The capital markets: An increasingly sophisticated market still grappling with the impact-return trade-off

The broadening and deepening of an increasingly sophisticated capital market

In the past, funding for rural finance was largely the remit of three types of providers of capital: 1) host country governments working through state banks; 2) agribusinesses allocating resources internally to assure sufficient supply; and 3) a small set of donors with a particular interest in expanding access to services through microfinance institutions (MFIs), banks, and a few leading NGOs. This funding ecosystem largely reflected the limited number of agri-finance models that were deployed by providers.

Over the last three years, just as diverse new service delivery models have emerged in the sector, we have also seen the capital market become broader and more sophisticated. In this landscape, ~ USD 9 billion in overseas development assistance, government funding (partially supported through IFAD and others), and targeted contributions by ~20 donors have continued to directly anchor a large part of the market.  However, we have also seen the emergence of a number of funds and facilities that are playing an increasingly important role in the landscape. In 2017, ISF identified ~ USD 19 billion dollars of funding in 80 impact-driven agricultural funds with a range of orientations that are now actively seeking pipeline. Major investments in digital agricultural finance have also been made, including the Mastercard Foundation commitment of ~ USD 200 million, and the entry of new MNOs, such as Safaricom and Econet. Meanwhile the emergence of a number of incubator/accelerator programs, such as Agrifin Accelerate, and aligned angel investor networks/venture capital funds, such as the Savannah Fund, have started to create more infrastructure to support early stage models.

The result of these new funding flows is a more diverse and sophisticated capital market than ever before.

A deeper look at the key market trends influencing the capital flows

To get smarter about this increasingly diverse capital market, it’s important to understand some key trends driving the continued evolution of the rural finance capital market, namely:

1. Digital innovation: An estimated USD 250 million of subsidy has been channelled into digital innovation for agricultural finance, sparking a fragmented but diverse set of new services with a particular focus on smallholder farmers. Some of this funding has been directly invested in service providers, while other funding has been channelled through intermediary programs such as Mercy Corps Agrifin Accelerate and AGRA FISFAP.
2. Structured funding: A range of funds and facilities are now structuring their funding for specific pipeline and/or service provider needs—for example, IFC GAFSP private sector window and the African Agriculture Fund
3. Blended finance: The importance of blended sources of capital was noted in the 2016 Inflection Point report and has only become more popular as a way to mobilize financing for emerging markets. Increasingly sophisticated tools, approaches, and structures are now being developed to offset risks and create ways for more commercial capital to participate in agricultural finance.
4. Capital advisory intermediaries: A maturing set of intermediaries (many of them multi-sectoral) have emerged to support more efficient capital allocation and structuring, this includes ISF Advisors, Lions Head, and Open Capital Advisors.
5. Convergence of multiple impact agendas: Capital providers are beginning to align funding around multiple adjacent agendas such as youth, climate, gender, sustainability, and nutrition.
6. Industry alliances: New consortia, such as the Farm to Market Alliance, Smallholder and Agri-SME Finance and Investment Network (SAFIN), and Aceli Africa have enabled funders to more systematically structure and synchronize their investments.

While these trends are playing out on a more global scale, there are national-level ecosystems that have a major impact on the availability of different forms of finance for service providers. The range of government initiatives, investments, policies, and enabling regulations here are vast and demand a more thorough treatment. However, government-backed funds such as NIRSAL in Nigeria, GIRSAL in Ghana, the Ethiopian Diaspora Fund in Ethiopia, and the government funded index-insurance scheme in India are all examples of major initiatives that fundamentally shape rural finance at a national level.

Despite the increasing sophistication of this capital market, there remains significant challenges to ensuring the right capital is going to the right service providers at the right time. Some of these challenges are not new to the agricultural finance sector. For example, many funds still struggle to find investment-ready pipeline aligned to their asset class and/or risk-return expectations. Meanwhile working with currency fluctuations and exchange rate risks are well documented and remain challenging. Other challenges though have emerged hand-in-hand with service delivery innovation, e.g., the struggle of fintechs and other innovators to attract follow-on venture funding to continue scaling their models. What results is a complex capital market that spans a broad set of impact-return intersections, servicing an increasingly complex and fragmented set of service provider needs. In this environment there is a continued need to establish ways to understand and unpack the complexity.

