We are grateful to Paul Brest and Kelly Born for their valuable contribution to the collective thinking about the impact of impact investing. In particular, we applaud the authors for emphasizing the concept of investment impact, alongside enterprise impact and nonmonetary impact. Root Capital believes that the impact investing community has largely neglected the question of whether the loans and investments we are making are “additional”—in other words, whether we are offering something that the market would not otherwise provide.
In our experience, impact investors confront two challenges. The first is to build a business model around investment impact. To the extent that there is a trade-off between financial returns and investment impact—and in Root’s experience, in the case of smallholder agricultural finance there is—investors’ challenge is to develop innovative business models to minimize or overcome the trade-off and achieve both.
Even if we are successful, the investment impact of our original activities will decrease over time, either because the level of unmet need declines or because other entrants arise to provide similar products and services. Therefore, the second challenge is to develop strategies for creating investment impact on an ongoing basis.
Fortunately, it is not difficult to evaluate additionality prospectively when considering a loan. Client-facing staff of impact investors—in Root’s case, loan officers who underwrite loans to smallholder agricultural businesses—are familiar with clients’ financing options. In the impact section of our due-diligence tool, a series of questions about the enterprise’s access to other sources of credit is the first item and informs how we assess our additionality.
This makes it possible for loan officers to prioritize enterprises that lack access to finance, whether because they are early stage, physically remote, or in poorly established value chains. We call this “pushing the frontier”—and our Financial Advisory Services department, referenced by Brest and Born, plays a particularly important role here. Root Capital’s investment impact is most evident with earlier-stage businesses for which we are the first and only source of financing (in 2012, we were the first source of financing for 27 percent of our new clients and we were the primary lender for 66 percent of all of our clients).
We are comfortable, however, continuing to support clients as they grow and access other sources of finance. We do this because both experience and data tell us that investment impact is a spectrum, not a binary. Our clients continue to experience financing gaps even as they become more “bankable.” Commercial banks might, for example, eventually offer loans secured by hard assets but still be unwilling to provide the trade financing backed by purchases orders that Root Capital offers.
In short, we embrace a cross-subsidization model. We seek clients whose financial needs are not met by existing sources, and we accompany those clients’ growth over time. Our clients’ growth not only increases impact but also underpins our business model, because the revenue from growing clients cross-subsidizes smaller loans to new early-stage businesses. Furthermore, we benchmark our pricing carefully to local markets to avoid crowding out commercial finance.
We find that opportunities for investment impact change as the borrower’s needs evolve. Investment impact is highly sensitive to context and opportunities for impact often arise in response to market volatility, natural disasters, or other shocks. In this way, even as the client grows and has greater access to some types of financing, impact investors can continue to have an additional impact by innovating to serve unmet needs.
Right now, for example, Root Capital is working, along with others, to confront the coffee rust blight that is depleting yields by 30 to 40 percent across Central America—a market where Root Capital’s track record is longest and where many of our clients now have access to other sources of financing. The crisis is focusing attention on long-standing issues related to aging plants and declining yields that threaten the long-term viability of smallholder coffee production. Financing and advisory models are critically needed for climate-smart tree renovation, on-farm investments, and income diversification to support smallholder livelihoods and the global supply chains that rely on them.
It is difficult for upstream investors, donors, external stakeholders, and indeed anybody who is not directly negotiating with clients to gauge investment impact. As the recipient of concessionary investment, however, Root Capital believes that the burden of proof on us is, rightfully, high. Without these dollars—for which we pay a fixed but non-market-adjusted return—we would be unable to bring investment impact to our clients within the parameters laid out here.