Eyes Wide Shut
The Harsh Realities of Impact Investing and Proposals for Reinventing the Industry
Impact investing has grown dramatically in the last two decades and shows no signs of slowing down. A report estimates invested capital from impact investing could range from $400 billion to $1 trillion over the next decade. A survey of 52 impact investors found they intended to deploy $3.8 billion of capital in the next 12 months.
While there is a burgeoning literature on whether the potential financial returns merit the level of excitement, there has not been much research on the structure of impact investment funds. This post examines the growth of impact investing and why returns are unlikely to meet expectations for the majority of investors. Unfortunately, structural differences between social enterprises and typical VC investments reveal that target rates of return are unrealistic for all but the very best impact investors.
Based on the type of social enterprises that are typical investment targets, there could be opportunities for rethinking the typical VC equity model for debt-based instruments that more closely meet the needs of developing country social enterprises. The post discusses why debt-based instruments hold promise, a few examples of types of financial structures that could be beneficial, and the barriers preventing change. Greater transparency, visibility and experimentation are required for understanding the true promise of alternative financing models in the world of impact investing. Overall, greater consideration should be given to debt instruments as a means of more effectively achieving financial and social fund objectives.
Introduction
Many involved in international development are looking to impact investing to catalyze new and scalable solutions to the issues surrounding poverty. The focus on the consumer and the bottom line has allowed social enterprises to scale more rapidly than most non-profits. The feedback loop of a consumer-focused company has created a more business-like approach to development. With a valuable “profit motive” underlying impact investing, social enterprises will thrive by focusing on creating value for their customers.
Though this growth has really helped diversify a means to international development, it is time to step back and take stock of how successful impact investing has truly been. Upon a candid reassessment, it may be time to recalibrate expectations and look to restructuring the model such that it can better achieve the goals of addressing social problems. This paper looks at the rise of impact investing, the major drawbacks, and a potential new model that can be explored.
The Rise of Impact Investing
In the early years of the 21st century, development practitioners began experimenting with a new model for development: social entrepreneurship. The idea that social good could be obtained in a profitable manner was expounded by business gurus and spread like wildfire. The most prominent writing, The Fortune at the Bottom of the Pyramid by the late C.K. Prahalad, kickstarted a new era for doing social good.
At the same time, the need to finance these social enterprises created a mirroring rise in a new field – impact investing. Though the term impact investing was not coined till 2007, the mainstream beginnings of the industry can be traced to the Acumen Fund’s creation in 2001. Jacqueline Novogratz started the Acumen Fund as a non-profit seeking to infuse capital in budding social businesses. While all returns would be recycled into the fund, the concept of seeking to extract returns and make “giving” financially sustainable was revolutionary.
Since then, impact investing has grown tremendously. Currently, over $40 billion in capital has been committed to impact investments, and a report estimates invested capital could range between $400 billion and $1 trillion over the next decade. In fact, a 2012 survey of 52 impact investors found they intended to deploy $3.8 billion of capital in the next 12 months.
What, then, is impact investing? Impact investing is defined by the World Economic Forum as “an investment approach intentionally seeking to create both financial return and positive social impact that is actively measured”. The industry has basically transplanted the traditional venture capital model to social issues and added elements of social return. This means typical impact investments share the following characteristics:
Typically equity or equity-like investments (money in exchange for ownership of the company)
Expected payout period of 5-10 years
Payouts generated through successful “exit” – sale of the company or IPO
In addition to money, investors often take a board seat and other accompanying provisions to guide the strategic direction of the enterprise
From early stage (seed) to late stage (Series C) capital
The difference for impact investments is the measurement of social returns and how financial returns are treated. First, all impact investors actively monitor not just the financial performance of their portfolio companies, but the performance on social metrics that are often individually defined. In addition, for some impact investors, they are motivated purely philanthropically and recycle all financial returns to other investments. On the other end of the spectrum, some investors look for market-level returns that are commensurate to the risk they are taking on.
With all the hype around social enterprises, impact investing has grown without much consideration on whether the model is working or needs refinement. There are a few main reasons that there hasn’t been enough discussion around the potential problems facing impact investing:
There is not enough transparency
The first problem is that the impact investing industry lacks transparency. Very few impact funds publicly report portfolio results, even in an aggregated manner. As a result, there’s very little data to analyse in terms of the industry performance. Acumen Fund, one of the few funds to discuss performance, found that its average portfolio company has an after-tax loss of 20%. If there was more information about fund-level performance, there might be greater concern and voice given to potential revisions to the way investments are structured.
