London Business School Coller Institute of Private Equity

QUOTED IMPACT INNOVATION FUNDS - SOCIAL INVESTMENT'S NEXT STEP?

10 October 2011 by Tim Gocher

Can public equity markets provide the step-change needed in capital supply to the Social Impact sector?

I’ll never forget sitting in an LBS classroom ten years ago when a visiting KKR executive (who shall remain anonymous) was asked the question “how does social good factor into your investments?” His chiselled expression, etched by years of hurdle rate decisions, didn’t flinch as he offered his standard response. “The regulators take care of that stuff. We stick within the law and focus on returns.”

I wonder what his response would be today? Maybe he’d say that their funds now comply with their Environmental, Social and Governance (ESG) guidelines. That’s better, but what would it take for the answer to be: “We have launched a range of funds targeting Base of Pyramid-focused enterprises that promote and measure social and environmental impact.” The answer is obvious. It will take data and track record.

As the red pen of Western austerity inevitably slashes through aid budgets, this is the hour for Social Investment to come of age and prove that it is a far more sustainable solution to poverty alleviation at the Base of Pyramid segment than the often dependency-creating aid model. But to do this, we need to create a step-change in the supply of capital and how it is managed.

Publicly-listed funds need to be part of the answer – I call them Quoted Impact Innovation Funds. They would invest in scalable enterprises that sell products or services to the high growth Base of Pyramid market and in doing so further a positive social and environmental impact. Because they would not be closed-end funds, as with most VC/PE funds, they would have greater timeline flexibility that is sometimes required to bring such portfolio companies to profitability. But perhaps more importantly, they will provide real-time prices for risk and return models in a sector that is stuck in the endless debate between whether there is a positive or negative correlation between returns and social and environmental good. A critical mass of such funds, and the listed enterprises they could spawn, will create a body of data that will drive financial innovation and portfolio theory so that we may even approach the holy grail of a portfolio model whose efficient frontier is a factor of risk, return and impact.

“Utopian idealist!” I hear you all cry. “Public markets are no place for early stage investments, let alone the political and operational risks inherent in Base of Pyramid investing.” But before you pass judgement, I ask you to take a look at a successful sector that, give or take a bit of license, has a profile not too dissimilar.

Various listed IP commercialisation funds have sprung up that are effectively early-stage funds taking often university-originated research to market. The profiles of their investments feature long-term payback, highly risky future cash flows, high regulatory risk and other hurdles that require funding and timeline flexibility. And yet AIM-listed Imperial Innovations plc raised a secondary offering of £140m in Dec 2010 and LSE-listed IP Group plc raised a further £55m in the choppier waters of June 2011. There is appetite for such risk. The key to success is 1) securing a credible pipeline of deals/innovations, 2) risk management and business building skills, and 3) superior investor relations and communication.

These investment firms often secure partnerships with universities to prime the pump. Similarly, there is no reason why Quoted Impact Innovation Funds couldn’t tie up similar partnerships with the many academic collaboration projects underway between Western and developing world institutions with a view to investing in and commercialising the output. If such a pipeline was combined with organisations such as Omidyar and Acumen Fund who already have on-the-ground networks experienced at managing political and operational risk, and some existing success stories to line the fund with track record and even cash flow, there is no reason why such structures couldn’t tap the public markets. They would form the thin end of a wedge – a funding source which could rapidly grow as institutions realise the true diversification provided by the Base of Pyramid consumer in a world of horribly correlated global asset prices.

There are already various initiatives underway to create social stock exchanges. This could be a key component to the capital mix of Social Investment, but we need to be careful that we don’t create “sub-exchanges” that fail to drive the liquidity necessary for this asset class to achieve its potential. If the liquidity isn’t there, neither will the accurate price data that will form the basis of financial innovation necessary to attract the mainstream investors.

The growth of Quoted Impact Innovation Funds will inevitably require the initial support of the large foundations and philanthropists currently sponsoring many other Social Investment models. But in time, the public market transparency of such funds, combined with the use of impact reporting standards such as IRIS and GIIRS, will provide institutional and eventually retail investors with the benchmarks needed to enter the market. The sooner we start collecting real-time price and risk data in the Social Investment space, the sooner will be the explosion in the supply of capital.

I’d like to end this note with a more profound idea than simply boosting capital provision to the Base of Pyramid. By creating Quoted Impact Innovation Funds, we are also providing the opportunity for the retail investor to contribute and more importantly connect to the efforts of the poor as they work themselves out of poverty. It is my experience, as Chairman of Dolma Development Fund investing in Nepal and Ethiopia, that Base of Pyramid entrepreneurs are the most dedicated I’ve come across. There is little agency cost – failure can mean starvation! These funds would not only provide investors with transparency of both return and impact data, they will provide a sense of participation and knowledge in the issues of the poor –a dynamic partnership that could stimulate the true globalisation of opportunity and human dignity. In the world of aid, too often the donor is removed from the impact. Quoted Impact Innovation Funds will provide direct, real-time feedback on impact and could pave the way to democratise Social Investment while proving the maturity of the asset class.

And so it is my hope that the graduating MBA class of 2015 hosts the proverbial KKR executive whose array of social and environmental impact funds are teaching the regulators how to attract and deploy capital for good.

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