Risk and Reward in Taking On Homelessness and Recidivism

Shifting the risk for delivering measureable social progress from government to private investors is supposed to be one of the key features of “social impact bonds,” a promising new way to finance programs tackling nitty-gritty challenges such as homelessness and prison recidivism (see “How Financial Innovation Can Save the World”).

But investors have been wary of shouldering such risks on their own. The two social impact bond programs announced this week, in Massachusetts and New York City, will provide early evidence of what the market might bear.

In New York, Goldman Sachs will provide a loan of $9.6 million for a four-year program to reduce the rate at which young men at Riker’s Island return to prison. If recidivism goes down by more than 10 percent, Goldman stands to gain a profit of $2.1 million, paid by the city’s Department of Correction out of savings it captures from a reduced prison population. If it drops by 10 percent, Goldman will get only its principle back. But if it drops less than 10 percent, Goldman will lose only $2.4 million, not the full amount, the result of a $7.2 million loan-guarantee provided by New York City Mayor Michael Bloomberg’s personal charity, Bloomberg Philanthropies.

That’s a shift from the original structure of social impact bonds, sometimes called pay-for-success contracts, in which private investors were to bear the full risk of unsuccessful programs.

“The objective of the government is to transfer the risk. The objective of the investors is to have someone share the risk,”Steven Godeke, a financial advisor who has been working with the Rockefeller Foundation to assess investor interest in the new financing mechanisms, told Impact IQ even before the recent announcements. “Early deals will have some risk-sharing. Social impact bonds will be about risk sharing, not risk transfer.”

The details of the Massachusetts offering are still being worked out, in particular the metrics to be used to determine the repayments to investors and the agencies carrying out the program. Philanthropic investors are the most likely candidates, given the likely deal structures. “There will be profits, yes, but always at a very modest level,” George Overholser of Third Sector Capital, which will manage the offerings, told the Globe. “The returns are well below the market rate, compared to the risk.”

In that regard, the New York City program may be more interesting in terms of gauging the commercial market for such offerings.

“The goal should be for there to be risk-sharing, to lure in the commercial investors, so they learn how to underwrite and assess these transactions,” Godeke said. “Down the road, they will need less and less credit enhancement, and they will be able to do it without the government and philanthropies having to provide the risk-transfer.”

(Note: For a terrific primer on social impact bonds, see Laura Callanan’s report from McKinsey & Co., “From Potential to Action: Bringing Social Impact Bonds to the U.S.” And there’s a wealth of information at the Nonprofit Finance Fund’s Pay for Success learning hub at http://payforsuccess.org/.)

Sizing the Impact Investing Market

A new crop of private equity investors are seeking — and measuring — social impact in their portfolios without lowering their expectations for financial returns.

Such “double bottom line” investors fueled the growth of private equity impact funds, to a total of $4 billion in assets under management, according to a new survey by PCV InSight, the research arm of Pacific Community Ventures in San Francisco.

InSight’s team surveyed 300 private equity funds and identified 69 that can be considered impact investors — defined as explicitly seeking social impacts as well as financial returns and tracking and reporting such impacts to limited partners or publicly.

The total of $4 billion indicates fast growth in the last decade but still represents a tiny fraction of the $1 trillion private equity market in the U.S.

InSight identified social impacts that included the delivery of products and services with intential social or community benefit such as in health care and education, as well as job creation, economic development in underserved areas, supply chain impacts and responsible contracting, employee wealth creation through shared ownership and other measures.

The biggest growth came in so-called “double bottom line” funds, which tripled in the past ten years, and grew in size, suggesting, according to InSight director Ben Thornley, “that funders are more convinced that the strategies of recent arrivals can concurrently deliver market-rate financial returns and documented social benefits.” Such funds represented $1.5 billion in assets.

Explicitly “impact first” funds, in which investors are willing to take a financial discount in pursuit of social goals, represented $400 million of the total and did not increase substantially in the last decade, the survey found. Conversely, “financial first” funds, at $2.1 billion, are more conventionally focused on financial returns and seek social outcomes as a secondary consideration.

Transparent Deal Data for Impact Investors

Everybody is in favor of open data, it seems, except when it comes to their own.

So it is in impact investing, where many investors say limited information about financial results and social and environmental impacts is keeping significant capital on the sidelines. But that doesn’t mean they’ll disclose their own results or deal terms.

“Privately owned enterprises have not been legally required to share any impact performance data. And their investors are not required to do so either,” Cathy Clark, Jed Emerson and Ben Thornley write in The Impact Investor, the background document for a collaborative research project that is documenting the practices of impact investing funds. “The resulting lack of clarity about financial performance goals and results across the field’s players, big and small, is a barrier to the field’s development.”

