Innovative solutions to the world’s social problems abound – if you can raise the money to pay for them. Charitable foundations, while helpful, have too few resources to tackle all the world’s needs. Many countries are still recovering from the 2008 global recession, and government contributions have declined as tax revenues have fallen.
Into this vacuum, an entirely new form of financing for good works has emerged: Impact Investing (II). The concept recognizes that philanthropy alone will never raise enough funding and that, once the money is spent, the charity must raise more. In contrast, II harnesses the power of the global financial markets to raise capital for projects – often start-up businesses – that have social or environmental benefits. The investments pay real returns to investors while generating an ongoing stream of revenue for worthy causes.
“We’ve got a great idea here that can transform our societies by using the power of finance to tackle the most difficult social problems,” British Prime Minister David Cameron, who hosted a global II conference in 2013, told the delegates. “Problems that have frustrated government after government, country after country, generation after generation.”
US$3.8 BILLION AND GROWING
II was born at the Rockefeller Foundation in 2007 but has spread worldwide. According to a study by US investment bank JPMorgan Chase, the II market attracted US$3.8 billion in new capital in 2013 alone. JPMorgan Chase estimates the market will grow to US$400 billion in the next two decades.
“While the market is still in a very nascent state, we’ve noticed an increased number of investors who are actively exploring investing using these strategies,” said Luther M. Ragin Jr., CEO of the Global Impact Investing Network, a nonprofit organization dedicated to increasing the scale and effectiveness of II. “Managers who had first-time funds several years ago are now launching second and third funds that are raising significantly higher capital from newer and more robust groups of investors.”
How does II work? Consider a UK business that collects waste oil from motorcar service stations. Offering automobile owners an alternative to dumping their motor oil down a drain creates an obvious positive benefit to the environment, yet it might have trouble attracting start-up capital. But Bridge Ventures, an II fund manager in London, raised US$460 million in capital from a group of pension funds, creating a general II fund that provided capital to the company. The pension funds earned a return on their investments of between 12% and 20%, comparable to other market-rate returns.
Lundin Foundation, provides farm equipment at affordable rents that convert to ownership. (Image by Eliot Marcus, © Rent-to-Own Zambia)
Other II projects have included start-up companies that help the poor get food in California, make mobile payments available to the unbanked in India, and let patients in countries where drug counterfeiting is common use their cellphones to determine if their medicines are genuine. All the investments have one thing in common: They must have a social or environmental benefit in addition to providing a real return on initial investment. Most of the investments are done as private equity, meaning investors buy a part of the company; others come in the form of loans.
“Financial inclusion and renewable energy infrastructure are two areas that offer fantastic risk-adjusted returns while achieving great social and environmental benefits,” said Adam Wolfensohn, who runs the Impact Investing area of fund manager Wolfensohn Fund Management, L.P. of New York, London and New Delhi.
“We focus on green energy, energy efficiency and resource efficiency like water treatment,” said Anthony Hewat, managing principal at Johannesburg, South Africa-based Lereko Metier Sustainable Capital Fund. “But it’s no different from our normal investment process.”
Hewat last year raised 690 million South African rand (US$61 million) to fund newly private power companies in Africa that use renewable energy. Investors included TransNet, the pension fund of former South African government transportation workers.
II DIVERSITY INCREASING
Impact investments attract capital from several sources, primarily pension funds and high-net-worth individuals with excess capital to invest who want to create social benefit at the same time.
An investor can invest directly in an end-user. For example, a major US insurance company recently made a US$120 million investment in bonds to finance a housing complex for low-income individuals. Interest on the bonds will be paid from rental income generated by the housing project.
In an II fund, a team of advisers collects investors’ capital and then buys shares in a variety of companies. More than 280 II funds now exist, mainly in Europe and the USA, but also scattered throughout Asia, Africa and Latin America. Backing multiple projects helps reduce the individual risk to investors because their funds are spread over several activities. The managers also have more experience evaluating II than normal fund managers have.
2013 saw the rise of II fund of funds, which pool investors’ money and use a middleman manager to invest in a variety of different II funds, reducing the risk and increasing the reach of each investment dollar. The first to market was a US$55 million II fund from UBS, the Swiss bank, which raised funds from its private-wealth customers.
“The whole notion of responsible behavior is much more part of everyone’s thinking than a generation ago, so the next generation will clearly have more affinity and more interest for Impact Investing,” said Mario Marconi, UBS’s global head of family services.
Another innovation is the so-called social impact bond (SIB). Bank of America Merrill Lynch raised US$13.5 million in December 2013 for the State of New York using an SIB to fund a job-training program for formerly incarcerated individuals, which reduces their chance of returning to prison. Thanks to the backing of state governments, investors got market-rate interest and lowered risk.
Often, big investors like pension funds are reluctant to take on big risks, especially those that are difficult to quantify. To lower the risk, a group of first investors agrees to provide “catalytic first-loss capital,” accepting the lion’s share of an investment’s initial losses. First investors get paid a higher rate of return for their higher risk, but they also protect pension funds against some initial losses if the investment turns sour.
CHALLENGES REMAIN
II still faces a number of hurdles. One problem is size. Most large institutional investors want to invest in chunks of US$50 million or more; they lack the time or personnel to manage many smaller investments. Also, laws often prohibit them from owning more than 20% of a fund. Because II funds are relatively small, institutional investors may have difficulty finding investments of sufficient size.
Quantifying risk is another issue. Most investors know the risk of a power station in London, for example, but what about a similar project in Zambia? Companies are springing up to offer risk-assessment services, but lack of information remains an impediment.
Still, proponents believe the future for II is bright. “When we look around us today, some of us can feel that we are on the brink of a new entrepreneurial revolution, a social revolution,” said Sir Ronald Cohen, chairman of the G8 Social Impact Investment Taskforce organized by the world’s eight largest industrialized countries. “Impact Investing portends a real revolution driven by innovation.” ◆
Charles Wallace is a former foreign correspondent who writes about global finance from his base in New York.
GIIN’s Luther Ragin discusses Impact Investing: http://www.youtube.com/watch?v=PTA2BqXWjjc
