by Lauren Burnhill, aka @LaurenOPV
This post started as a thought piece on achieving optimal returns across financial, social and environmental parameters. Along the way, it evolved into a discussion of capital allocation across the innovation investment life-cycle because the types of resources we apply to the challenges of social and environmental change have a direct impact on the kinds of outcomes we can achieve.
Return on investment can include financial, social, environmental and sometimes ethical returns (although I’ll save discussion of this last for another time). These returns (financial + social + environmental) together sum to 100%. For convenience sake, let’s label these FROI, SROI and EROI. Collectively, we’re talking about multiple bottom-lines or “MBLs”. The formula I’m using here is: FROI + SROI + EROI = 100%. One of the challenges of impact measurement is finding good methodologies for quantifying SROI and EROI. Somewhere down the road, I hope that we can calculate an all-in numerical return. For example, an impact investment might produce:
FROI = 10%
SROI = 10%
EROI = 5%
Total Return = 25%
In the old school investment world, FROI is set at 100% – social and environmental outcomes are considered externalities, although it is hard to imagine an investment that does not have some type of social or environmental implication. The result is that in mainstream investment, your SROI and EROI may be less than or greater than zero percent, depending on whether the social and environmental effects of the investment are negative or positive, but there is no CONSCIOUS intention to consider these outcomes when reaching an investment decision or structuring an investment product. If we’re only looking at FROI, we may be ecstatic to earn a 25% return but it is entirely possible that the outcome looks more like this:
FROI = 10%
SROI = (10)%
EROI = ( 5)%
Total Return = 10%
True, you’re not paying for the negative social and environmental returns in this scenario, but society as a whole must absorb those costs.
In my lexicon, “impact investment” is any investment, in any asset class, that has a clear plan to generate SROI or EROI, and preferably both. Many people translate this as meaning that an impact investment must, by definition, generate positive social and/or environmental outcomes. The reality of our world is that in some cases, supporting business models that reduce social or environmental harm may be as worthwhile as focusing on models that seek to create positive outcomes. Why? Basically because we may not always be able to generate positive non-financial returns but where we cannot, we should at minimum seek to do less harm. Put another way, you might consider “sustainable oil and gas investment” to be an oxymoron, yet a sustainability approach to fossil fuels is likely preferable to a purely financial return driven model.
Why do I make the “any asset class” point? Essentially, if all investments have social and environmental outcomes, then the concept of a “100% impact portfolio” is both relevant and viable. You can put cash into community banks and credit unions. If you prefer fixed income instruments, you can buy loan participation notes or bonds that support affordable housing and basic infrastructure projects for transport, waste, renewable energy, communications, etc. ESG (environmental, social and governance) and RI (responsible investment) practitioners offer a range of equity and debt products around individual firms, specific geographies, sector portfolios and indices and special interest themes. Whatever geography, sector, value or instrument you want to put money into is available to you in some form or other. The caveat is that optimizing across multiple bottom-lines means continually examining your beliefs, values and risk tolerance and then making consistent decisions on the basis of this information.
One of the ways that impact investing as an “industry” can optimize for MBLs is to look at the spectrum of needs that, when addressed, can catalyze experimentation, innovation and sustainable, positive results. Here’s where the resource allocation issue arises. What type of financing is appropriate for what types of impact and innovation focused activities?
Innovation outcomes are always uncertain. Effectively allocating financial resources to address MBL priorities means taking an enlightened approach to risk. Each stakeholder group in the total resource pool has a role to play that should be connected to the type of capital resources that they command. Grant funding should support initiatives with great potential that lack proven methods and models for achieving operational success. Arguably, if not enough grant recipients fail to prove/meet their objectives, we are not taking enough risk. Mankind did not make it to the moon by incrementally tinkering with the transportation status quo. We’d have flying cars by now if that had been the case ;o)
Validating the possibility of failure takes the CYA pressure off the grant making due diligence process and can enable more flexibility for creative approaches to intransigent social and environmental problems. Tech applications that simplify the mechanics of impact reporting together with consensus-building around reporting norms and standards will boost the quality of grant evaluations at lower human and financial cost. Creating a pool of “success funds” that make it quick and easy for philanthropic organizations to help successful grantees grow could speed up the pace of innovation and the spread of its benefits.
