Sarah Barlow and Rachel Shah
This post is part of a learning series exploring good practice, examples, or new applications of MSD.
Challenge funds are popular as a way of allocating development support because they are deemed low-cost to administer, as well as fair and transparent. Many a market systems development (MSD) facilitator digs into their toolbox to find a mechanism that will help them identify partners or come up with an innovative business model and pulls out a challenge fund. Although critics argue that challenge funds have been tested and come up wanting, many programmes that claim to be using the MSD approach rely heavily – sometimes almost entirely – on the use of challenge funds as a facilitation tactic. So, are challenge funds a ‘systemic’ facilitation tactic or is their convenience to aid programmes their main advantage?
There’s a saying in MSD that “no tool is banned”. The underlying principle is that you can use any facilitation tactic as long as there is a good reason for doing so, backed up by strong analysis, a realistic vision and a plan for how scale and sustainability will be achieved. It is generally not tactics that are systemic or not, it is the way they are used.
That said, some tactics do come with inherent risks that make them harder to use to advance systems change, and challenge funds are one of these. Challenge funds aim to stimulate innovation by offering support, typically grants or assets, to underwrite the financial risk of market players piloting solutions to a development problem. The competitive nature of challenge funds provides a transparent means for programmes to disseminate funding, with low administrative overheads.
The difficulties of running a challenge fund in practice are well documented. For example, an OECD review done for Sida titled “What works for market development: a review of the evidence” outlines many of the pitfalls challenge fund managers can fall into. Here we explore these and other pitfalls in relation to the core principles of MSD:
Analysis: Challenge funds cannot replace in-depth system analysis – the purpose of which is not only to identify system level constraints, and their causes, but also to assess potential partners, and their incentives (and capacity) to change their behaviours. When programmes use challenge funds without first conducting rigorous market systems analyses, there is a very real risk that key systemic problems and their causes will be ignored or misunderstood. At the same time, the use of challenge funds, even following strong analysis, can encourage facilitators to focus only on the problems that challenge funds can help them address rather than the priority constraints. For instance:
- Sometimes what is needed to facilitate change is technical advice, information, linkages or other resources which are not readily advertised through challenge funds. A challenge fund typically limits the facilitation options open to MSD programmes, and its inherent focus on providing successful applicants with a grant or asset obscures the other forms of support the programme could – and often should – provide.
- In a challenge fund, applicants are all offered the same kind of support and often very similar degrees of support irrespective of need, but MSD analysis often shows that different players need different kinds of support, depending on what incentive or capacity blocker is preventing them from changing their behaviour. Financial risk is not the only obstacle that prevents market players changing their behaviour – and even where financial risk is an important constraint, a one-off grant provided to a handful of lucky challenge fund recipients rarely results in the kind of systemic change that is sustainable and scalable.
- MSD analysis is likely to uncover a range of market dysfunctions, but challenge funds are only suited to addressing a very narrow subset of these – namely stimulating innovation by providing the necessary resources to help enterprises trial an innovation “whose public benefits are proven but whose financial returns are uncertain” (OECD, pg. 93). Challenge funds are particularly poorly suited “to delivering policy or regulatory change, or the improved institutional delivery of support functions provided by the public sector” but “without such changes, it may not be possible to deliver impact” (OECD, pg. 94).
Partner identification: partner identification is part of market analysis, but as challenge funds are often used as a shortcut to identify potential partners, it is worth exploring the pitfalls associated with this component of analysis in particular. Experience shows that some players with genuine incentives to adopt new ways of working are put off by challenge funds, which are often accompanied by heavy reporting requirements and bureaucracy and equated with distortive aid support. Similarly, some players have learned the development ‘game’ and are very good at accessing public funds, often receiving grants and support from multiple donors. These are rarely the best players for an MSD programme to partner with, but they may well be the ones that write the most competitive submissions to a challenge fund. They therefore receive support not because they are the most innovative or because they are most likely to invest long-term in a new (and replicable) way of working, but because they are the best at playing to donor-funded projects’ incentives.
Furthermore, challenge funds tend to target private sector-players, but sometimes an MSD programme needs a range of partners, including public sector or civil society players, in order to address the most critical supporting functions.
Adaptive management: effective facilitation requires a high degree of flexibility and intervention adaptation. Challenge funds, by their very nature, require upfront decisions and commitments that can limit flexibility during the intervention process.
Achieving scale: challenge funds’ direct focus on grant recipients, rather than on addressing system level constraints for the benefit of a wider range of market players, is an inherent obstacle for reaching scale. In addition, challenge funds do nothing to test the appetite for replication of a new way of working across a system. In fact, by their very visible nature, they may distort existing incentives for replication by creating an expectation among players across the system that they will be ‘rewarded’ or compensated for adopting the new way of working.
Achieving sustainability: MSD encourages programmes to be as invisible as possible to avoid distorting the markets they work in. Challenge funds, by their very nature, position programmes as visible, donor-funded grant makers. Furthermore, the end prize of a grant or asset creates incentives for engagement that obscure the permanent incentives in the system. This may be because longer-term incentives don’t exist, or because the players incentivised to apply for a challenge fund are not the players incentivised to adopt a new way of working long-term.
Given these pitfalls, it’s clear that there are substantial risks when MSD programmes adopt challenge funds as either a way of assessing market systems, and/or as a facilitation tool. Although challenge funds are widely seen as useful and convenient fund disbursement mechanisms, their main advantages of economy and transparency primarily benefit aid programmes, not the systems they are trying to improve. The substantial risks inherent in their use, suggest that MSD programmes should root around a bit longer in that toolbox of facilitation tactics before relying on challenge funds.
As you’ll frequently find in this A-to-Z series, there are few hard and fast rules in MSD, but there is a growing body of experience that suggests that challenge funds shouldn’t be the predominant tool an MSD programme relies on to advance systems change. Crucially, there are no circumstances where their use can adequately replace the usual MSD approach, including taking time to do in-depth market system analysis – that might even be a hard and fast rule, after all!
 Sida has a simple explanation of how challenge funds work at: https://www.sida.se/en/for-partners/private-sector/challenge-funds
 See pages 91 to 95 of https://www.oecd.org/derec/sweden/What-works-for-market-development-a-review-of-the-evidence.pdf
 Discerning readers may notice that in many ways challenge funds are more closely aligned with private sector development approaches than with the market systems development approach. For a very useful analysis of the synergies and points of departure between these two approaches, see: https://www.marketlinks.org/sites/default/files/media/file/2021-12/MSP%20Brief-Towards%20Transformational%20Impact-Synergies%20of%20PSE%20and%20MSD.pdf