Today’s impact investment funds use a model pioneered by the venture capital and private equity industry—typically an annual management fee of around 2 percent of assets, an annual performance fee around 20 percent of profits, and an exit in 7 years or so.
But there is reason to believe that such a model is ill suited to creating value that goes beyond the financial. In their book, Impact Investing, authors Antony Bugg-Levine and Jed Emerson observe: “This fund structure forces the investor in slow-growing social enterprises to liquidate the fund before many portfolio enterprises have taken off. Relying on the standard management fee also limits fund managers’ ability to cover the costs of executing the many small deals they find and the additional services they need to provide investee companies."
We believe that an alternative model merits attention, one with a twist on a time-tested structure: the holding company. What we call “open holding companies” are well suited to the complex conditions that characterize today’s impact-investing market. Such companies can magnify social value creation, create a stronger social safety net, and advance inclusive growth.
Permanent capital, by allowing for strategic continuity, magnifies social value creation.
A fund must return money to investors at a pre-set dissolution date. This means that the fund may have to liquidate its portfolio before its portfolio companies mature. In contrast, a holding company can allow each enterprise in its portfolio the time it needs to flourish.
Business history attests to the importance of strategic continuity. As Michael Porter and Mark Kramer documented, for example, when Nestlé built a dairy in Moga, India, only 180 farmers were prepared to supply milk. Nestlé set up collection points and paid for veterinarians, nutritionists, and agronomists. It provided training, financing, and technical assistance. Not surprisingly, milk production rose—fiftyfold. The standard of living improved: Moga has five times as many doctors as its neighbors. The number of farmers contributing milk touched 75,000. Nestlé replicated its success in Brazil, Thailand, and a dozen other countries. But the most telling statistics point to the importance of time: Nestlé set up shop in Moga in 1962.
“Meaningful scale is achieved in different ways but invariably takes time. ... Most small enterprises require at least a decade to reach significant scale,” concluded consultants from the Monitor Group, after a study of more than 300 business models capable of transforming poverty. “We would count any time span short of a decade as remarkable,” they observed, “and anything within the 10- to 15-year range as aggressive but realistic.”
Another social distinction is the distribution of financial gains: The management fee and carried interest arrangement of funds creates a sharp distinction between general partners (for example, fund managers) and limited partners (such as outside investors).
In contrast, all stakeholders would jointly own a holding company. The Vanguard Group, for example, is one of the world’s largest mutual fund companies and charges customers only one-sixth as much as other mutual funds. An important element of Vanguard’s approach—unchanged since Founder John Bogle conceived it—is a mutual ownership structure.
Implicit in Vanguard CEO Bill McNabb’s explanation of the firm’s performance is corroboration of the importance of strategic continuity. “The secret to our success,” McNabb told consultants from Bain and Company, “is how we have managed our repeatable model to get better and better every year, while still adapting and adhering to the deep business principles that were set in place at the time of John Bogle. This discipline has not only led us in the right direction, but often prevented us from going astray.”
An open holding company creates a social safety net by letting social entrepreneurs diversify their risks. It is also more inclusive.
A fund is a temporary-capital vehicle and so can offer only cash. A holding company, as a permanent-capital vehicle, can also offer shares in itself. For social entrepreneurs, such shares can cut their personal financial risk (by diversifying their future income across several enterprises, not just their own), without compromising their commitment to social impact (because the enterprises share similar values).
Moreover, as the portfolio diversifies, the benefits to each entrepreneur increase. The group becomes stronger, creating a virtuous cycle that deepens and extends the social impact of the holding company. An increase in portfolio membership increases the number of potential buyers for any entrepreneur who wishes to sell his holding company shares. This increased liquidity makes the holding company more attractive and thus more valuable.
As time goes by, the demonstration and signaling effects of healthy relations between the holding company and its portfolio enterprises act as magnets, attracting other social entrepreneurs ready to sell partial ownership in enterprises that they wish to continue running, possibly at prices lower than they might demand from temporary partners.
There is an irony at the heart of fund-mediated impact investment: The law prevents beneficiaries of the investment from becoming partners in the gain. Only accredited investors—defined by the US Securities and Exchange Commission as individuals whose net worth exceeds one million dollars—qualify as limited partners.
A holding company erases this distinction between the beneficiaries of impact investment and their benefactors. Members of both groups can share ownership; they are true partners working for inclusive growth.
A holding company with permanent capital can be patient.
Why should an externally imposed deadline—the end of a fund’s lifecycle—interrupt the value-creating dance between investors and social enterprises? Patience allows a holding company to work with rather than against the grain of social enterprises. It does not imply inaction. A well-run holding company would use time to add value to its portfolio enterprises, exactly like an able venture capitalist.
An open-ended commitment can enhance value. Short track records make cash-flow projections uncertain, dampening buyers’ willingness to pay high prices. A longer track record increases the likelihood of attractive valuations. More time also gives other investors a chance to discover the merits of the company’s investment thesis. Better-informed buyers are more likely to pay a price that strikes sellers as fair, whether the seller is the holding company itself or one of the enterprises.
Making investments is as labor-intensive for a holding company as for a fund. But because it need not exit by a set date, a holding company can benefit longer from the effort it puts in. Stakeholders in the holding company and in portfolio enterprises can create and share more value when their relations are more closely aligned and subject to fewer constraints. Holding company managers have more time and thus more opportunities to contribute to portfolio companies.
Precedents exist, but there are no true open holding companies.
One prototype is Indian handicrafts retailer Fabindia. A subsidiary, Artisans Micro Finance Private Limited, has set up 17 companies owned in part (typically 26 percent) by weavers and other artisan-suppliers. By 2010, three years after establishment, 16 of these were profitable and in a position to declare dividends. By 2011, Fabindia had organized the 17 companies into three groups containing 40,000 shareholders.
Family businesses often use holding companies to balance family control and business growth. Sometimes, as in the case of France’s Wendel family, only family members can own shares in the holding company. Others, such as Thailand’s CP Group, extend eligibility to trusted managers. Open holding companies set up by impact investors can go further, extending eligibility to all participants in their portfolio enterprises.
Holding companies also comprise certain types of businesses, particularly finance-related ones. One example is PlaNet Finance, established in 1998. Another is ProCredit Holding, a German company that holds 20 microfinance institutions and SME banks.
Another example is Upstream 21. “We wanted to create a company in which all stakeholders’ long-term interests would be considered and balanced,” Upstream 21’s chairperson Leslie Christian told the Capital Institute. “This is an explicit rejection of the prevailing model in which short-term profits that are ostensibly mandated by shareholders outrank long-term creation of value.”
Christian’s description of Upstream 21 captures both the promise and the struggle of pioneering the holding company structure in impact investing: “Potential investors do not always understand that we are not a fund; we are an individual holding company. Institutional investors such as venture funds or foundations often don’t know what ‘box’ to put us in. We like to point out that we are not a fast, high-rolling company with a hockey stick trajectory for growth. Rather, we are building a family of companies that will be solid, long-term contributors to their local economies.”
Most of the pieces are in place, at various stages of development. Corporate forms like low-profit limited-liability companies, L3Cs and Benefit Corporations or B Corps. New exchanges are also emerging, like NeXii, an impact-investing intermediary that allows social businesses to publicly list debt or equity securities. The Singapore-based Impact Investment Exchange Asia, considered the region’s first platform designed to help social enterprises raise money, has attracted some 200 investors.
If impact investors are to bring to society all the value that they are capable of creating, they must think more boldly. They would do well to consider the many benefits of open holding companies.