5 Myths Preventing Catalytic Capital From Going Where It’s Needed

(Photo by iStock/lilly3)

The size of the worldwide impact investing market has now crossed the trillion-dollar mark, according to the Global Impact Investing Network (GIIN). However, together with that impressive scale it is increasingly constrained by the requirements and expectations of mainstream finance. As a result, impact capital largely lacks the flexibility to push into many of the areas of urgent need facing people and planet. Indeed, the GIIN itself continues to report that “appropriate capital across the risk/return spectrum” is the top challenge facing the impact investing market.

In late 2020, I wrote about the crucial role being played in impact investing by catalytic capital, i.e., capital that is flexible in pursuit of positive impact that otherwise would not be possible, typically because it accepts disproportionate risk and/or concessionary returns. In the case of an unproven fund, enterprise, or innovation, catalytic capital might be the investment that helps things get going, building a track record that can attract other investors to riskier opportunities.

One of the best-known examples is that of microfinance, where patient catalytic capital support of early pioneers like Grameen paved the way for what is now a $200 billion global market that helps millions of poor households to improve their incomes, quality of life, home environment, education and more. A more recent case is that of the off-grid solar sector which is now estimated to be a $2.8 billion annual market that has benefited nearly half a billion people globally. In a blended finance transaction, catalytic capital works to mobilize additional capital from the private sector through a guarantee, subordination, or first-loss investment: One example of this is the SDG Loan Fund put together by Allianz Global Investors which attracted $1 billion in private money thanks to a $111 million first-loss from Dutch development bank FMO and a $25 million guarantee from the MacArthur Foundation. Catalytic capital is deployed by a range of actors, ranging from development finance institutions and government agencies, to family offices and foundations (typically through program-related investments in the case of US foundations).

In the same article, I wrote there was a pressing need to better understand the capital gaps across the market that give rise to the need for catalytic capital—without a clear understanding of these gaps, it is difficult for investors and advisors to develop sound strategies to address them. Since that time, the Catalytic Capital Consortium (C3) has been funding a range of efforts to remedy that lack of knowledge, building an evidence base on capital gaps around the world and, in many cases, how catalytic capital has already been deployed to meet those needs. This work has illuminated a diverse array of capital gaps and importantly dispelled a number of myths about them. Here are five of the most important of those myths:

Myth #1: Gaps only occur in poorer, less economically developed parts of the world.

When thinking about capital gaps, it would be natural to start with the parts of the world that have more limited availability of local capital and less-developed financial sectors, which tend to be the poorer, less economically developed parts of the world. International investors are often dissuaded from investing in such countries due to prevailing economic and political risks. As such, there are indeed many capital gaps in these areas, such as the financing of small- and medium sized enterprises (SMEs) in Africa with particular challenges in essential sectors such as agriculture and health care.

The reality is there is a huge diversity of capital gaps out there: Large and pressing capital gaps can also be found in areas such as the rental housing sector in Europe, advanced “hard tech” ventures fighting the climate emergency, and BIPOC-owned businesses in the United States. Having a well-developed economy with an abundance of capital and a sophisticated financial sector certainly does not prevent capital gaps from emerging and persisting. And the existence of gaps in these areas means that conventional impact investing is not even close to addressing the full need (nor potential) here. We need to do more and do better, all around the world.

Myth #2: Gaps are pretty easy to spot—just look for the absence of capital on offer to potential investees.

In common usage, a gap is an “empty space” or an “opening,” so one would expect capital gaps to be marked by the absence of capital available to potential investees, and in many cases that is true. However, in many other cases, capital is available but just not in the amounts, and on terms and conditions, appropriate to the investee.

Take the example of African SMEs that are unable to put up the collateral required by mainstream lenders or are being offered finance at unaffordable or damaging terms—while there is capital available, it is misaligned with the needs and constraints of enterprises, such that very little ends up flowing into those areas. The IFC’s analysis of the MSME finance gap includes in its definition of credit-constrained firms those discouraged from applying either because of unfavorable terms and conditions or because they did not think the application would be approved; the terms and conditions that discourage firms include complex application procedures, unfavorable interest rates, high collateral requirements, and insufficient loan size and maturity.

This picture is confirmed when we look at the actual features of catalytic capital deployed in SME finance in a country such as Ghana: Across 72 financing schemes examined by researchers, 63 percent of capital providers offered non-traditional terms tailored to the SME’s needs, and 42 percent offered longer financing timelines. Interestingly, concessionary pricing was a feature offered by only 8 percent of providers, which underscores the importance of not defining catalytic capital by price concessionality per se.

Being able to recognize all the identifying features of capital gaps is key to ensuring that we correctly spot them, even the ones that are less obvious, and not pass over areas of need that superficially appear to be served.

Myth #3: Gaps stem from weaknesses on the part of potential investees, not anything to do with investors.

This is a misconception reinforced by language in common usage. How often have investors discussed how investees “lack investment readiness,” or how particular communities are “hard to serve?” This reflects the prevailing power dynamic in which the supply side (investor) perspective has greater legitimacy and gets listened to, while views from the demand side (if any are even given an airing) are overlooked. Thus enterprises and communities are simply labeled “hard to reach” without the necessary questioning of why investors are “reluctant to serve.”

In truth, capital gaps result from misalignments between investors’ knowledge, attitudes, requirements and expectations, and investees’ profile, situation, values, and wider context (which in turn drive their needs and constraints). Pinning the problem on the demand side alone is not only inaccurate—it is also profoundly unhelpful in trying to resolve the issue, because the narrowing of capital gaps in many cases will involve developments on both demand and supply sides.

