> Financial Innovation:
Unleashing Full Potential of
Impact Investing
By Gorgi Krlev
Many relevant fields and geographic areas are blank spots on the impact investing landscape, because they appear too risky or offer too low returns. If impact investing is to contribute to the SDGs, this needs to change. Financial innovation could be a way to work towards this goal. What we need are financial instruments that give social ventures more time than commercial ventures to mature, keep them on track and enable a longterm perspective through private and public interaction. We also need to find ways of combining investments to level out risk or return across fields or geographic regions.
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mpact investing is meant to address the world’s most pressing problems.
In theory, this can work, when financial investors put social impact first and are willing to compromise on market returns. In line with this, there has been a gradual increase in the discourse that investments should be made for impact, and not only with impact. The European Venture Philanthropy Association (EVPA) is spearheading this philosophy, but reality shows it is easier said than done. Recent research has shown that impact investments for sustainable development are least placed in areas where they are most needed. A study of the Overseas Development Institute (ODI) shows that blended finance is least active in countries with low (or no) credit ratings. An investigation by the OECD has shown that the amount of private finance tends to be lower in regions marked by social fragility and security issues. But if such countries and regions remain blank spots on the impact investing landscape, the market’s transformative potential in view of the Sustainable Development Goals (SDGs) is seriously hampered. Similar, if less dramatic, observations can be made of social investments in industrialised countries. Social impact bonds — whose “bond” designation has been criticised, since they are actually private-public funding and service partnerships — often focus on areas where potential state savings are biggest, or where outcome achievement is easily monitored. This is the case for work-integration enterprises or resocialisation programmes for prisoners. The Peterborough Prison social impact bond in the UK, for example, has become known as a world first. Areas with lower (indirect) financial 54
"An investigation by the OECD has shown that the amount of private finance tends to be lower in regions marked by social fragility and security issues." returns and higher risk, such as interventions on homelessness or drug addiction, appear less attractive. Equity investments, in a less-than-transparent market, often focus on social tech ventures, such as digital health platforms, or sustainable consumer goods, such as edible straws. These may become financially self-sufficient efficient in a reasonable timeframe. Ventures that will take a long time to succeed on the market — or will always be based on a hybrid income model consisting of earned income, subsidies and donations — are often ignored. These could be innovative neighbourhoodsupport or shared economy models, or interventions that prop-up cultural exchange and address extremism. Given the challenges of individual isolation and newly resurgent cultural conflicts, most would agree that effective action in these areas is needed. Both observations taken together show that there is a de facto exclusion of a large range of fields and geographical areas for impact investing. If we care about making impact investing a tool for moving towards the SDGs, this should concern us. The question is, how can impact investing unleash its full potential? One answer is: by promoting financial innovation. We need structured, mezzanine finance CFI.co | Capital Finance International
products, which enable the involvement of private and public investors, introduce a longterm perspective, and contribute to risk-sharing. At the level of individual deals, if investors want to give investments a chance that are high-risk, low-return, but of high societal importance, two options in particular should be considered. The first is to employ mezzanine instruments that combine a loan, equity and/or bond logic. Ventures would initially receive a loan at a below market return of x percent. Only after break-even would this be topped-up by an equity component for the investor, or by a fixed-income component of y percent to be delivered by the investee. The achievement of predefined social impact key performance indicators (KPIs) by the venture would be rewarded by no additional financial return expectations. Missing them, for example due to “mission-drift, would be “punished” by an additional return expectation of z percent. Such an instrument protects the start-up phase of a venture and keeps it on track for its social mission, while satisfying social and financial return expectations. The Financing Agency for Social Entrepreneurship (FASE) reports that their use is becoming more common. Secondly, investors could seek strategic partnerships with foundations or governments. Foundations, based on their prosocial mission and high endowment, might be willing to offer first-loss guarantees, giving the ventures more time to sustain themselves and buffer investor risks. Governments might, in the medium- to longterm, enable financial sufficiency for a nonmarket venture through introducing a service into public contracting on regulated quasi-markets for social services.