We’ve all heard the saying “It takes money to make money”. A basic interpretation of this would be that starting and running a business requires capital. Debt financing, both short-term for working capital needs and long-term for investment needs, is important, but responsible lending requires a company to have some kind of equity capital in place first.
One of the key things that makes equity different from debt is the upside. For impact investment, indeed for all socially responsible investment, the big question is how much upside can we reasonably expect to see and how should it be allocated across relevant stakeholders? What is a “reasonable” upside? Last year SAC Capital earned a 13% return net of fees. If one of the largest, most successful hedge funds on the planet is returning 13%, is it realistic to assume than an impact investment fund can achieve a 25% IRR? When our target upside far exceeds the margins on the businesses we invest in, the end results are not going to be pretty.
For the sake of argument, let’s assume we do our homework on the types of businesses we want to invest in and reach a target upside that looks feasible. What does this upside need to cover? Certainly it needs to include growth capital / expansion capital for the company since we want these ventures to ‘scale up’ and reach large market constituencies. The upside absolutely needs to include a return to investors since without their capital, the upside wouldn’t materialize. In addition, we need to provide fair performance-linked compensation for the company’s managers and employees.
What is fair? How do we set compensation levels or formulate compensation plans? Are founders, managers and employees all treated equitably? How much of the upside should flow to the people who create it versus the people who finance its creation?
What’s the time frame for generating upside? Are we taking this into account when we’re discussing compensation for managers and returns for investors? If you’re expecting a four year investment cycle, an 80%-20% split (investors/fund managers) probably sounds good. If, on the other hand, you know the social enterprises in your portfolio will follow an eight year investment cycle, is 80%-20% still a good way to align incentives? Are you assuming that a low management fee is offset by this 20% carry? If you are, does it bother you that our fund manager is potentially going to hire less experienced talent to make his budget work? Wouldn’t you think that getting the right human capital in place – and giving them appropriate incentives – would lead to better value creation and stronger performance?
In mainstream finance, you wouldn’t strike out on your own to launch a fund until you’d made enough money to do that comfortably. In fact, you probably couldn’t strike out on your own because we assume that if someone hasn’t made a chunk of money then they aren’t a good manager. What about the people who have come up through social finance and economic development, always accepting sub-market compensation so that they could accomplish meaningful things? For some of us, maximizing our learning and the value of our contribution to society has been more important than getting rich. Unfortunately, even though this is a conscious decision, our lack of capital prevents us from claiming a seat at the table, no matter how strong our track records and qualifications may be.
Once upon a time, banks liked to make loans because they produced a steady stream of interest income. With lending rates higher than the interest rates paid on savings accounts, a well-run bank with a good loan book could be fairly certain of having a stable, positive net margin. A steady stream of income is generally a good thing for businesses and investors alike, but somewhere along the line we lost track of this notion. Trading income may be highly volatile but thanks to market inefficiencies (among other things) it can also be quite large compared to interest income on lending. Given the short-term focus in publicly traded markets, it isn’t surprising that many banks would rather bet on upside returns from trading than focus on business lending that produces steady income streams but no upside.
When we look at investment, even socially responsible investments that aim to benefit the “base of the pyramid” (BoP), we tend to hope not just for upside but for an outsize return. The outsize returns we hear about (Google, Apple, etc) are really white swan events, They are the exceptions rather than the norm. And yet, we’re trying to create investment structures that produce white swans rather than investment structures that realistically and appropriately account for the risks and rewards of what we are trying to accomplish. We think a lot about what our investment cycle should look like (short!) and much less about what the business life cycle of our portfolio companies implies with respect to returns and sustainability.
When we think of “the investment problem” as distinct from the “business life cycle” challenge, we lose perspective. First, we overlook the need to understand the level of financial return the underlying business can reasonably expect to achieve over the long-term. That smallholder value chain project in agriculture may substantially improve the socio-economic well-being of thousands of farmers and their families, but you’re unlikely to have any IPO exits or windfall gains. If your target return was 30% and the project return is 15%, you (or your investors) will probably be less satisfied than if the target was a 10% return and you achieved 15%.
