Capitalism Reimagined | May 25, 2022

Risk off? Savvy investors go ‘impact on’ to stay on track in a volatile market

Dennis Price
ImpactAlpha Editor

Dennis Price

ImpactAlpha, May 25 – Markets have gone risk off. Savvy investors who have gone impact on are weathering the economic downturn. 

Speculators in crypto, high-growth venture capital and meme and tech stocks are watching valuations in freefall. In contrast, investors in microfinance, affordable housing, community development and other sectors with stable businesses and real revenues are prepared to weather yet another downturn. 

“We underwrite for resilience and adaptability,” David Lynn of Mission Driven Finance tells ImpactAlpha. The San Diego-based lender has provided more than $34 million in flexible capital to local business and nonprofits based on community impact and quality of management rather than credit score. “While these types of community investment portfolios don’t tend to have big hockey sticks, we do believe they tend to be lower volatility.”

‘Uncorrelated returns’ was an underappreciated advantage of many impact sectors during the long bull market in stocks. As the S&P 500 hovers near bear-market territory, the meaning of “market-rate” has changed. Steady returns, however modest, look increasingly attractive, while previously “safe” investments look risky.

Caught in the tech downdraft, so-called ESG funds have had a rough year. But small loans to small businesses with products tied to productive uses, such as food, clothing and other essential household items – rather than consumer trends and speculation – have proved reliable, says Courtland Walker of Developing World Markets, which provides debt and equity to microfinance institutions and other financial institutions in emerging markets. The impact “is ultimately what makes this lending more stable,” Walker says.

Lower volatility has also explained the historic performance of microfinance, one of the largest segments of the impact investing market. Through multiple downturns over the last dozen or so years, including a global pandemic, annual loan write-offs in microfinance have averaged roughly one-quarter of one percent of total assets, or 25 basis points. 

Strength through adversity

In some cases, the kind of innovative and flexible financing solutions needed to bridge market gaps that have kept many founders and ventures from accessing capital markets have turned out to be sources of strength. Such tools may be less susceptible to broader economic swings and more useful for spotting opportunities in a downturn.

Helping a diverse set of entrepreneurs succeed in good and bad times drives the investment model of firms like Founders First, which provides financing recoverable through a percentage of future revenues (up until a cap). 

“We ensure that recipients of capital are well-equipped to manage through difficult cycles,” says Founders First’s Kim Folsom. That means emphasizing multiple revenue streams, developing models for recurring revenue, avoiding customer relationships that rely on one-time transactions, and expanding the companies’ networks of partners and peers, she says.

Now is not the time to flee impact, but to double down, says Chat Reynders of Reynders McVeigh Capital Management. The firm has helped Founders First, Sunwealth and other impact capital providers design vehicles that are attractive from both impact and economic perspectives. 

Such vehicles are “replicable, scalable, reliable” and feature “a low risk profile,” says Reynders. “We view many of our impact vehicles as complements to or replacements for traditional fixed income products.”

Impact first

Ceniarth’s Greg Neichin says the family office’s impact-first investment portfolio has yet to see the panic gripping public equity and bond markets. More of a concern, says Neichin, is global inflation and supply chain disruptions in food and agricultural inputs exacerbated by the war in Ukraine. 

“For the world’s poor, price shocks can put pressure on already vulnerable communities and could, at some point, have a noticeable impact on sectors such as microfinance, affordable housing, and energy access,” he says. “That said, we have yet to see that impact flow through to the majority of our borrower’s ability to comfortably service debts.”

Only a select group of managers “generate enough credible impact to fit in our portfolio while also generating uncorrelated commercial-enough returns to be attractive to the finance-first crowd,” Neichin says. Examples include Lendable, Community Investment Management, Jonathan Rose Affordable Housing.

He expects few “finance-first” investors to seize the opportunity to balance risks with impact-first investments. Instead, they’ll demand higher yields on debt. Inflation and supply-chain shocks mean there’s little room to raise borrowing rates on customers, he said.

Impact and community investment can be a strong diversifier in a portfolio, says Beth Bafford of Calvert Impact Capital. The assets and economic activity that underpin much impact and community investing (think people and government agencies paying rent, or community-based businesses making loan payments) are often divorced from the economic drivers of the stock market, including short-term corporate earnings, macroeconomic uncertainty and war.

Community development financial institutions, or CDFIs, experienced some of their fastest-ever growth following the Great Recession, says Aeris’ Matthew Royles. The Philadelphia-based CDFI ratings agency observed a similar pattern during the pandemic, when CDFIs increased their lending activity and grew their capital. 

“As patient, mostly non-profit, lenders, CDFI loan funds are able to leverage tools to manage risk and support their borrowers through economic downturns,” with time, technical assistance, and grants, Royles says.

Liquidity crunch 

The counterpoint, says Bafford, is that when the core of people’s portfolios are underperforming and dropping in value, “they batten down the hatches and aren’t open to anything new/different/strange and flock more toward more traditional ‘safe’ and more liquid securities.”

When the market is flooded with capital, it’s hard to pick winners and losers, says Mercy Corps Ventures’ Daniel Block. Now that capital is coming off the table “it will start to become clear which models are actually built for success long term and which aren’t.”

The nonprofit investor has backed more than 30 “inclusive” fintech, crypto and climate-resilience ventures. The market correction is aligning social responsibility with commercial success around “productive use” of loans, Block says.

“If you have a strong value proposition and real-world use-case for the fintech products that you’re delivering, you’re going to continue to grow,” Block says. “Those that are skimming something off the top of frothy economic headwinds are going to be most hard-hit and struggle to keep their users sticky as the economies and markets shift.”

Will Poole of Capria Ventures, which backs emerging-market impact fund managers, said only one of the 250 companies in Capria’s global portfolio failed through the pandemic. “I do expect that many of our investments will outperform, despite the back-to-back shocks to the global economy,” Poole tells ImpactAlpha

In an earlier economic slowdown in 2019, Poole predicted “that consumption-driven companies in well-selected emerging market economies will demonstrate substantial financial resilience.”

Growing consumer populations would continue to consume essentials, went the logic, and the early and early-growth businesses that the providers of consumer essentials would perform robustly. He says the thesis holds. Too many high-flying businesses have built growth-at-any-cost models on top of shaky foundations.

“The businesses that fare the best will be those with strong fundamentals,” he says. “It has played out well.”

David Bank and Amy Cortese contributed reporting.