www.ifc.org/thoughtleadership NOTE 66 • MAR 2019 Blended Concessional Finance: Governance Matters for Impact By Kruskaia Sierra-Escalante, Arthur Karlin & Morten Lykke Lauridsen Blended concessional finance, the combination of concessional funds with other types of finance on commercial terms, has great potential to mobilize capital and accelerate high-impact private sector investments in new and challenging markets. Yet full development of these efforts requires strong governance. IFC has been working for some time to develop a robust governance system for blended concessional finance, guided by the Development Finance Institutions Enhanced Principles, a set of principles that employ special operating procedures and checks and balances when using blended concessional finance for private sector projects. While no universal approach will fit all implementers of blended concessional finance, good governance is a common challenge. These institutions need to learn from each other to ensure good governance, as the sharing of experiences is crucial to building global trust in the use of concessional funds. And to work well, governance structures need to be transparent and focus on solving potential conflicts of interest. The combination of concessional funds and other types of launch important private projects and crowd in sources of finance on commercial terms is called blended concessional commercial finance. These first demonstration projects can finance.1 It can play a central role in creating and help unlock new markets. reinforcing markets in developing countries and can help Commercial finance and development finance institution these countries reach their development goals. This type of (DFI) finance at commercial terms can address the finance has great potential for development impact through financing needs of many projects (Figure 1). Blended the provision of finance to private firms where access to concessional finance is used where impactful and commercial finance is limited. Along with advisory services transformative development projects cannot be and policy reforms, it can be part of a comprehensive implemented on fully commercial terms and need a solution to overcome constraints that prevent private sector temporary push to move forward. led growth. With the increasing focus on providing development The focus of IFC and World Bank Group efforts in private finance to high-risk and lower-income countries, blended sector development is increasingly moving toward high-risk concessional finance is becoming more and more environments and lower-income countries where needs are important, and strong rules are therefore needed to avoid greatest. In these difficult environments there may be a misuse or ineffective use of such funds. 2 need for temporary use of some concessional funds to help About the Authors Kruskaia Sierra-Escalante, Senior Manager, Blended Finance—New Business and Portfolio, Blended Finance, Economics and Private Sector Development, IFC; Arthur Karlin, Consultant, Blended Finance—New Business and Portfolio, Blended Finance, Economics and Private Sector Development, IFC; and Morten Lykke Lauridsen, Principal Economist, Thought Leadership, Economics and Private Sector Development, IFC. Their emails are ksierraescalante@ifc.org, akarlin@ifc.org, and mlauridsen@ifc.org. 1 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. These principles include: Lower-risk commercial activities • Economic Rationale for Using Blended Fully (Commercial investors) Concessional Finance. Concessional finance should commercial be used for projects that contribute significantly to Higher-risk commercial market development. This generally means that the activities (DFIs) financing will help overcome a market failure and provide returns to society beyond the investors’ returns. Area of Not fully commercial By facilitating and pioneering private sector projects, focus Gap: In need of temporary subsidy significant improvements can be achieved in the enabling environment, and private markets can then become Requires Not fully commercial open to additional companies that can operate without subsidy Gap: Needs a long-term subsidy concessional support. • Crowding-in and Minimum Concessionality. Since Permanent Subsidy (Government / NGOs) concessional funds are scarce, they should be used to the minimum extent possible to make projects viable and attract as much private commercial finance as possible. • Commercial Sustainability. Projects and sectors need to FIGURE 1 When Blended Concessional Funds Make Sense become commercially sustainable over time to contribute to Source: IFC market development. Investments should thus have a clear path to sustainability, with a plan for how concessionality in the sector can be phased out over time. Operating Principles for Blended Concessional Finance • Reinforcing Markets. Concessional funds should While blended concessional finance can help achieve high create and reinforce markets. Markets started with development impact by creating markets where normal DFI concessional funds can become dependent on subsidies, or commercial finance is not sufficient, use of concessional preventing commercial players from engaging. To avoid finance by definition cannot apply the “market test” this, attention should be given to all aspects of the that disciplines commercial finance by requiring that market that are preventing the viability of commercial projects provide adequate returns on investment. Without