The side-effects of Impact Investing – inevitable market complications!

Here’s a piece where I try to showcase “another side” of impact investing – a controversial and less frequently discussed side, where Impact Investing does a fair bit of harm to markets, in the process of correcting market failure.

After 4 years in management consulting, and before going to business school, I chose to invest a full year of my professional life in the Impact Investing or Social Enterprise space. To be completely honest, I was seeking new adventures. But the most important reason for this was the possibility to pursue a different career direction, with the ultimate aim of finding a better path to reach my longer-term goals (which are “social” in nature). But part of me also wanted to understand whether this space is real. Not real in the sense of whether it exists – clearly this space is huge and here to stay, but rather whether it will actually create the impact it claims to be creating, namely the potential to drag millions if not billions out of poverty – in other words, the potential to “Save the world”. Part of me was always going to be a little skeptical – even if it does to some extent, start to “Save the world”, what are some of the side-effects? I wanted to see for myself, and understand first hand.

This Impact Investing or Social Enterprise space is absolutely humungous now. Between 25% and 50% of my business school classmates are showing some interest in it – many of them will fill the talent gap in this space, and will likely take huge pay cuts for “the greater social good”. There are hundreds of funds now and billions and billions of dollars to invest in this space. At the recent SOCAP Conference in San Francisco this momentum was present in full force. There was much fanfare on display, and plenty of coolade available for those who chose to indulge. At the same time there were also many serious questions raised – Will our small ticket-size fund economics ever be financially sustainable?; Can we ever measure the second bottom line using a standardized methodology that minimizes the potential for manipulation?; Why is there still such a massive talent gap in this space, and what can we do to address it?; Why do we have billions of dollars to invest, but still so many social entrepreneurs complaining about lack of capital? The list of serious fundamental questions is very long, and the dozens of conferences which now take place around the world do not seem to provide sufficient time or space to address them all.

And these are all good questions – but here’s a set of even more fundamental questions which I have been asking, which are almost never raised. In our quest to be market driven, are we doing damage to the very markets we are trying to create? How much of what we are doing is good, and how much is harmful? Can we ever figure out where to draw the line? Do we even have the right structural incentives to draw the lines in the right places, or will we likely get carried away? And why don’t we openly acknowledge these harmful side-effects or distortions? Why can’t there be a healthy debate or discussion on them?

I recently visited a microfinance institution in Kenya, one which has successfully raised and deployed capital from impact investors to reach strong profitability. Now, let’s be very honest and clear here – the capital this institution raised from impact investors is at least 10 percentage points cheaper than the capital it would be able to raise through the markets, either by building a deposit taking capability, or borrowing from local banks. In essence, the impact investors are providing this institution with a 10 percentage point subsidy – presumably, in order to help it get on its feet. Even though it was in the red last year, its most recent financial results show a 4 percent return on assets, a level which many banks would kill to reach (of course no one is willing to subsidize pure commercial banks, even though the likes of Equity Bank have positioned themselves as social enterprises, and received cheap capital in return). So if the impact investors were to leave tomorrow, this institution would be 6 percent of assets in the red.

Clearly philanthropy is supporting this institution – but in this case there’s a tension between philanthropy and market-driven profit which seems to be creating an interesting situation, especially with all the unique objectives and incentives of each of the players involved. So while this institution has reached 4 percent return on assets, the impact investors do not want it to become too profitable. In fact, they have declared an acceptable range of return on assets, which is between 2 percent and 5 percent. In other words, while they do not want to see this institution make a loss, or even a very low profit, they do not want to see their subsidized capital generate what some might deem to be an excessive profit. They have capped profit at 5% return on assets.

Even though it has already reached 4 percent, the institution still has plenty of room to further improve its return on assets. As it continues to grow and build scale, fixed overhead or head office costs will be spread over ever larger field operations. Also, there is potential to make field operations more profitable at the unit level by focusing on the operating level drivers of efficiency or the basic nuts and bolts of a loan officers day e.g. optimal geographic zoning, efficient route planning, providing more efficient transportation through motorbikes, etc.

So what will happen next? If the subsidy is withdrawn, i.e. if the impact investors exit, the institution will drop to 6 percent of assets in the red. But I would argue that the Impact Investors do not really want to exit – they certainly don’t want to see this institution fail. In fact, they want to continue to see this institution grow, and would like to showcase it as a successful example of their investments (in whichever way they might measure or demonstrate this). So they will not exit in the foreseeable future.

So, then! What does the management team do?! They could continue to rapidly build scale and become more efficient. But will they want to do this? I hate to be a cynic, but there are easier ways for them to spend their working days, and this highly profitable subsidy cushion will diminish the need for them to focus on accelerating growth or achieving greater efficiency. They could reduce the interest rate at which they lend to clients. This could be a reasonable way to pass on the subsidy from the philanthropists to the end beneficiaries. But the interest rate which the institution charges to end users is already at the lower end of the broader market, so this “distortion” is likely to make the lives of all the other “market” players more difficult. Alternatively or in addition to this, they could invest their excess earnings in buying top quality expensive equipment, deploying top-notch technology, hiring expensive people, etc. or in other words bloating their operating costs in order to keep net returns low. I suspect that they will do a combination of all the things mentioned in this paragraph – none of which should be done in a more perfect world.

