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Optimising the investment process for greater impact a toolkit for impact investors

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  • 1. Op#mizing  the  Investment  Process     for  Returns  and  Impact   Madeleine  Evans   Please  contact  the  author  before  ci1ng  this  presenta1on  or  using  the  material  in  other  works.    
  • 2. Impact  inves#ng  and  the  big  ques#ons  
  • 3.  An  introduc#on   §  An  impact  investor  has  a  financial  and  a  non-­‐financial  objec6ve,  with  certain   performance  requirements  for  a  given  level  of  risk1     §  These  investors  face  a  unique  strategic  challenge:  simultaneously  managing  these   two  objec6ves  to  produce  an  investment  with  “shared”  or  “blended”  value2   §  This  presenta6on  offers:   §  A  framework  for  understanding  the  drivers  of  blended  value   §  A  strategic  toolbox  for  cul6va6ng  impact  and  desirable  risk-­‐adjusted  financial  returns  in   one’s  own  porGolio     §  Insight  is  drawn  from  DFIs  and  funds  inves6ng  in  for-­‐profit  or  social  enterprises   Entrepreneur   proposes  an  idea   Entrepreneur   goes  a@er  profit   Investor  wonders  what   happened  to  impact   Accep#ng  below-­‐market  returns  for  a   given  risk  in  exchange  for  greater  impact   Requiring  market  risk-­‐adjusted   returns  on  impact  investments   Social-­‐first  Finance-­‐first  
  • 4.  The  big  ques#on   What  drives  an  investment’s  impact  and   financial  returns?         How  can  investors  manage  these  drivers   to  produce  blended  value?        
  • 5. 5  factors  that  maIer  for  performance  
  • 6.  The  big  ques#on   What  drives  an  investment’s  impact   and  financial  returns?    
  • 7. Opera6ng  environment   The  building  blocks  of  performance   Financing  environment     Management  &   stakeholder   values   Business   model  &   technology   Decision  by  management   Financing   incen6ves  &   requirements    The  building  blocks  of  performance   §  A  simplified  view  of  performance  drivers,  grounded  in  incen6ve  theory  and   expanded  in  light  of  impact  inves6ng  prac6ce  
  • 8. Opera6ng  environment   The  building  blocks  of  performance   Financing  environment     Management  &   stakeholder   values   Business   model  &   technology   $$   i   Decision  by  management   Financing   incen6ves  &   requirements   $   i    The  building  blocks  of  performance   §  A  simplified  view  of  performance  drivers,  grounded  in  incen6ve  theory  and   expanded  in  light  of  impact  inves6ng  prac6ce   §  Five  “factors  that  maTer”  drive  resource  alloca6on,  impact  &  financial  returns   PorGolio   results  
  • 9. Core  opera#onal  synergies   §  The  business  model  &  technology  define  whether   profitability  and  impact  are  easy  to  jointly  achieve     §  Cross-­‐subsidy  models  rely  heavily  on  management   ini#a#ve  to  generate  impact  from  profitable   opera#on   §  The  fact  of  profitable  opera#on  can  ensure  impact  in   “lock-­‐step”   §  Conflicts  limit  value  for  the  investor  by  forcing   management  to  trade-­‐off  profitability  for  impact   §  Synergies  maximize  value  as  impact  enhances   expected  profitability  and  vice  versa   1.  Business  models  maIer   §  Prac6cal  examples:   §  So@ware  business  funds  founda#on  that  develops  charter  schools  in  the  Bronx   §  Solar-­‐powered  water  pump  is  sold  in  Kenya   §  Tex#le  factory  converts  to  more  costly  wind  power     §  Leather  tanning  opera#on  in  Bolivia  invests  in  technical  training  and  primary  educa#on  for   workers,  developing  posi#ve  rela#onships  that  reduce  risk  of  costly  strikes  or  boycoIs   $$   i   Decision  by  management   Business   model  &   technology  
