Catalytic capital is a fast-growing subset of impact investing that addresses capital gaps left by mainstream capital. From reaching underserved populations and geographies, to de-risking novel products and building meaningful track records for new solutions, catalytic capital is demonstrating how markets and finance can be different.
As usage of catalytic capital has expanded, so have the questions from a range of investors investors and actors, including foundations, family offices and ultra-high net worth individuals, and development finance institutions, about the roles and uses of the tools.
The Catalytic Capital Consortium (C3) partnered with FSG and Courageous Capital Advisors on the development of this frequently asked questions resource, which we hope will provide valuable information and insights to catalytic capital investors. This resource lays out the initiative’s current thinking on these queries, drawing from our various exchanges with field leaders and our own experiences.
We do not intend the resource to be comprehensive, and welcome the opportunity to continue the dialogue with others in the field on these questions (and beyond). My contact information is below—please feel free to reach out to me at any time.
Below is a condensed version of the document produced for ImpactAlpha. The full frequently asked questions about catalytic capital can be found here.
– Emily Duma, C3 Grantmaking Program Officer ([email protected]).
1. What is catalytic capital?
As defined by Tideline (2019), “catalytic capital accepts disproportionate risk and/or concessionary return to generate positive impact and enable third-party investment that otherwise would not be possible.” Catalytic capital seeks to address capital gaps, i.e., investment opportunities that mainstream commercial investment markets fail to reach, partially or fully, because they do not fit the risk-return profile or other conventional investment norms and expectations that such markets require.
Capital gaps can arise in relation to aspects such as, but not limited to:
- Population: the ability to reach underserved populations/demographics;
- Place: the ability to reach underserved geographies;
- Innovation: the capacity to de-risk novel products, services, or financing models;
- Early-stage: the building of a meaningful track record or adequate scale for a solution or a new team/org;
- Business model: the addressing of small transaction sizes, high transaction costs, or other economic issues related to product or service (e.g., capital intensity);
- Resilience or flexibility in the face of shocks and crises; and
- Historical biases in capital allocation (e.g., marginalization of BIPOC investees and communities in the United States).
Over the last several decades, we have seen increasing amounts of capital deployed for positive impact, particularly in sectors such as financial inclusion and clean energy, and across emerging and developed markets. Catalytic capital played a critical role in developing and de-risking what are now vibrant markets for impact and commercial capital that previously did not exist, and enabling both individual enterprises and solutions—and entire impact-focused sectors—to scale.
But the unfortunate reality is that numerous opportunities to deliver much-needed impact fail to attract investment from many impact investors—this is particularly the case for those opportunities targeting poor and marginalized communities, and in sectors where capital markets are less mature. As the impact investing field grows and becomes more mainstream, it is more important than ever that catalytic capital continues to push the boundaries of impact investing into capital gaps—and impact needs—that otherwise would not be addressed.
2. Where and when is catalytic capital needed?
The three “roles” of catalytic capital outlined in Tideline’s 2019 report give us a high-level guide to the kinds of gaps that exist, and what is needed to address them.
In the Seeding role, catalytic capital can back impact enterprises and investment managers that are advancing the frontiers of impact, but with neither a track record of their own nor ready comparables that would be required to attract mainstream capital.
The Scaling role picks up where the Seeding role leaves off. Even after pioneering impact enterprises and investment managers demonstrate early success, they can struggle to attract mainstream capital, as their track record might be limited, their size still sub-scale, and the markets they play in relatively underdeveloped. In these cases, catalytic capital can step in to help them scale and expand their business or strategy—or support other players in replicating these models and strategies—to reach further situations, population segments, and geographies.
The Sustaining role of catalytic capital is rather different in nature from the first two roles, in that it meets an ongoing (i.e., long-term or permanent) need for capital that will accept concessional returns and/or can absorb disproportionate risk, in order to maintain a focus on serving hard-to-reach beneficiaries or otherwise operate a business model that cannot achieve full commercial viability.
The Seeding and Scaling roles typically come with the implication (or at least an investment thesis) that the capital gap is transient, that ultimate success is about closing the gap at the market level, such that mainstream investors would be able to pursue similar opportunities down the line without needing the involvement of catalytic capital.
In contrast, the Sustaining role typically assumes that the capital gap is permanent or at least unlikely to change significantly over the long term, and that it is mainly about accepting concessional returns rather than disproportionate risks at the transaction level.
3. How is catalytic capital relevant to the key issues we are facing today?
Catalytic capital is playing a critical role in addressing the key issues and challenges facing people and the planet. Take racial inequity in the United States. A long history of structural racism (as seen in discriminatory financial practices and norms such as redlining) has held back BIPOC communities in building their wealth through avenues such as housing ownership and entrepreneurship, giving rise to vast disparities in wealth between ethnic groups, and between Black and White populations in particular.
