Sectors, Not Just Firms

It was roughly five years ago, in a late summer gathering of investors and thought leaders, that the term “impact investing” was coined. The practice, of course, is more than five years old. Omidyar Network, for example, had been investing for both social and financial returns since 2004.

In the past five years we’ve seen an exponential growth of interest in our industry, much of it focused on individual firms. Most impact investors see their primary goal as finding and investing in enterprises that yield strong financial and social returns—a goal we share and support. But we worry this singular focus may miss the forest for the trees.

In this online series, we argue for a shift in focus—toward the goal of scaling entire industry sectors, in addition to individual firms. Our experience from the past eight years is that impact investors can massively increase the number of lives they touch by concentrating investments in specific industry sectors in specific geographies, and by investing in a range of organizations to accelerate the development of these industry segments. The need for investment is particularly acute at the earliest stages of innovation, which provide the foundation in which entire new sectors can emerge and scale rapidly by tapping commercial capital markets.

Creating and scaling entire sectors can make the difference, for example, between supporting one solar lantern company that can provide safe lights to thousands of children who otherwise can’t study for school at night—and accelerating an entire solar lighting industry that could provide these lanterns to millions, if not hundreds of millions of students. 

Tools for the Journey

Easier said than done, you may rightly be thinking. After all, many industry sectors, especially those serving disadvantaged populations and with weak infrastructures, can take decades to develop. Microfinance, one of the most heralded innovations for the poor, first emerged in the 1970s and, despite strong growth, is still available to only a minority of the world’s poor.  

But consider this. Accelerating the development of the microfinance sector by just three or four years means extending critical financial services to tens of millions of people—well above the scale than any single firm can reach. 

The nascent medical technology sector serving the base of the pyramid in India offers another example of the potential of market acceleration. According to a 2011 study by McKinsey & Company, accelerating the growth trajectory of the affordable medical technology sector in India by just three to four years could mean that poorer consumers have access to an additional two billion medical treatments per year by 2015. For some of those customers, having access to such treatments could mean the difference between life and death.

In this series we offer several ideas on how to spark, nurture, and scale new sectors for social change. In our next article, for example, we lay out three specific types of organizations that together help build an industry sector—innovators, scalers, and infrastructure players. Each of these organizational types has very different risk and return profiles, but they all need to be adequately capitalized in order to speed up the development of any given sector. 

The paucity of financial and human capital available for high-risk, early-stage ventures (what we call “innovators”) and for sector-specific industry infrastructure poses a massive impediment to the healthy growth of the impact investing sector. Everyone loves to invest in the occasional impact investing “homerun” that promises strong financial and social returns—and these homeruns have an important demonstration effect for the viability of the industry as a whole. Unfortunately, relatively few appear willing to step up to the hard and uncertain work of sparking and nurturing the innovations that ultimately generate a robust flow of investable, high-return impact investments.  It is as if impact investors are lined up around the proverbial water pump waiting for the flood of deals, while no one is actually priming the pump!

An excessive focus on the individual firm, we believe, also has caused many impact investors to underestimate the importance of policy and political sensitivity, particularly when serving the disadvantaged. In article four, we detail how three policy levers—promoting competition, ensuring consumer protection, and promoting entrepreneurship—can speed up or delay the development of industry sectors, often by decades. We also note how a lack of appreciation of political dynamics can cause firms, and entire sectors, to suffer serious setbacks. Oddly, despite the dramatic fallout of microfinance in the Indian state of Andhra Pradesh, there seems to be relatively little discussion of the extent to which profit-making firms serving the disadvantaged are particularly vulnerable to backlash from a wide array of players, including concerned politicians, a skeptical press and citizenry and entrenched economic interests.

Our Own Evolution

Pierre and Pam Omidyar established Omidyar Network with a uniquely flexible structure—enabling us to deploy whatever type of capital, whether grants or for-profit investments, we thought could best help solve a problem. Pierre believes that for-profit firms might have advantages in achieving rapid scale that are unavailable to many non-profits—such as access to commercial financing and the ability to reinvest profit to sustain growth. To date, Omidyar Network has invested more than a half a billion dollars in typically early-stage social impact organizations, almost equally split between for profit and not-for-profit investments. Many of the observations and insights in this series come from our own explorations about how best to take advantage of our flexible structure. 

In the past few years, we’ve noticed lots of new investors piling into the impact investing arena, many with the expectation of finding a steady stream of relatively mature businesses offering both social impact and risk-adjusted returns. We have found a real shortage of such deals.

Concern over inadequate deal flow was one of several factors that led us to reevaluate our own approach to what we referred to as the “gray space” between grants and risk-adjusted return investment. Historically, we were always comfortable with traditional grantmaking, where we expected one hundred percent loss of principal. But when we did for-profit investments, we insisted on deals that would yield risk-adjusted commercial rates of return. This was driven by concerns about distorting markets and the desire to be as rigorous as possible in our investments. With time, we realized that this insistence on risk-adjusted returns would cause us—and the impact investing industry as a whole—to systematically under-invest in creating the conditions under which innovations, and entire new sectors, could be sparked and scaled.

Since 2007, we have also invested in businesses that we did not expect to earn risk adjust returns, but which we DID expect would help advance entire sectors. For example, in 2008, we invested in MFX , a company that helps microfinance institutions decrease the foreign exchange risks of borrowing money in western currencies and lending out in local currencies. MFX is a for-profit company, but we knew we might not achieve risk-adjusted returns on our investment, and discussed this question in great detail. We decided to move forward, because we were clear that MFX would make a large contribution to accelerating the microfinance sector as a whole.

We realized that if we truly cared most about sector creation, then we needed to develop a way to account for the total value creation of the firm, including sector value creation as well as the firm’s direct social impact and financial returns. This led us to refine the process by which we consider investments across the entire returns continuum, from grants to risk-adjusted returns—and particularly those that fall in the middle of the spectrum. While this has required much greater discipline around identifying sector-level value creation, we also think it has given us new tools for priming the pump for sector-level change. 

The observations, insights, and changes that we will highlight in this series were, for us, neither immediately obvious nor easy to adapt. The appropriate role of below market returns, for example, continues to be the source of considerable debate within ON and across the sector. More broadly, the impact investing sector remains in its infancy and we are just beginning to examine critical questions, such as how to create entire new markets for social change. Our insights will grow and deepen in the years to come. 

Though we are eight years into our journey, we are still on a steep learning curve. Our intent with this series is NOT to try to present the definitive blueprint on how to spark, nurture, and scale entire new sectors for social change. We are committed, rather, to contributing our experiences and thoughts to the ongoing dialogue that is shaping the incredibly promising impact investing sector. We invite you to participate in this dialogue with us, to push back, to help us refine our own thinking. Even more importantly, we invite you to collaborate with us on this challenging but critically and inspiring journey. To truly scale sectors in impact investing, we will need all hands on deck.

Read more stories by Matt Bannick & Paula Goldman.