What Investors Need to Know to Embrace Catalytic Capital

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The latest investor survey by the Global Impact Investing Network (GIIN) makes it clear that the impact investing sector is no longer a philanthropic niche: With major financial services institutions entering the field, it has grown steadily to roughly $715 billion in 2020.

Yet even as impact capital grows, it has failed to fully address critical needs around the globe—many articulated by the Sustainable Development Goals (SDGs)—largely due to inflexible expectations for investment returns. Every year over the past six years, appropriate capital across the risk and return spectrum has been the top challenge for the industry, according to the GIIN survey.

One struggle is that moving into the full range of impact sectors—beyond the established comfort zones of financial services, asset-light models, and well-developed capital markets—means investments come with lower risk-adjusted returns, longer time horizons, and fewer exit options, as reported by Lok Capital, Omidyar Network and other veteran impact investors. In India, we can see an example of the results of such constraints: More than half of impact investments there have gone toward financial inclusion, while the agriculture and education sectors, for instance, pull in just 4 percent and 5 of the total, respectively.

The situation may be worsening in recent years as more and more people in the field have gone from seeing market-rate returns as an optional goal to seeing it as a required one. With ten years left to achieve the SDGs and the COVID-19 crisis, we can't afford any more delays.

To move forward, we must stop expecting investees and the communities they impact to always kowtow to established investor expectations. The contortions should instead become capital's responsibility. It needs to support—not hamper—solutions that work, and investors should be the ones adjusting their behavior.

Catalytic capital—which the MacArthur Foundation and Tideline define as capital that accepts disproportionate risk or concessionary returns to generate positive impact and enable third-party investment that otherwise would not be possible—has been at the forefront of this push. 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 in areas such as energy access. In a blended finance transaction, catalytic capital might mitigate risk through a guarantee, subordination, or first-loss investment. It has been a critical component of impact scaling efforts, such as community development financial institutions (CDFIs) in the United States and microfinance around the world.

Despite these strengths and achievements, catalytic capital can and should do much more. However, knowledge gaps riddle investors' understanding of the concept, a weakness that the Catalytic Capital Consortium (C3) is aiming to correct with the launch of its market-building grants program. (Full disclosure: C3 has commissioned work by FSG, where I am a managing director.)

For one, we're missing a full explanation of why and where catalytic capital is needed—we still aren't describing market capital gaps and their implications in a clear and granular way. We also need greater transparency on catalytic capital deals and terms. And we need to show how to effectively deploy catalytic capital to maximize its results and allay the concern that it is just sloppy investing.

Finally, we must articulate these insights in terms of the needs of different types of investors. Development finance institutions (DFIs) and private foundations are two particularly important segments because they represent substantial sources of capital that have already begun to push into catalytic investing but could be doing much more. Based on recent research undertaken by FSG for C3, we explore the specific challenges they face in using catalytic capital:

Development Finance Institutions (DFIs)

DFIs are government-supported entities that invest in developing countries on a broadly commercial basis to create jobs and spur economic growth. There is an expectation that their financial returns will be at or approaching market rate. Their dependence on taxpayer money pushes them to be very transparent, demonstrating investment efficiency, judicious use of any subsidies, and avoidance of unintended harmful impacts. Our research revealed the major barriers to their use of catalytic capital to include:

• A lack of evidence on capital gaps in the market that, ideally, connects the gaps to recognized market failures, such as externalities and information asymmetries.
• Difficulties in determining the appropriate or efficient level of subsidy, and in minimizing the risk of market distortions through the use of subsidies.
• A lack of well-developed catalytic investment strategies, structures, and practices that are relatively easy and quick for an investor to comprehend and use.

Some DFIs have managed to overcome these barriers. One example is CDC Group, the United Kingdom's official DFI. In 2019, following several years of testing, it launched the $2 billion "Catalyst" initiative, which enabled new types of high-impact deals. These have included local currency loans to back consumer access to clean energy, building the venture capital and private equity ecosystem in Myanmar, and using volume guarantees to shift the pharmaceutical manufacturing market toward more affordable diagnostics and vaccines.

