“Fund structures are not designed to meet the needs of most enterprises”

For decades, there was one financial tool for use in combating poverty: a 100 percent loss-making grant made typically to non-profit organizations. Starting with innovations such as microfinance and, in the US, program-related investments, the field has evolved to encompass new capital vehicles and innovative business models. The non-profit and for-profit binary condition has also evolved to reveal a much more heterogeneous universe of actors and instruments actively engaged in combating poverty. The financial instruments supporting this movement away from a grants-based approach broadly fall under the term of ‘impact investing’.
However, in the quest to attract capital, we feel that the field has lost its focus on the primacy of the mission. The predominant focus in the literature is on financial return expectations, in particular the quest to prove that market rate returns are achievable in impact investing. However, most enterprises making meaningful contributions to poverty alleviation lack the ability to deliver commercial rates of return. The field has evolved to meet the needs of the investors, and insufficient attention has been paid to the realities and needs of the enterprises themselves. There is a real risk of mission drift as funds—pressured by the lack of deals that can deliver high returns and full impact in a limited time frame—sacrifice intentionality, which is essential to impact investment.
It is time to flip the narrative. Let’s not ask, ‘How does this enterprise fit into my portfolio?’ and instead ask, ‘What kind of skills, support and funding does this enterprise need to be successful, and am I in a position to provide it?’ More robust data and increased transparency could help create a more realistic understanding of the limitations and capabilities of the field.

Financial return targets do not reflect enterprise performance
From our experience, most enterprises in the Global South that have a real impact on people living in poverty can generate average net income in the low single digits. These enterprises carry not only the risks faced by all emerging market companies of economic and political instability, infrastructure challenges and commodity price shocks, but must also face the added challenge of adapting and refining business models to engage people living in poverty, who typically have previously either lacked access to the product or service being offered or have had it provided for free. By contrast, most impact investors target double-digit net returns. The Global Impact Investing Network (GIIN) reported that 84 percent of respondents were targeting risk-adjusted market rate returns or close to market rate returns. For a fund manager to generate a net 10 percent to 15 percent US$ portfolio return, then assuming typical costs and losses, they must seek individual transaction returns of 20 percent to 25 percent or more. We know few impactful enterprises capable of achieving this.

Fund structures are not designed to meet the needs of most enterprises
Most enterprises making a meaningful difference for people living in poverty take 7 to 10 years to come close to financial break-even, as they constantly need to adapt their products, services and business processes to meet their impact and revenue goals. Even once these enterprises mature, they remain fragile and susceptible to internal changes (e.g., loss of key staff), as well as external shocks (e.g., weather-related for those in climate-sensitive zones). These enterprises, therefore, want and need patient (i.e., greater than 10-year) capital with return expectations reflective of the costs and risks they face in achieving positive social change. By contrast, most impact investors have adopted 10-year closed-end funds modelled on private equity. Irrespective of the financial return targets, these fund structures do not match the low and slow financial growth characteristics of most impactful enterprises. The scarcity of reported positive cash exits realized to date by impact investors reinforces our view that there is a mismatch between financial structure and market performance.

The need for user-centered products supported by smart subsidy and patient capital
Enterprises that contribute to poverty alleviation are often making a slow ascent from grant funding to more sustainable forms of capital. For these enterprises, smart subsidy and patient capital approaches are often more financially efficient options to traditional grants, at a minimum, and can create bridges across ‘the valley of death’ to other forms of investment. Impact investors report this same problem as a lack of investment-ready pipeline. Notable examples of enterprises that have achieved significant impact and scale (such as d.light and MKopa) have typically benefitted from millions of dollars of such support over many years prior to securing— and often alongside—investment capital.
This mirrors the development of microfinance and mobile money. At the moment, most enterprises are offered a binary choice between grant funding that seeks impact with no financial return, or commercial investments that seek a net return on capital. We urgently need to progress to more patient capital models that seek to maximize impact while accepting varying levels of return of capital. Without such support we suspect most promising social enterprises will fail to meet their impact potential or become financially viable.