  • 10. Opera6ng  environment   $$   i   Decision  by  management   §  The  opera6ng  environment  affects  the  cost  and   revenues  of  business  ac6vi6es,  making  certain   business  models  more  likely  or  feasible   §  Consumer  preferences   §  Supply  chain  dynamics   §  Regula#on  &  government  programs   §  NGO  ac#vism   §  Beliefs  about  the  environment  need  to  be   consistently  updated   §  Changes  in  the  opera#ng  environment  may  turn   complementari#es  into  conflict  or  vice  versa   Business   model  &   technology   2.  The  opera#ng  environment  maIers   §  Prac6cal  examples:   §  European  customers  pay  premium  for  “Fair  Trade”  label  on  flowers  à  aIen#on  to  labor   health  &  safety  standards  creates  value  despite  costs  by  boos#ng  revenue     §  NGOs  protest  community  impact  of  Ugandan  power  plant  à  ac#ve  engagement  and   reseIlement  premiums  creates  value  by  reducing  risk  of  associated  cost-­‐overruns  
  • 11. Opera6ng  environment   Management  &   stakeholder   values   $$   i   Decision  by  management   §  Management  values  influence  resource   alloca6on  by  shaping  intrinsic  rewards   §  Prac6cal  examples   §  Turn  a  tradi#onal  for-­‐profit  business  into  a   business  subsidizing  separate  impact  ac#vi#es   §  Create  profitable  businesses  in  high-­‐impact  areas   §  Generate  impact  at  expense  of  profitability  or   return  when  objec#ves  are  in  conflict     Business   model  &   technology   3.  Management  values  maIer  
  • 12. Incen6ves  &   requirements   Incen#ves  &  requirements   $$   i   Decision  by   management   §  External  rewards  or  punishments  contained  in   financing  payoff  structure  can  guide  resources   toward  op6mal  performance   §  Maximize  both  profit  and  impact  under  lock-­‐step   or  synergy  model   §  Enhance  impact  when  management  pursues   profit  at  expense  of  impact   4.  Incen#ves  and  requirements  maIer   §  Requirements  in  terms  and  condi6ons  enhance  and  complement  incen6ves   §  Ensure  investor  has  ability  to  monitor  performance  and  correctly  apply  incen#ves     §  Control  level  of  impact  or  financial  performance  prior  to  investment     §  Prac6cal  examples   §  Marginal  cash  payoff  structure  of  equity  or  debt  incen#vizes  beIer  financial  performance   §  Share  bonus  for  hi^ng  certain  impact  targets  un#l  investor  exit  directly  incen#vizes  impact   §  Minimum  impact  requirements  callable  as  event  of  default  let  investor  and  management   bargain  over  punishment  for  low  impact  later   §  Offer  of  financing  condi#onal  on  demonstra#ng  certain  observable  impact  or  financial  metrics  
  • 13. Conducive  financing  environment   Financing  environment     $$   i   Decision  by   management   Incen6ves  &   requirements   $   i   Contract  &   rela6onship   §  The  financing  environment  affects  the   scope  for  crea6ve  contract  structuring  and   long-­‐term  financing  rela6onships,   constraining  external  incen6ves  and   requirements     §  Funding  op#ons   §  Legal  requirements  on  por_olio   §  Forces  of  compe##on   §  Beliefs  about  the  environment  need  to  be   consistently  updated   §  Changes  in  the  financing  environment  may   undermine  the  power  of  implicit  incen#ves   §  Prac6cal  examples   §  Compe##on  from  solely  for-­‐profit  lenders  constrained  environmental  impact  objec#ves   pursued  by  DFIs  un#l  financial  value  of  such  objec#ves  was  widely  accepted   §  Rising  compe##on  can  undermine  implicit  incen#ves  for  impact  as  value  of  financing   rela#onship  diminishes  from  investee’s  perspec#ve   5.  Financing  environment  maIers  
  • 14. The  impact  investor’s  toolbox  
  • 15.  The  big  ques#on   How  can  investors  manage  these   drivers  to  produce  blended  value?    
  • 16. §  These  building  blocks  can  be  adjusted  as  part  of  investment  strategy  in  order   to  improve  expected  returns  for  a  given  level  of  impact,  or  vice  versa     §  Arrangements  that  align  management’s  incen6ves  with  the  investor’s   objec6ves  help  minimize  the  fric6ons  that  limit  or  distort  performance   §  Three  simple  tools,  already  used  by  many  investors  for  different  objec6ves   §  Selec#on  and  screening  for  conducive  business  models  and  investment   environment   §  Structure  of  the  investment  contract     §  Long-­‐term  financing  rela#onship  and  (condi#onal)  offers  of  future  financing   §  Incen6ve  theory  and  investor  experience  suggest  how  to  use  these  tools  to   achieve  or  enhance  the  blended  value  of  investments   Blended   value    The  investor’s  role   Smart   acquisi6on   Smart   financing  