projects, such as issues with respect to regulations, this test, special analyses and processes are needed to suppliers, and skills. Supplementary advisory services determine if a project is worthy of support and if the right and capacity building interventions may be required to amount of concessionality is being used. The required address these issues. analytical processes must also guard against potential negative outcomes from the use of concessional resources, • Promoting High Standards. All development projects including unnecessary allocation of subsidies to DFIs or should have high standards for environmental, social, other investors, or the creation of barriers to entry for and other issues, but those with concessional finance commercial institutions, which can undermine market have a particularly high burden because of the direct development. public contributions. The use of concessional finance also requires strong governance processes to ensure that Development finance institutions that invest in the private all the above principles are implemented. sector have agreed to a strong set of operational principles (the DFI Enhanced Principles) that specifically address Overall, in deploying blended concessional finance based on these issues. the DFI Enhanced Principles, it is essential to apply analytical rigor and transparency in assessing market failures, determine the size of temporary subsidies that may be needed, and DFI Enhanced Principles for Blended Conces- evaluate the potential for market creation and development sional Finance in Private Sector Operations impact from providing concessional support. • Economic Rationale for Using Blended Key Role of Governance for Concessional Finance Blended Concessional Finance • Crowding-in and Minimum Concessionality The presence of concessional funds can affect the • Commercial Sustainability profitability and risk profile of an investment project and the expected returns and risks for other investors in the • Reinforcing Markets project. There can thus be a conflict of interest between • Promoting High Standards the providers of concessional funds and DFIs or other suppliers of funds on commercial terms. Without strong 2 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. IFC Management/ Decision Structures IFC Processes Analytics Project Structures • Separate concessional fund • Blended concessional • Concessional element • IFC investment with donor teams finance principle addressed • Analysis of Expected Rate • Sponsor investment in the • Independent decision throughout project cycle of Returns project making through Blended • Same policies as IFC • IFC’s strategy processes • Performance incentives Finance Committee or • Presentations to Blended the Blended Finance Finance and Investment Department Director Committees • Training/Guidelines • Transparency—Donors, Board, Public FIGURE 2 Elements of IFC Governance for Blended Concessional Finance Source: IFC discipline, development finance institutions may seek to Conflict-of-interest issues are also common in the financial employ concessional financing beyond what is required industry. For example, in private equity funds there can be to make projects viable in an attempt to improve their different interests between general partners who receive fees own financial returns or to improve the financial returns and manage several funds, and limited partners who invest of project sponsors or other investors beyond what is in the funds. These conflicts are managed through agreed necessary to allow a project to proceed. As financial decision rules regarding different investment situations, institutions, DFIs may also have volume targets in certain and in many cases the use of limited partner investment sectors that lead them to focus on getting deals done even advisory committees that review transactions where there when there is not a clear path to commercial sustainability. is a potential conflict. Another example is in commercial Governance structures are therefore needed to manage banking, where there may be a need to ensure that loan these potential conflicts and ensure maximum impact of officers with volume targets maintain high credit standards. scarce concessional funds. To provide the needed checks on investment departments, a separate, independent credit department can be employed Implementing the DFI Enhanced Principles also introduces to approve all loan decisions. important requirements for analysis outside of the normal governance processes of DFI operations, such Thus, although approaches to managing conflicts of interest as identifying the economic rationale for concessional vary greatly depending upon the situation, approaches finance, assessing minimum concessionality, and can include transparency of decision making, independent considering whether it will be feasible to phase out decision reviews or separate decision-making bodies, concessional finance over time. It requires clear processes restrictions on certain information sharing, and detailed and experience to make these assessments, although care processes to ensure rules are observed and appropriate should be taken to ensure these added processes do not analyses are done. These lessons should be deployed for unnecessarily slow down project execution. finding the best possible solutions for handling potential conflicts of interest in DFIs and others engaging in their use Demand for special governance arrangements where there of blended