Success is more prominent than failure
Due in part to the lack of transparency, the few notable successes from the impact investment world have been much more public than its failures. The best example of this is the area of microfinance – described as “the most established and mainstream of inclusive business sectors”. Due to the massive success of a few startups in the microfinance space (SKS, Ujjivan, Equitas), investors have seen the potential for successful exits.
Instead of noting the rarity of these successes amongst impact investments and the unique nature of the growth of microfinance over the last two decades, the returns have been glorified. Even these successes demonstrate the need for moderating optimism – Unitus Capital reports that net IRR for equity-based microfinance investment vehicles achieved 12.5% growth. Even as the most notable success, the returns are not considerably above market returns, showing that more modest returns must be expected in other social businesses.
Failure takes a long time for early-stage investors
Lastly, failure takes a long time in the investment world. This is not a problem unique to impact investing; it is one that has plagued the venture capital world as well. The typical problem is as follows: VC raises Fund 1 at time t=0, with an expected return to Limited Partners (LPs) in 5-8 years. In year 3 or 4, or t=4, the VC raises an even bigger Fund 2 highlighting the imminent success of Fund 1. The discussion of the success of Fund 1 is prior to the actual results being available, so promising startups in the portfolio dominate the discussion while ignoring looming failures. By t=5, a new fund has been raised with another 5-8 year window. At t=8, the VC may find that Fund 1 has not been successful, but the VC is already in business through t=13. Therefore, in this basic scenario, a VC takes 13 years to fail! Impact investors face the same fundamental misalignment, except their investment horizons are often longer (7-10 years). This means failure could take 15-20 years to truly materialize, which is why we are still in the early stages of understanding impact investing.
That being said, the hype has grown to the point where there is growing dissension amongst the development community on the role of impact investing. The next section will turn to a discussion of the problems the typical venture capital model is facing when applied to the world of social impact.
Harsh Realities
Background on VC Economics
In the venture capital world, success and failure are worlds apart. Success is defined as a sale of the company or an initial public offering (IPO) that generates substantial financial returns for the early investors of the company. Successes generate enormous returns that justify the many failures in their portfolio. To oversimplify a bit, a typical VC seeks to generate 2-3x returns for their limited partners. Accounting for the investment horizon, management fees, and the typical failure rate, they need the winners to generate > 5x returns.
Why is this? Fred Wilson, one of the most famous VCs, describes a typical portfolio as 1/3 winners, 1/3 “money-back”, and 1/3 failures. In this world, the winners need to generate 6.5x returns for the VC in order to reach the desired fund-level returns. The data makes the story even more stark: From 1979-2011, a study found that the top 10% of invested capital generated 60% of the value. In addition, 55% of invested capital has gone to the failure category, or those that can’t return the money invested.
Therefore, if a typical VC makes 20 investments of $10M each (for the sake of simplifying math), they would hope the portfolio would play out as follows:
Table A: VC making 20 investments of $10M each (total fund size of $200M)
Starting out with $200M, the VC would hopefully double the money by generating 3 big wins that return 10x, which comprises more than 70% of their fund returns. When you take into account the period over which the VC fund operates, this translates to a ~20-30% net IRR (internal rate of return) annually.
This is just the theory. In fact, studies of the venture capital industry find that most VCs do much worse than these estimates. A recent study by the Kauffman Foundation found only a third exceed returns from public markets, and half don’t even return full investor capital. This just illustrates that even in very developed markets, it is extremely difficult to find the winners that justify the immense risk early-stage investors take on.
Applying the VC model to Impact Investing
Impact investors have traditionally looked at investing in the same manner – generating substantial successes in a few of their investments that create decent fund-level returns. In fact, when 176 impact investment funds were assessed for their target IRR in 2013, the results were surprising to say the least. 35% of impact investment funds are targeting similar returns to typical west-coast VCs in their fund. Even for those that expect more modest 6% fund-level returns, they still require the “winners” to generate ~3-4x returns.
Where the model breaks down
Unfortunately, upon closer inspection, transplanting the model doesn’t make sense because of the fundamental differences in most social enterprises, especially those trying to reach the base-of-the-pyramid in developing countries. There are two main differences that merit further discussion: the upside of a “winner” and the much greyer notion of failure in the context of social enterprises.
