Use of blended finance in fund structures

Blended finance is increasingly playing an important part in addressing this gap, by catalysing additional funding from investors with a more “commercial” focus (commercial investors).

Blended finance can take many forms. It is usually provided by investors who are focused more on development outcomes, such as development finance institutions, multi-lateral development banks, charitable foundations, or philanthropic investors (development investors).

What is blended finance and how does it work?

Blended finance is a broad term that, in the funds context at least, is used to describe arrangements where different investors provide capital but in a way that allows different return profiles and risk mitigation strategies to implemented in the structure. A simple example would be where one group of investors is able to agree to a subordinated and/or lower return with the aim of attracting other investors who are perhaps more risk averse.

Blended finance can be differentiated from the usual funding provided by development investors due to its specific purpose of mobilising additional capital from commercial investors. In this way, the increased funding can assist in delivering outcomes in key SDG areas, such as energy transition, climate mitigation, food security or digital infrastructure. 

An effective blended finance arrangement is focused on addressing the concerns of commercial investors, by way of alleviating any potential downsides and enhancing the potential upside.

Using blended finance within a fund structure

Blended finance can be used at various levels within a sustainable project, including within fund structures. A fund can use blended finance to attract additional fundraising and therefore enable it to grow to a more viable size. Blended finance arrangements in a fund can take various forms.

Technical assistance

Instead of or as well as providing concessional finance within the fund structure, development investors provide support in the form of technical assistance. Specific examples of this support include: improving governance controls; providing training on ESG standards; and financing feasibility studies for a fund’s potential investments.

Fundraising or operational financial support

This can take the form of grants or concessional loans which are then used to support the fund manager’s costs and expenses. Usually, this form of support tends to be used to cover a portion of the fund’s establishment expenses; thereby also lowering overall costs to investors.

First-loss/subordinated interest

This is often what people first think of when considering the use of blended finance within a fund structure. A first-loss tranche can be used to alleviate concerns of commercial investors on the extent to which they will bear potential losses on a fund’s investments. First-loss monies are often structured as either grant funding or as a subordinated fund interest. 

A subordinated fund interest will also only receive returns once more senior fund interests have received proceeds from the fund. The exact nature of the subordination will be detailed within the fund’s distribution waterfall, including the extent to which senior fund interests are repaid in priority and possibly also receive a preferred return before the junior fund interests can participate in investment proceeds.

A first-loss tranche tends to take up 20-30% of a fund’s total commitments. However, first-loss investors should be mindful of how such first-loss arrangements may impact discussions between investors if, for example, a fund is under-performing. In such circumstances, commercial investors may not be so concerned with looking at traditional fund governance protections if they simply think that the first-loss investor will instead take the brunt of any such exposure.

Return enhancement

This is used to better align the prospective returns for commercial investors with a fund’s higher risk profile. Enhanced returns to commercial investors can be achieved by tailoring the fund’s distribution waterfall so that proceeds to a development investor above, say, a minimum hurdle rate are instead diverted to commercial investors.

Development investors may also want to consider how to avoid providing unnecessary upside to commercial investors should a fund end up performing extremely well. One way of addressing this could be by capping the commercial investor’s enhanced return, with any excess proceeds above that cap being diverted back to the development investor again.  

Addressing the evidence gap

Whilst blended finance is used to address fundraising gaps, development investors also need to ensure that they are addressing any “evidence gaps”. By collating meaningful data, both development investors and fund managers can each determine how successful the blended finance was for crowding-in commercial investors and increasing the fund’s development impact.

Development investors need to ensure that they are avoiding excess subsidies whilst ensuring that the fund’s use of blended finance is meaningful enough to sufficiently mobilise commercial investors.

Structuring considerations

Financial modelling is often helpful to consider various fund performance scenarios and how they can impact the risk-return profile of a fund. Development investors also take a collaborative approach in reviewing the merits of their respective existing blended finance arrangements. This collective feedback is often invaluable for tailoring solutions in the future.

There is no “one size fits all” model for blended finance, either in the amount of the concessional finance being provided or how it can be structured. Funds are very well-designed to accommodate different risk-return profiles and objectives of commercial investors, whether in the choice of fund structure or establishing different categories of fund interests, as well as when drafting allocation and distribution waterfalls within the fund’s documentation.