Confessions of a Reluctant Impact Investor
Jocelyn Brown, Class 13
Is it possible to be an impact investor without being aware of the fact? When I joined Finance Wales to serve my Fellowship as part of Class 13 in July 2008, I saw myself as an early-stage investor, albeit one investing within a regional economic development bank in the United Kingdom. The deal appraisal process within the firm was largely identical to those of my peers in traditional venture capital (VC) houses, and the assessment criteria were purely commercial. It wasn't until I met Brian Trelstad, Chief Investment Officer of the Acumen Fund and a Fellow in Class 12 that I first heard the phrase "Impact Investing" and understood how it might apply to our particular situation.
A recent report by J.P. Morgan, the Rockefeller Foundation, and the Global Impact Investing Network (GIIN), stated that "Impact investments are investments intended to create positive impact beyond financial return."1 The organization where I served my Fellowship was investing in one of the most economically underdeveloped parts of mainland Britain, and the political and social context in which we operated was inescapable. It was a strategic priority for the Welsh government to ensure sufficient commercial funding to develop the private sector.Finance Wales was founded in 2001, and at the point I joined had just raised Fund VI, a £150 million fund which brought their total assets under management to £300 million. The investments team made debt and equity investments from five funds: early stage investments, growth, strategic investments which focused on management buy-outs and buy-ins, as well as two specialist funds for social enterprise and media projects, whether film, television or new media. From the start, our Limited Partners (LPs) had been a mix of private sector and government funders, with support from the Welsh Assembly Government and the European Union. Sian Lloyd Jones, Chief Executive of Finance Wales, explained that, "Our long term ambition is to develop sustainable funds for reinvestment in Welsh businesses and building a profitable long-term track record is a key goal for us."It was a relief to find like-minded peers within the Society of Kauffman Fellows with whom I could share my experiences investing within a socially responsible context. We formed the Impact Investors Special Interest Group in February 2009 with 6 members; within 18 months we had attracted 54 members from 11 classes, including our first Mentor. We welcome any Fellow who has an interest in investing for a return broader than the purely financial, and hold regular speaker events to promote knowledge-sharing and develop a community of leading-edge practice driven by and for active practitioners.As a group, we were pleased to have the opportunity to reflect on the Impact Investing space in this article, to assist our peers in mainstream funds in understanding who is an impact investor and what they are looking for, and to provide an example of successful co-investment between mainstream funds and impact investors.
Defining Impact Investors
One of the challenges in identifying who should be considered an Impact Investor is the range of terms used for what are a series of closely overlapping activities. The Monitor Institute2 refers to a terminology "Tower of Babel," with such terms as Socially Responsible Investing, Triple-Bottom Line, and Mission-Related Investing, as well as many more. It is beyond the scope of this article to explain the subtle distinctions between these, but in practice the membership of the Special Interest Group (SIG) is broad, with organizations represented ranging from philanthropic bodies to government agencies and multilaterals. There are also a large number of venture capital firms, some of which are impact investing specialists and others that would be more generally perceived as mainstream investors.
Figure 1 shows the number of SIG members by organization type, with some example funds listed. It is striking that half of the group are in mainstream VC funds or work within operating roles. While the majority of these are not currently active in the impact-investing ecosystem, it is notable how many are in emerging regions where the venture capital model is only recently established. A parallel observation is that the areas for investment may well be less rigid than in mainstream firms. In my two years at Finance Wales, I led five Seed and Series A investments, and served on the Boards of five early-stage businesses in the Health and IT sectors. The house approach was strongly generalist, and while investment managers might choose to specialize in one or two sectors, it was simply not feasible to cover one narrow sector or industry given the dealflow. When speaking with peers in the impact investing network, I found that this approach was more prevalent than in mainstream funds, where the trend was to move toward subsector specialism.
Figure 1. Number of Special Interest Group (SIG) Members by Investment Type*Omidyar Network is used to refer to both the for-profit LLC and the Omidyar Family Foundation.
