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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
Apply a rigorous investment process and integrate social impact analyses to successfully select and invest in social impact investments Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis is a must-read guide for investors and wealth managers entering the social finance investment space known as "impact investing." This book walks readers through the demanding task of properly executing an impact investment strategy, providing solutions to some of the most vexing challenges that arise when investing for both financial return and social impact. Readers will learn how impact investing is different from other strategies, how the organization's mission affects investment decisions and structures, and what to look for in an organization prior to investing. A running example of a village distribution company illustrates the methods and concepts in action, and a full-fledged case study utilizing downloadable professional level analytical tools consolidates all examples into a real-world setting. Impact investing is generating significant momentum, but many individuals operating in this space come from alternative backgrounds and lack the knowledge to form a rigorous investment process. Disparate funding sources, immature markets, variations in fund economics, and the need to generate and report social impact all complicate the industry even further, creating a barrier for curious investors. This book is a guide to applying standard investment processes and social impact analyses to impact investing, helping readers: * Adjust standard analysis techniques to suit the particularities of impact investing * Discover how social mission influences the entire investment from entry to exit * Plan and execute a robust custom impact investment strategy * Understand social impact entities and the management of impact investments Investing with the goal of social impact doesn't remove the need for rigorous investment techniques and diligent processes. Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis is a guide to putting it all together, for a more targeted approach to impact investing.
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Seitenzahl: 513
Veröffentlichungsjahr: 2015
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Table of Contents
Title Page
Copyright
Preface
Acknowledgments
Chapter 1: Introduction to Impact Investing
What Is an Impact Investment?
Who Makes Impact Investments?
How This Book Is Designed
Notes from the Field
What This Book Is Not
Setting Forth
Chapter 2: Sourcing and Screening
Sourcing Strategy
Geographic Analysis
Country Economic Analysis
Beyond Geography and Economics
Sourcing for Impact
Screening Process
A Look at Three Potential Investments
Moving Forward with an Investment
Concluding Thoughts on Sourcing and Screening
Chapter 3: Investment Analysis and Valuation
Information Exchange
Solero Bottom-Up Analysis
The Solero Projection Model
Valuation Multiples
Desktop Due Diligence: Social Impact Mapping
Continuing the Investment Process
Chapter 4: Due Diligence and Investment Structuring
Due Diligence
Utilizing Due Diligence Information
Liquidation Preferences
Creating an Investor Base and Downside Case
Bridging Potential Valuation Gaps with Convertible Debt Structures
Agreeing to Terms
Chapter 5: The Term Sheet and Definitive Documentation
The Term Sheet
Anti-Dilution
Definitive Documentation: The Subscription Agreement
Definitive Documentation: The Shareholders' Agreement
Finalizing the Investment
Chapter 6: Post-Investment Monitoring, Management, and Value Building
Reporting and Monitoring
Common Reporting Metrics
Solero's Example Impact Reporting Framework
Post-Investment Case Studies
Methods of Exit
The End of the Investment Process
Chapter 7: Impact Investing Funds
Private Equity or Venture Capital?
The Basic Construct of a Private Equity Fund
The Economics of a Private Equity Fund
Key Considerations in Fund Economics
The Differences between Traditional Funds and Impact Investing Funds
Benchmarking
Concluding Thoughts on Impact Investing Funds
Chapter 8: Investment Alternatives, Challenges, and Outlook
Investment Alternatives
Impact Investing Challenges
Impact Investing Outlook
About the Companion Website
About the Authors
Index
End User License Agreement
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Guide
Cover
Table of Contents
preface
Begin Reading
List of Illustrations
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List of Tables
Table 2.1
Table 2.2
Table 7.1
Table 7.3
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Impact Investment
A Practical Guide to Investment Process and Social Impact Analysis + Website
KEITH ALLMAN
XIMENA ESCOBAR DE NOGALES
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Cover design: Wiley
Copyright © 2015 by Keith Allman and Ximena Escobar de Nogales. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
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Preface
Lebanon is a beautiful country, with picture-perfect coastlines, lively cities, and, unfortunately, abject poverty in many regions. It was there, in Beirut, that my venture into impact investing began. I was conducting a pro-bono workshop on credit risk, for local microfinance analysts that were supported by the charity Relief International. On the Israeli border towns I took my first onsite visits to clients who received loans and observed how they utilized the funding to operate and expand their businesses. I was truly impressed with the effect the funding had, as I was able to see real businesses in expansion.
At that time in my career, I had just left banking at Citigroup and was still primarily engaged in private-sector finance. I thought critically about that trip, though, and questioned whether I should make impact investing my full-time effort. I hesitated because of prior experience with nonprofit entities that operated very inefficiently. I also struggled with finding clarity on whether my experience and skill set were best utilized in existing impact investing organizations. For years, I maintained my private-sector focus, but furthered my work with Relief International, consulting on microfinance capital market's issuances, and eventually joining its board of directors.
I persisted with traditional finance and combined my prior securitization experience with early-stage company analysis to work on venture debt transactions. As I learned more about venture company drivers and private equity fund operations, I couldn't get the thought of impact investing out of my head. And as fate would have it, right around that time a former Citigroup colleague informed me about a new private equity fund that had spun off of a large commercial microfinance debt investor. The Oasis Fund, managed by Bamboo Finance, was created to invest for profit, in early-stage, private companies that also had significant social impact. When I researched its investment criteria and the impact it sought, I was enthralled.
