Different sectors and organisations define “blended finance” in different ways. It is not a new concept but historically blended finance structures have been used more in the impact finance and development finance sectors. Blended Finance is simply a description of a type of structured finance that strategically uses public capital to incentivise investment from the private sector. In this article, we discuss how blended finance can be (and is) used outside the development finance and impact finance context to plug the funding gap for climate, nature and sustainable development.

Using structuring techniques to reduce the risks associated with private sector investment (which may be geographical, financial or derived from other factors) and, in some cases, enhancing the financial returns for private sector investors so that they can meet their investment criteria, blended finance applies public sector and other concessional capital (including philanthropic finance) to catalyse private sector investment.

The aim is to use the minimum amount of concessional capital to catalyse private sector investment which may not have otherwise been invested.

Blended finance not only opens up new opportunities for private sector investment but has been revolutionising public sector investment: instead of giving grants and writing-off financial assistance, the structures also provide potential for public funding returns, so that profit can be made and subsequently reinvested.

So what is blended finance?

There might not be universal agreement to the definition of “blended finance” but Convergence defines blended finance in The State of Blended Finance 2024¹ as using “catalytic capital from public or philanthropic sources to increase private sector investment in developing countries to realise the Sustainable Development Goals (SDGs) and climate goals. Blended finance allows organisations with different objectives to invest alongside each other while achieving their own objectives (whether financial return, social/ environmental impact, or a blend of both)”.² The use of the term “blended finance” varies. Some require application in developing countries, others not. Some require a combination of climate and social goals to qualify, others not. Some refer only to debt, some only to equity, others a mix of the two. Different geopolitical or regional perspectives will also shape the approach to blended finance. And blended finance may be proposed to be implemented under multiple different potential structures (more on that below). So it is important to pin down the intended meaning when engaging in discussions on the subject, noting that the idea is always to combine private and public or other concessional capital in a funding structure that addresses barriers that private capital funders might otherwise face when investing for relevant purpose-driven outcomes – including high perceived and/or real risk (eg due to geographical risks and/or credit/ financial challenges and/or technological risks) and otherwise uncompetitive or insufficient financial returns.

Convergence’s “Archetypes”: Typical blended finance structures

Blended finance covers a range of different structures and they are not “one-size-fitsall”. Convergence has identified four key structural archetypes,³ which are helpful to consider. Below we show them as they combine into a blended finance structure:

Figure 1: Typical blended finance structural features

Taking each of these in turn, we look at how these models work in practice, noting that structural features can be, and often are, combined to calibrate the desired risk profile and financial returns for an investment

To understand how these features combine in action, it is helpful to consider a case study and we have set out some detail regarding the Africa Agriculture and Trade Investment Fund (AATIF) below:

AATIF is a blended finance vehicle which invests in businesses along the agricultural supply chain. The fund’s aim is to “increase food security, strengthen income among people employed in the agricultural sector, and strengthen the competitiveness of local agriculture businesses”. DWS manages the fund and provides direct finance to commercial farms, processing companies and cooperatives, and invests in financial institutions and large agricultural intermediaries on-lending to small and medium companies.⁵
Fund characteristics:

• financing: debt, mezzanine or equity;
• $6m TA Facility: supporting beneficiaries, including for due diligence impact assessment and accounting;
• first loss guarantee from Federal Ministry of Economic Cooperation and Development (Germany);
• investment from KfW and Deutsche Bank at mezzanine level; DWS equity investment and European Commission at junior equity level.

See here for more detail about the AATIF.

There are many barriers to private investment for climate, sustainable development and nature

Although blended finance is not a new product, it is not mainstream yet. Transactions remain complex and bespoke, often with many negotiating parties who have conflicting expectations and documentary requirements. Consequently, transactions can take a long time to arrange, increasing cost and reducing its use. And a lack of commonly accepted terms and documentation makes it more difficult to scale blended finance to achieve the volumes needed.

For example, in emerging/developing economies in the Asia-Pacific region, the drive towards meeting the Sustainable Development Goals and other climate change mitigation and adaptation goals can involve the education and co-operation of multiple parties and stakeholders, across both private and public sectors.

Private capital investors require transparency and accountability assessments, including whether blended finance projects have adequately complied with their social, environmental or nature goals, which need to be implemented and monitored regularly. These bespoke requirements and structures require time, co-ordination and cost, which can impact commercial assessments of risk and return and could result in traditional/ mainstream providers of capital and global financial institutions being reluctant to finance blended finance structures, instead opting for more well-established financing structures.

