The purpose of blended finance is to attract capital to impact investing by pooling risk and then redistributing it in such a way that it addresses the financial and impact objectives of various investor types.

Philanthropic capital is relatively scarce compared with financial capital. To attract more capital, of all types, to fund impact investments, the blended finance design has to leverage the philanthropic capital so as to create investment products that appeal to the purely financial investor who may have no interest in the impact objectives.

A blended finance structure should therefore have a tranche that appeals to philanthropic investors that is junior so as to de-risk senior tranches which might appeal to purely commercial investors. Very likely, the returns of this equity or first loss tranche will not be as high as one would expect from the same tranche in a purely commercial structured finance vehicle. The risk return of this philanthropic first loss tranche would be, more return with a lot more risk.

The purely commercial tranche might be in the mezzanine tranche which would be designed to yield or return as much as an investment of similar risk. This tranche would be aimed at non-philanthropic investors who expect a market rate of return for the relevant risk.

An idea would be to have a philanthropic senior tranche aimed at philanthropists who would provide cheap (or free) funding to the structure.

Inflation has dominated investors’ attention since 2021. In 2023, core inflation cooled from 6.6% to 4.0%, a significant move yet well above the 2.0% target of the Federal Reserve. Meanwhile, the Fed raised rates 4 times from 4.50% to 5.50% and while it signaled that market expectations for rate cuts in 2024 might be premature, investors had begun to place bets on such rate cuts and bought up equities. Equities (MSCI World) are up almost 18% while bonds (Global Aggregate) are up almost 2% with a month to go to the year end.

At the end of 2022, we made some predictions as to what the economy would look like not just in 2023 but into the future. In summary, they were:

• Inflation would be structurally higher.
• Economic growth would be structurally higher.
• Such economic growth would be more inclusive and of higher quality.

See: Ten Seconds Into The Future 2023 Outlook for details.

We still hold these views. Let’s reiterate the reasons why.

• Inflation will be structurally higher:

  • China demographic dividend fading.
  • Near-shoring is less efficient than specialisation and trade.
  • Climate crisis mitigation and adaptation investment.

• Economic growth will be structurally higher and more inclusive.

  • Constrained monetary policy and increasing expansionary fiscal policy.
  • Net transfers from rich to poor, from capital to labour, from corporates to households.
  • Less inequality leads to lower savings rates and more consumption.

These are long term dynamics. In the shorter term the picture is complicated.

Recession

In 2023/2024, we may already be experiencing recession. However, as investment in near-shoring and climate crisis mitigation accelerates, national income accounts are flattered even as some segments, such as manufacturing, fall into recession. Europe is most vulnerable to tight monetary policy and is already in recession. The US is also in a manufacturing recession with non-manufacturing just hanging on to expansion. China’s economy is suffering from a property bust which threatens financial contagion and has already substantially dampened consumer and business sentiment. India is a bright spot among the larger economies and continues to show expansion in services and manufacturing.

Interest Rates

Going purely on the economics, we expect interest rates to rise.

• Inflation to settle at a higher equilibrium level.
• Fiscal policy to remain expansionary.
• Increased demand for capital from investment from supply chain near-shoring and climate crisis mitigation.

However, one has to consider the consequences of simply holding rates where they are.

• Recession already underway.
• Cost of debt has yet to increase as corporates have termed out liabilities.

Regionally.

• Europe. The ECB is likely to have to begin cutting rates sooner than the US Federal Reserve. Financial conditions are already tight, inflation is falling due to recession and the economy is less robust and able to withstand higher debt costs.
• The US economy is more robust against higher debt costs with less reliance on bank funding.

Bottom Line.

There are a couple of moving parts to this, inflation and the term premium. Currently, yield curves are still inverted albeit less than they were a year ago.  2 year UST rates are 4.60% with CPI at 3.20% for a real rate of 1.40%. Assuming inflation is sticky at 3.20% and a reasonable real 2Y UST rate of 1.00%, this suggests the nominal 2Y could trade to 4.20%.

If the 10 year UST trades 0.50% higher than the 2 year, that implies a nominal 10 year rate of 4.70%. (It trades at 4.25% today).

2 year bund rates are 2.70% with Euro CPI at 2.90% for a real rate of -0.20%. The market has surely moved ahead of the ECB and brought real rates back into negative territory. This could stay the hand of the ECB from any rate cut expectations in 2024. Assuming inflation settles into the 2.20% range (job done for the ECB), and a reasonable real 2Y bund rate of -0.60%, this suggests the nominal 2Y bund could trade at 1.60%. Assuming a 2-10 spread of 0.25% puts the 10 year bund at 1.85%. (It trades at 2.36% today).

Equities

The S&P500 has returned 10.8% per annum since 1970, 11.6% since 1980, 10.2% since 1990, 7.1% since 2000, 13.2% since 2010. US equity valuations are high relative to history. It is reasonable to expect that returns will be lower from here on for the next 10 years; we expect 5%-7% is a reasonable range, all things being equal. Much depends on the path of interest rates discussed above. If rates play out as above, equity returns while modest can be sustained. If rates rise beyond the above then expect equity returns to be lower and more volatile. If, however, rates moderate further, then equity returns could be higher.

