(Photo by iStock/Alexmia)
Development finance institutions (DFIs) and impact investors have long sought to create impact beyond the actual transactions they finance, and the idea that development finance should ultimately be judged by whether sustainable markets develop (rather than whether individual transactions succeed) is not new. IFC’s “Creating Markets” strategy was initially presented nearly a decade ago, as a then-distinctive approach to development finance.
There has, however, been an unmistakable and recent surge in the way these kinds of impacts are taking center stage in the sector. Neil Gregory’s ODI paper on new growth theories argues that DFIs should focus on potential spillover effects rather than direct impact, and recent CGD work by Sam Attridge and Mary Svenstrup on private capital mobilization reaches a similar conclusion (from a different direction), emphasizing that the central challenge is not a shortage of capital but the absence of investable opportunities, functioning local capital markets, and the institutions that connect the two.
It would not be too much to say that the sector, as a whole, has moved toward embracing this rhetoric. British International Investment’s newly released strategy is explicitly framed around “Building Markets,” FMO has been expanding its market creation program, initiatives such as the Private Infrastructure Development Group explicitly frame their work around market building, and networks such as the Catalytic Capital Consortium and the Growth Firms Alliance bring together foundations and investors around the idea that philanthropic and impact capital should be carefully deployed to address market-wide challenges.
All of this is a welcome development for the sector. Economic growth ultimately comes from functioning markets rather than isolated investments. Yet there is a substantial difference between adopting the language of market building and actually changing the nature of how investments are sourced, assessed, and measured. If institutions continue to operate with the same processes and incentives as before, market creation risks becoming old wine in a new bottle rather than a durable paradigm shift.
To ensure this shift becomes a new paradigm, rather than a passing fad, institutions have to change their core approaches and incentives rather than just their communications. To do so, DFIs should:
1. Put Market Effects at the Center of Impact Assessment
Most development finance institutions still evaluate investments primarily through direct effects, using metrics like direct jobs created, proportion of women employees, number of SME loans disbursed, and households reached. Even metrics that are more focused on outcomes rather than outputs, such as local income generated, are tethered directly to the actual investment. This preference is understandable: Direct effects are easier to observe and easier to attribute than indirect impacts, providing a high degree of confidence in the data.
However, the overwhelming share of long-run development impact is generated through the much messier indirect channel of market development beyond the deal’s direct “use of proceeds.” A bank that uses a line of credit to develop a new SME lending methodology or product may reach a few hundred or even thousand SMEs, but replication of the approach could reach an order of magnitude more businesses. The first equity fund in a market may make only a handful of impactful investments, but its viability and the local fund management talent incubated by the effort encourage the creation of future funds that will likely be larger. A successful investment in a pioneer firm bringing new technologies to a sector may generate direct new jobs, but the real impact will come with that firm anchoring a growing sector, birthing new competitors, spin-offs, and suppliers.
Nearly all DFI impact assessment frameworks have at least some incorporation of likely market impact. The IFC AIMM system, for example, is laudable for being particularly transparent about how they do this. But in general, market impact is one consideration of many and can get crowded out by an “everything bagel” of different, small-scale direct impacts.
To truly shift toward a market lens, these systems must consider market effects not only alongside but above direct impacts in both ex-ante assessments and in evaluating success. This probably means accepting an uncomfortably lower degree of measurement precision, and a move toward identifying and tracking credible—but less easily quantifiable—accounts of influence and replication.
2. Move Beyond ‘Additionality’ as the Sole Suitability Test
Additionality remains one of the most important concepts in development finance. Public and concessional capital should not displace commercial investors, and additionality tests play a critical role in avoiding crowding out private capital.
However, if market creation is the goal, then additionality is not enough to justify an investment. A transaction that fills a legitimate but company-specific financing gap for one enterprise and a transaction that establishes replicable financing structures or supports first entrants into new sectors all satisfy traditional additionality tests.
The implications for market development for these transactions, though, are dramatically different: The relevant question is not only whether the necessary capital is available, but rather whether a given investment has the possibility of changing the conditions that made capital unavailable in the first place.
A recent SSIR article by Harvey Koh and Ben Smith on addressing liquidity constraints in impact investing illustrates some ways that market creation can look in practice. Secondary funds, listed vehicles, and public market pathway creation all represent investments that not only have narrow additionality but also build infrastructure and demonstrate approaches that can make a whole financial system work more effectively. Other market creation pathways that go beyond additionality include combining investment capital with deep institutional capacity-building that will endure long beyond the life of the investment, doing the messy policy and legal work to launch a first-of-its-kind locally domiciled fund, designing aggregation vehicles to solve ticket-size mismatches for institutional investment, and incorporating technical assistance in a way that gradually but deliberately moves toward reduced donor subsidy.
3. Acknowledge Trade-Offs
A few years ago, I was at an impact investing conference during which a prominent industry leader stated conclusively that “there is no trade-off between impact and returns.”
This is not true. Investors can indeed achieve both positive financial and impact returns, of course. But this does not mean there are no trade-offs. Pretending these trade-offs do not exist at all would prove disastrous for generating market-level impact.
Market creation involves bearing significant risks, and adjusting return expectations accordingly, in the service of potential outsized indirect impacts. It may require supporting first movers in unfamiliar sectors, financing intermediaries or products with limited track records, investing in fragile markets, dealing with unclear policy environments, or accepting long periods before commercial viability becomes evident. Critically, some of the benefits generated by these investments will accrue to future investors and future firms rather than being captured by the participants in the initial transaction.
If market creation is a serious institutional objective, organizations will need to become more comfortable discussing these trade-offs openly. If they do not, they risk a reversion to investments that satisfy financial return expectations, while generating only limited spillover and market-level impact.
4. Treat Mobilization as a Process Rather Than a Ratio
Capital mobilization has become a central objective across the development finance community, and featured heavily at this year’s World Bank Group Spring Meetings. Unfortunately, this concept is generally translated into transaction-level leverage targets that measure how much private capital accompanies a specific investment. This metric is useful, but from a market-building perspective it misses the forest for the trees.
Market development involves many transactions over a long period of time. Pioneering catalytic investors may never co-invest with (and therefore never technically “mobilize”) the commercial capital providers that come into a much more mature market many years later. But although these later investors are by definition not visible during structuring or even the life of the initial catalytic transactions, they are much more important indicators of market building than the leverage ratios in the pioneering capital stacks.
5. Deepen Partnerships Across Capital Sources
Market creation is inherently a collective endeavor. It requires a combination of capital, policy reform, technical expertise, institutional capacity building, and market coordination that no single institution type, much less single institution, can provide on its own. DFIs and other concessional investors should prioritize considering their role within a broader ecosystem that includes donors, foundations, policy makers, advisory organizations, and commercial investors. The objective should be to combine the distinct capabilities of different actors to address market-level constraints. In practice, this could mean expanding investment activity in a market where donors and local government have effective enterprise capacity-building programs, providing liquidity to secondary funds operating within regulatory frameworks shaped by foundation-supported policy work, or offering guarantees to banks receiving donor-funded technical assistance. While many DFIs have advisory and technical assistance capabilities, they are often modest relative to those of the broader development ecosystem. A market-building approach requires greater coordination with these actors rather than attempting to replicate their functions internally.
More Than Words
The growing embrace of market creation by DFIs, impact investors, and foundations should be welcomed. But whether this becomes a genuine shift in practice will depend less on strategy documents than on the incentives, metrics, and investment processes that institutions use every day, and organizations that succeed will need to be clear-eyed and focused on what’s needed to move from words to actions.
Read more stories by Matt Guttentag.