by: Jeff Kushner, Partner, Social Venture Partners
A few weeks ago I had the privilege of helping to lead the Alliance for Business Leadership’s discussion of “Sustainable Investing” at the Alliance’s 8th annual Fall CEO Summit. It was a lively discussion that has prompted the development of an Alliance for Business Leadership Task Force on Social Impact Investing & Giving which will host a breakfast in Cambridge MA, January 13th (RSVP here).
This emerging discussion within and beyond the Alliance comes at a moment of outstanding growth in sustainable and responsible investment. Two weeks ago, The Forum for Sustainable and Responsible Investment (“USSIF”) report showed that the size of the Social Responsible Investing (“SRI”) market grew an astonishing 76% over the past two years.
SRI is a now a $6 trillion plus market. This represents one in every six investable dollars in the US. There seem to be two primary reasons for SRI’s remarkable growth. First, investment managers are responding to investor demand. Second, assets screened for Environmental Social and Governance (ESG) factors often offer superior returns AND risk diversification. This makes investing in assets screened for ESG performance an obvious choice for many.
The biggest area of growth is in what USSIF calls ESG Integration. This simply means that asset managers are now looking at ESG factors both as a negative screen (where assets are deselected for negative ESG considerations) and positive screens (where assets are included for positive ESG considerations). The use of positive screens is a relatively new development. If you look a little deeper, climate change and gun safety are two of the most commonly used screens.
While this is certainly good news, most of this investing is focused on publicly traded companies and as such, it still belies a relatively slow trajectory for growth in early stage investment capital for what I would call “Socially Focused” (i.e. not related to eco-efficiency or health) issues. These “Socially Focused” “Impact Investments” seek to deliver returns that are explicitly “social” in that they benefit networks people as a network and are, therefore, difficult to quantify with traditional performance metrics. Relevant areas include education, workforce development, and food security to name a few. It is estimated that the amount of money available for this type of social impact investment is only between $40-60 billion. Which seems like a huge amount of money until placed into the context of the capital markets where a single investment management firm like Bain Capital can manage over $85 billion and where charitable giving in America totals more than $250 billion each year.
What Are the Non-Financial Impediments to “Social Impact Investments”?
The question is why has socially focused “Social Impact Investing” been slow to develop? What are the barriers to a more robust impact investing market? While there are many ranging from investor education, market infrastructure, and the types of social ventures that can support impact investing, there are other issues that may be less transparent, that have a major influence on the pace of growth of the Social Impact Investing market.
I think these often “informal,” non-institutional, impediments to market growth can be surfaced through personal interviews with those interested in participating in the Social Impact Investing market. Over the past several years I have spoken with both potential investors and investees and regularly heard about five impediments to raising early stage capital for socially focused impact investments. These are: too little capital invested in risk reducing capacity building, too few social entrepreneurs planning for the business of capacity building, the fact the average size of social impact investment opportunities are too small for fund investment, the lack of standardized investment processes and documents, and investors’ professional pride in their investment acumen which investors are wary to risk in the “new” Social Impact market.
Too Little Capacity Building, Enterprise Risk Reducing, Capital:
The first barrier is that in order for many of these investments to work, some form of catalytic capital is required. In the for-profit space, this capital would typically come from entrepreneurs, friends and family, or angel investors. In the social sector, this capital can come in a number of forms. It can come in the form of donations to a tax-exempt 501c(3) organization. Or, in the case of community housing, it could come in the form of the Community Reinvestment Act, which requires banks to meet needs in low and moderate income communities. Loan guarantees from government agencies can also act as catalytic capital. Regardless of the form, catalytic capital is risk reducing, making it easier for other investors to get involved.
At present there is far too little of this type of capital, especially donations to be used for capacity building, non-program, purposes. Foundations are a major source of investment funds in the social sector and they typically give money for program and not for capacity building. Which often means a disparate community of high net worth individuals and corporates must supply the capital for capacity building. The fragmentation of the supply-side of the market for capital to support social sector capacity building, increases risk and leaves many socially purposed enterprises unable to scale. Additionally, social purposed “investments” in enterprise risk reducing capacity is regularly not clearly distinguished from “donations” given to advance program goals. Consequently, this creates confusion for both investors and investees.
