Gaps in the Impact Investing Capital Curve

In the last article, we described three distinct types of organizations—innovators, scalers, and infrastructure players—which together can spark, nurture, and scale entire sectors for social change.

But capital is not evenly available for all these types of organizations. Not surprisingly, most impact investing capital appears to be available primarily to scalers—firms operating in sectors that have already been substantially de-risked and which offer the prospect of strong financial and social returns. By contrast, innovators and industry-specific infrastructure firms often struggle to raise necessary funds and to get the human capital support often so critical to success.  Indeed, capital appears to be thinnest precisely where it is needed the most: to prime the pump of innovation and deal flow.

The Innovator’s Deficit

The biggest funding gap, by a wide margin we believe, is for early-stage innovators. There are very few impact-oriented investors willing to assume the high risks and uncertain and/or low returns associated with investing behind socially impactful early-stage businesses, particularly in geographies and industries where sector risk is perceived to be high. This deficit was described extensively and compellingly in the Monitor Group’s recent report, “From Blueprint to Scale: The Case for Philanthropy in Impact Investing.”

In 2010, JP Morgan and the Global Impact Investing Network estimated that the impact investments in the developing world would grow to between $400 billion to $1 trillion dollars worth of capital deployed within the decade. Although good data is hard to come by, it appears that the percentage of this capital flowing to early-stage investments in companies serving disadvantaged populations is quite modest —probably ranging in the low hundreds of millions of dollars globally per year. These estimates are based on activity levels of a handful of leading players doing early stage impact deals in the developing world.

For example, Acumen Fund, one of the pioneering investors in impact investing for the base of pyramid has committed roughly $73 million in investments over 10 years. Gray Ghost, another early-stage industry pioneer investing in low income communities, has committed a similar amount of capital—$100 million since 2003.  Other leading BOP investors boast similar ballpark figures, for example Elevar ($46 million invested since 2006), Ignia ($48 million invested since 2007), and Aavishkar ($53 million since 2007). Of the $550 million of capital that Omidyar Network has invested since 2006, more than $250 million has gone to early stage BOP investing, about a third of which went to grants.

Early stage investing requires not only a keen understanding of the market and excellent business judgment; it also requires a commitment to identifying top entrepreneurs and helping them scale up their capabilities and their team. It is quite common for the costs of these human capital efforts to exceed the size of the financial commitments, particularly given the small dollar amounts invested in early stage innovators. 

Omidyar Network’s average deal size for early stage deals in the developing world is about one to two million dollars. This is a modest size for a developed world venture capital investment, but a large amount of capital for an early stage firm in places such as India. Indeed, recent research by the World Bank, for example, suggests the gap in early stage funding for the BOP in countries like India is not just at the typical venture capital range, but at the angel and seed stage (tens to hundreds of thousands of dollars per deal instead of a million dollars or more). Of course, even decent financial returns on investments of this size would be quickly swallowed up by transaction and human capital costs. Thus, we ourselves often struggle with the challenges of going even earlier stage with our investments.

The reality, of course, is that if we wish to build an impact investing industry that successfully delivers on the promise of bringing market-based solutions to disadvantaged populations, our success depends on our support for these early stage innovators. It is today’s fledgling innovator who sets the stage for tomorrow’s next great scalable innovation that can also produce strong financial returns.

The Infrastructure Gap

It is encouraging to see infrastructure for the impact investing sector being built at the global level. Organizations such as the Global Impact Investing Network, the Aspen Network of Development Entrepreneurs, and the European Venture Philanthropy Network play key leadership roles in stewarding the impact investing industry at global and regional levels. The emergence of promising new entrepreneurs and entrepreneurial ventures, however, is also dependent upon a robust industry-specific infrastructure built at the national (and sometimes state) level.

For example, the previously mentioned 2011 McKinsey research on the medical technology sector in India, identified a host of infrastructure and ecosystem interventions that could collectively help increase the availability of medical services to the poor by millions of treatments per year. Such interventions included training institutions for medical device technicians, efforts to establish a national regulatory regime for medical devices, and the establishment of a center for excellence in social marketing for medical devices. 

Many of these needs could be met by non-profit and low-profit organizations. Unfortunately, ready sources of funding for such efforts are hard to come by from impact and commercial investors who prioritize financial returns and/or measure their success on the basis of individual firm-level outputs rather than the development of industry sectors as a whole. 

Where’s the Money?

So, if there are yawning gaps in the capital curve for both innovators and infrastructure, then where is the capital likely to come from?

