The next wave of development finance innovation

Impact investing has typically been a practice reserved for foundations, private equity or venture capitalists, but a new crop of alternative investment opportunities are emerging that are bringing traditional financial institutions more into the mix. In practice they are merely slight variations to the everyday debt and equity instruments that banks deal with in large volumes every day. But these financial products add a development objective to an investment goal and establish a key link between sustainability targets and commercial capital.  

In doing so they address a major funding dilemma facing social enterprises and sustainability-focused small and medium-sized enterprises. Never before has so much capital been available at such low costs, yet very little of it makes it way to social enterprises. An estimated $210 trillion is currently invested commercially by institutional and retail investors around the world. On any given day, global banking giant Citigroup alone moves $3 trillion through its system.

But funding gaps for social enterprises and SMEs are pressing. In developing countries it is estimated to range between $2.1 trillion and $2.5 trillion — the result of being too big for microcredit and too small for commercial loans.

Commercial finance can and should play a large part in funding a sustainability agenda.

“There is a role for finance to provide a solution where there has been market failure for the provision of a global public good,” Caroline Anstey, global head of UBS and Society, the Swiss banking giant’s impact investing arm, told Devex. “The key is to do things that are going to make sense and be marketable as well, because if you want to scale up projects they have to appeal to investors.”

Here are some innovative financial instruments that aim to do just that:

Development impact bonds

An offshoot of social impact bonds, they are an emerging option to link commercial finance with development goals. They are results-based contracts in which an investor provides upfront capital and is paid back principal plus a return if certain targets or objective are met. These objectives are often sustainability targets or results linked to social programs and development initiatives.

Development impact bonds are not bonds in the traditional sense in which coupon or interest payments come at fixed intervals. Repayment is contingent on the achievement of specified social outcomes, with a possibility that an outcome may not be achieved altogether. Development impact bonds therefore more closely resemble an equity investment than a conventional debt instrument.

UBS and Mumbai, India-based NGO Educate Girls are currently involved in the world’s first and only commercial-scale development impact bond. The Swiss banking giant is the principal investor, providing $267,000 over a three-year period that goes towards funding educational programs and boosting primary school enrollment rates in India. Under the arrangement, Educate Girls is the service provider and operates a program that aims to enroll 18,000 children from 150 villages across Rajasthan.

For every increase in female enrollment and the attainment of other educational targets, the outcome payer — the Children’s Investment Fund Foundation — will pay UBS a portion of a return on its investment. As with any investment, UBS assumes the first loss risk should any targets not be met.

Development impact bonds give banks an opportunity to invest in development projects and earn a return that is not generated through donations or charitable giving. It allows them to fulfil their core objective of seeking a return on investment. For civil society program implementers, a development impact bond can be a useful option for leveraging a foundation’s finances to mobilize early volumes of commercial capital for development.

However, the transaction costs of both principal and return can be quite burdensome for outcome payers. They must also consider whether those financing costs are truly producing a saving over other intervention programs. It can be a cumbersome process and is one reason why development impact bonds have been slow to scale.

Social success note

Similar to a development impact bond, but adding a slight twist, is the social success note. It also aims to leverage commercial capital for social impact by serving as an agreement for an outcome payer to reward an investor with a yield if a social enterprise achieves certain pre-agreed targets.

However, with social success notes the social enterprise pays back the principal and the outcome payer only has to pay out a bonus for every outcome achieved, allowing philanthropic dollars to go further. Yunus Social Business — a social accelerator that incubates and finances local entrepreneurs — is partnering with the Rockefeller Foundation to create the first social success note and prove the concept. Through this structure, the model assumes that the note will achieve a unique distinction of creating a market price for both sources of value creation by a social enterprise — financial and social outcomes.

The idea behind the difference with development impact bonds, according to Yunus Social Business Founder and Chief Executive Saskia Bruystein, is that it allows a social enterprise to focus on its mission and to grow it operating model, without worrying about payments which would otherwise drive them upmarket and away from a base of the period target market.

Green bonds

A popular sustainability-focused financial instrument that is more widely issued by commercial entities and which will likely come in greater focus in the run-up to the next United Nations climate summit in December are green bonds.

A green bond is a debt security that is issued to raise capital specifically in support of climate-related or environmental projects. Those projects typically include renewable energies, energy efficiency, sustainable waste management, clean transportation, biodiversity, sustainable land use and climate change mitigation and adaption. The green bond market has grown exponentially in recent years, going from $4 billion in 2010 to over $37 billion in 2014, according to the World Bank.

The World Bank and its private sector lending arm, the International Finance Corp., are active issuers in the market. As of June 2015, the World Bank has issued $8.5 billion through more than 100 green bond transactions in 18 currencies that have supported roughly 70 climate mitigation and adaptation projects in the developing world. The IFC, meanwhile, has issued more than 37 green bonds to date that have raised approximately $3.8 billion in nine currencies.

But private commercial lenders are also active in the green bond market. Bank of America has issued two green bonds — one for $500 million in November 2013 and another for $600 million in May 2015 — to finance renewable energy projects in solar, wind, geothermal and energy efficiency.

Green bonds are a convenient and conventional way for sustainability-focused investors to channel their resources into investments that aim to produce specific environmental impacts. To promote transparency for shareholders and investors around the investment process, a consortium of the world’s largest investment banks developed a set of green bond principles in 2014. The principles were drafted with input from investors and environmental groups to boost disclosure and integrity in the development of the green bond market.

Pandemic bonds

The Ebola outbreak in West Africa last year advanced the idea of pandemic bonds as a potential financial instrument to address future crises. Pandemic bonds have yet to reach commercial scale but they are a similar concept as the more widely traded catastrophe bonds. It would involve a public entity issuing a bond to an investor, with the understanding that the investor would forfeit the principal repayment if a public health pandemic were to occur. The principal payment would instead go towards various expenditures to mitigate the public pandemic. Absent the pandemic, investors would be paid back a healthy return.

Catastrophe bonds are commonly issued securities by insurance companies to mitigate the risks that they face in covering large premiums for serious natural disasters. The World Bank has adopted the practice as well, issuing it first catastrophe bond last year. Its three-year $30 million transaction is intended to cover earthquake and tropical cyclone risks in 16 Caribbean countries.

The social returns for a similar investment vehicle to cover pandemics and disease outbreaks can be enormous. Studies have shown that one dollar spent early on can save $20 or more later on in disaster relief. But the extension of the concept to pandemic bonds issued by governments to capital markets is still in its infancy. The idea is gaining traction, however. Earlier this year at the World Economic Forum in Davos, World Bank President Jim Kim outlined a plan to create a global fund that would issue bonds to finance pandemic-fighting measures such as advanced training for health care workers.

But finding a suitable pricing mechanism for pandemic bonds is a difficult challenge for potential issuers. Because of their low default rate, catastrophe bonds — and likely pandemic bonds — are attractive for investors and expensive for issuers. Insurance industry experts have said that in order to accept a one percent chance of default, investors typically require about a three percent yield.

A question that issuing entities such as governments must grapple with, therefore, is whether it would be better to pay $3 million to support a bond issuance that has a one percent probability of paying out $100 million? Or whether that $3 million itself can be invested in preventative measures.

Development impact bonds, social success notes, green bonds and pandemic bonds are only a shortlist of a growing cadre of financial instruments that allow commercial capital to invest in sustainability targets. Capital markets are expected to play a large role in financing the recently agreed Sustainable Development Goals and these types of alternative investment vehicles provide a key link in that process.

Article taken from https://www.devex.com/news/the-next-wave-of-development-finance-innovation-87139