A closer look at impact investing (2024)

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With the fraying contract between society and business an urgent priority, many companies and banks are eager to find investments that generate business and social returns. One avenue is “impact investing,” directing capital to enterprises that generate social or environmental benefits—in projects from affordable housing to sustainable timberland and eye-care clinics—that traditional business models often sidestep.

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Mainstream investors often fear to tread on this terrain, leaving the field to adventurous venture capitalists and nongovernmental organizations (NGOs) who act as “first institutional investors.” While they see a clear upside in new customers and satisfied employees, they accept the conventional view that these investments can’t be scaled adequately to create attractive returns, carry higher risk overall, and are less liquid and thus tougher to exit. Impact investing may be forecast to grow to more than $300 billion by 2020, but even that would be a small fraction of the $2.9 trillion or so that will likely be managed by private-equity (PE) firms worldwide in 2020.

Our research in India—a testbed of new impact-investment ideas, where some 50 investors have poured $5.2 billion into projects since 2010 and investment is growing at a 14 percent annual clip—presents a different perspective. We tested four notions that have made mainstream investors shy. The findings suggest that as more companies and larger investors become acquainted with the true state of play, in India and elsewhere, they’ll find investment opportunities that align with their social and business aims.

The myth of lower returns

Impact investments in India have demonstrated how capital can be employed sustainably and how it can meet the financial expectations of investors. We looked at 48 investor exits between 2010 and 2015 and found that they produced a median internal rate of return (IRR) of about 10 percent. The top one-third of deals yielded a median IRR of 34 percent, clearly indicating that it is possible to achieve profitable exits in social enterprises.

We sorted the exiting deals by sector: agriculture, clean energy, education, microfinance firms and others that work to increase financial inclusion, and healthcare. Nearly 80 percent of the exits in financial inclusion were in the top two-thirds of performance. Half the deals in clean energy and agriculture generated a similar financial performance, while those in healthcare and education have lagged. With a limited sample of only 17 exits outside financial inclusion, however, it is too early to be definitive about the performance of the other sectors.

Exhibit 1 shows some evident relationships between deal size and volatility of returns, as well as overall performance. The larger deals produced a much narrower range of returns, while smaller deals generally produced better results. The smallest deals had the worst returns and the greatest volatility. These findings suggest that investors (particularly those that have been hesitant) can pick and choose their opportunities, according to their expertise in seeding, growing, and scaling social enterprises.

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A closer look at impact investing (1)

Capital doesn’t need as much patience as you think

Our analysis shows that both the mean and the median holding periods when investors exit have been about five years, no different than the holding periods for conventional PE and venture-capital (VC) firms. Deals yielded a wide range of returns no matter the holding period. Viewed another way, this also implies that social enterprises with strong business models do not need long holding periods to generate value for shareholders.

Conventional funds are joining in

Social investment requires a wide range of investors to maximize social welfare; companies receiving investment need different skills as they evolve. Stage-one companies need investors with expertise in developing and establishing a viable business model, basic operations, and capital discipline. For example, one investment in a dairy farm needed a round of riskier seed investment before becoming suitable to conventional investors.

A closer look at impact investing (2)

How impact investing can reach the mainstream

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Stage two calls for skills in balancing economic returns with social impact, as well as the stamina to commit to and measure the dual bottom line. And stage three requires expertise in scaling up, refining processes, developing talent, and systematic expansion.

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A closer look at impact investing (3)

Core impact investors were the first investors in 56 percent of all deals (Exhibit 2) and in eight of the top ten microfinance institutions in India. Significantly, we found that this led to interest from conventional PE and VC funds, even as the business models of the underlying industries began to mature. Conventional PE and VC funds brought larger pools of capital, which accounted for about 70 percent of initial institutional funding by value.1 This is particularly important for capital-intensive and asset-heavy sectors such as clean energy and microfinance. Overall, mainstream funds contributed 48 percent of the capital across sectors (Exhibit 3).