  • 17. Opera6ng   environment   A   Management  &   stakeholder  values   Business   model  &   technology    1.  Selec#on  and  screening     §  Investors  can  focus  screens  on  compa6ble  business   models,  opera6ng  environments  and  management  values   §  Invest  in  profitable  businesses  whose  fact  of  opera#on   produces  a  definable  &  jus#fiable  impact  (e.g.  providing  life-­‐ enhancing  services  to  underserved  loca#ons  or  popula#ons)   §  Iden#fy  and  invest  in  businesses  that  exhibit  underlying   synergies  between  profitability  and  measurable  dimensions   of  impact  of  interest  to  stakeholders  the  investor   §  Invest  in  businesses  in  opera#ng  environments  where   preferences  of  customer/stakeholders  are  increasingly   aIaching  a  financial  value  to  posi#ve  impact     §  Insights  from  interviews   §  Screening  for  “social  entrepreneurs”  is  popular  in  new  early-­‐stage  funds  but  is  not  a  silver   bullet;  conflicts  can  remain  in  the  business  that  undermine  returns  for  a  given  impact   §  Shi@s  in  consumer  values  and  NGO  agendas  to  reward  strong  labor  standards  and  punish   poor  environmental  standards  provided  cri#cal  support  for  these  standards  in  DFI  por_olios   §  Management  who  personally  values  impact  is  cri#cal  to  maintaining  impact-­‐oriented  policies   within  the  business  when  the  opera#ng  or  financing  environment  reduces  the  desirability  of   impact  ac#vi#es  (e.g.  standards,  abatement,  community-­‐engagement  ac#vi#es)  
  • 18. Opera#ng  models  in  detail   What  rela6onship  between  profitability  and   impact  should  I  expect  to  see?     Separate   ac6vi6es?   Impact   feedback?      Separate  and        subsidize   A  core  ac#vity  generates  profit,  and  impact  is   created  through  separate  ac#vi#es  funded  by  a   por#on  of  profits  from  the  core  business     Y   None      Lock-­‐step   Impact  is  generated  by  the  simple  fact  of  profitable   opera#ons   N   N/A      Synergy   Greater  impact  enhances  profitability  of  core   business  (reduces  expected  costs  or  enhances   expected  revenues)  and  vice  versa     Y   Enhances   profitability      Trade-­‐off   The  two  ac#vi#es  conflict,  and  management  is   forced  to  allocate  resources  to  either  profit-­‐ genera#ng  ac#vi#es  or  impact-­‐genera#ng  ac#vi#es   Y   Drags  on   profitability   §  Management  allocates  resources  toward  profit-­‐genera6ng  and  impact-­‐genera6ng  opera6ons,   which  may  be  separate  or  integrated   §  Impact  may  “feed  back”  and  affect  revenue  and  cost  structure  of  profit-­‐genera6ng  ac6vi6es   §  Posi#ve  feedback  enhances  profitability,  while  nega#ve  feedback  drags  on  profitability   Screening  opera#onal  models  
  • 19. Opera#ng  environment  in  detail   §  Customers  will  pay  a  premium  for  the   business’s  products  or  services  if  the  business   aIains  posi#ve  social  impact  or  mi#gates   nega#ve  impact   §  Nega#ve  impact  carries  a  direct  cost  (cost  of   complying  with  mi#ga#on  rules,  etc.)     §  Nega#ve  impact  carries  an  expected  cost  to   the  business  (NGO  demonstra#ons  damage   reputa#on,  etc.),  such  that  mi#ga#ng  risk   enhances  expected  financial  performance     §  The  investee’s  supply  chain,  distributors  etc.   reward  impact     §  Posi#ve  impact  opens  up  new  higher-­‐revenue   or  lower-­‐cost  business  opportuni#es   Conducive  to  synergies   Likely  to  cause  trade-­‐offs   Selec#ng  a  conducive  opera#ng  environment   §  High  impact  is  highly  costly  rela#ve  to   altera#ve  low-­‐impact  scenario   §  High-­‐  impact  goes  unrewarded  by  customers,   supply  chain  etc.  rela#ve  to  low-­‐impact   business   §  Nega#ve  impact  goes  unpunished  by   regula#on,  NGO  ac#vism,  etc.    
