“How strange it is that a bird, under the form of a woodpecker, should have been created to prey on insects on the ground; that upland geese, which never or rarely swim, should have been created with webbed feet; that a thrush should have been created to dive and feed on sub-aquatic insects; and that a petrel should have been created with habits and structure fitting it for the life of an auk or grebe! and so on in endless other cases. But on the view of each species constantly trying to increase in number, with natural selection always ready to adapt the slowly varying descendants of each to any unoccupied or ill-occupied place in nature, these facts cease to be strange, or perhaps might even have been anticipated.” – Charles Darwin (1859), On the Origin of Species
In recent weeks, there has been a flight of investments out of so-called emerging markets and back into the warmer waters of the USA, Japan and the UK. It is estimated that around $6 billion fled those markets in the last week alone. These countries vary widely in performance but they are all seen as next stage developing nations and include countries such as Mexico, South Korea, China, India, Brazil and South Africa. Huge sums have poured into these countries over the last six years as a result of (primarily) QE (quantitative easing) in the USA. This is now being “tapered” so the fear of funds drying up begins. Stock markets are down throughout and currencies are weaker against the strengthening developed nations like the $, £, Euro and Yen.
Financial experts believe that these “emerging” countries have the ability to reward normal (if higher risk) investment. Investors constantly seek out businesses that have already established themselves but where the risk / reward ratio is different from the more developed areas. This is the search for wider niches where improved financial rewards can be found.
Investors in such emerging markets do not normally consider the social good of that investment – investment managers are charged with having to return a competitive return to their investors. The “quality” of the investment considers risk and volatility but not the social return. This (understandably) means that emerging economies overall may benefit when money is coming in but (as now) see key projects suffer when the money turns away – as there is no “buy-in” to the investment beyond return on investment. Investors can move quickly back to their safer zones.
Over the past few years, the finance world (possibly after government badgering) and in its constant search for investment opportunities has built a signpost towards the social quality of investment. It is called Impact Investing and its intentions are notable enough for those such as Sir Ronald Cohen (chair of the G8 Social Impact Investment Taskforce and one of the top venture capitalists of our age) to shout about the potential benefits and opportunities – as he did in his recent Mansion House speech.
Impact investing is an attempt to link financial investment with “social returns”: building non-financial returns into investment criteria so that not only quantity and normal qualitative issues such as risk are taken into account in making decisions but so that a variety of social benefits (less poverty, more jobs for local people, better services) are developed – the typical social return for organisations that have a double bottom line.
In evaluation terms. it provides the investment community’s equivalent of the “cost-benefit analysis” of the 1970’s that was predicated on government (local and national) expenditure and was an accounting tool for evaluating non-financial outcomes and providing a financial outcome to them (outcomes that recent flooding problems in the UK may well have seen exacerbated by as a result of cost-benefit “rules” made hurdles by the UK Treasury).
Impact Investment has emerged as a potential move by the investors to invest in areas that will not provide the highest quantitative return on investment. It may seem to resemble CSR – corporate social responsibility – made by companies but Impact Investment is driven by independent investors that are not trying to offset externalities caused by their businesses. The investment is seen as totally different to donations or companies doing good things (like fundraising efforts by staff) – the typical form of investor involvement in charitable ventures as a return on investment is required.
The Evolution of Impact Investment
The tradition of philanthropic “giving” goes back to before the 19th Century – a period of great wealth for some sections of society that fostered the desire in some to give back some of their wealth to society. In Victorian England, the wealthy would see it as their duty to provide funds for the poor and many trusts and foundations originated in this period. As Government began (mainly after World War One) to encroach on charity territory, philanthropists (already complaining of high taxation) saw it progressively as a government responsibility to look after the worse off in society. This was a natural outcome of the welfare state – where government expenditure grew to around 40% of GDP or more and progressive taxation became the norm in developed economies.
