When policy imperatives prevail over commercial considerations, an SIF may find it difficult to attract private capital. Mechanisms to reduce risk or enhance returns, financed by the public share of the SIF's capital, may help to overcome this challenge. For example, if public finance within the fund is used to increase the risk-adjusted rate of return for private investors, an SIF may leverage private funds that invest in relatively high-risk regions or projects, yet need finance with low-risk premiums. Typical instruments for this are first-loss equity and capped return. First-loss equity means that the public sector investors take equity stakes in an SIF with a first-loss position, thereby increasing the number of projects within the SIF that can fail before the private sector investors lose money. In a capped-return arrangement, the government's return on the capital investment is capped, allowing co-investors access to higher upsides on their investments. The European Fund for Southeast Europe is an example of a first-loss arrangement (box 7). 

Box 7. A Strategic Investment Fund with a First-Loss Arrangement

The European Fund for Southeast Europe (EFSE), based in Luxembourg, is a hybrid strategic investment fund (SIF) with €756 million ($1.1 billion) in commitments from donor agencies, international financial institutions (IFIs), and private investors. The public-private partnership approach enables the EFSE to mobilize funding from private institutional investors to top up international public donor funding for development finance. In addition, it provides a platform for the coordination of donor activities in its regions. This pooling of resources multiplies the impact of public funding. The EFSE operates as a market enabler, facilitator, and risk taker as well as an innovator and incubator for new financial products. Donor or public capital constitutes the first-loss tranche –  that is, the tranche to be used first in the event of losses. IFIs invest in the mezzanine tranche, private investors in the senior tranche. Because of its investment structure, the EFSE is able to provide access to long-term finance at market conditions to qualified investors. To undertake an investment, different sources of funds representing different risk-level tranches are pooled into a single source of financing for the EFSE. For the investment portfolio in each country, the proportion of the different risk tranches contributing to the total amount of pooled funds remains intact. Hence, donors and other investors hold a specific share of the pooled funds in the amount of their original nominal contribution to the EFSE. 

An SIF could also seek to attract impact investors or commercially oriented financial institutions that identify with the policy objectives of the fund and often require a lower financial return than traditional investors (box 8). For example, AREF received financing from Sustainable Energy for Africa, a fund administered by the African Development Bank, at a rate of return capped at 4 percent.  

Box 8. Public Finance and Impact Investment

Emerging and frontier economies hold significant promise for private investors and corporations that seek to diversify their portfolios and enter new high-growth markets. Yet, the high level of risk (real or perceived) is often a barrier to investment. Public and philanthropic funders can use their resources to shift the risk-return profile of investee projects or companies to create favorable conditions for private sector engagement. Such blending of public, philanthropic, and private resources can in turn significantly scale up investment in areas that are critical for sustainable development, including infrastructure, climate change solutions, agriculture, health care, and financial services.

Impact investors have diverse financial return expectations. Some intentionally invest for concessional returns in order to maximize impact or to catalyze additional investment capital by accepting a riskier position in a deal. Others pursue market-competitive and market-beating returns, which are often linked to their fiduciary responsibility toward investors. According to a survey of impact investors carried out in 2015 by the Global Impact Investing Network – a nonprofit organization dedicated to increasing the scale and effectiveness of impact investing – 25 percent of respondents were pursuing below-market returns at close to the market rate, and 16 percent below-market returns close to capital preservation.

As outlined in section 2, governments finance their SIFs in various ways, including through equity investment or lending. In particular, a fund's public sponsor may undertake on-lending to the fund at the interest rate that the sponsor is eligible for. Countries that have a strong credit rating or borrow from international financial institutions (IFIs) may be able to secure a margin between borrowing costs and expected risk-adjusted returns on their sovereign fund's investments. An SIF capitalized with government borrowing will have the option of using the spread between the expected risk-adjusted return of the fund's investments and the cost of borrowing, to provide favorably priced credit or return enhancement to attract private investors, thereby increasing the multiplier.  Also, by carefully structuring the price and time profile of its on-lending, the government can de-couple its obligations to the original lender from the SIF's repayment schedule, allowing the SIF to manage its investment independent of the original debt repayment schedule. In accordance with the principles of good public finance management, equity investments and/or on-lending to the fund need to be channeled through the ministry of finance (representing the ownership of the fund), be included as liabilities in government accounts, and receive parliamentary approval.  

Like other financial institutions with government involvement, SIFs may have a comparative advantage over traditional financial institutions thanks to their privileged access to PPP investment opportunities, and a relationship of trust with public and private local investors. Clark and Monk (2015) suggest that this type of advantage may explain the remarkably high financial returns achieved by several SWFs with a domestic investment mandate in spite of their social and economic objectives. Examples include Singapore's Temasek (18 percent total shareholder return over 40 years), Malaysia's Khazanah Nasional Berhad (10year IRR of 13 percent), South Africa's Public Investment Corporation (10-year IRR of 16 percent), and the Palestine Investment Fund (10-year IRR of 10.3 percent). These funds, the authors observe, have taken on the role of wealth creators rather than wealth appreciators, acting like PE and VC investors by taking relatively large, direct stakes in projects and thereafter being actively involved in the operations of their investments. Furthermore, by being co-investors in PPP projects, SIFs allow governments to benefit if PPP projects turn out to be lucrative and provide comfort to the country's stakeholders that their interests are protected, thus reducing the likelihood of PPP contract renegotiation in the future.