Impact IQ is gearing up to tackle that information deficit

But Impact IQ itself faced the same inherent contradiction as other companies when it came time to push the button early this morning and make our financing proposal to the Knight News Challenge public on their website. Did we really want to telegraph all of our moves? Knight favors open scrutiny and review, so we took the plunge and put our strategy online.

Because the application rewarded brevity, the document serves as a decent primer for Impact IQ. Here are the highlights:

What do you propose to do?

Impact IQ will provide data and analysis of deal financing and impact metrics to open the marketplace for investments that combine social, environmental and financial returns.

How will your project make data more useful?

Real-time deal data will catalyze private capital for social impact by providing proof points — beyond anecdotes! — of the emerging market for “impact investments.” Impact IQ will dig out and aggregate data and add editorial context to help investors account for social and environmental returns in their capital-allocation decisions.

How is your project different from what already exists?

Private data about impact deals is not broadly available. Data from intermediaries is partial and proprietary. Static impact directories don’t capture real-time deals. Data on other “alternative investments” ignores social and environmental impacts. Impact IQ is an openly licensed, inclusive, dynamic resource for all stakeholders.

Why will it work?

Impact IQ will pioneer a new kind of business reporting. Investors increasingly are seeking an information edge through nonfinancial social and environmental indicators. Combined with aggressive reporting, open data provides the transparency buyers and sellers need (even as they guard their own information). Disclosure of social-impact data allows investors and companies to distinguish themselves; non-disclosure can signal trouble. Impact IQ’s founding partners include investor networks, industry leaders, and financial intermediaries seeking to accelerate dealflow and expand the circle of impact investors through increased transparency. The broad business news audience wants richer detail and more rigorous analysis of companies’ social and environmental impacts.

Hedging with Impact Investments?

I was intrigued by a line in the piece in the Financial Times by Alex Friedman, the chief investment officer at UBS and Patty Stonesifer, the former head of the Gates Foundation that urged investment managers and banks to step up their impact investing activity:

“In today’s low-yield investment climate, impact investing is becoming more attractive because it is relatively uncorrelated to the broader market.”

I hadn’t previously heard the non-correlation point raised in the discussion of impact investing’s risk/reward equation, and it’s particularly salient coming from UBS (since it doesn’t sound like something Stonesifer would have written). UBS is increasing its own impact investing activity under Friedman, who was previously the Gates Foundation’s chief financial officer.

Non-correlation is part of a broader argument gaining currency that impact investments, especially those that focus on basic needs such as food, water, health care and education and on real assets, such as agricultural land, may have lower long-term risks than otherwise comparable investments. But correlation is important argument in its own right. Turmoil in global stock markets means stock across industries increasingly rise and fall together. I found data from Bloomberg: The 30-day correlation coefficient between the MSCI World Index and its members in that industry is 0.92, compared with the average since 1995 of 0.73. A reading of 1.0 would indicate total lockstep. (MSCI World, according to Wikipedia, is a stock index of 1,600 world stocks that is a benchmark of global stock funds, but is something of a misnomer as it excludes stocks from emerging and frontier economies).

Post-2008, hedge funds and other “traditional alternative investments” have turned out not to be as uncorrelated to the broader market as previously thought, part of the trigger for the rash of hedge-fund liquidations.

Is it really possible that impact investments are becoming the safe bet for mitigating market risk?

New details of $25 million JP Morgan-Gates-Rockefeller African farm fund

The $25 million African Agricultural Capital Fund was billed as “first of its kind” when it was announced last year, but backers were a little hazy about exactly what it was the first of.

A new case study of the five-party negotiations that led to the fund, issued by the Global Impact Investing Network, usefully illuminates what’s special about the fund, which is seeking to invest $25 million in deals of between $200,000 and $2.5 million, intended to improve the lives of 250,000 smallholder farm families in East Africa by increasing their annual income by at least $80 each over the next five years.

The AACF’s backers specifically intended the deal’s structure to be replicable by other investors. Most interesting is the fund’s two-tier structure: In one tranche, J.P. Morgan’s $8 million in debt-financing (50% guaranteed by the U.S. Agency for International Development) means the bank is “forsaking upside in exchange for more downside protection,” said Amy Bell, vice president of J.P. Morgan’s social finance unit. It was the first time J.P. Morgan had taken advantage of a USAID guarantee, “so we needed to learn and appreciate its nuances,” Bell said.

For the other tranche, The Gates and Rockefeller foundations, which put in $10 million and $2 million respectively, made program-related investments – for-profit investments on their grant-making, not endowment, side. Under U.S. tax law, PRI’s must be targeted on charitable purposes and not primarily designed to generate income.

The report notes that two tranches earn different rates of return aligned with the risk profile and capital structure, but it doesn’t break out the two rates of return. A person familiar with the deal structure confirmed that the equity investors expect net returns of 15 percent, while J.P. Morgan’s can expect 6 percent from its partially guaranteed debt instrument. Overall, the fund is targeting a 12.5% net return, after 3.5% in costs and fees. (Note: this paragraph was updated with new information July 22.)

