Innovating with Blended Capital for Climate Equity Funding

The role of blended capital in accelerating climate innovation and impact is widely accepted. India's Finance Minister Nirmala Sitharaman has advocated the blending of (concessional) capital to increase the amount of private capital invested in high-impact climate and SDGs-focused businesses and innovations in both the Union Budget 2022 and reiterated in Union Budget 2024.

It has dominated agendas at many recent climate conferences and unlocking climate finance was one of the primary themes for COP29. Blended capital has clearly been identified as a gap in the climate capital stack and the need for blended instruments to spur climate innovation and impact has been established.

The biggest challenge to date, not just in India but globally, has been developing and demonstrating blended capital structures that address a clear market need,  are clean, financially viable, and utilize catalytic capital efficiently.  

While certain models have proven effective in directing capital to a particular project or instrument, there are as many or more instances in which models have often been overly complex, cost more to structure than the instrument value, cannot be replicated or just plain fail to fulfil the intended purpose. 

There are several examples of blended capital being used to support debt availability (guarantees, green bonds, etc.). Debt is an important part of the climate capital stack and is absolutely necessary for many businesses to scale, projects to be developed, green infrastructure to be built and customer financing of mature technologies. However, from these examples, as with market function, debt is a low-to-no-risk instrument that, by definition, is not compatible with de-risking innovation. 

In the very early stages of climate innovation, a mix of grants from universities, national labs, incubators, corporate innovation challenges and philanthropies, paired with angel investment from climate enthusiasts, support unprecedented growth in India’s early innovation ecosystem.

Despite sound business fundamentals, as high-impact climate innovations reach certain levels of maturity, access to capital becomes a challenge. These startups often sell physical products or commodities into large and growing  B2B markets, with businesses or customer segments that may require financing. Fundamentally these are not riskier businesses, generally the contrary, but require funders to blend PE and VC evaluation approaches to evaluation, provide fit-for-purpose climate finance, and support strategic innovation de-risking and commercialization.

Within the capital stack, equity is the most appropriate source of de-risking capital to align investor and founder interests (also why, in efficient markets, debt is traditionally expected to have lower returns than equity).

Amongst private capital providers, however, climate innovations carry the perception of “extra risk” due to several factors including: past climate investment boom and bust cycles, concerns about green premiums and market viability of products, as well as the fundamentals of high impact businesses not aligning to historic investment paradigms.  Venture capital thrives when investing in high growth, asset-light, winner-takes-all markets, while private equity is most comfortable with proven businesses with a stable customer base and an ability to establish high levels of confidence in business projections. 

Despite this, equity remains the best mechanism for de-risking and accelerating the growth of climate startups.  

A blended equity approach can bridge the gap between existing equity models and market requirements. Equity investors who understand and are responsive to the nuances of the market have the ability to deliver market-competitive financial returns for commercial investors, additionality and financial returns that can be recycled for catalytic investors and accelerated commercialization for startups and the market.  

Philanthropic capital also plays an important role in supporting early innovation, but with limited quantum as compared to the market requirements, it can be better leveraged to bring capital earlier in the capital stack and support innovations in bridging the innovation-to-industry gap.

Implementation of a Blended Finance Equity Approach

A blended equity model can take several forms. These different models use catalytic capital to incentivize the participation of commercial capital in a new sector or model through the various mechanisms of guaranteed returns, preferential returns and preferential payment schedules.

Each model comes with different pros and cons and alleviates different types of risks with different levels of catalytic capital efficiency.  

It can be structured such that all commercial capital is paid out first, and only then is catalytic capital returned; differential hurdles are provided to the two classes of investors; or differential returns are provided on an investment-by-investment basis. 

It’s important here to call out that a blended equity fund that provides differential returns to catalytic and commercial funders is distinct from blanket guarantees across a portfolio, that underwrites overall fund manager risk as opposed to specific investment risk. Similarly, a blended equity fund predicated on commercial capital receiving all returns before catalytic can start receiving returns reduces the ability to recycle returns on catalytic capital rapidly into the market and create higher capital efficiency. 

If the objective of using catalytic capital is to crowd in commercial capital and demonstrate the investability of climate technologies, the most efficient way to leverage catalytic capital in a blended model is on a deal-by-deal basis, de-risking climate technologies and accelerating the adoption of high-impact innovations while providing financial upside to all pools of capital.

Implementation of a Blended Finance Equity Approach In India

Operationalizing a blended finance equity approach in India will require a careful understanding of possible fund structures and compliance, as well as a robust ability to execute on investment de-risking. 

Not specific to use in equity or climate finance, in May 2023, the Securities Exchange Board of India (SEBI) announced a moratorium  on the ability of Alternate Investment Funds (AIFs) to offer differential returns to investors through an Indian structure. As of the end of September 2024, the SEBI Board issued a press release indicating further updates on the ability of certain types of named investors to subscribe to junior classes of units of AIFs with less than pro-rata rights in the investments of the scheme. More details and clarifications are awaited on this.

Notwithstanding, under the current regulatory guidance, it is still possible to blend capital and offer differential returns to non-Indian investors using a master-feeder structure with an offshore feeder. The India AIF will function as the Master Fund, with an internationally domiciled Feeder Fund pooling all catalytic capital.

In this structure, all returns can be attributed to Indian investors and the feeder on a pro-rata basis. At the Feeder level only, returns can be divided between commercial and catalytic investors; the model will leverage concessional capital to incentivize commercial capital earlier into the capital cycle and provide capital to high-impact startups when it is most needed. 

There are several domicile options for the offshore Feeder Fund (Mauritius, Caymans, Delaware, Singapore, etc.), each of which will have varying benefits and challenges from a capital instrument, tax efficiency, operational cost and compliance perspective; these will have to be specifically understood keeping in mind a fund’s investment mandate and investor pool.

Even with evolving regulations and guidance, setting up a blended equity structure in India is eminently possible, and doing so can create an innovative and efficient solution to mobilize the urgently needed private capital for climate investment. 

*SEBI implemented this moratorium while evaluating how structures might be used to conceal bad assets or offered to the detriment of retail investors. This moratorium is still under discussion and there is movement within the government to allow differential returns for climate finance. Differential returns from funds are otherwise permitted globally.