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Catalytic capital: Reshaping risks and rewards to make markets work in 2020



ImpactAlpha, Dec. 19 – Attractive returns are in the eye of the beholder. For some investors, catalyzing capital for high-impact ventures – or better yet, whole new markets – is a bona fide home run. Those able to accept higher risks or lower returns, more flexible terms or longer repayment periods, get to bridge not only capital gaps, but conceptual gaps about how much finance can do. Such catalytic investors “are relatively rare in capital markets today but are invaluable for the growth and scaling of impact enterprises and development of new impact industries,” the consultancy Tideline found in a report last spring. 

Making catalytic capital cool is one aim of the Catalytic Capital Consortium of the MacArthur and Rockefeller foundations and Omidyar Network (all long-standing partners of ImpactAlpha). Instead of below-market, concessionary, sub-commercial and subsidized, think high-impact, innovative and strategic. And, of course, “smart” – too much or the wrong kind of subsidy can distort markets, impede competition or prop up unsustainable enterprises. Still, catalytic capital can help businesses with uneven cash flows, longer runways to profitability or modest operating margins. By lowering risks or raising returns for other investors, catalytic capital can help enterprises attract commercial capital needed to scale. “We want very much to see market-rate capital grow and continue to grow,” says MacArthur’s Debra Schwartz. “But we have to recognize that market-rate capital doesn’t work in all circumstances. If we don’t have a healthy commitment to the catalytic piece, we’ll be leaving impact behind.”

– David Bank and Dennis Price

1. Moving beyond tradeoffs.

Expect investors to become more intentional about where they play. Tired: Debating whether impact investing requires a tradeoff between impact and returns. Wired: Embracing your position on the continuum of capital. Whatever their appetite for risks and returns, investors can craft investment strategies and portfolios with positive social and environmental impact. Capital that is explicitly prepared to make concessions can nurture nascent markets with unproven models, particularly those that serve low-income customers. “One of the things that is going to be really critical is to see catalytic capital flow into the market,” said Robynn Steffen to kick off last spring’s “Beyond Tradeoffs” podcast series produced by ImpactAlpha in partnership with Omidyar Network. Rather than dismiss such investors as unserious, those seeking fully risk-adjusted, market rates of returns should embrace them as part of the impact capital continuum. Catalytic capital is helping build markets for global health innovationplastic waste prevention and smallholder agriculture.

2. Incubating financial innovations for impact.

Expect more products to finance scalable solutions for climate change and income inequality. Bonds for climate-smart rice, cataract surgeries and air-pollution reduction (“breathe better bonds”). Insurance for coastal reefs and climate resilience for smallholder farmers. Public banks. Regulatory “sandboxes” for nature. Finance wonks are turning investment mechanisms into catalytic tools for change. Global Innovation Lab for Climate Finance has mobilized $1.4 billion for three dozen innovative climate-financing structures. The Rockefeller Foundation has incubated 50 “zero gap” models to find those that can mobilize at least $1 billion to meet the Sustainable Development Goals, and established an impact fund to finance the most promising. 

  • ImpactAlpha is watching for: Insurance industry competition to cover the $1.2 trillion global protection gap for natural catastrophes, mortality, healthcare and other risks, especially in emerging markets.

3. Preserving capital by putting it to work for good.

Expect more wealthy families to adopt ‘capital preservation’ strategies to maximize impact. “What should a return look like when you’re funding social justice?” asks Lynne Hoey of Candide Group, which advises high-profile investors such NFL player Derrick Morgan and Libra Foundation president Regan Pritzker. Candide’s Olamina fund raised $40 million from investors that accepted lower returns to invest in women, people of color and Native people in underserved U.S. communities. Wealthy families don’t necessarily need high returns – they’re already rich, notes Ceniath’s Diane Isenberg. She announced last year Ceniarth’s goal to move 100% of her family wealth into “impact-first capital preservation.” In a guest post on ImpactAlpha, Greg Neichin details Ceniarth’s deployment of $100 million in impact-first investments. One high-leverage investment: Ceniarth’s $3 million in higher-risk debt helped unlock OPIC’s $50 million commitment to Global Partnerships’ Impact-First Development Fund. 

4. Investing in system change.

Expect more Agents of Impact to focus on structural change. Impact investors can’t invest their way out of structural problems. Dozens of philanthropies and investment firms, including Open Society FoundationsOmidyar Network and Encourage Capital are mapping whole systems on issues like inequality, discrimination and resource exploitation. A growing recognition of the importance of policy is spurring funding for research, tools, training and networks. The first project of the new Tipping Point Fund, established this month by nine private and corporate foundations, is a request for public engagement and policy initiatives for impact investing in the context of the 2020 U.S. election. Impact investing “must get political,” says Amit Bhatia of the Global Steering Group for Impact Investing.

  • ImpactAlpha is watching for: Smart mixes of capital, community organizing and policy to tackle problems such as unique, secure financial identities to give individuals in emerging markets greater access to loans other services.

5. Incentivizing impact with compensation and capital.

Expect impact- and results-linked finance to put a value on impact. More entrepreneurs, company executives and fund managers are tying compensation and financing to impact and sustainability results. Limited partners seeking impact are tying fund managers’ carry to the social outcomes of portfolio companies. Foundations, development banks and other “outcome payers” are paying companies that reach impact objectives. Banks are lowering the cost of capital for corporations that deliver on sustainability improvements – and reduce risks. Social and development impact bonds repay investors only if funded projects reach their social and environmental objectives. 

  • ImpactAlpha is watching for: The results of impact-linked finance pilot projects in Mexico, Honduras and Peru and the performance of Root Capital’s agribusiness loans across Latin America.

6. Blending better capital stacks.

Expect pressure on development finance institutions to take more risk to crowd in capital. Blended finance was supposed to grow billions into trillions to deliver on the 2030 Sustainable Development Goals. The results to datebillions to…billions. For every $1 of philanthropic and public capital, blended finance deals have attracted about $4 of commercial capital. To scale blended finance, practitioners need to grow the number of $1s or boost the ratio. Skeptics point to the complicated nature of blended finance transactions. Advocates are calling on publicly funded development finance institutions to take on more risk in such deals. Other fixes: focusing on revenue-generating development projects; getting smarter about subsidies; and standardizing, aggregating and simplifying structures.

  • Bright spots. Corporations participated in 29% of blended deals over the last three years. The Teachers Insurance and Annuity Association, or TIAA, is one of the most active commercial investors. 
  • ImpactAlpha is watching for: More structures that both aggregate assets and transfer and reduce risk, à la International Finance Corp.’s Managed Co-Lending Portfolio Program and Climate Investor One. “The really giant transactions happen when you put those two principles into the same deal,” says Convergence’s Joan Larrea.

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