Early Stage Impact Investing – Where’s the Beef?

Much of the initial thought work around impact investment kicked off in 2006-2007. Financial markets were bubbly, microfinance was expanding nicely and the need to move from “access to finance” to basic quality of life themes (i.e., housing, education, healthcare) became an increasingly recognized priority. Two of the biggest obstacles to financing new ventures with social impact (VSIs) at that time were: (1) low levels of enterprise investment readiness; and (2) lack of seed funding for new ventures. Programs to address these gaps were developed by a range of industry leaders and existing programs were also expanded. In the enterprise development space, Skoll Foundation, Ashoka, ANDE, Endeavor, SOCAP and others offer excellent support to entrepreneurs. Addressing the seed capital gap, TONIIC, Investors Circle, First Light Ventures and others have worked diligently to help new VSIs get started. As a result of these and other efforts, investor interest in impact investment is at an all-time high and a growing number of VSIs are completing pilot projects and looking for scalable growth.

Sounds great, but there’s a big cloud on the horizon, namely the incredible scarcity of money for early stage impact investing (ESI), which means that many promising VSIs will wither on the vine. How did this happen and what can we do about it?

  • ESI is not Venture Capital. For impact investment, we’re usually talking smaller investments, far from home that boast multiple bottom lines and require a unique approach to hands-on value-added. VC’s, for the most part, are looking for tech driven innovation relatively close to home, with high potential exit multiples. VC is not going to rush into impact investment any time soon.
  • The business model used for early stage microfinance investing (stand-alone, closed-end, structured funds) is costly and inefficient, but few industry actors are focused on finding better models or structures for ESI. If exit multiples are likely to be constrained (which they are), reducing the real costs of investing is one of the only ways to boost financial returns. Stand-alone funds serve a small number of firms (and most ESI funds are themselves new and early stage) and usually spend 18-24 months looking for capital before they can serve even this limited number of firms. There are ways to address the scalability of ESI, but few of us are waving this flag.
  •  Less than 20% of the funding in microfinance investment vehicles represents equity, which has a limiting effect on the potential spillover of MF equity to broader impact investment themes and also on the talent pool available for impact investment ESI. Investors tend to prefer debt as being less risky, especially since the exit issue becomes moot. Nevertheless, it is rather hard to gear up lending unless potential portfolio companies also have access to equity capital. The scarcity of funded intermediaries, combined with this debt preference, means that there is no systematic ESI market, although some deals are funded on a sporadic, opportunistic manner.
  • Early stage for impact investment is a relatively length period of time. A one-off investment, whether at the A,B or C round, may not be provide enough juice to reach a scale that allows a strategic exit. Multi-round financing strategies can overcome this problem by ensuring that VSIs that meet financial and non-financial return goals have adequate access to growth capital. In essence, you can double or triple down on strong performers, reducing exit risk and enhancing return prospects at the same time. With no follow-on financing in sight, VSIs with seed funding won’t be able to grow.
  • Marketplace initiatives (like Mission Markets, GATES Impact and Microplace) are also in the early stages of their own growth and development. Meeting US regulatory requirements, serving investors and helping VSIs work through due diligence to list an offering are all big challenges. Marketplaces can and will make ESI easier in the medium term, but in the near term transaction volume will be limited (especially until the regulations underlying Dodd Frank are all in place and clearly understood).

What can we do to increase the availability of ESI? Following are some of my ideas, but if you have others, please share/comment!

  1. Grant making organizations should consider adding a program or policy that encourages innovation around ESI business models and supports “new” managers (by new, I mean that the fund or firm is new; the individuals behind the entity should, of course, have the appropriate skills and track record). Financial services and financial intermediation entrepreneurs are as critical to a healthy ecosystem as is the presence of VSIs ready for growth capital.
  2. Investors should look for fee structures that align interests and match the budgetary requirements for implementing strategy/product goals. The managers who work on your behalf should be as creative in their approach to adding value as they are rigorous in their fiduciary responsibility. Balance your notion of “skin in the game” with middle class reality – many of the people we need to attract to impact investment can offer human capital but not financial capital. Money, talent and experience don’t necessarily go hand-in-hand, but leaving ESI innovation to the wealthy and highly compensated isn’t the way to go. If you want productive and dedicated investment managers, you need to make sure that the operating budget includes health care, retirement savings and other standard benefits that assure stable quality of life. If your fund manager has to moonlight as a consultant to cover medical bills or school tuition, performance and ethical issues arise. Will portfolio companies get less attention? Will your manager burn out or leave for a job with better benefits that protect his/her family? Remember, we’re not trying to make one group (the working poor) better off at the expense of another group (middle class impact investment professionals) who are trying to help. Our goal is, or at least should be, to make everyone better off.
  3. Both philanthropic and mainstream investors can look for ways to support impact investment ESI through new business models that offer scalable, responsible and cost-effective approaches to reaching (generally) small VSIs. Don’t just look for a “better fund” or an experienced individual – look at the whole investment model. While the model itself may be new, dynamic innovators are applying tried and true techniques from other areas of finance and capital markets to create intermediaries that are lower risk than stand-alone funds even though targeted outcomes may be similar. If you aren’t seeing models that reflect your business know-how, demand something different – and be prepared to put your money where your mouth is!

By Lauren Burnhill (@LaurenOPV)

#impinv, #socent, #earlystage, #microfinance

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