The Critical Role of Non-Commercial Capital in Funding of Impact Investments

On September 19^th, the World Economic Forum hosted a panel discussion in New York to introduce its just-published report, “Fromthe Margins to the Mainstream – Assessment of the Impact Investment Sector andOpportunities to Engage Mainstream Investors”.  The panel included Goldman Sachs, Morgan Stanley, Equilibrium Capital and Social Finance USA.  The discussion and the report itself made a number of points of relevance to microfinance and other impact sectors targeting low income populations.

Among the good news:  a survey of the “millennial generation” finds them most often identifying  the purpose of business as “improving society”, albeit followed closely by generating profit; both financial intermediaries, like those represented on the panel, and advisors like Cambridge Associates appear to increasingly incorporate impact sectors into their portfolio constructs for clients. 

Among the challenges:  family offices / HNWIs and Development Finance Institutions continue to be the leading source of capital for impact investments, but these sources represent just a small proportion of total global asset ownership:  2.5% compared with 48% and 39% held by pension funds and insurance companies, respectively.  And these institutional investors continue to find impact investments challenging, due to scale, standardization and in some cases, risk adjusted return mismatches. 

In addition to these features of the landscape, the report tries to add further precision and substance to the discussion of what qualifies as impact investing in ways that resonate with current discussions within the microfinance community.  For example, while the report concurs that, consistent with the view of many in the microfinance community,  “intention” to achieve positive results is essential, it also insists that measuring results against impact goals is also essential; good intentions are not enough.

The discussion highlighted some further themes that preoccupy microfinance.  For example, one panelist noted that a bit more honesty is warranted about what impact investing requires, noting that market rate, mainstream capital can only get so far on its own:  in the major “impact” sectors in the US, nearly all housing and small business loans benefit from some government guarantee or enhancement. This is not a transitional phase towards maturity, but is a permanent feature of the landscape, albeit possibly in need of redesign.  Similarly, it can be expected that at least some of the newer impact sectors are likely to also require ongoing support in the form of credit enhancement or below market rate funding. 

The discussion also touched on the position taken by some microfinance managers that impact objectives are really just prudent risk management, with one panelist stating that “the word impact never passes my lips” when speaking with investors.  Instead the focus is on long term risk mitigation and the need to enhance value across many dimensions in order to meet long term needs of beneficiaries --  pension and insurance companies obligations viewed from a 30 or 50 year perspective.  While perhaps effective with investors though, this approach would still seem to require some magical thinking to dispense with the problems of externalities and free riding.

Finally, the discussion emphasized the central role played by credible and meaningful metrics of impact – still an issue of debate within the microfinance community.  Social impact bonds, a development that has received a lot of attention and enthusiasm in the UK and now the US, for example, require social metrics – and more specifically, data on social outcomes – in order to work.  Of course, they also require some source of revenue or return – typically government or philanthropy -- that can monetize the social benefit.

Microfinance generally does not have such a source and doesn’t benefit from tax incentives.  What incentives it has benefited from, for example in the Netherlands, have been reduced in recent years in the face of budget constraints.  The response of the microfinance community has been to work towards eliminating the need for non-market capital.  The discussion suggested that such an approach is likely to fail or to result in a significant reduction in the impact achievable.  Rather, the experience of the impact community broadly defined seems to point in the other direction:  some form of subsidy or source of monetization of social benefit is indeed essential and always will be if the sector is to achieve its social objectives.  The question is then not whether subsidy is required, but where it will come from particularly given the concentration of assets in the hands of mainstream institutional investors.

For the foreseeable future, microfinance will require continued philanthropic and government support to “crowd in” private financing through credit enhancement and pre-investment capacity building.  In the long term, though, if impact sectors are to grow in the face of constrained government and philanthropic budgets the goal has to be to create a meaningful bucket of private portfolios within the “total portfolio construct” that is willing to accept higher risk / lower financial returns in return for rigorously documented social benefit.

Grassroots is launching a fund to provide financing to MFIs committed to high social benefit that in its first stage will rely on traditional sources of non-market capital.  But in the medium term Grassroots will work to complement this fund with a parallel effort to develop the pool of private capital that will replace this initial capital, providing an exit and a basis for continued growth in the sector beyond what official and philanthropic sources can sustain.