When 60 Decibels put together its “Microfinance Index” assessing the impact of global microfinance organizations, it found a 400% difference between the best performing organization and the worst. The example, says Bjoern Struewer of catalytic capital manager Roots of Impact, is why the impact investing community can’t take impact for granted.
“We often have this assumption that a company or a project is intrinsically impactful. There is no linear path to impact. It’s fluctuating all the time,” he says. Companies have to be directed to achieve impact. “You can really outperform on impact if you have the right incentives in place.”
Roots of Impact has been experimenting with how to incentivize companies to deepen their impact for the past eight years. The organization has now published its learnings on impact-linked finance since first testing it with a form of bonus payments called social impact incentives, or SIINCs, which it structured to help a healthcare provider in Mexico reach more vulnerable patients. Roots has since added new incentive structures to its toolkit, helping investors direct investees to deepen their impact with interest-rate step-downs, cash incentives, lower repayment amounts, and longer repayment terms.
“Evidence shows that impact-linked finance can be an effective means for unlocking the potential of high-performing enterprises. Moreover, the practice has proven effective to steer different kinds of enterprises towards achieving positive outcomes that they would not have been able to pursue otherwise,” Struewer and his colleague Natasha Dinham write in their report. “It has a strong potential to lead to greater levels of inclusivity and tangible impact.”
One of the team’s biggest takeaways is that impact incentives can be designed into any form of finance, including mechanisms for the mass market, such as sustainability- and impact-linked loans.
“Sustainability-linked bonds today are designed with a loose environmental, social and governance matrix, but you could tweak the features a little bit and design them to have concrete and ambitious outcome targets,” Struewer tells ImpactAlpha. “That would give you an impact-linked finance structure at scale.”
Positive externalities
Impact-linked finance uses financial rewards to direct companies to deeper and broader impact. In the first SIINC transaction, the Swiss Agency for Development and Cooperation set aside a pot of money to pay Mexican diabetes care provider Clinicas del Azucar for reaching more low-income patients. The purpose was to incentivize a growing company to stay focused on and deepen its commitment to Mexico’s most vulnerable patients.
Another SIINC was designed to help Root Capital, a lender for agricultural cooperatives and organizations, to ensure its loans were directed to organizations supporting smallholder farmers. Novulis, a dental care provider in Ecuador, was given SIINC payments to refocus post-pandemic on rural patients.
SIINCs are a form of outcomes-based finance in that they reward impact outcomes. But they are not “outcomes-based finance”; that term is used for a specific type of structure that involves derisking publicly-funded programs by using private capital to test whether social or environmental interventions work before public agencies foot the bill.
Outcomes-based finance has itself evolved from the early days of social impact bonds, or SIBs, which were set up to fund everything from recidivism reduction to workforce readiness for new immigrants. SIBs were costly, time consuming and complicated to structure. Fund managers are now rolling out funds to channel capital to community social initiatives more efficiently.
What differentiates SIINCs from outcomes-based finance is they’re about “tweaking enterprises toward better outcomes, not about paying for social interventions,” Roots explains in its report. Roots likens SIINCs to carbon credits: “it’s a way to monetize positive externalities by creating an additional revenue stream for the enterprise,” encouraging them to steer toward impact even when their business environment and opportunities change.
Managing ‘impact risk’
SIINCs and other forms of impact-linked finance help the companies align their strategies for impact at critical growth and pivot periods. They also help impact investors manage “impact risk,” says Struewer.
Clinicas del Azucar could have shifted its business model to wealthier or urban patients as it expanded its network of diabetes care clinics. Novulis could have expanded its urban operations at the expense of rural patients, since these were what kept the business afloat during the pandemic.
In the off-grid solar sector, Zola has opted to cater more to middle-class and urban customers than stick to the rural customers it served in their early days of business. In contrast, M-KOPA has shifted its product offering but has doubled-down on low-income customers, incentivized in part by a $200 million impact-linked debt package.
“We live in a dynamic environment. Businesses can develop to perform better or worse on impact in the future,” says Struewer. “I’m an entrepreneur by myself. I know what it means to manage a company either toward impact or toward other objectives.”
The Root team argues that every impact fund should incorporate impact incentives of some form, as should technical assistance facilities.
Lenders like Beneficial Returns, Balloon Ventures, Iungo Capital and others reward portfolio companies with preferential terms for achieving specified impact targets. SEAF, for Small Enterprise Assistance Funds, is requiring companies that receive funding through its Daraja Impact initiative to allocate a portion of the capital to improving impact measurement and reporting.
The spectrum of impact-linked finance products now includes loans, revenue-share agreements, matching funds and more. A growing number of fund managers are going a step further and pegging their own compensation to their impact achievements.
Design for the mass market
Though expanding, impact-linked finance remains rare and niche within the broader world of finance. The one exception is sustainability-linked bonds, which either raise interest rates for missed outcomes or lower interest rates for achieved outcomes.
The Root team argues that adaptations to sustainability-linked are the clearest path to mainstreaming impact-linked finance. Originations of ESG- and sustainability-linked bonds, however, fell by nearly 25% year-over-year last year because of investors’ concerns about greenwashing.
“It’s the execution that makes the difference. The execution is what makes a transaction work or not work,” Struewer says.
Improving and accelerating the practice requires a lot of catalytic capital to fund cash payouts, interest-rate reductions and other incentives that market-rate investors are unlikely to pay for.
“The amount of catalytic capital and the additional positive impact that can be achieved are correlated,” Roots team writes. Struewer argues that there is plenty of catalytic capital already available in the market.
“There are incredible amounts of subsidy in the market. We just have to channel these subsidies toward these structures,” he says. That would make it possible to do billion-dollar impact-linked finance deals.
Measure better
If catalytic capital is the carrot for accelerating impact-linked finance, regulation is the stick. Roots’ report primarily focuses on the former; Struewer makes the case for both.
“If regulation would support banks that provide loans based on their costs to society, then this [form of finance] becomes the default,” he says.
In the meantime, other efforts are underway to strengthen the practice of impact-linked finance. Five years ago, Roots, Boston Consulting Group and BCG Henderson Institute published the “Design Principles for Impact-Linked Finance” to help practitioners structure and benchmark effective deals. Roots’ is soon launching a “simplified and open-source” self-assessment methodology based on the design principles.
The organization is also partnering with Dalberg and the Swiss Agency for Development and Cooperation to convene the Impact-Linked Finance Collaborative. The goal of the Collaborative is to bring together practitioners to organize data, size the market, educate potential funding partners and ultimately help impact-linked finance scale.
“The only thing between now and this becoming the new normal is being able to measure impact properly,” predicts Struewer, “and this is getting better day by day.”