Understanding Impact Investors' Goals
It is broadly accepted in the current debate that there are two types of impact investors categorized by their differing motivations. A well-received report from Bridges Ventures, the GIIN, and the Parthenon Group proposed that
although investors in Impact Investments share the vision of combining financial returns with positive social/economic impact, they can be categorized into two broad groups: Financial First Investors and Impact First Investors.3
They cite research from the Monitor Institute, which defined the two groups as follows:
Impact first investors, who seek to optimize social or environmental impact with a floor for financial returns. These investors primarily aim to generatesocial or environmental good, and are often willing to give up some financialreturn if they have to. Impact first investors are typically experimenting withdiversifying their social change approach, seeking to harness market mechanismsto create impact.4
Financial first investors, who seek to optimize financial returns with a floor for social or environmental impact. They are typically commercial investors who seek out subsectors that offer market-rate returns while achieving some social or environmental good. They may do this by integrating social and environmental value drivers into investment decisions, by looking for outsized returns in a way that leads them to create some social value (e.g., clean technology), or in response to regulations or tax policy (e.g. the Green Funds Scheme in the Netherlands or affordable housing in the United States).5
Finance Wales was a Financial First Investor, although the hybrid set of LPs meant that the reporting requirements were complex. The corporate LPs were interested in financial metrics, while the public sector LPs required us to report on the number of jobs created in addition to the investment activity rate (i.e., how much capital we were deploying to how many companies per quarter). Our experience highlights one of the most active areas of debate at present: agreeing on a common set of performance management metrics that integrate financial and impact reporting.One of the key initiatives in this space is the GIIN's Impact Reporting and Investment Standards,6 which proposes a common framework for reporting the performance of impact investments. Other initiatives in this space include the Global Impact Investing Rating System (GIIRS), which is under development by B Lab. Although the standards are still evolving, Dimple Sahni of Class 10 and a Partner at DS Inc., comments that in her experience at Omidyar Network and as an advisor to other impact investing firms, "at the macro-level, we're all looking for a demonstrated level of success: financial return through an exit and measurable social impact."7Two particular challenges were identified in conversations with the members of the Special Interest Group: no alignment around return expectations and the perception of a lack of exits. However, the J.P. Morgan report8 identified average return expectations for a number of different instrument types, and it is hoped that this will promote debate in this area. As for exits, Brian Cayce, a Principal at Gray Ghost Ventures and member of Class 13, highlights his firm's investment in Cellbazaar, which generated a successful return on invested capital.
Cellbazaar: Case Study
Based in Bangladesh, CellBazaar connects buyers and sellers in an electronic marketplace over their cell phones. It addresses one of the most significant challenges to everyday life in developing economies—buying and selling basic goods with limited access to computers, the internet, or viable substitutes. With CellBazaar, the seller and buyer can use their personal or community cell phones to check market prices, buy or sell their products, and see information that can be leveraged to attain favorable prices or make an informed decision about traveling to the market. As quoted in The Economist, "All kinds of firms, from giants such as Google to startups such as CellBazaar, are working to bring the full benefits of the web to the mobile phone."9
Working Effectively with Impact Investors
The question of how mainstream venture capital firms or corporates can work effectively with impact investors has not yet been well researched, in part because this is still a relatively rare occurrence. Victor Hwang of T2 Venture Capital and a Fellow in Class 12 comments, "We are motivated by the desire for broad impact, which means we do very few conventional venture deals." However, there are a few examples such as d.light where Fellows from both impact investing specialists and mainstream funds have co-invested. Raj Kundra of Acumen Fund and a Fellow in Class 14 comments,
d.light was particularly interesting to us because of where they sit at the nexus of commercial ventures that are focused on social outcomes, and specifically because of the potential of a market-focused consumer product company to scale by serving the poor.
d.light: Case Study
d.light design is a fast-growing international consumer products company serving people without access to reliable electricity. Its mission is to enable households without reliable electricity to attain the same quality of life as those with electricity, beginning with replacing every kerosene lantern with clean, safe, and bright light. d.light offers revolutionary energy and lighting solutions that are affordable and energy-efficient. Incorporating the world's best product design principles, along with cutting-edge solar and LED technology, d.light creates products that are high quality, durable, and dependable. d.light products are particularly designed for its customers and their environ-ments at price points they can afford.