I decided then that I would give impact investing my full attention and moved to Switzerland to work for the Oasis Fund, where I became an investment manager tasked with sourcing, structuring, and managing for-profit, impact investments. My first year at the fund was mainly getting oriented with the fund's existing investments and simultaneously building my network for new investment opportunities. I also started learning more on topics foreign to me, such as what defines social impact and how to source investments within a social criteria.
By my second year, I had become heavily integrated into the impact investing industry. I was in the field every few weeks, combining trips to work with the Oasis Fund's portfolio companies, meeting with new companies for potential investment, and conducting due diligences for companies that had progressed through the investment process. I regularly attended and sometimes hosted industry events such as general and sector-specific conferences, dinners, and talks. The second year culminated with successfully sourcing and closing two investments for the Oasis Fund and joining the board of directors for two of its existing portfolio companies.
In what would be my final year with the Oasis Fund, I was promoted to senior investment manager and started working on new fund strategy and fundraising. Those tasks and responsibilities provided a more encompassing perspective on the industry. However, over the course of that last year, I encountered undercurrents of problems that I felt were systemic in nature. Difficulty sourcing investments that met most investors' social criteria was a theme that echoed across my peers. This led to very competitive situations where some nontraditional investors took approaches that lacked rigor and led to inflated valuations. With costs of capital near zero for these entities, the problems could be sustained, but ultimately, it was no longer commercial investing at that point, but a charitable intermediary.
There is efficacy in the models in between commercial investing and pure charity, but the scale is restricted by the sources of capital. Unlocking consistent sources of capital from pension funds, insurance companies, and traditional investors requires a meticulously designed investment thesis that is executed professionally, from sourcing to exit, and provides reliable, measurable financial and social returns. I believe that in order to build the desired volumes for a replicable, scalable investment model, there will have to be different social criteria for varying financial return expectations.
Creating investment portfolios that deliver such financial returns and demonstrate that a specific social impact has been generated is what will define entities in impact investing. This is why the brunt of this book and the electronic files accompanying it focus on the investment process and social impact measurement. There are many publications available that have striking images of rural villagers using innovative technologies and compelling stories of impact-oriented companies, but these are largely motivational and show basic causality. It's the day-to-day tasks of impact investors—which involve accounting, corporate finance, valuation, statistical measurement, and social metric analysis—that are the most difficult, but the most important.
Although I left impact investing as a full-time endeavor because of some of these issues, I remain committed through select investments in solar and energy efficiency that my current position allows for and pro-bono work with impact investing entities. I anticipate a full-time return at some point. In the interim, I can offer this book that tries to address proper investment execution and social impact measurement. As with any of my books, I stand behind the learning process and offer my email directly if you have questions: [email protected].
Keith A. Allman
New York 2014
I have had the privilege of walking the narrow streets of Mumbai slums and speaking with micro-entrepreneur women whose endurance and creativity merit recognition and respect. I have also heard businesspeople in luxurious offices in Geneva argue that it is not possible to build an ethical gold supply chain. Impact investing builds a bridge between apparently disconnected realities. Impact investing is the promise of channeling private capital to solve intractable social problems while delivering impact, inclusion, and sustainability.
But, is impact investing delivering on its promise? Keith Allman's kind invitation to be a contributing author of this book sparked a desire to share the lessons learned by Bamboo Finance on the importance of adding rigor and accountability in defining, measuring, and assessing impact. Even if we are only at the beginning of the learning journey, we follow from due diligence to exit a responsible investment process aimed at delivering impact.
The impact promise begs for more accountability. Too much money has been deployed with little analysis on effectiveness. Impact investing marries the rigor of the industry of investing with the (nascent) rigor of impact measurement. If impact investing wishes to deserve its name, it needs to be evidence-based investing. Building evidence on what works and what doesn't requires a collective effort. The broader the participation is, the richer the learning will be. The voices of customers at the base of the pyramid, on whose behalf we too often speak, are central to our learning. Also, the entrepreneurs, investors, and academia need to join the conversation. This book seeks to contribute to that learning. I am grateful for the opportunity and excited to read your reactions. [email protected]
Ximena Escobar de Nogales
Geneva 2014
A NOTE ABOUT THE WEBSITE
Readers will find professional-level investment material on this book's website: www.wiley.com/go/impactinvestment. See the appendix for more details.
Acknowledgments
While impact investing demands a large body of financial knowledge, it would simply be traditional investing without the social impact analysis. I'm thankful that Ximena joined this project to provide her expertise in social impact and be the counterweight that allows this book to cover the full spectrum of challenges and solutions for impact investment.
Also, while I identify the inception of my work in impact investing many years ago through Relief International, it was my work with Bamboo Finance that accelerated my understanding of direct investments and industry-wide issues. I'm thankful for all of the collaboration, discussion, and engagement with Jean-Philippe de Schrevel, Christian Schattenmann, Eric Berkowitz, Keely Stevenson, Natalia Mouhape, Florian Ulmer, Ana Maria Aristizabal, Marlene Mueller, Elvira Espejo, Anu Valli, and Geetali Kumar.
