The recent Elazig Hospital Project has showcased an approach to leveraging public funds to attract institutional investors at sums several times larger than the public investment.
Nevertheless, time is of the essence. It is approaching four years since the world adopted the SDGs, with little dent in the investment gap to date. In fact, recent data released by the Organisation for Economic Co-Operation and Development indicates a decline in external finance to low-income countries, despite the commitments by developed countries to increase flows, especially in private finance.
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The reality of tapping into the vast pool of capital managed by institutional investors has proven more difficult in practice. At the OECD’s recent Private Finance for Sustainable Development conference, panelists representing impact funds asset managers highlighted several reasons why securities generated by blended transactions have had limited success at attracting private investors.
They mentioned impediments such as small size, foreign currency, being unrated, illiquid investments, lack of a track record, and/or an imbalance of risk and return. There is no silver bullet to overcome these obstacles.
Nevertheless, a securitization mechanism developed decades ago could hold potential to be part of the solution. Asset-Backed Commercial Paper programs provided a funding mechanism for assets that hit many of the same hurdles mentioned above. At their peak, the aggregate value of ABCP programs exceeded $1 trillion.
The financial crisis exposed its flaws, especially the mismatch of short-term funding of commercial paper, lack of transparency, and bundling of assets with poor credit quality, to name a few. This led to regulatory reforms and a contraction of the market to around $250 billion today.
Nevertheless, if the concept is repurposed and redesigned responsibly with medium-term notes that match the duration of assets in the fund, full transparency, and the right risk protections and liquidity assurances by MDBs, DFIs, and donors, it could create a promising vehicle to pool hundreds of these securities into a conduit viable for institutional investors to invest tens of billions of dollars.
The process has multiple steps — but it is not as complicated as it seems at first glance. First, an MDB or DFI would form and administer the asset-backed conduit as a bankruptcy-remote special purpose vehicle, or SPV.
Donors and investors may have to move into uncharted territory for innovative financing mechanisms to lead to meaningful investments.
It would be designed to finance the purchase of assets originated in developing countries that serve a development goal by issuing medium-term notes of varying maturities to large institutional investors matching the weighted average remaining life of the assets in the SPV.
The securities would be issued in U.S. dollars, registered according to Security and Exchange Commission guidelines and highly liquid. The SPV would be rated by all three major credit rating agencies structured to achieve at least a “BBB” rating. Credit enhancements applied to the SPV would include a cash reserve account funded by excess spread, a subordinated debt tranche, or a liquidity backstop — either could be provided or funded by an MDB and/or DFI, possibly subsidized by a consortium of donor countries — and a varied mix of assets, with risk mitigated by the diversity of sector, country, maturity, etc.
Imagine there is a water project or local financial institution issuing bonds to finance a development goal in a low-income country. To qualify for the SPV, the bond has to have the risk characteristics of an “A” rated security, a common minimum threshold. This would mean the SPV could only buy the senior tranche in a subordinated structure or a bond with a high degree of overcollateralization in an unsubordinated pari passu format.
The security would need to be layered with a foreign exchange swap if issued in local currency and insurance covering the principal, i.e. a credit default swap or guarantee, if the SPV is supported by a liquidity backstop, both of which could be eligible for donor support to limit the costs to the originator. There could be a challenge in getting the conduit started at first. However, one solution would be to make an initial purchase of a dozen or so existing assets that meet the desired characteristics, but just needed that extra credit protection by donor funds to qualify.
“Do no harm” is the ethos of doctors and development professionals alike. The risks posed by the further financialization of development are certainly a cause for caution. Yet the stubborn lack of finance available for development is a stark reality, especially in low-income countries.
It is also increasingly a necessity to be innovative with official development assistance flat and slipping relative to other forms of development finance, coupled with the public’s attitude toward development assistance spending in many OECD countries.
While this solution does not offer a silver bullet, it is worth consideration and warrants careful study by the development community to determine whether it would be a viable, effective, and appropriate vehicle for financing development.