Raj explains:
In 2007, a group of social investment funds including Acumen Fund and Gray Ghost Ventures provided seed capital to a young group of entrepreneurs from Stanford University who wanted to build a company to bring solar powered light to the base of the pyramid in India and Africa. The entrepreneurs and investors had all observed the disastrous economic, health, and environmental impacts of kerosene-based lighting and believed that the time was right for a better solution—and that solar lanterns sold into rural communities could be the first step in this shift. Silicon Valley venture funds were also interested in d.light as they saw a tremendous market opportunity to bring solar innovations to the over 500 million people in India who were not adequately covered by the electricity grid.
Finding appropriate deal structures for deals where impact and mainstream investors co-invest can be a challenge. Eric Hallstein is a Fellow in Class 15 serving his fellowship at Omidyar Network (ON), who also invested in d.light as part of a 2010 financing round. He commented:
ON invests in for-profit and non-profit organi-zations because innovation can emerge from either type of organization and because the right combination of for-profits and non-profits in a single sector can be powerfully complementary. The phenomenal growth of microfinance is a good example. Grants sparked and nurtured microfinance while for-profit capital helped it scale. Ideally, it should be possible to use foundation dollars to act as ‘seed' stage capital before commercial investors come in at a later stage as the project de-risks.
This approach relies on partnerships to manage risk-sharing, both in terms of bringing capital to the table as well as other resources.Kiki Tidwell, a Fellow in Class 15, combines a strong track-record in cleantech investing with a personal interest in philanthropy through her family foundation. Her research focuses on one promising area within Impact Investing, Program Related Investing or PRI, which is a special IRS-approved use of the required 5 percent grants payout budget.A foundation is required to distribute 5 percent of its asset value each year, but with a PRI, may make an investment (rather than a grant) from this 5 percent that furthers the foundation's mission. The investment must have the expectation of mission goal return, and cannot have the expectation of market or above-market financial return, although these returns consequently can be achieved. "Another way to view this," says Kiki "is that the risk to the investor has to be greater than what an average investor would want to bear in terms of capital loss or lower return." She explains:
Foundation board members and finance committee members have traditionally refrained from deploying their endowment dollars to achieve a charitable impact because of their strong culture of stewardship and risk aversion to any actions which might reduce the endowment capital corpus. But this has resulted in schizophrenic activity; a medical foundation may invest its investment dollars with an investment manager holding shares in cigarette manufacturers, while dedicatedly trying to reverse the incidence of cancer with its grant dollars at a level of five percent of the investment dollars.
Kiki recently interviewed the Bill and Melinda Gates' Foundation on their approach to PRI, as part of her Kauffman Field Project on overcoming the barriers to venture investing by charitable foundations when using a mission-related investing lens. She identified that although the Foundation is an LP in the number one equity fund in Africa,
in general, the Foundation prefers direct investment as it is much easier to demonstrate mission alignment. There is a feeling that an investment can not be as targeted in the Foundation's specific program areas if it is an investment in a VC fund with a range of investments. At this point, the Foundation would prefer to co-invest in a direct investment alongside a VC fund rather than going into the fund.
No individual organization can provide all the support required—partnership is critical. There will need to be multiple players in the ecosystem, from the private, public, and not-for-profit sectors. At Finance Wales, our investee companies were part of an ecosystem of support fostered by the Welsh Assembly Government, the devolved government who provided the funding for many of the ecosystem initiatives such as the Technium incubator network, as well as grant funding to individual companies to offset against their capital costs and research and development expenditure. To Victor and his partner at T2 Venture Capital, Greg Horowitt of Class 15, this follows from the observation that
impact investing is filling in the gaps where traditional venture has not been successful. This means they will be operating at the intersection of policy, new geographies and deploying non-standard sizes of capital, probably smaller.
There is also a lifecycle dynamic at work, similar to that in microfinance. In a recent report, CAF Venturesome described how,
in order to achieve success, microfinance first needed to prove the concept worked—an arduous task that required visionary leaders, patient funders, and a willingness to challenge assumptions. Following this was a busy market-building phase which saw the establishment of the required elements of a functioning marketplace, while ‘movement-building' and cultural factors simultaneously catalyzed the support and energy needed to animate this structure.10
These same dynamics may well play out in impact investing.Victor explains:
If we look at market failure, why is the standard model failing? Well, micro-lending doesn't happen naturally. Historically the transaction cost wasn't worth it where size was so small and/or the transaction costs were so large. Also, the initial costs are so high because there is no proven business model and the prevailing wisdom at that time was microfinance wouldn't work. Therefore, only impact investors such as Professor Mohammed Yunus at Grameen Bank were willing to bear the initial cost. But eventually efficiencies make it commercially profitable.
