Blended finance structures

The problem blending solves

A commercial investor funds a project when its expected return justifies its risk. Many worthwhile projects fall just short: the risk is a little higher, or the return a little lower, than a commercial investor requires. Blended finance closes that gap by placing a layer of concessional or catalytic capital in the structure, on terms that make the rest of the capital acceptable to commercial participants. The concessional layer takes more risk, or accepts a lower return, so that others can commit. When it works it draws in commercial capital that would not otherwise have arrived, an effect usually called crowding in.

Four building blocks

• First-loss capital. A subordinated layer that absorbs losses before anyone else does. It is the most direct way of moving risk away from commercial participants.
• Guarantees. A commitment by a creditworthy party to cover part of a lender’s loss if a borrower defaults. A guarantee requires no cash at the outset, which is why a small capital base can support a large volume of lending.
• Concessional debt. Lending at a lower rate, a longer tenor or with a grace period, placed alongside commercial debt so that the blended cost and profile of the facility become viable.
• Technical assistance. Grant money that pays for preparation, structuring and capacity building rather than the investment itself. It is the least visible building block and often the reason a transaction reaches financial close.

Currency-risk facilities, which absorb the mismatch between hard-currency funding and local-currency revenues, are a fifth block that matters particularly in African markets.

A worked example (illustrative)

Take a R100 million project that a commercial lender will not fund alone. Structured in layers, it might carry R20 million of first-loss capital from a donor-backed facility, R30 million of concessional debt from a development institution, and R50 million of senior debt from a commercial lender. If the project underperforms, the first R20 million of losses falls on the first-loss layer and the next R30 million on the concessional layer before the commercial lender loses anything. The lender is protected until the project’s value falls by half, a position it can price. Nothing about the underlying project has changed. Only the arrangement of risk has.

What blended finance is not

It is not a subsidy paid to a business, and it is rarely a product a business applies for directly. The layering is normally arranged at the level of a fund, a guarantee scheme or an intermediary’s on-lending facility, and a business meets it as a lender or fund offering better terms than the market would. The practical question for a founder is not how to get blended finance, but whose money sits behind the cheque on offer and what conditions came with it. Why blending now funds so much of African startup finance is examined in the market analysis; this lesson is the mechanism underneath it.

Costs and limits

Blended structures involve several parties with different mandates, which means longer timelines, more documentation and higher transaction costs than a single-lender deal. They suit transactions large enough to justify the complexity, or vehicles that spread it across many small borrowers. Concessional capital is also finite, and funders prefer to use only as much as a deal needs, a principle known as minimum concessionality. A structure that uses more concession than it needs is a warning sign rather than a bonus.

Where mezzanine and blended debt sit within a debt structure is covered in mezzanine and blended structures; the vocabulary above is defined in DFI acronyms and terms defined.