Unlocking the promise of blended finance

The annual financing gap for India’s Sustainable Development Goals, which was already large, is estimated to have almost doubled after Covid. According to the government, the funding for the social sector has grown to 30 per cent of nominal gross domestic product but is still constrained by limited resources. This capital gap can be addressed through blended finance — the use of financial instruments to combine private, public, and philanthropic capital to (i) increase the capital available for development and (ii) allocate this capital efficiently towards achieving socio-environmental outcomes. Blended finance in India is now at an inflexion point and has tremendous potential to address various market failures. 

It does this by (i) leveraging subsidised capital to unlock commercial funds available in global markets, and (ii) re-balancing the risk–reward profiles of pioneering, high-impact investments and public-private partnerships that would otherwise be too risky to fund. Blended finance is a framework that operates across asset classes on the social finance spectrum ranging from environmental, social, and governance (market return) to impact investing (near-market return) to venture philanthropy (low return). 

Blended finance structures can be categorised into four archetypes based on the mode of intervention, the nature of financing gap and capital market barriers that may deter funders from financing for social impact. The first type of structure is concessional capital or catalytic funding from development organisations or government with the intention of bearing below-market returns and/or absorbing higher investment risk to attract risk-averse commercial investors. The common forms include subordinate debt, junior and first-loss equity and returnable grants.

Second, risk mitigation tools or guarantees act as insurance to cover downsides for commercial investments. Unlike concessional capital that is deployed hand-in-hand with commercial capital, risk mitigation guarantees a portion of future losses on an investment, helping augment market efficiency because capital only covers losses when they occur. Examples include first-loss credit guarantees and advanced market commitments.  Third, support mechanism structures strengthen the quality, efficiency and financial sustainability of development projects and the probability of their financial close. Common forms include technical assistance facilities, design grants and project facilities to help cover transaction related costs.

The final and potentially most interesting type of structure, results-based financing, is using innovative, outcomes-oriented or pay-for-success contracts that incentivise participants based on achievement of pre-agreed, measurable performance targets. Such structures are unique because capital is not deployed to satisfy the cost of inputs but to reward the achievement of desired outcomes by end beneficiaries.  Results-based financing is becoming increasingly popular due to the accountability it begets. Common forms include social/development impact bonds, conditional cash transfers, and outcome-linked interest rate loans. 

Blended finance can strengthen the government’s efforts to support the underserved sections of society by promoting efficient use of the limited resources and supporting long-term sustainability. For commercial investors, wary of investing in the development sector due to unfavourable risk-return trade-offs, blended finance reduces the risk involved in financing social projects and increases the pipeline of relevant investment opportunities. The biggest benefits, however, accrue to India’s social sector, which is highly underfunded and limited in its ability to drive large scale impact. Blended finance structures can catalyse the flow of capital into the most effective and well governed non-profits and social enterprises, allowing them to scale-up dramatically.

Despite this immense potential, the ecosystem is still in its infancy in India, but growing fast. Building an environment that is conducive to the designing, structuring and execution of blended finance will require overcoming four main gaps: (i) lack of regulatory and financial reforms; (ii) greater standardisation of impact measurement metrics; (iii) fear of market distortion due to subsidisation; and (iv) complexity and high cost in structuring.

As we explain in our recently published white paper, it is worth addressing these gaps and having a deeper dialogue on the relevance of blended finance interventions. There are various initiatives the government can take to leverage blended finance in critical social sectors. In agriculture, we can set up a dedicated fund of funds for agri-tech investments or technical assistance facilities to support adoption of precision-agriculture. In education and healthcare, the government can participate as an outcome funder in impact bonds to attract more commercial capital. In financial inclusion, we recommend setting up a credit guarantee fund for impact-focused non-banking financial companies and interest subvention-rebates for measurable impact creation. In climate change, there is a need to incubate more early stage innovations and set up a pooling vehicle to fund decarbonisation in hard to abate sectors.

The last few years have seen the emergence of a vibrant social finance ecosystem in India. We have also seen several examples of blended finance transactions that have helped create financial returns and social impact. Given this evidence, blended finance can clearly play a key role in the collective responses of the government, foundations and investors to accelerate India’s socio-economic development. This requires coordinated action among stakeholders and is thus greatly facilitated by government recognition of social finance broadly and an enabling regulatory framework: From corporate social responsibility regulations that allow for outcome funding to the emerging standards on ESG to the budget announcements on a government-backed blended finance vehicles for climate to the social stock exchange, with its enabling provisions for listing blended finance instruments.

It is heartening to see the increasing interest among policymakers, investors, and development professionals in using blended finance for funding India’s ambitious development goals. We hope the recommendations outlined in the white paper can be taken up for active consideration by the government, private investors and donors to truly unlock the potential of blended finance. 

Desai is founder of Desai & Associates. Pai is CEO of the Impact Investors Council. The white paper is available at https://iiic.in/research-publications