We all know that there isn’t enough seed or early stage funding available for ventures with social impact (VSIs). Many of the Impact Investment conferences I’ve attended lately have held roundtables and workshops on this topic, hoping to identify the key that will unlock a flow of new funds.
One of the ideas that is increasingly popular with social enterprises and pretty much a non-starter for for-profit investors is the concept of creating shared local due diligence firms or arrangements that international investors could use to lower the cost of making seed investments.
Where did this idea of shared due diligence come from? As near as I can tell, it’s either plain old wishful thinking, or a misplaced convergence link between hedge funds and impact investment funds. The “TPS” in the title of this post stands for Third Party Service Provider. In the hedge fund world, TPMs or “Third Party Marketers” are critical to fundraising, given restrictions placed on what the hedge funds themselves are allowed to do. It’s possible that shared due diligence comes from the idea that outsourcing certain tasks to third parties can be an effective and efficient operating decision.
Impact investment does need specialized TPMs so that the fund managers can focus on pipeline and portfolio development (i.e. making financial and non-financial returns) rather than resource mobilization. TPMs could make impact investment funds more efficient – and this might even reduce the budget requirements for ImpInv fund managers – but it won’t solve the seed/early stage funding gap. Neither will shared local due diligence TPS.
Due diligence for seed and early stage investments is always going to be expensive in relation to the size of the investment itself. Local investors have a cost advantage when it comes to due diligence, and I’m sure this is part of the rationale for shared third party due diligence services. The problem, however, is that due diligence is part of the “secret sauce” in being an investor. The one area in which I absolutely do not want to outsource my involvement is this initial discovery process.
I’d sign up for a TPS that offered less expensive access to legal reviews that check for outstanding liens, court cases etc. I’d potentially sign up for an accounting service that highlights differences between local and international accounting standards or that provides benchmarks vis-à-vis other companies operating in the same industry. But the actual due diligence work – kicking tires, testing operational processes and, most importantly, getting to know management – isn’t something I’d ever be willing to outsource. Why am I so adamant?
1. Field due diligence is the only way to get at the intangible factors that influence a company’s success. I want to know the company, and it’s competitors, regulators, suppliers etc. Not only do I want to be part of that work, I want to use it as a training ground for junior staff. It takes a long time to develop a “nose” for what works, what doesn’t and why – and tagging along behind someone with a good nose is a fantastic apprenticeship;
2. If I use a shared service, the analyst helping my fund might also be working with my competitors. I don’t want to transfer information to someone who might (inadvertently or otherwise) share that with a competitor. Nor do I really want someone in the local market commenting on my due diligence requirements versus the next guy’s. How we apply due diligence information can be as important as what information we ask for. I once overheard one of my clients telling a potential new client that while he was surprised I hadn’t asked for his grandmother’s dental records given the level of detail I wanted, it was absolutely worth the effort to have the right kind of investor on board. That remark still warms my heart many years later!
3. In the early stages of due diligence, I don’t necessarily want anyone – friend or foe – to know who I’m looking at. I might have to pass on the investment for technical or policy constraints and I don’t want to hurt the company’s prospects just because someone hears I’m not moving forward. By the same token, there’s a lot of “me too” pipeline development out there, and I don’t want to pay a higher price because someone hears I’m interested and rushes to get a hand in the game.
For the most part, early-stage impact investment – as with many new investment themes – happens through club deals. No one wants to be first, no one wants to be left out and no one wants too much risk. On an informal basis, we try to figure out which of our colleagues would be interested in a particular deal and could add value as a co-investor and create a small “club” of like-minded potential investors. As part of a club deal, shared due diligence often works well as a cost-reducing, efficiency- increasing option. Why is shared due diligence ok in a club deal structure but not as a third party service? I’d say the bottom line is trust.
Can we use technology to leverage trust and create more club deals more effectively? I’ll have to offer a definitive “maybe” on that. Right now, I think the impact investment industry is highly fragmented, with conversion starting to happen around a broad range of themes: social capital, venture philanthropy, venture capital, responsible investing, ethical investing, corporate social responsibility (CSR) programs, mainstream “environmental, social and governance” (ESG) and so on. I don’t think technology can enhance the club deal equation until we get better clarity and focus around “convergence”. It’s far more complex than adding a pinch of VC to a non-profit structure!
So, how DO we get more seed and early-stage money into ventures with social impact? I’d argue that we need to create incentives (blending non-profit and for-profit funding sources) and structures that change the risk-reward trade-offs on behalf of the early investor.
What do YOU think are the main challenges to getting more seed and early stage funding into impact investing? Setting aside the ongoing turmoil in global financial markets, should we focus more on reducing cost? Increasing diversification? Creating “market-makers” that can tackle the exit challenge?