Tag: returns

An underdeveloped market for risk

~ Sasha ~ 2 Comments

So much of the conversation in impact investing is about returns: what are they, what should they be?  Now and in the future?

Not so much talk about risk, though.

It strikes me that in traditional investing, people are rewarded for risk-taking and the most successful investors are those that become good at taking the right risks, good at discovering information asymmetries, good at making the well-placed bet early.

My hypothesis is that our biggest ability to create impact is going to come from finding the “next big thing” business models, the ones that solve problems that haven’t been solved yet – whether in energy distribution, sanitation, water, education, healthcare, etc.  And it feels to me that it’s unlikely that, in most cases, betting on new, untested business models – meaning creating new markets with huge amounts of friction (bad roads, poor ports, unreliable distribution, corruption) serving customers who are, by and large, new consumers of whatever you’re selling (so high acquisition costs, etc.) – is going to fully financially compensate investors and entrepreneurs for the risks they’re taking.

[To be totally clear, I’m differentiating between “good” and “astronomical” returns here, and arguing that if we’re clear-eyed about the risks you have to take to solve problems that have never been solved before, then “good” financial returns aren’t good enough, if your yardstick is a simple financial risk/return analysis.]

Of course the whole point is that there are funds and investors that are willing to accept lower returns because they DO value social impact.  And I hope that space continues to grow.  But what keeps me up at night is whether there’s a strong reinforcing mechanism that rewards risk-taking in that part of the capital curve?

Meaning: are the kinds of people who place real value on social returns, by disposition and in terms of feedback loops in the marketplace, likely to be rewarded and culled and selected for their ability to take big, well-calculated risks?  Or is it easier to soft-pedal on risk when the upside is mostly non-financial?  And, if that’s true, are we systematically under-investing in the highest-potential opportunities, because we shy away from risk?

What it takes to build dreams – Part 2

~ Sasha ~ 2 Comments

Paula Goldman, Omidyar Network’s Director of Knowledge & Advocacy and co-author of the excellent “Priming the Pump” blog series made a very helpful and clarifying comment on the last post (emphasis added):

Sasha, excellent post. I agree with you that as a field we need to get a lot smarter about the risk/social impact equation — this will make or break the field. I also agree with you that the path to scale here isn’t just about making this an asset class. Commercial markets are already incredibly good at allocating capital efficiently, including to businesses that generate positive impact and solid financial return. The risk is that by pumping up the industry in this way, there will be nothing incremental or new about investments labeled as impact investing.

I would ask you though to reconsider the use of the term ‘crummy’ economics. While the economics in many cases for impact investing are sometimes different than traditional investing, taking on additional and different types of risk doesn’t necessarily mean lowering financial returns.

This comment shines a light on exactly the distinction I’m trying to make, because, for this conversation, I’d like to take a pass on the whole discussion of what the returns are in “impact investing” (and whether or not they are “crummy”) since I don’t believe you can answer that question without better defining which segment of impact investing you have in mind.

Instead I’d like to ask whether, as I observe anecdotally, there are sectors/project outside of impact investing that attract huge amounts of capital that have “crummy economics.”

To recap the sorts of conversations I’d love to redirect:

Question 1: “What is the risk/return profile for impact investing?”

My current answer: “It really depends on what you mean by ‘impact investing.’  For some (significant) part of what could broadly be defined as impact investing, the financial returns may well compensate an investor and her LP well for the financial risk she is taking.  However, there are also big and important parts of impact investing – including those segments where the non-negotiable is impact; and those segments focused  on the poorest, hardest-to-reach populations – where the financial returns likely won’t fully compensate the investor or her LPs for the risks they are taking.”

Question 2: “But if the returns aren’t there, doesn’t that mean that the sector will never grow? Doesn’t that mean that capital will never flow in in significant ways, in which case the sector will never scale and reach its potential?”

AHA!  THIS is the question I’m aiming to dig in to, not the prior one.   This is why I said that I’d observed that “increasingly across sectors I meet more and more people who acknowledge that most of the most important (dare I say the most “impactful”?) work they do has crummy economics.”

Namely, I’m finding the discussion on “what the returns are” to be circular, because it hinges on how you define “impact investing” and what particular niche/sub-segment you are in.  The dead-end I’m trying to break through is the one that says “IF the returns aren’t there versus the risks people are taking, then capital won’t flow in.”

