By Michael Etzel
Impact investing, which promises both financial
returns and intentional, measurable social returns,
is attracting more and more money—most of it
from private investors. Foundations are hard-wired
for social purpose and would seem to be natural
candidates for impact investing, but so far they are
behind the curve. Today, foundations account for
only 6 percent of the approximately $60 billion in
total impact investments under management worldwide.1 In India,
foundations account for an even smaller portion, just 2 percent of
impact investments, according to a recent report by Intellecap, an
India-based research and consulting firm.2
The bulk of impact investment has been made by private
investment fund managers and development finance institutions,
which together have put up more than 80 percent of the money
flowing into impact investing. It’s not surprising that most private
investors (55 percent) seek to earn “competitive, market rate returns,”
according to the most recent J. P. Morgan impact investor
survey.3 Another 27 percent aim lower but still hope to achieve
returns “closer to market rate.”
Enterprises that provide social returns and are highly profitable
don’t have much trouble raising money from impact investors.
But enterprises with an unproven business model, or
ones that focus on serving the poorest of the poor, find that
the vast majority of these dollars are out of reach. These types
of enterprises—capital-starved social businesses with strong
growth prospects but little chance of producing market-rate
returns anytime soon—are, however, ideal candidates for philanthropic
impact investment. Deploying “repayable capital” in
this way has distinct advantages. Social enterprises get muchneeded
growth capital, and funders get some or all of their
money back—sometimes with interest—to reuse for another
social investment. And all of this can be done without having
to achieve market-rate returns.
Perhaps nowhere in the world is the opportunity for this type
of below market-rate impact investing more striking than in India.
Nearly 75 percent of the country’s 1.2 billion people live on
less than $2 a day, and much of this population lacks access to
basic services, such as clean water, sanitation, energy, and education.
Providing these services creates opportunities for social
entrepreneurs to develop bottom-up enterprises, but few of these
businesses will generate competitive market-rate returns, at least
for the foreseeable future.
Take, for example, the solar lantern company d.light. The
company was launched in 2008 to create a safe, nonflammable,
and long-lasting light source for low-income consumers. It secured
backing from leading impact investors like Acumen, Gray
Ghost, and Omidyar Network, plus from more traditional venture
investors like DFJ and Nexus India. D.light has sold more
than 10 million low-cost lanterns in South Asia and sub-Saharan
Africa. But the company’s rapid growth would not have been
possible without the early support of impact investors willing
to embrace the market risks involved in pioneering a product
tailored to the needs of poor, first-time consumers and also
willing to accept the possibility of below-market returns. For
every d.light, however, many other social enterprises will never
achieve market-rate returns.
Such enterprises deserve more attention from funders,
says Indian-American entrepreneur and philanthropist Desh
Deshpande. “Impact investing
may not be the way to get
great returns, but it’s definitely
a great way to take a solution out to a lot of people and scale it really
fast.” (Read “Q&A with Desh Deshpande.”)
The Right Rate of Return
The need (and opportunity) for some impact investors to
accept below-market-rate returns is not always acknowledged
by impact investing enthusiasts. Indeed, the first
comprehensive global analysis of impact investing’s financial
performance by the Global Impact Investing Network (GIIN)
and Cambridge Associates largely argues the opposite. The study
compared the financial performance of market-rate-seeking impact
investments and comparable conventional investments and
declared nearly a dead heat.4 “The data show that market-rate
returns are achievable in impact investing,” says Hannah Schiff,
senior research associate at GIIN. “Impact investing could be a
great way for companies to create positive changes in society and
the environment while still producing financial returns.”5
Major financial institutions have entered the arena and are
banking on the prospect of earning market-rate returns. Black-
Rock, the world’s largest asset management firm, announced in
February 2015 the launch of BlackRock Impact, a business unit
dedicated to impact investing. Prudential committed to investing
an additional $1 billion in socially responsible businesses by
2020. And Bain Capital hired former Massachusetts Governor
Deval Patrick in April 2015 to found a new business unit that
“will focus on delivering attractive financial returns by investing
in projects with significant, measurable social impact.”6 For the
most part, these investment funds target market-rate returns—on
average a double-digit internal rate of return, a standard measure
of profitability for private investments.7
But generating market-rate returns for investors isn’t the right
path for all, or even most, social enterprises that provide useful,
adoptable, new products or services to the poorest of the poor. A
Monitor Inclusive Markets study of 439 “inclusive” businesses
(those aimed at bottom-of-the-pyramid communities) in nine sub-
Saharan African countries found that only 32 percent were commercially
viable and had the potential to scale up significantly in size.8
The situation is similar in India, where impact investors
have put $1.6 billion into 220 enterprises, with 60 percent of
that amount going to just 15 investees. Moreover, 70 percent
of all impact investments in
India—most coming from
outside the country—have
gone to microfinance and financial
inclusion businesses,
where interest rates and repayments
are fairly predictable.
