London (HedgeNordic) – It is now widely accepted that ESG investing can be consistent with strong risk-adjusted returns and might even enhance them, but there is more debate over whether different types of impact investing need to sacrifice some risk-adjusted return for their objectives. The answer is yes and no according to blended finance. One group of private sector investors can invest in impact projects with competitive risk-adjusted returns precisely because another group of mainly public sector and voluntary investors are prepared to bear a bigger share of risks.

Filling the Funding Gap

Blended finance is essential to fill the USD 4.2 trillion funding gap for meeting the UN SDGs by 2030 that exists in many emerging and frontier market countries, which is holding back their economic growth and fulfilment of potential in areas including health, life expectancy, education, employment opportunities (especially for women), and climate friendly growth. The Net Zero Asset Owner Alliance, which is chaired by Allianz board member, Gunther Thallinger, is not only focused on developed countries’ carbon emissions but also sees scope for a huge scaling up of blended finance to accelerate developing countries’ transition towards lower carbon future, set out in its “Scaling Blended Finance” paper published in November 2021.

Many developing economies are so small that some of these countries have no presence or only a tiny weighting in market cap weighted emerging market bond indices, which means they will not attract meaningful amounts of capital from passive or benchmark constrained investors. And even unconstrained active private investors will seldom invest independently and directly into such countries. “The perceived and actual risks include politics, credit risk, repatriation of capital, structural complexity and familiarity. Why risk sub-Saharan Africa when you could get the same yield in the EU or US?” says Nadia Nikolova, Lead Portfolio Manager in Development Finance at Allianz Global Investors.

“Blended finance aims to de-risk investments so that returns are commensurate with risk.”

“Blended finance aims to de-risk investments so that returns are commensurate with risk,” she says. Risk mitigants include development banks or other financial institutions and donors anchoring funds or individual deals by one or more of: taking a junior position that would bear the first loss in a structure; providing guarantees and investing over a longer time horizon to take care of time related tail risks. Whether or not there is any explicit political risk insurance, collaboration with development institutions provides a considerable degree of comfort: “Private investors are implicitly insuring against political risk by coinvesting with development banks,” argues Nikolova.

Which Countries?

Since China and some other larger and wealthier emerging market countries already have well developed capital markets, blended finance tends to focus more on dozens of countries in sub-Saharan Africa; the Caribbean and South Asia. “There we see the largest gaps between the need for investment and capacity, given constrained balance sheets. Many frontier and emerging market sovereigns were indebted before Covid, and they now have a higher debt burden,” says Nikolova.

“Many frontier and emerging market sovereigns were indebted before Covid, and they now have a higher debt burden.”

Some countries subject to certain EU and UN or other sanctions would need to be excluded.1 For instance, in South America: Venezeula and Nicaragua, and in Africa: Guinea; Mali; Libya; Sudan; South Sudan; Central African Republic; Democratic Republic of the Congo; Somalia and Zimbabwe.

Which Partner Investors?

In blended finance, private investors are partnering with public, hybrid public/private, and voluntary entities. Most development banks are publicly owned but a few such as the Netherlands’ FMO Entrepreneurial Development Bank may have some minority private shareholders. Foundations and charities usually raise funds from the private sector, including their founders, but some of them may also receive public funding. The foundations involved in blended finance tend to be the larger ones.

Development banks can be global, such as the IFC, regional, such as the Inter-American Development Bank. Mexico has several that invest in Mexico. They may be multilateral, like the EBRD or EIB or African Development Bank, or bilateral, such as the national development banks of most European countries eg Denmark’s IFU or Sweden’s Swedfund. Allianz in 2017 partnered with the IFC for the Managed Co-Lending Portfolio Program (MCPP) but has now broadened out the model to work alongside potentially hundreds of development finance institutions (DFIs).

Sometimes the first loss risk could also be shared with one or more development agencies, which might provide guarantees (the Swedish Development Agency (SIDA) provided a guarantee to the IFC for part of the first loss funding for MCPP).

Return and Risk Profile

The DFIs and donors invest in the junior tranche of a fund, which might be the bottom 10-15%, while the senior tranche is for private investors. “The thickness of the junior tranche is determined by cashflow waterfall, risk and diversification in the fund, and will vary between funds,” says Nikolova. The first loss attachment point is calibrated to give the private investors a return and risk profile comparable to investment grade credit, though neither the fund nor the underlying loans have any credit rating, let alone an investment grade one. This is not surprising when 88% of emerging market countries are not classified as investment grade.