The wealthy have had to develop their own ideas about the part they can play in the so-called “Third Sector” that remains – and which remains a critical part of society – their niche – and (perhaps) especially outside of the original philanthropists’ countries of origin. In the globally connected world of the 21st Century, we see a mirror on the nation state of the 19th Century – instead of each country being split into the well-off and the rest, now it can be seen on a global scale.
Bill Gates is a good example of the modern philanthropist – using his wealth through the Gates Foundation to make real change in the developing world in disease control particularly. This is mainly via the traditional use of donations (on a grand scale) using expertise learned in business to effect change that government-led, top-down schemes or traditional aid money has not accomplished outside of disaster situations.
More recently, as Sir Ronald Cohen voiced in his Mansion House speech, investment is now being applied to social welfare schemes where a financial return is envisaged. This is not a new phenomenon but is now, according to Sir Ronald, the coming investment mechanism for change. As Venture Capital was to business start-ups, so Impact Investment is touted to provide radical change where a social element is involved. This is a move into a new niche – combining, it is said, answers to investors’ search for new opportunities with social benefits.
The Global Impact Investing Network, an organization based in New York outlines four, central aspects of Impact Investment which are:
- · Intentionality – the explicit investment, part of which is for social gain;
- · Investment with return expectations;
- · Range of return expectations;
- · Impact Measurement.
The Impact Investment Evolutionary Niche
The mix of public and private sector undertakings, which followed social democratic principles in so many developed nations after the end of World War II, have seen stresses since the 1980’s – especially as a result of the Reagan / Thatcher period and the libertarian form of market economics that followers of Hayek would pursue. The Keynesian revolution fell out of favour as the mandate to minimize taxation and let the free market do the work came to be the norm – particularly in the English-speaking world. This reversed the tacit agreement that Keynesian economics had formed at the macroeconomic level, whereby government would manage economies to iron out excesses – particularly to offset major downturns or market bubbles. The impact of the change on the micro-economic side was that direct taxation was now reduced and that had to lead to reduced spending and more emphasis on people resolving their own problems.
The financial system melt-down of 2007/8 has exacerbated the problem. In the UK and elsewhere where government debt is deemed to be high there have been major cutbacks. driven by research such as the Reinhart and Rogoff paper which culminated in their book “This Time is Different”. Recently, much research has offered an alternative outcome and an IMF paper “Debt and Growth: Is there a Magic Thresshold?” seems to refute the evidence. Such cutbacks have severed an implicit bargain with the less well-off and threaten spending on international development (although the UK has maintained its 0.7% of GDP annual promise many other countries have not kept up to their Millennium development goal promises).
Additionally, questions persist about the value of top-down international aid (except for disaster aid). Those like William Easterly (author of “White Man’s Burden” and his new book “The Tyranny of Experts”) have emboldened philanthropists like Bill Gates to enter the social marketplace directly.
This mix of government pull-out on the one hand and social conscience of the wealthy on the other seems like a return to the 19th Century social balance – where government tended towards the minimalist. Hobsbaum in his “Age of Extremes” called this government through “brakes rather than engines”. In this situation, the social requirements that are not likely to be rectified by government intervention grow substantially and require intervention from elsewhere. The environment has changed significantly and, as huge wealth has been generated by the top 1% of society, it has to have outlets for investment.
The New Impact Investment Opportunity
In the 19th Century, wealthy philanthropists set up charities for various reasons. The two most obvious were (1) a view that society should benefit from their wealth (2) a view that by helping others, they could form a better, wealthier society that would entrench the status quo and lead to less dissonance in society.
Up to 1914, this view prevailed but after WWI and the terrors of the slump in the 1930’s, poverty overtook the ability of the wealthy or government to cope. Dissonance was the norm and led, eventually, via fascism and WWII to the Keynesian revolution that was finally allowed to develop.
