Impact investment: The case for early-stage investments

With impact investments expected to reach between $400 billion to $1 trillion over the next decade,1 those of us venturing into the field from an “impact first” perspective face a series of questions.

Among the most pressing:

  1. Should impact investors provide capital to back high-potential, early-stage solutions?
  2. Should we provide capital to back later stage, socially oriented companies?
  3. Should we focus on providing capital for sectors that will always need subsidies?

Guardrails: What tool when?

Why ask these questions? From the foundation’s perspective, they’re important because, across programs and geographies, we’ve begun to expand the range of financial tools we use to accomplish our mission. As we move forward, we need to establish clear guardrails that govern when, how and why we use a particular tool to accomplish particular goals.

From the perspective of the larger sector, such guardrails are important in helping to ensure that impact investing doesn’t casually drift away from the social side of its agenda.

In my last post I explained the foundation’s basic POV on impact investing. My next few posts will address the questions listed above. I’ll start with early-stage investments.

Should impact first investors provide capital to back high-potential, early-stage solutions?

Yes, definitely.  In early stages of innovation, commercial capital tends to be scarce. Low-income populations have little money, and their cash flow is irregular.  As a result, they’re usually ignored by market-based services and solutions. Helping to incubate innovations specifically designed to address these customers’ needs,  gives us the opportunity to demonstrate proof of concept (as well as the potential for profitability.) Just as importantly, taking an early seat at the table allows impact-first investors to help establish sector norms that adequately balance social and financial ROI—before commercial capital rushes in to take advantage of the new opportunity. Let’s look at how this dynamic played out in one sector.

Here’s how we see it: The tools are there. So are the opportunities. We owe it to our principals, and to the families and children we’re seeking to help, to step up and take on higher risks, and to shape markets in ways that others will not.

What we learned in urban microfinance

A decade ago, microfinance in India was purely a rural play. This wasn’t due to scale of need. Just like their rural counterparts, urban families had a clear need for access to formal financial tools. Commercial investors, however, were reluctant to back urban MFIs.  So, in late 2006, the foundation began working to open up an urban microfinance sector in India.

Our objective was explicit: We wanted to do more than help start a handful of institutions. We wanted to demonstrate that a sustainable, market-based model could effectively deliver microfinance to impoverished urban families. We believed that by taking early risks and showcasing the viability of microfinance in a new environment, we could catalyze other investors’ interest and kick start the sector. The end game? To open a new market that provided impoverished urban families’ with the baseline economic stability they needed to keep their kids in school and help them stay healthier.

Over the next three years, we invested in eight early-stage microfinance institutions (MFIs,) all focused on serving the urban poor. We saw signs of success: By 2009-10, urban microfinance was a recognized asset class . It had begun to attract high and sustained levels of interest, indicating that the market itself was ready to support growth of the sector.

Then, in October 2010, the Andhra Pradesh microfinance crisis hit. The industry as a whole received a shock. The crisis led to a number of reforms, innumerable articles, and substantial industry turmoil. It also reinforced the overarching responsibility that early-stage, impact-first investors have:  Establishing responsible norms for protecting customers who are both low income and highly vulnerable. (A subject more than worthy of its own series!)

Risks: Exploitation, lack of adoption, political interference, etc.

How can vulnerable clients be protected? It’s a question that we work to address every day.  In the case of microfinance, the foundation has supported important global and India-based efforts on responsible finance.  Just as important: Our early investments have allowed us to sit on the boards of urban microfinance investees, where we can directly influence norms and compliance – a mechanism whose importance is hard to overstate at the earliest stages of establishing new markets. In terms of industry standards for client protection, for instance, we ensure that our investees have the ability to conduct accurate credit checks to guard against over-indebtedness, that they’ve established adequate internal controls and procedures for client interactions, that they support client efforts to develop client awareness, etc.

Of course, the risks of kick starting markets through early-stage investment extend into areas far beyond concerns about client vulnerability. A partial run down:

  • Identifying social entrepreneurs who have the right combination of inventiveness and pragmatism (not to mention the ability to stay what will be a long and grueling course.)
  • Motivating adoption among target customers.
  • Navigating the high number of variables and unknowns that keep the risk levels high in any untested business model.

Even supposing that impact investors select investments that surmount those obstacles… even supposing that they manage to identify early-stage companies capable of showcasing unit economics and the promise of scalability… risks still abound. Among them: political interference, escalating costs and reduced margins, and competition from larger, established companies that see the potential of a new market segment.

So why take the plunge?

Rewards: Moving the needle in truly unprecedented ways

Because the goal of impact investment is to move the needle on social progress—and to do it in ways that are both scalable and replicable. Early-stage investments have the potential to foster truly breakthrough innovations that serve the poor: low-cost mobile banking applications, programs that link water and sanitation solutions with microfinance, low-cost emergency medical loans, effective educational data tools. The list of opportunities goes on.

Philanthropies have a unique and powerful role on this front. Social impact is in our DNA. It’s the sole reason we exist.  By taking a seat at the table early, we can, reduce inequalities in access, and define the ways in which these new sectors mature to ensure that, as they grow, they adequately prioritize and protect customer interests.  If commercial capital was willing to take these risks and responsibilities, philanthropies could avoid the messy world of market creation. But commercial capital rarely plays in this space, and even more rarely focuses on the social side of the equation.

Here’s how we see it: The tools are there. So are the opportunities. We owe it to our principals, and to the families and children we’re seeking to help, to step up and take on higher risks, and to shape markets in ways that others will not.

In the next post, I’ll look at impact investors’ roles in other scenarios–when companies are more mature, and when they’re neither high risk nor high reward.

This post is part of an occasional series on mission-related impact investing, and on its role as a tool for extending and accelerating social progress that directly benefits children and families living in urban poverty.

1 Impact Investments: An Emerging Asset Class published by J.P. Morgan Global Research as the result of collaboration between Social Finance at J.P. Morgan and The Rockefeller Foundation in partnership with Global Impact Investment Network.