TBN National Conf. '11 - Nick O’Donohoe - Impact Investing Report

December 2010 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L Nick O’Donohoe Antony Bugg-Levine Amit Bouri

Our research report covers six major questions
What defines and differentiates impact investments?
Who is involved and how do they allocate capital?
What makes impact investments an emerging asset class?
How much financial return are investors expecting and realizing?
How large is the potential opportunity for investments in this market?
What does risk management and social impact measurement involve?
1 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

What defines and differentiates impact investments?
Basic needs
Agriculture
Water
Housing
Basic services
Education
Health
Energy
Financial services
Process
Job creation
Energy efficiency
Facilitating asset accumulation
Utilizing BOP+ suppliers
Products for BoP+
Agriculture
Water
Housing
Education
Health
Energy
Financial services
Impact investing: Our definition Two-dimensional framework 2 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S Investments intended to create positive social impact beyond financial return
Provide capital
Transactions currently tend to be private debt or equity investments
We expect more publicly traded investment opportunities will emerge as the market matures
… to generate positive social and/or environmental impact
Positive social and/or environmental impact should be part of the stated business strategy and should be measured as part of the success of the investment
Expect financial returns
The investment should be expected to return at least nominal principal
Donations are excluded
Market-rate or market-beating returns are within scope
Business designed with intent …
The business (fund manager or company) into which the investment is made should be designed with intent to make a positive impact
This differentiates impact investments from investments that have unintentional positive social or environmental consequences
Business sectors for impact investing Means of impact

Who is involved and how do they allocate capital? Investors: Market participant examples
IFC
EBRD
OPIC
Etc.
Development finance institutions Corporates & HNWIs Pension fund managers Financial institutions Private foundations
Gates
Omidyar Network
Rockefeller
Esmée Fairbairn
Sainsbury
Etc.
J.P. Morgan
Citibank
Prudential (US)
Deutsche Bank
Storebrand
Etc.
TIAA-CREF
PGGM
Etc.
Starbucks
Danone
Etc.

What makes impact investments an emerging asset class?
CFA definition:
Homogenous
Mutually exclusive
Diversifying
Liquid
Our definition:
Unique set of investment and risk management skills
Organizational structures established to accommodate this skillset
Industry organizations, associations, education
Development of standardized metrics, benchmarks, ratings
An emerging asset class 4 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

How much financial return are investors expecting and realizing? (1 of 4) Instrument distribution Sector distribution Geographic distribution Source: GIIN, J.P. Morgan. Source: GIIN, J.P. Morgan. Source: GIIN, J.P. Morgan. * ”Other” includes community development finance. Survey sample
GIIN
Financial returns survey: Methodology
Investors’ Council
1,105 investments
24 respondents

How much financial return are investors expecting and realizing? (2 of 4) Return expectations vs. benchmarks: Average return expectations by instrument and region Source: GIIN, J.P. Morgan. Horizontal bars: Average realized returns for benchmark and average expected returns for impact investments, gross annual IRR or yield, in USD. Vertical lines: Range of expected returns reported, gross annual IRR or yield, in USD. Note: Benchmark returns are average annual returns for: J.P. Morgan’s Developed Markets High Yield index and Corporate Emerging Market Bond (“CEMBI”) Index, over the period 2002 – 2010 (our full data history); and Cambridge Associates US Venture Capital Index and Emerging Markets Venture Capital and Private Equity Index, for vintage years over the period 1989 – 2006. Impact investment return expectations are calculated by taking an average of survey responses (each of which represents a range of expected returns for a given investment instrument in a specified region) across the population of reported investments. The number of investors who responded for each instrument, and the number of investments in the sample (respectively) are: Dev mkt HY debt = 9, 219; EM HY debt = 10, 411; Dev mkt venture capital = 6, 91; EM venture capital = 15, 119. Readers should note the low number of Dev mkt venture capital investors represented. Note that the range of expected returns for developed market debt excludes a single investment reported by one respondent with an expected range of returns of 20-25%; all other data points fall within the range shown. Both the developed market and emerging market venture capital ranges include investments with expectations of 25%+ return (the range was not specified above that level). Developed market high yield corporate debt Emerging markets corporate debt Developed market venture capital Emerging market venture capital Benchmark 11% Impact 0-5% Benchmark 9% Impact 8-12% Benchmark 28% Impact 15-20% Benchmark 10% Impact 12-15%
Return expectations vary substantially, from competitive to concessionary
Average expectations for EM debt and equity impact investments appear competitive against traditional benchmarks while expectations for DM debt and equity suggest some trade-off
But these results depend on our choice of benchmarks (next slide)

