October 3, 2024
Five years ago, we made a proposal to help address a capital market gap that pervades the developing world: the lack of finance for young, innovative firms with potential for rapid growth and job creation. Innovation is no less essential for business success and growth in poor countries than in rich countries. That includes innovation that drives climate-related gains for both mitigation and adaptation. There is ample evidence of rich-world under-investment in innovation targeting poor countries, the slow infusion of rich-world innovation to middle-income and low-income countries, and limited support for local innovation. And we know that the business models, technologies, products and services, and distribution channels that work in the rich world do not necessarily succeed in low-income environments—there are unique needs that can only be met by innovators who understand the local challenges and opportunities.
Grant or seed finance at the very early, proof-of-concept phase for innovative firms is scarce. But arguably, finance at the next stage is even scarcer: when the innovative firm has proved the concept works, has a revenue track record, and is approaching or passing breakeven. At that point, external growth (including venture) capital is often essential to move toward scale and sustainable profitability. Many firms fail in what has been called “the valley of death,” not because of problems with their innovations, but for lack of growth capital.
Capital markets in many developing countries lack the experienced fund managers, financial products, funding structures, investor networks, and ecosystem necessary to support early-stage innovative firms. Venture capital markets remain tiny in most developing regions, with 2023 deal values of $3.0 billion in Latin America and $3.6 billion in Africa, compared to a global total of $285.2 billion. External development finance providers like multilateral development banks and development finance institutions could intervene to develop these markets, but they do little early-stage finance. It exceeds their risk tolerance for their own balance sheets and is therefore tightly constrained by the availability of donor concessional funding for off-loading risk. And it is mismatched with their financial instrument mix, which is concentrated in senior lending.
Our idea was to explore the feasibility of a multilateral funding vehicle, specialized for this purpose and specifically designed to partner with multilateral development banks (MDBs) and development finance institutions (DFIs) in ways that would expand scope of bankable projects and markets and build their pipelines for later-stage finance. And our aim was to design a financially sustainable vehicle, rather than another grant-making trust fund or financial intermediary fund (FIF) that is dependent on frequent infusions of donor contributions.
We posed ourselves the question: could a vehicle be designed in such a way that would:
- target risky but high-potential-impact, young innovative firms in the developing world;
- not lose money;
- offer a range of products better suited to the needs of innovative firms at this stage: early-stage equity, guarantees, and subordinated debt;
- be more catalytic than most MDBs and DFIs, mobilizing multiple dollars of private investment for every dollar committed on their own balance sheets; and
- be attractive to both governments and philanthropic investors interested in sustainable financing of young high-impact firms.
To answer this question, we modeled variants of a finance structure using data from two multilateral funds that finance early-stage firms (and funds that invest in such firms)—one globally and one for Latin America. Based on their track records, we assumed below-market expected returns on the various instruments and high management costs for a fund that offers this range of products.
The result was the Stretch Fund proposal, a permanent capital vehicle that satisfies all five of the above criteria. We found that it could be designed to meet a financial target of preserving its capital. Its financial instrument mix would be 55 percent equity, 35 percent subordinated debt, and 10 percent guarantees. Such a mix would be essential for the financial sustainability of the Fund: lending returns and guarantee fees provide the inflows needed to sustain it, given the illiquidity and long exit timeframes of early-stage equity investments. And with that portfolio mix, the Stretch Fund could achieve a 5:1 mobilization ratio (private finance mobilized per dollar of Stretch Fund commitments).
Funding growth in green innovators
Over the last five years, it has become increasingly clear that innovation is as important for addressing climate challenges as for development challenges. But the capital market gap we identified in poorer markets applies just as much to green innovations as to other innovations. And, while MDBs are being pressed into service to boost their climate finance, their risk tolerance has not fundamentally changed. Their capacity and willingness to engage in early-stage finance for green innovators remain highly limited, including innovations with the greatest potential for mitigation and adaptation gains.
Yet Stretch Fund modeling is still sound and its logic as a critical extension of the MDB toolkit is still compelling.
So why not deploy this structure specifically for financing young firms and funds working to scale green innovations: a fund to grow green firms?
Where would funding for the fund to grow green firms, or FGGF, come from? Governments and philanthropic (rather than commercial) investors with a focus on high impact and a willingness to accept below-market returns. Governments could redirect some of the concessional resources already committed for climate change that are now sitting in financial intermediary funds (totaling more than $50 billion). The MDBs themselves describe access to these resources as hard and inefficient, and researchers find significant problems with their allocation. This would be an opportunity to deploy some portion of FIF funds more efficiently, catalytically, and impactfully.
The original proposed size of the Stretch Fund was $500 million, which in hindsight was too small. An initial target of at least $1 billion for the FGGF makes more sense if it is to have global reach and if fund participation were open to public and private investors. In general, the larger the fund, the easier to cover start-up and management costs.
This would not be an easy lift. Offering such a broad range of financial products requires a lot of human capital and experience. It would be best for managing high risk if it operated in multiple regions to build a geographically diversified portfolio. But it would be too expensive to have a presence on the ground in many countries. For that reason, the FGGF would be reliant on MDBs and DFIs for much of its investment pipeline (as in the case of the successful ILX Fund that offers Dutch pension funds opportunities to participate in MDB syndicated loans). It would have the advantage of scarce risk-tolerant funding that would be very attractive to MDBs and DFIs. This funding would build MDB pipelines by make more early-stage investments bankable and by growing firms that can become future recipients of later-stage MDB finance. It would transform MDBs into financial partners that can serve firms effectively over their life cycles.
A key question is where the FGGF would sit. It could be placed under an MDB umbrella to give it access to back-office services and to country offices. But that is not essential for this concept. It is more important to ensure that it has independent governance that preserves its risk tolerant culture and that it is not captive to projects only originated by one MDB. Opening access to other MDBs and to DFIs would help furnish it with a robust project pipeline and enable a race-to-the-top for green innovation impact.
The time is ripe to consider an FGGF. The last five years have provided ample opportunity for finance for early-stage firms to emerge at scale from inside the existing MDBs and DFIs. It has not. It is time to try a new purpose-built, more risk tolerant structure focused on financing young, green firms—one that would work in partnership with existing multilateral and bilateral finance institutions to boost their climate-related impact and drive finance to the firms with the highest sustainable growth potential.
Disclaimer
CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.
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