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.

Efficiency at the Base of the Pyramid

Efficiency doesn’t come naturally to the Base of the Pyramid. Everyone needs to understand it. Someone needs to champion it. Our low income customers eventually benefit.

Let’s start by decoupling funding and operations. Operations are often treated like a black box – money goes in, and money (also let’s not forget social impact) comes out. Funding is often the focus – “Given my operating model, and my social mission and social impact, can you provide me with funding?” said the CFO to an impact investor – or even a grant funder. Some impact investors will turn around and say, “I think you need to tweak your operating model to become more efficient”. Time for the CFO to move on to the next investor or funder – according to one CFO in the sector, there’s a list of 300 investors they can approach, and basic funnel dynamics tell you that at least a handful can be converted, no matter what the underlying model looks like. Blame it on the ego of that particular impact investor – some of these conversations do tend to degenerate into pissing contests, and it takes incredible soft skills to manage some of the people in this otherwise well-meaning space. But it’s very easy for things get murky – and inefficient.

At a recent dinner conversation I heard the inside story of a ‘Social enterprise’ with USD 7 m in costs, and USD 500 k in revenues. It is a large and well respected organization, doing some terrific work and it has been around for 20 years. For each of these 20 years, costs have exceeded revenues by at least 4 times, and this gap has been plugged by grant funding. It sells an engineering product to deep rural customers. Deep rural distribution can be very costly, especially when it’s for a new innovative product, one which requires a large capital outlay on the part of the end user – not just soap, shampoo and SIM cards which are readily sold in standard mini bite sized chunks.

But the organization is engineering and technology centric, with a good, charismatic and well-connected fund raising team. They are able to excite grant funders year after year and keep the operating model going. The painful exercise of reviewing the operating model and bridging this enormous gap between costs and revenues requires an operations and business strategy centric ex-consultant (not that I am offering my services here) to come in, and make a few game changing changes. There has to be a lot of latent value which can be captured to bridge this gap – geographic footprint optimization, partnerships with other players e.g. MFIs (not that I am offering Juhudi’s support here), performance management systems, etc.

On this note – as an MFI we get many requests for partnerships. In fact we get so many, we are often a little under water. On a given day at least 2 people will walk into our offices and pitch their product or idea to us. On some days we get to do nothing but meet these social entrepreneurs and potential partners. They want both, access to our deep rural loan groups, and want us to administer the loans, which makes sense because as an MFI we have the systems and processes to do this very well. Many of these conversations have resulted in new products, some of which have been tremendously successful – a win-win for all.

But I often wonder why players try to over specialize in rural distribution at the base of the pyramid. It is just so inefficient – and emanates from an urban ‘complexity economics’ mindset, where greater complexity and specialization has been the key source of our collective expanding wealth.

In my view, sales and distribution across multiple players, products and functions has to be consolidated at the base of the pyramid, if we are to deliver efficiency to our low income customers. We have to learn to be good in two or three areas, if we want to realize our true potential. I like to use my cricket analogy. Traditionally, or even as recently as back in the 80s and 90s, a typical cricket player was either a good batsman or bowler or just a specialist a wicket-keeper. Fielding was never really considered a key skill until Jonty Rhodes from South Africa showed everyone in the late 90s just how much of a difference good fielding can make (and he could do nothing else but field). Over time the Aussies realized that if they could push every player to be good in at least two of these four disciplines, they could hold a very serious edge over any other team. They found many players, who were meeting these standards, and this set the new bar – they dominated cricket for the best part of a decade. Now every player in every good team, be it India, Sri Lanka, South Africa, England or even Pakistan has to meet this bar. Australia has finally been unseated – cricket has never been this exciting or competitive.

Similarly, we need to have organizations at the base of the pyramid which, for example, can both administer loans, and build rural value chains – often getting directly operationally involved in both areas. As social enterprises, we often don’t have a natural incentive to consider efficiency. But if we look at the for profit sector, there are plenty of examples of efficiency emerging naturally from the system. For example, it’s what the traditional seed and fertilizer input providers have realized holds enormous value. They have to go out and visit all these farmers anyway – why not finance their seed in addition to selling it to them as well?

Simple MFI is another beast. It’s an incredible innovation, and I am currently trying to catalyze its business development, so that the sector can benefit from it. It’s an Android smartphone application designed to transform Microfinance operations. Deployment of Simple MFI, along with a broader streamlining of systems and operations can shave 3 to 4 percentage points off the interest rate charged by MFIs to their clients – and at the same time reduce clutter, reporting errors, fraud, and other operational risks. Yet, it is a very hard sell. For some MFIs, it brings out too many legacy systems and operational issues – skeletons they would rather keep in their closets. For others, efficiency is just not a concern – especially when they are satisfied on the funding side, and the model is “sustainable”.  In fact “sustainability” is one of the most dangerous terms in social enterprise – I shall cover it in another blog post on another day.

In the meantime, I feel like a door to door salesman with my pitch pack and little IDEOS phone. I am sure it will take off eventually – buts lots of hard work is in store until then. And it was always going to be a challenge. Championing efficiency requires both leadership within an organization and also collaboration across organizations. I was recently reading a great, super insightful book by Antony Bugg-Levine and Jed Emerson, titled “Impact Investing”. According to the authors the social enterprise space is maturing, where the old charismatic cheerleaders are being replaced by people with hard and soft business skills, who will eventually bring things like efficiency to the sector. It adds a bit of clarity to the first part of my previous post on Social Enterprise and Impact Investment (http://mambojambosalama.blogspot.com/2011/09/on-social-enterprise-impact-investment.html). This is the start of the age of the less visible champions – but champions nevertheless. Keep championing.

