Institutional investors are all rational, but they’re not the same

16 Apr 2020

Written by Ladé Araba, Managing Director, Africa at Convergence Finance

Twitter handle: @LDAraba

 Institutional investors have become increasingly open to non-traditional, high yield investment opportunities as they grapple with low yield environments.

We have seen an increase in their appetite for blended finance transactions with examples such as Allianz SE, the world’s largest insurance company, placing $115 million in the Emerging Africa Infrastructure Fund (EAIF) in 2018. EAIF is a blended finance fund that lends to infrastructure projects across Africa, with significant exposure in the least developed countries. The fund has lent $1.2 billion to 64 projects, while attracting co-investment of $10 billion since its inception in 2005.

As institutional investors start showing up in more blended finance transactions, it is important to remember that they are a heterogeneous group with varying mandates operating within diverse regulatory constraints. Similar investors in different regions will also behave differently. Below, we take a closer look at insurance companies and pension funds, including their constraints and their appetite for and activity in blended finance. You can also access a more in-depth analysis of institutional investor segments and blended finance in our Who is the private sector? report.

How insurance companies are beginning to embrace blended finance

Insurance companies value income over capital appreciation and will therefore be drawn to the premiums offered by alternative assets. In delivering on their long-term obligation to policyholders, they are guided by the duration of their liabilities, the risk-return profile of investment options, and their regulatory limitations.

Convergence’s data on historical deals shows that insurance company AXA has participated in nine blended finance deals, with an average transaction size of $303 million. Two-thirds of these investments have been in funds (both debt and equity funds) – with two direct investments in companies and then one investment in a facility. These transactions have been primarily focused on the financial services sector.

The higher exposure to funds points to a global trend observed by Convergence that 44% of all closed blended finance deals over the last two decades are funds. Investing in funds is an effective strategy for spreading risk and diversifying portfolios. It’s also a lower risk entry point for investors.

Blended finance has the potential to open doors for pension funds

For pension funds whose fiduciary responsibility requires capital preservation to lead their investment strategies, we see a different ethos that hinges on regulators’ requirement for the application of prudence and diligence. Pension funds therefore face stringent restrictions on riskier asset classes in the form of percentage allocations and instruments. However, consistent income is preferred, and we see this in their portfolios.

In Kenya, where the Retirements Benefits Authority (RBA) provides statutory limits for allocations to various asset classes, less than 20% of total assets under management are allocated to alternatives, falling well below the statutory ceiling. One of the biggest reasons cited is the inadequate understanding of alternatives and their risk profiles; belying the conservative nature of local pension fund managers. Strengthening the capacity of the investment teams and their trustees could unlock their potential for a more diversified portfolio of long-term yield generating assets, income growth, and capital appreciation.

We see a role for blended finance here. Blended finance can help these conservative investors better understand the market, its opportunities, and how they can build robust portfolios that are structured to minimize their risk exposure. There’s also potential to share valuable knowledge and experience from their peers in more developed markets, who have direct investment expertise in blended finance transactions.

In developed markets we see pension funds building investment portfolios that include blended finance transactions in emerging and frontier markets. PensionDanmark and Christian Super with AUM of €31.5 billion and $1.5 billion, have invested in blended finance funds in the agriculture and energy and energy and financial services sectors, respectively. Although PensionDanmark reported its infrastructure investment returns at 12.98% in 2017, from investments made in projects in Europe, North America, and Taiwan, there is a dearth of data on the actual performance of historical investments into these assets, and especially those that are blended. This is an area that requires additional research and transparency, to attract greater investment from other institutional investors.

Blended finance and the private equity market

In an emerging market like South Africa, where the Johannesburg Stock Exchange’s (JSE) performance has slowed in the past few years with lower returns expected in the medium term, institutional investors such as Sanlam have acquired stakes in medium sized companies such as MicroEnsure, and have invested in blended private equity funds such as Climate Investor One where concessional capital is present in subordinated form or is used to provide technical assistance. Blended finance has effectively offered these investors a bridge between public equities that are not meeting their return targets and private equity; which would otherwise be deemed too risky in absolute terms, irrespective of its prospective incremental returns.

Across the private equity market, RisCura/SAVCA’s Q4 2017 Report shows that private equity in particular outperformed the JSE’s All Share Total Return Index over a 10-year period to Q3 2017. Given the role of blended finance in creating better performing investable opportunities, there could be a continued uptick in investments in alternatives. Moreover, as Convergence data on global trends shows, the number of blended deals has been increasing in earnest since 2009, with over $140 billion of financing reported in Convergence’s State of Blended Finance Report 2019.

Blended Finance appeals to diverse investors for distinct reasons

The World Bank report, “Contribution of Institutional Investors: Private Investment in Infrastructure” for the period 2011 – H1 2017 showed that 41 projects had institutional investors. An important finding was that “country ratings are not a key consideration if backed by Development Finance Institution or government support.” That support is structured through various blended finance archetypes. Most of the projects were domiciled in countries with “speculative” and “highly speculative” ratings in sub-Saharan Africa and Latin America/Caribbean.

What the World Bank report and Convergence’s own data tell us is that there is appetite among institutional investors for alternative asset classes and blended finance transactions, however, their structures must be clear and robust and should appeal to the distinct mandates and regulatory constraints facing each investor.

Originally published on Convergence Blended Finance’s blog.

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