Opening the Floodgates: Increasing Institutional Investment in Impact Investing
The field of impact investing is experiencing steady momentum as corporations feel an increasing societal pressure to adopt sustainable practices and create a more integrative approach to capitalism. Famed business theorist Michael Porter wrote, “Capitalism is an unparalleled vehicle for meeting human needs, improving efficiency, creating jobs, and building wealth. But a narrow conception of capitalism has prevented businesses from harnessing its full potential to meet society’s broader challenges” (Porter & Kramer, 2011, p.64). Impact investing has emerged as a way for investors to generate significant and measurable social impact alongside financial return by investing in businesses that have social impact embedded into their business model. Impact investing was pioneered by philanthropists and family offices due to their unique ability to take a longer-term perspective and explore innovative means to addressing social issues (Wilson, 2016). However, the industry began to make tremendous gains when institutional investors including UBS, JP Morgan, and BlackRock decided to explore the space (Hehenberger, Mair & Metz, 2019). These institutions wield gargantuan amounts of capital and influence that can be channeled into social impact investing to drive meaningful and sustainable social outcomes. However, they have largely been reluctant due to concerns over capital efficiency, financial risk-to-return and business failure. Institutional investors must increase their participation in highly intentional impact investing and can do so while achieving capital-efficient financial returns and creating significant and measurable social impact.
Understanding the Stakeholders
The impact investing industry has emerged in the last 20 years, with $208B currently under management between impact investing and venture philanthropy funds, pension funds, philanthropic foundations, nongovernmental organizations (NGOs), hedge funds, and banks, with the figure expected to grow to $307B by 2020 (Hehenberger, Mair & Metz, 2019). That being said, the literature seemingly suggests that the social investment space suffers from two primary concerns: limited access to funding and inadequate tools to measure impact. The impact measurement space is continually innovating, with the development of standard social impact measurement systems like the Global Impact Investing Rating System (IRIS), the analysis of more causal links within the impact value chain and transitioning towards metrics that focus on outcomes rather than inputs (Wilson, 2016). However, while the measurement gap is being addressed, funding still remains a critical issue, especially for social purpose organizations (SPOs).
Existing impact investors cite a scarcity of high-quality hybrid investment options with consequential and measurable social benefits and more traditional institutions cite an inherent trade-off between financial returns and social impact (Lee, Adbi & Singh, 2019). Additionally, high failure rates in the social investment space lead to traditional institutional investors requesting high expected financial returns, weakening their ability to provide social good. Institutional investors have tended towards an Environmental, Social and Governance (ESG) approach to public equity investing, because of their propensity to focus on stable financial returns at acceptable risk levels (Wong & Yap, 2019). ESG investing represents a step in the right direction, however, academics and impact practitioners assert that large corporations can implement impact-lacking CSR initiatives in order to score well on ESG factors, particularly with the lack of transparency, objectivity, and uniformity in ESG evaluation (Stubbs & Rogers, 2012). Finally, on the issue of institutional funding, academics suggest that the supply of impact capital is constrained by burdensome regulations that regulate how institutional asset managers can invest capital in addition to a lack of co-investment opportunities (Wood, Thornley & Grace, 2013).
However, social entrepreneurs and enterprising non-profits vehemently disagree with this assessment of the landscape. Social enterprises assert that there are many high-potential impact ventures that are left undercapitalized and thus cannot achieve close to their potential. As Stephanie Dodson details, traditional SPO funding is piecemeal and miniscule, meaning that they are forced to demonstrate the value of their innovative ideas with an amount of capital that allows them to build a skeleton of what their idea could be. Additionally, social enterprises often require investors to invest over a longer-term horizon. This does not align with the traditional VC-exit model, which looks to exit an investment within five to seven years. Because social enterprises have a social or environmental mission at their forefront, reaching adequate profitability within the typical five to seven years can be challenging and untenable. However, impact investors that are willing to enter early and remain invested over an extended timeframe will be more likely to realize exponential gains. Ned Breslin, CEO of Water for People, wrote, “When your mission is social benefit, the ‘when’ of the ideal exit is in a sense very simple. It isn’t when enough clean water has flowed that you think your efforts have paid off. It is when the problem that was preventing enough clean water from flowing has been solved” (Breslin, 2013). Social ventures that resolve to remedy some of the world’s most prevalent issues like food insecurity, access to clean water and climate change cannot be thought of investments to exit after five years for a 250% return. To truly realize the immense financial and social gains, institutional investors must shift their mindset to ensure they are making investments that are the “right fit” for that particular venture. This could entail modifying the funding structure, investment vehicle or investment timeline.