concessional finance. are potential conflicts of interest is by no means new in the financial sector or among DFIs, and methods for dealing IFC’s Governance for Blended Concessional Finance with the requirements for blended concessional finance has been sought from similar situations. For example, Drawing on some of the experiences and ideas highlighted within DFIs, a common issue is the potential for conflicts above and the DFI Enhanced Principles, IFC has been between providing advice to governments and investing developing, in accordance with its policies and procedures, directly in projects affected by that advice. Managing these structures and processes to ensure strong governance when situations usually involves the separation of investment and using blended concessional finance. The major structures and advisory teams, clear rules about what data can be shared processes are highlighted in Figure 2 and are discussed below. between teams, and disclosure to all parties involved about Team Structures the potential for conflicts of interest and the processes employed to manage those conflicts. IFC has established a dedicated team to handle concessional finance investments, separate from the 3 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. investment teams that manage IFC’s own funds. Although level of concessionality in similar projects.3 Minimum separately staffed and managed (reporting to different concessionality may also be determined by examining management up to the vice president level), the teams expected returns on the project, with a comparison to share information on the project and work in partnership. appropriate benchmarks. However, the concessional finance team represents the Blended concessional finance projects also go through interests and monitors the engagement requirements of the the normal IFC decision processes which, under IFC’s concessional finance providers in the transaction, both at Creating Markets strategy, provide a holistic focus on all the investment stage and during portfolio supervision. This elements, public and private, that are necessary to create ensures that donor financial interests and development and reinforce markets. This includes extensive diagnostics requirements are strongly represented, and that of key private sector constraints with the World Bank, concessional finance principles are observed. The blended a private sector development strategy in each country, finance team may be supported by sector economists in the the Maximizing Finance for Development and Cascade identification and analysis of the economic rationale for approach4 to ensure public and private actions are used in providing concessionality. an appropriate mix to open markets, and application of Decision Processes technical assistance to help open markets where needed. In addition, staff managing blended concessional finance IFC also uses a senior level, independent decision-making projects must articulate how the projects are reinforcing process for blended concessional finance, either through markets, presenting this information to the Blended Finance the Blended Finance Department Director, who reports to Director or the Committee and in Board documents. a vice president outside of operations, or, for more complex or non-routine projects, through a special committee called Staff Guidelines, Training, Internal Promotion the Blended Finance Committee. This committee is chaired IFC offers internal training programs for investment by an IFC vice president outside of operations and is officers on adherence to concessional finance principles. comprised of directors who are not involved in the project Joint sessions have also been held between blended finance and do not oversee IFC’s own account investment. If any investment staff and IFC sector economists to refine potential conflicts of interest are identified, the committee’s the techniques for understanding and articulating the members may recuse themselves from the decision. The economic rationale for blended finance. Approval templates committee or the Blended Finance Director reviews and and Board and Blended Finance Director/Committee approves the use, structure, and terms of concessional documentation includes discussions on adherence to donor funds at both project concept and approval stages concessional finance principles. Training on blended finance and is also involved in important decisions with respect to and concessional finance principles is included for all new any significant portfolio events, including restructurings. staff at the induction course for IFC. The team managing the concessional funds leads the presentation of each project to the Blended Finance Reporting, Monitoring, and Transparency Director or the committee, and most donors delegate full IFC strives to have donors and Board members fully decision-making for use of their concessional funds to IFC. informed about the important aspects of blended Embedding Concessional Finance Principles and Analytics concessional financial transactions. Reports to donors generally include projects funded, expected impact, and IFC teams managing concessional funds participate rationale for blended concessional finance, as well as details throughout the project cycle and are responsible for on the concessional co-investment. Board reports for each applying IFC’s principles with respect to concessional project include a section discussing the economic rationale finance, drawing from