We believe there is growing interest in renegotiating more DFI mandates to create new catalytic capital allocations and strategies. However, as the challenges listed above make clear, DFIs need more research-based evidence to help them convince their government shareholders of the value of the catalytic investments. They also need best practices to be streamlined and codified, to make execution efficient, transparent, and effective.

Private Foundations

Private philanthropic foundations operate very differently from DFIs. They typically have more specific impact objectives, lack an emphasis on financial returns, and undergo little external scrutiny. Their budgets also offer great potential for catalytic capital investing: While they are mostly deployed as a grant, they can also be invested with considerable flexibility around risk and return. In the United States, this is classified as program-related investment (PRI).

Foundations share an interest with other investor types in understanding specific market gaps and the needs for catalytic capital. Unlike others, however, they must determine where and when catalytic capital is the right approach as opposed to a grant. They also need to consider why the investment could not be made with market-rate investment capital from the foundation’s endowment (rather than program budgets), referred to as mission-related investment (MRI) in the United States. The latter question requires foundations to deeply understand catalytic capital's “additionality”—how it contributes to larger-scale or deeper impact than conventional investment capital.

Such additionality is illustrated by the MacArthur Foundation’s $6 million catalytic PRI in Energy Savers, a program that finances retrofits for owners of multi-family housing developments, reducing utility costs and carbon footprints. The foundation has explained how the greater risk tolerance and flexibility of PRIs allowed it to “test the theory” on this promising but unproven idea in a way that conventional finance could not. As the model proved successful, other lenders joined with MacArthur, and Energy Savers has now provided $27 million in loans and grants for energy upgrades to more than 66,000 apartments, helping to keep rents affordable and stabilize incomes for small-shop property owners. Moreover, Community Investment Corp., a leading nonprofit lender, has now made Energy Savers’ approach to underwriting and loan sizing standard practice for all of its loans.

Another example from the Michael & Susan Dell Foundation (MSDF) shows how catalytic capital and grants can play distinct but complementary roles. In 2009, MSDF took a big risk with a $1 million initial investment in Micro Housing Finance Company, which was providing "micromortgages" to informal-sector, low-income borrowers—such as street vendors and taxi drivers—who lacked documented proof of income. What seemed a preposterous idea at the time has turned into a booming impact sector with loans totaling more than $4 billion. MSDF also provided grants (including to FSG) to create better market information and inform effective public policy.

For more foundations to play catalytic roles, we need better research into where, how, and why catalytic capital has delivered additional impact relative to conventional capital or a grant. We also need to help foundations see the relevance of catalytic capital to their current program priorities by identifying specific opportunities.

Other Ecosystem Needs

Both DFIs and private foundations represent significant sources of catalytic capital, but their effectiveness depends on working in conjunction with other types of investors who have distinct and additional requirements.

Investment managers, for instance, need to know who provides catalytic capital, as well as their terms and priorities—which may vary widely since the deals don't follow conventional market norms.

Institutional investors are also important. While they are unlikely to provide catalytic capital, they could participate in deals alongside or after a catalytic investor, and would benefit from better awareness of how to get involved. They would need to see concrete examples of past deals, including structures and term sheets.

Catalyzing Change

With rising urgency around the SDGs, the surge in impact investing, and trillions in upcoming inter-generational wealth transfers, the time is now to help interested investors mobilize more catalytic capital for greater impact. We need to explain the why, what, and how of catalytic capital at a more granular level for different investor types. We must do the research on both supply-side providers and demand-side opportunities. And we should explore improving the regulatory frameworks that can influence the flows of impact capital, demonstrated by solidarity-based funds in France and Opportunity Zones in the United States. Taking these steps will help expand catalytic capital, moving us closer to realizing the large-scale solutions that the world needs today.

Read more stories by Harvey Koh.