Give Impact Investing Time and Space to Develop

Note: this piece originally appeared on the HBR Blog.

Impact investing has captured the world’s imagination. Just six years after the Rockefeller Foundation coined the term, the sector is booming. An estimated 250 funds are actively raising capital in a market that the Global Impact Investing Network estimates at $25 billion. Giving Pledge members described impact investing as the “hottest topic” at their May 2012 meeting, and Prime Minister David Cameron extolled the potential of the sector at the most recent G8 summit.  Sir Ronald Cohen and HBS Professor William A. Sahlman describe impact investing as the new venture capital, implying that it will, in the next 5 to 10 years, make its way into mainstream financial portfolios, unlocking billions or trillions of dollars in new capital.

As this sector moves from the margins to the mainstream, it’s important to consider: What will it take for impact investing to reach its full potential?  This question is hard to answer because, in the midst of all of this excitement, there aren’t clear success markers for the sector.  Without those, the institutions managing the billions of sector dollars won’t be able accurately to assess the risks they are taking and, more important, the returns, both financial and social, they hope to generate.

Impact investing is not just a new, undiscovered corner of the investing world. It has the potential to join traditional investing and government aid and philanthropy as a third way to deploy capital to address social and environmental issues. A fully developed impact investing sector will incorporate the best features of markets—rigor and speed; quickly evolving business models; strong revenue models; and access to capital as ventures show signs of success—with the best features of government aid and philanthropy—serving unmet needs; reaching populations that are bypassed or exploited by the markets; investing in goods with positive externalities; and leveraging public subsidy to extend the reach of an intervention—to solve social problems.

Impact Investing_Time to Develop_1

Because impact investing really is something new, the old ways of assessing risk and return are not enough.  And yet, like a moth to a flame, those in the sector are endlessly drawn to discussions around what constitutes the “right” level of expected financial returns.  There is no single right answer to this question.  Under the broad umbrella of impact investments lie myriad sectors, asset types, and investment products, most of which still need to be developed and understood.  It looks something like this:

Impact Investing in 2014: Colorful, full of potential, and highly disorganized

Impact Investing_Time to Develop_2Note: Each circle represents a business and each color represents a business vertical (e.g. sanitation, housing, mobile banking).

To make sense of this kaleidoscope, three things need to happen.

First, impact investing needs time to develop. This is a nascent sector where entrepreneurs and investors are still figuring out business models, developing new financial products, and proving exit strategies and exit multiples, and only a handful of players are using agreed-upon metrics for assessing social impact.  Whether it’s solar lighting, mobile authentication, micro-insurance, mobile banking, drinking water, urban sanitation, low-income housing or primary health care, entrepreneurs need time to test, modify, and refine business models.  These entrepreneurs are looking for support from risk-seeking investors who have an appetite for failure, are willing to be pioneers, and who value the social returns they’re creating.

As the sector grows through this period of creative destruction, models that don’t work will die out, models that survive will attract copycats, operating costs will go down, and winners will rise to the top.  The sector will organize itself across the spectrum from philanthropy to investing, and the resulting clusters will demonstrate the differences in risk, financial returns, target customer, and social impact across the various sub-sectors of impact investing.

Impact Investing in the Future: Developed clusters across the spectrum

Impact Investing_Time to Develop_3

Second, in addition to time, the sector needs a framework to measure success, one that makes sense of the sector’s inherent diversity.  Akin to the Morningstar Style Box, such a framework would allow an investor to easily identify best-in-class social and financial performance across and within the various sub-sectors of impact investing.

Third, the sector needs practical, widely-adopted, and standardized tools to measure social impact.  This is easier to describe than it is to do.  Although investors value both financial and social return today, the sector only measures financial return well. The big, unspoken risk is that we’ll end up ranking and sorting impact funds by the only thing they can be ranked and sorted by – money – without assessing or valuing the different levels of social impact these funds have.

