An introduction to blended finance: an underutilised tool for driving positive impact and competitive returns
- Juan Lois
- Apr 1
- 4 min read
Updated: Apr 16
In this first part of our three-part series on blended finance and its dual role supporting investment for impact and returns, we discuss the fundamentals of this investment structure. In future posts, we will discuss practical applications of blended finance vehicles available to faith-based asset owners and examine actual investments that successfully integrated the principles of blended finance.
The problem
When undertaking impactful projects, particularly in emerging markets or sectors addressing critical societal challenges, project sponsors frequently encounter a fundamental financing gap.
The expected financial returns simply don't align with the risk profile or return expectations of conventional market-rate investors. This misalignment creates a persistent obstacle: despite the project's potential social, environmental, or developmental significance, it struggles to attract sufficient capital when relying solely on market-rate investment sources. Project sponsors find themselves in a challenging position, unable to proceed with initiatives that could deliver meaningful impact.
The solution
The challenge of this financing conundrum has led project sponsors to pursue the necessity of securing alternative funding approaches—specifically, strategically incorporating the use of grants and catalytic capital that can help mitigate risks for market-rate investors, thereby unlocking the full spectrum of capital needed to bring these valuable projects to fruition.
This approach is often referred to as blended finance and it has long been considered a viable strategy for organizations, including faith-based entities, to address some of the world’s most pressing environmental and social challenges, while also generating attractive financial returns. Despite its robust and relatively successful history, however, with some estimating that blended finance has mobilized ~$249bn in capital towards sustainable development in developing countries to-date[1], many faith-based investors have yet to take advantage of this unique structuring approach to help achieve their values-based and fiduciary-focused investment objectives.
Overview of blended finance
A core characteristic of blended finance structures is that they allow organizations with different objectives to invest alongside each other and simultaneously achieve their own goals. Collectively, this makes the project viable and allows project sponsors to attract additional capital. For example, investors primarily focused on generating social/environmental impact (such as development finance institutions (DFIs) or philanthropic investors) will provide risk-tolerant, catalytic capital (i.e., concessionary / below market rate) in a way that allows institutional investors to receive the higher market rate return they are seeking, which more closely aligns with their long-term return targets.
In effect, this structuring approach can significantly scale the amount of public and private capital flowing to solutions such as renewable energy, affordable housing, healthcare, education, and agricultural projects, where traditional market mechanisms often fall short.
How blended finance works
Blended finance is built on the notion that investors in a given fund will be repaid in a specific order (i.e., a tiered capital structure) and at varying rates of return based on the amount of risk they are willing to take. Each tier in the capital structure is often referred to as a “tranche”.
Think of a blended finance project like a multi-layered cake, where each layer serves a different purpose while contributing to the whole dessert. The "tranches" in finance work much like these layers—they're distinct portions of the overall investment that carry different levels of risk and reward. Just as you might choose a slice with more frosting or fruit based on your preference, investors select tranches that align with their risk tolerance and return expectations. When it's time to serve the cake, some layers are consumed first (like senior tranches getting repaid first), while others wait their turn (like junior tranches). This layered approach allows different types of investors—from conservative institutions to impact-focused organizations—to participate in the same project while meeting their unique financial requirements.
It’s worth noting that an additional mechanism is often put in place to further mitigate the risks to which the senior tranche investors are exposed. This mechanism is known as first loss protection. Concessional capital from DFIs/philanthropic sources often serves as a form of subordinated debt that commits to absorbing any initial losses from underperforming loans, thus providing the first layer of “loss protection”.
First loss protection is particularly beneficial for institutional investors because it allows them to engage in investments with a lower risk profile, knowing that they have a cushion against potential losses, which ultimately enhances the attractiveness of the senior tranche for investors seeking market rate returns. Overall, this setup makes projects more palatable to traditional and values-based investors who might otherwise avoid riskier ventures.
Common blended finance investment structures
The following is a summary of common blended finance tranches, including key elements of each tranche, offered to meet different risk appetites and varying return expectations:
Senior Tranche: This tranche typically receives priority in repayment, offering lower risk and therefore lower expected returns, typically targeting a range of 3% - 7%. It often attracts institutional investors seeking stable, market-rate returns. The risk to senior tranches frequently equates to a bond with an investment grade rating.
Mezzanine Tranche: Positioned between senior and junior tranches, mezzanine financing has a higher risk but potentially higher returns compared to senior debt. It might serve investors willing to accept more risk in exchange for the possibility of enhanced returns, with return targets typically ranging from 8% - 12%.
Junior Tranche: This tranche faces the highest risk, as it is the last to be repaid in times of default and is often filled by catalytic or concessional capital provided by DFIs, philanthropists, or other entities that can accept lower rates of return to prioritize generating and scaling social and/or environmental impact. Despite this tranche having the highest risk, return targets generally range from 0% - 10%.
Conclusion
Blended finance can play a pivotal role in mobilizing resources toward projects that create lasting, positive impact around the world, while also generating returns that meet a range of investor expectations. By creating a tiered return structure, based on varying levels of expected risk and return, and offering risk mitigation mechanisms like first loss protection, blended finance structures provide a viable solution to helping fund the financing gap that arises from high impact projects/loans in high risk or emerging/frontier markets.
In the next article in this series, we will focus on practical ways in which faith-based and traditional investors can leverage their capital to participate in these innovative and impactful structures.
