UK’s ambition to invest in Africa is an opportunity for blended finance

An opinion published of

This week, the United Kingdom announced
its ambition to become the largest G-7 foreign direct investor in Africa
by 2020. To make this happen it aims to generate up to £8 billion
($10.26 billion) of U.K. public and private investment
in Africa. Over the next 3 years, CDC, the U.K.’s development finance
institution, will aim to invest up to £3.5 billion in Africa while the
U.K. government aims to mobilize a further £4 billion of private
investment.

 

This announcement is the first tangible
action announced by a G-7 country since the June 2018 Charlevoix
Commitment on Innovative Financing for Development, where G-7 leaders
committed to support innovative financing approaches
for development.

 

 

It is also the latest example of a trend
where governments are turning to innovative finance, mobilizing the
private sector to make their development funds achieve larger impact.
Other examples include Germany’s compact 
with Africa and Canada’s Feminist International Assistance Policy.

 

 

The need to mobilize private investment
in Africa is clear. Africa has the lowest income per capita, the highest
population growth rate, and lags in most indicators in the Human
Development Index. The African Development Bank
estimates a financing need of some $650 billion annually in Africa and
the International Monetary Fund identifies the need to create 20 million
new jobs annually.

 

 

While the U.K. government announced a
sizable capital increase for the successful Private Infrastructure
Development Group, it does not provide details on how it plans to
mobilize private investment. Presumably, CDC funds will
be co-invested on equal or comparable terms with private sector
investment, but this approach will not reach those segments with the
highest unmet financing needs, such as small- and medium-sized
enterprises — which the AfDB estimates will create 80-90 percent
of jobs in Africa, due to the significant challenges of mobilizing
private investment to Africa.

 

Among these challenges is the high risk
of investment: Half of Africa’s 54 countries have a median credit rating
of “B+” and the large majority of private sector borrowers in Africa
have an implied rating of “CCC” — extremely
high risk. These ratings imply an expected probability of default and
expected losses for a typical borrower around 12-20 times higher than
investment grade. Very few investors are prepared to invest at this
risk. Compounding traditional credit risk on the
continent is the very high currency risk.

 

Another challenge is the mismatch in
financing needs and criteria: Most African SMEs financing needs are
quite small, ranging from $1,000-$5,000,000. Most institutional
investors, however, invest much larger amounts — typically
$50 million or higher per investment.

 

So how can the U.K. government mobilize
£4 billion of private sector financing to African countries when they’re
considered high risk and there is such a mismatch between the
countries’ investment needs and the investment criteria
of private investors?

 

“Blended finance makes it possible to
create investments that meet the criteria of most private investors by
(i) reducing risk to an acceptable level and (ii) bridging the huge gap
between perceived and realized risk in developing
countries.”

—

 

The answer to these challenges is blended
finance — the use of development capital from development agencies and
philanthropic foundations to attract commercial capital from
private-sector investors.

 

Blended finance makes it possible to
create investments that meet the criteria of most private investors by
(i) reducing risk to an acceptable level and (ii) bridging the huge gap
between perceived and realized risk in developing
countries. Time and time again, the realized risk — i.e., actual losses
— has proven to be much lower than perceived risk — i.e., expected
losses — in emerging markets. This is strongly evidenced in the
recurring profits of multilateral development banks and
DFIs such as the European Bank for Reconstruction and Development and
the International Finance Corporation. 

 

Using development capital to create
risk-return profiles acceptable for the private sector and to scale up
African investments allows the U.K. to achieve its development
objectives while attracting new investors and critical investment
to Africa.

 

Given the challenges listed above, a blended finance solution that can reach those in highest need could include:

 

1. Creating a portfolio of investment assets diversified across several companies/projects, countries, and currencies.

 

2. Mobilizing private investors to invest
in senior notes while the U.K. government provides junior capital to
bear first losses and bridge the risk perception gap.

 

3. Ensuring a good percentage of the portfolio includes financing to SMEs.

 

Using blended finance to mobilize private
investment into Africa isn’t new. Based on Convergence’s database of
over 300 historical blended finance deals representing $100 billion,
over 50 percent of blended finance transactions
have targeted Africa. But in a highly fragmented and inefficient way.

 

The U.K. government’s ambitious
commitment tells us that this number can only be expected to increase,
and places it in a position to lead its G-7 partners and other
counterparts to execute blended finance deals to draw in more
private capital to the places that need it most, at the scale required.

 

In the last few years, there has been a
surge of interest and optimism in the potential of mobilizing private
capital toward the Sustainable Development Goals. Blended finance offers
a unique opportunity to channel this optimism
into real-world impact.