On Social Enterprise & Impact Investment

Readers – Here’s my first, one hour, 1,000 word, blog post. I will be examining a couple of facets of social enterprise, based on two sets of separate yet insightful conversations with friends out here in Nairobi. Hope you also find them to be interesting and insightful.

Posture on social enterprise

Social enterprise or impact investment is hot. There are obviously those who disregard it as “hippy stuff”, but among those who are part of the industry, or deeply interested in it, broadly speaking, there are two extreme positions (with lots of ground in the middle of course):

i)                    Strong belief and passionate advocacy

ii)                   Skepticism with highly critical judgment

Jacqueline Novogratz, the CEO of Acumen Fund, is firmly in Category I. Someone like yours truly is closer to Category II, but believe it or not, not all the way to the extreme. Both sets of positions are valuable – both sets of players have a contribution to make to this space.

Acumen Fund has attracted millions (and in the future it shall probably attract billions) of dollars of capital into this space, and inspired thousands of man-hours of top end talent to contribute to this broad cause. Jacqueline Novogratz would not be able to achieve this if her speeches in, for example, a large Acumen investor event, positioned her somewhere in the middle.

For someone like me, it would be counterproductive, if not downright immature to show strong intellectual discourse in these forums, even though some sweeping statements on social enterprise cause me to instinctively and reflexively cringe. And many enterprises would not get valuable counsel; help, advice and support were it not for the critical thinking and push which truth telling individuals like myself try to drive across the organizations that we support and serve (in a politically and diplomatically effective manner of course).

So there are the “marketeers” or “cheer leaders”, and there are the “critical thinkers” or “part-curmudgeons”. Intrinsically, the former set values fairness as an end more than anything else whereas the later set values truth-telling as the means more than anything else (notwithstanding the other many strange characters in this space e.g. those who are completely blinded by the coolade, or those who are chronically contrarian). I say – pick a position and fulfill your role.

What defines a social enterprise?

There can be many definitions for social enterprise. I don’t think even any of the large and well established impact investment organizations working in this space have a crystal clear definition. It varies by the individual you speak to. Here are two possible and fairly common definitions:

i)                    Any enterprise which serves customers or works with suppliers at the base of the pyramid

ii)                   Any “sustainable” enterprise  which solves a well-defined social problem

“II” is the more classic social enterprise, the kinds of investments you would associate with the Acumens and GBFs of the world. It includes entities which solve “in your face” social problems, such as financial inclusion, healthcare, clean water, sanitation, clean energy, housing development, etc.

“I” includes everything from telcos, to FMCG distribution companies and FMCG procurement companies to even SMEs– in addition to some of the enterprises which solve “in your face” social problems. Let’s throw in Celtel, MTN, Coca-Cola, Unilever and Nestle, a few unknown SMEs, along with some microfinance organizations, or healthcare service providers. These organizations are all creating jobs, and/or providing goods and services which consumers at the base of the pyramid demand and value, thus impacting the lives of the poor.

The big buzz-term is social enterprise is “double bottom-line” i.e. profitability and social impact. “I” are by definition truly sustainable and subsidy free. But for “I”, even though profitability is clear, social impact is often very hard to measure and market to the rest of the world – thus not even considered. These organizations therefore, often slip through the radars of the Acumens and GBFs of the world, even though they do not always have easy access to finance. As some of my friends working in this space will tell you, many of them are SMEs with good truly sustainable business models, but which are unable to get the financing they require, and thus not able to scale up and succeed.

For “II” true profitability is often missing, but they do tend to be “sustainable” – funded through indirect subsidies. Because their social impact is well defined and easy to measure, these organizations are able to market themselves very well. They are thus able pull on a lot of low cost impact investment capital, an indirect subsidy, and are also able to attract many volunteers and below market rate top talent, also often a significant indirect subsidy.

It’s not that their business models are necessarily flawed or cannot be made truly sustainable, even though sometimes this is the case. But because marketing “in your face” impact is relatively easy, they are able to attract value and transfer it to their customers at the base of the pyramid – tangibly this translates to reaching more customers and/or being able to provide a lower price. As one friend in Nairobi, who is heading one of these enterprises once remarked, “We now have access to so much low cost capital; we don’t need to charge higher interest rates, even though our customers would probably still pay.”

I am not saying that it is a bad thing to transfer value to the base of the pyramid – often it makes a huge difference in people’s lives, and that too very subtly. Instead of giving them simple handouts which destroy dignity and create a culture of dependency, we provide them with what they perceive to be a market driven service, thus preserving their right to choice and their dignity. It’s a very powerful and ingenious route to charity. And let’s not even use a strong word like “charity” – it’s at least partially market driven, so let’s just call it a “value transfer”.

Those funding the subsidy, either through the opportunity cost of their time, or the true opportunity cost of their capital are providing a valuable and selfless service. But let’s recognize these subtle differences, so that we are truly aware of what we are doing and what we are not – who we are able to support, and who gets left out – and thus be able to better accomplish what we set out or strive to do.