Catalytic capital has long played a role, and continues to play a role, in bridging these capital gaps. For over 30 years, catalytic capital has enabled the community development finance institutions (CDFIs) to provide affordable credit and other needed financial services to communities excluded by the mainstream banks. CDFIs’ responsible mortgage lending is enabling BIPOC borrowers to get on the housing ladder and achieve the security of owning their home.
More recently, catalytic capital has helped to develop and scale the Entrepreneurs of Color Fund (EOCF) model, targeting the gap in growth capital for minority-owned small businesses. Beginning in Detroit and now being replicated across the United States, the EOCF model aims to change the wealth trajectory for communities of color, through business growth that drives both entrepreneurial profits and local job creation.
4. Is catalytic capital just another way to refer to concessionary returns?
Concessionary return expectations can indeed be a feature of catalytic capital deals, but they are not a necessary or universal feature. As mentioned above, catalytic capital is defined by Tideline (2019) as capital that “accepts disproportionate risk and/or a concessionary return to generate positive impact and enable third-party investment that otherwise would not be possible.”
In some cases, concessionary financial return expectations are essential as part of the flexibility required to address identified capital gaps, in pursuit of impact that otherwise could not be achieved. For example, Root Capital extends loans to early-stage agribusinesses in remote areas (in countries such as Haiti and the Democratic Republic of Congo) that provide vital market access and related services for farmers, but these enterprises have both limited track records and little collateral, and operate in challenging business environments. Root Capital’s analysis of over 1,200 loans to agribusinesses in remote areas shows that charging the full risk premium to borrowers would make the loans unaffordable. As such, Root Capital has needed to take a concessionary approach in order to preserve the quality of impact, which it intends.
However, in many other cases, the predominant characteristic of a catalytic capital deal might be disproportionate risk (i.e., elevated risk or uncertainty beyond that which the market will tolerate, and for which the investor may or may not be fully compensated) rather than concessionary returns. For instance, the critical role played by catalytic capital in standing up new BIPOC-led fund managers pursuing previously neglected BIPOC-oriented themes in the United States (as described under Question 3 above) has nothing to do with returns concessionality and everything to do with backing opportunities that are unfamiliar to mainstream capital and are therefore regarded (at least initially) with skepticism.
Note that we are discussing return expectations, which need to be distinguished from actual, realized returns: In catalytic capital investing, as in any other kind of investing, investments may under- or outperform in financial terms relative to expectations.
Stepping back, we would also note that a narrow focus on returns alone can distract from what we think is most critical: Our starting point should always be the question of how flexible capital can enable impact in sectors, communities, and situations that mainstream capital would otherwise not reach.
5. Do catalytic capital investments lead to market distortions?
Addressing this question requires us to unpack what we mean by market distortion in this context. Typically, concerns about market distortion effects here revolve around situations where concessional (i.e., non-market-priced) capital “crowds out” other available capital in the market, e.g., mainstream investment capital, conventional bank lending.
We would argue that these effects are minimal where concessional catalytic capital is used as intended since, as described above, catalytic capital seeks to address capital gaps that mainstream investment markets fail to reach (e.g., serving specific populations/demographics who would otherwise be left behind).
By definition, therefore, such capital does not crowd out mainstream finance because it targets those opportunities that tend to fall outside the ambit of those markets, providing that catalytic capital investors are clear about the specific capital gaps they are addressing and how they are additional to what is otherwise provided in the market, and consider how they can most effectively target their deployment of capital, minimizing “leakage” outside the targeted capital gap. However, it is equally important to not allow concerns around market distortion to become a blanket concern—or reflexive excuse—that leads to paralysis.
6. What is the relationship between catalytic capital and blended finance?
According to Convergence, the global network for blended finance, blended finance is “the use of catalytic capital from public or philanthropic sources to increase private-sector investment in sustainable development. Blended finance is a structuring approach that allows organizations with different objectives to invest alongside each other while achieving their own objectives (whether financial return, social impact, or a blend of both). The main investment barriers for private investors addressed by blended finance are (i) high perceived and real risk and (ii) poor returns for the risk relative to comparable investments. Blended finance creates investable opportunities in developing countries which leads to more development impact.”
Given this definition, catalytic capital is the essential ingredient within a blended finance structure, meaning that the capital is deployed “vertically” within a capital stack and coincident with the financing that it seeks to leverage. However, catalytic capital can and is often deployed “horizontally” without blending, meaning that it is invested at an earlier stage than the capital it seeks to mobilize (i.e., sequentially).