First, the upside of a “winner” for social enterprises is unlikely to be as great as a typical startup. The concept of 10x returns understates just how enormous the growth of these successful companies is expected to be – taking into account the dilution of further investments, these companies have to grow to 20-25x their value at the time of investment to generate 10x returns for investors.
Realistically, is this type of growth possible? First, there’s a fundamental difference in the market size: The market size in the US for advertising or enterprise software is orders of magnitude higher than the market in India or Africa.
It definitely is possible to generate significant growth, but much rarer and more difficult given the inherent limitations on the market size. This does not even address the additional barriers posed by the type of customer – BOP customers have a much lower ability to pay and often have greater distribution costs in reaching them, creating even greater hurdles to outsized financial success. Again, this is not to say that market-based financial returns are not possible in this sector – only that the upside is typically more limited than a typical Silicon Valley investment.
The upside being limited has a tremendous impact on the fund-level returns. If we revise the same table from before with a more modest upside, the fund-level economics are transformed dramatically:
Table B: Impact investor making 20 investments of $10M each (total fund size of $200M)
By changing the upside to 3.3x instead of 10x for winners, the fund level returns now basically return the fund money. The fund-level IRR is now less than 1%, well below the expectations of most impact investors. In order to realize greater upside, there are two ways investors are moving: lower their expectations such that they will not achieve commensurate risk-adjusted returns, or move into markets that are serving higher-end populations. Acumen Fund, the most philanthropic of impact investors, is an example of the former. They have stated objectives of achieving 1x returns (0% IRR), which is much more realistic given the potential upside just discussed.
On the other hand, others call for reaching more developed, wealthier populations as a means of achieving more significant upside. The poor are actually quite a diverse group: the poorest 80% of the world fall into four strata.
Professor Hopkins of Yale University argues that “financial-first” impact investors ought to seek the low and medium income populations that live on between $3 and $16 per day. He argues that these people tend to operate in more well formed markets and offer greater opportunities for return-oriented investors. The only problem with this logic is that there’s a natural trade-off with the true social benefit being provided. By ignoring the 2.6 billion people living on less than $3 a day, impact investors would be truly compromising on their ability to have a substantial social impact. Additionally, given the failures of most VCs to achieve their expected level returns, it is not hard to believe that many impact investors will struggle to achieve even the more modest 3x returns in these areas.
The second main difference is the notion of failure and success in the context of social enterprises. For typical VC investments, success usually is witnessed through what is referred to as “hockey stick growth”.
While users and revenues grow slowly at a linear pace (with profitability suffering early on), at some time an inflection point is hit where exponential growth is achieved. Products that achieve significant penetration and meet an essential desire of the population start spreading in a viral manner. This is the typical tech story – explosive user growth eventually leads to monetization and massive profitability. In this world, the non-winners are those that never reach that inflection point - they end up shutting down (failures) or being acqui-hired (money-backs).
This story doesn’t translate quite as well to social enterprises. Hockey stick growth is really hard to find as the upside is generally capped as was discussed previously. In addition, there aren’t as many network effects when dealing with a BOP population. The reason exponential user growth is so prevalent in the technology space is the presence of positive network externalities: for example, a social network is more valuable to any individual user the more users that utilize it. Therefore, at some point, the network externalities of many technology products eventually translate to exponential growth.
For social enterprises, even the best-case scenario is often much more linear growth. Many social or poverty-related interventions do not have the same network externalities. In addition, the cost of distribution to reach a broader and more disparate customer population means that marginal costs are a much bigger part of the equation. There are a few notable exceptions to the absence of network externalities (e.g. microfinance, vaccinations), but overall, social enterprises tend to have a more steady, linear growth trajectory.
The few winners of an impact investment fund still have the same “exit” – a sale of the company or an initial public offering. It is the non-winners that I hypothesize look very different in this world. For those that do not reach the traditional hurdle to be defined as a winner, failure may not be as stark. These companies often have achieved customer growth and are still in operation, but have not reached the scale or level of profitability to be a viable public business. Given the nature of the social impact, I suspect fewer businesses will go out of business, but instead stay static or even evolve into a purely philanthropic effort.
