Judith Karl on blended finance and deal flow in frontier markets

Executive Secretary of the UN’s Capital Development Fund talks about investing in the SDGs

Blended finance is often touted as a key way to drive private investment, aligned with the UN Sustainable Development Goals (SDGs), to frontier markets. RI speaks to UN Capital Development Fund Executive Secretary Judith Karl about its latest report on Blended Finance in the Least Developed Countries (LDCs). Executive Secretary Karl is giving a keynote address on ‘the future of financing in frontier markets’ at RI Americas 2018 today.

Q. The report writes of barriers to private capital in LDCs including a weak domestic enabling environment. How can blended finance help to hedge against this risks/barriers.

A. In untested markets you don’t really have market comparators or a track record of working in this kind of regulatory or governance environment. Blended finance uses concessional resources that can include a range of different instruments to share the risks and to lower the overall costs. So through blending we are adjusting the risk/return profile for private investors and crowding in commercial investment focused on positive impact for the sustainable development goals (SDGs). We also think blending is a very important part of the demonstration effect for other investors to do deals – and for domestic banks, entrepreneurs and governments. Usually innovation happens before the regulatory and the policy landscape changes.

Q. The report says institutional investors such as pension funds and insurance companies are large sources of private capital, but believes the figure of investments in LDCs is likely far lower than 1%. How can this change?

A. One lesson from the report is that boots on the ground are an incredibly important part. Familiarity with these markets is a very important part of having the confidence to move into these markets. The (finance) industry overall could start to look at whether incentives for linking compensation to longer-term returns is there. Another way is to look to create LDC-inclusive products to help redistribute the risks. One example is our recently launched ETF on the New York Stock Exchange with our partner Impact Shares, a not-for-profit fund manager. It creates an index vehicle of companies that are performing above average against ESG indices and at the same time they have operations in LDC and low to middle income countries. The criteria for companies meet very high and robust criteria for impact. Soon we are launching a new third party managed fund investing in last mile projects in LDCS. We bring to that fund our familiarity of conditions on the ground, our pipeline origination capacity and our due diligence capacity.

Q. At the end of the report it writes about “An Action Agenda”. Where do institutional investors fit into this?

We are proposing actions that really engage stakeholders, including investors, to improve the practice of blended finance. In investment, the very important thing is much greater robustness in investment and impact measurement, and transparency of the impact measurement. So it’s not just companies claiming their own SDG results and criteria but actually having a commonality so that the average investor really knows what they are seeing and understands what they are putting their money behind.

Also all of us investing more knowledge sharing and evidence so that we can understand better whether or not we are achieving our ultimate goal which is to get SDG finance right and to get the impact side of it right.h6. Q. How can blended finance providers avoid crowding out other investors? Do you think this is true, or are there additional opportunities for pension funds and other investors beyond what development finance institutions are already working on?

It’s a complex question. The intention of blending is to intervene where and only where markets are not working on there own. The intent of blending is to crowd in other investors, both domestic and international, not to crowd them out. This issue of boots on the ground, understanding how to partner up and how to develop those opportunities is a big impediment probably for a lot of institutional investors. They are seeing development finance institutions (DFIs) that do have an advantage when it comes to access, familiarity with these markets and identifying good opportunities. It means there is a great opportunity to redefine the partnerships to give greater access and insight to institutional investors into these markets.

“There really is no limit to deals out there.”

There really is no limit to deals out there. I don’t think DFIs have somehow soaked up all the good deals. I think the problem is trying to find the partnerships and the formulas to be able to make the transactions work. For providers of blended finance we have to be careful not to do transactions that can be funded by private capital exclusively, that we are not distorting markets and that we are not subsiding the private sector. At the institutional investor level it’s about how do we partner in ways that can help drive investment opportunities that will not bring down returns ratio to their clients but also give them entry into areas that are SDG positive.

Q. Why should large global pension funds care about investing in macroeconomic stability in these markets?

There are two reasons. There clients increasingly wanting them to do it. There is tremendous demand from the individual investors to see their dollars being investing in ways that are not damaging to the future of the planet – which just means governments not spending more public money to counteract the negativity put into the environment through private dollars. It is more a virtuous circle when private dollars are investing to further the agenda of what governments do through public policy.

Second is that these are the global markets of the future. This is where global capital markets are headed and investing in lower middle income countries are also where many new opportunities are going to be coming up. It’s part of a new highly diversified long-term portfolio approach that gives you access to new frontiers. A lot of the innovations that is happening in terms of fin tech and digital and renewable energy solutions is happening in lower middle income countries and LDCs as they are leapfrogging technology so there is tremendous potential there.