Finally, it's been three years since I've worked with the team at John Wiley and Sons and I still can't thank them enough for the opportunity to publish on their platform and work with their talented staff. In particular, Bill Falloon has worked with me throughout the years and is a great sounding board for ideas and bringing a concept to reality. I'm also very thankful of the work Meg Freeborn, Helen Cho, Maria Sunny, and the rest of the Wiley team completed.
Keith A. Allman
New York 2014
Many people have contributed to the learnings and insights on impact management shared in this book. I am particularly grateful to the individuals whom this industry seeks to serve. In a quest to better understand their needs, we often intrude in their lives. They generously allow us in, even when our “studies” do not always result in gains for them. Thanks also to our investee companies who help us seek evidence of what products and distribution models deliver the expected impact.
Much of my learnings on impact investing come from over four years at Bamboo Finance, and I am most grateful to Jean Philippe de Schrevel, whose tenacious belief in the power of private capital to solve intractable social problems inspires many of us in this industry. I am also thankful to my colleagues at Bamboo Finance and in particular to Sarah Djari, Ana Maria Aristizabal, and Anu Valli for many hours of engaged discussions on identifying, measuring and expanding impact, and to Tracy Barba, for helping us articulate our achievements and challenges.
I have also benefited from the insights of industry-wide social performance and impact management initiatives, specifically the Global Impact Investing Rating System (GIIRs), the Social Performance Task Force (SPTF), and the European Venture Philanthropy Association (EVPA). Many thanks to Neha Kumar, Olivia Muiru, Flory Wilson, Emmanuelle Javoy, Kelly McCarthy, Laura Foose and Lisa Hehenberger. On a more personal note, I would like to thank my daughter Camille for ongoing stimulation.
My greatest gratitude is to Keith Allman for having invited me to contribute to this book.
Ximena Escobar de Nogales
Geneva 2014
Chapter 1Introduction to Impact Investing
It is an extremely tempting proposition: Invest money in a business whose product or service offers financial return and at the same time generates positive social impact. All parties seem to win, with an investor making a return and society benefiting. A charity could direct money into an organization that accomplishes the same social mission as one it grants to, but instead is able to receive back and reinvest the granted funds. What could hinder such a paradigm?
This idealistic form of capitalism has surged in the last few years. As of 2014, over USD12.7 billion has been committed to impact investing, representing a growth of 19 percent from the prior year.1 Numerous investors are active ranging from lone high net worth individuals to a multitude of private equity funds. Even larger-scale financial institutions and investment firms have dedicated funds and resources to impact investing. Ancillary services have emerged to support these investors and further develop the industry including secondary market platforms, capital advisers who specialize in impact investments, and services to validate and rate social performance.
With such fervor, why does it still seem like the impact investing market is constrained? The simple answer is that it is not easy to both create a profitable business that has a significant social impact and also scale that business so that it generates commercial returns for investors and continues to progress its social mission. It comes as no shock, then, that for a number of years in a row, J.P. Morgan's impact investing survey cites “a shortage of high quality investment opportunities with track records” and a “lack of appropriate capital across the risk/return spectrum” as primary hindrances to the growth of impact investing.2
Part of the issue is that impact investing appeals to our senses and consciences through innovative solutions to pressing social problems. This thought should not be misinterpreted though, as many of the entities and businesses an investor encounters when reviewing social enterprises legitimately intend to or are actively creating significant positive social value. The problem is that a majority of these businesses are not commercially viable and will not generate the return that many investors require. Our morality wants to support these investments, so the industry has grown considerably to encourage social enterprises, but as investors, we must maintain a fiduciary responsibility and invest at the appropriate risk-return level.
However, as we seek to increase the scope of suitable investments, we run the risk of going over an inflexion point, where social impact has been compromised so much that the investment can no longer be considered an impact investment. This can either occur by investing in businesses that actually do not have significant social impact or by investing in a social enterprise that alters itself to become a traditional company. At that point, we have become traditional investors and the paradigm is lost.
We now find ourselves in a delicate situation, balancing financial viability, monetary return expectations, and social impact. How do we achieve the correct balance? As with most industries, the solution is basically hard work and being equipped with the right resources and knowledge. We must know how to look for the right investments and how to screen out ones that are not financially sustainable or demonstrating the right level of social impact. Once found, we must adhere to a rigorous investment process and vet a company to establish its financial and social value. The investment structures created need to properly balance risk and reward. Documentation needs to be done professionally to accurately reflect the structure created and the intentions of all parties. We have to endure far beyond the investment phase, helping businesses scale and exit positions with financial and social success.
It is easy to discuss the beneficial attributes of impact investing and package it in a way that sells a good story. The hard work is in proper investment execution. To get there, this book addresses the following:
Knowing how to source deals domestically and internationally, while mitigating foreign exchange and business cycle risk
Properly mapping out the social impact of a company and the metrics that prove it
Being able to understand, build, and utilize multi-method valuations
Drafting a term sheet that takes into consideration commercial and social mission risk
Monitoring and managing an investment to ensure financial and social returns
Understanding the economics and realities of leveraging other people's money in impact investment funds
Although a shortage of quality investments vis-à-vis investors exists and will most likely be commonplace with the high degree of interest in impact investing, excellent investments can be found that marry profitability and social impact. This book and the online resources that accompany it will assist investors in choosing the right investments, help align risk and reward, and contribute toward investors building financial and social value.
