In a timely move, the UK government recently announced the recapitalisation of its development financial institution, CDC Group. The injection of £735m (US$1.1bn) into the investment arm of the Department for International Development (DFID) marks a wider trend towards donor engagement with the private sector—both in terms of long-term impact (the Group aims to drive job creation through support to businesses) and by attracting other sources of finance, including private equity.

Engagement with private finance to support social goals is not entirely new: instruments like social impact bonds, for example, are already making waves in certain sectors.  What is new is the recognition that these forms of "returnable investment"—that both mimic private investment models and attempt to leverage private finance—should be mainstreamed into development financing. Indeed, DFID’s recent paper talks of a "double bottom line approach" that sees development impact coupled with modest financial returns that can be reinvested into further programming. Similarly, the Making Finance Work for Africa Partnership recently announced a new initiative focused on long-term finance in Africa.

How does this translate into practice and what does it mean for the role of donors?

Firstly, we are seeing a re-orientation towards approaches that try to channel pre-existing private finance flows towards longer-term "impact" investments. This is no mean feat given the argument that if the investment opportunity was good enough, private finance would already be pouring in. This is perhaps the key role for development agencies—they must recognise, and foster, high-potential growth opportunities in environments where that growth is currently stunted for a host of reasons.

In India, for example, where the country’s lowest-income states attract only one fifth of domestic, and just 2.4% of foreign, private investment, DFID is investing up to £35m in the Samridhi Fund, a venture-capital fund managed SIDBI, the leading public-sector development bank in India. The fund is investing "patient" capital in socially orientated enterprises across the eight lowest-income states, based on the premise that, once successful, business should be able to attract more regular private capital, continue to grow and provide direct and indirect social benefits. 

On its own however, alignment with private finance institutions and funding models is unlikely to be enough to ensure long-term, sustainable investment from private sources.

To state the obvious: private finance is not aid. Private finance flows both seek out strong market opportunities and continue to strengthen them—not necessarily reaching those areas that perhaps need them the most. Development agencies have a major role to play therefore not just in engaging with private finance but in encouraging it to stick around.

This requires capacity building on both the demand side and the supply side of finance and needs to take place at all levels of the market: micro, meso and macro. For example, how can individuals build up their credit ratings, start investing and attract more finance? The Financial Sector Deepening Trust Africa (FSDA) has put some thinking into this as part of its Skills and Innovation for Micro Banking in Africa (SIMBA) initiative.

At the market level, what lessons can we learn from those places that have successfully strengthened their capital markets to the extent that they are already attracting private investment? South Africa is a good example; the country’s financial system is deep enough to attract both local and international investors and has also become an investor in its own right, with capital flowing into neighbouring countries, helping to strengthen growth in the region as a whole.

On the supply side, what are the skills required by investors (both domestic and international) needed to assess a sound investment in these sometimes challenging markets? What policies and regulations help to facilitate responsible, sustainable investment? Sometimes, funding itself might be the missing link, as for example in the case of the Netherlands Development Finance Company’s support to financial institutions/intermediaries in Sri Lanka and India, where an injection of finance capitalised on the skills and institutional capacity already in place to support promising businesses. 

It’s clear that the ability to leverage private finance for development is, and should be, a key focus for development agencies. While still important, traditional official development assistance (ODA) on its own is not dynamic enough to maximise on the myriad of opportunities for long-term impact. This doesn’t mean that development agencies have been rendered obsolete, far from it; they can add significant value both by facilitating the initial engagement with private finance and by building capacity at all levels to help to sustain and deepen this engagement.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of The Economist Intelligence Unit Limited (EIU) or any other member of The Economist Group. The Economist Group (including the EIU) cannot accept any responsibility or liability for reliance by any person on this article or any of the information, opinions or conclusions set out in the article.