Another area of negotiation concerned measurement of the impact on smallholder farmers in East Africa, in line with the fund’s investment thesis that improved access to markets, goods and services can boost farm family incomes. Pearl Capital Partners itself proposed that its fund managers’ compensation be tied to the measureable impact on small farmers.Pearl, along with the Gatsby Foundation, has published a useful study of the social impact of five investments in African agriculture by their previous fund.

According to the new case study, it was the fund investors who said no to such strict impact accountability. Concerned about the quality of data around small farm operations, and AACF’s limited influence as a minority investor, they opted instead for a more traditional metric: investee business growth.

The investors did set overall portfolio targets – improve the lives of 250,000 smallholder farming households, increasing annual income by $80 each over five years and created an impact committee to screen potential investments. To help ensure its investments are used for their stated purpose, AACF uses an “intent vs. use” clause that allows the fund to withdraw their investments if they are used in ways that undermine smallholder farmers.

The case study also provides detail on the fund economics: Pearl Capital’s fund manager’s fee is 2 percent of committed capital or 2.5 percent of invested capital, whichever is greater. Pearl also receives carried interest of 20 percent of distributions after return of the principal, and a preferred return of 6 percent per year.

Both Justina Lai of Rockefeller and J.P. Morgan’s Bell said part of their motivation was simply demonstrating that such a deal could be done. The negotiations were time consuming, Bell said, but added, “Any deal we created together could serve as a precedent for the impact investment industry by illustrating how investors with different risk/return profiles can come together to create a new investment solution.”

$1.5 million for mobile app to boost African farm incomes

Virtual City, a mobile-technology company based in Nairobi, is redesigning its agricultural supply-chain system to help small farmers raise their incomes, through $1.5 million in convertible debt financing from Acumen Fund.

The deal, announced last week, is an example of how financing from impact investors can help ventures in the developing world re-focus their existing products for low-income producers and consumers through lower prices and simplified systems that are available via low-cost phones. Virtual City has previously targeted its mobile products to up-market customers able to pay higher prices for its systems.

John Waibochi, Virtual City’s CEO, said Acumen’s investment will help Virtual City serve more than 3 million farmers in the next five years, up from 300,000 to date. Virtual City’s Agrimanagr is used by agricultural cooperatives and processors to track crop and dairy purchases from farmer to processors and coordinate mobile payments to farmers.

“This redesign represents a game-changing innovation that will connect farmers to markets, allowing them to increase their income, build records of farm production and payment and receive the appropriate reward for increased attributed yields,” said Maurice Nduranu, Acumen’s East Africa portfolio manager.

In a follow-up email, Nduranu said Acumen did a convertible note to provide a measure of security in the first two years of the investment as the product is developed and rolled out, after which the debt would be converted to equity. He said Acumen would take a board seat and hold the company to certain “impact” covenants, including information and other rights around processes and decisions.

The redesigned system will make it easier for smaller farmers to participate in networks of agricultural processors and aggregators and bypass so-called “gate brokers.” Such networks have been shown to help smallholder farmers increase their earnings between 40 and 100 percent. The Virtual City “app” is expected to boost those earnings an additional 10%, or more than $100/year.

(Note: this post was updated with additional information on June 14.)

Entrepreneurs in Africa 1 of XX

The Kauffman Foundation is bullish on entrepreneurship in Africa and will push it at the African Innovation Summit at the end of the week:

Governments in the region seem to be valuing bottom-up movements for entrepreneurship in their efforts to set in motion a long-term economic growth strategy. According to the 2012 Doing Business report by the World Bank, 36 of the region’s 46 economies implemented regulatory reforms making it easier to do business between June 2010 and May 2011. Several African countries are among the top reformers, namely Cape Verde, Sierra Leone and Burundi. And these are on-going efforts. During the past six years, Rwanda (45th) has made more progress than all but one country in the world, pushing it to the third spot in the region—behind Mauritius (23rd) and South Africa (35th). By other measures, the same performers stand out, leading the way for its regional neighbors. In the Index of Economic Freedom, for instance, Mauritius is ranked among the top 10 worldwide. In the 2012 Index, Mauritius became the first sub-Saharan African country ever to advance to that height in the rankings, thanks to the island’s continued commitment to structural reforms and policies that promote integration into the global marketplace. By intent at least, people in the region are reacting positively to their government’s efforts. According to an October 2011 Gallup poll, sub-Saharan Africa has the highest percentage of adults (20%) planning to start a business in the next 12 months.

Can the African Lions follow the Asian Tigers? A partnership to promote pro-entrepreneurship public policy in Africa, Lions@frica, was launched at the World Economic Forum last month.