The future of impact investing depends on our ability to embrace what we’ve learned over the course of economic history: solving social issues requires both private and public capital, a combination of risk-seeking investors and incentives and subsidies from public actors to make it easier and more attractive to reach underserved segments of the population.  Hospitals, parks, educational systems, sanitation infrastructure, low-income housing — globally, risk-seeking investors build these solutions in partnership with the public sector, which plays its part to adjust incentives, act as a major customer, and provide subsidy where needed.

What the sector needs is enthusiasm about the future and patience around the time it will take to get there.  In traditional investing there is a premium on liquidity, low beta, and lower risk, all of which justify higher or lower returns. In impact investing, we need to find a way to place that same premium on social impact by valuing the public good being created – just like we do in early stage R&D in science, IT, health, and biotechnology. We allowed microfinance and the venture capital industry the time and space to develop over a few decades. Surely we can do the same for impact investing.

Is ______ an impact investor?

On Monday I had the chance to speak at the iiSummit on Impact Investing,  organized by Kellogg and the Chicago Booth School.  It is exciting to see the level of interest in impact investing growing everywhere (beyond the obvious hotbeds of New York, San Francisco, and Washington, DC).  The goal of the conference was to explore how the tools of impact investing could be applied in the Midwest.

During one of the conference breaks, I had a conversation with a student who wanted my take on whether Bank Rakyat Indonesia, the Indonesian microfinance bank where I worked a decade ago, is an impact investor.

I was and continue to be stumped by the question, and I think the question sheds light on a worrisome trend in our space.

Let me explain.

What the question seemed to be about was whether BRI aims to have social impact, specifically because the interest rates are “high” (~25% p.a.); because it does collateralized lending (as opposed to group lending); and because, it was implied, BRI is highly profit-seeking.

My take on BRI is a little different: 25% p.a. interest rates are in line with global microfinance interest rates (so I have trouble arguing that they should be lower); limiting itself to collateralized lending does mean that BRI is likely serving the better-off segment of low-income customers, but these customers still clearly have a need for these services;  and, at least when I was there, BRI had a 4:1 ratio of savings to lending – which is only possible because it is a regulated financial institution.   Since I personally think that savings might be more powerful to the poor than lending as a tool to smooth consumption and have capital available for big expenditures (which is really what a lot of microlending is all about), I think this a really big deal.  So, in sum, I’m a fan of BRI from what I saw when I worked there.

But I digress.

What the question got me thinking about was that, rather than asking, “Do you think that BRI is having significant, positive social impact?” the question was “Is BRI an impact investor?”

The implication seemed to be that “impact investing,” as the coolest, hottest trend in our space, is a proxy phrase for doing good work, a notion that was reinforced by the numerous speakers who qualified lots of worthwhile, not-so-new activities (negative screen, public market investing first pioneered by Domini; positive screen, public market investing best represented by Generation Investment Management; CRA lending everywhere; everything that OPIC has done for the last few decades) as “impact investing.”

Personally, I don’t care what is or is not “impact investing.”  What I care about is whether we are creating positive social change.

Impact investing, to me, is nothing more and nothing less than the use of investment tools for social ends. Our collective “aha moment” was the realization that investors can strike a deal with sources of capital whereby social impact goals are made explicit.  This allows investors (stewards of others’ capital) to pursue social goals without shirking their fiduciary responsibility to maximize profits.   Volia, we have more tools (not just grants) that we can use to pursue social impact.

This is simple enough and hard to disagree with.

But from this perspective, I find myself discouraged by the “finance first” and “impact first” terminology that’s become popular in our space.  It feels trite.  Isn’t the whole point of “impact investing” the “impact” piece?  Without that you have investing – which can create all sorts of impacts (positive and negative; financial and social).  But either you set out to create positive social change or you don’t.  The idea that you’d set out to create only a little positive social change…what exactly does that mean?

I don’t want to know whether you or I or anyone else is an impact investor. I want to know how much social impact you and I are creating with a dollar (or a euro, or a rupee, or a shilling, or whatever).  Everything else, to me, is just old wine in new bottles.