Making innovative partnerships for impact finance work: the five big trade-offs

Partnerships urgently needed

As the interconnected nature of climate action, sustainable development and disaster risk becomes increasingly-well recognised, we are running out of ways to say we need to work across professional silos in the pursuit of the necessary finance.

Innovative “partnerships”, “coalitions”, “triple/quadruple helix approaches”, “holistic / integrated approaches”: almost every major development-focused agency with an interest in financing their desired outcomes (especially when they have not historically been set up to self-arrange finance) has issued recommendations calling for innovative partnerships to finance their targeted sustainable development goals.

Across the spectrum of mission-led organisations, teams are experimenting with this. In a previous post, I highlighted one such partnership, the Dutch Fund for Climate and Development, a government-funded facility managed by a consortium including a development finance institution, a development agency, a non-profit organisation (the WWF, in this case) and a climate finance manager.

Beyond ‘bankability’

The growing adoption of such multidimensional partnerships is contributing to the progression of another idea – also discussed in a previous post: that the array of positive impacts (co-benefits, spillover effects) derived from projects must be more systematically identified and their economic benefits monetised where possible.

Put together, these two revolutions are driving a fundamental shift in the way the financeability of large mission-driven investments is determined: the concept of ‘bankability’ – once a constant point of reference for private sector-led development finance – is now fading from the literature in favour of a more balanced approach: one in which delivering targeted impacts is no longer simply either a matter of safeguards (i.e. to avoid having Greenpeace at one’s office doorstep) or a “virtue signalling” exercise but in fact a make-or-break factor in mobilising finance.

This shift towards maximising impacts is, in turn, changing the trade-offs that dealmakers need to compose with when designing new-style financing partnerships: from matchmaking between supply and demand for investment to resolving a five-way dilemma.

Conventional public-private finance: the four-way dilemma

Much of the commentary on ways to overcome “barriers to investment” in sustainable development especially in the Global South has been bedevilled with the kind of minutia which, to borrow a clichéd expression, misses the wood for the trees: I remain sceptical as to whether many of the “laundry lists” contained in numerous research and working papers detailing these barriers have resulted in much practical application beyond policy circles.

In more generic terms, arranging the financing of a large project requires considering at least three essential trade-offs; four when involving the public sector:

  • Profitability (risk and return)
  • Complexity (barriers to investment)
  • Dealmaking (private sector mobilisation): matching supply and demand

In a conventional investment transaction between two private sector counterparties, dealmaking is akin to a matchmaking exercise whereby an investment with more or less complex properties commands a cash flow and profitability profile which are attractive to a set of investors: corporate buyers, private equity, infrastructure funds, high-yield debt investors, etc.

Should the degree of complexity (barriers to investment) be excessive relative to the rest of the market of investment opportunities, risk and return expectations will thin out to the point of lacking a market. Reducing complexity (i.e. de-risking an investment through contractual commitments, environmental and social safeguards, legal and regulatory conditions, equity injections, etc) can help with restore market balance and is therefore the main concern of the project developer, sponsors and interested intermediaries.

Crucially, the common thread – i.e. the answer to this three-way equation – is a cash flow profile that is achieves optimal equilibrium.

  • Value for money

When the public sector is involved, a fourth key trade-off is the need to “hardwire” a fair (financial) outcome for all parties, especially the public sector – this is the central purpose of public investment procurement and the raison d’être of intricate risk allocation frameworks such as conventional Public-Private Partnerships (PPPs).

Here again, the solution to the four-way equation is a ‘bankable’ cash flow profile that optimises the four key dimensions.

For instance, if the profitability required by the private sector is deemed excessive, the situation could call for further transfer of risk from the private back to the public sector (e.g. government guarantees, viability gap payments, etc.) or the stakeholders could intervene to reduce the complexity of the project (e.g. technical assistance, legal and regulatory reforms, long-term contractual commitments, etc.).

However, should the trade-off in complexity transfer too much risk and financial commitment to the public sector, then the value for money of involving the private sector may be questioned: why involve a private company if the government (with or without aid assistance) can achieve comparable outcomes while shouldering the financial costs and risks?

