Editor's note: The last year has seen significant churn in the impact investing sector, most notably with the wind down of E+Co. Today we're starting a new ongoing series, What's Next for Impact Investing, in which fund managers and other practitioners discuss how they are building and evolving business models to achieve both maximum social impact and solid returns. You can read all of the posts in the series on The Big Idea Page.
Impact investing has been building momentum both in the United States and abroad, promising to be a new model for sustainable development.
Numerous reports in the past two years have pointed out the growth of the industry. In 2011, for example, overall investments reached more than $4 billion, according to a J.P. Morgan study. Additionally, the projected market value of potential profit ranges from $183-667 billion; that is, real returns resulting from sound investment with social impact.
What is the basic premise of the impact investing model? It is that financing social or mission-driven enterprises through debt or equity-like financial instruments can produce both financial and social returns, with the former providing financial sustainability and the latter contributing to the greater social good. Different organizations can use different models with varying tradeoffs between expected financial and social returns, but the thrust remains the same: sustainable social good can be achieved through investing in social enterprises.
Despite this promise, the industry faces many challenges. E+Co’s recent restructuring reminds us of this quite clearly. What began and flourished as an organization dedicated to investing in clean energy in developing countries recently has been abruptly restructured. This was due, in part, to the difficulties that all impact investors encounter, including: conducting rigorous, cost-effective due diligence; ensuring debt repayment; and finding practical exit opportunities.
E+Co certainly had its share of successes. It was able to provide clean energy to 78 million people globally, and offset 48 million tons of carbon in its operational lifetime. But ultimately, E+Co was unable to collect on its debts and thus could not make its own payments. And despite a social mission, investment organizations ultimately answer to their funders - whether they are investors, creditors, or individual and institutional donors. After transferring most of its portfolio to private equity firms, E+Co set up a private investment fund to manage the rest of its clients, a structure that may prove to be very beneficial for the future of impact investing.
At the Grassroots Business Fund (GBF), we have found that a formal fund structure is able to address many of the challenges of impact investing in ways that a simple non-profit entity cannot. To begin with, the legal and operational requirements of a formal fund help ensure transparency and a culture of discipline that many times are absent in a non-profit entity. GBF is held accountable not only by its donors and clients, but also by its external investors, who expect real returns on their investments.
Impact investing inextricably links sustainable social impact to financial returns, however modestly targeted. In turn, meeting expected returns, both social and financial, is dependent on rigorous due diligence (legal, financial, market, etc.) that should not be ignored just because the targeted investments are enterprises with a social mission.
That is, in the end, sustainable social returns are dependent on fully investigating conventional business risks to ensure the business model is viable and financially sustainable to achieve a social mission. Or, ensuring that the business provides a product or service that the market is willing to purchase, and that the product or service produces financial returns for business sustainability along with social returns consistent with the business’ mission.
The above may be largely uncontroversial. But we would further contend that rigorous due diligence (and subsequent investment supervision) and the desired accompanying sustainable financial and social returns are heavily dependent on having a formal fund structure rather than simply a conventional NGO structure.
The former is more likely to insist on consistent and thorough monitoring, whereas the latter is less likely to require it or even to have the capacity to do so.
This is not to say that the NGO structure cannot achieve desired returns through impact investing. However, such a structure often lacks (1) formal investors with clear expectations (e.g. returns, risk parameters, etc.) set through private placement memorandums, limited partnership agreements, etc. and (2) a governance structure to help ensure that expectations are pursued and corrective measures are taken if they are not. Perhaps it comes down to the simple fact that the governance players in a formal fund (investors) are directly supervising the return on their own investment, whereas those of a conventional not-for-profit are not.
The impact investment ecosystem has seen movement in trying to address at least some of this issue. For example, ANDE (Aspen Network of Development Entrepreneurs) and USAID have launched an industry initiative to reconfigure the financial statements of impact investment “funds” having a pure NGO structure to better reflect actual investment performance. Doing so would help potential investors or donors better compare the performance of various impact investment funds in which they planned to invest or provide financial support. This should increase the rigor in NGO investment practices and performance, but there may be additional opportunities to link investment performance to the investors themselves, thus further promoting a stake in the outcomes.
GBF took a giant leap in this direction by recently establishing a hybrid model that includes: (1) a formal fund with institutional and angel investors (with the rigor, transparency, and performance they demand); and (2) its not-for-profit serving as both the fund manager and the vehicle for “side-car” business advisory services, providing support for the fund’s portfolio companies.
In this structure, investors in the formal fund:
• Have a clear and transparent picture of fund financial flows (management fee to manager, fund legal costs, portfolio investments, investment interest, dividend and principal reflows)
• Set clear expectations for financial and social returns and any tradeoffs thereof
• Have an active seat at the governance table
• Can incentivize the fund manager through some type of carried interest in the fund’s performance
Moreover, the fund agreements and governance structure are in place to set, track, and incentivize fund performance expectations. These fundamentals should drive investment performance, including both financial and social returns, in a manner that an NGO structure may not.
Impact investing is a tough business for a variety of reasons. Even the best of structures do not guarantee success, which so heavily depends on the expertise of the fund manager, the operating environment, and of course, the performance of the social enterprises themselves. Accordingly, it is far from certain that a formal fund structure could have prevented E+Co’s collapse or that GBF’s “hybrid” structure will lead to achieving its mission.
However, such a structure should increase the probability of achieving financial and social returns. In turn, this should lead to a virtuous cycle of sustainability, with individual investment success leading to fund success, which would further attract the investment capital required for impact investing to really scale and fully realize its promise.
Bob Webster is the Chief Operating Officer for the Grassroots Business Fund, for which he had previously served as a member of its Portfolio Advisory Committee. The author thanks Libby Ragan for her contribution for this article.