Impact investment – news from the scene of capitalising social innovators from an up-to-date research perspective
Accessing financial resources has been and remains to be a major barrier for social innovators. Their widely acclaimed potential to contribute to solving severe problems of modern societies is severely threatened by challenges in financing and resourcing social innovators in many fields of activity. This holds for all TEPSIE partner countries as well, as our recent research in the course of work package 4 on Generating capital flows has confirmed once more. The six TEPSIE partners have conducted a total of 59 interviews, and 444 social innovators have provided valuable responses to our online survey. One of the central (yet fairly unsurprising) findings is that securing funds is still a key challenge, both to develop social innovations to reach maturity and to scale them up in order to achieve broad and lasting impact.
For the latter, social innovators may or may not have demand for growth capital from investors or funders. Actually, one key finding of our research is that while the majority of innovators do want to grow, many of them prefer to scale up organically deploying the resources generated in regular day-to-day activities. However, there is also demand for investment growth capital. Among a number of approaches to meet this demand – from regular commercial bank loans to philanthropic giving from foundations or individuals – not just recently private capital market-based instruments have been gaining increased attention under the umbrella term of ‘impact investment’: The concept is that investors use do not exclusively target financial but also social and/or ecological returns and potentially adjust their financial return expectations accordingly. From the field of social innovation, it has been repeatedly and increasingly argued that investment practices should be used to attract more capital and generate financial and social returns or blended returns. The argument is that social innovation is very much capable of generating income, both in markets and elsewhere. In turn, this – is argued –renders social innovation ready for investment from actors expecting both financial and social returns. This line of argument has recently led to what may be seen as a ‘hype’ for impact investment.
However, our research has raised (or re-confirmed previously existing) doubts on whether this approach is workable on a broad scale for large parts of the social innovation field: As already said, willingness to acquire investment capital is limited, and of those who would be willing to attract investment, many are not ‘investment-ready’, for they could not repay a principal and a return to the investor on top, particularly since returns (and thus capital costs to the innovator) are often very high due to underlying risk calculations. Nevertheless, we must not dismiss the impact investment approach right away, since it still yields a vast potential for attracting massive amounts of capital for socially innovative ventures. Indeed, on the one hand there are hints that the number of private individuals who would be willing to invest (individually relatively small but collectively quite substantial) sums of money into social ventures, if they could expect to get it back alongside a very modest rate of return. And on the other hand, a substantial share of the social innovators we interviewed or surveyed state that they could manage to repay the principal and a modest rate of return in the range of 2-5% - which would be below market rate but still could attract some investors to the field.
However, the amount of capital available at that rate is still very limited in most fields where social innovators are active, which could be explained by the transaction costs investors incur and by the risk profiles of social innovators’ ventures. Thus, to fill this gap may well be seen as one of the key challenges to the social innovation in order to open up and develop new sources of capital for the field. So the question is how to achieve that by applying the appropriate financial instruments.
One of the most promising ways to do that consists in increased and better synchronised collaboration between actors with very different resources, interests and expectations. The central concept underlying a number of promising approaches is called ‘credit enhancement’: It is commonly used in traditional financial markets, but could also gain more prominence in impact investment. The approach is to increase the credit worthiness of a particular investment opportunity in order to improve its risk-and-return profile with the aim of lowering its capital cost to the investee. Tools that can be used to provide credit enhancement include for instance letters of credit, over-collateralization, insurance, reserve accounts, and first-loss capital. The Global Impact Investing Network has recently published a research brief focusing on catalytic first-loss capital (CFLC) as promising tool to promote impact investment. The brief defines CFLC “by three identifying features:
• It identifies the party, i.e., the Provider, that will bear first losses. The amount of loss covered is typically set and agreed upon upfront.
• It is catalytic. By improving the Recipient’s risk-return profile, CFLC catalyzes the participation of investors that otherwise would not have participated.
• It is purpose driven. CFLC aims to channel commercial capital towards the achievement of certain social and/or environmental outcomes. In addition, often—though not always—the purpose can be to demonstrate the commercial viability of investing into a new market.” (p. 5)
So like most other credit enhancement mechanisms, CFLC requires several investment parties to collaborate and synchronise their efforts in order to achieve a common goal. Social innovation could well serve as such a shared objective when tools such as CFLC are applied to meet various actors’ different interests in social innovation: For foundations or the government, social aspects may play a more important role than financial returns (‘impact first’ investors). Thus, they could play the role of a CFLC provider, which would help to unlock capital from investors with more interest in financial returns (‘finance first’ investors).