From a public policy perspective, governments welcome the noticeable rise in social entrepreneurship. Federal, provincial and municipal governments seek to address issues like housing affordability, food security, climate change, etc. through large, publicly funded programs. Social entrepreneurs are able to respond to a diverse set of social issues with a capitalistic nimbleness and passion for social advocacy (Erpf, Bryer & Butkevičienė, 2019). Government funding is not able to efficiently solve large-scale social problems and by contrast, social entrepreneurs can substantially bolster government efforts to create greater societal welfare (Erpf, Bryer & Butkevičienė, 2019). In fact, MaRS estimates that, “less than $1 out of every $100 of government spending is backed by even the most basic evidence that the money is being spent wisely.” However, the historically rigid institution of government must adopt a more agile engagement strategy with the sector in order to extract social innovation’s potential. While governments are well-intentioned, they have done little to mobilize institutional capital towards the impact investing domain and have instead opted for small, restrictive grants administered through charitable proxies. Canada’s Social Finance Fund (SFF) represents a marked departure from this format, with a $750M capital commitment into the social finance sector. However, the fund has been slow to deploy, which has prompted an ask from some of Canada’s most prominent social finance actors, including SVX, Center for Social Innovation, and the National Social Value Fund, to rapidly deploy $400M of the SFF to create a strong social finance response to COVID-19.
Society also stands to gain tremendously from increased institutional capital flows into highly impactful ventures. Because social entrepreneurs typically address pressing social issues and underprivileged individuals, social innovation can catalyze mass societal progress, whether it is empowering women in North India or reducing poverty in China (Mercader, 2017). Furthermore, as monolithic financial institutions like BlackRock begin to shift their focus towards impact investing, it makes society more conscious of their role as innovators and problem solvers for a collective good. J. Gregory Dees, a Social Entrepreneurship Professor at Duke University, argued that this change in behaviour can consequently impact our quality of life and address crises related to poverty, violence, lack of education, disease, discrimination and other socio-economic factors (Dees, 2007). Social enterprises have also been found to be more likely to offer jobs to individuals at risk of social exclusion compared to traditional enterprises (Rey-Martí, Ribeiro-Soriano & Sánchez-García, 2015).
For example, Invest Detroit is a certified Community Development Financial Institution that seeks to stimulate commercial growth in Detroit, MI by combining resources from the public, private, and philanthropic sectors. Detroit faces high vacancy rates, low investment, rampant poverty, and high crime rates, meaning that this initiative to stimulate job growth and revitalize distressed areas works to maximize the happiness of all residents of Detroit, across the income and need spectrum (Naatus & Corea, 2016). Initiatives like Invest Detroit work to address social issues like criminality, poverty, and investment, which effect the richest and poorest people in Detroit. Consequentially, greater amounts of prosperity and happiness will be generated for the citizens of Detroit, regardless of their social status.
Notable business minds and economists are supportive of this movement. Famed business strategist Michael Porter argued for the notion of shared value creation, which rejects the narrow conception of profit-maximization and instead accepts profitability as an element of the value-creation matrix alongside societal value creation (Kissick, 2012). In a 2012 interview, Porter stated that, “A purpose containing shared value moves well beyond getting your employees fired up about being in business to create shareholder value, which I think is not very motivating” (Driver, 2012). In this, Porter asserts that in today’s changing workforce with rising social awareness and a growing appetite from society to effect social change, businesses who focus solely on maximizing shareholder value will suffer. Particularly, businesses will suffer in attracting and retaining talented human capital. Additionally, in the 1980s, writers like Edward Freeman began to advance the concept of stakeholder analysis. This model suggests that the stakeholders of a corporation transcend shareholders to include employees, customers, the government, communities and the environment (Kissick, 2012). Stakeholder analysis rejects the single-minded obsession for shareholder returns and advances that it is a better modus operandi because it responds to the demands of modern society, accords with the emerging legal reality, is morally superior and is a more effective business strategy in this century.
A Government’s Approach to Mobilizing Institutional Capital
The Japanese government has done a tremendous job at enabling growth within the impact investing industry. From a legal perspective, Japan has not created a legal entity for social enterprises, but the Cabinet did conduct a report to define social enterprises and estimate the market scale (Acevedo & Wu, 2017). Additionally, from a policy perspective, the Japanese government has undertaken a number of initiatives to spur growth in the sector. A Social Impact Investment Taskforce was created, and this led to the passage of two key policies. Firstly, the Japanese government passed a law authorizing the use of dormant capital in bank accounts for impact investing purposes (Acevedo & Wu, 2017). This provides a large influx of capital into the impact space, providing social enterprises with the capital required to scale. Additionally, the government launched three pilot projects around social impact bonds in 2015, specifically focused on family care, aging support and youth employment (Acevedo & Wu, 2017).
Spending on social issues is not a new phenomenon in Japan. In fact, the government spends more than 20% of GDP on social issues (Acevedo & Wu, 2017). J. Gregory Dees said, “Government service delivery, including in the relatively successful arenas of education and health care, has been criticized as bureaucratic, ineffective, wasteful, too political, and antithetical to innovation” (Dees, 2007). Considering Japan already spends a significant portion of GDP on social welfare, it is perfectly reasonable that Japan would have a vested interest in spurring social enterprise to increase economic efficiency. Although Japanese impact investments only comprise 2.07% of global sustainable investment assets, potential for growth is promising given Japan’s large presence of high net worth individuals and increased government participation in the impact investments space through the Japan Finance Corporation (Acevedo & Wu, 2017).