My hunch – and the thing I’m looking for data on – is that this statement might be empirically incorrect.  My hunch, informed by conversations with people in sectors far away from impact investing, is that the overall NET returns for huge swaths of projects that create public good (and have an underlying long-term economic logic) might be low (aka “crummy”).  But these projects and the people backing them find a way to make them happen at scale – whether by layering capital, layering risk, layering returns, bringing in philanthropy….. in such a way that lots of stakeholders and lots of stripes of money get what they want.

And so, my non-empirically-proven hunch is that the fundamental net (total project, total portfolio) return being low doesn’t inherently limit the ability of billions, even trillions of dollars, to find its way to meaningful project that have a blended return.   That’s the data I’m looking for.

One reader kindly pointed out the Kauffman Foundation’s recent report that revealed that 78% of their traditional venture capital funds “did not achieve returns sufficient to reward us for patient, expensive, long-term investing.”   And yet $22 billion a year still flows into venture capital.

Not exactly what I had in mind, but that seems to be a pretty great data point showing that failing to compensate LPs adequately for the risks they take doesn’t mean that money won’t flow in.

What it takes to build dreams

~ Sasha ~ 4 Comments

I keep on bumping into the same parallel conversations around the future of the impact investing sector.

With those in the trenches, what I hear continuously is that it is a long, hard slog.  That companies take a long time to build, that the costs of getting things right are high, that grants and really forward-looking and patient risk capital is key, and that there’s not a straight path from here to there.

And yet the reports that keep on coming out and the sectoral conversations continue to cheerlead about all the capital that is coming into the space – prevailing estimates for total potential market size by 2020 are in the $500 billion (Monitor Group) to $1 trillion (JP Morgan) range – and to get there, we’re told, impact investing has to become an “asset class.”  Part of getting from here to there, it’s implied, might mean sweeping under the rug the significant segments of impact investing where the economics don’t seem to fully work and where the financial risks are too big relative to the expected financial returns.

An investor I recently met at a roundtable on understanding and quantifying impact put it simply to me: “anyone who is looking at less than a ‘market’ rate of return is mispricing risk.”

(Whereas I think the big problem in the world is that we’re mispricing returns by equating returns with what we can see in a discounted cash flow analysis, thereby demoting “impact” to a fuzzy, non-quantifiable something for which it’s not worth taking actual, real risk.)

Without getting dragged into what is clearly a definitional conversation – namely, until we agree on what we mean by “impact” we can never have a serious conversation about the economics of “impact investing” – I have an observation that keeps on nagging at me: increasingly across sectors I meet more and more people who acknowledge that most of the most important (dare I say the most “impactful”?) work they do has crummy economics.  Getting these projects/endeavors/businesses to happen requires the dogged determination to get many different stripes and flavors of capital to come together, lots of irregular stakeholders to develop a shared vision of the future, and, usually, a healthy dose of subsidy or public funding because there’s a clear public good being created when you succeed.

And yet in the impact investing sector we often hear that if investors aren’t fully financially compensated for the risks they take, capital will never flow in any serious way.

If that’s right, how do we explain away the fact that we have managed to create trillions of dollars’ worth of parks or mixed-use developments or hospitals or museums or great schools, most of which don’t make full economic sense but all of which are integral to a vital, vibrant society?  The truth is that markets don’t fully work all the time, and yet huge amounts of capital are regularly mobilized to create things that are worth creating.

What I’m struggling to do is to better explain, by looking outside our sector, my feeling that the conversation we’re having in the impact investing sector is far too narrow and binary.  When I identify the underpinnings of what makes vibrant, successful societies – you know, all those things that disappeared for a little while when Hurricane Sandy hit – and if I think about all of the incredible pure market plays that have been built on top of the existing infrastructure that was provided by the public sector….well it becomes clear that the “markets” / “not markets” conversation we’re having is far too simple.

And yet I don’t know specifically which data to look for to help tell this story.   I need more examples across sectors and history, more evidence that helps explain clearly and succinctly what I know to be true: that solving big, intractable problems for disadvantaged communities by and large doesn’t pay (nor should it pay) handsome financial rewards.  And the fact that it doesn’t isn’t some sort of failure of a prevailing orthodoxy, it is in fact a vindication of a rich history of bringing public, private and third sector players together – to bring the best of what each has to offer, including skills and preferences and the right kind of capital – to solve big problems.

I’ll be talking about some of these questions next month at the Global Philanthropy Forum, and I’d love your great ideas on how to prepare for this talk.

So, help, please! What are the best examples out there from other sectors (housing, roads, infrastructure, parks, museums, schools, biotechnology, the Internet, telecommunications…) that will bust open this “market return” mindset that is hobbling our thinking about how to create real and lasting change through impact investing?