Lack of robust data is compounded by sales hype
Given the blended return objectives of impact investing, we are disappointed by the disproportionate focus on proving the case around financial returns. In contrast, there is limited reporting of impact achieved. Transparent reporting of impact provides the basis for learning about how enterprise-led solutions can help combat poverty, and to ensure that successful approaches can be replicated. Most publications have instead focused on assessing financial returns associated with impact investing. Arguably the most comprehensive of these is the report by Cambridge Associates and the GIIN10 which states that ‘market rate returns are attainable in impact investing’.
However, this same report included no commentary on the associated impacts achieved, relied significantly on the performance of funds focused on the theme of financial inclusion (which, at least for microfinance, has depended on decades of subsidies), and draws its conclusion from a small pool of funds that were targeting market rate returns. Yet, reports such as this play an important role in influencing the views of investors and serves to reinforce a common narrative that is amplified and echoed in the press and in secondary research. It is critical that reports are more balanced and representative of the breadth of experience and the existence of tensions between impact and returns. Failing to do so will result in cheerleading that raises unrealistic expectations and harms the field more broadly.

Intentionality to achieve impact is getting sidelined
Key to impact investing is the intention to generate a measurable, socially or environmentally beneficial impact that contributes to poverty reduction while generating a financial return. While many businesses generate positive social impacts, these are typically a consequence of decisions taken primarily on financial grounds, and do not therefore fulfil the ‘intentionality’ requirements that would classify them as impact investment. In the struggle to find investment-ready impactful enterprises, funds are re-branding investments as impact investing, when previously they would have been considered mainstream investments – albeit ones with strong environmental, social and governance (ESG) performance.
Instead, the field should get better at identifying mechanisms at enterprise level that can lock in the prioritization of social impact and funds should demonstrate clear intentionality and employ business processes, (e.g., defining impact strategies, setting impact targets akin to financial hurdle rates, measuring and analyzing the data) that put impact at the center of their work.
Impact investment arose out of a desire by investors to preserve capital while making positive impact. In doing so, it was able to reach enterprises and have impacts that financial markets were not able to serve. Newer entrants are instead chasing higher returns while hoping to preserve impact.
This paper argues that this risks discrediting the sector through generating unrealistic expectations about financial returns from impact investments. This may lead both to capital being drawn away from (or not attracted to) vital investments that deliver low or zero returns, and also to the wider perception of failure of the sector if expectations of high returns and high impact are not met.

Oxfam and Sumerian Partners propose six recommendations to resolve the challenges highlighted in this paper: 

  1. A shift of approach in the market is needed; from one wherein we tailor funds around the needs of investors to instead developing products that serve the needs of enterprises seeking to combat poverty. Specifically, a wider adoption of alternative fund structures is needed—such as permanent capital vehicles and evergreen funds—and new financial tools that reflect the predominantly ‘low and slow-returns’ of most enterprises prioritizing social impact;
  2. Greater transparency is needed around reporting both the impact and financial returns (gross and net) achieved by impact investors;
  3. Donors and philanthropists need to deploy smart subsidy and patient capital (return of capital) to support enterprises capable of making a meaningful contribution to poverty reduction, and to support hybrid financing models alongside impact investors seeking a net return on capital;
  4. More independent research is needed to understand the enterprise-level experience and analyze which structures, approaches, and incentives best assist enterprises to maintain an intentionality to optimize impact;
  5.  We call on impact investors to agree to a voluntary code of practice that enshrines the intentionality to behave and take decisions in ways that have a primary focus on achieving impact;
  6. Impact investors should adopt incentives for optimizing, measuring, and reporting impact as well as achieving financial return targets.

Excerpt of: M. Bolis, C. West, E. Sahan, R. Nash and I. Irani (2017). Impact Investing: Who are we serving? A case of mismatch between supply and demand. Oxfam and Sumerian Partners.

Download the full paper here.