Venture Philanthropy (VPhil) is a relatively new socio-economic actor that responds both to a capital resources gap (human and financial) and a desire to avoid perpetual cycles of poverty, charity and dependence. VPhil today is perhaps a bit too enamored of the word “venture”, but the concept of delivering social and/or environmental benefits through commercial models to the extent possible is critically important. Not all development challenges can be addressed through commercial models, but given finite resources, more needs filled through commercial ventures equates to greater resource availability for problems that cannot be served by market solutions. Business structures and disciplines are key to realizing FROI, SROI and EROI, but we don’t yet know WHICH structures work best for new markets or for delivering new social and/or environmentally proactive products and services, hence the need for VPhil.
For example, to improve suburban and rural health, do we need more tele-medicine facilities that leverage existing (primarily urban) infrastructure, more stand-alone ambulatory care clinics or hub-and-spoke hospital systems? If we need two or three of these – or these and other solutions as well – how do we prioritize resource allocation? We’ll need to try lots of different approaches, gather data on the outcomes and analyze the lessons learned to inform the next set of innovation efforts. If we begin with baseline knowledge and then use operating results to understand usage patterns and uptake rates, we’ll eventually know a lot about what works best in what conditions and cultures. From that point, whether we’re scaling up or replicating the best models, we’re on our way to achieving a healthier, happier world.
The moment when MBL return outputs and data reveal sustainable operations is when the venture can really start to expand and scale – or when we can document the model to replicate it elsewhere with a different set of stakeholders and funders. This is also probably the moment when VPhil needs to step aside and let the venture capital / micro private equity / impact investment world step up.
In other words, if philanthropy is pre-commercial, VPhil is quasi-commercial and the VC/PE/ImpInv actors are stepping in to finance the commercial stage of development. Commercial success will be key to viability and sustainability, but it requires us to demonstrate tangible SROI and EROI, as well as reasonable FROI numbers. VPhil should be targeting inflation-adjusted return of principal but not necessarily seeking star ventures that can generate double or triple digit financial returns. Theoretically, VPhil should experience fewer failures than pure philanthropy, in part because the first round of failures dropped out at the grant-making stage of innovation experimentation. There is still, however, a need to try bold new solutions at the quasi-commercial stage. As was noted in a recent issue of the Stanford Social Innovation Review, technology is not the problem, it’s getting people to adopt it and use it consistently that makes disruptive innovation so challenging.
While smart VPhils will find ways to leave some skin in the game during the growth & expansion phase of innovation, growth money should, in general, be coming from VC/PE/ImpInv firms that aim to generate positive returns across at least two bottom-lines (if not three or four) and can tap into large pools of commercial capital.
I know a lot of impact investment practitioners with solid investment strategies fundraising on the premise of 20-25% ROE in frontier markets, new sectors and young firms. They hope they can deliver that high a financial return, but mostly they’re selling that number because they believe that’s what investors need to hear in order to make a commitment. The relatively small number and low dollar value of second, third and Nth funds is a signal that collectively, our risk-reward projections are inaccurate. When we’re selling smoke and mirrors, we are putting the future of impact investment at risk.
If I promise an FROI of 25% and I deliver an FROI of 10%, my investors will be unhappy even if my SROI and EROI are stratospheric. On the other hand, if I commit to achieving an FROI of 8% and deliver 10% plus positive SROI and EROI, most investors will sign on for the next fund quite happily. In impact equity funds, you could think of the hurdle rate in the investment manager’s compensation formula as your probable FROI versus the notional 20-25% promised in the offering memo. However, if this is true, we should probably be experimenting with compensation structures that reflect a better distribution of costs, risks and returns. The ability to invest in human capital and tech infrastructure implies higher fee levels but it can also mean better performance and higher overall returns to investors. We probably need to make different trade-offs between the management fees that generate results and the allocation of upside after exit results are known.
I’ve questioned the 2% fee / 20% carry structure in the past. Think about the size of most of the impact investment funds getting started. What kind of operating budget will a 2% fee provide on a US$10 million or US$20 million fund? Does that operating budget cover the cost of providing true “value-add” services, including reasonable wages for staff? Or are we assuming that the investment manager will somehow function with inadequate resources because the potential upside provides good motivation? If our investment managers need to flip portfolio sooner rather than later to make up for uncovered costs and sub-market salaries, how can we hope to provide patient capital? I’ll close this post with one last thought on the link between compensation and performance. If we want our impact investment managers to generate positive social and environmental returns alongside positive financial returns, why do we keep linking compensation exclusively to financial performance?
The Money in the Middle 