What’s holding us back?
Specifics vs. the system
The opportunities explored in the previous section each present their own specific challenges, but underpinning them all and others not discussed, are a number of general market barriers and constraints that are holding back the overall efficacy and growth of investment activity.
These relate to both the supply and demand sides of capital, and to intermediation between them. They also include deficiencies in policy, capability, information, awareness, understanding, leadership, and resources for market building and organising. Overall, increasing impact investment will be dependent on a functioning marketplace, or ‘ecosystem’. Precedents from other markets indicate that this will require a coordinated approach, starting with a holistic diagnosis of current limitations. We provide a high-level scan of these factors below.
The supply of capital
Increasing the supply of capital is obviously important. However, focussing on volume alone is missing the point. It is not just the quantity of capital that matters, we have to also consider other aspects of supply, and how they interact with demand in the market.
Diversity of supply
Most of the impact investors in the market at this early stage are explicit in wanting conventional market-rate returns. However, much of the current market demand is for concessional / blended finance or requiring ‘patient’ terms. This has the potential to cause frustration as actors spend time engaging with counterparties who can’t give them what they want. The issue is not the expectation of market-rate returns per se, but rather there not also being other offers available to match the full spectrum of demand. This mismatch underlines why many small-scale impact investments are being undertaken via crowdfunding, as it is currently the most accessible channel to capital for ventures with tailored needs.
Diversity also extends beyond return to being responsive to other characteristics, including the purpose that the capital is used for – i.e. the Chantier de l’économie sociale Trust focuses specifically on property deals, or the sector that impact is delivered through – i.e. Scotland has specialised impact funds that focus on areas as niche as waste recovery and fast moving consumer goods. In all cases, be it return profile, purpose, or sector, having a diversity of (explicit) offers in the market creates efficiencies in matching supply with demand, and also enables additional value to be brought to the deal through inherent specialisation. Diversity, in many respects, is a natural outcome of market maturity but it can also be planned for, with the biggest areas of demand being pro-actively served by design.
Chantier de l’économie sociale Trust
The Chantier launched the Fiducie du Chantier de l’économie sociale was established in 2007 to provide patient capital and quasi-equity to social and collective enterprises. It blends public and private funds. The new “product” is a form of debenture, an unsecured investment repayable after 15 years. This patient capital is intended to support the operations of social economy enterprises and contribute to their growth, especially through real estate investments. Loans are available for between $50,000 and $1.5 million. Over 10 years, the Fund has made direct investments in 168 social enterprises totalling CAN$53m, generating a sum investment of CAN$374 million in the Québec economy. In addition to financing a range of social and environmental initiatives, the Fund has resourced the creation of over 3,100 good quality jobs.
Much of the current investment pipeline is characterised by propositions that are early-stage, small-size, and / or have long-term lock-ups. This creates liquidity issues for investors who, in many instances have no obvious pathway to exiting an investment at the point of making it. The prospect of investing without a clear exit plan is in itself a barrier but with a social purpose organisation there is the potential of additional reputational risk – as few investors would want the notoriety of undermining the work of a social good organisation in order to get their money back.
High transaction costs
At this early stage of market maturity, investments typically have high transactions cost as most deals are individual in structure, impact area, parties involved etc. This is also complicated by the fact that unlikely partners are needed to come together in partnership for most deals – groups who aren’t used to working together, nor speak the same language. Both of these aspects can be deterrents for investors who seek frictionless arrangements.
While deals do get done at the submarket end of the spectrum, they are often overly reliant on the social capital and networks of the individuals seeking investment. This is also common in other impact markets in development. For example, Luke Terry, the social entrepreneur behind Vanguard Laundry in Australia, had to strike deals with 72 different investors to raise just AUD$6m. Accessing capital in this way is highly inefficient and excludes the majority of organisations who may have the potential to make good use of investment if they had access to more visible, organised, and tailored sources of capital.
Beyond diversity and accessibility, another key consideration in the supply of capital is continuity, or the ‘continuum of capital’, i.e. to what degree is there appropriate finance available to ventures at different stages of maturity – from early-stage through to expansion and scale. In functioning markets, these progressive stages of finance are present and also connected, facilitating pathways for growth. At this time, there is little or no structured continuum of impact capital, again leading to inefficiencies and precarious financing gaps for organisations going through iterative stages of development.
While these issues relate to the supply of capital, they are clearly interdependent with the quality of demand, and also the availability of intermediation. All of these individual components need to be considered simultaneously, and viewed collectively, with the other factors that we now go on to explore.
The pipeline of investment opportunities
More important than growing demand, is strengthening the quality of demand, especially when successful precedents and investor confidence remain limited. There is no means to appraise the quality of overall deal flow, but insights gleaned from the Government’s unpublished demand-side research and the pilot round of the ‘Impact Readiness Fund’ suggest that interest in impact investment exceeds genuine suitability for it. While the breadth and depth of investment propositions would seem to be growing, there are a number of factors that undermine the quality of deal flow, and therefore the potential to increase market activity.