the DFI Enhanced Principles. for blended finance and other blended concessional finance IFC policies require teams to use the same standard principles and how they apply to the project. Board of care for donor funds as they would with IFC’s own reports also include the project structure and the role funds. This includes the use of qualified staff and the and amounts of concessional finance, including the level application of relevant policies and procedures, including of concessionality as a percent of total project cost. For environmental and social performance standards and measuring impact, all IFC projects are evaluated using integrity due diligence with respect to lead investors and the “Anticipated Impact Measurement and Monitoring” project managers. Specific discussion of concessional (AIMM) framework that measures project contributions to finance principles is required at early endorsement and final market creation along the dimensions of competitiveness, approval stages of projects and in project Board documents. integration, resilience, inclusion, and sustainability.5 On Special analyses are often required to ensure adherence average, blended finance projects tend to have higher to concessional finance principles. For example, to help AIMM scores than IFC’s projects not supported by donor assess and justify minimum use of concessional funds, a funds. This provides another element of comfort that quantification of the concessional element in a project is concessionality is delivering additional impact. required, including, when relevant, a comparison to the 4 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Public documents regarding IFC’s blended concessional commercially), to align interests between IFC and the finance projects include pre-board disclosure that blended donor. Thus, in case of a restructuring, IFC would have concessional finance will be used and, when possible, the a similar interest to the donor in negotiating the possible instruments employed and financing amount, and may levels of compensation for holders of the subordinated include the rationale for use of concessional finance. If debt. While this is not always possible, in particular in requested by donors, public donor reports are prepared the context of low-income countries and fragile situations showing projects funded and expected impact. Also, where there are no markets, strong governance structures overall levels of blended concessional finance used by IFC, can help assess when this alignment of interest is desirable and the total cost of the projects financed, are released in or possible. public documents including the annual report. Since 2017, the DFI Working Group on Blended Concessional Finance Different Approaches to has also been reporting on blended finance activities Handle Conflicts of Interest across 23 institutions, including leverage, breakdowns of In addition to IFC, many DFIs have been making volumes by instrument and, more recently, volumes by significant progress in implementing concessional finance country income level. principles, including strengthening their decision-making Project Structures and governance processes and internal capabilities.6 Many institutions have made a priority of having strong IFC generally requires certain structural features for operating guidelines that specifically draw on the Enhanced investments to provide appropriate incentives for all parties Principles, as well as transparency regarding concessional involved to strive to achieve commercial sustainability. For funds use. DFIs are also putting in place various types example, IFC’s approach to blended finance requires an of checks and balances on the use of concessional funds. own-account investment in all blended concessional finance Although there are many variations of these checks and projects and requires that sponsors are directly invested in balances, some of the main approaches include: the project. These are important elements to align interests across relevant stakeholders. For financial institution • Team structures range from: 1) use of regular projects targeting small and medium-sized enterprises, operational staff for structuring both the concessional concessional funds are often provided in the form of finance and any DFI own-account finance, but performance-based grants, to incentivize the achievement with special detailed policies and guidelines for use of development targets. of the concessional funds, and with independent internal reviews; 2) use of dedicated and independent IFC Blended Finance Governance Systems in Action concessional finance staff, working with regular An example can illustrate how the IFC Blended investment units, representing blended concessional Concessional Governance structures can improve projects. finance issues in approval committees; and 3) independent concessional finance teams reporting to IFC was considering financing the construction of one management outside of the investment departments. of the first solar power plants in a lower middle-income country in Latin America, which would demonstrate the • Decision committees also vary. Some DFIs have a feasibility of utility scale solar projects in the country separate blended concessional finance committee, while and region. Due to country risks, first mover challenges others use the regular approval committees, but rely on with the new technology, and limited financing from the specialized and independent concessional finance