  • 20. Incen#ves  explicit  in  the  contract   §  Apply  crea6ve  contract  structuring  to  ensure  incen6ves  and   requirements  are  op6mized  to  produce  desired  porGolio  results   §  Think  beyond  contracts  that  purely  incen#vize  profit  maximiza#on  in   cases  where  the  underlying  business  model  exhibits  trade-­‐offs  or  follows   a  separate  and  subsidize  model,  and  management  cannot  necessarily  be   trusted  to  pursue  impact  as  the  investor  would  like   §  Incorporate  explicit  incen#ves  for  impact  into  the  investment  contract  in   the  form  of  e.g.  equity  share  bonuses  or  step-­‐downs  in  interest  rates  in   order  to  alter  cost-­‐benefit  calculus  of  genera#ng  impact     2.  Crea#ve  contract  structuring   Investment   contract   Incen6ves  &   requirements   §  Insight  from  investor  interviews     §  Investment  contracts  always  incorporate  strong  incen#ves  for  financial  performance  (e.g.   simple  debt  or  equity  investment  contract)  but  seldom  for  impact  (save  one  investor)   §  Control  rights  generated  by  minimum  impact  requirements  are  frequently  used  by   development  finance  ins#tu#ons  to  incen#vize  pursuit  of  very  important  impact  objec#ves   §  Control  rights  let  investors  gauge  the  driver  of  devia#ons  from  expected  impact  and  respond   in  order  to  maximize  financial  performance  and  impact  in  the  longer-­‐term  
  • 21. Incen#ves  explicit  in  the  contract   §  Develop  a  valuable,  long-­‐term  financing  rela6onship  that  offers   addi6onal  implicit  incen6ves  for  the  investee  to  pursue  desired   impact  standards  or  outcomes   §  Addi#onal  financing  (implicitly)  condi#onal  on  mee#ng  impact  targets   can  alter  cost-­‐benefit  calculus  to  management  of  pursuing  impact   §  A  financing  rela#onship  must  provide  value  rela#ve  to  compe#ng  for-­‐ profit  investors  in  order  to  create  incen#ves:  lower  financing  cost,   technical  exper#se  or  market  connec#ons  (especially  as  necessary  to   enable  impact  that  brings  financial  value),  or  poli#cal  risk  mi#ga#on   3.  Long-­‐term  financing  rela#onship   Financing   rela6onship   Incen6ves  &   requirements   §  Insights  from  investor  interviews   §  Implicit  incen#ves  for  both  impact  and  financial  performance  common   §  Offer  of  future  financing  condi#onal  on  impact  is  a  cri#cal  tool  for  encouraging  management   teams  to  pursue  impact  objec#ves  to  investor’s  sa#sfac#on     §  The  value  of  the  financing  rela#onship  is  o@en  resourced  by  impact  investors  as  a  bargaining   chip  when  deciding  how  to  take  ac#on  in  response  to  a  devia#on  from  expected  impact   §  For  DFIs,  leveraging  value  of  rela#onship  as  incen#ve  for  management  to  return  to   compliance  o@en  takes  precedence  over  enforcement  of  legal  rights  
  • 22. Opera6ng  environment   Financing  environment     Assess  the  big  picture   Business   model  &   technology   Applying  the  intui6on  to  improve  porGolio  performance  and  minimize  trade-­‐offs   §  Assess  building  blocks  of  performance  for  compa#bility  or  fric#on  among  performance  drivers   §  Apply  impact  investor’s  toolbox:    Smart  selec#on  and  smart  financing   Management   &  stakeholder   values   Incen6ves  &   requirements   Compa#ble   or  fric#on?   Compa#ble   or  fric#on?   Compa#ble   or  fric#on?   The  big  picture  for  investors  
  • 23. Madeleine  Evans  is  a  direct  equity  investor  with  research  and   advisory  experience  in  both  impact  inves6ng  strategy  and  tac6cs  as   well  as  impact  measurement.       Madeleine  is  also  the  co-­‐founder  of    Finance  MaIers,  a  London-­‐ based  organiza#on  bridging  the  gap  in  knowledge  and  networks   between  mainstream  finance  and  the  UK’s  growing  impact   investment  sector.     She  received  an  Master  of  Public  Administra#on  with  Dis#nc#on   from  the  London  School  of  Economics,  where  she  aIended  as  a   Thouron  Scholar  and  focused  on  development  economics  and  policy.     Madeleine  holds  her  undergraduate  degrees  from  the  University  of   Pennsylvania’s  Huntsman  Program,  with  a  B.S.  from  the  Wharton   School  and  a  B.A.  in  Interna#onal  Studies  from  the  College  of  Arts   and  Sciences.     She  speaks  English,  Spanish,  and  German.    About  the  author  
  • 24. The  content  in  this  presenta#on  is  the  product  of  a  year  of  inves#ga#on,  culmina#ng  in   a  Masters’  disserta#on  en#tled:  “Mee1ng  the  challenge  of  impact  inves1ng:  How  can   contrac1ng  prac1ces  secure  social  impact  without  sacrificing  performance?”   The  disserta#on  presents  a  strategic  toolbox  for  investors  with  financial  and  non-­‐ financial  objec#ves.  Content  is  based  on  lessons  from  economic  theory  of  contracts  and   from  in-­‐depth  interviews  with  sixteen  Bri#sh,  German,  and  U.S.  impact  investors.         The  relevance  of  each  strategic  tool  will  depend  on  the  investor’s  control  over  the   underlying  por_olio,  the  legal  and  funding  constraints  on  contracts,  the  degree  of  ac#ve   management  pursued  by  the  investor,  and  the  objec#ves  of  compe#ng  investors.  The   toolbox  is  meant  as  a  direct  resource  for  investors  in  a  por_olio  of  companies  or   projects,  but  the  intui#on  should  be  valuable  for  funds-­‐of-­‐funds  as  well.     Copies  of  the  paper  or  details  of  methodology  are  available  from  the  author.    About  the  research  
  • 25. Assess  the  big  picture   Get  in  touch.   Evans.madeleine@gmail.com