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Tuesday, March 1, 2011

MethodLogical

MethodLogical


Social Impact Investing and Equity

Posted: 28 Feb 2011 05:07 AM PST

If you haven’t read Pam’s recent post on investing in income derivative streams of first graders, you should.  Personally, I’m not sure it’s ethical to allow minors (or even their parents) to commit future income streams (which are, at some level, equity derivatives).  But the post, and new models like Lumni, highlight equity as an investment form that I think deserves considerably more attention.

To get a bit finance-y (and way oversimplified), senior debt sits at the top of the capital structure and takes losses last.  It generally gets paid an interest rate untied to the business’s net income and is considered one of the safer investments.  Less risk, less reward, less downside.  Equity, in contrast, sits at the bottom of the capital structure and absorbs losses first.  If the business does well, though, profits are owned by equity investors (shareholders).

Most impact investment that I have seen to date is in the form of senior debt provided to social enterprises in Africa and South Asia.  Equity, when invested, seems to be offered in lower-risk social businesses and as a reinforcement to existing capital rather than seed funding.  For the impact investment world to truly get serious about the “impact” part, a whole lot more of the “investment” part needs to be in the form of common shares.

Why?

  1. Human capital for social businesses beyond the top manager level is weak and many social enterprises need to invest in and grow their employees.  To take this long view, they need to know that funding is available over the long term and that larger upfront losses can be absorbed by a larger equity cushion.
  2. Not all social entrepreneurs can bring their own equity to social businesses and it’s not desirable that they do.  First, lots of smart developing world entrepreneurs don’t have internal funds and come from poorer backgrounds.  There are ways to align incentives without requiring that entrepreneurs put in significant amounts of their own money into an enterprise.  Second, we castigate top managers when they make big profits “off the poor” but then also make them take all the risk via investing equity.  Good governance practices can be learned but there is a case for funds to assist with and systematize this, and use profits from investments for future social investment or social benefit, rather than forcing all entrepreneurs to learn this in the early stages of a startup
  3. Placing equity investments make investors much more bought into the long-term success of a business.  As a result, they are more involved in improving governance, establishing effective oversight and reporting systems, and more likely to bring in collaborators that enhance long-term value.
  4. I suspect, but from a relatively uneducated perspective, that banks would be willing to provide senior debt to social enterprises with good governance and strong equity bases.

Part of impact investing, in my opinion, is valuing social impact as a return and thus be willing to take on more risk without compensating higher returns (if this wasn’t true, commercial investors would go in; I simply don’t buy the argument that commercial investors are too scared of social enterprises to make good investment decisions at this point in time, it might have been true in the past).  This can be in the form of discounted interest rates on senior debt.  But I think it would be more effective in “overpaying” for shares on the equity side of the balance sheet and in taking real bets on social entrepeneurs who can change the future.

Anybody got the funds to help me start a venture capital fund for social businesses?