Impact capital is the new venture capital (Part II)

July 13, 2011

By Sir Ronald Cohen
The views expressed are his own.

The first part of this essay laid out the rationale for impact investing, whereby investors can simultaneously create social impact and achieve financial returns. How can we bring it about? First, we need an enabling environment. In the 1970s and 1980s, the venture capital community argued successfully for changes in taxation and the regulation of financial institutions to foster investment in venture funds. Governments were lobbied to improve the climate for start-up and early-stage ventures. Markets to raise equity and trade stocks in pre-profit companies were introduced in the US (Nasdaq in 1970) and in the UK (USM in 1979). Rates of direct, personal taxation were reduced. And, in 1978, amendments to the USA’s ERISA legislation were specifically designed to foster venture investment by U.S. corporate pension funds. Such liberalizing measures were adopted first in the USA, which, as it turned out, reaped most of the benefit of the high-tech revolution, largely funded through venture capital.

Social enterprise and impact investment need similar rule-changes to foster investment in mission-driven ventures that deliver social returns in combination with financial returns. We need tax incentives, as well as several rule changes: in the permitted scope of activities by charitable foundations; in the role of banks in low-income areas;  and in the rules governing institutional investment. In particular, the restrictions on investment by charitable foundations and financial institutions need to be adapted to enable the inclusion of social investment. For example, regulatory encouragement for pension funds is needed, so that social investments are included within the definition of prudent investment.

The Social Investment Task Force, which examined these issues in the UK over the period from  2000 to 2010, recommended the creation of a system to support social investment. Its specific proposals included the introduction of Community Investment Tax Relief, fashioned after the U.S.’s New Markets Tax Credits; the formation of community development venture funds to take a long-term view of equity investment in poorer, underinvested areas; greater disclosure of the lending practices of banks in low-income areas to encourage best practices, following the U.S. lead; greater latitude and encouragement for charitable trusts and foundations to invest in community development initiatives; and the strengthening of the community development finance industry through the creation of a professional association.

These recommendations were taken up by the Labour Government and the decade witnessed the emergence or development of many social enterprises, including Charity Bank, CAF Venturesome, Big Issue Invest, Breakthrough, Investing for Good, CAN, Impetus Trust, Bridges Ventures, Social Finance and Social Investment Business. We need to continue this momentum in the UK and elsewhere by focusing on building the enabling environment to support impact investing.

Next, there needs to be a wholesaler to channel capital into the social sector, which has, to date, been disconnected almost completely from capital markets and so has suffered from inefficiency in funding and capital formation. Social returns do not attract capital in the way that financial returns do. An organization is required to act as a financial engine for the social sector, attracting capital by blending social returns with financial returns and tax incentives.

In the UK, the Commission on Unclaimed Assets (CUA) and the Social Investment Task Force forcefully argued for the creation of a “social investment bank,” capitalized from the pool of unclaimed assets languishing for more than fifteen years in bank accounts and building societies. Now provisionally named the Big Society Bank, this initiative has strong backing from the Coalition Government.

A crucial role for the Big Society Bank is to devise new instruments for social investment. Social Finance, Ltd., a nascent social investment bank which grew out of the work of the CUA and the recommendations of the Social Investment Task Force, created the Social Impact Bond (SIB), an innovative financial instrument currently being piloted with the UK Ministry of Justice to reduce recidivism by prisoners released from Peterborough jail. SIBs provide a new mechanism for payment by results, whereby private-sector investors fund not-for-profit social ventures whose intervention results in a social benefit as well as financial savings to the government. A social venture that reduces very high reoffending rates, for example, would save money by reducing the prison population and the cost of the justice system.

The financial return on investment in an SIB varies directly according to the social benefit achieved. The first SIB, issued in September 2010, will pay investors up to an annual return of 13.3%, but only if reoffending is reduced by at least 7.5%. If reoffending is reduced by anything less than this benchmark, the government pays nothing and investors lose their principal. At the same time, SIBs provide long-term, upfront capital to not-for-profits. They do not bear any financial risk and instead, benefit from predictable working capital over the life of the bond. SIBs are likely to work best when applied to important social issues affecting clearly defined target groups, where there are effective not-for-profits, with interventions that are clearly understood and whose impact can be measured. The incentive to use SIBs exists wherever the cost of intervention is significantly less than the public-sector savings they deliver. In addition to targeting recidivism, social interventions that SIBs could finance include interventions that lower the drop-out rate in schools, increase rehabilitation rates from drug dependency, reduce homelessness, enable the elderly to live at home rather than a state-run facility, and decrease the number of children in the child welfare system.