In terms of solvency II risk weightings under the standard model, which are relevant to various public and private insurance organisations and some pension funds covered by Solvency II, the capital charge should be very close to investment grade.

In the current fundraising, for Allianz Climate Solutions Emerging Markets Debt strategy*, Allianz is anchoring the senior tier with $350 million, another $500 million is sought from external investors and up to $150 million will be in the junior tier.

The target IRR return for the senior tranche is an average of 4.5% net of fees at current interest rates, but since the loans are floating rate this could tick up if interest rates pick up. “The return is not only interest but also up-front and commitment fees, and varies between projects,” says Nikolova. “The senior tier of the fund is expected to have at least 90% exposure to senior debt of individual deals, but it could have small amounts of mezzanine or subordinated exposure when this suits projects,” she adds.

The first loss tranche receives a dividend, and the return target is not disclosed though profit is not the only motive. This is classified as “non-concessionary” financing, which is on terms that are more favourable to borrowers than normal market conditions. Thus, the first loss investors are potentially sacrificing some return for the impact objective, whereas the private investors are aiming for reasonable risk-adjusted returns.

Projects Major on Renewables

Allianz has previously managed blended finance funds focused only on infrastructure but now the mandate is broader: The Allianz Climate Solutions Emerging Markets Debt strategy focuses on Paris-aligned investments. It will lend to the private sector, often via special purpose vehicles dedicated to specific projects.

“Renewables such as solar and wind farms; solar panelled rooftops; energy efficiency; smart climate technology; electricity grids; smart agriculture; smart home cooking, and switching from old to LED electric bulbs are examples,” says Nikolova. The split between water, wind and solar power will vary depending on countries’ natural resource endowments. Progress towards electrification and electric vehicle charging infrastructure will also vary enormously between countries. Though some of the projects could drill down to small scale domestic objectives, this is not a microfinance strategy. The deployment of capital also broadens the relationship with development banks, which help to source the deal-flow, in addition to sometimes being junior investors in Allianz’s (or other) blended finance funds.

ESG, SDGs, Impact, and EU Sustainable Finance

The choice of projects is partly based on screening for positive and negative impact, in line with the IFC’s Operating Principles for Impact Management, which are also followed by 140 institutions, and Allianz’s private debt ESG policies.

“Excluded sectors include tobacco, weapons and some carbon intensive sectors. In Emerging Markets, there is a social cost of not investing in transition fuels such as natural gas. This is particularly the case in countries where electricity connectivity is low, or the economy is heavily dependent on gas/oil. With respect to natural gas, most Net-Zero investors tend to exclude new investment even in Emerging Markets,” says Nikolova.

Given the Paris agreement alignment, the strategy is clearly focused on UN SDG 13, and it could also touch on any or all of the other SDGs. Impact performance reporting will not necessarily be mapped onto the 17 SDGs however. “It is more important to be able to quantify impact indicators, such as how many people are employed in permanent positions, or how much carbon is removed. Carbon reporting will start with scope 1 and 2, and could over time add scope 3 plus breakdowns into different greenhouse gases, where this is available,” says Nikolova.

In terms of the EU Sustainable Finance Disclosure Framework (SFDR), the fund will target compliance with article 9, which is something of a moving target as the legislation is still evolving. “Although the scope of the EU Taxonomy is limited to European Union, and therefore emerging markets borrowers do not always disclose requested information, the strategy aim to “shadow” the taxonomy by initially monitoring screening for eligibility and alignment with the EU environmental taxonomy. When the social taxonomy comes into force, there could also be some screening for it,” says Nikolova.

Enforcing ESG Performance

The strategy’s ESG approach is distinguished by the DFI’s robust and very active methods of enforcing ESG compliance, which have also been adopted by other development banks. Whereas some impact strategies incentivize ESG improvements through coupon reductions, this strategy hard codes ESG requirements into loan covenants, and a breach of the covenants is classified as a default. “In cases of default the objective would be to engage and negotiate improvements to remedy the breach, rather than foreclose and call in the loan. The governance structure of deals gives the development banks a seat at the table which lets them influence ESG on each project,” says Nikolova.

This article features in HedgeNordic’s 2021 “ESG & Alternative Investments” publication.