While private investment can be a powerful tool for development, most aid professionals are not finance experts. Yet the new development equation is clear: Traditional donor resources are limited, but the pool of private capital is deep. Consequently, tapping into this pool requires action from a wider range of development experts.
Sign up for Devex Invested
Our weekly newsletter inside business, finance, and the SDGs.
By getting more investors to put money into funds and other investment vehicles aligned with development objectives, donors can substantially increase their impact.
One effective approach is the use of “catalytic funding,” which directs development resources into programs that reduce risk for investors in frontier and emerging markets — thus aligning private investment with development goals.
How and when, exactly, to use catalytic funding can also be confusing. The good news is that emerging resources and examples are being tested. Specialists can access these to better apply funding tools. The U.S. Agency for International Development’s INVEST initiative, for example, is testing a portfolio of approaches that helps fund managers structure investment vehicles to reduce risks and transaction costs.
Donors can also draw on a deep bench of interested fund managers and investment advisers, including members of the USAID Finance and Investment Network or other relevant professional networks, who understand the type of donor funding that will mobilize private investors.
By getting more investors to put money into funds and other investment vehicles aligned with development objectives, donors can substantially increase their impact.—
Here are a set of principles that development professionals and their partners can incorporate as they assess how to effectively deploy catalytic funding:
1. Support approaches that deepen markets in the long term
Most catalytic funding proposals demonstrate alignment with key development objectives, such as increasing energy access or creating jobs. Beyond ensuring alignment, donor funding can be prioritized for investments demonstrating long-term, multifaceted impact on the broader market.
The types of questions to ask include: Is it a pioneer transaction that will pave the way for similar investments? Will it have ripple effects that benefit businesses across a larger value chain? Consider what problem these questions are addressing, the extent to which private capital is already trying to solve the problem, and who would benefit from the proposed investments.
2. Ensure additionality
According to the Donor Committee for Enterprise Development, “additionality” is “the net positive difference that is expected to result from a donor-business partnership.” For example, donor support can increase the viability or credibility of a fund, enable access to hard-to-reach investors, accelerate raising capital by making an opportunity more attractive, or facilitate fund structuring, investor outreach, or the ability to raise capital.
Additionality ensures public funding adds distinct value and improves outcomes. The other side of the “additionality coin” is considering whether the transaction would occur with the same impact, regardless of donor support.
3. Get investors off the sidelines
When assessing a fund’s ability to mobilize additional capital, we recommend asking: How attractive is the opportunity to different types of investors? Would catalytic support make it appealing to a new set of investors? These questions help donors and partners assess whether an approach will “crowd in” private resources and increase impact.
During the proposal process, we ask for information that helps answer these questions. This includes target investors’ risk appetite and early feedback on the model, including the status of any existing investment commitment. Transaction advisers, who are familiar with the market and target investors, can also serve as a resource and “temperature check” on whether an opportunity is likely to be attractive.
Since traditional or Silicon Valley-type investment models are not always viable in emerging or frontier markets, INVEST tests new concepts and first-time funds, gauging market reactions to new investment products.
One such partnership is with linea capital partners, whose model may attract investors wary of the exit timeline on more traditional equity investments. Linea seeks to establish and scale a revenue-based financing approach, in which investments are repaid over time through a fixed percentage of a company’s future revenues. By providing a source of capital that doesn’t take away ownership from existing shareholders, it also meets the needs of many southern Africa growth-stage companies.
4. Prioritize sustainable approaches
When it comes to private finance in development, these are the tools and strategies in the spotlight this year.
When evaluating funds or capital structures, donors and partners should assess a model’s sustainability without future donor support. Without catalytic funding, will the future investor returns still be attractive? Does the fund plan to recycle a portion of returns into future efforts?
We have seen many sustainability approaches: fund managers recycling a portion of returns into a future fund, establishing permanent capital vehicles, or planning larger funds to make fund economics work.
While there’s no set formula, catalytic funding to mobilize private capital can help donors achieve greater development results, including helping more entrepreneurs and growing businesses thrive. As a result, the funding contributes to economic resiliency in the emerging economies in which they work.