SIBs appear to be the first financial instrument that enables social entrepreneurs to raise capital and allow investors to earn a return that is directly based on social outcomes. Already it has attracted attention in the U.S., where Social Finance has established a sister organization, Social Finance, Inc., based in Boston. Social Finance, Inc. is hoping to bring SIBs to the U.S. market. It is currently engaged in discussions with Massachusetts, New York City and other communities, and is pursuing applications in areas such as criminal justice and housing. At the same time, President Obama recently announced that his administration is to set aside $100 million for seven pilot programs using social impact, or pay-for-success, bonds. While significant opportunity surrounds this new instrument, we also need other impact investing products to help build the industry.

Finally, the mindset of the social sector needs to embrace output-based and market-based solutions that enable foundations to use their balance sheets to achieve social aims, rather than simply funding grants out of revenue. In a recent article, Harvard professors Robert Kaplan and Allen Grossman have noted that “most nonprofits attempt to keep their administrative expenses low and focus narrowly on short-term financial performance. As a result, they fail to build capabilities in strategy, leadership, fund-raising, performance measurement, and organizational development.” This is sometimes imposed on them by philanthropic funding that requires money to reach beneficiaries in the most direct way possible and precludes structured, long-term commitments necessary to build and finance growing organizations.

It is very significant that when Social Finance raised the first SIB of £5 million from charitable foundations and others, most of these investors, rather than treating the money as a grant, held it on their balance sheets as an investment. This demonstrates the interest in bringing charitable assets to support the development of the social sector alongside grants.

Of course, achieving the transformation advocated here will not be easy. Social entrepreneurs manage two bottom lines, one social and one financial, and often three if they target environmental issues as well. This requires special skills, which, in turn, suggests the need for special training and experience. For example, Social Finance, which raised the first SIB, has brought in-house expertise in recidivism to bear in supporting the specialist not-for-profits that will deliver the proposed interventions with Peterborough’s 3,000 released prisoners. This is akin to the way a venture capital or private equity firm would help an investee company. This is crucial to give investors confidence that the right blend of social and financial returns will be delivered over time.

Social enterprise will never render obsolete either philanthropy or government programs. But social enterprise and impact investment could dramatically change the mindset and role of the social sector in the way that venture capital and business entrepreneurship did in mainstream business in the 1980s and 1990s. As The Economist recently noted, the idea is “to transform the way public services are provided, by tapping the ingenuity of people in the private sector, especially social entrepreneurs.”

It is not just the established stars of earlier generations of entrepreneurs and investors, such as Bill Gates, Warren Buffett, Pierre Omidyar, Jeff Skoll, Chris Hohn and Michael Dell, who want to help. A new generation of entrepreneurs is coming forward eager to make a social impact. With the support of government, the philanthropic sector and the capital markets, these new social entrepreneurs will usher in a new, powerful way of dealing with social issues that will help stabilize society and improve the economy. What entrepreneurship has done for business in recent years, social entrepreneurship can now do for society.


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We at Santa Clara University’s Center for Science, Technology, and Society believe that changing investment rules may accelerate impact capital, and importantly the benefit delivered by social entrepreneurs receiving the funds. We also believe that a critical element will be what we term “horizontal capital aggregation” – syndicating funding partners by aligning key objectives among different capital investment structures.

In fact, we are releasing a new report through our work with the Aspen Network of Development Entrepreneurs (ANDE) that shows why impact capital investors face far greater challenges in creating efficient investment ecosystems than traditional VCs. Among the challenges: due diligence is conducted remotely; syndicates are assembled globally but impact measured locally; and the majority of impact investments still come from wealthy individuals or family foundations — not the corporate or professional money that supports the U.S. VC machine. Our report seeks to identify where opportunities exist to create consistent sources of capital flows to these socially-minded businesses, so they won’t have to scramble for new money at each stage of development. We hope this will catalyze exponentially better chances of success and therefore greater impact to the base-of-pyramid communities, creating nuclei for economic growth and systemic alleviation of poverty. The full report can be found here.

Thane Kreiner, Ph.D., executive director of the Center for Science, Technology, and Society at Santa Clara University. fm

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