Mobilising European Institutional Investors into Emerging Markets and Developing Economies: three critical areas to address

Next week, policy makers, business leaders and prominent investors will gather in Davos for the annual World Economic Forum. No doubt discussion will focus on mobilising much greater volumes of private capital to support the green transition and sustainable development. However, international discussions on mobilising institutional investment such as pension funds and insurance companies into emerging markets and developing economies (EMDEs) often get bogged down by focusing too much on Multilateral Development Banks (MDBs) and Development Finance Institutions (DFIs). Sure, these institutions are important, but they are just one piece of a much larger puzzle. This narrow focus can overshadow bigger, systemic issues that need our attention.

Recent discussions at an ODI Europe and EDFI event identified three critical systemic areas that need more understanding and discussion in international forums, as well as increased attention from policymakers. By expanding our conversations, we can start to understand and tackle these underlying challenges and create a more holistic approach to more effectively mobilise institutional investors

1. Despite a strong long-term case for EMDE investment, allocation remains low. Investor leadership, political commitment and drive are essential to overcome a conservative investment culture and increase EMDE investment.

EMDEs are often overlooked in the strategic allocations of institutional investors, particularly in private equity and debt. To address this, it is essential to understand the criteria that drive strategic allocation.

For institutional investors, competitive, risk-adjusted returns are the top priority. Thus, when determining strategic allocations investors compare these returns across all opportunities to consider the relative value of every investment. Historically, this point-in-time relative value assessment can paint volatile EMDEs as underperformers compared to developed markets. However, a longer-term perspective reveals a different story. ODI Global’s recent research found that since 2010, emerging markets bonds have outperformed developed market bonds and over the past two decades emerging market equity returns have matched those of developed markets and even outperformed them, excluding the US.

Investment conservatism is rife. Many investment advisors and asset managers tend to favour domestic or nearby markets, where they feel more familiar and have easier access to information. This home bias is fuelled by a conservative approach to fiduciary duty obligations which generally requires pension funds and insurance companies to manage investments in the best interests of the beneficiaries and policy holders. Yet, by limiting their allocations to these markets, investors are limiting potential diversification benefits and neglecting key growth investment opportunities. Morgan Stanley's recent analysis suggests that investors are missing out on opportunities in emerging markets. The bank modelled three common investment strategies and found that typical emerging market investments are as little as one-sixth, of what would be recommended by any rational allocation strategy.

Emerging market equities: optimal versus action allocation (%)

To meet the future pension obligations of an aging European population, investors must look beyond Europe's limited growth prospects. EMDEs are expected to drive global growth in the coming decades, currently contributing more than 60% of global GDP and an increasing share of global market capitalisation. Europe’s older workforce and sluggish productivity growth are expected to dampen the continent’s average annual GDP growth to just 1.45% for the decade leading up to 2029. This lies in stark contrast to the US’s 2.29% growth or EMDE’s 5-6% growth over the same period.

Adopting a long-term investment strategy that aligns with the maturity of insurance and pension fund liabilities highlights the compelling opportunities in EMDEs, despite short-term uncertainties. Furthermore, as investors increasingly focus on sustainable investments to hedge against future risks like climate change, EMDEs are expected to offer more concentrated opportunities in this space.

Investment culture must change to leverage these attractive EMDE investment opportunities. Key to this will be investor and political leadership. The Dutch case offers inspiration. Their financial system has become a leader in EMDE investment and impact investment, especially in EMDEs, where the need for sustainable development is greatest. This has been driven and enabled by strong government and regulatory support including by the De Nederlandsche Bank who in 2016 established a task force and sustainable finance platform which brings together the financial sector, supervisory authorities and ministries together to promote sustainable investment. One important outcome of this drive has been the creation of ILX, a SDG-focused emerging market private debt fund in 2022, which has successfully mobilised large Dutch and Danish pension funds. Major Dutch asset managers like APG have been proactive and led the way, allocating significant financing towards impact investment in EMDEs, with nearly 20% of their assets dedicated to SDG-aligned investments in EMDEs.

2. Current European regulations, although well-intentioned, may hinder increased EMDE investment, but there's potential to minimise these negative impacts.

Even if insurance companies and pension funds decide to invest in EMDEs, they face a maze of regulatory hurdles. Solvency II, a cornerstone of European insurance regulation, steers insurers towards safer, more liquid assets, making riskier EMDE investments less attractive.

