By Andrew Haimes and Steve Zausner
In Parts 1 and 2 of the ImpactAlpha series, Fellow Travelers, we explore the the divergent paths of impact investing and emerging market and took a deep dive the data on impact capital flows and investment returns in less-established markets. In the third and final part in the series we offer ideas on how to re-ignite impact investments in small and growing businesses in emerging markets.
Fellow Travelers, Part 1: Bringing emerging markets and impact investing back together
Fellow Travelers, Part 2: Impact investing in emerging markets is growing, but not fast enough
Part 3: Where impact investing in emerging markets goes from here
Despite the hope that impact investments would provide the necessary capital for emerging markets’ missing middle, only a portion of the wider $2.5 trillion annual funding gap for the Sustainable Development Goals (according to Rockefeller Foundation President Judith Rodin), this summary of our research and experience unfortunately leaves us with a pessimistic assessment of impact investing’s role in the broader development of emerging market economies. The amount of capital needed is just too large.
Relatively poor prospects for large-scale funds, the wide geographic spread of impact investments, and investor’s comparative lack of enthusiasm for early and venture stage firms and, maybe, most importantly, preference for debt over equity, demonstrate that a new approach is necessary to fill the capital gap for SGBs and scalable new enterprises in emerging markets.
Instead of trying to fit a square plug into a round hole — make impact investing a key component of international development — we believe that a broader look at the role and requirements of private sector investors could lead to a more productive conversation.
Product market fit
A simple first step would be to actually ask institutional investors for their thoughts on emerging markets and impact investing. Similar to the concept of Human Centered Design, we believe a focus on Investor Centered Design will be key to increasing the flows of capital toward emerging markets. While many DFIs may get excited about the concept of attracting ‘blended capital,’ the common complaint we hear is that the products they create are too cumbersome and time-consuming to use. As one veteran emerging market investor, who invests across all sectors, asset classes, and geographies said:
“When I was a small fund, I would often try and raise capital from or work with OPIC products. It was a necessary evil. They treated me like a supplicant, its products were clunky and it took forever to get anything done — 12 months to 2 years, which doesn’t fly in the commercial world. As I got larger, I realized, I didn’t need them and had had such bad experiences, I will no longer work with them. They now need me more than I need them.”
We believe that this investor is hitting on one of the basic problems the public sector faces in attracting much of that $218 trillion in global capital: the private sector often has had bad experience with the public sector; the public sector’s products are often inappropriate, complex, and time consuming, and it tends to treat the private sector as supplicants, not patrons. As we learned early on in our careers, whoever has the most capital, sets the terms. Approaching investors through Investor Centered Design would entail working with the investors to pull from them exactly what they are looking for from a product or financial structure. Essentially, asking them what types of products, services, and partnerships they would like to see from DFIs to facilitate their investment into emerging markets’ mature companies and SGBs.
A second key step would be standardization. As a licensed broker-dealer, we, on a daily basis, raise capital for projects in emerging markets across many different geographies, asset classes, and sectors.
The most prevalent issue preventing investors from allocating capital is not that the investment itself is unattractive, but that it is too small to justify the transaction costs, especially as it relates to documentation. For example, without transactions costs, the Internal Rate of Return (IRR) on a $5 million Power Purchase Agreement for a clean energy project might be attractive; however, with legal costs running 1–2 percent of the size of the transaction, there is a general perception that the deal is ’not worth doing.’
Leveraging a new focus on Investor Centered Design, 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. By reducing transaction costs through standardization, many otherwise marginal or unattractive projects might produce the returns commercial investors require (whether investors seek market or below-market rates of return). Unlike the BlackRocks and Bain Capitals of the world, which focus on more mature Series C and D investments, the more numerous, smaller impact investment funds could be key to filling the Series B funding hole in emerging markets (building on the growth already seen in Series B or growth-stage financing).
Finally, alongside the standardization of documents, there should be a focus on utilizing the tried-and-true methods for providing capital for SMEs that we see in developed markets, not the least is 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.
For example, as is often pointed out in the US, less than 1 percent of companies will ever receive equity investment from outside investors. Also, even quasi-mature businesses with real cash flows and assets often find it difficult to get bank financing. Yet small businesses do get capital. Where do they go? In a healthy financing ecosystem, small businesses are able to use factoring, vendor financing, revenue-based capital loans, and warehouse lines of credit. Despite this, we find that impact investors too often think like return-maximizing commercial investors. As one founder of an early-mover in the world of impact investing recently said to us:
“I get debt, I just don’t like it. I tend to feel that if I am taking all that risk, I should get the reward and debt caps off my rewards. I like hockey sticks.”
Technically, he is correct: debt is more like a put, with a downward sloping return (you can only make so much, but you can lose everything); equity is more like a call (you can only lose your investment, but the upside can be infinite). Commercial investors need to focus on asymmetries: finding investments where the return considerably outweighs the risk. Impact investors shouldn’t have to.
Indeed, we would make the argument that by promoting these investment asymmetries, and showing that the number of times where the bet goes in the money versus bust, would be a huge boon to emerging market investing. Bond markets only work because defaults tend to be low, repayments high. Microfinance works because of this dynamic. Our experience says that SGB lending does as well. Focusing on debt might make impact investors, well, more impactful.