Add the goal of offering affordable goods and services to low and lower income populations back into the question of upside and return. Are our investment structures capable of producing this kind of outcome or do our current funding practices and allocation of upside translate into higher prices for our target market? I love formulas that link improved operating efficiency to reductions in the price of goods or services offered to the company’s customers. In other words, the more efficient the organization becomes, the less it charges its customers. Get that right and you can generate stable financial returns while continuously growing your social returns. That’s a win-win in my book.
Second, we forget that our social, and potentially our environmental returns, are indeed returns on our investments. The result of an impact investment is not, for example, an X% IRR. It is a X% IRR plus an X or XX% SROI plus potentially an environmental ROI as well. Seen in the light of two or three bottom lines, the pie is much bigger than we assume when we think only of the financial return. If the pie is bigger, perhaps we can be kinder, more reasonable, more rational in how we allocate upside. I’ve seen investors negotiate brilliant deals (for themselves) that killed the underlying venture by preventing other potential stakeholders from coming into the deal because there is no upside left for them. And I’ve seen companies that kill themselves by refusing to ‘dilute’ their ownership and upside even though they need capital to grow. Any way you look at it, 100% of nothing is a lousy return on investment!
Third, when we are blinded by the prospect of a brilliant upside, we get lazy about doing our homework. The limited availability of data related specifically to impact investment, i.e, investment that is meant to produce both financial and social returns, becomes an excuse for believing in white swans. There are a number of meaningful efforts under way to gather and analyze impact investment data so as to provide directly comparable benchmarks. I applaud and support these initiatives, but the fact remains that good longitudinal data requires time. We won’t have 10 year benchmarks until we’ve been doing and tracking our impact investments for 10 years.
In the meanwhile, we can make more of an effort to explore proxy data as a means of understanding potential financial returns. If you want to invest in a network of health care clinics that serve the BoP, it should be helpful to start by understanding the costs and operating structures of health care clinic networks that do not explicitly target social returns. Is your network going to have higher costs? If so, what specific costs do you think will be higher and why is that the case? Will they always be higher or is cost structure something that will benefit (eventually) from economies of scale? Or is it perhaps that your margins will be lower because you need to charge less for the services you offer? Maybe both of these factors will have an impact on your BoP healthcare network but you won’t necessarily figure that out if you start by setting a target return based entirely on what you want out of the deal rather than what the deal can offer.
I think one of the most significant hurdles we face in impact investment is not some inherent limit on financial returns but rather our mindsets. We’re still thinking of social returns as some kind of bonus on our financial returns rather than a key outcome of our investment activities. We assume that ventures with social impact are inherently riskier than standard commercial ventures. I’d suggest that a social start-up may be less risky than a purely commercial start-up. Both have a high risk of failing, but the former may create some lasting social value before it goes under. The small farmers who’ve learned about irrigation, business management and global trade practices retain that knowledge even if the processing plant doesn’t get built or can’t operate sustainably.
Although I’m primarily focused on equity capital, much of the above is relevant to term lending for impact investment as well. The first step in aligning interests is to understand our own motivations and core values. The second step is understanding the motivations and core values of other stakeholders. Where things get really tricky is step three, figuring out how to optimize financial and social returns to all stakeholders. There is no single correct answer to how to approach this challenge, but if we can apply a collaborative, cooperative and flexible mindset to finding solutions, we’ll be headed down the right path.
The good news is that an increasing number of experienced, talented, values-driven professionals are working on finding innovative and appropriate solutions to the challenges of sustainable, responsible investing. If you’ve been successful in creating new structures, practices and policies that support double or triple bottom line investing, please share your story! Comments are always welcome – and if you’d like to provide a bit more detail, ping me on Twitter @LaurenOPV, or send me an email (Lauren.OPV at gmail dot com) – my blog is your blog 🙂
Lauren Burnhill aka @LaurenOPV