international and local banks, the project was not bankable staff or teams to represent the donor viewpoints. A third on commercial terms. approach is to use the regular approval committees for decision-making, but with the advice and review of To make this project viable required a combination of an independent technical level committee, which can concessional and DFI senior loans to improve the cash be composed of in-house experts not connected with flow, and concessional subordinated debt to improve the operations and may include outside experts and peers. risk profile for senior lenders. Initially the project was structured with donor, IFC, and commercial senior loans The type of structures for checks and balances used by and a donor subordinated loan. DFIs are driven by several factors: However, lessons from previous investments indicated that • Level of interaction with donors. Some donors sometimes subordination of donor investments to senior approve each project, providing a strong level of lenders can be difficult to manage, as conflicts regarding oversight that reduces the need for checks and balances losses and payments can arise between IFC and other within the DFI. Other donors delegate decision-making senior lenders and the sub-lenders when there are financial on individual projects to the DFI, placing a stronger issues. The IFC Blended Finance Committee therefore requirement for independent decision structures within conditioned the larger donor sub loan on IFC investing a the institution. small amount in the form of a sub loan (in that case priced 5 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. • Volume of blended concessional finance Second, the incentives of the different actors involved in operations. Separate concessional finance units and blended finance transactions need to be understood from decision-making committees require a large volume the start of any transaction, as the motives of a financial of activity to support overhead costs but may be intermediary might be different from those of donors. justified over time. For example, at IFC, the governance The governance structures should focus on managing structures evolved in stages as blended concessional potential conflicts of interest and on implementing strong finance grew over almost two decades. principles for the use of concessional finance, based on the DFI Enhanced Principles. This is even more crucial as • The need for processing speed. Separate decision concessional finance is entrusted to private sector actors committees introduce an additional decision layer in that may not have experience in managing public resources investment processing and can slow processing down. or providing concessionality to private sector operations. One way some DFIs address this issue is to use blended concessional finance committees on an exception basis, Third, any governance solution for the use of blended that is, only in cases with special issues, and delegate concessional finance should be based on transparency, decision-making for other projects to lower levels. both for private and public actors involved in investments. Disclosure of information on concessionality is essential to Going Forward—Key Issues providing the required trust among all actors and should be a key element of DFI cooperation. DFIs should also Effective management of concessional funds requires share evaluations and monitoring of results from the use of different operating processes and decision-making concessional funds. structures to implement appropriate principles and to address potential conflicts of interest. As demonstrated in ACKNOWLEDGEMENTS this paper, there are a range of structures and processes that can be employed to achieve effective governance, The authors would like to thank the following colleagues for depending on each DFI or other blended finance their review and suggestions: Martin Spicer, Director, Blended implementer’s specific circumstances. Finance, Economics and Private Sector Development, IFC; Nneka Okafor, Counsel, Conflict of Interest Office, IFC; To scale up the use of blended concessional finance, strong Neil Gregory, Chief Thought Leadership Officer, Thought governance is required that ensures impact, the crowding Leadership, Economics and Private Sector Development, in of private investments, and trust for the donors that IFC; and Thomas Rehermann, Senior Economist, Thought provide concessional funds. Going forward, three issues Leadership, Economics and Private Sector Development, IFC. are key for progress: Please see the following additional EM Compass Notes First, DFIs need to continue to share experiences with about blended finance in emerging markets: Blended different governance approaches in order to make Concessional Finance: Scaling Up Private Investment in Lower-Income improvements that ensure that concessional funds are used Countries (Note 60); Blended Finance - A Stepping Stone to Creating effectively and efficiently, with maximum impact on market Markets (Note 51); Blending Public and Private Finance (Note 3). creation. Governance models should evolve based on their effectiveness, with a joint vision of learning from each other. 1 The DFI Blended Concessional Finance Working Group defines blended concessional finance as Combining concessional finance from donors or third parties alongside DFIs’ normal own account finance and/or commercial finance from other investors, to develop private sector markets, address the Sustainable Development Goals (SDGs), and mobilize private resources. 