What Is an Impact Investment?
An impact investment can take many forms, but all share the idea that capital can be deployed into an entity making a good or providing a service that offers positive social impact, while also generating some level of financial return. The Global Impact Investing Network (GIIN), one of the major impact investing industry organizations, defines impact investments as “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.”3 Critical to this definition is the intentionality of the investor to deliver on financial and social returns.
The form of investment can be as straightforward as investing money for shares of equity in a company or much more complicated, such as a convertible debt structure. Core investment funds may not even have to be exchanged, as in the case of credit guarantees. The unifying thought, though, is that an investor is committing capital to a commercial business, which aims to compensate the investor for his or her investment.
Geographically, impact investments can be made anywhere. Impact investments exist in emerging or developed markets, as long as the focus remains on coupling social or environmental impacts with financial returns. Although examples in developed markets are less common, programs such as investment funds that target small businesses in East London could be considered impact investments.
With all of these options, the two primary forms of investment into social enterprises are debt and equity, mostly in emerging markets. Much of the recent enthusiasm over impact investing has been targeted at investments in social enterprises. These are companies that are for-profit, but have created a good or service that provides significant social impact. Given their early stage and venture nature, the more typical form of investment in these companies is equity. Debt does come into play in impact investing, particularly with new debt funds creating specialized products, but equity is still the predominant force in early stage social enterprises.
Debt is also relevant for impact investing when we consider microfinance, which is a specialized sector of impact investing. Microfinance involves lending small amounts of money to individuals or groups of individuals, who then use that money to fund their own businesses. The borrowers agree to pay back the loan, plus interest. Microfinance institutions, which provide the direct borrower funding and collection services, have grown over the years and are recipients of debt and equity investments themselves. All of these would be considered a type of impact investment.
For the most part, what has been described so far are investments. An investor provides capital and expects return. The key differentiator for impact investing is the impact. We will work to define impact later in this chapter, but an impact investment differs from a traditional investment in that the core business product or service provides a positive social impact. A healthcare company that provides high-quality, affordable tiered services for low- to middle-income patients, for profit, would most likely qualify as an impact investment. A healthcare company that builds clinics for wealthy clients and donates 1 percent of profits to charity would most likely not be considered an impact investment. The social impact has to be engrained in the business operations, product, or service.
A specific feature of impact investing is the investor's engagement to measure and report on social and environmental performance and impact. Impact investments should aim to be evidence-based investments. This means the industry needs to build data on the type of interventions that have a positive development impact. Impact investors need to examine and share learnings on the combination of products and services, the type of designs, the pricing and distribution models, and the accompanying services that will result in positive societal impact on the targeted population. Obvious as it is, it may be worth reiterating: Without evidence, we will not make evidence-based investments. In this book, we go through the challenges of defining adequate impact models, identifying appropriate indicators to track, and monitoring and analyzing output, outcome, and impact indicators.
Who Makes Impact Investments?
As we will come to learn later in this book, no other field within finance has a greater disparity of participants than those found to be impact investors. Impact investors differ from traditional investors in a number of ways, but the most important differences relate to return expectations, investment holding periods, and investment motivation. To understand this varied landscape, we should start by looking at some of the oldest impact investors, government institutions.
The International Finance Corporation (IFC), a member of the World Bank Group, is one of the oldest, largest, and best-known impact investors. It invests in a large range of projects, from direct and indirect private equity investments to large-scale infrastructure projects. It would be considered a government institution because it is funded by World Bank member countries. There are a number of other large-scale government funded impact investors, such as IFC, Norway's Norfund, and the UK's CDC Group. The key to these types of investors is that they have a specific mission and seek commercial-style investments, but have a very low cost of capital and longer holding periods than average, which allows them to make investments that strictly traditional investors may not make.
Similar to government-funded investors, in terms of low capital cost and long investment time horizons, are charitable organizations that make impact investments. These organizations can range from nonprofit institutions that use donation money for investment, like Acumen Fund or EnterpriseWorks/VITA, a division of Relief International, to organizations such as Soros Economic Development Fund, which utilize funding from profitable private-sector enterprises to make impact investments.
In the middle of the range of impact investors are high-net-worth individuals who provide their own capital directly into social enterprises. Often they will provide catalytic capital to early-stage ventures or fund business plans that materialize into companies. Similar to the other types of investors already mentioned, these investors have long investment time frames, low costs of capital, and personal motivations for investment that afford them a high degree of flexibility.
Finally, we move up the scale of commerciality to for-profit investors such as GrayGhost Ventures, DBL Investors, and Bamboo Finance. Each of these institutions has a varying commercial approach toward impact investing, where returns and investment horizons are more in line with traditional investors.
How This Book Is Designed
The bulk of this book is designed to guide an investor through every stage of the investment process, with a specific look in the last chapter at considerations for an investor who is creating or working for an investment fund. While there are many aspects that work universally for investors, there is a particular focus on equity investments, given that they are the predominant force in impact investing. To help immerse readers in the investment process, a fictitious company is selected amongst three potential investments. This company is then taken through each stage of the investment process. Figure 1.1 provides a graphical overview of the core chapters with a brief discussion of each section following.
Figure 1.1 This book generally follows the investment process that an investor would encounter.