Commercial Investors
The largest source of potential capital is in commercial capital markets, which represent trillions of dollars of investable assets. Commercial markets work quite well in allocating capital to businesses that the market believes will yield risk- adjusted financial returns. So-called “returns first” impact investors—those impact investors who prioritize returns above social impact—appear to many to be a subset of the commercial capital market. In most cases, commercial funds—whether they are impact investing funds or not—are tapped in later stages of market development, after specific innovations and business models are de-risked. Large scale commercial funds did not flow into microfinance, for example, until several decades after the generic microfinance model had been pioneered with the support of multilaterals and philanthropy. Commercial capital is thus of exceptional importance in the later stages of scaling up impact investing industry sectors (and it recently did this for microfinance); it is unlikely, however, to fill the gap in funding needed in for innovators and infrastructure.

Established Foundations
US foundations alone deploy about $47 billion per year (and sit on total assets of about $650 billion dollars). They are another major potential source of funding for the innovation cycle in impact investing. Indeed, many foundations have active Program Related Investment (PRI) initiatives, enabling them to invest in for-profit organizations delivering a positive social impact.  However, notwithstanding the pioneering efforts of foundations such as Gates, Rockefeller, Hewlett, and Skoll, PRIs still represented only one percent of capital deployed by foundations in 2009. Moreover, most of this capital went to relatively low-risk debt instruments. Only five one hundredths of one percent of US foundation capital deployed went to equity PRIs, which represents the type of capital necessary to help fund innovators.

Substantially increasing direct foundation investments in “innovators” would also require a dramatic mindset shift—from seeing philanthropy’s primary role as addressing market failures to also embracing its potential to catalyze markets. Tapping foundation endowments, meanwhile, would require similarly fundamental shifts in endowment objectives and strategy.  Given these obstacles, we think it is unlikely that foundations will dramatically increase their direct investments in early stage ventures. It is possible, of course, for foundations to provide funding to early stage impact investing funds, as Rockefeller did with Acumen. There is also great potential for foundations to provide funds for infrastructure and ecosystem work in industry sectors with strong social impact. 

Already, existing initiatives such as the AGRA Alliance for Agriculture in Africa (supported by government and development institutions as well as foundations) and pioneering drug discovery for developing world diseases hold great promise in creating more opportunities for private sector innovators by increasing innovation and reducing risk. Large-scale, broad-based initiatives could be supplemented by more targeted short-term grants that benefit specific emergent business sectors and even firms.

Development Institutions and Banks
Development institutions and banks could be excellent sources of funding for innovators in impact investing, particularly in emerging economies. They deploy billions of dollars every year with the explicit goal of combating poverty and contributing to economic growth in poor countries. However, incentive structures within these institutions are sometimes an obstacle.  Employees of development banks are often rewarded for volume of capital deployed, which makes it difficult to support smaller, early-stage deals. And aid institutions often are not encouraged to take on high-risk equity investments. Indeed, development banks frequently need to justify their continued funding by demonstrating solid returns, making it relatively unattractive to pursue high-risk, early-stage investments.

Despite these incentive structures, however, we see a number of hopeful examples of development banks and agencies taking on higher-risk, earlier-stage profiles.  Programs like USAID’s development innovation ventures, the World Bank’s development marketplace, and the IADB’s Multilateral Investment Fund (MIF), and Opportunity for the Majority Initiative are steps in the right direction. We are also encouraged to see institutions such as the International Finance Corporation, the UK Department for International Development (in cooperation with CDC) and the Dutch development bank, FMO, take advantage of their equity windows to increase their involvement in early-stage investment.  Development institutions and banks could also play a pivotal role in supporting the development of industry-specific infrastructure.

High Net Worth Individuals
We see the increased involvement of high net worth individuals in impact investing as potentially catalytic to the sector. Individuals such as Pierre Omidyar, Vinod Khosla, Steve Case, Jeff Skoll, Sir Ronald Cohen, and others have deep entrepreneurial backgrounds. They not only embrace innovation and have a high risk tolerance; they are also quite willing to experiment with market-based and for-profit approaches to achieving social impact. 

We believe that individuals with similar approaches could have a transformative effect on the impact investing industry by investing in early-stage, high-growth ventures, and by funding industry-specific infrastructure to support these. We are eager to find creative ways to expand and support such efforts.

Directing Capital to the Right Places

One of the great successes of the impact investing movement is that it has drawn attention to the fact that businesses can generate tremendous social impact as well as financial return. There is ample capital out there; the key is tapping into appropriate sources for appropriate needs. 

In so doing, investors will need to grapple with the complex and controversial topic of subsidy. Under what circumstances should investors consider using grant funds or concessional debt or equity in support of impact investing work? We turn to this topic in our next article.

Read more stories by Paula Goldman & Matt Bannick.