Beats | April 13, 2016

IFC: Five Ways to Reduce Risk and Expand Investments in Global Development (2 of 3)

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In my previous post, I pointed to the importance of economic fundamentals and the investment climate when structuring blended-finance solutions. I also encouraged careful thinking about risk. In this post, I identify some proven approaches to using public finance to crowd in private finance in ways that expand the universe of viable projects that get funded.

fullstackHere are a few pointers in how to think about deploying scarce public funding to increase the flow of private investment:

1. Allocate risks between public and private finance carefully. Structuring a project well means allocating risks to parties best able to manage them. That reduces overall project risk. Public institutions with a relationship with the government — such as multilateral development banks — are better placed to manage political risk than private investors. For example, the Multilateral Investment Guarantee Agency (MIGA) offers affordable political risk insurance because its member governments provide a counter guarantee.

Risks are properly allocated when they are calibrated to the different risk appetites of different parties. A key benefit of public finance is that it can accommodate different risk appetites and time horizons. This offers opportunities for blending public and private finance in ways that structure assets to meet the risk and time profiles of the private sector. For example, public finance, which usually has a longer time horizon, may guarantee longer tenors, allowing private investors to take shorter-term risk.

Alternatively, the public sector can take on the project risks of construction — which it may be better able to monitor and manage — and then sell down assets to private investors once construction is completed and when those risks are past. Before jumping in with subsidized capital, donors should first consider what can be achieved through patient capital.

2. Expand investors’ risk appetite. Risk appetites are constrained by the size of balance sheets. Investors decide how much capital they want to put at risk for different risk exposures. Hence, a constraint to getting large investments financed is that the investment required for each investor may exceed their risk limits — either for that deal, or for their total investment portfolio of that asset type.

Financial intermediaries can help — by distributing assets across multiple investors to reduce the risk exposure of each investor, as in syndicated loan programs. But at the portfolio level, investors may soon reach their thresholds for specific risks (e.g. small countries, fragile states) even though investment needs remain unmet in these areas.

This is where blended finance can make a critical difference. It can expand the risk appetite of private investors by partially guaranteeing their exposure. For example, a 50–50 risk-sharing arrangement can double the exposure that an investor is willing to take in a certain type of investment. But it can do more than that — by introducing investors to new classes of risk that they have not previously had exposure to. It can also help them calibrate their risk perceptions — as their perception of risk comes down, the share of risk that public finance needs to take can also decline.

3. Combine projects to crowd in international institutional money. One-off deals are often too costly to appraise. They result in too much risk concentration. Aggregating assets allows risks to be diversified. It can create large enough ticket sizes to attract developed market pension funds, insurance companies, sovereign wealth funds, and endowments. Public finance can have a larger impact by participating in structured-finance transactions for portfolios of assets rather than project-by-project financing.

4. Crowd in local finance, leverage local savings. Most investments, especially in infrastructure, generate revenues in local currencies related to the performance of the local economy. Financing these investments from local capital markets removes currency risk. Governments and development finance institutions should look at ways to mobilize domestic savings pools — which are increasing as populations age and more people save for retirement, and as growing middle classes save more and buy more insurance.

These savings can be intermediated through domestic bond markets, through domestic financial institutions, and through domestic corporations that finance infrastructure and other investments on-balance-sheet through corporate finance. Of course, this works better in larger emerging markets — where financial institutions and capital markets are big enough to intermediate significant capital flows. For smaller countries, regional financial institutions and capital markets can play a similar role, but unless the region shares a common currency, some currency risk will remain.

5. Simplify project preparation. In smaller, frontier markets, donors are keen to support “capacity building.” But more attention should be paid to streamlining project origination — making it simpler to assemble projects, rather than working through complex processes. This means deal terms and instruments should be standardized to a greater degree, common appraisal standards should be developed, and bottlenecks in government and regulatory approvals should be removed.

[seperator style=”style1″]Disclosure[/seperator]

This post originally appeared on Medium and was reposted with the author’s permission.

Photo: © Allison Kwesell / World Bank

This blog is the second in a three-part series on blended finance (see part one). The third part will draw lessons from IFC’s blended finance program, which has developed over the past 10 years to achieve development impact with a disciplined, time-bound use of subsidy.