The new lords of finance come, not to bury capitalism, but to refine it
Financial innovation got a bad rep in the financial crisis. But inside the well-barricaded Federal Reserve Bank in downtown San Francisco last month, the financial engineers were at it again.
Teams of financial statistical whiz kids pitched complex new bonds, loan-guarantees, and hybrid structures of debt and equity. Their target? It wasn't mortgages. It was women's economic empowerment. It was energy efficiency improvements and ranchland conservation. It was small businesses in Africa.
The Occupy movement has tarred Wall Street with a broad brush, while economists like Yale's Robert Shiller have tried to rescue finance from the consequences of its excesses. At the Fed, the MBA students competing in the second International Impact Investing Challenge were part of a new crop of financial engineers taking a different tack: tweaking risk and reward to directly tap at least a small part of the $60 trillion private capital markets for positive, measurable social impact.
The contest winners, who come from Stanford, have a plan to bring electricity to remote Indonesian islands -- and 5 to 7 percent returns to investors -- by financing local micro-grids through special-purpose vehicles owned jointly with community co-ops. The runners-up, from the Kellogg School of Management at Northwestern, aimed to help slum dwellers in Mumbai get higher-paying jobs, financing job-training by offering private investors 7 percent of graduates' paychecks for two years.
"These are not idealistic kids," the mastermind of the contest, David Chen, CEO of Equilibrium Capital Group LLC in Portland, Ore., said of the student financiers. "They are making a judgment call on the future. This is the equivalent of investing in hedging strategies or emerging markets, or high-tech 25 years ago. In each of those cases, the market efficiency and information efficiency gains went to those that were first."
HIGH FINANCE FINDS A HEART
"Impact investing" is catching on among investors who want to use finance to make more food, cleaner water, better health care, smarter children, and a richer bottom-of-the-pyramid. Morgan Stanley has an "investing with impact" offer for its wealthiest customers, and AOL founder Steve Case told The Economist that impact investing was the hottest topic of conversation among a group of billionaires gathered in Santa Barbara.
In the broadest view, impact investors are simply betting on fundamental trends. In a volatile and resource-constrained world, investments to provide food, water, energy, health care, education and sanitation to a growing and increasingly affluent global population arguably have lower risks and higher long-term returns. But on the ground, even innovative efforts to meet basic needs often are hampered by inefficiencies and market failures that prevent those who create value from getting paid for it.
Enter the financial innovators.
If J.P. Morgan can use credit default swaps to bet that corporate credit ratings would rise in a volatile economy, why not let other investors use newfangled investment vehicles to bet that job training can keep ex-offenders from returning to prison or that transitional housing can reduce the ranks of the chronically homeless? The savings to governments in unbuilt prisons and unfilled beds in homeless shelters could be significant.
HOW FINANCE CAN REDUCE CRIME
A British import offers a way to collateralize such win-wins. "Social impact bonds," sometimes called pay-for-success contracts, let private investors buy low-interest bonds to finance preventive efforts and get repaid, with a small premium, from those government savings. The new bonds effectively leverage the value of prevention, an ounce of which, Benjamin Franklin taught us, is worth a pound of cure.
If the social interventions meet its benchmark, a government agency pays off the bondholders out of the substantial savings from lower costs associated with jail-time, nursing homes and emergency room costs. If the programs flop, too bad. Budget-crunched agencies pay only for what works.
So far, exactly one such bond has been issued, to be repaid by the U.K Ministry of Justice if re-entry services for released prisoners lowers their recidivism rate by at least 7.5 percent. But Massachusetts is getting ready to back bonds to finance housing and other services for the chronically homeless, to improve their well-being, and reduce Medicaid costs. The Labor Department is committing $20 million for pay-for-success contracts for state-level workforce development; the Justice Department is backing contracts for prisoner re-entry programs.
"We hope to show that you can securitize a new form of cash flow out of government savings based on the spread between prevention and cure," says Tracy Palandjian, who heads Social Finance, the Boston-based nonprofit that is organizing a number of demonstration efforts.
If it sounds sketchy, consider that financing methods we now take for granted were once edgy as well. The 30-year amortized mortgage was introduced by the Federal Housing Administration in the 1930s to unlock bank lending during the Depression. In the late 1970s, federal regulators let pension fund fiduciaries invest in venture capital, fueling the tech explosion.
CAN "MORAL" FINANCE REALLY MAKE MONEY?
Now there's a rush to "crack the code" for unlocking private capital to meet the needs of the world's poor. For example:
-- The government's Overseas Private Investment Corp., or OPIC, agreed to put down $285 million last year in a half-dozen "impact" funds that pledged to raise another $590 million in private capital.
-- The Small Business Administration has committed $1 billion over five years to finance job-creation in low-income communities and clean energy projects, matched by private capital.
