Why I hope Impact Investment is NOT the next VC

When I began working in the field of economic development, the relevant paradigm / theory of change was shifting from the “do good” Peace Corps model of JFK to the “private enterprise” model of the Reagan era. Having already seen firsthand that teaching a man to fish is useless if there aren’t fish in the water to catch, I was keen on applying private sector business solutions to public-private development challenges.

For the most part, the application of business disciplines to economic ,and now social, development efforts is a good thing. No matter how pure our motivation, our efficiency can be enhanced by well-run operations and well-managed back office systems and processes. There are limits, however, to applying ‘standard business practice’ to innovative social business models. When I read that “impact investment is the next VC”, my heart sinks. While there are elements in the VC model that can be applied to #impinv, the wholesale application of VC to social enterprise would be more of a death knell than a cause for celebration.

I’m down with asking social enterprises to run their operations in efficient, business-like fashion. Nevertheless, when we try to cram mainstream financial behavior into social investment, we are trying to apply “conventional wisdom” to creative problem-solving to no good end. First, conventional wisdom isn’t necessarily very wise, or even “best practice”. It’s just a reflection of the behaviors we have become comfortable with. Second, if we truly want positively disruptive innovation, we need to consciously rethink what’s been done already versus what is possible if we collaborate toward desired goals.

Over the next few months, I’ll be writing about different elements of “aligning interests”. How do hidden biases in the pricing process influence outcomes? Do compensation practices reinforce goal-seeking or dampen performance? How do we incorporate concepts of fairness and sustainability into an industry (finance) that only vaguely values these ideas? Are there ways to segment impact investment so that risks and rewards are appropriately distributed in a pro growth manner?

Let me leave you with something to consider. Supporters of impact investment are quick to insist that market returns can be obtained, despite the fact that no one really knows what “market” is. Past performance, after all, is no indication of future results. There is, however, a huge gaping hole in the concept of market returns on #ImpInv that results from our approach to human capital.

Anytime you insist on paying #ImpInv fund managers sub-market compensation to keep fees low, you are introducing a subsidy into the system at the expense of the very individuals you expect to deliver exceptional returns. That’s just dumb! Without the right human capital, your investment dollars are worth very little.

Is it fair to expect an #impinv manager to accept sub-market compensation just because you’re giving them a carried interest somewhere down the road? Is the standard VC upside carry formula of 80% to investors and 20% to the manager reasonable in the context of impact investment? Is this still true when we speak of base-of-the-pyramid (BoP) business models in emerging markets? How much of a fund’s true operating cost is covered by the proposed management fee? Low fees may make you happier as an investor, given the uncertainty surrounding financial returns, but does this make sense? Think of it this way: if your mechanic told you that your brakes were shot and that new brakes for your car would cost $500, would you pay the $500, or would you give him $250 and tell him to do his best?

by Lauren Burnhill aka @LaurenOPV
If sustainable social change interests you, please follow me on Twitter!

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6 responses to “Why I hope Impact Investment is NOT the next VC

  1. What’s VC and #impinv?

    Sent from my iPad

    • VC = venture capital

      ImpInv = impact investment

      Sometimes those twitter hashtags spill over into ‘regular’ writing… sorry for the undefined acronyms! I normally manage to avoid them and will add a mental reminder to define my abbreviations going forward.

  2. Some answers that we gave to those questions – although perhaps only partially responsive to your fair pay/reasonable incentives issues – are as follows: In creating an investment fund (for-profit) that makes loans to charities and non-profit organizations (NFPs), we created a manager that is itself a non-profit corporation (NFP). This management company works on a cost-recovery model for its compensation. The regular staff of this manager are largely consultants, making their living from fees paid by the manager. The manager also provides financial coaching services to its potential investees (borrowers) and other NFPs, and utilizes volunteer resources for some of its services. The volunteers are usually mature or semi-retired professionals who are happy to be “giving back” without the obligations of full-time work or pay.

    The Fund’s investors are largely community foundations which normally grant about 3% of their asset value annually to local NFPs. By investing in a for-proft Fund, however, they can both meet their fiduciary duty to invest some of the “other 97%” conservatively (altho given market downturns, even mutual funds and blue chip equites are hardly conservative investments) and stay within tax laws, and re-cycle capital to more NFps when the loans are repaid. If one of “their” NFPs gets a loan from the Fund, or even just financial coaching, they are increasing the benefit that their grant brings to that same NFP. Even if none of their NFPs got loans, they recognize that the whole NFP community benefits from the increased financial literacy, exchanges of information, NFP operating models/ideas, and networking that the Fund makes possible.

    Bottom line: The manager’s NFP status and cost-recovery model gives the Fund investors the comfort that the Fund will maximize financial benefit to them and additional support for their mandate, but does not penalize or disadvantage the manager’s staff/consultants.

    • Sounds like a reasonable approach to a debt fund structure! I was primarily referring to equity, where the challenge resolves around determining what the upside is and how it should be allocated. I’ll tackle the question of upside in my next post!

      Thanks for sharing how you’ve approached the issue of compensation and investor confidence!

  3. I wholeheartedly agree with you that impact investing is a different beast and so applying business principles can be detrimental. But, I have interpreted many articles about making #impinv more like VC differently. As I understand them, it is less about pushing conventional wisdom, and more about opening up accessibility to funding.

    These articles point out that the VC model understands and allocates for the overhead and operating costs of business ventures. They also point out the range and total spectrum of VC options available for all stages of business development. In that sense, I would like to see #impinv become more like VC.

    • To the extent that VC has attracted large sums of investment capital and significant human talent, I’d like to see those things occur in impact investment as well. The VC model, however, works best for tech ventures that involve creating intellectual property. When we mimic VC traits without adequate filtering around the realities of multiple bottom line investing, we’re missing a major opportunity to innovate. Copying models like #Y-Combinator into the social enterprise space doesn’t make a lot of sense to me. I’ve written before about my concerns related to the boom in incubators and accelerators, particularly the large gap in financial markets that will face graduates of these programs. The @AgoraPrtnrships model added an incubator/accelerator as part of a larger investment and value-added proposition, which I want to acknowledge and applaud. Mostly, I see programs that are too short, involve too little capital and struggle to connect the right kind of non-financial support to participants. Maybe that’s part of the growth process of our industry, but what’s missing is integral thinking about business life cycles and how these relate to funding structures in social finance. I don’t see VC as being accessible to all stages of business development and there seems to be a lot of credibility given to the notion that founders and innovators can and should survive without income (or with very little) while launching a new venture. In effect, we punish entrepreneurs and their families for their willingness to be innovative, much in the same way we punish those who want to work in economic and social development by insisting that those who work on behalf of the poor shouldn’t expect market compensation for their skills and efforts. I can’t help but think that we can create better models for growing businesses and serving our communities, especially since a lot of our challenges arise directly from our own mindsets.

      Which structures, lessons learned and practices should we be adapting from VC for #ImpInv? I don’t think we should be trying to replicate VC “as is” but I’m very willing to believe there are things we can learn from and adapt for socially responsible finance!

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