Microfinance Informs Impact Investing

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    While the term “impact investing” (or social capital) has garnered substantial attention in recent years, the more traditional field of microfinance, still by far the largest share of impact investments, gets less attention yet has decades of experience doing social capital. Here are a few of lessons from the micro finance sector worth reviewing as this strategy matures:

    Microfinance-photo

    Measuring Social Impact

    In a nutshell, impact investing brings the discipline and financial sustainability of private capital, including an intense focus on revenues, profits and financial return, to the problem of solving critical social problems. As argued by Tilman Ehrbeck in this Huffington Post article, to accomplish its purpose to social ills, impact investing needs greater clarity on defining and measuring social impact.

    Although there are no simple ROI-like metrics to measure social gain, the microfinance field has made progress in this area, such as obtaining more rigorous impact assessments to better understand what kinds of interventions truly benefit which customer segments.

    Ehrbeck points out that it’s not enough to count heads in private elementary schools in developing countries; we need also to measure the education these children receive to evaluate whether it is truly a good investment for poor families who make real long-term sacrifices to pay school fees.

    Financial Expectations for Impact Investments

    The second issue relates to financial return. A recent survey found that 65% of impact investors seek market returns. This attitude is not very realistic or helpful. If impact investments offered market returns, almost everyone would be willing to invest that way, and there wouldn’t be any need for social capital.

    There is a need for impact investors precisely because of the “market failure” caused by capital markets that won’t invest in projects with a high social return yet a lower-than-market financial returnThere inevitably will be tradeoffs between balancing social and financial returns.

    Those tradeoffs cannot be wished away by assuming the profitability of social ventures will be comparable with ventures that offer market financial returns and low social returns. Where there are exceptions — ventures that provide market financial returns AND high social returns — conventional capital is available and impact investments will not be needed.

    If impact investors truly want to improve the world with their capital, they need to accept lower returns, less security (collateral, guarantees), or greater risk, with the explicit understanding that the social benefit the project generates is part of the total return from their investment.

    Philanthropic Capital and Impact Investments

    Similarly, in many cases philanthropic capital is necessary to prove a new concept and to bring in new sources of capital; many of the deals we’ve worked on have a capital stack that includes a combination of philanthropic and impact investment capital along with conventional debt. For these kinds of deals, impact investors are necessary but seldom sufficient.

    Active Governance by Impact Investors

    And finally, microfinance has learned that effective impact investing requires active governance by impact investors, to find that sweet spot that best balances longterm profits and impact. It takes hard work and good governance to set the right targets and incentives for management to achieve that balance, which is far more complex than incentivizing management solely to achieve certain growth and profit levels. Similarly governance is needed to develop and implement an exit strategy that protects the social priorities as well as the capital investment.

    These are a few of the lessons from the micro finance experience that should inform our efforts to grow the impact investment sector. Learning from the past is usually the easiest, and cheapest, way to improve prospects for the future.

    Good luck!