An Impact investor is often seen by many as an effective way to finance the achievement of the Sustainable Development Goals. Much is made of the trillions of dollars invested each year by investors and how this cash could be utilised to transform the humanitarian sector.
But there is still remains a lot of uncertainty on how effective impact investing is and if impact investing is creating measurable sustainable systemic change.
Much of this debate focuses on the lack of dialogue between impact investors, philanthropists and development finance institutions others working in the humanitarian sector.
This lack of engagement has resulted in a mismatch between what impact investors offer and what is needed and wanted by entrepreneurs. In its 2020 Research Report Disruption with Impact report Next Generation Consultants suggest that philanthropists are uniquely positioned to add value to both impact investors and social enterprises if funding is leveraged in different ways.
Oxfam recently released a research backgrounder The Demand Side of Impact Investing: Elevating the perspectives of local entrepreneurs in the impact sector. This report looked at impact investing from the demand side to understand what is working and what is not and we believe that many of the challenges identified could be solved with co-operation between impact investors, philanthropists and social enterprises.
As we elaborated on in a previous article New economic models for a new world, there is a lack of consensus on the definition of impact investing. This has resulted in contestation over how impact is measured and how investors choose recipients.
Largely the differences in definition stem from the fact that the investment sector has not engaged with social entrepreneurs and this has a major impact on how the impact investment sector is structured and managed, the returns they expect and the time horizons for these returns. To date the impact investing sector has followed mainstream investment logic and this is not well-suited to the needs of social entrepreneurs.
Oxfam’s Jessica Jones explains: “Without the guidance of local entrepreneurs’ experiences, investors may continue to make investment recommendations that follow mainstream investment logic such as venture capital models, an approach that can yield incomplete decisions and unintended outcomes. Expecting the same scope and scale as venture capital investments, for example, may not be realistic for these entrepreneurs.”
This sentiment is echoed by a report by the Global Impact Investing Network titled Unlocking the Potential of Frontier Finance which says: “Fund managers often find a mismatch between investors’ time horizon preferences and on-the-ground realities, in which investors often prefer to target a five-to-seven-year time horizon while many frontier finance opportunities require ten years or longer to realize their impact and financial potential.”
Both reports point to the importance of the investor-entrepreneur relationship and the importance of focusing on non-financial metrics. They also agree that the investor voice has far greater influence in the relationship and has largely shaped how impact investments are structured and setting of benchmarks. This brings with it immense risk because without proper consultation with entrepreneurs, there are likely to be miscalculations in how capital can be allocated and impact measured effectively.
Jones in her report suggests that for decades impact investors have been making assumptions about what entrepreneurs need and want from impact investors and this has resulted in unrealistic expectations about the financial and social returns they can expect. She suggests the impact investment sector should be focusing on how the sector can find ways to deliver capital that is affordable and sustainable to meet the needs of impactful enterprises rather the solely focusing on meeting the needs of the investor.
We propose that one solution is look beyond existing models and adopt a blended finance approach that brings together impact investors and philanthropists at different points in the social enterprises lifecycle to bridge the gap between the needs of the investor and the entrepreneur.
Both reports suggest that there is inherent tension in the impact investing sector around:
- Conflict between business goals and the mission of the organisation that flows from placing too great an emphasis on performance targets rather that creating cohesion between the social impact that will flow from achieving business targets.
- Typically, commercial enterprises prize scalability and financial returns while social enterprises focus on sustainability. This results in uncertainty around when social impact should trump returns.
- Resource acquisition in the social enterprise sector is often seen as the end goal, rather than a process that enables the organisation to deliver on social impact. This creates a belief in the need to acquire capital at any cost.
- The time spent on fundraising often detracts from time spent running the social enterprise. For those unfamiliar with the impact investing sector this can be compounded by the additional time required to learn how to navigate the space.
- Growth in social enterprises may differ to growth in commercial enterprises. This means that investors may need to concentrate their capital in the early stages, a time of greater risk.
- The consequences of failure among social entrepreneurs is very different to failure in commercial enterprises. As funding is often linked to success, entrepreneurs are discouraged from failing and learning which contributes to a diminishing pipeline of new social entrepreneurs.
The report engaged with social entrepreneurs to understand their key concerns which include:
- Prioritising finance over impact due to the overwhelming influence of conventional finance models on processes and expectations of scalability.
- Many entrepreneurs in the global south point to the tendency by investors to invest in funds run by those that hail from similar backgrounds to them as they present a perceived lower risk, as well as higher levels of trust.
- Differing views of what is considered impact and that often impact is defined by the investor when impact targets should be co-defined.
- Investors often constrain growth and innovation when they only look to invest in mature organisations to mitigate their financial risk.
- Assumptions that investors are more knowledgeable means that entrepreneurs are often undermined and undervalued for the contribution they bring to the table.
- There continue to be education gaps across the capital chain which puts entrepreneurs at a disadvantage when seeking funding.
- Impact investing language can be exclusionary and means that many social enterprises may not be able to structure the finance to their advantage.
- Unequal power dynamics between the investor and the entrepreneur means that social enterprises are often forced to accept less-favourable terms to secure a cash-injection that can undermine their ability to deliver.
- Poor understanding by impact investors of the risk that social entrepreneurs have already taken.
Within this context there is clearly room for more innovative approaches to enhance how the sector operates and align with the needs of social entrepreneurs.
Our research suggests six ways that the sector needs to change to accommodate both impact investors and social enterprise needs:
- Develop more flexible financial instruments and structures to strengthen the appropriateness of investment products to the operating context of social entrepreneurs.
- Use more innovative blended finance models that see philanthropists providing funding during the start-up phase with impact investors providing funding at later stages to mitigate risk to investors while ensuring social enterprises secure funding when most needed.
- Philanthropists and impact investors must clearly identify their impact intentions to act as a guiding star for their investments and communicate these widely.
- Impact investors and philanthropists together with social entrepreneurs must mutually define their individual and collective impact targets to ensure that they speak to measurable impact and financial returns.
- Encourage impact investors to be more inclusive by funding organisations that come from different demographics and geographies.
- Encourage impact investors to align their investment with the real market needs to have a greater impact.
- Work together to identify ways to reduce transaction costs without affecting the impact intentions and targets.
- Expand and strengthen partnerships at both a local and global level to secure capital during the start-up phase and during growth and scale phases.
- Strengthen forums for investors and entrepreneurs to exchange ideas and share lessons learned between all stakeholders and create a space to celebrate success.
Read more about this topic download Next Generation’s 2020 Research Report Disruption with Impact here.