Explainer: Impact investing and international development

This is the first in a series of explainers related to international development finance from Steven Zausner and Andrew Haimes of Office:FMA, a financial strategy and advisory firm focused on emerging and frontier markets. It's a good time to be in the impact investing business. Major mainstream asset managers BlackRock Inc., Bain Capital, LP, and Goldman Sachs, are entering the space. Assets under management and the number of deals are expected to grow by 17 percent and 20 percent, respectively, in 2017. While this is all good for the field, it's less clear what impact investing's growth means for international development. Many had hoped it would be a major private sector driver encouraging investment in developing markets. The numbers, however, haven't borne that out. Roughly half of impact assets have focused on U.S. or other developed market-based initiatives. Equally important, much of the big-money investments through mainstream funds will be focused around investments that might not, strictly, fit the definition of an impact investment. While impact investing and the development of emerging and frontier 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 together in the future, it is worth deconstructing the three key attributes of impact investments: Definitions, scope and returns. Defining impact investing Impact is a tricky thing. It can mean many different things to many different people. Facebook creator Mark Zuckerberg, who recently founded a major impact investment fund, 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. 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 — and in contrast to traditional investments — impact investments should have a commitment to measuring the good they are trying to do as a means of reporting of the social and environmental performance and progress of the investment. This is a key philosophical bridge into the world of international development: Socially responsible investing has been around for decades, but it was largely based on negative and positive screening. Negative (or avoidance) screening refers to excluding companies that manufacture certain products that are objectionable, such as weapons or tobacco products. Positive (or affirmative) screening is more proactive, selecting companies that show leadership in product design, employee policies, environmental protection, human rights or other practices. For the most part, however, these were reactive tools, focused on large, publicly listed companies, rewarding those who did good and excluding those who, well, didn’t do so much good. Similar to international development, impact was supposed to be proactive; its goal was to drive capital to areas that were underinvested 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, or 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 an asset class, where 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 small and growing businesses. But SGBs, despite being the major source of economic and employment growth in most economies, are generally too risky and small for most investors to invest in. SGBs are different from small and medium-sized enterprises in that SGBs are explicitly not small, sustenance-providing businesses that are meant to remain small. Additionally, unlike medium-sized firms, SGBs usually lack the resources — including access to finance and education — required for growth. Research from the Aspen Network of Development Entrepreneurs convincingly argues that SGBs can and have played a preeminent role in driving economic growth by providing for increased job growth, improved tax revenue generation, and burgeoning ties to local and global distributors and value chains. Beyond simply improving economic growth, SGBs are force multipliers, expanding access to critical goods and services among 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 percent of jobs and 50 percent of GDP in the U.S. 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 more than $200 billion in AUM, 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 funds. These allocations lean heavily toward larger and more established firms that can achieve a risk-adjusted market rate of return, which predominantly lean toward developed markets rather than 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. It has, however, not necessarily been a good thing for emerging markets. Across the industry, however, firms are seeing cases of investors who are prepared to make an impact investment, but would rather spend their money on problems at home such as inner-city schools, health care and the arts. Scope of investments BlackRock is not alone in investing the bulk of its impact investments in developed markets. Indeed, developed markets actually account for roughly half of the $113.7 billion in impact investments, according to a recent benchmark survey. While the emerging markets field is growing in general — with sub-Saharan Africa maintaining its relative primacy — developed markets will likely maintain their lead over emerging markets. There are substantial differences between emerging markets and developed markets in terms of the investee’s stage of development and sector. Of the assets going to emerging markets, there is a clear and growing focus on growth stage businesses (47 percent), which may bode well for the development of job and economic growth, creating SGBs over the long term. Slightly less than half of assets are being invested in mature or publicly traded companies, which, while important, are not the net generators of jobs. While there appears to be a strong preference for private debt (62 percent) over private equity (27 percent) in emerging markets, this may not be as clear as it seems. The same survey research found that 42 percent of global private debt went toward microfinance. Given the predominance of microfinance in emerging markets relative to developed markets, it is likely that a significant portion of emerging market private debt consequently was targeted at microfinance organizations, and not toward SGBs (which therefore may entail much of the private equity investments in emerging markets). In general, equity investments are not conducive to SGB growth. Equity requires an exit. Most emerging markets lack liquid markets and the mechanisms for traditional exits (trade sales or going