Blended Finance

Blended finance has emerged in recent years as an important tool in financing sustainable development projects. Despite record growth and increasing interest from practitioners, blended finance has drawn little attention in academia. As a result, there is a lack of commonly accepted definitions, quantitative analysis is suboptimal, and the discussion of related challenges has been scarce. This is particularly true for regulatory challenges of blended finance. This blog post, based on our paper, addresses that gap.

Blended Finance: Definition, Delineation

We define blended finance as a type of structured project finance in the Global South that combines mission-linked capital stemming from donors and the public with return-seeking private funds (often non-concessional debt), with a view to supporting private sector projects aimed at creating positive externalities (ie, sustainability impacts).

We go on to distinguish blended finance from project finance, impact investing, public-private partnerships and structured finance and clarify that the blended finance’s uniqueness lies in its diversity of funders’ goals: some contributors seek private returns, while others aim primarily for public returns.

Further, our paper establishes as key elements of blending (a) a combination of private and public returns, (b) the presence of two types of actors (public and private actors), and (c) particular financing terms resulting in the provision of concessional and non-concessional finance.

The combination of public and private returns is the core feature of blended finance. Risk-tolerant catalytic capital is blended with risk-averse private capital; some investors primarily pursue public returns (positive sustainability impacts) while—most often—private investors expect market-adjusted financial returns.

Regulatory Challenges of Blended Finance

We identify five key legal challenges that are present in most blended finance projects, including diverging interests among different investors (public, philanthropic and private), contractual complexity, an overall weak institutional environment in the project countries of the Global South, information asymmetry due to a lack of transparency, and a strong role of public stakeholders.

We further find that the diverging contributors’ interests come with challenges in the project set-up and execution. What separates blended finance projects from other types of structured finance transactions is that in blended finance, the public-return-seeking participants stand at the bottom of the insolvency pyramid, while private return-seeking participants stand above them. This assigns the function of residual claimant to the providers of the catalytic capital, yet the pursuit of the goals represented by the participants higher up in the insolvency pyramid does not necessarily further the goals of these residual claimants. This results in a conflict between private and public return-seeking participants, and the need for a mediating institution that permanently rebalances public and private returns throughout the project duration.

Regulatory and Policy Considerations 

At the same time, because many blended finance projects are executed within an environment characterized by weak institutions, the question remains what role law and regulation can realistically play in addressing such issues to ensure that blended finance functions as a valuable sustainable development tool.

We consider a number of policy solutions. Among others, blended finance vehicles could be mandated to report on sustainability impacts, and their reporting could be revised by independent expert auditors. We also consider a modification of fiduciary duties to ensure the successful pursuit of the dual mission inherent in blended finance projects, as well as a self-regulatory approach through labelling and rating. Needless to say, none of the former is a panacea, while elements of them are present in vehicles often used, or even tailor-made, for blended finance projects.

Against this background, we evaluate the laws of the blended enterprise in the UK, the USA and Canada, and look at the Luxemburgish investment fund laws governing alternative investment funds in an attempt to identify potential legal transplants for successful blended finance projects, with a view to addressing the existing practical and regulatory challenges of blended finance today.

The authors’ full paper can be accessed here.  

Dirk Zetzsche is a Professor of Financial Law at the University of Luxembourg.

Pedro Vilanculo is a doctoral researcher in the Department of Law at the University of Luxembourg.