Bridging the gap between impact investors and social impact opportunities
January 2017 | EXPERT BRIEFING | BANKING & FINANCE
For impact investment to be able to unlock its true potential in targeting positive change around the world, both sides of the impact investment spectrum must be satisfied: there must be a robust supply of capital and a sufficient number of investable opportunities.
There is a great need to tackle some of the most serious problems around the world, and the current level of funding, which is being raised through traditional funding sources such as grants and donations, is insufficient. Meeting the United Nations Sustainable Development Goals (SDGs) will require additional investments of $2.5 trillion a year on social interventions including, health and education. A further $13.5 trillion is needed by 2030 to implement the Paris climate accord, according to the International Energy Agency. Therefore, we have our work cut out and there needs to be a significant market on both the supply and demand side.
There is an argument to suggest that the reason for an inadequate supply of investable opportunities stems from a disconnect between investors and the types of investment opportunities that are aligned to investors’ profiles and investment criteria. “The global impact investment market includes diverse investment opportunities and investors with a wide range of interests,” says Amit Bouri, CEO of the Global Impact Investment Network. “While people debate whether the market has too much capital or too many deals, it is clear that the current market isn’t clearing efficiently – capital and deals aren’t connecting the way that they need to be. This is characteristic of a young market.”
Numerous structures to achieve social impact investment
What differentiates impact investment from other forms of investment is the positive social or environmental impact that the investor seeks to achieve, alongside its financial return. Although there are numerous structures for impact investment (linked to environmental, social and governance or ESG principles), impact funds, cross-border funding platforms and social impact bonds have received particular attention in recent years from both the investment community and the development sector.
In the expanding world of impact investment, it may be daunting for potential investors, and those establishing an impact investment programme, to determine what may be the best structure for investment. There are also a variety of investor types and deciding the best type of opportunity will depend on whether such investor is an ‘impact first’ or ‘investment first’ investor. The most flexible structures ideally attract both types of investors toward delivering a social impact through the targeted intervention.
Types of structures
There are a number of different structures available, all of which have different features and may attract different investors. Commingling funds, for example, combine philanthropy with commercial capital. While the ideas may vary, in terms of the target social outcomes and the way they are structured, they also share several attributes. All commingling funds are designed to achieve a financial return alongside a clear social impact, and to use their governance structures to define and protect the fund’s social mission. For this reason, they can appeal to both philanthropic and more commercially driven investors. Philanthropic investors, like trusts and foundations, use commingling funds to explore their distinctive role as investors. These funds enable foundations to leverage commercial capital that might not otherwise be invested for a social purpose by providing cornerstone investments and taking different risk positions. This allows the funds to achieve social outcomes at scale and address entrenched social problems that require a large investment. There are a number of ways in which such funds can be further structured, differentiated mainly by the way in which the foundation risk helps leverage commercial investment such as in, pari-passu funds, risk-reward funds and ‘but-for (foundation)’ funds. Examples of such funds are the Bridges Social Entrepreneurs Fund, The Big Issue Invest Social Enterprise Investment Fund, the African Agricultural Capital Fund and the Global Health Investment Fund.
Private placement structures typically include investments through private equity, private debt and private real assets. They principally involve making unlisted equity and debt investments in private businesses or assets.
Blended finance structures combine private, financial return-based sources of capital with either public sector or philanthropic funds. The latter often takes up the ‘first loss’ position in the capital structure in order to incentivise greater private sector funding.
Performance based structures include social impact bonds (SIBs) or development impact bonds (DIBs). There are a number of parties in any impact bond: the intermediary, along with other service providers that deliver positive social impacts against specific targeted interventions, the investor that provides the upfront working capital during the life of the project, the outcome payer that pays the investor upon the success of the project and an independent impact evaluator that validates the level of social impact achieved against an agreed impact evaluation metric. These structures can be particularly effective when the metrics of success measurement are clearly defined and where such a measurement is clearly achievable to demonstrate a positive social impact. The Educate Girls DIB is a good example of such a structure; it targets the education of children in Rajasthan. Around 44 percent of the girls targeted in Rajasthan have been successfully enrolled, meaning that the UBS Optimus Foundation (the investor on the transaction) has potentially recouped 40 percent of its investment after just a year, with currently around two years left to run.
In addition to these social impact finance structures, there could be a number of additional structural features that can be built into a transaction to address particular investor requirements such as: (i) match funding; (ii) diaspora remittance channels; (iii) crowdfunding; (iv) insurance schemes; (v) guarantee features; and (vi) below market rate bonds.
Impact investment opportunities
The range of investment opportunities available to impact investors is broad and growing. These opportunities are diverse in terms of their impact objective, asset class and return expectation.
Both impact first and investment first investors have helped to dispel a number of myths about the impact of finance opportunities and greater investment. Most notable myths such as the notion that profits and impact are (and need to be) mutually exclusive, that impact investing is philanthropy, that impact investing implies financial sacrifices, that high returns imply low impact, and that impact investment works only in emerging markets and poor countries, have all been shattered.
At the heart of every impact investment opportunity are a few key questions that influence the ultimate structure of the project. Firstly, what is the social issue or the nature of the targeted intervention? Also, where is the project aimed at making the social impact? This question is important as it tackles the issue of the geographical location (or locations) of the project, as well as the actual underlying targeted population or the community. While impact investing is often associated with global investments which support entrepreneurs in developing countries, local investing is a frequent entry point for many impact investors, both individual and institutional.
The question of return on investment must also be tackled. What kind of financial returns are being offered to investors? Are they performance based or not? How is repayment to be structured? Are parts of the return on investment guaranteed by any outcome payers on successful achievement of social outcomes?
In terms of the degree of control, what are the capabilities of an investor and how actively do they wish to participate in the allocation and management of the impact investment? How involved does an investor wish to be in the decision making process or the actual running of the underlying projects that are being funded by the impact investment?
With regard to impact reporting, the extent of which data and empirical evidence need to be collected and reported on to demonstrate the extent to which positive social impact is achieved as a direct or indirect result of the investment must be considered. For example, investors might only want to invest in enterprises or funds that have been rated by the Global Impact Investing Rating System.
The investors themselves must be considered. The location of the actual investors is a key factor when structuring a transaction, particularly from a tax, regulatory and funds flows perspective.
Finally, agency and servicer roles must be factored in. The identification of the relevant third-party agents and servicers that must be appointed in order to ensure the execution of the project and also, actual delivery of the project on the ground, must be a consideration.
Within the growing community of impact investors and investment capital, there must be adequate opportunities for investment capital to be deployed. Investors will become frustrated if they do not find a ready supply of viable investment opportunities.
The best structure for a particular project will depend on the nature of the intervention itself, as well as the financial returns sought to make it an attractive proposition for investors, the degree of flexibility that is afforded by a particular structure to attract investment from a range of sources and whether the transaction structure may be replicated for other interventions.
From a finance perspective, the bottom-line is that an appropriate structure can be put together and we have seen a number of innovative structures being brought together, which meet all of the necessary criteria. It is encouraging to see that a number of innovative structures are being brought to market, which will only help in tackling some of the most critical social issues around the world, while helping to develop a more mature market where investment opportunities and social impact projects can thrive alongside each other.
Ranajoy Basu is a partner at Reed Smith LLP. He can be contacted on +44 (0)20 3116 2827 or by email: firstname.lastname@example.org.
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