There is Good News and there are Challenges



It appears that the ESG market is gaining increasing traction. So why is it so hard to create an investing model for investors to invest in early stage social enterprises?

Last week there was extremely good news around the growth of the Sustainable Investing universe. According to The Forum for Sustainable and Responsible Investment (“USSIF”), the size of this market grew by an astonishing 76% over the past two years. It now stands at over $6trillion. This represents one in every six investable dollars in the US. The reasons for the increase are twofold. First, investment managers are responding to investor demand. Second, ESG assets in many cases offer superior returns AND risk diversification. This makes investing in ESG assets 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 Environmental, Social, and Governance factors both as negative and positive screens. The latter is a change from the past. If you look a little deeper into where investment dollars are going or not going, climate change and gun safety are the two most impacted areas.

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 non-environmental issues. These “Impact Investments” are in areas including education, workforce development, and food security to name a few. It is estimated that the amount of money available for impact investment is only between $40-60billion. Keep in mind that Bain Capital alone manages over $85billion and that charitable giving in America totals over $250billion per year.

The question is why Impact Investing been slow to develop? What are the barriers to a more robust impact investing market? While there are many ranging to investor education, building infrastructure, and types of social ventures that can support impact investing, there are other issues that while less transparent, have a major influence on the pace of growth of the Impact Investing market.

In my conversations with potential investors and investees, there are at least five impediments to raising early stage capital for impact investments.

The first is that in order for many of these investments to work some kind 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 space this capital can come in a number of forms. It could be donations to a 501 © 3 entity. Or for 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.

The issue is that there is far too little of this type of capital, especially donations to be used for non-program purposes. Foundations typically give money for program and not for capacity building leaving this role to high net worth individuals and corporates. Additionally, mixing of donations and investments can be confusing especially to the investee.

The second barrier is size of transactions. This applies to both investors and investees. Outside of the environmental space, deal sizes are small. Many social ventures are service businesses, which require relatively small amounts of capital. These small transactions are not typically interesting to larger funds that might decide to allocate a portion of their fund to impact investments if they could source an investment large enough to pay for the diligence required. Therefore these investments typically go to dedicated impact investing funds which to date have struggled to raise significant amounts of capital.

Exacerbating this challenge is the third barrier to growth. The impact investment market reminds me of structured credit 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. Increased liquidity and the larger capital flows that come with it are at least partially dependent on standardization of instruments. Highly bespoke instruments will work for a given transaction but may act as a hinderance to broad market growth.

Take the example of Social Impact Bonds (“SIB’s”). This highly touted instrument for social investment is simply not scalable or replicable in its present form. It is simply too complicated for most investors to understand and each bond will be materially different. This increases fees to bankers and lawyers helping to make SIB’s the world’s most expensive bridge loan. That is not to say that the technology behind SIB’s is not useful. Its 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.

This leads us to the fourth barrier. Many 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. Many of these leaders are reticent to engage with “investors” out of concern of losing focus on the mission. To be fair, many social missions cannot support investing, as they do not have cash flows that can generate a return. On the other hand, many social enterprises would be enhanced by taking money from impact investors to grow to scale.

Perhaps the biggest issue with social enterprises is the need to present their businesses in a fashion that more traditional investors are accustomed to. What I mean by this is having an early focus on capacity building that allows for strong accounting and finance, business planning, marketing/development, and understandable metrics. I believe that this is where impact investors may be most useful. Many potential investors not only seek to invest their financial capital but their intellectual capital as well. Creating networks of investors/mentors is an important step in the growth of early stage impact investing.

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 whom are likely to be a significant portion of the impact investing space.

As I heard 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. Philanthropy 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 lack of or fuzziness of metrics in the social sector.

Investing on the other hand has one clear goal and one clear measuring stick It also has a not insignificant ego element attached to it. For many investors being successful in investing is not just about making money, it’s about being right! So while its fine to make a donation that doesn’t go well, it’s more than a financial problem if an investment, impact or otherwise isn’t successful.

It is this fact that keeps many potential investors on the sideline. They correctly see that measuring success in impact investing is more layered and complex. At present the measure of success is unclear.

The solution is a combination of marketing and metrics. We must do a better job of making clear what Impact Investing is, where it matters, and for what kind of social issues it works for. 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 money further. We must teach social entrepreneurs how to tell their story in a way that is compelling, consistent, and clear. Just like for profit entrepreneurs do it.

A couple of months back I was a panelist at the Alliance for Business Leadership’s session on Sustainable Investing. A member of the audience took me to task for claiming that all impact investing was concessionary in some way. He stated that we need to stop giving up the high ground. He is 100% right! The point I wanted to make is that if the FINANCIAL returns were the same as a traditional investment then is it really an impact investment?

The reality is that many impact investments produce greater returns than their non-impact comparable once you factor in ALL of the returns; financial, environmental, and social. Now all we need to do is create metrics that are clear, simple to understand, and comparable. If we want to attract investing capital to the social arena then we must find a way to simplify and standardize our method of communicating across the sector. The Global Impact Investing Network (“GIIN”) has gone a long way to creating metrics and disseminating the information. But still there are just too many metrics with too much information for the average investor to fathom.

I understand that highly specialized and specific information is valuable, and it must be available. I also am aware of the concern that may mission driven organizations have with being categorized and being encouraged or even pushed to engage in mission drift. I have two answers to that concern. First, as stated above, the more detailed information must be available both for investors and for the organization so that it can constantly measure its effectiveness. Secondly, it is the hope of many investors that comparative metrics will better allow everyone to put capital with the organizations that are having impact. Investors need ways of easily identifying successful social enterprises, ones that will have impact. After all, isn’t this the point of impact investing?

I welcome any and all responses, questions, and thoughts on this topic. We must find a better way.




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