In the Stanford Social Innovation Review in 2012, Kevin Starr from the Mulago Foundation highlighted some of the problems or challenges associated with Impact Investing. It is a short, but insightful, article. It led us to wonder: has anything changed in 4 years?
The frame of reference for the article is important. Mulago Foundation "finds and funds high-performance organizations that tackle the basic needs of the very poor". According to Starr, Mulago Foundation also expects sub-market returns as investments that provide "a big return don’t count: the market will take care of those, and we don’t need conferences to get people to put money into them."
In that context, the original article identified four key problems with impact investing:
(1) Few solutions that meet the fundamental needs of the poor will get your money back.
(2) Overcoming market failure requires subsidy.
(3) Revenue does not equal profit
(4) Impact investing can drive organisations off mission.
Perhaps the most obvious observation here is that this only deals with impact investments targeting poverty alleviation in the context of developing countries. Over recent years the range of social and environmental objectives covered by impact investments has increased significantly.
According to the impact investors surveyed by JP Morgan in 2015 ('Eyes on the Horizon' Report), capital deployed by impact investors is:
diversified across regions, with about half invested in emerging markets and half in developed markets. Housing accounts for 27% of respondents' assets under management, as do Microfinance and Financial Services (excluding microfinance) combined. A further 10% is allocated to Energy, while Healthcare and Food & Agriculture account for 5% each.
Likewise it probably goes without saying that the relative purchasing power of the poor in different countries makes a big difference. For example, the ability to identify and develop successful business models that deliver an impact to the poor in a developed country, such as the US, may differ markedly from those in developing countries or regions, such as sub-Saharan Africa.
Over recent years there have been some successful Bottom of Pyramid (BOP) businesses in developing countries, as well as some hard lessons learned through some high profile failures. As highlighted by Simanis and Duke (HBR, 2012):
Profitably selling to the bottom of the pyramid is difficult, but it can be done. It requires companies to focus on business fundamentals and start their ventures with a rigorous understanding of two key challenges in low-income markets: changing consumers’ behavior and changing the way products are made and delivered. Companies that underestimate these hurdles miscalculate the resources, innovation capabilities, and time involved, and project teams end up poorly equipped to accomplish the task.
While it remains true that government plays an important role in addressing market failure in developing countries, it is equally true that governments in developed countries are facing greater budgetary pressures and as a result are increasingly prioritising the delivery of services. This creates unique opportunities for impact investors, as noted by Rod Schwartz:
The receding state is creating a void into which impact enterprises are moving. UK charities and social enterprises have been and will continue to be under considerable pressure as government grants dwindle. As a result, many are exploring entrepreneurial models as a way to deliver public services to beneficiary groups without dependence on grant income. These new businesses are in need of values-aligned investment to fund operations, innovation and expansion.
Starr makes valid observations about the challenges in converting revenues to profits in impact investments. He puts it simply: "Delivering at a price point the poor can afford almost always translates into very small margins." He also challenges the conventional wisdom that scale begets profits, which works in technology businesses in developed markets but is less certain in the developing world (or at a minimum, requires truly massive scale to deliver material profits).
Likewise, Starr provides a warning to impact investors over creating pressure (knowlingly or not) on social enterprises to deliver financial performance ahead of their impact goals. This is potentially true of any investor - investee relationship. Getting alignment upfront on the core objectives of the social enterprise and, most importantly, how success will be measured and therefore how resources will be allocated, is critical.
So, what are the challenges for impact investors today?
The JP Morgan 2015 survey of impact investors identified three core challenges to the sector:
(1) Insufficient capital across the risk/return spectrum
(2) Insufficient high quality impact investment opportunities
(3) Limited exit strategies for impact investments
Put simply: the reality of impact investing now needs to match the hype.