The smart subsidy goal and the “efficient impact frontier”

In the 2016 Inflection Point report, we acknowledged that the vast majority of service delivery models required some form of subsidy. This research called on capital providers to work on unlocking new, more efficient and better-matched sources of capital for providers of services —also known as “smart subsidy.” In the context of directly supporting providers, the objectives of providing subsidy to service providers can be very different and include:

• Buying long term impact in impact-first provider models that are unlikely to transition to higher levels of financial sustainability. In these “investments,” smart subsidy means the highest possible level of impact per donor dollar, something that is notoriously difficult to assess with credible benchmarks. Recent financial benchmarking analyses by Aceli Africa and Dalberg Advisors is one recent effort working to establish these benchmarks for agri-SME lending.
• Subsidizing innovation in the short term in provider models with a clear plan to transition to higher levels of financial sustainability. In these “investments,” smart subsidy means identifying high-potential product, distribution, or business model innovations and working with providers to chart an efficient course towards scale and sustainability.
• Creating capital leverage through using subsidy to enable the participation of more commercially oriented funding (the blended finance approach). In these “investments,” smart subsidy means high levels of capital leverage, a metric where credible benchmarks are beginning to emerge such as the recent Dalberg review of 117 blended finance deals where each dollar of donor capital generated 79 cents of private investment.

With this diversity of approaches to using subsidy, more sophisticated models and benchmarks are needed to credibly manage the impact-return trade-offs involved.

Recent thought leadership by service providers and sector leaders has made important advances to considering these dynamics. For instance, Root Capital developed the “Efficient Impact Frontier” concept to analyze and optimize the performance of their portfolio such that it achieves the highest social and environmental impact while also allocating philanthropic and investment funding efficiently. The Mastercard Foundation RAF Learning Lab has also worked with IDH Sustainable Trade Initiative to publish research and case studies that present a holistic assessment of Service Delivery Models (SDM) to help financial service providers optimize key business model ingredients—including smart subsidy—to serve smallholders profitably and at scale. Meanwhile, Omidyar Network has produced a series of studies about early stage investing for financial returns and social impact in emerging markets.

These approaches enable capital providers to interrogate, with increasing sophistication, the ways in which impact-return trade-offs are navigated within clearly understood service delivery models. The smallholder finance market is far too diverse for the question of “what is smart subsidy?” to be easily answered. However, these new frameworks, tools, and benchmarks are contributing to a more robust conversation.

The next step in sophistication: Considering capital needs through a pathways lens

In our latest research, we have identified another game-changing framework: transition pathways that represent a more dynamic model of rural client needs. In our first blog of this State of the Sector series, we laid out a series of pathways that smallholder households naturally follow as they transition from one livelihood state to another. For example, from resilient subsistence farmer to intensified commercial farmer to rural services entrepreneur.

Aligned with these transition pathways are a series of financial service providers that offer pathway-relevant services through a range of delivery models. The new typology of service delivery models captured in our second State of the Sector Pulse blog showcases how complex service models can be segmented to better meet the needs of smallholders throughout their different transition pathways.

The next question for us to answer is: How does capital provision align with this new pathways framework?

In the capital orientation map above, you can see how different types of provider models align to both profitability profiles (and types of capital) as well as pathways. In this mapping, provider profitability is considered as the current profitability of a provider excluding any subsidy. Capital types are aligned with these profitability profiles on that basis. The prevalence of provider models is depicted as a bell curve of sorts that shows the alignment of demand for different forms of capital based on the underlying profitability of the model. Seen through a pathway lens reveals a stylized global picture of rural finance models, their prevalence, and capital needs.

Viewing the rural finance demand for, and supply of, types of capital in this way creates a capital “map” of sorts, rich with intersections and potential capital gaps that lie at the heart of the global agenda.  While the prevalence mapping is illustrative (based on expert opinion) and may vary from reality, what it does show is that supporting pathway transitions involves capitalizing service delivery models with very different profiles.

With this new model there are a number of new insights that can be visualized in the new capital orientation map below. These insights are core to understanding how the capital market practically works and reveals some areas where more efficient allocation can be achieved.

Why we believe this new view of the capital markets matters

Building on the insights that come from a pathways view of the market, we see a new opportunity for capital need to more effectively and efficiently match capital supply. We are not in a position to be deterministic about these intersections, defining each service provider or capital provider’s profile (which would necessarily only represent a snapshot in time). However, using a common language and the intersections revealed in the capital orientation map, the gaps in the market can become much more apparent.

Said differently, this research presents a new standard for describing market positioning—for service providers and funders—that can help channel the right capital more efficiently to the right service providers at the right time. It can also help the sector as a whole, understand how different forms of capital relate to one another within a given market, ecosystem, or pathway.

To that end, we propose that every service and capital provider should be able to clearly articulate where they sit within the pathway-based capital orientation map, along the lines indicated in the figure below. In doing so, service providers will be better positioned to pursue right-fit capital, while capital providers will ensure that their subsidy is utilized in a “smart” and efficient way.

What comes next?

Our thinking on the capital markets continues to evolve as the overall State of the Sector picture comes together. Over the next few months, we will continue developing the model and building out the implications and insights to help the industry consider how best to align capital with the financing needs of both service providers and their underlying clients. In particular, we hope to:

• Further enhance the “capital orientation mapping” model, including clarifying investment pipelines and identifying major capital gaps
• Deepen and validate research on key capital market trends
• Enrich the analysis on how global trends are translating to experience at a country level
• Refine a set of blended finance case studies and examples