Sourcing and Screening
The first phase of the investment process involves identifying potential investments. Most investors have a specific investment thesis that they, or if organized as a fund, their investors believe in. Therefore, it's imperative that the investments the investor sources fit into the investment thesis. For instance, if a healthcare investment fund is funded by high net worth individuals who have an interest in making equity level returns, while trying to address global health problems, the investor must be very careful to find healthcare related investments at good valuations that will lead to strong exits.
While sourcing and screening investments that fit an investment thesis seems relatively straightforward, time and resources constrain an investor. Time works against an investor since costs constantly accrue. The longer it takes to make investments, the longer it will be before the investment exit returns value. In order to properly place funds, resources are needed, both financially and tangibly. It costs money to undertake onsite due diligences, and to hire consultants, lawyers, or accountants. Often, an investor will hire multiple resources to help with the process. Effective investors place money efficiently and strategically, minimizing costs along the way.
Knowing how to identify regions, economies, and industries that are investable and poised for success is critical to being an effective investor. Specific to impact investing, the social mission must be fully understood, mapped out, and tested against the investors' social investment thesis. Weighing both financial and social mission viability early on is critical to selecting the right investments for due diligence.
Investment Analysis and Valuation
Sourcing and screening sets an investor on a path with a limited number of investments. The next stop on this path is vetting the company's operations, financial potential, and social mission scope. Usually, due diligence is split into two phases, with the first being a less-committed “desktop” phase, where business plans and financial statements are analyzed. This allows both an investor and investee to be efficient with their time and resources, since deal-breaking issues can sometimes be garnered from such analyses.
For equity investors, valuation discussions start early to make sure there are no significant gaps in perceived value. In order to have such discussions, an initial investment analysis is necessary since it lends to the creation of a valuation range. This range is later refined during the due diligence phase. Valuation is one area that impact investors must think carefully about. Impact investing is unique in that it brings together a range of investors with very different costs of capital and required returns. In some cases, these return expectations are not commensurate with the risk being assumed.
Due Diligence and Investment Structuring
Eventually, a company will warrant further analysis and full, onsite due diligence is executed. This entails reviewing all operational aspects, management, competitive analyses, finances, and social mission achievement and plan. Another goal of due diligence is for investors to establish their own opinions on the necessary investments structure. Debt investors will want to review all risks and mitigating factors related to cash flow or collateral value. Equity investors will want to check the assumptions made to create the valuation range and determine what investment structure might be necessary.
When a due diligence is complete and an investor is still interested in a company, negotiations around the investment structure ensue. Some investment structures can be very simple and quick to come to agreement, while others can take a considerable amount of time and develop into very complex arrangements. Debt investors will negotiate covenants to protect their priority over cash flow or collateral. Equity investors will agree to a valuation and possibly negotiate preferential rights.
Impact investors have the added requirement of ensuring that the social mission is preserved after investment. This requires properly aligning interests and making sure the structure is able to respond to changes.
Term Sheet and Documentation
Expressing the agreed-on investment structure in documentation is critical to a successful impact investment. The beginning of this phase of the investment process starts with a term sheet that covers the investment structure, preferences, and specific rights. The goal is to have a document that can be converted into a subscription agreement that defines an equity investment or an indenture for a debt investor. Additionally, for equity investors, a shareholder agreement is needed to cover shareholder rights.
Impact investors should also negotiate specialized clauses that protect the social mission and allow the investor flexibility if the social mission is compromised. As an example, a put option, where the equity investor can sell shares back to the company, might be written into the subscription agreement if the social mission deviates too far.
Building Value to Exit
Ultimately, an equity investment realizes value when it is exited. Debt investors technically have their exits through periodic interest and principal amortization. After the investment, but prior to exit, a value-building phase exists. Active investors will take part in board meetings to help shape the company's strategy. Passive investors will be more focused on financial and social metric reporting that is established at the end of the investment and provided periodically. At some point, exits must be completed properly to return funds to the investors at levels that are aligned with their expectations.
Private Equity Funds
Investors frequently establish or work for funds that utilize other entities' money for investment. Leveraging the platform of a fund can greatly increase the amount of money invested, but it brings with it a host of economic, organizational, and impact-related considerations. Most funds operate on management fees that have to be carefully managed vis-à-vis fund expenses. Organizational issues, such as the ratio and size of investments relative to investment managers, need to be carefully thought through. For impact investing private equity funds, a core responsibility is safeguarding the social mission by properly incentivizing investment managers and adhering to strict social criteria for investments.
Impact Investment Evolution
The concluding chapter to this book explores recent developments in the impact investing industry and thoughts on how it may evolve and scale. It's clear that there are problems unique to individual impact investments that stem from investors' disparate sources of capital, sometimes causing irrational risk/return profiles. A brunt of this book seeks to provide solutions to individual impact investment problems through a sound and rigorous investment process. Investment products are also evolving to help mitigate some of these problems and further develop the industry.
However, when looking at a portfolio investment strategy there are contentious issues that divide market participants. Some argue that portfolios can be constructed where there is no trade off between financial and social return. Others believe that for an effective, for-profit commercial strategy to be successful there has to be compromise and capital placed in a gradient of investments, from high impact to traditional. The final chapter in this book explores such topics and takes a position on effective portfolio strategy.