If we are now back into a position of similarity with the 19th Century, albeit at a much higher GDP level in the developed world, we are also a more global society so that extreme poverty, lack of medical assistance and social deprivation across the world are now closer to us than before and more intertwined with our well-being.
From the second half of the 20th Century onwards, large companies have begun to understand the need to be sustainable and have felt the pressure from customer requirements that tend towards the ethics of the product / service and those behind it. This has led to the development of a substantial focus on CSR (Corporate Social Responsibility) as referred to above. Many large companies have now entrenched the notion of CSR but it remains for most an exogenous criteria rather than an intrinsic and internalised desire or part of the corporate vision or mission. Social good is rarely part of corporate vision beyond customer care. Harvard Business School still questions the notion in its new course, for example – “Private Sector, Public Good – what role, if any, does business have in creating social good?”
This question has been asked for many years and the fact that it is still being asked attests to the fact that most companies believe that they are tasked to maximize shareholder returns – hopefully, in the longer term but not always. Social factors remain as “externalities” despite the work of organisations such as TEEB and its work on natural capital to make companies aware of the burden they can place on society. Publicly traded companies do not receive credit for lower share prices just as bankers asking for lower bonuses for the social good they create. This is a natural outcome of the environment that exists within a market economy focused as it is on goods and services – not public goods or social need.
However, vast wealth has accumulated to individuals in and of the financial sector (and other business sectors) and that sector has been notoriously reticent about social good or direct involvement in social enterprise. CSR within the financial sector is a very low priority (although exceptions do exist, charity fundraising and giving in general form a tiny percentage of sector profitability). The financial sector now has the role of society’s corporate enemy number 1 after the sub-prime generated disaster of recent years. So, while it is clear that many well-meaning philanthropists would enter into social (or impact) investing (as many already provide donations with no financial return expectations whatsoever) it remains unclear why the financial sector (e.g. venture capital companies) should consider lower financial returns offset by some social returns as acceptable – which is the premise that most assume in impact investment.
The answer to this quesion is that, in reality, returns are being generated that are similar to those available elsewhere and it is pretty clear that returns are sought that equate to other forms of investment.
The vacuum in the economic environment provided in part by government not wishing to be involved as much in social activities plus a more widespread belief that private enterprise can achieve more than government is providing the opportunity for venture capital to move quickly into the space provided.
Sir Ronald Cohen was one of the first to see the opportunity. Bridges Ventures was set up by him in 2002 and operates as follows according to its website:
“Bridges Ventures is a specialist fund manager, dedicated to using an impact-driven investment approach to create superior returns for both investors and society at-large. We believe that market forces and entrepreneurship can be harnessed to do well by doing good.” and its provides ample evidence of its success.
A recent (“Fall 2013”) study in the Stanford Social Innovation Review by Paul Brest of Stanford Law School and Kelly Born of the William and Flora Hewlett Foundation has shown no lack of desire on the part of impact investors to enter into such investments, but mainly on the basis that they will pick up normal returns on their investment.
While it is clear in many cases that social benefits do occur from such active investment, the ability of such investments to return full amounts is as a result of “I see something that you don’t see” according to David Chen on Equilibrium Capital – as quoted in the Stanford article. This suggests that, for the investor, impact investing is about pushing into new territories but using different knowledge to access good returns on investment.
What is particularly interesting is that the investment community is now willing to invest in such social programmes / projects because it sees, in the main, the opportunity to gain good returns. The investors gain access to the opportunities through social entrepreneurs or charities that uncover them in the same way that venture capitalists uncover pure market-related opportunities that are presented to the venture capital firms.
The Stanford article shows the “frictions” in the market that investors have to overcome (in order to make their returns) as follows:
- Imperfect information. Investors at large may not know about particular opportunities—especially enterprises in developing nations or in low-income areas in developed nations—let alone have reliable information about their risks and expected returns.
- Skepticism about achieving both financial returns and social impact. Investors at large may be unjustifiably skeptical that enterprises that are promoted as producing social or environmental value are likely to yield market-rate returns.
