Heidelberg University (CSI) on Financial Innovation: Unleashing Full Potential of Impact Investing

Heidelberg University, Germany: Facade of the main building

Many relevant fields and geographic areas are blank spots on the impact investing landscape, because they appear too risky or offer too low returns. If impact investing is to contribute to the SDGS, this needs to change. Financial innovation could be a way to work towards this goal. What we need are financial instruments that give social ventures more time than commercial ventures to mature, keep them on track and enable a long-term perspective through private and public interaction. We also need to find ways of combining investments to level out risk or return across fields or geographic regions.

Impact investing is meant to address the world’s most pressing problems.

In theory, this can work, when financial investors put social impact first and are willing to compromise on market returns. In line with this, there has been a gradual increase in the discourse that investments should be made for impact, and not only with impact.

The European Venture Philanthropy Association (EVPA) is spearheading this philosophy, but reality shows it is easier said than done.

Recent research has shown that impact investments for sustainable development are least placed in areas where they are most needed. A study of the Overseas Development Institute (ODI) shows that blended finance is least active in countries with low (or no) credit ratings.

An investigation by the OECD has shown that the amount of private finance tends to be lower in regions marked by social fragility and security issues. But if such countries and regions remain blank spots on the impact investing landscape, the market’s transformative potential in view of the Sustainable Development Goals (SDGs) is seriously hampered.

Similar, if less dramatic, observations can be made of social investments in industrialised countries. Social impact bonds — whose “bond” designation has been criticised, since they are actually private-public funding and service partnerships — often focus on areas where potential state savings are biggest, or where outcome achievement is easily monitored.

This is the case for work-integration enterprises or resocialisation programmes for prisoners. The Peterborough Prison social impact bond in the UK, for example, has become known as a world first. Areas with lower (indirect) financial returns and higher risk, such as interventions on homelessness or drug addiction, appear less attractive.

Equity investments, in a less-than-transparent market, often focus on social tech ventures, such as digital health platforms, or sustainable consumer goods, such as edible straws. These may become financially self-sufficient efficient in a reasonable timeframe. Ventures that will take a long time to succeed on the market — or will always be based on a hybrid income model consisting of earned income, subsidies and donations — are often ignored.

These could be innovative neighbourhood-support or shared economy models, or interventions that prop-up cultural exchange and address extremism. Given the challenges of individual isolation and newly resurgent cultural conflicts, most would agree that effective action in these areas is needed.

Both observations taken together show that there is a de facto exclusion of a large range of fields and geographical areas for impact investing. If we care about making impact investing a tool for moving towards the SDGs, this should concern us.

The question is, how can impact investing unleash its full potential?

One answer is: by promoting financial innovation. We need structured, mezzanine finance products, which enable the involvement of private and public investors, introduce a long-term perspective, and contribute to risk-sharing.

At the level of individual deals, if investors want to give investments a chance that are high-risk, low-return, but of high societal importance, two options in particular should be considered.

The first is to employ mezzanine instruments that combine a loan, equity and/or bond logic. Ventures would initially receive a loan at a below market return of x percent. Only after break-even would this be topped-up by an equity component for the investor, or by a fixed-income component of y percent to be delivered by the investee.

The achievement of predefined social impact key performance indicators (KPIs) by the venture would be rewarded by no additional financial return expectations. Missing them, for example due to “mission-drift, would be “punished” by an additional return expectation of z percent.

Such an instrument protects the start-up phase of a venture and keeps it on track for its social mission, while satisfying social and financial return expectations. The Financing Agency for Social Entrepreneurship (FASE) reports that their use is becoming more common.

Secondly, investors could seek strategic partnerships with foundations or governments. Foundations, based on their prosocial mission and high endowment, might be willing to offer first-loss guarantees, giving the ventures more time to sustain themselves and buffer investor risks.

Governments might, in the medium- to long-term, enable financial sufficiency for a non-market venture through introducing a service into public contracting on regulated quasi-markets for social services.
For specific fields, industries, or geographic areas, structured financial products could help achieve viable risk-return profiles. Investments could be combined across regions, where more stable ones provide a counterbalance to those that are less stable, levelling out the overall risk. They could also be placed within a region but across fields, so that for example market rate return investments in booming areas, such as green tech, would help fund empowerment.

The structured investments mentioned here could be designed like Asset Backed Securities (ABS), which got notoriously prominent because of their role in the past financial crisis. However, instead of being driven by high-return expectations — via the restructuring of low-risk products into high-risk derivatives — they level-out risk (or return) to a moderate degree. A positive side-effect could be the potential aggregation of many smaller scale investments to make them attractive for institutional investors, such as Germany’s Ananda Ventures, which typically aims for deals above €500k.

These are only a few options, but I believe they could be crucial for getting impact investing into areas where it is most needed. Investors, market-shapers and intermediaries should consider them, and if they already employ them, share their experiences.

Next to the structural barriers discussed here, our lack of knowledge about players and deals in impact investing is the second-biggest challenge in the path towards the SDGs. i

About the Author

Author: Gorgi Krlev

Gorgi Krlev holds a PhD from Oxford University (Kellogg College). He is a postdoctoral researcher at the Centre for Social Investment (CSI) at the University of Heidelberg. His research focuses on social finance, impact, entrepreneurship and innovation. The book, Social Innovation — Comparative Perspectives, won the Best Book 2019 Award of the Public and Non-profit Division of the Academy of Management (AOM). He can be found on Twitter @gorgikrlev.

About CSI

The Centre for Social Investment is a research centre at the Max-Weber-Institute for Sociology in the Faculty of Economics and Social Sciences of Heidelberg University. It is an interdisciplinary centre for research, education and training.