The Pitfalls of Leverage Targets

Since the 2015 financing for development agreement, donor governments and their development finance institutions (DFIs) have all been singing from the same hymn sheet: we must do more to mobilize private investment. One way of measuring mobilization is simply to count how many private dollars are co-invested alongside public dollars, in each deal. The new Blended Finance Taskforce’s report—Better Finance, Better World—has compiled some “leverage ratio” estimates, which show the average development bank private sector window brings in 1.5 private dollars for every public dollar. The report calls for banks and DFIs to set themselves targets to multiply their leverage ratios.

Is that a good idea? It’s easy to think of objections. Speaking at a recent conference, Jeremy Oppenheim, Taskforce program director, made a forceful case: “Things just don’t change unless you target them. We know that from all walks of life.” But, he acknowledged, designing the right targets won’t be easy, will require nuance, and it must be done right.

Here I will argue that setting leverage targets in isolation might not get us what we want: more investment in developing countries. Overall investment volumes in chosen markets may make a better target, but any incentives must be soft to minimize the temptation to put public money where it is not needed.

Getting incentives right

The problem of incentives within DFIs is not new. World Bank president Jim Yong Kim, who is trying to transform the institution from a lender and investor into a facilitator of private investment, acknowledged in a speech last year that DFIs have all too often “competed with each other to finance projects—especially, the low-hanging fruit that the private sector, with a little help, could finance on commercial terms.” He recognizes that his staff face incentives to get large loans agreed, so when they involve private investors in projects they are often “working against their own interests.” The development banks have between them agreed a way to define and attribute mobilization. Kim said the bank is “working to change the incentives . . . so we can reward every effort to crowd in private financing,” but so far leverage ratio targets have not been announced.

The most obvious concern with targeting leverage ratios is that it will bias DFIs towards middle-income countries where it is easier to attract private co-investors. Or maybe I should say, further bias. Oppenheim and his colleagues see this danger clearly and argue the bias can be offset by other incentives within DFIs to reward doing deals in difficult places.

Targeting mobilization may also further tempt DFIs to participate in projects that would have gone ahead without them. A high leverage ratio can be reported by contributing a small sum to a large private project that has no need of it. A new OECD report, Making Blended Finance Work for the SDGs, found that of all the instruments they track, guarantees appear to have mobilized the greatest quantity of private investment, but that just raises the question of whether the private participation can really be attributed to those guarantees. No private lender would turn away generously discounted credit risk insurance, but that does not mean they only invested because of it.

Not all dollars are equal

There is also a more fundamental problem with how leverage is measured. The way it is currently done uses the face value of public and private contributions, which makes little sense. We want to know how much private investment we are getting per dollar of public money, but the cost to the public sector of contributing a $10m grant is not the same as of contributing a $10m loan. Similarly, whilst blended finance instruments are intended to raise risk-adjusted returns over the threshold where private financiers are willing to invest, the value of such instruments to private investors is not measured by their face value (it would be measured by how much private investors would be willing to pay for it).

Yes, leverage targets could be differentiated by instrument, guarantees, subordinated debt, and so forth. But to the extent that DFIs are able to vary the terms of any given instrument, a leverage target could tilt them towards greater concessionality where the reported leverage ratio would be higher, but not necessarily the biggest bang for public buck. In principle leverage ratios should be calculated after first re-basing the public contribution as a grant equivalent; in practice that may be too hard to do.

A better measure of the cost to the public sector would also help with value-for-money questions. Sometimes the price we may have to pay to induce the private sector to participate in commercially unappealing projects may be too high. A price might be worth paying if, for example, the private investors learn something that leads to subsequent investments without public assistance. But in some cases, all they may learn is not to touch certain types of project without generous public support. It is hard to see why aid should be diverted simply to induce private participation in investments, if that’s all that would be achieved. Thus far the debate on blended finance has had very little to say about when mobilizing the private sector is too expensive.

Misleading metrics

Perhaps the greatest problem with leverage targets was identified in a classic management studies paper, written in 1975, called “On the folly of rewarding A, while hoping for B.” We hope to increase the total quantity of investment in the service of development, but what we are measuring is the ratio of public and private capital within a set of transactions that have public involvement. These are not the same thing. If we succeed in changing the ratio of public and private money in each DFI deal, what have we achieved? Nothing if the total quantity of investment has not changed. In principle making greater use of private money in each project could free up public money to take on more projects elsewhere, but the audience at two recent blended finance conferences in Paris were repeatedly told that money is not the problem, investment opportunities are. Especially in Africa.

It is tempting to conclude that because what we are really trying to achieve is more investment, then that is what DFIs should target. If we knew, for example, that the global set of DFIs is only capable of investing $50bn annually off their own balance sheets, then if we set them a target of $200bn total deal volume (including private contributions) that would implicitly target a 1:3 leverage ratio. Targets could be set for each DFI and differentiated by market or sector. This approach is instrument agnostic, leaving DFIs to figure out which instruments offer the greatest value for money.

Sadly, it too suffers from the rewarding A hoping for B problem. We hope for additionality, we’d reward any investment that combines public and private investors. Pressure to “get money out the door” is bad enough already. If additionality is observable at all, it is tacit knowledge inside DFIs. Nobel prizes in economics have been awarded for research into the performance of contracts when the desired outcome is partially unobservable. In such circumstances contract theory says high-powered incentives can be inefficient. That suggests it may be better to try to reward staff when they are informally “known” to have created additional investments with private participation, rather than explicitly reward metrics that can be gamed.

So where does this leave us? The Blended Finance Taskforce is certainly right that the incentives within DFIs must change, to turn competition with private investors into collaboration. And that change should manifest itself as higher leverage ratios. Explicit leverage ratio targets are problematic, but so is the status quo; the priority is to improve on it, not to attain perfection. Soft incentives that reward increased overall investments with greater private participation, where we want it, are needed, but the incentives must not be strong enough to bulldozer those within DFIs whose job it is to hold the line on additionality.