Development Finance Institutions cannot close the SDG funding gap

By | 2018-10-01T11:28:09+00:00 October 1st, 2018|

The current fad in the world of international aid is all about moving from “billions to trillions” through the mobilisation of private capital combined with blending for impact investing. Development Finance Institutions (DFIs) can and should expand and blending can help. But even with the best of intentions and efforts, DFIs will not be able to plug anything more than a fraction of the SDG funding gap.

The current fad is all about moving from “billions to trillions” for “private sector development” through the “mobilisation of private capital” with the aid of “blending” for “impact investing.” Except that this is not really new. DFIs have been focussing on private sector development and mobilising private capital, sometimes through the use of blending and measuring the impact of their investment, for decades.

What is new is the current, sometimes breathless, rhetoric on scale and speed. While DFIs worked in relative obscurity until recently, the focus on the funding gap for the Sustainable Development Goals (SDGs) and the rising star of private sector development has put them front and centre. The recent report of the Blended Finance Task Force, for example, calls the DFI model “easily scalable.” Donors have started imposing mobilisation targets on DFIs. Is this a good idea and is the model in fact “easily scalable”? How much of the USD 1 trillion – USD 2.5 trillion SDG funding gap for developing economies can DFIs and blending help to plug?

The task force’s response in short: most of it. Sadly, it uses heroic assumptions and mathematical gymnastics to reach its optimistic conclusion, saying: “if around USD 100 billion could be deployed in blended finance vehicles that mobilise USD 3 in private capital for every USD 1 of development capital … with further leveraging at the project level of another USD 3 this could close the trillion dollar SDG funding gap.”

Unfortunately, the task force is far from alone in misunderstanding what blending can and cannot do, and how scalable the DFI model really is. Far too many donors also overestimate how much blending can achieve and misunderstand how DFIs work and what they can deliver. To understand this better, we need to look into how DFIs operate.

Typically, the “change model” of a DFI works through demonstrating the feasibility of profitable private sector investments so that other private sector investors, both domestic and foreign, can step in. While on paper they provide capital at market rates in the form of direct or indirect equity and debt, often the problem is that there are few other providers of capital. The DFIs often take a hands-on approach and help improve the quality of management, business models, governance and sustainability of the businesses they invest in by using the DFI’s own experience or expertise, or through the use of external partners.

Often DFIs look at sector-wide approaches and sometimes invest in upstream and downstream businesses to make sectors like agribusiness viable as a whole. The DFI model of change works through multiple channels that include the provision of financial capital to the private sector, as well as supporting the build-up of human capital, business knowhow, best practices and the completion of supply chains. At heart, this means that DFIs are able both to improve the profitability of the projects they invest in and to make them more sustainable. Measuring the development impact of their dimensions is a critical part of the DFI model, and the core of the “impact investing” ethos.

Because DFIs are good at due diligence, their mere involvement in a project can reduce its perceived risk and induce other investors to invest alongside. Since DFIs are able to provide a more long-term stable form of capital and added value in the form of knowledge, this also helps lower the real risk of businesses and enhance profitability.

While it is true that DFIs can reduce the real and perceived risk of a project and improve its underlying profitability, there are limits to this. While a DFI can make an otherwise marginal project more attractive and profitable, it cannot turn a fundamentally unviable project into a profit-making opportunity. A thought experiment can help give a useful insight.

There are perhaps millions of ways one can give away money, equivalent to a 100 per cent loss. There are only thousands of ways to lose just 50 per cent of money invested, only hundreds of ways to make just a 10 per cent loss, and only dozens of ways one can turn a profit. The number of potentially investible projects declines exponentially as expected return increases. DFIs, which expect their investments to be profitable, only have a limited number of investible opportunities.

DFIs have been successful in being profitable and having a development impact only because of their bottom up model, wherein each investment they make is evaluated on potential profitability and impact. This requires good discipline and is manpower-intensive. A typical DFI employee is only able to turn around one-to-three investments each year without compromising due diligence and quality.

The more difficult the country – a fragile or post conflict state like Sierra Leone, for instance – the greater the costs of search and due diligence. In poorer economies the typical DFI investment is smaller, perhaps only a few million dollars rather than the tens of millions of dollars in richer emerging economies such as India. There is far more commercial money interested in India compared to the private capital that can be induced to invest in a country like Sierra Leone.

All of this puts serious limits on the ready scalability of DFIs. Even with blending, the supply of projects that can be brought to profitability is limited. The biggest constraint to scaling up is manpower. DFIs would need to increase their headcount to increase the number of projects they can assess, and this takes time. In any case, economically unsound projects can’t be made investible by DFIs. The pressure to scale up may also distort DFI investments towards emerging economies away from the more difficult least-developed countries and fragile states where it is most needed.

Donors need to temper their expectations. DFIs can and should expand and prioritise the mobilising of capital. And blending can help. But even with the best of intentions and efforts, DFIs will not be able to plug anything more than a fraction of the SDG funding gap.

The opinion piece first appeared on Development Today and can be accessed here.

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