public). SGBs, in emerging markets, also tend to be multigenerational. Since many emerging market businesses likely have many partners — numerous individual family members pooling resources to support an enterprise — many business owners and operators shy away from adding a further voice, via an equity investment, to the chorus of people telling them how to run their businesses. Similar to looking at the stage of development of the investee, the data on emerging market-focused investments is not particularly hopeful in terms of the sector. Off the bat, 40 percent of investees are in microfinance, which inherently is not a SGB and have not been shown to scale dramatically, if at all. Beyond microfinance, it is not clear to what extent the remaining 60 percent of AUM is being invested in SGBs versus other entities that may not share SGBs’ scalability in terms of job creation and economic growth, regardless of their level of impact. Unfortunately, the more one digs into impact investing, the less capital is directed toward the potentially game-changing sectors and SGBs within emerging markets that will likely be key to these states’ economic development. Instead of helping to drive a new generation of small and medium-sized goods and services providers integrated into global supply chains, much of impact investment appears to be directed toward efforts to ameliorate the status quo, not change it. ROI(mpact)I While the expectation of a return is implicit in any impact investment — otherwise it is a grant — the rate of return can range widely. Returning to BlackRock Impact can be illustrative. Given its fiduciary responsibilities, its small share of actual impact investments likely focus on liquid investments that provide a market rate of return. While there may be some market rate of return producing SGB investments in emerging markets, they are neither the majority nor particularly liquid. From this vantage point, it would be financially unwise for BlackRock to make these investments. Within emerging markets at large in 2017, 60 percent of investors sought risk-adjusted market rate returns, 25 percent expected below, but close to market rate returns, and 17 percent simply wanted a rate of return closer to capital preservation. According to a benchmark developed by Cambridge Associates using 2016 figures, for equity investments, average emerging markets’ market rate return expectations were 16.8 percent and below market rate return expectations were 11 percent. Emerging markets private equity and venture capital impact investing funds launched between 1998-2004 have a net internal rate of return of 15.5 percent. However, more recent vintage funds tell a different, but nonetheless interesting, story. Emerging market PE and VC funds have underperformed return expectations for over a decade, only surpassing the 16.8 percent market rate of return expected by investors for funds started between 1998 and 2001. For 2011-2014 vintage funds, the return has been particularly poor at 7.93 percent. Investors tend to be data focused, and the data around emerging markets PE and VC (the priority for SGBs) is not encouraging. Those that have invested have been disappointed; those that are considering investing would be “fighting the tape.” This poor average is coupled with a substantial spread of returns; IRR ranged dramatically in this most recent period with some funds performing very well and others underperforming substantially. If we compare funds by size (smaller or greater than $100 million), it becomes clear that smaller funds tend to significantly outperform larger funds. This may reflect the difficulty of conducting extensive due diligence on or sourcing of the many investments required to allocate an entire large fund to investments like emerging markets SGBs. It could also reflect the lack of a sufficient quantity of investment-ready SGBs in individual countries, requiring the expensive expansion to multiple target countries. Despite hopes that impact investments would provide the necessary capital for emerging markets’ missing middle, the amount of funds going to emerging markets is minuscule compared to the substantial $2.5 trillion needed for the Sustainable Development Goals. Looking ahead Relatively poor prospects for large-scale funds, the wide geographic spread of impact investments, and investors’ comparative lack of enthusiasm for early and venture stage firms demonstrate that a new approach is necessary to fill the capital gap for SGBs and scalable new enterprises in emerging markets. A new approach will likely develop along three seemingly parallel, but hopefully converging, roads. First, ESG and more traditional SRI will continue to expand in emerging markets as investors focus on chasing returns. Although these investments may lean toward more mature and publicly traded companies, as opposed to SGBs, any job-creating or sustaining investment in emerging markets like this would be inherently impactful. Second, investors will continue to design new assets and instruments that provide the necessary quasi-equity or debt attributes to compensate for the inherent limitations of SGBs in these markets. Finally, and maybe most revolutionary, it is time to change the name: get rid of the word investment. Investments have returns. Investments have to sit along the efficient frontier. When you call something an investment, all sorts of folks from compliance and oversight at investment banks get in the mix. The thundering herd of financial advisors at Merrill Lynch will never offer “an investment” that promises a below market rate of return. They can’t: by the “Prudent Man Rule” a financial advisor has a fiduciary duty to maximize a client’s risk-adjusted return. They cannot knowingly swap out an anomalous social gain for a tangible financial return. Indeed, since the returns in emerging markets have been so poor, perhaps we should call it by its less prosaic, but more correct description: return-based philanthropy. As different investors traverse these three roads, we will likely see an eventual convergence that will truly signal impact investing’s role in bridging the gap between private capital and international development. Check out more practical business and development advice online, and subscribe to Money Matters to receive the latest contract award and shortlist announcements, and procurement and fundraising news.