Under Solvency II, the 'matching adjustment' allows insurers to discount long-term liabilities favourably but only for investment-grade assets with fixed cash flows, excluding many EMDEs with lower sovereign ratings. Moreover, the capital charges under Solvency II often don’t accurately reflect the risks of EMDE investments, and yet this reduces the overall returns and profitability of assets in these geographies. For example, investing in Africa requires insurers to set aside 13% against 10 year unrated non-OECD project loans, even though updated models suggest a much lower 4% is more appropriate.

The EU Sustainable Finance regulation adds another layer of complexity, potentially hindering the EU’s Global Gateway ambitions and investors' sustainability goals in EMDEs. With issues including a lack of reliable ESG data, rigid European legal frameworks and criteria not tailored to EMDEs, these regulations can limit investment flows. Even when EMDE investments meet European sustainability standards, they do not count towards key performance indicators like the Green Asset Ratio (GAR), which measures the proportion of EU green taxonomy aligned assets compared to total assets. For example, green investments outside the EU are not eligible for inclusion in the numerator for the calculation of the GAR but are included in the denominator. As a consequence, the GAR of the Dutch development bank, FMO, and other European DFIs is 0%, despite their robust portfolio of sustainable green investments. FMO and EIB have both expressed concern at the reputational risks that this new regulation poses to them.

However, reforms are on the horizon. Post-Brexit, the UK has relaxed matching adjustment criteria under Solvency UK, which could improve EMDE allocations. For the EU, a revised Solvency II is expected by 2026. As part of this, the regulator, European Insurance and Occupational Pensions Authority (EIOPA), should review capital charges for non-OECD infrastructure. This would be similar to what EIOPA has done before, like when it adjusted the Solvency II capital charges for OECD infrastructure assets after stress tests in 2015/16. The Global Emerging Markets Risk Database (GEMs) Consortium, a collaboration of 26 MDBs/DFIs, has released promising new credit risk performance data for EMDEs. This data could help adjust regulations for EMDEs. However, it mainly reflects MDBs and DFIs with preferred creditor status, leaving a gap for institutional investors who venture into EMDEs without the protective 'halo effect' of these institutions.

3. Large systemic challenges can only be addressed through a collaborative approach among MDBs, DFIs and institutional investors.

Institutional investors face several challenges, with two major hurdles standing out: scale and capacity. Many require opportunities of at least $100 million to make it worth their while and meet their diversification needs. However, large-scale single investments in EMDE private markets are limited. This scarcity is compounded by the fact that large institutional investors typically avoid taking substantial stakes in investment vehicles like funds due to capital efficiency reasons. To address this, the development of larger-scale investment structures is essential.

MDB and DFI capacity also remains a significant challenge. Many lack the necessary structuring capabilities and deep understanding of institutional investors’ needs. To bridge this gap, MDBs and DFIs must invest in building their mobilisation capacities. Many institutional investors are unfamiliar with private market investment in EMDEs, and with their decades of experience, MDBs and DFIs are ideal partners. They offer valuable insights and risk mitigation strategies, market knowledge, making investment in these markets more accessible and less risky – yet they are often invisible to big asset owners and managers.

However, differences in investment approaches and culture between these groups can create barriers. The shift from transaction-based to portfolio-based models by MDBs and DFIs holds promise, though complexity will remain if each institution customises solutions for different asset managers. A common understanding and aligned strategies would help unlock more significant investments in EMDEs.

Another emerging point of debate revolves around how concessional capital should be deployed, and whether it’s always necessary. While many MDB and DFI investments in EMDEs already attract commercial capital without concessional support (e.g. the ILX Fund), concessional finance still plays a crucial role in mobilising institutional capital into high impact sectors or smaller frontier economies with sub-investment grade sovereign ratings. Yet, concessional capital can create trade-offs. While it can make EMDE investments more appealing by boosting returns, it can also limit the pool of investable opportunities, particularly if fund structures are tailored to the preferences of concessional providers seeking to focus on specific geographies or themes. Balancing this trade-off is critical to ensuring that MDB and DFI structured funds remain scalable and attractive to institutional investors, particularly those seeking large-scale, replicable structures.

In summary, the path to unlocking institutional investment in EMDEs requires a broader, more collaborative approach. While MDBs and DFIs are vital, addressing systemic challenges like investor leadership, regulatory barriers, and intermediation issues are equally important. By shifting focus to long-term growth potential, aligning regulatory frameworks, and fostering better collaboration, we can create the conditions for more sustainable, scalable investments for the benefit of people and planet.