Within social enterprises and impact-led organisations operating in, or entering, market environments, there are often gaps in commercial capability. This is especially true in relation to activities such as investment which requires specialist skills-sets, and a sound understanding of particular terms and concepts. Without experience, or close guidance, it is difficult for any organisation to have realistic expectations of investment processes and requirements, even when they have viable propositions.
Culture and attitude
Linked to capability, is the extent to which practitioners working on social / environmental issues are comfortable in taking investment-backed strategies. In this respect, individual doubts can be amplified by organisational cultures that are not predisposed to risk-taking. This can relate to the mindset of governing boards (which, ironically, often include people from commercial backgrounds) who are inclined to minimise risk in relation to finances and reputation, rather than set strategies that involve innovation and / or growth. It can also pertain to the mindset of management teams, who may be less motivated to act entrepreneurially when there is a lack of individual incentives for upside performance as a result of the underlying (asset-locked) structure of the organisation.
Viable business models
As with all businesses, access to investment is predicated on the robustness of the underpinning strategy and the ability to generate revenue to service the investment. While mainstream businesses have long been able to access external assistance to develop and structure their propositions, social enterprise and impact-led organisations often face barriers (real and perceived) to accessing similar support. This is changing, with an increasing range of impact aligned capability building options available. But the fact that Callaghan Innovation are only now considering how they can be more responsive to organisations in this field suggests there are still barriers to remove.
Further to the development of sound business models, there is also the issue that many impact-based business models work within markets, or market mechanisms, that have strong dependencies on government policies, or on government as a customer (as in the case of most ‘payment for results’ contracts). Both of these aspects create risk around revenue and can undermine the attractiveness of an investment case.
Demonstration of impact
As a counterpoint to business models, there is also widespread inconsistency in the presentation of impact models and reporting. This, in part, reflects the lack of specialised skills required to develop and maintain appropriate frameworks, particularly in teams primarily coming from commercial backgrounds who are, perhaps, new to working in areas of social and environmental change.
However, it also reflects a more systemic issue in that there are no commonly accepted standards or methodologies adopted across the market, or even general agreement as to what constitutes good practice. While there are a number of well-tested methodologies available internationally, here in New Zealand, mixed levels of capacity, combined with the lack of an overall organising / regulating force, result in impact reporting still being highly individualised and contextual. This makes it hard for investment propositions to be appraised in terms of their impact potential, and even harder to compare and benchmark.
Capacity to engage in investment / capital raising processes
In addition to having the requisite capability and business / impact models, organisations seeking to raise investment require the basic capacity to engage in what can be a long and demanding process. As referenced in the Vanguard Laundry example, the emergent and inefficient nature of impact investment markets can make the challenge of raising capital more costly and protracted than even the most conservative estimate. In a report that investigated why more social enterprises weren’t accessing investment, Social Enterprise UK found that capacity demands and unclear expectations about the overall process were key barriers.
Circling back to the previous points made in relation to the supply of / access to appropriate capital, it is clearly beneficial, on any number of levels, to have a strong alignment and clear expectations between both sides of a deal from the outset. Signposting and brokering these relationships is where intermediaries can play an important role in fostering efficient and effective activity.
Intermediation can be understood as “any institution that facilitates the channelling of capital between the supply and demand-sides of a market.”
Intermediaries are common in mainstream financial markets to the point that they are often taken for granted, and there is little public recognition of the term – they are mostly known as ‘financial institutions’. In any case, intermediaries play an important role in the creation and functioning of markets both at a micro level – creating relationships between supply and demand side actors, and a macro level – developing the mechanisms and infrastructure that enable scale. They have the capacity to receive and pool capital, and then structure and distribute it in the form of investments. In addition, they play an important role in evaluating investments, managing risk, and reducing transaction costs (to all parties).
Beyond the same (and important) roles that intermediaries play in mainstream markets, in the context of impact investment, they take on additional functions. This includes managing the increased complications of measuring impact and appraising risk in additional dimensions. It also includes the careful facilitation / interpretation required to achieve good relationships and fair deals between participants, who may have more inherent differences than commonly found in conventional markets – i.e. a community organisation engaging with an investment banker.
In mainstream markets, intermediaries have built a system of compensation based on fees taken from the transactions they facilitate. This is enabled by market maturity – rapid throughput, large transactions, and strong margins. In a nascent market, such as the current state of impact investment, there is not the basis to sustain intermediaries in the same way. This means we currently have a deficit of these important actors in the ecosystem, and a chicken-egg conundrum in how to resource them.