-- In the UK, the Big Society Fund launched recently with 600 million pounds (more than $950 million) to invest in social enterprises. Two-thirds of the money comes from dormant bank accounts reclaimed by the government and the rest from four big banks.
"There are all these funds trying to prove that certain types of investments are not as risky as traditional investors perceive them and that commercial money can get into the sector," says Christian Schattenmann, CFO of Bamboo Finance, which has raised $250 million and is now focused on solar power in the developing world. "In 10 to 15 years, mainstream and impact investing will merge and become one sector again and everybody will be looking at environmental and social impact."
A GOOD BET IS HARD TO FIND
Suddenly, everybody seems to be looking for "impact" investments that promise measureable social and environmental benefits along with financial returns. But it turns out such ventures are not that easy to find. An increasing number of companies around the world are seeking "the fortune at the bottom of the pyramid," as the late C.K. Prahalad put it, but most are too young or too risky to be "investable" by investors' criteria.
For example, the new $25 million African Agricultural Capital Fund provides a hunting license for Pearl Capital Partners in Kampala, Uganda, to find 20 agribusiness deals that can together raise the income and productivity of at least 250,000 East African households. "Even putting aside the impact thesis, there are some really interesting opportunities in the market to address the needs of low-income people," says Amy Bell, head of J.P. Morgan's social finance unit, which brokered $17 million in equity investments - not grants - from the Gates, Rockefeller and Gatsby foundations, and itself made an $8 million commercial loan. But J.P Morgan's assessment of the risk was aided by a guarantee by the U.S. Agency for International Development for half of its loan.
In Nairobi, M-Kopa LLC is creating a way for low-income consumers to use their mobile phones to pay-as-they-go for solar power systems, farm equipment, sewing machines and other productivity-enhancing equipment, was swarmed by impact investors eager to help it move from testing to rollout. That was partly a function of its pedigree: the venture was incubated by Signal Point Partners, the mobile-services incubator started by Nick Hughes, who as Vodafone's head of global payments in 2004 launched M-Pesa, a mobile payments system now used by more than 10 million Kenyans to pay bills and transfer money. The rush was also spurred by risk-insurance from USAID, which mitigated some of the local currency risk for international investors.
Jacquelyn Novogratz, head of Acumen Fund, a pioneering impact fund that put $1.1 million into M-Kopa, is unapologetic about the need for risk-reducing subsidies. "The dirty secret is, I'm not seeing a lot of people making money in this field," she says. "There's so much desire, so much talent, so much money. What we don't have is deals on the ground."
Acumen, along the consultancy Monitor Group, recently issued a report calling for even more subsidies. Unlike angel investing in advanced markets for technology or health care, investments in new ventures for the poorest of the poor can't promise outsize returns to outweigh the early risk. "With an iPod, there are some early adopters who will pay through the nose for it, says Monitor's Ashish Karamchandani. "There are no early adopters will to pay through the nose for a low-cost irrigation system."
'I DON'T WANT TO BURY MODERN CAPITALISM'
To mitigate low and volatile returns, the report calls for "enterprise philanthropy," in which foundations play the role of seed investors and market-makers, staking entrepreneurs to startup capital and stimulating customer demand for new approaches or whole new categories, plowing the ground for for-profit ventures.
"There's a lot of interest from investors and there are certainly social needs that need capital, but the market is not clearing," says Antony Bugg-Levine, co-author of, "Impact Investing: Transforming How We Make Money While Making a Difference," who as a program officer at Rockefeller Foundation made early grants to build up the field. Bugg-Levine, who now heads the Nonprofit Finance Fund, argued in a recent article in Harvard Business Review that different types of investors can get paid in different types of currencies -- charitable investors into a social venture can reap their returns in lives saved or girls educated, for example, leaving higher financial returns for more profit-oriented investors. You can think of that as a subsidy, he says, or as a high-leverage strategy to bring in additional capital and reduce the charitable outlay required to get the equivalent result.
Just as in high-tech investing, many early-stage social investments will fail. But the few that succeed may present opportunities for truly sizeable investments in new products and services for a global market.
There's a fine line between the "breathless maximizers" who champion private impact investment as the cure for all global ills and the "derisive minimizers" who dismiss the whole opportunity, Elizabeth Littlefield, OPIC's chief executive, said at the Global Philanthropy Forum in April. The appropriate comparison for impact investing, she said, is not to the entire global capital market, but to the pittance that now goes to foreign aid and economic development. A one percent shift in asset allocation toward sustainable development would generate $2 trillion, she said, 10-times the global budget for foreign aid
"It's not just new money. It's new money tied to newer, more efficient, more innovative generations of technology and infrastructure and services," Littlefield said. "I don't want to bury modern capitalism. I want to cultivate it."