We’ve all read those mutual fund warnings that advise us that “past performance is no indication of future returns”. Unfortunately, we consistently use past performance results to predict what our future returns will be. If there ever was a time that the economy and financial markets rolled along smoothly and predictably, this is NOT that time. Global financial markets and economies have changed permanently in the wake of the 2009 financial crisis. Just as important, financial markets don’t generally price for social or environment impact, whether positive or negative. In mainstream finance, social and environmental impact are “externalities”, or at least, they’re treated as externalities until a community, labor or environmental group files a lawsuit (hello, toxic waste superfunds!). If we need to modify our financial return expectations and factor in social and environmental returns, then chances are that our current pricing methods aren’t up to the task.
What’s Wrong? I’m not the only one saying that pricing, particularly in equity markets, is off-base. In March of 2012, the Economist featured two articles on defining and understanding risk premiums from a general investor perspective and in the context of planning for retirement. In the January 24, 2013 edition of The Economist, the Buttonwood column takes a look at calculating equity risk premiums (ERPs), including some notions around how to adjust for the changing nature of the global economy. On February 9th, the Buttonwood column Beware of the Bias warns us that our views of equity returns are too optimistic. The technical research on ERPs gets a bit mind-bendingly mathematical for me, but it seems safe to say that ERP valuation frameworks are in need of a re-boot.
Setting aside the question of a realistic ERP, our next challenge is that mainstream finance isn’t pricing for a finite-resource planet, or for sustainability in general. When I got my MBA from Wharton, we had to do a group advanced study project instead of a thesis. At that time, emerging markets were just beginning to come in vogue, but domestic investors were concerned about pricing and transparency issues. My group, under the aegis of a Citibank Risk Management director, set about to create an econometric pricing model for emerging market secondary debt. Guess what one factor had the most influence on daily share price? Would you believe yesterday’s share price? Yup, that’s what our model found. Past performance does influence pricing decisions, consciously or unconsciously. For more scientific – and very well-written – insights into this kind of hidden bias, have a look at Nobel Prize winner Daniel Kahnemann’s brilliant book Thinking, Fast and Slow.
My second piece of anecdotal evidence derives from my days in project finance investment banking. My team worked on long-term cross-border project finance transactions in Latin America, primarily telecommunications, oil & gas, energy and mining, all of which threw off dollar revenues that could often be captured offshore, reducing all kinds of currency and political risk. Most banks were pricing long-term project finance debt fairly conservatively, because the Latin American debt crisis of the mid 1980s was a leading influence on risk perception. Initially, we priced bids based on the prevailing LIBOR interest rates and financial projections, reserve requirements, the nature of risk-mitigating features (fixed priced engineering and procurement contracts, airtight off-take agreements etc) and other market and sovereign risk factors.
As competition for Latin American deals increased, we began our pricing exercises the same way, but then adjusted the results (fees and interest rates) based on what we thought our competitors would bid so that we would be more likely to win. More competition meant lower pricing margins, regardless of the level of underlying risk and almost purely as a result of competitive pressure. At lower interest rates, we were less willing to hold chunks of our deals on balance sheet. Much as with the more recent collapse in collateralized mortgage and debt obligations (CMOs and CDOs), diligence standards tend to loosen when the paper will end up on someone else’s books. Eventually, we stopped bidding on many deals because our models were showing higher risk levels than competitive deal pricing would support. Head office wasn’t keen on using the balance sheet for long-term deals with risk pricing gaps, which made us less competitive when we did put in a bid. Mismatched risk and pricing meant that less financing was available for the market as a whole. Artificially low interest rates may benefit the few who get funded, but less financial access for everyone else is an unfortunate consequence.
What’s Missing? If pricing in general is “broken”, it’s doubly broken for impact investment. Not only do we need to wrap our heads around new risk paradigms when pricing debt or equity, we also need to figure out appropriate ways to incorporate premiums or discounts related to social and environmental impact aka returns aka performance.
We price impact investments the same way we price traditional financial instruments, in terms of cost of funds, risk and margin, mostly without factoring in positive or negative environmental, social and governance (ESG) factors Arguably, a social enterprise that loses 100% of financial capital could still generate social or environmental returns in the process. If you accept that premise, then we should be producing higher valuations on double and triple bottom-line companies than on traditional profit-maximizers, ceteris paribus. Another perspective is that if we recognize that so-called good business can be bad for the environment, we should value pro-environment and sustainable businesses more highly than resource gluttons and polluters.
