What Additionality Brings to Blended Finance
This post originally appeared in Devex. Read the original piece here.
By Natalie Alm, INVEST Communications Advisor, and Sharon D’Onofrio, INVEST Director of Learning
Additionality in development finance is described by the Organisation for Economic Co-operation and Development as “additional financial or non-financial input resulting in additional development outcomes that would not have materialized without the intervention.” Drawing from USAID’s use of catalytic funding, we can use additionality to evaluate both financial and ecosystem-level outcomes.
Along with other public and philanthropic organizations, the U.S. Agency for International Development has been exploring using blended finance to achieve its development goals. Since May 2019, under an initiative called INVEST, USAID has helped mobilize over $140 million in new investment using catalytic funding, with an additional $98.5 million being sought. Catalytic funding can be used for two primary purposes.
First, it can enable fund managers to create a first-loss layer within the fund’s structure, meaning that it absorbs the first economic losses if the investment does not yield returns, reducing risk for investors, which incentivizes more to come on board. Second, it can be used to defray operational costs, giving fund managers more flexibility and time to explore new investment strategies, build new relationships with potential investors, or develop pipelines of investible opportunities.
Measuring the impact of catalytic funding, however, can be complex. That’s where the concept of additionality is particularly useful. Additionality refers to achievement of an outcome that would likely not happen without donor support. Donors can use this lens to understand how support can be catalytic, mobilizing capital when financing would not have been possible otherwise, or spurring fundamental changes in the investment process, and demonstrating that resources haven’t been wasted on a project that would have ultimately been successful without their involvement.
Based on USAID’s experience, here are seven types of additionality to evaluate the impact of catalytic funding:
1. Capital mobilization: This is usually expressed as financial leverage or the ratio of capital mobilized to donor support. While it can be a useful data point, a leverage ratio doesn’t always tell the whole story. In our experience, they have ranged from 5:1 to 47:1, varying substantially across sectors and geographies. Renewable energy support, for instance, may lead to a much higher ratio than a project mobilizing resources for water, sanitation, and hygiene, given differences in market size and potential for commercial returns.
2. Acceleration: Catalytic funding has the potential to accelerate timelines, allowing fund managers to move more quickly from raising capital to making impactful investments. For instance, USAID provided catalytic funding to Endeavor SA, an NGO that supports high-impact entrepreneurs, to establish the Harvest Fund II. With this support, Endeavor quickly raised funds from a diverse group of investors, allowing for the deployment of close to $3 million to six firms in less than a year from the fund launch.
3. Sources of finance: USAID’s experience facilitating investment in new and underdeveloped markets demonstrates the need to engage a large and diverse group of potential funders. Globally, commercial funding — banks, private equity, pension funds — make up 40% of funding in blended finance transactions. However, commercial investors make up only 19% of capital mobilized among funds supported by INVEST, demonstrating the still nascent stage of many of the markets in which USAID is present. Ushering in new sources of financing can be a significant catalyst to market development in these contexts with new types of funders serving as a signal to their peers, creating a crowding-in effect.
4. Innovative finance: A lack of appropriate financial products is one of the most common constraints in developing markets. For example, many small and medium enterprises have trouble finding financing aligned with their business models; women entrepreneurs in particular often lack the collateral required from traditional funders such as banks. Catalytic funding can lead to innovation in the terms, structure, and cost of financing for these kinds of businesses. For example, USAID support is allowing Linea Capital, an African SME-focused fund, to pilot an innovative revenue-based financing model in which they invest upfront working or growth capital in a company, and the company repays a percentage of future revenues up to a repayment cap, but with no fixed repayment date. This nondebt, nonequity financing leaves ownership and the incentive to scale with company founders.
5. Safeguarding mission: One of the most important outcomes that donors like USAID can target in their use of catalytic funding is helping development-oriented funds safeguard their mission. Donors can use their influence to encourage or ensure social and environmental accountability in fund bylaws or investment policies. This can protect against potential mission drift and facilitate the fundraising process by helping attract other investors looking for proof of strong systems and commitments.
6. New financial intermediaries: In low- and middle-income countries, funds or financial vehicles capable of addressing development priorities are typically few or too small, or inexperienced to have impact at scale. Even relatively small amounts of catalytic funding can help newer fund managers build a track record, ultimately cultivating a larger universe of capable people in local investment ecosystems. In southern Africa, for example, USAID engaged both experienced and first-time fund managers. While the more experienced firms were quicker to secure commitments and ultimately raised more capital, new fund managers, such as ThirdWay Africa Rural Development Corporation, achieved gains in priority sectors like climate-resilient agriculture.
7. Demonstration effect: While it can be quite hard to measure, an important outcome of catalytic funding is the demonstration effect or incentive for replication by other stakeholders. Donors such as USAID can pilot new approaches to develop proofs of concept and share market and performance data, increasing the visibility of priority markets and drawing attention to major challenges. In sub-Saharan Africa, USAID provided support to the Nutritious Foods Financing Facility, which aims to address the lack of affordable and nutritious food by supporting SMEs in the food value chain. The facility plans to pioneer a robust set of metrics on nutrition and food to encourage other investors to enter this market.
Blended finance is all about bringing different types of stakeholders together and developing structures for them to collaborate. With catalytic funding, USAID is not investing, but it is still enabling investment. Additionality via catalytic funding is a critical function and likely one of the most important a donor can play.
For more on mobilizing investment for development through catalytic funding, read USAID INVEST’s learning brief or Catalytic Funding 101 resource guide.