Eric agrees with this assessment, noting,
In the 1980s and 1990s, most microfinance institutions were grant-funded NGOs. As microfinance's impact and commercial viability became apparent, business investors, many with strong social motivations, invested heavily in commercial Microfinance Institutions (MFIs), helping them grow rapidly. The percentage of the world's top 50 MFIs that were for-profit banks increased from 22 percent to 62 percent between 1998 and 2008.11 This creates a new challenge for impact investors: does it become detrimental to put foundation funds to work in markets that have become primarily for-profit, where their tax-advantaged dollars could unfairly subsidize non-profit competition and crowd-out sustainable, commercial competitors?
Victor also observed that
by definition we will see innovation in this space as with microfinance people had to experiment iteratively with different models. It's a laboratory model, and the impact investing community provides a peer support model for trying out new models, which helps sustain the testing period with an "If you're crazy, then we're all crazy" mentality.
I agree with Victor's observation that the members of the network "are all motivated by the same spirit but come from…very diverse organizations." He notes, "with the SKF you get different cultures and geographies, which supports lateral knowledge-sharing from people who have applied it or experienced something completely different."
Learning from the Reluctant Impact Investor: Looking Ahead
Rather than be overly prescriptive in our definition of who can be an impact investor, I hope that we can maintain an open mind in this rapidly developing space. It was something of a shock to my firm, who perceived themselves as a commercial investor working within an emerging region, to hear that our current approach might actually place us closer in spirit to some of these "impact investors." The concern was that this might be used as an excuse to see us as a provider of "soft money," undoing the hard work of the last ten years to position Finance Wales as one of the largest providers of commercial funding to small and medium enterprises in the United Kingdom. As impact investing evolves as an asset class, there needs to be room for both self-identified and "reluctant" impact investors to play their part.Thanks go to the following Fellows who helped shape this article, in alphabetical order: Brian Cayce (Class 13), Eric Hallstein (Class 15), Greg Horowitt (Class 15), Victor Hwang (Class 12), Raj Kundra (Class 14), Josh Raffaelli (Class 13), Dimple Sahni (Class 10), Kiki Tidwell (Class 15). Thanks also to two members of the Finance Wales senior management team for their comments on this article: my mentor, Steve Smith, Director of Early Stage Investments, and Nick Moon, Strategy and Communications Director.
Jocelyn Brown
Jocelyn is a Corporate Governance Advisor for the Financial Reporting Council (FRC), the UK's independent regulator responsible for promoting high quality corporate reporting to foster investment. Prior to the FRC, Jocelyn served her fellowship as part of Class 13 within Finance Wales (FW), and served on the Board of five early-stage companies. Jocelyn is a graduate of the University of Cambridge, and holds an MBA with Distinction from Imperial College London. She began her career as a technical manager in two startups before moving to roles in management consultancy with Capgemini and technology transfer with Imperial Innovations.
1 J. P. Morgan Global Research and the Rockefeller Foundation, "Impact Investments: An Emerging Asset Class," (29 November 2010), 7.2 Monitor Institute, Investing for Social and Environmental Impact: A Design for Catalyzing an Emerging Industry (January 2009), 11.3 Bridges Ventures and The Parthenon Group, Investing for Impact: Case Studies Across Asset Classes (25 March 2010), 6.4 Monitor Institute, 31.5 Ibid.6 Global Impact Investing Network, "Impact Reporting and Investment Standards" (2010).7 All quotes from Kauffman Fellows are taken from interviews by the author conducted between January and March 2011, and have been approved by the interviewees for use in this article.8 J. P. Morgan Global Research and the Rockefeller Foundation, 17–32.9 The Economist Newspaper, "The Dream of the Personal Computer," The Economist (27 July 2006): para. 6.10 Paul Cheng, ed., The Impact Investors' Handbook: Lessons from the World of Microfinance (CAF Venturesome: Market Insight Series, February 2011), 9, available from Charities Aid Foundation.11 Matt Bannick, "A Flexible Approach to Funding Engineers, The Conversation [blog]" (27 August 2010), para. 6.
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