Impact investing is a marriage of opposites, finance and philanthropy. And while “opposites attract” is an accepted maxim, what is often glossed over is that although opposites attract, keeping opposites together and satisfied is hard work. For impact investing, one of the greatest obstacles to success is the dearth of investible products that adequately satisfy both social impact and financial requirements.
Many stories about impact investing trumpet the industry as a panacea. They argue—with ample evidence—that impact investing will not only save the world, but give investors a handsome profit as well. In the JP Morgan and the Global Impact Investing Network (GIIN) annual survey of large impact investors, two-thirds of respondents said they were targeting market-rate returns. Firms such as LeapFrog Investments, which has invested in emerging market insurance companies, promise market-rate returns. Many environment- or real estate-oriented funds—JP Morgan’s Urban Renaissance Property Fund targets both—already attract retail investment and provide market-rate or above market-rate returns as well.
However, for investments that target social issues such as poverty and education, the path to providing both financial returns and alleviating social ills is far more difficult. According to Triodos Bank’s Dan Hird, there are two reasons for the paucity of investible social impact investments.
“Typically, services have been provided by governments or charities in the third sector,” he said. “There’s a transition of social services away from the public sector into the third sector and the private sector. Organizations or businesses that are looking to raise investment aren’t yet investment-ready. Providing impact is not the problem.”
Triodos and other impact investors often help NGOs or charities issue bonds, though reaching market-rate returns is a struggle.
“When [the organizations] are investment-ready, how attractive are the returns?” Hird continued. “We’ve done some work with that. If you’re balancing financial returns for your investors and generating social impact, inevitably, there’s a bit of a compromise on financial return available to investors.”
Contrary to mainstream media reports, many impact investments must settle for below market-rate returns in order to achieve social impact goals.
“We joke that we are at the high-risk low return sweet spot of impact investing,” Root Capital’s Catherine Gill said. “I say that because it is right and I’m not trying to pretend that I’m a cake and eat it too impact investing product. I’m a skeptic of that proposition. Small agricultural businesses are really hard to finance. All of the problems that people saw are real risks. They can be mitigated, but it is costly. But obviously it is one that rewards that investment and building the economies of those communities is a long-term reward. We’re not trying to pretend that we’re going to compete with some low-risk high-return private equity.”
Even though the promissory notes offered by Root Capital mostly result in below market-rate returns, Gill believes there is a place for Root Capital in traditional portfolios. Impact investments can attract investors and even mitigate problems facing companies such as water shortages or supply chain deficiencies.
“I believe that a sophisticated investor is going to come to this idea with an overall asset allocation strategy where Root Capital should make sense in the way that a municipal bond should make sense,” Gill said. “We’re trying to credit enhance up the wazoo so we can reduce some of that perceived risk so we can strengthen our position as a low-yield fixed-income product. I think we’re a great anchor product.”
For those hoping to achieve both social impact and financial returns, government is a good place to look. Governments are creating impact investment funds as well as new products such as social impact bonds. With social impact bonds, non-government entities that do preventative work are awarded a proportion of the savings resulting from improved social outcomes. For example, in 2012, Goldman Sachs invested in $9.6 million bond to combat recidivism in New York City. Goldman Sachs is funding MDRC, a social policy research organization, to implement social programs. After four years, an independent evaluator will determine the program’s progress. If recidivism drops by more than 10%, then Goldman Sachs could make $2.1 million in profit. However, social impact bonds are still an experimental instrument.
“We don’t know if social impact bonds work,” the Center for American Progress’s Kristina Costa explained. “Preliminary data from [the first social impact bonds in the United Kingdom] should be available this year or next year. No one is getting returns yet. It’s going to vary so much from deal to deal.”
With many governments facing austerity measures, they are more willing to experiment with social impact bonds as a means to balance budgets and combat social ills at the same time. Social impact bonds are not appropriate for every situation, however.
“Realistically involve a certain degree of trust,” Costa said. “You need a program area where an outcome can be well defined. It’s necessary that good administrative data are available so you can set it against a historical baseline. It helps if there are preventative interventions that exist because social impact bonds are an unproven tool. You shouldn’t use social impact bonds to fund core government functions. Because if it seems likely that a deal will fail, the external organization is really incentivized to walk away if it.”
In the case of social impact bonds and other high-return impact investments, the primary obstacle to scaling is that they are unique. Hopefully with more innovation and experimentation, impact investors will be able to develop products that both provide social change and handsome financial returns.
Social Impact Investment photo via CreativeCommons
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