Pricing Issues for Investors: Impact investors need to understand that higher returns in the social impact space often require longer time frames – for the base of the pyramid (BoP) focused social enterprises, we’re more likely talking 8-10 years as opposed to 3-4 years. Management fees need to be assessed not by whether they match the notional standards of 2% on equity funds and somewhere around 1% on debt funds, but by whether they will cover the cost of implementing the manager’s value-add strategy. Many impact equity managers believe they must live with a 2% management fee, even though their fund is quite small. One of the ways they adapt is by hiring analysts and junior staff instead of bringing in more expensive – and more experienced – partners or senior staff. Achieving impact investment upside requires human capital as well as financial capital.
Making impact investments – at home or abroad – is challenging work. Targeting new and innovative business models to reach lower income populations means understanding all of the traditional startup business needs, as well as sector or industry structure and then adding on impact measurement and reporting and governance. Off the shelf solutions rarely work, they require adaptation and the impact investment manager is a big factor in how easily or rapidly this occurs. Make sure your managers have enough budget to do the job right! If you think it’s important that they participate in regional venture capital associations or industry associations, the membership dues need to be in the annual budget. If you want quarterly reporting, the manager needs the finance staff and systems to deliver those reports.
Pricing Issues for Managers: Managers, on the other hand, need to grasp the concept that their people really are – or at last can be – their greatest asset. They need to fight for appropriate staffing and salaries and they need to develop budgets that will allow them to add value to their portfolio companies as well. In order to achieve a sustainable impact investment industry for the long run, business planning should include team building and hiring senior talent. Investment in management information systems – even when an outsourcing strategy is planned – has to be part of the operating budget too. I’ve seen a couple of good funds run into trouble when poor reporting practices undermined investor confidence, caused a lot of second guessing around deals in the pipeline and ultimately led to termination of the management agreement. The thing about transparency is that it’s much easier – and cheaper – to talk about than it is to provide.
Given that impact managers probably need more fee income up front, the allocation of eventual upside should probably NOT follow the standard 80-20 allocation of carried interest. The fee level needs to cover the budget, but recognize that fees reduce investment capital and potentially upside returns to investors. I’d go so far as to say that if the management fee is higher than 2%, the carried interest assigned to the manager should be lower than 20%. The carry should take a hair cut to reflect the appropriately larger up front running costs.
My other issue with carried interests as performance incentive is that they are based exclusively on financial hurdle rates. If an impact manager commits to deliver financial AND social returns, shouldn’t part of her reward reflect social performance as well? My guess is that whatever the agreed upon carry, 100% payout of that carry should require meeting or exceeding both the financial hurdle and some type of social impact indicator(s) as well.
Pricing for the BoP: What about the target market, you ask? What about those people at the BoP – how do you price products fairly? Different question, but the quick response is that if cost of funds and fees are set equitably and rationally, the cost basis for pricing should be lower than for a single bottom line enterprise. If you’re investing directly, rather than through a fund, one nifty way to ensure that the target market benefits from increased growth and efficiency is to link DECREASES in product pricing to INCREASES in operating efficiency. The goal here is not necessarily to offer the lowest possible price, but to offer reasonable, sustainable pricing for appropriate, high quality goods and services. You wouldn’t be happy if your “affordable coffee” turned out to be mostly chicory, but I bet you’d be thrilled if the price of fair-trade coffee decreased over time!
Why you should care about pricing: As I noted above, when we price financial products in a way that overlooks critical risks and non-financial returns, we end up reducing access to finance. 40 years ago, when microfinance existed solely in the form of subsidized loans and grants made through non-profits, private capital stayed away. Non-profits in countries like Bolivia started lending at market and experiencing higher repayment rates than those of the subsidized loan providers. In light of this success, continued growth meant finding ever larger amounts of funding. Commercial capital, however, was willing to invest in microfinance only when it became clear that both the legal and financial structures of emerging microfinance institutions (MFIs) could produce attractive investment returns.
What Next? Lending to and investing in enterprises is a fundamentally different business than lending to and investing in financial institutions. The experiences and best practices of microfinance cannot be imported wholesale into impact investment. We need to develop new instruments, structures, policies and practices that are appropriate for impact investment if we want to attract and retain large amounts of capital. Many talented, dedicated and passionate individuals and organizations are working toward this goal, but we’ll all need to practice understanding each other’s perspectives, goals, values and needs to get there. In my governance work this week, I ran across an interesting article on good governance by William George, former CEO of Medtronic and a highly experienced Board member. Our views on governance, Mr. George notes, are shaped by what seat we hold at the table. Worth keeping in mind as we try to develop innovative and equitable pricing formulas!
By Lauren A. Burnhill aka @LaurenOPV
The Money in the Middle 