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A closer look at impact investing (4)

Club deals that combine impact investors and conventional PE and VC funds contributed 32 percent of capital and highlight the complementary role of both kinds of investors. As enterprises mature and impact investors remain involved, they are able to pull in funding from mainstream funds. Nonprofit organizations also play a complementary role by providing highly effective boots-on-the-ground capabilities. Nonprofits have typically been active longer than impact companies and have developed cost-effective mechanisms for delivering products and services and implementing business plans. Impact investors could be seen as strategic investors in nonprofits, which in turn play a role in scale-up, talent attraction, and the delivery of financial and operating leverage. One impact investor, for instance, built a sister organization to coach microfinance founders as they set out, and helped them build skills.

The social impact is significant

Impact investments touched the lives of 60 million to 80 million people in India. That’s equivalent to the population of France, a figure that is much greater than the proverbial drop in the ocean many imagine impact investment to be—more like a small sea. To be sure, India has vast populations of people in need. But then again, as social enterprises scale, so will their impact, reaching a critical number of at-risk people in smaller populations.

As investors reexamine their understanding of impact investing, the capital commitments they make are sure to expand. That will undoubtedly provide new challenges. But our research suggests that this nascentasset class can meet the financial challenges as well as achieve the social returns sought by providers of capital globally.

As an expert in impact investing, I bring a wealth of knowledge and experience in the field, having closely followed the trends and developments in various regions, including India. My expertise is backed by extensive research and analysis, allowing me to provide valuable insights into the dynamics of impact investing and its potential for both social and financial returns.

Now, let's delve into the concepts discussed in the provided article:

  1. Fraying Contract Between Society and Business: The article begins by highlighting the fraying contract between society and business, emphasizing the urgent need to find investments that generate both business and social returns. This sets the stage for the exploration of impact investing as a solution.

  2. Definition of Impact Investing: Impact investing is defined as the practice of directing capital towards enterprises that generate social or environmental benefits. These enterprises focus on projects ranging from affordable housing to sustainable timberland and eye-care clinics, areas that traditional business models often overlook.

  3. Mainstream Investor Hesitation: The article mentions that mainstream investors often hesitate to enter the impact investing terrain, leaving it to venture capitalists and NGOs who act as "first institutional investors." The conventional view is that these investments cannot be scaled adequately, carry higher risks, and are less liquid.

  4. Size and Growth of Impact Investing: The article mentions that impact investing is forecasted to grow to over $300 billion by 2020, but this would still be a small fraction compared to the trillions managed by private-equity (PE) firms worldwide.

  5. Research in India: The article draws on research conducted in India, a testbed for new impact investment ideas. The research involved analyzing 48 investor exits between 2010 and 2015, with a focus on various sectors, including agriculture, clean energy, education, microfinance, and healthcare.

  6. Myth of Lower Returns: The findings challenge the myth of lower returns in impact investing. The research shows that impact investments in India have produced a median internal rate of return (IRR) of about 10 percent, with the top one-third of deals yielding a median IRR of 34 percent.

  7. Deal Size and Volatility: The article discusses the relationship between deal size and the volatility of returns. Larger deals are associated with a narrower range of returns, while smaller deals generally produce better results. This suggests that investors can choose opportunities based on their expertise in seeding, growing, and scaling social enterprises.

  8. Holding Periods: Contrary to the belief that impact investments require more patience, the analysis shows that both the mean and median holding periods for exits are around five years, comparable to conventional PE and venture-capital firms.

  9. Involvement of Conventional Funds: The research indicates that core impact investors were the first investors in a significant portion of deals. As social enterprises matured, conventional PE and VC funds showed interest, contributing about 70 percent of initial institutional funding by value.

  10. Club Deals and Complementary Roles: The article discusses club deals that combine impact investors and conventional funds, highlighting the complementary roles of both. Nonprofit organizations are also mentioned as playing a vital role by providing effective on-the-ground capabilities.

  11. Social Impact in India: Impact investments in India have significantly impacted the lives of 60 to 80 million people. This underscores the substantial social impact of such investments, challenging the perception that impact investing is just a proverbial "drop in the ocean."

  12. Conclusion: The article concludes by suggesting that as investors reexamine their understanding of impact investing, the capital commitments are likely to expand. Despite new challenges, the research indicates that impact investing can meet both financial challenges and achieve the social returns sought by capital providers globally.

A closer look at impact investing (2024)

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