7. How does catalytic capital relate to terms such as “impact-first investing” and “patient capital”?
As a concept, catalytic capital is highly aligned with the term “impact-first investing” as first introduced by Monitor Institute, promoted by the family office Ceniarth, and more recently highlighted by Bridgespan, as well as with the term “patient capital” as popularized by Acumen (although we would note that “patient capital” is also used in many financial circles to denote long-term capital without any reference to impact).
As such, we believe that those who have an interest in these topics should be interested in discussions about catalytic capital, and we welcome them unreservedly. Our intention in building the field of catalytic capital is not to exclude anyone, but to invite in all who share our interest in increasing the use of more flexible, patient, risk-tolerant capital to advance the frontiers of impact.
8. Is it just philanthropic organizations that can provide catalytic capital?
No, though philanthropic institutions are certainly a key group of catalytic capital provider. In the United States, for instance, foundation program-related investments (PRIs) are well suited to catalytic capital deployment, as they are required to have clear impact objectives (as the name suggests) and cannot have financial return as their primary motivation.
Beyond philanthropy, public-sector overseas aid budgets and official development finance institutions (DFIs) are active providers of catalytic capital. Governments can also support catalytic capital efforts domestically. One such example is Big Society Capital, which is working to build the impact investing sector in the UK and has had a significant success in areas such as the domestic charity bonds market where over £230 million has now been issued. Private HNW investors and family offices can also play a significant role in catalytic capital investing (Examples include Ceniarth and the Blue Haven Initiative).
At the other end of the spectrum, private institutional investors are perhaps the least able of all asset owners to step into catalytic capital due to the limitations of their mandates and regulatory constraints (e.g., fiduciary duty requirements), though even here we have seen innovative moves into catalytic capital: A notable example is that of Prudential Financial creating a catalytic capital portfolio that—unlike Prudential’s main impact investing portfolio—is excluded from its standard asset-liability matching process, and can therefore tolerate higher risk and volatility.
9. Is grant funding catalytic capital?
We see catalytic capital as investment capital, a definition that historically excludes grant funding. However, we recognize that some grant funding now blurs the line between grant and investment as conventionally understood. In recent months, we have engaged in discussions with colleagues across the field about this topic, and have been reconsidering the exclusion from the catalytic capital definition of grant funding that is positioned and structured to have investment-like attributes.
In particular, grants deployed as capital into transactions (e.g., as equity-like financing in pioneering early stage ventures, or a first-loss layer of credit enhancement in the capital stack of a blended transaction) are increasingly viewed as a type of investment capital by participants in the market. In some cases, these grants are also recoverable, i.e., they contain provisions for repayment if certain conditions are met. As such, we recognize that categories including capital grants and recoverable grants should be added to our conception of what catalytic capital is, and we support efforts to learn from and advance the practice of providing such capital in pursuit of greater impact.
We continue to recognize and appreciate the value of more conventional grant funding that is not being deployed as a part of impact transactions, but instead facilitates and supports them (such as through technical assistance, design or structuring work, research, impact measurement), and that helps to build the wider ecosystem. While these types of grant funding do not fall within the definition of catalytic capital, we do see them as enormously valuable tools that can work in powerfully complementary ways with catalytic capital deployment to achieve impact that otherwise would not be possible.
10. Does the concept of catalytic capital reflect all the ways in which investors can play a catalytic role?
Our use of the word “catalytic” is not intended to monopolize discussions about what it means to be catalytic in the field of impact investing, or otherwise seek to claim exclusive rights to use of the word. Instead, we see ourselves as part of a broader community that shares an interest in how impact investors can play the most effective role they can in driving toward impact for people and the planet.
We recognize that the word “catalytic” in impact investing will show up both within and beyond the discussions about catalytic capital. Our discussions with colleagues across the field have pointed to a wide range of actions that seek to catalyze additional transactions and impact, and other developments in the impact investing sector. Examples include:
- At the transaction level: funding up-front transaction costs; leading a fundraising round; lending one’s name where helpful in attracting other investors; helping to design the structure of the deal; helping to assemble or strengthen an investee team; supporting an investee with expertise and networks; and sharing market intelligence or due diligence findings with other investors; and
- At an ecosystem level: generating and disseminating market information; developing new financing constructs; establishing deal sourcing platforms; and providing investment readiness supports for enterprises.
The actions above can (and often are) taken in connection with the deployment of catalytic capital, but they can also be taken in unrelated contexts. We absolutely welcome the use of actions like these above to enhance the effectiveness of catalytic capital in achieving its intended goals.