Wednesday, November 7, 2012

Priming the Pump for Impact Investing

The Omidyar Network makes a compelling case for a sector-based approach to impact investing.

Originally published in the Social Impact Bond Tribune.

Alongside leviathan public foundations like Rockefeller, Ford and Robert Wood Johnson, a crop of private upstarts has emerged much more recently founded by highly-engaged billionaire entrepreneurs like Bill and Melinda Gates, Jeff Skoll, Michael and Susan Dell, and Laura and John Arnold, many of whom bring the same market-based orientation to their philanthropy.  In 2004, eBay founder Pierre Omidyar and his wife Pam founded the Omidyar Network (a funder of Social Finance US, and affectionately referred to as “ON”), which describes itself as a “philanthropic investment firm dedicated to harnessing the power of markets to create opportunity for people to improve their lives.”

It’s fair to say that the jury is still out on whether this younger generation of philanthropists will prove more innovative or nimble than their elders that comprise the foundation establishment.  But this is an auspicious time for new models.  One momentous example is the announcement on April 12, 2012, by the redoubtable Clara Miller, who became President of the F.B. Heron Foundation on the very first day of that same month, that “we will invest the full spectrum of our capital (100 percent of our endowment) through a single capital deployment office, removing the traditional foundation's operating distinction between investments and grantmaking.”  

Another is the publication of “Priming the Pump:  The Case for a Sector-Based Approach to Impact Investing,” a six-part series by ON’s Matt Bannick and Paula Goldman (with assistance from Jayant Sinha and Amy Klement, an observer of Social Finance US’s board) in the September 25, 2012 issue of the Stanford Social Innovation Review.  The articles are important not only for the insights they provide about what it will take to realize the full potential of impact investing, but what they portend about ON as a new kind of foundation.

Herewith, a brief summary with editorial comments.

Part 1
Sectors, Not Just Firms

The authors begin by setting the audacious “goal of scaling entire industry sectors, in addition to individual firms,” asserting that “impact investors can massively increase the number of lives they touch by concentrating investments in specific industry sectors in specific geographies.” Recognizing that impact investing is not an incremental game, they point to a fundamental disconnection between the weapon and its target:  

“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!”

Concerned about the lack of adequate deal flow, ON saw the need to think about the “gray space” between grants and investments that provide risk-adjusted returns.  The authors realized that insisting on the latter as the only alternative to grant-making would cause ON “to systematically under-invest in creating the conditions under which innovations, and entire new sectors, could be sparked and scaled.”

Part 2
Embracing the Full Investment Continuum

Bannick and Goldman drew three key insights from their analysis.  First, “social impact needs to be measured at the SECTOR as well as the firm level.”  Combining direct firm impact with sector-level impact yields a new measure of the value of impact investment, “total social impact of a firm.”  

Second, they identify three categories of actors “meant to apply to the development of for-profit markets for social impact,” rather than those served primarily by grant-making.  The “market innovators” believe in a product or service before its profit-making potential has become obvious.  Their job is “derisking the generic model of an innovation or product,” so it shouldn’t be surprising that these “high beta” firms have the greatest unmet need for patient impact investment.    

The “market scalers” follow the innovators “to refine and enhance the generic model.”  The disruptive tension between old and new approaches noticeably increases because “many market scalers DO earn risk-adjusted returns,” which “may threaten entrenched economic interests” and “raise concerns among politicians who ... may be uncomfortable with private sector approaches to social problems.”

The last group of players develop the “market infrastructure” without which a supportive ecosystem cannot take root (as our British visitors have realized).   As we know all too well, these essential contributors often face the toughest sledding in terms of viable business models, but the authors look reality in the eye when they observe that “LACK of infrastructure can disrupt an otherwise burgeoning sector ...”

Third, “investments in all these different vehicles and return profiles are necessary to move a sector.”

Part 3
Gaps in the Impact Investing Capital Curve

The sector faces “yawning gaps in the capital curve” for early-stage innovators and infrastructure developers, neither of which offer the kinds of risk-adjusted, market-rate returns that attract commercial capital.  The authors are not sanguine that traditional foundations will make a “dramatic mindset shift—from seeing philanthropy’s primary role as addressing market failures to also embracing its potential to catalyze markets.”

Instead, they “see the increased involvement of high net worth individuals in impact investing as potentially catalytic to the sector. Individuals such as Pierre Omidyar, Vinod Khosla, Steve Case, Jeff Skoll, Sir Ronald Cohen, and others have deep entrepreneurial backgrounds. They not only embrace innovation and have a high risk tolerance; they are also quite willing to experiment with market-based and for-profit approaches to achieving social impact. We believe that individuals with similar approaches could have a transformative effect on the impact investing industry by investing in early-stage, high-growth ventures, and by funding industry-specific infrastructure to support these.”

This analysis moves beyond the anecdotal experience of many in the impact investing space to a compelling argument for a fundamentally different rationale for the new generation of entrepreneurial foundations.  More than just a call to action by their peers, the “Priming the Pump” framework reveals why the emergence of a robust impact investing marketplace cannot be assumed, but instead won’t take off unless it is nurtured by a new cadre of funders who see capital market innovation itself as a strategic objective.