Notes from the Field
Throughout this book, readers will notice excerpts called “Notes from the Field.” These are experiences that the authors have had that directly relate to the topic at hand. We hope that these extracts provide context to the topics.
What This Book Is Not
There are two important distinctions that should be made from the start regarding the focus of this book: It is not focused on microfinance nor social/green bonds. While we will reference microfinance in a number of sections and provide examples, the focus is not on how to make a loan to an individual nor solely on how to invest funds into a microfinance institution (MFI). There are many good books specifically on this topic. Similarly, social and green bonds have gained popularity, but they are also very specific forms of debt that lend to an entirely different strategy and analytical process.
Setting Forth
Impact investing is a unique and demanding field that requires an unusual range of skill sets. This book dives into both social and financial analyses in detail and provides online resources that readers can use professionally. Those with limited financial backgrounds will gain valuable insight into the investment process and the underlying components required to invest competently. Those with limited social impact backgrounds will learn the topics and methods necessary to evaluate and measure social impact. Most importantly, readers will learn how both the financial and social impact aspects of impact investing intertwine, creating a challenging, but highly rewarding form of investment.
1
Yasemin Saltuk. J.P. Morgan, “Spotlight on the Market: The Impact Investor Survey,”
Global Social Finance
(May 2, 2014), 5.
2
Ibid., 6.
3
The Global Impact Investing Network, “What is Impact Investing?”
www.thegiin.org/cgi-bin/iowa/resources/about/index.html#1.
Chapter 2Sourcing and Screening
Investors are in an exceptional position in that they have to do very little beyond saying that they have money to invest in order to get the attention of entrepreneurs. They will receive pitch after pitch for investment opportunities. However, for most investors, resources such as funding and employee's time are limited, and the repercussions of focusing on and choosing too many bad investments are severe. A well-planned sourcing and screening process can avert time- and resource-draining mistakes. Passive sourcing may work for seasoned investment houses whose reputations attract the best and most desirable entrepreneurs. However, for individual investors, advisers, or new funds, an active sourcing strategy is necessary to find enterprises that excel beyond their peers.
Sourcing strategies generally focus on three critical aspects: geography, industry sector, and impact. Although the first two are common for mainstream investing, the third aspect, impact, is unique to impact investing. Impact investors seek an assurance that the investment fits their criteria and is likely to have a positive societal impact. Active sourcing can be done by trying to connect with local or foreign entrepreneurs; however, time and resources can easily be drained if the country of domicile or business operations is too risky for the investor, if the sector is outside of the investor's expertise, or if the impact is insubstantial. Of these sourcing elements, geographic appropriateness is unique in that it does not require dialogue with a prospective company to properly assess. Top-level analyses can be done to expose problems with investing in certain countries and prevent drained resources from pursuing investments that ultimately are too precarious due to sovereign risk.
Sector appropriateness requires less analysis, but often requires at least some type of information from the prospective company and blends into the screening phase. Usually, an investment teaser or pitch is available and initial dialog is initiated with the target company. Asking the right questions at this time is essential to quickly screen away investments that are inconsistent with an investor's strategy.
An effective screening phase focuses on key components of an investment's sector, stage, business, strategy, finances, and social impact. Deal-breaking issues should be revealed as early as possible, while primary strengths and weaknesses must be weighed carefully before moving the investment along to the next phase of investment process.
Sourcing Strategy
Sourcing potential investments is truly the inception of the investment process for any investor, whether impact focused or not. The methods employed and the decisions made at the sourcing stage lead to a variety of paths that often have an influential role for decisions at later stages of the investment process. A robust and effective sourcing strategy can help ensure that the paths with the highest probability of closing a strong investment in an efficient manner are taken, while paths that lead to wasted time, stalled negotiations, or eventual value declines are avoided.
While the concept sounds relatively simple, what does it actually mean to be sourcing? Passive sourcing is a luxury of many well-established venture and private equity funds, where some of the best entrepreneurs deliver well-laid-out business plans with financial projections or early stage businesses with rapid growth that are poised for success. Many early-stage or less-well-known impact investing investors and funds will be inundated with entrepreneurs pitching business ideas, but the average quality of the investment will be lower.
There are numerous reasons why the quality is perceived to be lower:
Some of the best entrepreneurs in developed markets take their business ideas to well-known investors and investment incubators, where they compete for funding and, more importantly, mentorship and connections from successful entrepreneurs. While these are typically tech-oriented, it does dilute the pool of high-level entrepreneurs.
The social impact element can be implemented with varying degrees of intensity. Although the heart of impact investing suggests that financial return can be achieved with social returns, there is always a point at which the social mission can impede on financial viability. Many social entrepreneurs create business plans that can be viewed as weaker from a business functionality point of view because the social mission is too aggressive.
Impact investments often have heightened risk because of their geographic focus being mostly outside of the developed world.
For these reasons, a passive strategy is not ideal for impact investing.
Active sourcing involves targeting investments that are aligned with the investor's focus, risk tolerance and expertise in a region and sector. The easiest place to start is determining if a region or geography is suitable for investment. Local investors clearly will not have to deal with such a macro analysis, but for any individual or fund that has a regional or global scope, country market analysis should be the first step. Country analysis is also particularly important for impact investors since the source of funding and the need for funding are typically in two very different geographies. For this reason, a more intense review and example analysis is provided on this topic.