The deficit of specialised intermediaries highlights a broader point of the general lack of relevant capability and skill sets in the market. We covered how this was a constraint for demand-side organisations but it is equally so on the supply-side, especially in matters relating to impact appraisal, management, delivery, and risk. An example of this is found in the RIAA Benchmark report of Australia, where only 4% of asset managers track the unintended consequences of their investment. Capability gaps also pertain to professional service providers who are required to develop novel ways to structure transactions, accounting models, and, in some cases, hybrid organisations.
While pools of expertise are growing in this field, appropriate technical capability is far from widespread and not easily accessible. And to date, there is little or no substantive and high-quality professional development offered domestically in the field.
Quality of evidence
Deficits in technical capability, and the lack of opportunities for professional development are compounded by the paucity of good quality evidence and information in the field. Beyond anecdotal insights and the expertise of a relatively discrete number of individuals and organisations, there is no domestic body of knowledge, or active research, to provide insight on what constitutes effective practice, policy, governance, or market development. We have very little evidence of what actually works.
This work is happening in countries overseas, and at the Global Steering Group level, but applying it to the Aotearoa New Zealand context will only be useful in a general sense. Again, comparing requirements to what is established in mainstream financial markets, the impact investment market will need to be supported by a relevant knowledge and evidence base. This should contribute to ensuring standards and practice at the transactional level, all the way through to informing policy and development strategies for the overarching market.
Following on from the previous two points in respect to the lack of technical expertise and evidence, it is no surprise that we have no deliberate or directly enabling policy for impact investment. There are policies, some discussed in relation to the areas of opportunities, that will support the prospects of impact investment activity (including the early regulation to support crowdfunding), but nothing that addresses the development of the market itself.
Examples of enabling policies in other jurisdictions include:
- The Social Investment Tax Credit in the UK, where citizens receive a credit for making a social investment in a way analogous to how New Zealanders receive a tax credit for making a charitable contribution.
- The establishment of Big Society Capital in the UK to provide wholesale finance to the market and also foster the overall development of an intermediary sector.
- The establish of B Corporations in the US to enable companies to hard-wire social purpose into their constitution and align capital and governance as a result.
- The Australian Treasury’s policy principles on impact investing, which includes funding support of AUD$30 million over 10 years, to guide the Government’s involvement in impact investment and create an enabling market environment.
With the upcoming ‘Well-being Budget’ to be implemented in 2019, it will be interesting to see whether the Government has the appetite, and indeed awareness, to build an aligned capital market. The proposition is innovative in its intent but the Government will also need to support innovation in the market to realise the full potential of private sector participation. While the establishment of the Green Investment Fund is evidence that Government understands the requirement for specialised capital on an issue basis, it is not obvious that the connection has been made between the Living Standards Framework and the enabling potential of an overarching impact investment market.
Ownership and leadership
While future activity in an established impact investment market will largely be driven by progressive businesses, hybrid organisations (i.e. social enterprise), and investors (of all types), the process of establishing a functioning market is beyond the capability of individual actors alone. Market building has always required intervention from the public sector, working with pioneering organisations who have the foresight and interest in seeing new ecosystems take shape, and it will be the same here.
Alongside the regulatory grunt, policy incentives, and resource that Government brings, the market also needs its own convening force and strategic direction. In the recently established IINABANZ, which is now formally a member of the Global Steering Group, we have the blueprint for this vehicle. But in order for it to perform a productive and effective role, not least mobilising the established but largely dormant Impact Investment Network, it needs resourcing and currently has no obvious financial model outside of government, philanthropic, and corporate sector support.
Put simply, if we want leadership to coordinate and grow the market, we will need to put our money where our mouth is, and invest in investing.
Big Society Capital and the role of impact investment wholesalers:
In 2012, Big Society Capital was established by the UK Government, partly by leveraging significant amounts of capital from dormant bank accounts, and became the world’s first impact investment wholesaler dedicated to providing specialised finance to the social sector and building the impact investing market. A wholesaler can play a pivotal role in scaling impact investment by building a market that extends far beyond their direct activity, particularly in the areas of awareness raising, capacity building, and developing strong intermediary structures. Wholesalers invest into funds and intermediaries, while drawing in investment from other organisations, such as institutional investors, catalyzing wider investment flows. They seek to supply and develop a broad impact investment market.
Big Society Capital and its co-investors have now made £1.25bn of impact capital available to date, with nearly £800 million taken up by over 1,000 social enterprises. In six years, Big Society Capital has boosted the availability of risk finance by six times, helped increase the number of intermediaries with over £50 million in assets under management from one to eight, and helped create Access – The Foundation for Social Investment to, among other things, lend small amounts at affordable rates to small social enterprises.
- There are a number of factors holding back the development of an impact investment market in Aotearoa New Zealand. These relate to constraints on both the demand and supply sides, and intermediation between them. They also include wider enabling factors such as data, capability development, policy, strategy, and governance.
- New markets require development support during their inception, and it is usual for governments to play a key role in building market infrastructure. In other jurisdictions, the establishment of an independent investment wholesaler, and also a market governance body, has had multiple benefits.