Impact maximising and the radicality of a five-way dilemma

The advent of impact investing and blended finance, and their adoption by the philanthropic and development community at large has truly disrupted (in the most “tech” sense of the term) the development finance game: the big development financial institutions and multilaterals such as the World Bank are no longer the only game in town when it comes to financing for social, environmental and economic impact.

And as the push for innovative financing partnerships accelerates, it is revealing the need to consider a fifth essential trade-off in financing partnerships: the maximisation of targeted impacts.

The reasons for this go beyond the desirability of public goods, public image “virtue signalling” and reputation risk. Indeed, there is recognition that more often than not, the cash flows of a particular company or project alone are insufficient to attract investment, particularly in the Global South where the so-called sustainable infrastructure investment gap is the hardest to bridge. However, when combined with the co-benefits that these companies and projects produce, the financeability of an overall economic ecosystem can be enhanced.

This is the general principle behind impact investing, as well as land value capture (i.e. using the appreciation of real estate values to contribute to financing infrastructure), Pay-As-You-Save procurement models (i.e. repaying an upfront investment in infrastructure by earmarking forecasted operating cost savings resulting from that investment) or the more cutting-edge use of insurance premium savings to co-finance infrastructure as currently being applied by pioneering mangrove restoration financing initiative RISCO.

Rightsizing

The maximisation of impacts will require partnering with an expanded set of participants which in a more conventional financing would be viewed as more arm’s length stakeholders: thematic NGOs (e.g. conservation, health, water, etc.), local governments, taxpayers, etc.

This comes with a potentially heavy coordination cost which can impact the entire five-way equation: even in the case of ‘traditional’ PPPs that mainly only involve the public and private sector, coordination and associated complexity are key reasons why such frameworks tend to only be applied to the largest projects and require the establishment of dedicated project delivery units such as PPP offices.

The trade-off for maximising positive impacts must therefore involve “rightsizing” the number of partnership participants for the overall financing to be workable: optimise the “complexity” dimension while maintaining an equilibrium with the four other factors.

From matchmaking to business model making

We need to talk less about the technology, and more about the problems (…). We’re looking at use cases and business models [along] with the customer (…): Who makes money? Where is the money? What’s the value for the dollar when it comes to the entire ecosystem? What is the role of each of these people and what is the pie of money that each of these people are going to get?

Danial Mausoof – Global Head, Enterprise Services Sales, Nokia (quoted from the Analyse Asia podcast, 17 Dec 2017)

Another major consequence of impact maximisation on the five-way equation is on the dealmaking trade-off: from a matchmaking exercise between supply and demand based on financial parameters, the process becomes one of consortium-building for designing a business model that maximises benefits and captures the economic value where it is generated across both the value chain and the stakeholder ecosystem.

Perhaps out of fundraising necessity, the non-profit sector has been the earliest adopter of finance partnership models, but the logic is spreading into the private sector, notably in areas related to the “smart” economy and “smart cities” which place a premium on connectivity and therefore have an interest in taking a cross-cutting perspective.

For instance, global accounting and consulting firm Deloitte has outlined an approach to smart cities and infrastructure financing which involves systematically incorporating direct revenues, indirect revenues (e.g. associated advertising revenues from urban furniture) and, crucially, value capture. Meanwhile, global technology company Nokia’s networks business is shifting its commercial approach from being a vendor of products and services to selling business models to their clients: identifying income streams across the value chain and co-beneficiaries in order to support the financing of network infrastructure; a perspective discussed in an insightful podcast.

For the private sector, a game of musical chairs

The mood music has changed: most organisations have now recognised the urgency of innovative partnerships for finance. However, like many aspects of the global (and, hopefully, “just”) transition to a more sustainable way of life, these innovative financing partnerships are an unchartered area.

Upon hearing the music, many organisations remain on the side lines, observing and learning lessons: they are tempted to learn how to dance when in fact they are in a game of musical chairs, and those organisations who will be the quickest to sense the opportunity will be able to secure a first-mover advantage not just in terms of business, but in their ability to tie up with the best partners: even in the largest organisations, capacity for partnership is not unlimited, and therefore those with the ability to most adequately address these new five-way trade-offs will gain a new level of attractiveness.

To all the wallflowers in the ballroom: this is not a ball; it’s time to start eyeballing some chairs.

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