Geographic Analysis
Geographic appropriateness can be thought of as the first and widest filter to move items to a deeper screening. Such an analysis starts by collecting a robust collection of data sets that capture basic investing requirements and specific investment thesis characteristics. A method of weighting the importance of the data sets should be implemented in order to determine a list of countries of interest and a heat map of their relevant qualities.
Data Sets
There are innumerable data points for each country, but a few key ones that both debt and equity investors should take a deeper look at. A straightforward method to understand the sourcing potential and investment suitability of countries is to create a country ranking system and heat map, based on desired investment-related characteristics. Standard investment characteristics to rank countries could include:
Ease of starting a business
Level of investor protection
Level of contract enforcement
Ability to mitigate insolvency
Many of these characteristics are implemented in analyses done by the World Bank's Doing Business project.1 The data here are very understandable and comparable across different topics using the World Bank's country ranking system.
For impact investing, additional metrics should be considered. One important metric is the Human Development Index (HDI), which ranks countries by submetrics of human development. The lower the HDI, the greater the need for impact investments. General sectors can also be targeted at the country ranking level. For instance, if healthcare is a focus of the impact investor, then an index such as one measuring maternal mortality could be integrated into the analysis. The goal of the analysis is to understand on which countries to focus active sourcing efforts.
To delve deeper into creating such a country ranking method, open the file Country_Ranking.xlsm from the website. This workbook contains multiple country ranking data sets and a method to synthesize the data into usable output. Ultimately, an ordered list of countries that exhibits the qualities an investor is seeking should be discernable from the analysis. To get there, though, the starting point is the underlying data.
In this analysis, there are six independent worksheets that contain data sets relevant to investors and some specifically to impact investors:
Inv protect:
This data set focuses on investor protections. Many countries differ in their attitudes toward investors and the levels of disclosure, board of director liability, and the ability of shareholders to take legal action against companies. Most investors will want transparency, low legal liability for the assigned board director, and the ability to navigate negative situations through legal action. Countries are ranked by the composite level of investor protection for investments in the listed country, with 1 being the best and 189 being the worst.
Start business:
The ease of starting a business can be indicative of how well a government facilitates the needs of entrepreneurs. This data set ranks countries based on four metrics: the number of procedures required to start a business, the time it takes to register a firm, the cost to register based on fees, and also equity required.
Contract enforcement:
For both debt and equity investors, contracts transform conceptual and verbal agreements into a common understanding. More importantly, if one party deviates from that understanding, there should be a strong and efficient legal system to mitigate the situation. This data set ranks countries based on three metrics related to contract enforcement: the time it takes for dispute resolution, the cost of working through such a dispute, and the number of procedures required to achieve resolution.
Insolvency:
Important for debt investors is the ability to lay claim to a company's assets if it becomes insolvent. Debt holders often invest with a priority over the company's assets and accept a lower return proposition than equity holders for such privilege. However, if the ability to recover value is diminished or difficult the reduced return may not be worth it. The insolvency data set looks at the time it takes to close a business, the cost of closing the business, whether the business is sold off in pieces or as a whole, and, very importantly, how much money a claimant recovers given insolvency.
HDI:
If the prior four categories were the only data sets to include in this sourcing exercise, the top countries would primarily be developed economies that have less widespread need for impact investing.
2
For an impact investor the developmental need is a priority and should be reflected in the analysis. To facilitate this, the Human Development Index (HDI), a statistic created by the United Nations Development Programme (UNDP), is used to rank countries. It scores countries based on life expectancy, education levels, and standard of living.
Maternal mortality:
A sector-based investor may want to include his or her specialty in the analysis. In the example provided, a healthcare oriented investor can assess the development and need for maternal care in a region. Any other specialty can be similarly integrated depending on investor focus.
NOTES FROM THE FIELD
In 2005, while I was working for Citigroup, we were looking to fund investment in a certain Eastern European country. The investments would be mortgage related and required a high degree of certainty regarding contract enforceability and bankruptcy protection. As part of the deal team, we noticed that the laws were very loose in these regards. We engaged in local country due diligence and met with federal government officials who told us, “Don't worry, we will be changing those laws in the next few months.” After a lengthy plane ride home, we sat around a conference table the next day, and someone asked the best follow-up question, “If they can change the laws in just a few months in our favor, can't they change them just as quickly against us?” The investment was never made.
Data Aggregation and Weighting
Once the data are loaded, it should be aggregated on a single sheet. The Data Agg sheet does just this by listing all potential countries with the relevant rank to the right. Note that there is a guide to the rankings in row 6, called Target. This is to keep track of whether a high or low number indicating a weak or strong rank is desirable. For instance, a country with a low score for contract enforcement means that it has a high standard of contract enforcement. This is desirable for most investors. However, a low HDI rank indicates a very developed economy and may not be the best country for an impact investor. Figure 2.1 shows the top part of the data aggregation.
Figure 2.1 Country rankings are aggregated and prepped for weighting.
Once the country data are aggregated, a weighting method can be applied to layer in the investment thesis preferences. Effectively, a weighted average score is needed. However, one needs to be cognizant of whether a high value or low value is desirable. In this example, for five of the six metrics it is desirable to have a lower score. To work with the weighting method of having a higher percentage influence a higher rank converting the low scores to a high score is necessary. Conversion can be done by subtracting the count of countries for each data set by the rank for all of the factors except HDI. With the correct ranking figures, a weighted average can be calculated by multiplying the weights by the ranks.3Figure 2.2 provides an overview of the weighted calculations.
