Scaling Impact Investing – An Outsider’s Perspective

“Can we ever scale impact investing?”

This is a question that the impact investing community is all too familiar with, but one that I only confronted in the past year. I joined Investing For Good (IFG) as a part-time intern in February 2020, a month before COVID-19 took hold.

My background was in brain sciences. Without any knowledge of finance, I learned everything from scratch – from basic things like the distinction between a bond and a loan, to more niche concepts like blended finance. I also picked up on the impact investing language, like ‘SIFI’, which stands for Social Investment Finance Intermediaries, or ‘SIB’, which is short for Social Impact Bond. Of course, I now know SIB isn’t actually a bond, but a form of pay-for-success contract that shifts the risk of public service delivery onto private investors.

What I was most surprised to learn was perhaps how impact investing – as with my understanding of it – is still in its infancy. Even though the practice of socially responsible investing dates back hundreds of years [1], the term “impact investing” was only coined in 2007 at a Rockefeller Foundation forum [2]. With the term, came greater clarity and consensus around how best to practice impact investing [3]. The sector is also coming up with ever more innovative social finance models that ultimately aims to solve the problem of ‘scale’, or of attracting larger scale private capital [4].

My main role at IFG has been to research these innovative models. A few models, like SIBs, have made headway but are still largely being driven by public institutions or impact-first investors [5]. Others such as sustainability linked loans (or bonds) are more controversial, because while they are gaining popularity among mainstream investors [6], the impact targets are often modest [7]. In short, no model has scaled both the impact and the investment component of impact investing.

Why scaling impact investing is tricky

It is arguably a wicked problem. At its root, the problem stems from what our economic system does or does not put a price tag on (e.g. the price of a T-shirt may include raw materials and labour, but not costs to the environment or the workers’ wellbeing). The additional costs or benefits that stem from the production or consumption of goods/services, but that are not captured by the price, are called externalities. The difficulty is that even if we all suddenly agree to include all positive and negative externalities in the calculation of the so-called investment ‘return’, this cannot happen overnight, because the challenge of effectively quantifying impact (and standardising this) is another ‘beast’ in and of itself [8].

Impact investing is an important concept and tool in which some of this failure could be overcome by considering social return alongside financial return. However, there are challenges also at the implementation level, because impact investing deals often have markedly different requirements and characteristics compared to traditional finance-oriented investments.

By its very nature, impact investing deals involve lending money to organisations that do not seek to maximise profit. So from the investee’s perspective, the capital needs to be more ‘patient’ and risk-bearing [9]. Yet from the investor’s perspective, the risk-reward tradeoff often cannot compete with mainstream investment; the lack of a secondary market also means most investments are effectively illiquid. Impact investing deals also tend to be small in size with more complex needs, so they are more expensive to set up and manage than traditional investments [10]. The conundrum faced by an intermediary like IFG is therefore how to meet the idiosyncratic needs of a particular deal, while keeping the contract ‘lean’ and low-cost. Standardisation could help to some extent, but it takes time to develop the appropriate model.

An example: Quasi-equity model

Despite the non-trivial challenges, various ideas and solutions have been proposed. For example, quasi-equity models have emerged as an interesting candidate for providing more patient capital to investees [11]. It is so termed because it reflects characteristics of both debt and equity instruments, where a typical arrangement allows the investor to take a fixed percentage of the organisation’s future revenue or cash flow.

Aside from grants, social purpose organisations are most familiar with debt funding (e.g. a fixed rate loan) [9]. But debt is only suitable for a relatively mature organisation that is able to generate stable income. A quasi-equity instrument is more ‘patient’ than debt because the organisation does not need to repay until it is generating revenue, and its cash flow is also protected during economic downturns.

However, the quasi-equity model faces an interesting paradox. From the investee’s perspective, if they can confidently predict their revenue, taking a conventional fixed rate loan will most likely be cheaper. So it could be those that privately believe their future revenue streams will be disappointing that accept any quasi-equity deal; while those that are confident about their revenue streams would not. This is known as the adverse selection problem [12].

From the investor’s perspective, quasi-equity models are also riskier when used in the non-profit context, because unlike investing in a for-profit company, outstanding loans cannot be converted into equity (e.g. an NGO cannot issue shares due to its legal structure).

Importantly, the above critiques remain assumptions until tested. As of 2016, quasi-equity deals represent just 0.8-1.4% of all social investments [13]. There is insufficient empirical evidence to say if the adverse selection problem arises in practice, or if investees perceive the downside protection of the quasi-equity model to outweigh its costs.

Time and willingness to experiment

So perhaps what the sector needs most is time, and lots of, lots of data. Indeed, the quasi-equity model represents just one example of how, very often, the critiques and praises for a social finance model only exist at the theoretical level.

Even for the supposedly well-established SIB, there is still insufficient evidence to conclude that they produce cashable savings [14]. To highlight the immaturity of SIBs – the world’s first ever SIB was only commissioned in 2011. Its goal was to reduce reoffending by short-term prisoners in Peterborough, its final evaluation was published as recently as 2017 [15]. In this case, the reoffending rate was cut by 9% compared to a national control group (above the target rate of 7.5%).

