In essence, catalytic capital is investment capital (debt, equity, guarantees, etc) with which the investor accepts reduced financial expectations in order to bring about a greater social or environmental impact. Lowered financial expectations refers to not only higher risk or lower return profile, but also a longer liquidity window or subordinate position in the investment structure than a more conventional investment. Other terms for this type of capital include concessionary capital, patient capital, and flexible capital, among others.
Catalytic capital fits in the middle of the spectrum of capital, which demonstrates a gradation of investor return expectations, from 100% loss (a grant) through commercial returns at rates set in accordance with conventional financial benchmarks that do not price in “externalities” (conventional equity investments). It can work to fill critical gaps for social entrepreneurs, particularly in early stages of development. It can also encourage third-party investment that may have not been otherwise possible (e.g. a development finance institution taking a subordinated position to entice private investors).
Tideline, an impact investing consulting and research firm, warns: “Capital willing to accept disproportionate risk and/or concessionary returns is in short supply and can have market-distorting effects if not deployed appropriately. Evaluating potential positive and negative impacts of catalytic capital (including its built-in financial concession and the activities it supports) is essential to its effective use.”
Blended finance is the term used when public or philanthropic funds are used to catalyze private capital investment (particularly in frontier markets). It has been envisioned as a way to help bridge the funding gap to achieve the UN Sustainable Development Goals, leveraging public and philanthropic capital to bring more private capital to the development finance table. Typically, the public or philanthropic entities provide a type of concessionary and catalytic capital that lowers the risk profile of a particular investment for the commercial or private entity. This allows the entities to invest together while allowing different parties to define their measure of success.
Blended finance is not limited to a specific transaction type, but instead is a structuring approach with three key characteristics:
Impact, particularly in regards to the SDGs, is a motivating factor in the transaction
Financial returns are expected, although different parties may have different return expectations
Public or philanthropic capital is leveraged to act as a catalyst for the addition of private capital.
How are blended finance deals structured?
Grants – public/philanthropic partner gives money to support the project that has no expectation of being repaid. These funds can be used to support non-income generating activities or early stage preparations.
Guarantees – public/philanthropic partner offers protection (often in the form of insurance) from capital loss. (lowers the risk or increases the credit rating)
Technical Assistance – public/philanthropic partner offers direct support to an entrepreneur, typically through a technical assistance facility or an incubator.
Junior Equity – public/philanthropic partner buys ownership in the investment, but accepts a subordinate position in the structure, effectively accepting higher risk for lower returns. This structure is also sometimes referred to as concessional or first-loss capital.
Flexible Debt – similar to junior equity, the public/philanthropic partner can accept subordinate terms to the debt structure, allowing for more favorable terms than the market offers.
All of these strategies act to reduce the riskiness of an investment for private investors, thus leveraging the public or philanthropic funds provided to accomplish certain SDG goals.
What are some examples of Blended Finance structures?
Convergence is a global network that was launched in 2016 to focus on blended finance. The organization maintains a database of blended finance transactions, including the following types, outlined in the table below:
Transaction with concessional development funding
Development agency invests concessional debt or junior equity into a fund, improving risk-adjusted return for private investors
Transaction with market rate public and private investment
Public and private investors invest in a structure either pari passu or in different tiers, but at pricing fully reflecting seniority, tenor and other features
Grant-funded TA facility alongside transaction
Commercial fund has associated grant-funded Technical Assistance facility to build pipeline and support impact
Below market-rate risk miti- gation provided by development funders
Development funders provide guarantee to bond issuance to improve credit rating and attract private investment
Private investors provide working capital for set of interventions and are repaid with a return by development funders if intervention achieves pre-agreed results
Advance Market Commitment
Development funders guarantee a market for a product, incentivizing private investment
Project Finance Facility
Facility that only provides grant funding to infrastructure projects to reach bankability with the ultimate goal to attract private capital to projects; underlying transactions considered blended
Transaction with grant funding for design and launch
Development funders provide grant funding for vehicle design and launch
According to Convergence and their data: “The most frequent private investors are asset/wealth managers and private equity/venture capital firms. The most frequent public investors are development finance institutions, governments, and multilateral groups. The most frequent philanthropic investors are private foundations.”