More Mobilization and Impact: Adapting MDB Private Finance Models

The shareholders of the private finance operations or windows (PSWs) of the multilateral development banks (MDBs) expect them to pursue three objectives simultaneously: (1) market returns, (2) high mobilization rates (dollars of private finance raised per PSW dollar committed), and (3) high development impact. It is no surprise that in the real world there are often tradeoffs among these objectives. Yet shareholders send mixed messages about where their priorities lie. The actual PSW track records suggest more success on objective (1) than on (2) and (3). 

This confused status quo becomes untenable in the context of the enormous challenges of financing the Sustainable Development Goals (SDGs), the disappointing data and trends for actual private finance flows for development, limited aid dollars, and tight fiscal constraints on developing country government capacity to fund infrastructure and other development spending. A 2018 report estimates that a total of $60 billion of private finance was mobilized by PSWs in 2016, hardly a sufficient contribution to addressing annual SDG financing gaps in the trillions.

Some inside and outside these institutions are urging them to evolve from lenders to mobilizers—a change that does not mesh well with PSW financial models that favor profitable lending for their own account. Guarantees, for example, account for only about 5 percent of PSW commitments but generate about 45 percent of private finance mobilized.

All this suggests an urgent need to change PSW business models to maintain their financial sustainability while doing much better on mobilization and development impact. Two factors are critical for meeting this challenge: enhanced risk management capability and greater flexibility regarding risk-adjusted returns. Crowding the private sector into projects with high development impact can be advanced by disciplined use of blended finance to reduce or share risk, boost returns, or form a partnership in which one party accepts delayed or below-market risk-adjusted returns.

Adapting the PSW model

PSWs need a better way to be effective and efficient partners in blended finance arrangements. To this end, I have proposed that special purpose vehicles (SPVs) with separate balance sheets be added to the PSW toolkit. They would be purpose-built for taking on more risk, while the core PSW balance sheets would retain their AAA rating and their profitability. The SPVs would target pervasive gaps in capital markets such as limited early-stage finance for firms, local capital markets, and pre-operational infrastructure projects; and scarce finance for the riskiest project tranches like junior equity or debt. The SPV financial goal would be simply to preserve shareholder equity at the entity level.

The basic idea is for the two parts of the PSW—the SPV and core operations—to offer a seamless continuum of products and services to clients. In some cases, this would make deals bankable that otherwise would not pass credit committees. In others, it would make scale and larger deals possible. And in still others, it would mean a smooth handoff from the SPV to the core PSW operations when clients or markets are ready for commercial finance and growth.

Capitalizing such SPVs would offer attractive features to MDB PSW shareholders:

1. The new capital requirement would be relatively small compared to PSW core balance sheet needs.

2. The resources funding the SPV would take the form of shareholder capital rather than one-time contributions to individual donor trust funds or reliance on IDA replenishment resources. SPV capital adequacy and the need for possible capital increases could then be periodically assessed.

3. The SPV shareholder and governance structure could be established de novo, that is, without dilution worries for shareholders that do not wish to participate.

4. Shareholders would be deploying their new capital in a way that directly advances the institutional change they seek—more openness to innovation, more mobilization, and a greater focus on areas and projects with high development impact.

A better approach than creating an SPV for each MDB would be to establish just one SPV that all MDBs could access. It could be structured in a way that facilitates both collaboration across MDBs to gain more access to SPV resources as well as healthy competition to ensure that the best projects are selected.

One other desirable innovation would be to allow private investors to participate in capitalizing the SPV. A public-private SPV would give risk-tolerant private impact investors and philanthropists a chance to participate in funding projects where mobilization and development impact are high. For their part, public shareholders would not have to bear the whole burden of capitalizing the SPV. Private shareholders would of course then rightly expect to have a seat at the governance table. This seems both logical and sensible if public and private shareholders are united around the same mission. As we’ve seen in other public-private partnership spheres, the private sector can introduce efficiencies and innovation that accelerate institutional change.