“True early stage funding is
still not available and … getting
venture debt is next to
impossible from our [Indian]
banking system,” according to a 2014 Intellecap report.9
That assessment echoes the conclusions reported in a Winter
2013 Stanford Social Innovation Review article, “Closing the Pioneer Gap.”10 “One of the most striking findings of our research is that
few impact investors are willing to invest in companies targeting
the poor, and even fewer are willing to invest at the early stages of
the creation of these businesses,” wrote the authors. Willy Foote,
founder and CEO of Root Capital, a global social investment fund,
has dubbed this orphan zone for impact investing a “high-risk,
low-return sweet spot.”11
Think of the “sweet spot” for philanthropy’s impact investing as
a gray zone, flanked on one side by traditional philanthropic grants
that have no financial return, and on the other side by impact investors
seeking market-rate financial returns. (See “Philanthropic
Impact Investing’s Sweet Spot,” above.) The gray zone, encompassing
small losses to modest gains, is where philanthropic money
can and should concentrate its efforts. It is where a large number
of financially underserved social enterprises attacking poverty,
crime, homelessness, education, green energy, and other issues
reside. In Kenya alone, where Root Capital has a major presence,
Foote estimates that there are thousands of early-stage businesses
“that have outsized potential for impact but still lack access to the
financing and support they need to grow.”
In the United Kingdom, a recent report analyzed 426 closed
social investment deals and found a total return of minus 9.2
percent—giving investors roughly 91 cents back on every dollar.
Contrary to standard investment measures, researchers found
that number encouraging. “It would be disingenuous to interpret
this as bad,” concluded the report, The Social Investment Market
Through a Data Lens.12 “This high level of capital preservation
suggests that the social investment market is indeed investable.”
And it underscores the opportunity for philanthropy to chart new
ground by deploying more repayable capital.
Matching Mission to Financial Returns
By embracing lower financial returns, philanthropic impact
investors can support enterprises that are explicitly seeking
to serve the most marginal populations. “As you come to
the bottom of the pyramid, people don’t have money, so you can’t
really build a highly profitable company,” says Deshpande. But
by creating a social enterprise,
even a marginally profitable
one, “you get two big benefits:
you can scale it to a large number
of beneficiaries and also make
sure that the solution is what
they want,” because people are
willing to pay for it.
By contrast, impact investors
typically assume that it’s up
to social entrepreneurs to figure
out how to increase earned income to boost return on investment.
The reality, particularly for most early-stage organizations, is that
fine-tuning a business model takes time. Profitability may take
years, if it arrives at all. Meanwhile, the pressure to hit financial
targets can push a social enterprise to place profit ahead of mission.
Philanthropy is well positioned to counterbalance a tilt toward
profit by providing patient capital to create high-impact, sustainable
enterprises that reap below-market returns.
Social entrepreneurs can smooth the way for such philanthropic
investment by clearly understanding their own economics and
where their business model sits on the investment spectrum. This
assessment can shape the story they convey about their organizations,
including a deeper understanding of the type of funding
and funding partners they need to grow.
But not all social enterprises are even candidates for impact
investment. Although some manage to cover a substantial amount
of their operating costs from earned income, they still need grants
to cover unmet expenses. Take One Acre Fund, for example, an
organization that provides training, tools, loans, seeds, and fertilizers
to 280,000 of the poorest farmers in East Africa. It covers 75
percent of its field operating costs out of earned income but uses
grants to subsidize the remainder of its costs. An impact investment
could force the organization to go “up market” and serve betteroff
farmers to satisfy investors. “We know it will be a challenge to
operate our field program without some donor subsidy,” says Matt
Forti, managing director of One Acre Fund USA.
For those social enterprises that can make a good case for
growth capital from impact investors, there’s a temptation—and
pressure—to craft rosy financial projections to woo market-rate
investors. In fairness to them, the untested business models pursued
by many social enterprises make accurate projections all
the more difficult. But if optimistic forecasts don’t pan out, these
enterprises must spend significant management time identifying
additional sources of capital. This is the situation faced by
Acelero Learning, a pioneering for-profit focused on closing the
achievement gap for thousands of pre-school children in Head
Start programs.
Founded in 2001, Acelero raised $4 million in venture capital
in 2005 after it had been awarded its first contracts to operate Head
Start programs. Investors came forward, basing their decision on
the premise that Acelero’s superior operating performance would
lead to a regulatory change to allow the company to make a modest
profit on Head Start grants. By quickly building its portfolio of
Head Start contracts, Acelero aimed to become both a social and
a financial success. The company delivered on its social bottom
line, growing to $50 million in annual revenue over a six-year period
while producing best-in-class achievement gains. But critical
regulatory changes stalled in the US Congress, undermining
Acelero’s original financial assumptions. Eager to grow in a new
direction, in 2011 the company launched a separate business unit,
Shine Early Learning, to market its programmatic innovations to
the wider child-care and education community.
To satisfy investors who had first backed the company a decade
earlier, Acelero set out in the
spring of 2014 to restructure its
debt. It completed that process
in May 2015 with a $4 million
program-related investment
loan from the David and Lucile
Packard Foundation, repayable
at a 1 percent annual interest
rate. Henry Wilde, Acelero’s
cofounder and chief operating officer, says the Packard investment
“will give the company the flexibility to continue to prioritize
pursuit of our social impact goals.” Meanwhile, early investors,
like Ironwood Equity and the Kellogg Foundation, agreed to a
financial return in the low double digits.13
Another example of a social enterprise that had to find a new
business model in order to continue its social mission is Embrace.