2 For a discussion of DFI use of blended concessional finance in lower-income countries, see Sierra-Escalante, Kruskaia, Arthur Karlin and Morten Lykke Lauridsen. 2018. “Blended Concessional Finance: Scaling Up Private Investment in Lower-Income Countries.” EM Compass Note No. 60, November 2018. 3 The “concessional element” is the grant equivalent of any concessional finance instrument. For instance, the “concessional element” of a grant is 100 percent, while the concessional element of a low interest rate loan might range from 5 to 25+ percent. 4 Under the World Bank Group’s Maximizing Finance for Development approach, private sector solutions to development are prioritized first so that scarce public resources are devoted to those areas where they are most needed. Where private sector solutions are not yet possible, advice is provided to governments to improve the investment climate so that private sector solutions can become viable. Where full commercial private sector investments are still not viable, concessional funds may be used along with commercial finance to help launch important private sector projects. See World Bank Group. 2017. “Maximizing Finance for Development: Leveraging the Private Sector for Growth and Sustainable Development.” Report prepared by the World Bank Group for the Development Committee, September 17, 2017, pp. 1–2. 5 For more information on IFC’s AIMM framework see: https://www.ifc.org/wps/wcm/connect/topics_ext_content/ifc_external_corporate_site/ development+impact/areas+of+work/sa_aimm 6 “DFI Working Group on Blended Concessional Finance for Private Sector Projects, Joint Report.” 2018. https://www.ifc.org/wps/wcm/ connect/9ae7c66a-d269-4707-9f4d-0fb79947ede8/201810_DFI-Blended-Finance-Report.pdf?MOD=AJPERES 6 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. This material is copyrighted. Copying and/or transmitting this work without permission may be a violation of applicable law. 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The contents of this work are intended for general informational purposes only and are not intended to constitute legal, securities, or investment advice, an opinion regarding the appropriateness of any investment, or a solicitation of any type. The findings, interpretation, views and conclusions expressed herein are those of the authors and do not necessarily reflect the views of the Executive Directors of the International Finance Corporation or the International Bank for Reconstruction and Development (the World Bank) or the governments they represent. Additional Selected EM Compass Notes Previously Published by IFC Thought Leadership MARCH 2019 APRIL 2018 Note 65: Natural Gas and the Clean Energy Transition Note 53: Crowding-In Capital Attracts Institutional Investors to Emerging Market Infrastructure Through Co-Lending FEBRUARY 2019 Platforms Note 64: Institutional Investing: A New Investor Forum Note 52: Crowding-In Capital: How Insurance Companies and Growing Interest in Sustainable Emerging Markets Can Expand Access to Finance Investments Note 51: Blended Finance—A Stepping Stone to Creating JANUARY 2019 Markets Note 63: Blockchain and Associated Legal Issues for JANUARY 2018 Emerging Markets Note 48: Increased Regulation and De-risking are Impeding Note 62: Service Performance Guarantees for Public Utilities Cross-Border Financing in Emerging Markets and Beyond—An Innovation with Potential to Attract Investors to Emerging Markets OCTOBER 2017 Note 47: From Farm to Fork: Private Enterprise Can Reduce NOVEMBER 2018 Food Loss Through Climate-Smart Agriculture Note 61: Using Blockchain to Enable Cleaner, Modern Energy Note 46: Precision Farming Enables Climate-Smart Systems in Emerging Markets Agribusiness Note 60: Blended Concessional Finance: Scaling Up Private Investment in Lower-Income Countries SEPTEMBER 2017 Note 45: Beyond Fintech: Leveraging Blockchain for More OCTOBER 2018 Sustainable and Inclusive Supply Chains Note 59: How a Know-Your-Customer Utility Could Increase Note 44: Blockchain in Financial Services in Emerging Access to Financial Services in Emerging Markets Markets—Part II: Selected Regional Developments Note 58: Competition Works: Driving Microfinance Note 43: Blockchain in Financial Services in Emerging Institutions to Reach Lower-Income People and the Markets—Part I: Current Trends Unbanked in Peru AUGUST 2017 SEPTEMBER 2018 Note 42: Digital Financial Services: Challenges and Note 57: Blockchain Governance and Regulation as an Opportunities for Emerging Market Banks Enabler for Market Creation in Emerging Markets JULY 2017 JULY 2018 Note 41: Blockchain in Development—Part II: How It Can Note 56: A Practical Tool to Create Economic Opportunity Impact Emerging Markets for Low-Income Communities Note 40: Blockchain in Development—Part I: A New JUNE 2018 Mechanism of ‘Trust’? Note 55: Peru’s Works for Taxes Scheme: An Innovative JUNE 2017 Solution to Accelerate Private Provision of Infrastructure Note 39: Technology-Enabled Supply Chain Finance for Small Investment and Medium Enterprises is a Major Growth Opportunity for MAY 2018 Banks Note 54: Modelo Peru: A Mobile Money Platform Offering MAY 2017 Interoperability Towards Financial Inclusion Note 38: Can Blockchain Technology Address De-Risking in Emerging Markets? 7 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. IFC 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 U.S.A. ifc.org/ThoughtLeadership