Social Entrepreneurs Need Capacity Building Focused Planning
Those being invested in create the second impediment to a more robust social impact investment market, I have noticed. Namely, social entrepreneurs regularly do not focus enough, or effectively enough, on the business of capacity building. This may be because most leaders of social enterprises are not accustomed to or comfortable with the concept of taking “investments.” They have traditionally sought donations or grants to fund their mission; not their enterprises and the efficiencies of process and scale that growth can enable.
Many of these leaders may be reticent to engage with “investors” out of concern for losing focus on the mission and losing control of their organization. To be fair, many social missions cannot support investors, as they do not have cash flows that can generate a return. On the other hand, many social enterprises (and by extension their missions) would be helped by taking money from social impact investors to grow to scale.
Indeed, one of the areas in which social impact investors are best prepared to assist with expertise, network, and capital is in helping social enterprises plan and present in a manner that more traditional investors are accustom. This includes having an early focus on capacity building that allows for strong accounting and finance, business planning, marketing/development, and understandable metrics. Many potential investors not only seek to invest their financial capital, but their intellectual and personal capital as well. Creating networks of investors/mentors similar to what we see in the private sector should be an important step in the growth of early stage impact investing.
Most Investment Opportunities Are Too Small For Funds
A third barrier to scaling the Social Impact Investing markers is the average size of transactions. This applies to both investors and investees. Outside of the clean energy sector, average deal sizes are very small for a capital market. Many social ventures, which tend to be service organizations, need relatively small amounts of capital. These smaller transactions are not typically interesting to larger funds that might decide to allocate a portion of their fund to impact investments if they could get an investment large enough to pay for the diligence involved. Therefore, these investments typically go to dedicated funds which to date have struggled to raise significant amounts of capital.
The Investment Processes & Documents Are Not Yet Standardized
Exacerbating the challenge of very small deal size is a fourth barrier to growth: a lack of systemization of process and standardization of documents. The social impact investment market reminds me of the structured credit market in the mid 1990’s before CLO’s, CDO’s, and ABS deals became commonplace. Every transaction not only has its own specific entity risk, but also has its own idiosyncratic documentation. This increases the risk as well as the resources needed to make an investment decision.
Take the example of Social Impact Bonds (“SIB’s”). This highly touted instrument for social investment is not scalable or easily replicable in its present form. It is simply too complicated for most investors to understand and each SIB is materially different. This increases fees to bankers and lawyers, making it the world’s most expensive bridge loan. That is not to say that the technology behind SIB’s is not useful. It’s just that in order for SIB’s to be widely adapted, investors and investees will need to reach a compromise that allows for standardization of documentation. This will include tenor, events of default and compliance, and, most importantly, metrics. Simply put, the perfect is the enemy of the good. This must change so investors can focus on the specific entity risk of an investment.
Investors May Be As Interested In “Being Right” As They Are In Mission
Ahhh, those investors. Over the past couple of years I have had many conversations with individuals who might be impact investors. These individuals in all cases participate in both philanthropy and investing. They should like the idea of investing for social as well as financial gain. But for the most part they are skeptical at best. To quote a hedge fund manager that I spoke with, “When I want to do good, I’ll make a donation and when I want to invest, I’ll invest in a company that I understand”. I have heard similar comments from many other high net worth individuals and while there are other targets, high net worth is likely to be a significant portion of the impact investing space.
As I heard a version of this answer again and again, I began to think about why people feel this way. My conclusion is that wealthy individuals, particularly those who made their money rather than inheriting it, placed philanthropy and investing in very different realms, viewing philanthropy through one lens. It is about doing good but in many cases there is less rigor around donating than around investing. To be certain, this is in part due to the current lack of, or fuzziness about, “return” metrics in the social sector.
More important, commercial investing has a significant ego element attached to it. For many investors, being successful in commercial investing is not just about making money, it’s about being right! So while it may be acceptable to high-net worth individuals to make a donation that doesn’t go well, it can be a blow to their ego if an investment, impact or otherwise, isn’t successful.
I think this dynamic keeps many potential “social” investors on the sideline. The solution is a combination of marketing and metrics. Those interested in social impact investing must do a better job of identifying the segment of investors interested in it, making clear what Impact Investing is and how it can make a positive difference in addressing carefully defined and understood social challenges. We also need to make the case that impact investments are part of a portfolio and “investing” in addition to “donating” can stretch the impact of philanthropic money further. We must teach social entrepreneurs how to tell their story in a way that is compelling, consistent, and clear- to investors. And just like for-profit entrepreneurs, their capacity building “growth story” needs to be relevant, quantified and convincing.