The organization got its start as a class project at Stanford University
in 2007, when a group of graduate students were challenged
to design a neonatal hypothermia intervention that cost less than
1 percent of the price of a $20,000 state-of-the-art incubator. It
launched as a nonprofit the following year with a single product,
the Embrace Warmer, priced at about $200.
After garnering evidence that its warmer helped to save lives,
Embrace sought to grow, but its nonprofit status in India barred
it from securing investment capital to build a sales and marketing
force. So it split into two legal entities: a for-profit, Embrace Innovations,
which could take on debt or equity financing, and the
nonprofit Embrace, which owned the patent for the warmer and
could continue to pursue grants. Embrace Innovations received
startup funding from impact investor Vinod Khosla, who focused
on long-term impact, not short-term market-rate gains.
Embrace Innovations controlled R&D, manufacturing, and
sales to health institutions and government agencies that could
afford to pay full price for the warmer. For each warmer sold, the
for-profit paid a patent royalty to the nonprofit. Meanwhile, the
nonprofit donated warmers to clinics that served the poor, offering
technical training and support for health workers and families. If
this arrangement sounds complicated, it was. “There were times
when we’d both show up at the same hospital,” says Alejandra
Villalobos, executive director of Embrace, the nonprofit.
The two-prong approach worked for a while, but then the
organizations ran into trouble. Embrace Innovations initially
relied heavily on contracts with the Indian government, says
CEO Jane Chen. But a change in national leadership in 2014
froze government budget allocations to purchase the warmers
just as the social enterprise was close to landing a major corporate
investment. The budget freeze delayed contracts, and
the investment deal collapsed amid a significant change in the
corporate investor’s leadership, leaving Embrace Innovations in
a difficult financial situation. With encouragement from Khosla,
the company rewrote its business model along the lines of
Toms Shoes to launch a line of US-market baby warmer products
called Little Lotus. According to the plan, with each Little
Lotus product sold, a donation would go to selected nonprofits
working on newborn health.
In July, Embrace’s nonprofit arm found a new home, merging
into Thrive Networks. The merger integrates the Embrace warmer
into Thrive’s suite of durable medical equipment developed for
emerging markets around the globe. “By pooling resources and
sharing expertise, we can expand the scale and scope of our existing
solutions and work to develop even more effective tools,”
says Carrie Eglinton Manner, Thrive Network’s board chair and
a senior executive at GE Healthcare.
There are many lessons for social entrepreneurs in Embrace’s
rollercoaster ride, but one critical to the organization’s survival
was that Chen’s original investors encouraged the social enterprise
to experiment with new business models and to pivot in significant
ways until it found the right one. “One reason we were so
attracted to Vinod Khosla’s partnership was that he wasn’t about
setting arbitrary metrics,” says Chen. “He encouraged us to look
at the long-term vision, and to constantly run experiments to figure
out what would work best, whereas other investors we talked
with focused very much on cost cutting.”
The Path to Philanthropic Impact Investing
As the number of social enterprises in need of below-marketrate
investment grows, philanthropy is uniquely positioned
to become a leading source of patient investment capital.
Rising to that opportunity, however, requires changes to mindsets,
skills, and processes.
Philanthropists need to make room in their toolkit for the
type of impact investing that takes the patient-capital approach
best suited for most emerging social enterprises. Evidence from
recent research reports shows that philanthropists can expect
to be repaid most, if not all, of their investments, making money
available for future redeployment. Philanthropists should not,
however, expect these investments to generate market-rate returns.
But impact investing requires a set of skills from different grantmaking.
Social enterprises that pioneer new business models for
social change have a high level of trial and error. They struggle to
build management teams and find a reliable customer base. All
this adds to the capital requirement and calls for investors to take
a long view of the possibility of getting a financial return on their
investment. Some US-based foundations have created teams
working on program-related investments that also vet and manage
impact investments. But for most philanthropists, whether in
the United States or India, managing social investments will push
them into unfamiliar territory.
Regardless of the type of investment they make, funders
should adopt a bottom-up approach that involves social entrepreneurs
in helping to write their own deal terms, determining
what amount of money can be repaid, over what time frame,
and at what rate. This is not the way conventional investment
agreements usually take shape. Deal terms are often set by the
investors, who, when push comes to shove, may force social entrepreneurs
to compromise social impact in favor of meeting
financial targets. Giving social entrepreneurs a strong voice in
setting the terms of the investment invites a conversation between
the entrepreneurs and the investors about purpose and
profit that otherwise might not happen.
The time is right for philanthropists to become more active
impact investors. Whereas private investors may focus on
finding businesses that can provide market-rate returns, philanthropy
would do well to build its capacity to invest in the
many sustainable enterprises that may never achieve outsized
financial results but are capable of achieving some returns and
significant social impact.