The problem is equity-based instruments offer no means of capturing returns from non-exits. Though the company may have steady revenues and even small profit margins, there are limited means of extracting money due to the equity structure. Therefore, despite the fact that in many development areas, failure will look quite different for social enterprises, this is not adequately accounted for in the equity financial model. Once you take this into account, the fund-level returns start to look disastrous:
Table C: Impact investor making 20 investments of $10M each (total fund size of $200M)
With less of an ability to sell off the company (even at a lower price tag), it is much more likely that there would be no “exit” that yields a payout for impact investors. In this case, this would mean returning 50% of the initial capital after 7-10 years, a far cry from potential market returns. These are just rough calculations that do not capture all the complexity, but they illustrate an important point: at least some impact investors are soon to face harsh realities when they come to terms with the potential returns from their investments. Given these differences, the VC model may not be the most aptly suited for the domain of impact investing. The next section delves into new ways for reimagining the approach.
A New View
In many cases, social enterprises look fundamentally different than those serving wealthier populations. Investors need to account for these differences when designing investment vehicles that meet the needs of both entrepreneurs as well as investors. Perhaps conventional equity instruments are not the best means of financing most social enterprises.
Instead of conventional equity-based model, the paper proposes using more flexible debt or hybrid-based instruments to finance social enterprises. There are four main advantages to utilizing debt or debt-like structures:
1. Allows for faster turnover of funds
For many more philanthropically minded impact investors, returns from the fund are recycled into new investments. With equity, typical “exits” are not created prior to 7-10 years, during which the capital cannot be redeployed. On the other hand, debt with set repayment schedules can return capital to investors on a more regular, early timeframe such that it can be redeployed into new investments. Impact investors often measure the number of “turns” a dollar generates, with the idea being that it is more impactful than charity since a dollar can create impact multiple times if returned. By utilizing debt, these dollars can be recycled even faster and create an even wider impact.
2. Capture limited returns from “failures”
As mentioned earlier, the notion of failure is much greyer in the world of social enterprise. Social enterprises on a more linear growth trajectory may never reach the size or scale of a typical exit, but may be operating with revenues and low profit margins. With debt-based instruments, it may be possible to extract money from these non-winners and create greater fund-level returns. To compare the two,
Table C: Impact investor making 20 investments of $10M each (total fund size of $200M)
Table D: Impact investor making 20 loans of $10M each (total fund size of $200M)
Though the upside on the winners is lost due to only capturing interest, the ability to extract significant capital from the other investments creates a much more desirable fund-level return. This does not even account for the fact that these funds can be recycled more rapidly and thus create greater “bang for the buck” from an impact perspective.
3. Social enterprises often lack access to debt even at later stages
Another benefit of debt instruments is that they are sorely missing from social entrepreneurs in today’s landscape. Within emerging markets, it is amazingly difficult and costly for small businesses to take loans. The risk inherent in these markets and the inability to pay is the same barrier individuals face. While microfinance emerged as a means of addressing the individual, nothing analogous has emerged for smaller businesses.
4. Provides potential for investing in non-profits as well as for-profits
Finally, debt instruments allow for greater flexibility in the type of enterprise that receives investments. When looking at social impact, there are plenty of revenue-generating non-profits that have potential for scale. One Acre Fund is a prime example – structured as a non-profit, the One Acre Fund reaches over 150,000 families annually by providing inputs and training to improve incomes for rural farmers. As a non-profit, the One Acre Fund cannot sell equity, but it can easily take on debt.
One Acre Fund is not alone. Especially when serving the poorer sectors of the BOP, many essential services cost more to provision than the poor can afford. On its face, this is logical: how can those living on less than $2 a day afford to pay for health emergencies, children’s education, or productivity-enhancing inputs? Just because the services cost more than the poor can afford doesn’t mean the poor can’t afford to pay anything at all. In fact, research has shown that the poor are incredibly discerning consumers e.g. choosing low-fee private education when free government education is bad.
Therefore, even in those areas in which profit may not be possible, revenue still is. Instead of the traditional profit or non-profit dichotomy, debt-based instruments allow for thinking about development in new terms: revenue-generating organizations versus purely fundraising-based organizations. For revenue-generating organizations, the business survival still depends on creating value for consumers in an efficient, scalable manner.
Instead of the false dichotomy between impact investing and grant-making organizations, debt instruments provide a more agnostic form of financing that are examining the value of the service provided and the cost of providing it.
Proposals for Reinvention
There are several basic debt-based alternatives that could be useful to social enterprises and generate greater financial and social value for many impact investors.