Ravi Menon, Singapore’s Ambassador for Climate Action & Senior Adviser (National Climate Secretariat) also identified similar barriers in his speech on 12 September 2024 at Unlocking Capital for Sustainability 2024 that Asia’s transition financing needs are large but private capital is prevented from flowing to Asia due to:

• a lack of expertise in preparing and developing projects; high capital outlays;
• higher risks connected with technology, regulations and foreign exchange risks; and
• unfavourable payback periods (as it can take a long time to start construction and there are challenges in obtaining permits).

Increasing the volume of blended finance structures requires standardisation and growing understanding of how structures work

• Standardising transaction structures: in line with the Convergence archetypes, the structures identified above could be mainstreamed in the market alongside key understanding of “ways of working together” amongst the main participants – this is a design point, to assist mobilisation of funding quickly, reducing legal and other costs.
• Understanding the needs of key private capital investment allocators: by gaining a deep understanding of the red lines around investment opportunities for institutions, insurers, pension funds etc and then shaping more “off the shelf ” blended finance investment products around these, capital volume and speed to execution could be improved. Participants should look to harness private sector expertise in structured finance to solve the many difficulties in creating a repeatable, investible product which is attractive to multiple different private capital allocators. Additionally, expertise and product knowledge are developed with each transaction, and human resource capabilities and awareness are enhanced, particularly with local talent in emerging markets.
• Evolving the reputation: blended finance needs to evolve from being understood as primarily a smaller scale “impact” product into a large-scale climate, sustainability and nature financing vehicle, which is designed for significantly sized, risk adjusted and efficient capital allocation and speedy deployment.

Blended finance structures also suffer regulatory and other challenges

In addition to the market challenges for blended finance discussed above, there are also regulatory challenges in this space. Parties have to navigate an increasingly complex regulatory perimeter affecting blended finance. Regulations such as the EU Alternative Investment Fund Management Directive and the EU Securitisation Regulation (and UK Securitisation Regulation) pose compliance issues for some arrangements. Many investors have policies which prohibit investment in securitisations for example, or are subject to risk capital and liquidity rules that make blended finance investments unattractive, despite the obvious sustainability benefits and practical risk adjustment features being offered.

A regional or jurisdictional regulatory regime conducive to blended finance, for example with beneficial securities, trusts or insolvency law regulations as they pertain to blended finance structures, will be beneficial in encouraging more widespread adoption.

In addition, the tax system in many jurisdictions is designed for entities which are either not for profit or for profit – whilst blended finance structures often fall between the two. Even when regulatory and tax issues for a transaction are resolved for one set of investors, the addition of new groups of investors may entail structural acrobatics with multiple vehicles (potentially across a number of jurisdictions) and further differentiated terms, in order to bring everyone into the same deal. In this context, common pathways to “getting the deal done” including agreed arrangements on documenting level of impact/outcomes, financial reporting and compliance features, technical metrics, straightforward accommodation of multiple bespoke “investment policies and exclusions”, governing law and jurisdiction, acceptable credit ratings and due diligence processes, would be of significant value to sponsors and structurers (and as a result, ultimately to project beneficiaries, who will be able to access larger amounts of less conditioned capital at appropriate prices).

With commonality and consensus, the efficiency could translate to a quicker return-on-investment horizon and thus presents a more attractive investment opportunity for private sector providers of capital.

Governments are developing blended finance markets

There is evidence of a stronger governmental focus on blended finance, with the UK announcing the National Wealth Fund, designed to deploy catalytic capital to invest in five priority sectors: green steel, green hydrogen, industrial decarbonisation, gigafactories and ports. The UK Transition Finance Market Review also refers to the importance of blended finance.On 12 September 2024, Singapore’s Ravi Menon revealed Singapore’s blended finance platform “Financing Asia’s Transition Partnership” (FAST-P) which targets the areas which it identifies as “most pertinent to Asia’s transition” under three themes:

• the Energy Transition Acceleration theme;
• the Green Investment theme; and
• the Industry Transformation theme.

This initiative, with a target fund size of US$5bn, aims to utilise blended finance to play a significant part in bridging the energy transition financing gap across Asia-Pacific, with the increased adoption of concessional capital, the involvement of the multilateral development banks to provide technical expertise as well as regional financial institutions providing de-risking mechanisms and risk mitigation solutions for blended finance transition projects.

These are recent examples of governments embracing blended finance and we can expect to see much more from governments recognising the need to support blended finance markets.

This article was first published in the November 2024 issue of Butterworths Journal of International Banking and Financial Law.

Our global Sustainable Finance & Investment group brings together a multidisciplinary global team that provides clients with best-in-market support.  We are following the development of ESG regulation in the UK, the EU and globally closely so please get in touch if you would like to discuss.

This note is intended to be a general guide and covers questions of law and practice. It does not constitute legal advice.