Figure 2.2 The aggregated data and a weighted value for each country are calculated.
Controlling the Analysis
The weights can be adjusted depending on an investor's investment thesis. A scenario selector system is ideal for setting up various weighted cases. Figure 2.3 exemplifies such a system, which will be used in other analyses throughout this book.
Figure 2.3 A scenario selector system allows the user to enter investor preferences and toggle between scenarios.
Results
Once a scenario is selected, the Data Agg sheet calculates the appropriate statistics based on the weights and the results can be summarized. The Summary sheet shows the top 25 countries that are produced from the combination of the weights selected. Additionally, a heat map of the relevant characteristics is displayed so a user can see what is driving the results. Figure 2.4 shows the top 15 results for a global equity impact investing scenario.
Figure 2.4 The selected countries are summarized, along with a heat map of the relevant statistics.
The most noticeable feature of Figure 2.4 is that there are some affluent geographies on the list, such as Singapore and Hong Kong. Even though the HDI is heavily weighted, there are still four other factors that favor developed countries. For this reason, it is necessary to take a closer look at the heat map that shows how the rankings were created. It is clear that there are trade-offs with each country that was selected. For instance, the first choice is Rwanda, a country that is very favorable because of a high development need based on HDI and acceptable scores on investment protection and contract enforcement. Insolvency and ease of starting a business are not very good, but the other factors still outweigh the low scores.
The trade-offs are evident when Singapore is examined. It has the lowest HDI score of the top 15 countries shown, but makes it to the top 15 because of very high scores for contract enforcement and investor protections. It also has high scores for the ease of starting a business and insolvency mitigation.
Investors can customize the weightings depending on the focus of their investment strategy. For instance, a debt investor may put more emphasis on insolvency protection and contract enforcement given the first lien position of debt on the assets of a company. Change the scenario selector on the sheet to Global Impact—Debt. When this is done, the results change and Ethiopia takes the top spot, primarily because of a more favorable insolvency mitigation score, which is important for debt investing.
Keep in mind that this is only a method to start building a framework for geographic suitability and that each country should be examined in detail. For instance, Ethiopia as the top choice for Global Impact—Debt has a high need for development and a good insolvency mitigation score, but compared to the mean investor protection score amongst the top 25 (6.256), its investor protection score of 1.6 is very low. Depending on the risk appetite of the investor, this combination may not be suitable. Individual analysis is always required. Also, the data sets chosen here are not exhaustive or completely indicative of a perfect investment environment. Local due diligence should always be undertaken to vet country risk.
Finally, impact investing does not have to only be done in emerging markets. There are many companies that are domiciled in developed countries that have focuses abroad or, as mentioned in Chapter 1 earlier, even in areas domestically that demonstrate need. However, investors in companies that are domiciled in developed markets and do business in emerging and frontier markets should still do a country risk analysis of the primary operational regions. Indirect risks can disrupt cash flow and quickly put stress on the viability of the company as a whole.
Country Economic Analysis
Although the previous analysis on country suitability included many investment related characteristics, economic indicators were notably missing. There are many economic indicators one could look to but two important ones that capture multiple subrisks are business cycle and foreign exchange. Even if a country is suitable for investment, the timing might not be right because of these two factors.
Business Cycle
History has shown economists and businesses that there is a relatively standard pattern in the economy that creates a business cycle. Economies move through periods of growth, contraction, and back to growth. The time of each point in the cycle can vary widely, but this pattern is evident. Figure 2.5 depicts the standard business cycle.
Figure 2.5 The standard business cycle is important for investors to understand.
Countries can exhibit their own unique business cycles or be correlated to other countries that may influence their economies. For this reason, an investor should always gather economic data on the country in mind to understand the business cycle. Sector specific investors must think about their sectors vis-à-vis the business cycles and their expected evolutions. For example, a housing project company may look attractive during the growth phase shown in Figure 2.5 since the economy will be getting better, discretionary spending will be higher, and credit will be loosening. However, during a recession phase credit might tighten up, making mortgages difficult to obtain and consumers focus on savings.
Timing investment with the business cycle can be important given the holding time of many impact investments. Most equity impact investors hold on to their investments for five to seven years, if not longer. Debt investors average from one to three years for their investment horizons. The business cycle at investment and exit can have profound impacts.
An ideal situation would be to identify the early part of the growth phase for an economy. This can be difficult, as statistics that are being shown will be based on the recession phase. However, these statistics are where opportunity can exist. Businesses will generally be down and business valuations may have decreased. Investing at this stage could lead to a low entry price and future increase in performance. For debt investors, it would also be an opportune time, as sales will increase that should cover all or some debt service.
The contrary situation would be investing during a contracting phase. In this situation, the business valuations could still be very high, as they would be reporting data from the expansionary phase. Soon after investment, the economy could begin to shrink, sales could decrease, and credit could tighten. The combination of decreased sales and tighter credit can put a substantial amount of stress on an early stage company. If the company is unable to generate or obtain working capital, it will need more cash from equity or debt investors. Investors in these situations may find themselves funding the company until a growth phase begins.
Debt
