By Andrew Haimes and Steve Zausner
We were recently having lunch with a friend who works at a firm at the forefront of impact investing and emerging markets. She felt her career was at a fork in the road: Should she focus on emerging markets or impact investment?
This wouldn’t have been a question a couple of years ago: impact investing and emerging markets were joined at the hip. Impact investing was supposed to redefine the efficient frontier, while making emerging markets more efficient.
Now, she said, “I feel like more and more of my (impact) projects are focused around US or Europe, less and less in emerging markets.” Those initiatives are important, she said, “but not really what I had envisioned when I entered the field.”
While the times are good for impact investing, the moment is less certain for emerging market economic development and small and medium-sized enterprises (SMEs). Major, mainstream asset managers BlackRock Inc., Bain Capital, LP, and Goldman Sachs, are entering the space. This year, assets under management are expected to grow by 17%, and the number of deals by 20%, according to the Global Impact Investing Network’s (GIIN) 2017 Annual Impact Investor Survey (see, “How much money is there in impact investing?”).
Indeed, the very entrance and potential success of these vehicles threatens emerging markets as the dominant theme behind impact investment. First, large funds mean large investments. The chance that a multi-billion-dollar fund will do a sub-million-dollar deal is roughly nil. Fiducially, it would be irresponsible. Financially, it would be folly.
The second reason is just a matter of math. As more funds enter, and their focus shifts from emerging markets to developed economies, the percentage of emerging markets holdings in the mix has to go down. The GIIN survey shows this: roughly half of impact assets have focused on US or other developed-market initiatives.
We hope to stimulate a broad discussion of the role and requirements of private sector investors and invite institutional investors to share their thoughts on emerging markets and impact investing. We would encourage stakeholders to put together a series of meetings between investors, underwriters, government agencies, NGOs, and think tanks with the goal of developing standardized documents for various common transactions
Development-finance institutions, for example, may get excited about the concept of attracting ‘blended capital,’ but the common complaint we hear is that the products are too cumbersome and time-consuming to use. Another takeaway might be swapping the focus on equity, where the bulk of Series B investments are presently made, to debt, which is the lifeblood of the capital markets.
Impact investing and emerging markets were once clearly fellow travelers. They now seem to be heading down different roads. To get a sense of how these roads diverged, and how they might come back together, this three-part series will start to deconstruct three key attributes of impact investments: definitions, scope and returns.
Let’s start at the beginning: what exactly is an impact investment? Impact is a tricky thing; it can mean many different things to many different people. Facebook creator Mark Zuckerberg, who with his wife recently founded a major impact investment firm, summed it up, “A squirrel dying in front of your house may be more relevant to your interests right now than people dying in Africa.”
Going by the GIIN’s definition, impact investments are, “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.” As important, impact investments should have a commitment to impact measurement: the measurement and reporting of the “social and environmental performance and progress of the underlying investment.”
This is a key philosophical bridge into the world of international development. For decades, “socially responsible investing,” or SRI, has largely been based on negative screens of public companies — making sure that portfolios did not have “bad” investments, which included everything from tobacco to companies doing businesses with “bad” governments, a la apartheid-era South Africa.
If SRI acted as a boycott mechanism; impact investing was supposed to be proactive. The goal was to drive capital to areas that were underinvested in and might not stand up to the scrutiny of traditional investing along an efficient frontier. Impact investment was supposed to bring capital to emerging and frontier markets, the “missing middle” small and medium-sized enterprises (SMEs) in emerging markets, which had traditionally been left out of the capital markets, and other areas where tangible investment return was iffy, at best.
By attempting to create assets in which financial and social or environmental returns are used to buffet potentially below-market rate returns, it was hoped that impact investments would create a philosophical and technical framework to bring much-needed capital to what the Aspen Network for Development Entrepreneurs (ANDE) calls Small and Growing Businesses (SGBs). Despite being the major source of economic and employment growth in most economies, SGBs are generally too risky, and small, for most investors to invest in.
ANDE differentiates SGBs from SMEs in the following ways:
First, SGBs are different from livelihood-sustaining small businesses, which start small and are designed to stay that way. Second, unlike many medium-sized companies, SGBs often lack access to the financial and knowledge resources required for growth.
ANDE’s research convincingly argues that SGBs can and have played a preeminent role in driving economic growth by “creating jobs, paying taxes, purchasing from local suppliers, and selling to local and global distributors.” Beyond simply improving economic growth, SGBs are force multipliers, expanding access to critical goods and services amongst the ‘base of the pyramid,’ linking local communities to the global market, and empowering often marginalized groups. This improving entrepreneurial ecosystem tends to be more sustainable and innovative than other forms of economic growth. In fact, SGBs have encompassed 60% of jobs and 50% of GDP in the US and an even larger share in emerging markets.
The perceived massive potential for the private sector to boost investments in emerging market SGBs, however, has not materialized. BlackRock Impact illustrates why: despite (or maybe because of) having over $200 billion in assets under management, Blackrock Impact devotes only a small fraction of its funds to what the GIIN would define as impact investments. The majority of its assets are screened investments (SRI, effectively) or investments in a small number of Environmental, Social, and Governance (ESG) funds. These allocations lean heavily toward larger and more established, usually publicly listed firms that can achieve a risk-adjusted market rate of return, which predominantly lean toward developed over emerging markets.
This definition of impact as an expanded version of SRI has the benefit of encompassing a wide variety of investments and attracting quite a lot of positive attention and discussion, especially with younger investors who are about to inherit great wealth. My colleagues and I have had many conversations with asset allocators at mainstream wealth management firms or family offices who talk about their clients wanting their investments to be more meaningful than just producing a solid risk-adjusted return on capital.
Impact investing, however, has not necessarily been a good thing for emerging markets. A partner at a $50 billion asset manager based in the Mid-Atlantic region, which is developing an impact investment program, told us most of his investors are interested in doing something locally:
There are enough things broken in Baltimore, with the Chesapeake, inner-city schools, the arts and healthcare, that we don’t really need to look overseas for something to fix.