Emerging market debt investors debunk risk myths

Jessica Pothering
ImpactAlpha Editor

Jessica Pothering

The New York-based private credit provider Muzinich is betting big on the climate transition in emerging markets.

The investment firm is developing a billion-dollar private debt strategy to invest in infrastructure, real estate, agriculture, financial services and other sectors supporting climate change mitigation and adaptation. The strategy will put Muzinich in a tiny club of 10-figure emerging market impact debt fund managers.

“There are so many climate consequences we haven’t explored yet because we haven’t experienced them,” Muzinich’s Tatjana Greil Castro tells ImpactAlpha. “The more unpredictable the climate gets—to think that you’ll be able to make an 8% predictable annualized return over the next 100 years is absolutely ludicrous.” 

Risk perceptions

More than 750 funds are putting capital to work for social and environmental impact in emerging markets. Collectively they manage just $95 billion, about 8% of all impact capital and just 0.1% of total global assets under management. Private equity is the dominant asset class; fixed-income and debt funds account for less than half of that $95 billion.

Debt funds remain fairly small because of investors’ perceptions of emerging market risk. Last year, German insurance firm Allianz made headlines with its $1 billion blended finance SDG Loan Fund. The firm used multiple layers of guarantees and first-loss capital to coax investors in. Muzinich’s emerging market climate debt strategy will target “modest” but achievable returns, cushioned by commercial credit risk protection.

Investors’ skittishness is at odds with the portfolio performance of emerging market debt funds. Debt portfolio yields hover around 7.4%. Annual loan write-offs are just 0.4%, while the average loan-loss reserve is 2.4%, according to impact research firm Tameo.

“There’s a misconception about the perceived risk that’s not justified,” says Tameo’s Ramkumar Narayanan. “We can show with data that these vehicles are performing very well across the industry. Investing in emerging markets with debt strategies – it’s something that’s very low risk.”

Some investors want the risk, of course: in the zero-interest world of 2021, Variant Investments and other commercial investors provided 50% first-loss capital to Lendable for its $100 million financial services loan fund in exchange for a higher rate of return.

Debt funds

The number of emerging market private debt funds is growing. Close to 400 private debt impact funds are deploying capital, up from 113 a decade ago and 242 five years ago, according to data from Phenix Capital. More than two-thirds focus on emerging markets. 

“Investors like this strategy as a gateway to the emerging markets,” the firm wrote in its latest private debt report. 

Debt funds that focus on multiple sectors are thematically the most common, though there’s an increasing focus on climate debt strategies, observes Tameo’s Narayanan. 

In addition to Muzinich’s forthcoming climate debt strategy, Switzerland-based Symbiotics is in the market with a new $25 million multi-sector impact debt fund. The Emerging Credit Strategies Fund is a designated Article 9 fund under the EU’s Sustainable Finance Disclosure Regulation, which has stringent impact reporting requirements. It will target climate and social impacts, as well as ways to leverage technology in the energy, agriculture, financial services and transportation sectors. 

Symbiotics has also recently partnered with British International Investment on a second “green basket bond” to accelerate green lending for emerging market small businesses. Last year, responsAbility raised $106 million for a climate-smart agriculture fund.

Safeguarding portfolios

Narayanan says the fundraising environment for emerging market debt funds could become more challenging, with high interest rates making more familiar low-risk vehicles attractive to investors. 

“We might see more stagnant growth than in recent years,” he predicts. 

The real risk, says Greil Castro, is in not addressing the climate transition with greater urgency. She wants to see every financial asset owner invest 1% of their assets in climate change mitigation and adaptation.

“That would be sufficient for the climate transition,” she says. “But the big prize is that you are safeguarding your predicted returns on the other 99% of your assets. That’s the prize people need to understand.”