Credit

Credit spreads are thin and do not appear to be pricing economic fundamentals. This can change quickly as markets tend to overreact to noise as much as signal. There is a persistent complexity premium to be earned in markets like structured credit and securitisation, and strategies like solution capital and distress. It’s also an interesting landscape for investors who can trade the evolution of relative value between credit sub-markets. The long only buy and hold, or more accurately buy and hope strategy is going to be fraught.

Duration is another area of macro risk exposure that is sometimes ignored as investors hug benchmarks for comfort. Duration will be a tricky bet this year for a number of reasons. One, while inflation may be receding, central banks are unsure if this is durable or transitory. The focus on duration in the last two years have led markets to second guess central banks leading to overreactions to central bank signals. Central banks are increasingly high frequency data dependent which in turn leads to confusing signalling to the market. And finally, the complexity of the economy and financial plumbing make modelling and policy highly uncertain.

Blended finance is an efficient mechanism for intermediating capital in impact investing. There is scope for further development. 

An important innovation would be to establish a correspondence between impact (shortfall) risk and credit risk. This would require a generally accepted standard and framework for measuring and analysing impact metrics with a view to translating such data into commercial or financial risk, namely the risk of outcome payers not funding. 

Better understanding of credit risk in a portfolio of impact investments allows us to design richer capital structures to better satisfy investor risk appetites. In particular, the ability to obtain credit ratings on mezzanine and senior tranches would increase accessibility to larger pools of investor capital. 

Credit ratings would widen the market for blended finance. Adding improved liquidity would go further in attracting more capital. 

The role of government in blended finance represents a significant opportunity. In the US the mortgage agencies encourage private capital to fund what is regarded as a public good, namely, shelter for the masses. 

As climate crisis mitigation and social equality are public goods, there is a case for supporting them with policy and public capital. 

A Government Sponsored Sustainability Agency suitably capitalised could, securitise impact investments, make markets in certain liabilities and retain such risks as are considered important to the social agenda. 

What sets us apart from the planet’s other tenants is our ability to collaborate. We are the most intelligent known species on the planet, but even this intelligence pales before our ability to work together. This ability to collaborate has allowed us to not just live with what we have, but to shape our environment to suit our purposes. When our influence on the planet was yet small, we didn’t have to think too much about the consequences. The planet had the ability to absorb the collateral effects of our growth and development. As the impact and complexity of our constructs have grown, feedback has become more significant. Many living things change their environments but none with the scale that humans do. We build cities, roads, rail, infrastructure. We mine the earth for resources to build and to power. We enact laws and frameworks to guide how we interact with one another. We change the world. 

Every now and then, our relationships with one another become strained and unsustainable leading to wars and revolutions. We are naturally driven to improve our wealth, power, and prestige, and often this leads to competition which can reach unsustainable levels. Wars and revolutions are the system-resets of society.

Every now and then, our relationship with our habitat becomes similarly unsustainable. In the past this has occurred on a local scale. Today our industry and technology are sufficiently developed to allow us to threaten the environment on a global scale. What are the system-resets of environmental sustainability? A lower planetary carrying capacity? More competition for resources?

By 2023, climate volatility has reached acute levels with heatwaves, floods, and fires all around the world. The evidence supports anthropogenic causes. We urgently need to address this climate crisis. Decarbonisation and net-zero initiatives are means to this end. All dynamic systems are cyclical and net zero will be achieved with or without our efforts. Whether net zero is achieved with a planetary carrying capacity of 10 billion or 5 billion is the real question.

We have the means to achieve a more stable and habitable planet. If by working together we were able to house in cities 50 million people in 1900 to 4.4 billion people in 2020, we can reverse global warming. We need to work together, and we need incentives to encourage collaboration towards this common goal. Standing in our way is the tragedy of the commons or the free rider problem. A healthy and habitable environment is a public good. It is non-rivalrous, and non-excludable. Public goods tend to be undersupplied by the free market and hence must be provided by government. Without an international framework and enforcement, climate initiatives are likely to fall short.

Capitalism and free market economics have worked well for growth and development at the aggregate level. The natural tendency towards growing unequal outcomes stresses the social compact. Inequality has disadvantages beyond social justice impairing our understanding of economics and the efficacy of policy. Indeed, inequality likely impairs the functioning of the market economy as allocative and productive decisions become less diversified and less well-informed. As a result, we find that some goods which may be demanded by the many are undersupplied while goods demanded by the few are oversupplied. A more equal society is a public good and government has a duty to provide it through a more progressive tax code and appropriate fiscal redistribution.

In both addressing a sustainable planet and social justice, the private sector simply is not incentivized to provide solutions in scale. Private philanthropy through grants or concessionary capital will never completely meet demand or need. Only regulation and government can bridge the gap. Yet private capital is important to the cause.

High net worth individuals, foundations and family offices play an important role in funding impact investments. While regulation is needed to create the incentives to mobilize private capital, impact investments are often either too risky or earn concessionary returns. The mass of private individual balance sheets may not have the risk appetite for these investments. Investors whose wealth exceed, especially when they far exceed, subsistence requirements, are well placed to provide solution capital to de-risk impact investments for smaller investors. The unequal distribution of wealth in this case provides the capacity for different risk appetites and the opportunity for a class of larger, purpose driven investors to facilitate the impact investments of smaller ones. This is an opportunity for turning inequality, a bad, into a catalyst for good.