Hype vs reality: What India taught me about investing for impact
Microfinance is often heralded as the great impact investing success that other sectors should replicate, but the reality isn’t so clear-cut. In the fifth instalment of our Impact Papers series, Harvey Koh, who leads FSG’s work on inclusive markets, proposes four ways to do better at investing for impact in other sectors, while learning from the ups and downs of India’s financial inclusion boom
Historic levels of wealth inequality. Entrenched divisions within society and growing unrest. The continuing destruction of natural ecosystems, and the prospect of catastrophic climate change that could extinguish human civilisation as we know it.
If ever there was a time to question how we do business and invest capital, and whether that promotes the kind of world we want to see, it is now.
Hype vs reality
In 2011, I went to India join colleagues at Monitor Inclusive Markets (now part of FSG) working on what we called market-based solutions for development. This was not an attempt to apply market thinking to all challenges. Rather, it was a response to the reality that poorer, marginalised populations were already relying on the markets for much of what they needed – housing, water, healthcare, energy, livelihoods – but often got a raw deal. Compared with more affluent groups, they would typically get a much poorer-quality and possibly even harmful product or service; to make matters worse, they often had to pay more than affluent consumers.
I arrived in Mumbai with a great deal of excitement about the new breed of impact entrepreneurs who were breaking through these challenges, and the impact investment that was helping them scale.
Reality soon set in. Many of these business models were still young and unproven. Building and growing them was a tough slog. And impact capital wasn’t flowing as readily as I had imagined, especially when faced with tough operating conditions, thin margins, high risk and a long road just to get to profitability, never mind scale. Investments were made – but mainly, it seemed, in financial services models, as exemplified by microfinance.
All this led me to a number of observations and reflections about what it might mean to invest for impact.
The first observation was that it took two decades of patient trial and error, and an estimated $20bn globally in grants and concessional investment, until investing in microfinance providers became mainstream. My colleagues and I realised that this was a challenge common to many new impact enterprise models: the work of developing and refining them was difficult and risky, with high uncertainty about future financial returns, so investors with mainstream risk-return expectations were reluctant to support it. We called this the pioneer gap (for more, see From Blueprint to Scale (Monitor Group & Acumen, 2012) and Closing the Pioneer Gap (Stanford Social Innovation Review, 2013)). We therefore called for investors who could be more flexible in tolerating greater risk and time horizons to invest here, to build and refine the solutions of the future, just as that kind of capital had supported the gestation of microfinance.
It took two decades and an estimated $20bn in grants and concessional investment, before microfinance broke into mainstream investing
The second was that microfinance in India operated in a relatively clean and nationally regulated sector, typically required little bricks-and-mortar investment, and – as what some call a ‘pull product’ – tapped into ready customer demand. Many of the sectors we were looking at –agriculture, housing, safe water – were not so blessed, leading to greater operational challenges, and more challenging economics. We saw this disparity starkly in our own efforts to build a high-quality affordable housing sector over almost a decade: the housing developer models have progressed but struggle to scale, while the housing finance models have scaled dramatically, becoming essentially ‘the new microfinance’ in India today.
This is corroborated by data points from elsewhere. In 2017, McKinsey & Co estimated that the financial inclusion sector accounted for over half the impact investing capital deployed into India. Lok Capital, a leading impact investor in the country, recently announced that they would be launching a new ‘high-impact platform’ to target sectors such as healthcare and education for the underserved, where they would not be able to offer the level of financial return achieved on their earlier, microfinance-oriented funds.
Commercial pressure from investors was a key driver behind the ‘Andhra Pradesh microfinance crisis’
The third point was that even where impact models could graduate to mainstream capital markets, it is not clear that such progression would always be an unalloyed good. Indian microfinance grew rapidly through the 2000s, with the entry of commercial bank finance in 2003 and venture capital / private equity investors in 2007, and the IPO of SKS Microfinance in 2010, the first microfinance company to sell stock to the public in India. This fuelled aggressive lending growth at the expense of credit quality, with rising levels of multiple lending and debt rollovers, culminating in what has since become known as the ‘Andhra Pradesh microfinance crisis’: a spate of suicides involving over-indebted clients, thousands of borrowers stopping repayments, and the state government then moving to restrict microfinance activities across the state. Loan books contracted by $1.8bn, 35,000 people lost their jobs, and the sector was saddled with nearly $1bn in bad loans. While our analysis suggests that weak impact tracking and lack of appropriate regulation played their part in creating this crisis, it is clear that commercial pressure from investors was a key driver.
Four ways to improve
So, what can we do to invest for impact?
First, we need to start with problems and work out what’s needed to help solve them – rather than starting with a narrow view of our pre-determined requirements which we expect investees to meet. Have we grounded ourselves in the reality of the problem and its context, rather than projecting assumptions based on our own lived experience? Are we investing in the most effective solutions that we are able to, and with the most effective tools at our disposal? Are we deploying our investment in ways and on terms that will enhance the effectiveness of those solutions, and minimise the risk of hindering or derailing them? Be prepared: engaging with these questions may take you beyond conventional debt and equity instruments. It could, however, make your contribution far more effective – for more on this, I recommend reading Frontier Capital (Omidyar Network, 2015) and, more recently, Capital Evolving (Village Capital, 2019).
Second, we must have an uncompromising focus on impact. This includes planning for and measuring impact, but also actively managing for it and taking appropriate action when impact performance becomes an issue. In short, we should do everything for impact that we conventionally do for financial return in investing. Every impact solution and business model that I have seen is vulnerable to deterioration in terms of impact; again, in much the same way as no economic model for a business can be successful without continual vigilance and diligence in managing it. Unless we rebalance our orientation towards impact, there is a great risk that our attention will be consumed by the greater clarity and immediacy of financial return – not to mention the strong incentives around maximising that return – to the potential detriment of impact. Fortunately, in recent years, the sector has made significant strides forward in supporting investors in this area, including through the Impact Management Project.
Engaging with these questions may take you beyond conventional debt and equity – but it could make your contribution far more effective
Third, we should consider flexing our assumptions and expectations around financial risk, return and liquidity. This is not to say that we will always need to accept, say, higher risk or lower return. But equally: why should we assume that we would never need to? The Beyond Trade-offs series produced by Omidyar Network and FSG last year highlighted how different kinds of investors have found ways to work across the risk-return continuum of impact investing. These include not just foundations and family offices, but also institutional investors such as Prudential Financial. CDC Group plc, the UK’s development finance institution, has launched new strategies deploying flexible capital in order to achieve more ambitious impact. Most recently, the Catalytic Capital Consortium has announced $150m of flexible (or ‘catalytic’) capital in an effort to demonstrate the potential for such capital to extend and deepen the reach of impact investing.
Finally, we need to maintain an appropriate level of humility. Money is not enough to solve the problems we face, though it helps a great deal. Entrepreneurs, social leaders, political operators, and a range of other kinds of innovators have played crucial roles in the most transformative cases of market-based impact that we have analysed. At its best, investing for impact means being open to working with and alongside others, and developing the skills needed to do that effectively.
What’s been your biggest lesson in impact investing? What do you think investors should change or prioritise? Join the conversation on Twitter using the hashtag #ImpactPapers, or drop us a line: firstname.lastname@example.org.
Hear from thought leaders from around the world at EVPA's 15th Annual Conference, Celebrating Impact, taking place in The Hague, 5-7 November.