With respect to areas of growth, the Japanese government should likely bolster their support for intermediaries and relevant research. Additionally, the government should examine ways to mobilize the country’s network of high net worth individuals and corporate donors. Lastly, the Japanese government should strongly consider recommendations made by the Japan Impact Investment Taskforce. (Acevedo & Wu, 2017).
A Highly Credible Impact Investment Model
Root Capital is a lending company based out of the US that focuses on lending to agricultural businesses in Latin America and Africa that are too large for microfinancing but tare unable to secure credit from conventional lending sources (Brody, 2011). Since 1999, Root Capital has provided more than $1.4B to over 725 businesses in 30 countries, impacting almost 7M people that have benefited from higher and more stable incomes and improved livelihoods (Brody, 2011). Additionally, Root Capital has ensured that 2.1M hectares of land are under sustainable cultivation and that 97% of their clients operate in environmentally vulnerable areas (Root Capital, n.d.). Root Capital has extended such a large amount of credit but has achieved a 99% repayment rate from borrowers and 100% repayment to investors, rivalling the loan portfolios of Schedule 1 Canadian banks from a credit loss perspective (Brody, 2011). Additionally, the fund was 80% operationally self-sufficient by the end of 2010 and has since achieved self-sufficiency (Brody, 2011). This gargantuan impact that Root Capital has had on communities in Africa and Latin America has only been made possible because early investments by individual investors, socially responsible investment firms, corporations and foundations. The mobilization of institutional capital has resulted in the business scaling rapidly, from its inception in 1999, to $320M in credit extended by 2010, to $1.4B in loans made by 2020.
An early investor in Root Capital, Paul Leander-Engström of the 3W Foundation, invested because of his belief that impact investments are no different from traditional investments. Just like any other investment, impact investments require due diligence, commitment, engagement and nurturing for maximum results and impact (Brody, 2011). While Root Capital effects large-scale impact, it is vital to remember that the impact created is on a local scale with small social enterprises. COOPCAB, a coffee cooperative that represents 4,000 coffee-farming families located in a Haitian rainforest near the Dominican border, grows coffee under the shade of forest canopy (Brody, 2011). Considering only 1.5% of forest cover remains in Haiti, this practice links economic opportunity with environmental conservation, making it the quintessential social enterprise. The financing from Root Capital resulted in COOPCAB increasing their coffee exports by six times, allowing them to fund school fees for their member’s children and build a medical clinic (Brody, 2011). The future generations of children that will receive an education was only made possible thanks to the financing provided by Root Capital. This case study definitively proves that social enterprises can generate large-scale social impact while producing stellar financial results, alleviating many of the concerns of institutional investors.
A Multi-Faceted Strategy
Firstly, governments have a large role to play in ensuring businesses are investment ready and that institutional investors are adequately incentivized to invest in the space. With respect to ensuring SPOs are adequately prepared for investment, governments must invest in training programs and business support through local incubators, innovation networks and government-backed programs.
To increase the efficiency of capital deployed, governments should empower social entrepreneurs who can address need areas with scalable business solutions. Similar to Japan’s concept of creating SIBs for three identified need areas, governments should create a Social Impact Investment Fund that will provide investment and co-investment opportunities for social enterprises that address social issues identified by the government. As Ian Potter, a Fellow at the INSEAD Global Private Equity Initiative, notes, “Currently, the missing link is the key initial enable of the ecosystem: the credible and viable fund manager” (Potter, 2013). The government’s move to create a centralized social venture fund will ensure that the nation’s strategic priorities are being addressed while easing fears around investment risk for institutional investors. Additionally, governments must support social innovators in a less restrictive fashion (Shockley & Frank, 2011). By creating restrictive covenants and constraining policies, it only serves to dampen social innovation. For this reason, governments should create clear legal frameworks for social enterprises to address ambiguity and a centralized legal entity for social enterprise disputes. Governments can also contribute on the policy front to encourage institutional investment in social enterprises. Potential policies could include providing financial or reputational incentives for social benefit, setting regulatory floors for acceptable social and environmental performance, creating disclosure and transparency requirement on social impact issues, etc. (Wood, Thornley & Grace, 2012).
Institutional investors must also work to educate themselves about the impact investing space. For far too long, conventional markets have mispriced risk and impact investing can generate market and above-market-rate returns while working towards society’s betterment. This win-win for institutional investors means they must dispel with antiquated beliefs about a lack of high-potential opportunities so that they can develop resources to evaluate and invest in SPOs. The stigma that the inclusion of impact analysis results in a corresponding reduction in return is patently false and yet widespread in the view of hedge funds and institutional investors (Lieberman, 2018). Clearly, institutional investors can increase their participation in impactful investments without sacrificing returns and generating positive and measurable social impact.
As behemoths in the investment management sphere, institutional investors represent large swaths of people and capital. Institutional investors have been reluctant to adopt this new trend of impact investing out of fear that it is either too risky or requires the investor to accept diminished returns. There is a moral imperative and strong business case for institutional investors to increase their participation in impact investing. As Theodore Roosevelt said, “In any moment or decision, the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing” (BrainyQuote, n.d.). It is time that institutional investors abandon the sidelines and join impact investors across the globe to mobilize their capital to create a better future for society.