Take the case of correcting the historical lack of diversity in asset managers in the US: Incredibly, white-male-led asset managers control 98.6 percent of the investment industry’s over $80 trillion in assets under management. How does one start to close the gap for diverse-led asset managers? Demand-side efforts to inspire, encourage, train, mentor and fund more diverse teams (such as HBCUvc, BLCK VC and Girls Who Invest) are indisputably needed to correct this imbalance, but they are not enough. The investor supply side (i.e., asset owners) has also taken steps to change itself, beginning with awareness and recognition of the problem (something that has arguably accelerated since 2020), through understanding that diverse managers do not underperform their non-diverse peers, all the way to adapting their due diligence approaches so as to not systematically eliminate diverse managers from the selection pool.

Seeing issues on both sides as parts of the problem, and keys to the solution, is essential to addressing capital gaps.

Myth #4: The gap faced by innovative solutions is greatest at the outset and gradually narrows as they scale.

While some capital gaps are expected to persist in the long run (structural gaps), others might narrow or even close over time (transient gaps).

Transient gaps typically occur around novel solutions, models, markets, mechanisms, types of actors, etc. that carry a high degree of “early-stage risk,” and lack the track record and proof points required for them to be acceptable to mainstream finance. One might expect that these gaps are greatest at the outset and then progressively narrow, advancing linearly towards an eventual “graduation” from the need for catalytic capital.

However, reality does not always bear this out, and real-world scaling journeys often involve expansion into new areas that bring greater risks and/or costs. It is not unusual for second funds to require more catalytic capital, not less—examples include Women’s World Banking Capital Partners Fund II and Responsability’s Energy Access Fund, which both drew on proportionally more catalytic capital than their earlier funds (WWBCP Fund I and Responsability Access to Clean Power Fund, respectively) to support a step-change in fund scale alongside expansion to a wider range of geographies and investee profiles. Nor is this a newly discovered phenomenon. Over 10 years ago, my colleagues and I described the “pioneer gap” problem here in SSIR and explained how it is most pronounced in the middle parts of the scaling journey (the stages we called “validate” and “prepare”).

The “Valley of Death” concept well known in venture capital also reflects this, and Prime Coalition has taken this a step further in the case of science and engineering innovation, and identified at least three discrete valleys of death:

• Technology Valley of Death: between Technology Readiness Level (TRL) 3 (experimental proof of concept) and TRL 7 (system prototype demonstration in operational environment)
• Commercialization Valley of Death: between initial pilot and 1st commercial deployment
• Market Expansion Valley of Death: between 2+ commercial deployments and market leadership

Myth #5: Attitudes and values are not relevant to the discussion of capital gaps.

It is true that many capital gaps are driven by “hard,” tangible, objective factors. Take the example of SMEs in Sub-Saharan Africa working in sectors such as agriculture and health care, as mentioned earlier. These enterprises might typically be too small or not sufficiently profitable, or lack track record, or be located far from urban financial centers. They might also work in operating contexts that are resource-constrained or subject to disruption (due to poor infrastructure or weather variations, for example), and be exposed to various risks in the political and economic macro environment. All of these factors lead to divergence from the expectations of mainstream finance in an obvious way.

However, capital gaps can also open up because of misalignments in attitudes and values between supply and demand. In India, mainstream investors’ inability to accept differing norms in working patterns in artisan producer communities—such as work flowing around family and community priorities (such as religious observances) rather than the other way around, and distributed methods of productions and management in homes rather than in conventional factories—is a key factor leading to a lack of investment in impact enterprises working with those communities. Meanwhile, in many Indigenous communities, wealth is defined not only as financial success but also social well-being, community health, continuity of cultural practices, or environmental connection. Mainstream investors’ lack of understanding and acceptance of this can lead to capital being offered in ways and on terms that do not align with community norms, or to capital not being offered at all because of the perception that working with these communities is too difficult or costly.

Differing views on (and levels of commitment to) impact intentions can also create capital gaps. For example, employee ownership conversions in the US may gradually become more mainstream investable as more investor experience, track record, and understanding are built up. However, it is likely that some kinds of conversions could see a persistent structural gap, such as with “non-extractive deal structures” where the distribution of profits is done with priority given to worker-owners rather than to outside investors—while this approach gives powerful effect to the intention of fostering more equitable and resilient economic outcomes for workers, protecting them especially in leaner times, it also clashes with prevailing norms in mainstream finance.

Moving Forward

The research and analysis produced by C3’s Evidence Base grantees, as referenced above, is already helping investors illuminate capital gaps in much deeper and clearer ways. As described in C3’s Advancing Practice guidance notes, catalytic capital investors are also becoming more effective in how they articulate their strategies, as responses to both transient and structural capital gaps that they see in the landscape. As reflected on the newly launched C3 website, we are making progress thanks to the work of many different actors across the field, from investors, advisors and fund managers, to researchers, incubators and advisory support providers.

But there is much that remains to be done: Catalytic capital investors need more effective, integrated tools and practices for guiding strategy and deployment based on robust analysis of capital gaps. I will be leading work with C3 and partners over the coming months to advance this agenda, and look forward to hearing ideas, questions and suggestions of where good practice is already emerging in the comments below. Ultimately, we are striving to fulfil the potential of impact investing as a tool that will truly unlock better lives for billions of people and particularly for those who are most marginalized and vulnerable.

Read more stories by Harvey Koh.