- Inflexible institutional practices. Institutional investors may use heuristics that simplify decision making but that exclude potential impact investments, which, for example, may require more flexibility than the fund’s practices permit.
- Small deal size. The typical impact investment is often smaller than similar private equity or venture capital investments, but the minimum threshold of due diligence and other transaction costs can render the investment financially unattractive regardless of its social merits.
- Limited exit strategies. In many developing economies, markets are insufficiently developed to provide reliable options for investors to exit their investment in a reasonable time.
- Governance problems. Developing nations may have inadequate governance and legal regimes, creating uncertainties about property rights, contract enforcement, and bribery. Navigating such regimes may require on-the-ground expertise or personal connections that are not readily available to investors at large.
These may or may not be specific to social enterprises but it is not sure they are, overall, of a higher risk than other business opportunities. They are different. Having been provided with the opportunities, the assessment mechanisms then will evaluate those opportunities taking into account the “frictions” (including those above) in order to assess the returns and risks – much as would be done in a neutral impact (or more “normal”) investment.
The Reality of Impact Investing
Investing in social enterprises is not new but the emergence of a sophisticated push into social investments by the financial community through impact investing has created a degree of publicity and resulted in an industry with $40bn invested according to a paper recently presented at the World Economic Forum in Davos – an amount which is growing rapidly (although still a tiny fraction of the trillions invested by the financial sector).
Within the social impact sector, traditional, donation-led financing may gradually move aside as investments with a financial return move in – although the main benefit will be through impact investment taking up the slack that top-down government funding would have provided and maybe into areas not originally considered or under-funded. It can certainly be argued that such investments (in organisations such as Grameen Bank for micro-financing) seek to reap full returns while providing social benefits as well – even if the social benefits are actively pursued from the outset. The Stanford article suggests that no impact investment is such unless it has an “active” approach from the outset to providing real social returns over and above the financial ones and over and above what would have occurred without the investment. This impact is hard to uncover and measurement is not yet sufficiently in place and does not rule out the imperative of good financial returns (which are quantifiable).
One key question is whether impact investment is anything more than normal investment but with opportunities revealed by a new set of entrepreneurs – the social entrepreneurs – and with a new appetite and understanding for the risks inherent in this new sector. This appetite is emboldened as more of these ventures produce decent returns, as management of the “frictions” noted above are found to be possible and where the investment helps provide such as the “outstanding investment returns by delivering essential services to disconnected communities underserved by global networks.” as found by organisations like Elevar Equity quoted here).
With governments more likely to stand aside and open up spaces for investors, charities and social entrepreneurs have to seek out new financing and are doing so. The availability of serious amounts of investment is real and whether or not these are new and whether or not the investors care too much about whether the social impact is real or not, it has been shown that money is available but that (outside of the traditional donations market and outside of individual and foundation / trust philanthropists who, like a Bill Gates, wants to “do good”) most impact investment will be looking for good financial returns from this new, “friction”-filled investment area – where investment opportunities are brought to the investors by the newer group of entrepreneurs – social entrepreneurs.
This is a nascent environment but it is clear that the investment community is now working with a new form of social entrepreneur that find the prospects and is beginning to acclimatize itself to the specific risks (or “frictions”) that characterize the new marketplace in order to generate good financial returns. It is a marketplace that is being “sold” on the premise that “social returns” + “financial returns” = normal returns. It can be argued that the only element of the returns to be calculated (financial) is not necessarily lower than in other areas and that social returns are just over and above them. Nonetheless, the market is now available and social entrepreneurs have a growing opportunity to take advantage.
“But on the view of each species constantly trying to increase in number, with natural selection always ready to adapt the slowly varying descendants of each to any unoccupied or ill-occupied place in nature, these facts cease to be strange, or perhaps might even have been anticipated.” – Charles Darwin (1859), On the Origin of Species