Venture Debt
This makes sense for companies that are still early to mid-stage and not yet profitable, most of who are desperately in need a typical loan. In almost all cases, they do have revenues and/or accounts receivable that can justify repayment at reasonable interest rates.
Inventory revolving lines of credit
In many social enterprises, there is significant working capital risk as collecting payment is difficult until reaching a certain level of scale. A revolver is a loan that that is secured by the company’s receivables and/or inventory, where the available credit or loan is based on the current collateral available. This would require less funding, provide reasonable interest rates, and offer a valuable service to entrepreneurs.
Shared revenue models
In exchange for an investment, the investor gets a stake in the revenues of the company and is paid out like preferred equity or preferred debt over 2-3 years. In this structure, the company is left with greater control and ownership. For the impact investor, while the upside is limited, the downside is also much less risky and funds can be recycled more quickly.
Convertible note structures
These hybrid instruments may provide the best world for investors. Convertible notes are a type of bond that can convert to equity over a certain time period. With this, investors can convert to equity in the companies that show the potential to generate above-market returns. For the non-winners, the downside for investors is better protected by providing cash flow from coupon payments and the repayment of principal upon maturity.
All of these instruments are practically nonexistent within the impact investment space and may provide several benefits: improved fund-level returns for most impact investors, higher turnover for recycling funds, and more efficient capital deployment for social enterprises. With all these potential benefits, the question of why this hasn’t happened merits discussion in the next section.
Barriers to Change
Though there is potential for debt-based instruments, there must be several reasons why this hasn’t happened yet. A few of the main ones are presented below:
It’s just not as sexy
There has been so much discussion of the potential to achieve market rates of return and solve seemingly intractable social issues. This has drawn all kinds of interest from investors who want to do well financially and do social good at the same time. The underlying story for the new paradigm is not quite as optimistic – you should expect to achieve lower rates of return for businesses addressing social issues in emerging markets, and you should invest accordingly. This message doesn’t sell quite as easily and requires a more nuanced understanding of the populations, markets, and impact involved.
Risk ≠ Return
The upside is limited in nature - and given the riskiness of these markets, there is no way the return will be commensurate with other investment vehicles on a risk-adjusted basis. The problem with this viewpoint is that the upside of equity is limited as well. While in theory, the upside of equity is unlimited; in practice, the constraints of the population being served and the market size discussed earlier provides very real constraints on the upside.
Unfortunately, coming to terms with this requires a level of reflection that is foreign to most investors. This is the same reason almost all VCs tend to think of themselves as above average despite research demonstrating most fund-level returns are well below market rates. Until impact investors can be honest with themselves about what they hope to achieve, they will continue to think debt doesn’t provide a potential return commensurate to the risk, ignoring the fact that equity doesn’t either.
Not viable for certain investors
The explosion of the impact investment sector is meant to be realized through unlocking new sources of capital that have previously been inaccessible for social issues. Institutional investors, large financial banks, and others with financial motives would see the potential returns in social enterprises and deploy more traditional capital towards more beneficial causes.
In this revised paradigm, many of these investors will be unable or unwilling to deploy capital in these fields. While there may still be opportunities in the wealthier portions of the BOP ($10-$15 / day), debt-based capital focused on poorer sectors will be off-limits to certain investors.
With these barriers in mind, what will it require to see this shift take place? First of all, as mentioned before, investors will have to acknowledge the shortcomings of the current model, especially for poorer sectors of society. At some point, this will become inevitable as more funds reach the end of their lifecycles and do not reach their expected levels of IRR, but it could happen sooner to those looking with a critical viewpoint.
In addition, true change will require greater transparency and understanding of what’s happening in the social sector. There is hardly any data on the performance of social enterprises on an individual or aggregate level across sectors or geographies. This translates to an even bigger black box when it comes to assessing financial performance for impact investment funds.
Considering one of the primary goals of impact investors is to generate and catalyze greater social impact, there is a need for greater transparency to determine whether current vehicles are the most effective ways of doing so. Especially as a variety of debt instruments are considered, understanding repayment potential and growth trajectories of typical social enterprises will provide much better clarity and help de-risk potential innovations.
This post draws on research from the World Economic Forum, the World Bank, Monitor Group, Fred Wilson, the Credit Suisse Research Institute, Bo Hopkins and Abi Olvera, Kasturi Rangan and co-authors, Sasha Dichter, and Bruce Booth.