In my last few posts, I raised a series of questions about the role of impact capital in three specific scenarios: early-stage, high-risk investments; more mature companies; and organizations that will likely need ongoing concessional support.
In the first two scenarios, capital from impact investing primarily acts as a catalyst to commercial capital. For instance, it helps to showcase the viability and sustainability of new business models and products; it drives existing enterprises toward improved services, penetration into new geographies or providing services to new clientele; and it drives some profit margin.
Organizations that can cover their costs but that are unlikely to generate commercially attractive returns represent a different opportunity. For such organizations, mainstream capital will likely remain out of reach. But I’d argue that impact capital, which is meant to generate not just financial returns but social impact, has a vital role. Let me explain.
Lower margins, significant social value
Some sectors might never deliver returns that meet commercial investors’ expectations. Products and services that meet basic needs of the underserved, for instance, typically imply lower margins and higher costs of delivery. Two examples:
- Providing high quality education to first-generation learners and ensuring that they achieve certain learning levels likely costs more than offering the same services and outcomes to children of well-educated parents. The reason for the cost difference is simple: First-generation learners often have to overcome a more significant learning deficit than the children of better educated parents.
- Similarly, providing water and sanitation services to urban slums is more expensive than providing the same services in middle income neighborhoods. Again, the reason is straightforward: Urban slums lack basic water and sanitation infrastructure, while middle class neighborhoods are connected to city networks.
Most organizations working in these spaces try and mitigate these higher costs of servicing lower income populations through unique pricing structures, cross subsidization and/or much larger volumes. However, there will always be cases where it’s nearly impossible to recover full costs and generate attractive returns.
The takeaway for the impact investment community is simple: We should actively support sustainable, high-impact ventures, even if they don’t offer the promise of financial returns that are high enough to attract commercial capital.
Loans? Or grants?
Should we rule out the option of deploying investments in such cases, and simply resort to grant dollars? I’d make the case that, in these and other instances, impact capital (concessional loans, equity or guarantees) is often the right answer. Why? Because the impact investment community isn’t just after maximum profits. We’re after scalable solutions to long-standing social problems. Loans aren’t appropriate for every philanthropy-supported endeavor. But in some cases, they may be a far better fit than grants. And given that their availability far outstrips that of philanthropic dollars, they’re a tool we should use.
Let’s look at two additional examples that illustrate the role that loans can play.
- NGOs often undertake projects or act as service providers for the government. They’re necessarily dependent on government for recovery of costs. However, such payments often entail a time lag. Meanwhile, the NGOs, which need access to working capital to continue their operations, may be forced to take out loans. Depending on government policies regarding the cost of reimbursements, etc., the NGOs may or may not have the ability to bear the costs of market-relevant interest rates on working capital. In such cases, concessional working capital lines from impact investors are a much better option than grants. Such loans allow the NGO to establish a credit history and expose it to the more rigorous financial discipline of dealing with lenders versus donors.
- In most developing economies, healthcare facilities and hospitals that serve poor clients can charge clients for simple procedures and consultations, and recover costs. But much-needed treatments that are more complex (for instance, surgeries) are more expensive. Should hospitals refuse to treat such clients? Or to provide them with such services? Or can we design a structure whereby we provide hospitals with concessional capital to support more costly treatments for the poor?
I’d argue that these two examples – along with the education, and water and sanitation examples above – are among the scenarios where impact capital can and should play a role. Why?
- Because all are sustainable ventures. Neither NGOs nor the hospitals described above are likely to ever offer commercially viable returns, but in all likelihood they can cover their costs. By contrast, companies that provide education to impoverished clients, as well as those that provide water and sanitation services, may be commercially viable, but are unlikely to ever be high margin.
- Because a track record of payment allows these organizations to further shore up their sustainability and ability to scale, since organizations that effectively establish a credit history are then better positioned to tap loan funds from conventional sources.
Impact investing is about more than substantial financial returns
The takeaway for the impact investment community is simple: We should actively support sustainable, high-impact ventures, even if they don’t offer the promise of financial returns that are high enough to attract commercial capital. That’s a key part of our mandate as impact investors.
Don’t mistake me: I am not by any means saying financial returns are bad. (Read the whole series for more insight on my view of how we should balance financial and social returns.) I’m only saying that they are not the whole goal of impact capital. I’m reiterating that if we want to build scalable ventures that address the needs of the underserved, we need both forms of impact capital. Impact investors should continue to push the frontiers of cost reduction, better quality, target segment, etc. We have the mandate and the flexibility to put our funds to work in a variety of ways. After all, we are not profit-maximizing investors; we are impact-maximizing investors. Let’s be true to that goal!
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.