How much financial return are investors expecting and realizing? (3 of 4) Venture capital annualized returns in developed and emerging markets Source: Cambridge Associates
Benchmarking performance is always challenging, even more so when benchmarking return expectations against realized returns
For debt, we chose the US High Yield and Corporate Emerging markets indices over the period 2002-2010 (our full data history)
For equity, recognizing the early stage nature of many impact investments, we selected the Cambridge Associates US Venture Capital Index and Emerging Markets VC/PE Index for vintage years 1989-2006
The choice of time frame of vintage years has significant impact on the benchmarks: if we look only at vintage years post-dot com bubble (1999 -2006 vintages) the return for US VC is only 0.2% and for EM VC/PE over 14%
Additional five and ten-year VC returns are provided below
If we choose to benchmark equity return expectations instead against what we believe new managers target (net 15-20%), then impact investors’ expectations on DM equity appear competitive and EM equity concessionary
A note on our choice of benchmarks 7 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

How much financial return are investors expecting and realizing? (4 of 4) Respondents’ impact measurement system
Investment sizes remain small making costs high
Source: GIIN, J.P. Morgan. Number of deals per bucket; bucket sizes shown in USD mm. Investment sizes reported in USD as at time of investment. Distribution of reported investments by size Carry fees Source: GIIN, J.P. Morgan. Represents 374 investments ($582m of notional value). Source: GIIN, J.P. Morgan. Carry defined as % of fund's return retained by general partners. Represents 233 investments ($254m of notional value).
While investment sizes remain small, and costs are high, funds’ fees do not appear significantly higher than for traditional funds
Source: GIIN, J.P. Morgan. Investments for which no system was reported are not included. Third party system Investees’ system Proprietary system Total # of investments = 889 Total size of investments = $1,144m
Impact measurement systems are overwhelmingly proprietary
Management fees 8 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

How large is the potential opportunity for investments in this market? (1 of 4)
Operational challenges to developed business models
Access to finance
Logistics and infrastructure
Variable and unpredictable cash flows
Traditional businesses do not target BoP populations
The example of mobile phones
Government and philanthropic solutions are limited
Lack of government provision forces BoP to inefficient private providers
Impact investment complements rather than replaces grants and aid
Why does the opportunity exist? Impact investments require new, innovative, sustainable and scalable business models that address underserved communities around the world 9 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

Remove lowest income segment
Select case study
Determine income brackets of market customer base
Limit to urban or rural
Identify population in each income bracket, factoring in population growth
Estimate a penetration rate
Identify average price per unit
Estimate growth in customers
Estimate revenue opportunity
Estimate operating margin
Estimate sales / invested capital ratio
Sizing the market – a framework Step 1: Size the potential customer base Step 2: Size the revenue opportunity Step 3: Calculate potential profit opportunity Step 4: Size capital required to generate revenue 10 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

Business models transfer across regions
All potential businesses can be impact investments
Investments made over 10 years
Operating margin (EBIT) is the key profitability metric
Sales to invested capital is a constant
Key assumptions in sizing study 11 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

Established market, assumed 20% target penetration
Source: J.P. Morgan. Potential profit and invested capital to fund selected BoP businesses over the next 10 years Some exceptions to the framework Microfinance Agriculture Energy Technology Infrastructure
Multiple distinct markets, no obvious single case study
Wide array of product and business types; clean energy market in India alone estimated to be US$2.1 billion per year (IFMR/WRI)
Large overlap with other sectors
Not considered as a discrete subset of impact investment, an enabler in many areas
SME finance
Required annual investment of $900 billion per year (WEF)

What does risk management and social impact measurement involve?
Legal and reputational risks
What is a reasonable profit for a BoP business?
Financial risk
Company
Country
Currency
Social impact risk
Resource intensive and difficult to execute
Tension between feasibility, credibility, and cost
Complex impact inter-relationships
Cross sector comparisons difficult
Different investors have different priorities
Managing impact investments 13 I M P A C T I N V E S T M E N T S – A N E M E R G I N G A S S E T C L A S S

Key conclusions
Impact investing is emerging as an asset class; investors need to organize accordingly
The potential size of the market is huge: our framework suggests up to $1 trillion of capital may be required and up to $667 billion of profit may be generated over the next 10 years
Benchmarking returns is difficult but the evidence from our survey suggests a wide range of expectations with many investors expecting commercial or near commercial returns
Investment infrastructure is developing but more work is required on taxonomy, benchmarking, product accessibility and social impact metrics

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TBN National Conf. '11 - Nick O’Donohoe - Impact Investing Report

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TBN National Conf. ’11 - Nick O’Donohoe - Impact Investing Report — Presentation Transcript