Proponents of SIB may argue such programmes can be deemed a success as the model shifts the risk of failure onto private investors and encourages innovation in service delivery. While this is conceptually true, we still need to examine far more data to reach conclusions about SIBs. It is also unclear how much of its success can be attributed to the use of SIB – would the reoffending rate have fallen with a direct grant of equivalent magnitude? We simply cannot know this until we have data from many more similar deals.

Luckily, it is clear even just from my brief encounter with the sector that its participants are not afraid to experiment. Only last year Esmeé Fairbairn Foundation structured its first perpetual bond [16] – something of a rarity even among mainstream investments. This is a form of permanent capital with no fixed date of repayment. When done right, it is truly permanent – rumour has it, there is a 370 year old Dutch perpetual bond that is still paying interest to this date [17].

The growth of impact investing as a sector could be accelerated by once-in-a-century event like the COVID-19 pandemic, which acts as a magnifying glass for the inequalities built into our system [18] and a reminder that we needn’t take the old ways of doing things for granted [19]. If nothing else, COVID-19 has highlighted a greater need for impact investing [20] and how considering financial returns in isolation falls short for capturing the diversity of outcomes we value as a society.

Mandy Ho

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References

1. An often cited example is the Quakers and Methodists in the 18th century.
2. Harji, K., & Jackson, E. T. (2012). Accelerating impact: Achievements, challenges and what's next in building the impact investing industry. The Rockefeller Foundation.
3. Höchstädter, A., & Scheck, B. (2015), What’s in a Name: An Analysis of Impact Investing Understandings by Academics and Practitioners, Journal of Business Ethics, 132, (2), 449-475
4. The Rockefeller Foundation has a Zero Gap Fund dedicated to developing ‘innovative financial solutions that demonstrate the potential to catalyze large-scale private investment towards the Sustainable Development Goals (SDGs)’. https://www.rockefellerfoundation.org/initiative/zero-gap-fund/
5. Data from Government Outcomes Lab Project Database: https://golab.bsg.ox.ac.uk/knowledge-bank/project-database/; also see Gustafsson-Wright, E., Boggild-Jones, I., Segell, D., & Durland, J. (2017) Impact Bonds in Developing Countries: Early Learnings from the Field. Brookings Institute & Convergence.
6. Linklaters (2019) Sustainable Finance: The rise of green loans and sustainability linked lending. https://www.linklaters.com/en/insights/thought-leadership/sustainable-finance/the-rise-of-green-loans-and-sustainability-linked-lending
7. A notable example is the Enel sustainability-linked bond. Enel is an Italian energy company that issued a series of bonds in 2019, whereby a penalty (coupon step-up) would be issued if they missed their sustainability target. Specifically, Enel set out to increase their renewable energy capacity to 55% (of their total capacity) by the end of 2021. However, this target is far from ambitious because as early as November 2018, Enel already predicted 62% of their energy production will be emission-free in 2021. https://www.enel.com/content/dam/enel-common/press/en/2018-November/Enel%20Piano%20Strategico%202019-2021%20ENG%202.pdf
8. As soon as you try to quantify something qualitative, like social impact, you quickly run into the problem of “comparing apples to oranges”. Luckily, not all hope is lost: https://ssir.org/articles/entry/next_frontier_in_social_impact_measurement
9. Brown, D., & Fogg, D. (2020) Beyond Demand: The social sector’s need for patient, risk-bearing capital. Esmeé Fairbairn Foundation & Shift.
10. Many challenges with impact investing are highlighted in GIIN’s Annual Impact Investor Report (2020): https://thegiin.org/research/publication/impinv-survey-2020
11. Santa Clara University (2013) Demand Dividend: Creating Reliable Returns in Impact Investing. https://thegiin.org/assets/Santa%20Clara%20U_Demand-Dividend-Description.pdf
12. Cheng, P. (2008) Quasi-Equity: A Venturesome Case Study Using Revenue Participation Agreements. Charities Aid Foundation.
13. Flloyd, D. (2017) Social Shares: Risk finance for social enterprises and charities. Flip Finance & Access Foundation. http://access-socialinvestment.org.uk/wp-content/uploads/2017/02/Risk-Finance-slide-report.pdf
14. For a summary of the report by the London School of Hygiene & Tropical Medicine: https://www.lshtm.ac.uk/newsevents/news/2018/social-impact-bonds-have-role-are-no-panacea-public-service-reform
15. The background, method and the results of the Peterborough SIB can be found here: https://www.gov.uk/government/publications/final-results-for-cohort-2-of-the-social-impact-bond-payment-by-results-pilot-at-hmp-peterborough
16. Smith, B. (2020) Perpetual Bonds: An answer to equity-like social investments? Esmée Fairbairn Foundation.
17. Rumour has it… https://news.yale.edu/2015/09/22/living-artifact-dutch-golden-age-yale-s-367-year-old-water-bond-still-pays-interest
18. Many articles have been written on this topic. For example: https://www.weforum.org/agenda/2020/08/5-things-covid-19-has-taught-us-about-inequality/
19. For example: https://www.bbc.co.uk/programmes/articles/1tGpw4fG1PrfjN7Glvg2y1y/why-we-need-to-rethink-just-about-everything
20. Bass, R. (2020) The Impact Investing Market in the COVID-19 Context: An Overview. GIIN.