In a more perfect world, I would love to step in and take an equity and management stake in this company and make it as efficient as possible. I am one of those people who can be incentivized by financial upside, and would like to use my strategic inclination and managerial ability to create and capture some of the upside potential. I would strongly argue that efficiency ultimately lowers costs at an aggregated societal level, and creates the greatest possible greater good. When companies operate efficiently, their end users benefit through lower prices and lower costs. Efficiency wakes up the competition and forces them to spend their days and nights also worrying about how to be efficient or innovative. Ultimately, everyone wins. But the objectives, incentives and decision levers here are so misaligned, that there could be no real role for me or the current management team to play, other than that of a bureaucratic fat-cat.

In business school, we celebrate disruptive players like Wal-Mart, Capital One, Jet Blue and Amazon by reading about and discussing their success stories in class. Profit in the market driven sense is a great motivator – for one thing it is easy to measure – unambiguous, and not distorted by subsidies. And when these players push out the cost quality frontier, we celebrate them, because they ultimately do us all a great service. The make the economic system more efficient, and increase our collective wealth.

But I have shown you a real example in the Impact Investing space where we hit a dead-end. Whenever there is philanthropy involved, outcomes are likely to be sub-optimal relative to the market. The whole mantra of markets and philanthropy co-existing ignores the fundamental tensions or side-effects this can create. We often like to assume away problems and trade-offs – it is human nature to do so. It shouldn’t be surprising that most of us are currently doing so in the Impact Investing space.

You might turn around and tell me that I have only provided you with one somewhat peculiar example, or for the more statistically inclined, only one data point. It’s a rare company in this space, which is both profitable and pricing at the lower end of the market. Some might turn around and argue that the Impact Investors should have never capped profit at 5%. Another frequent response which I hear is that it all depends on the “people” and how they manage each particular situation – I do believe that good people can make a big difference, but I would also strongly argue that it is more often much more than people. It is the structural dynamics, incentives and broader norms which determine what happens.

So how about another example, which is more simple and begins to show a generalizable trend or pattern across this space? A family run hybrid maize seed company received an investment from an Impact Investor. This institution pitched itself as a social enterprise, because it works with small-holder farmers helping them boost their crop yield, and also operates in a market where the biggest player is a state owned giant, exercising significant market power. So the family run hybrid maize company gets a subsidy from the impact investor to improve farmers’ lives and take on the state owned monopoly. It is a profitable, for-profit business both with and without the subsidy.

A multi-national seed company, with presence in dozens of markets, expertise in hybrid maize seed production, and a very serious understanding of distribution to base of the pyramid considers entering this market. But it decides not to enter. It will never be able to obtain subsidized impact investment capital, because it is highly profitable in virtually every market that it operates in – in fact, many consider its giant market-driven profiteering ways to be the evil force that fleeces farmers. The subsidy or market distortion created by the Impact Investor to support the family run player, makes the long-term ability of the multi-national to compete on a level playing field uncertain, to the detriment of efficiency in the overall market. Real example!

I have so many Social Investor and Entrepreneur friends, who on the one hand benefit from some of the many forms of subsidies easily available across this space. They access them both directly and indirectly – straight grants; below market rate capital; grant funded technical assistance provided by third party service providers; volunteers coming in and supporting the organization; etc. So while they receive all these benefits, they start complaining any time one of their existing or potential competitors receives a subsidy. And most of them claim to be “market driven” – does anyone else see the contradictions? And can you imagine the uncertainty that a real market-driven potential investor has to live with? Are we not inducing real long-term market failure in this space?

I have described what is happening, but ultimately want to understand why it is happening. There are no clear answers, so I will end with a series of open questions:

Why is this problem not acknowledged and openly discussed in any of our many industry conferences? Do we have a blind spot? Is it too complicated, and requires an understanding of the economics on the ground, which only folks like me who have been there and seen it can bring? (There is a serious criticism which has frequently been written about in industry publications like the Stanford Social Innovation Review, that most of those who attend these conferences have not spent any real time on the ground, and thus do not understand what is really happening). Do we lack the right incentives to bring these problems up? Are we afraid to be really critical, especially when matters are really complicated? Do other people in this space see this problem, and become disillusioned by it? Are they not being listened to? Do they exit back into the real for-profit world and never speak up? Do the ends justify the means, so we cover up or choose to ignore many of our issues and even our detractors?

Or is this just too fundamental a critique of this space and thus makes everyone really uncomfortable? After all, who could possibly imagine that players which are correcting market failure are actually the ones perpetuating it, albeit in different ways.