Part 4
Do No Harm:  Subsidies and Impact Investing

Here, the authors address a surpassingly important question, “When, and in what circumstances, is subsidy appropriate?”  They thoughtfully compare the risks of firm subsidy—preventing a level-playing field for competition; subsidizing firms with limited scaling potential are an “inefficient use of capital”; and compromising the promise of the impact investing industry; with its positive uses—spurring market development; catalyzing other models of scale, and creating a pipeline for the impact investing industry.

This part of the article acknowledges that “in certain markets, there may be no chance of making impact investing a high returns business without first using subsidies to prime the innovation pump.”  They offer the example of microfinance, which “benefitted from more than a billion dollars of subsidy before reaching commercial viability.”

Eschewing sweeping generalizations, they conclude “there really is no simplistic ‘yes’ or ‘no’ answer, but rather a complicated and nuanced set of conditions under which different types of investments can play a complementary role in sparking sectors.”  The authors concede they are “reticent to invest in low returns businesses, lest that lead us down the path toward limited scale, sloppy investing, diminished expectations, and potential market distortion,” and simply acknowledge that “the biggest determinants of whether we will consider below market returns tends to be the income level and size of the market that the entrepreneur is trying to serve.” 

Part 5
Government Matters

If there is one place the authors fall a bit short, it would be the installment that considers the role of government.  While they appreciate the “urgent need ... to align interests between those who are trying to serve disadvantaged populations from a business perspective and those in government who feel they represent the disadvantaged,” they don’t quite achieve the same level of insight they displayed in analyzing the role of different types of foundations.

They start off on the right foot:  “Impact investors cannot afford to ignore critical political considerations. Enlightened politicians and policymakers have the potential to dramatically speed up the rate at which an industry can scale to responsibly serve hundreds of millions.”  And they are not wrong when they say that “the most important policy imperatives are: ensuring fair and robust competition; establishing appropriate regulation; and promoting entrepreneurship.”

What they fail to come grips with is the need to segment the government sector (just like the foundation sector) into those actors who have the capacity and inclination to foster impact investing and those who probably don’t.  Instead, they settle for the unhelpful observation that, “ultimately, success is best achieved when supportive politicians and policies are married with entrepreneurs and a diverse set of investors who are deeply committed to innovation and sector level change.”

Just as we need more enlightened foundations to make below-market-rate investments in innovators and infrastructure firms, we need to identify the factors that make government officials and their positions truly “supportive” of impact investing at scale.  In fact, there are attributes on both sides of the political aisle that lend themselves to fostering a more conducive environment for impact investing at the sectoral level, so there will be an opportunity to supplement Bannick’s and Goldman’s model.  

I’ll offer just one observation now.  The authors link to what is indeed “an excellent overview on the ways in which government can help drive a more entrepreneurial environment,” by Daniel J. Isenberg, a professor of management practice at Babson College and executive director of the Babson Entrepreneurship Ecosystem Project.  But Professor Isenberg’s worthy objective is to distill practices that “help build a vibrant business sector.”  Although business growth can certainly help reduce poverty, the advent of impact investing has been spurred by the need for more than just traditional enterprise.  

Part of the reason that much of social investment lives in the “gray space” between grants and market-rate investments is that we need to scale innovations, like prisoner reentry programs and permanent supportive housing, that span the public and private sectors.  Government needs to support impact investing not to help business or even nonprofits grow, but to improve the effectiveness of government itself.  We need to look for new structural models that are conducive to impact investing, perhaps along the lines set by Stephen Goldsmith and William D. Eggers in their seminal book, Governing by Network:  The New Shape of the Public Sector.

Part 6
Achieving Takeoff

Coming full circle, the authors reassert that “we must ask ourselves how we can create more innovations that achieve the kind of breadth and rapid expansion” needed to serve most customers, unlike, say, microfinance, which, after three decades, “still reaches a modest percentage of those in need.”  They settle on the idea that, in the developing world, using impact investment for the purpose of “accelerating the rate of adoption [of new innovation], even by a small amount, can yield extraordinary leverage in terms of the number of lives impacted.”  They propose focusing on “the emergence of sectors that have a strong chance of beating the typical ‘lazy S-curve’,” markets that aren’t unavoidably constrained by “limited scale and very slow adoption of a new product.”  

SOURCE:  Matt Bannick & Paula Goldman, “Priming the Pump for Impact Investing:  Part VI:  Achieving Takeoff,” Stanford Social Innovation Review (Oct. 2, 2012).

Now that’s a prescription I can endorse.  In fact, I offered a similar approach in my book for using performance-based philanthropy to scale growth-ready nonprofits.  In both cases, there are well understood models for exponentially increasing market adoption of disruptive innovations, of which the social sector and their funders are largely unaware. 

SOURCE:  Steven H. Goldberg, Billions of Drops in Millions of Buckets:  Why Philanthropy Doesn’t Social Progress, Exhibit 3.9, p. 108 (Wiley 2009).

I’ll confess to a certain amount of ambivalence when proponents of impact investing look to foundations as some kind of deus ex machina.  Bannick and Goldman don’t indulge in wishful thinking.  Instead, by identifying a special role for a specific class of foundations whose experienced teams should appreciate the insights and analysis of “Priming the Pump,” ON just might be leading the impact investing market exactly where it needs to go.

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