Introduction to blended finance, part II: A creative solution for impact & returns

In this second part of our three-part series on blended finance and its dual role supporting investment for impact and returns, we dive deeper into the mechanics of blended finance structures and discuss practical ways in which faith-based asset owners can participate. In our next and final post of the series, we will provide real examples of actual investments that successfully integrated the principles of blended finance to maximise impact and returns.

Review of common blended finance structures

As we discussed in our first post of the series, blended finance structures allow organisations with different objectives to invest in a project alongside each other and simultaneously achieve each of their unique goals. These structures serve as a viable solution to the common financing gap that often arises in projects with positive social or environmental impact goals. This is particularly relevant in emerging or frontier markets, when the financial return expectations of the project, absent a blended finance approach, don’t align with the risk profile or return expectations of conventional market-rate investors. These market rate investors are crucial as they provide the project with the necessary levels of investment that make the whole project viable.

To solve for this issue, blended finance structures offer a creative solution that gives institutional investors the market-rate returns they are seeking, while ensuring that other investors in the project, like development finance institutions (DFIs) or foundations, receive the environmental or social benefits they are seeking.

Here's how it works in practice:

Institutional investors commit capital with substantial risk protection measures in place, significantly increasing the likelihood of both recovering their principal investment AND achieving competitive, market-rate returns.
Meanwhile, other investors (like DFIs and foundations) lend their money to primarily support economic development and positive environmental and/social impact. They are less concerned with receiving a market-rate return and are willing to take on additional risk to achieve the impact they are seeking.
Providing institutional investors with the assurance they need that they’ll receive the market-rate returns they seek is challenging though. To accomplish this, the project manager secures commitments from grant makers, philanthropies, or other providers of catalytic capital to absorb significant losses from underperforming loans or defaults, thereby shielding institutional investors from risk exposure except in extraordinary events.
The project manager also secures commitments from investors primarily seeking economic development / impact to accept subordinated repayment positions, ensuring institutional investors are repaid ahead of them. This arrangement provides institutional investors the best chance of receiving market-rate returns they require to participate in the investment.

This type of structure is called a tiered capital structure that incorporates first-loss protection. Each tier – referred to as a tranche – maintains different levels of risk and return. Collectively, this structure enhances the overall return profile of the full project and provides each investor with the level of returns they are seeking at the level of risk they are willing to take to achieve their goals.

Typical tranches and characteristics of blended finance structures offered to meet varying risk and return expectations include:

In certain cases, if additional risk protection is needed to make the project viable, a blended finance structure may include an “equity” tranche. This tranche would become the riskiest layer of investment as it would be the first to take losses if the project underperforms and it would be last in receiving repayment. By providing an additional cushion that shields the rest of the tranches, the equity tranche mitigates the risk for the other less risky investors and enhances the overall risk-return profile of the project.

Ways to invest in blended finance opportunities

Blended finance may be particularly attractive for investors with dual investment objectives – such as faith-based asset owners (FBAOs) – who have developed (or are developing) a portfolio-wide approach to investing alongside their values. In addition to negative/positive screening, or a heightened focus on engagement, blended finance offers an additional option to a FBAO’s sustainable investment program that enhances its pursuit of solution-oriented impact investments.

Additionally, FBAOs benefit from a distinctive advantage: they often manage diverse capital pools, each with specific investment objectives and risk/return profiles, making them naturally well-suited to participate across the various layers of blended finance structures. For example, a FBAO’s various pools of capital can be leveraged as follows:

An Investment Portfolio Seeking Market-Rate Returns: This capital can be used to participate in senior tranches of blended finance projects, which often have return targets comparable to traditional investment grade corporate bond portfolios. Senior tranches of blended finance vehicles often benefit from enhanced risk mitigation through first loss protection, often improving the risk-adjusted return profile of the investment.
A Portfolio of Philanthropic Investments: This pool might engage directly in mezzanine or junior tranches where the FBAO is willing to accept a higher level of risk and return for generating significant social or environmental impact.
A Portfolio Focused on Providing Catalytic Capital: Funds set aside for grants and/or below market-rate loans help create the first-loss cushion in blended finance structuring. By accepting higher risk from providing this type of capital, the FBAO improves the risk profile of the overall investment fund, facilitating capital flow from more risk-averse, institutional investors.

Conclusion

Faith-based organisations – particularly those with diverse pools of capital – are in a unique position where they can catalyze impactful projects that align with both their values and their investment objectives by investing in the tranche that best meets their goals. Those that provide first-loss protection play a pivotal role facilitating other institutional investors to participate in senior tranches, creating a compelling case for the scaling of blended finance opportunities that yield both financial gains and social good.

While blended finance structures are complex and challenging, investors seeking to make a positive impact and generate competitive risk/adjusted returns should not be discouraged. Blended finance has been around for decades and there are many experienced asset managers with the requisite skills and track record to successfully deliver these unique and necessary solutions.

Check out the first post in this series: An introduction to blended finance: an underutilised tool for driving positive impact and competitive returns

Disclaimer

FaithInvest is an international nonprofit organisation that empowers faith groups to invest in line with their beliefs and values. FaithInvest is not authorised by the Financial Conduct Authority and does not provide financial or investment advice. Information provided on FaithInvest’s website or its other communication channels does not constitute financial or investment advice. If you wish to receive any form of financial or investment advice, please consult a qualified and independent financial advisor. You should conduct your own due diligence in relation to any investment opportunities or strategies you choose to pursue. FaithInvest does not promote any specific investments or opportunities and cannot therefore accept responsibility for any specific financial or investment decisions you make following participation on its website platform.