It is now the sixth month of operational existence for OurConservatory, and we have gained valuable first-hand insights into both expected and unexpected issues in the period.
To start off with, we would like to address a common question we face every day – why has it taken so long for impact investment to take off in Hong Kong? This is a long one - please bear with me!
THE CASE FOR IMPACT INVESTMENT IN EM
For the majority of dedicated impact investment funds – referring to those predominantly operating in the private investment markets, investing in early stage to growth companies and ventures (~50% of total impact assets, from the 2018 GIIN Survey) –Emerging Markets (EM) make up 56% of investment allocation. This is significantly skewed relative to “traditional” investments. For context, despite having already grown more important in recent years, asset growth in EM private equity (PE) funds totaled just $115b out of over $1tr of total inflows in 2017.
There are important drivers that justify this:
Multiplier effects – Maximizing Impact
Intuitively, investing in EM for impact makes sense because it’s simply where the most visible impact is. A lower baseline of economic development means that potential growth rates can, by definition, be higher – this is evident from the national economic growth rates. The fact that investing in basic infrastructure such as water & sanitation can transform lives is indisputable.
Extending this concept to the individual level, this can be captured in the following representation of the relationship between GDP per capita and Social Progress:
At earlier development stages, economic takeoff can have transformative impact on individuals’ quality of life, and the correlation between financial and social returns is extremely high. Digitalising a farm to improve planting, yield & inventory management smooths income volatility; digitalise ten farms and you have a cooperative to improve access to market. The impact on farmers’ income is multifold, and spillover effects on the economy are significant.
In some ways, to put it very crudely, the problems in EM are such that throwing money at them works. Of course, this also makes the role of impact investment that much more important.
Leveraging Risk Appetites – What Impact Investing is Really About
How is this different from “normal” investing? Typically, investors attempt to capture the greater inherent risks of investing in EM relative to developed markets (DM) through higher discount rates – e.g. up to low teens for “emerging” markets and up to twenty or beyond for “frontier” markets (FM). This holds throughout the asset curve – from sovereign rates (how much the country itself has to pay in return for capital) to equity investments – and because investors discount future projected cashflows at a higher rate, the implicit return that would justify an investment would necessarily be higher. The greater the risk, the higher the required return to attract investment.
Compare this to impact investing funds. Although public disclosure is not common, the targeted return (internal rate of return, or IRR) amongst most funds that we have met with is in the same ballpark as traditional PE investment funds. On a superficial basis, they are yielding “market rate of return” – but when you consider that their geographic mix is skewed towards EM/FM, whilst traditional PE funds invest in DM, this suggests that impact funds are taking greater risks for the same anticipated return.
Impact investors are willing to take greater financial risks in order to maximise social & environmental impact.
HOW THIS LOOKS LIKE IN DM
When we apply the same concepts to a developed market like Hong Kong, it is easy to understand why impact investing hasn’t “taken off” – firstly, general quality of life is already high, so the “pain points” are more nuanced, and more likely down to policy and execution rather than a lack of financial resources; secondly, without the boost from higher GDP growth or discount rate adjustment, it is hard to compare the returns from a DM impact investment project with commercial alternatives.
But does this mean that impact investing can’t take off in DM? Perhaps it simply means that investment targets, deal structure and the targeted “end-game” may all look a bit different:
Solutions vs Products – Perception of Scalability
An unexpected issue that we have discovered since developing OurConservatory, is that a significant proportion of social enterprises in HK are product-based. This is not necessarily negative; in fact, in some cases the product innovation could be a positive sign of the advancement and sophistication of our engineering colleges.
That said, the capital commitment required to support “hardware” product development – say, for a medical device – is necessarily longer and larger than the capital requirements for an app or a software platform. This means that risks are inherently higher, and it becomes difficult to perceive true scale – even if the product is attractive, how would distribution work? Can we get the product to areas where it could yield the most impact?
Contrasting with EM/FM, where typical impact investment targets offer community solutions that are relatively cheap to implement, and with multiplying impact on beneficiaries. The return profile on such an investment would be more attractive, as the project is more likely to generate cashflows within a foreseeable timeframe. Low upfront costs also improve perceived replicability into other areas or markets.
Therefore, to common assertions that the deal pipeline in HK is too poor – although there may be some truth in this, but we also highlight a more structural problem – the social investment ecosystem is mismatched. Deal progress relies on effective matching between the capital demand of fundraisers, and the willingness of investors to supply. The gap in capabilities, appetite and positioning gives rise to persistent mismatch in the risk/return profile and expectations between parties, and constructive dialogue would require open and improved understanding (and hopefully, the work of a committed intermediary like OurConservatory!).
Catalysing Behavioural Change
Applying impact investors’ greater willingness to take certain risks in return for social impact, DM deals can deploy private capital to deliver unproven solutions that the government or civil society cannot afford to take, with the view that proof of success could reshape policy.
Case in point would be the Social Innovation Fund Workforce Development programmes in the US, in which three communities are now leveraging the Pay-for-Performance provisions to shift contracts addressing youth employment and education towards career and living wage outcomes. Early education, preparation and initiatives funded by the private sector and lobbied by civil society has culminated in the potential for large-scale national rollout of innovative policy structures.
Assessing Risk-adjusted Returns
It is difficult, and likely self-defeating, to ask investors to “sacrifice” returns; and in fact, most investors do still target market returns (~2/3, according to GIIN Annual Impact Investment Survey 2018). The more constructive question is therefore: what outcomes would you like to achieve? What are the necessary requirements and how can we support the requirements to maximise probability of success?
A typical case would be “patient capital”. For example, recent community property projects announced within the city target similar IRR over the lifetime of the project – but over a slightly extended investment horizon. In other words, investors are willing to make the same amount of money, over a longer period (i.e. lower p.a. rate of return) in exchange for better community outcomes.
The above overview represents some reflections we have come up with in our experience so far – this is admittedly subjective, and not intended to be exhaustive. If you have comments, criticisms or alternative suggestions, please do reach out – we would love to learn more!