OFFICE:FMA Series on Impact Investing Featured by ImpactAlpha

In early June, a three part series by OFFICE:FMA Partners Andrew Haimes and Steve Zausner was featured by ImpactAlpha. All three parts of the series are presented below, while the original series can be found here,

When you come to a fork in the road, take it

By Andrew Haimes and Steve Zausner

We were recently having lunch with a friend who works at a firm at the forefront of impact investing and emerging markets. She felt her career was at a fork in the road: Should she focus on emerging markets or impact investment?

This wouldn’t have been a question a couple of years ago: impact investing and emerging markets were joined at the hip. Impact investing was supposed to redefine the efficient frontier, while making emerging markets more efficient.

Now, she said, “I feel like more and more of my (impact) projects are focused around US or Europe, less and less in emerging markets.” Those initiatives are important, she said, “but not really what I had envisioned when I entered the field.”

While the times are good for impact investing, the moment is less certain for emerging market economic development and small and medium-sized enterprises (SMEs). Major, mainstream asset managers BlackRock Inc., Bain Capital, LP, and Goldman Sachs, are entering the space. This year, assets under management are expected to grow by 17%, and the number of deals by 20%, according to the Global Impact Investing Network’s (GIIN) 2017 Annual Impact Investor Survey (see, “How much money is there in impact investing?”).

Indeed, the very entrance and potential success of these vehicles threatens emerging markets as the dominant theme behind impact investment. First, large funds mean large investments. The chance that a multi-billion-dollar fund will do a sub-million-dollar deal is roughly nil. Fiducially, it would be irresponsible. Financially, it would be folly.

The second reason is just a matter of math. As more funds enter, and their focus shifts from emerging markets to developed economies, the percentage of emerging markets holdings in the mix has to go down. The GIIN survey shows this: roughly half of impact assets have focused on US or other developed-market initiatives.

We hope to stimulate a broad discussion of the role and requirements of private sector investors and invite institutional investors to share their thoughts on emerging markets and impact investing. We would encourage stakeholders to put together a series of meetings between investors, underwriters, government agencies, NGOs, and think tanks with the goal of developing standardized documents for various common transactions

Development-finance institutions, for example, may get excited about the concept of attracting ‘blended capital,’ but the common complaint we hear is that the products are too cumbersome and time-consuming to use. Another takeaway might be swapping the focus on equity, where the bulk of Series B investments are presently made, to debt, which is the lifeblood of the capital markets.

Impact investing and emerging markets were once clearly fellow travelers. They now seem to be heading down different roads. To get a sense of how these roads diverged, and how they might come back together, this three-part series will start to deconstruct three key attributes of impact investments: definitions, scope and returns.


Let’s start at the beginning: what exactly is an impact investment? Impact is a tricky thing; it can mean many different things to many different people. Facebook creator Mark Zuckerberg, who with his wife recently founded a major impact investment firm, summed it up, “A squirrel dying in front of your house may be more relevant to your interests right now than people dying in Africa.”

Going by the GIIN’s definition, impact investments are, “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.” As important, impact investments should have a commitment to impact measurement: the measurement and reporting of the “social and environmental performance and progress of the underlying investment.” This is a key philosophical bridge into the world of international development. For decades, “socially responsible investing,” or SRI, has largely been based on negative screens of public companies — making sure that portfolios did not have “bad” investments, which included everything from tobacco to companies doing businesses with “bad” governments, a la apartheid-era South Africa.

If SRI acted as a boycott mechanism; impact investing was supposed to be proactive. The goal was to drive capital to areas that were underinvested in and might not stand up to the scrutiny of traditional investing along an efficient frontier. Impact investment was supposed to bring capital to emerging and frontier markets, the “missing middle” small and medium-sized enterprises (SMEs) in emerging markets, which had traditionally been left out of the capital markets, and other areas where tangible investment return was iffy, at best.

By attempting to create assets in which financial and social or environmental returns are used to buffet potentially below-market rate returns, it was hoped that impact investments would create a philosophical and technical framework to bring much-needed capital to what the Aspen Network for Development Entrepreneurs (ANDE) calls Small and Growing Businesses (SGBs). Despite being the major source of economic and employment growth in most economies, SGBs are generally too risky, and small, for most investors to invest in.

ANDE differentiates SGBs from SMEs in the following ways:

First, SGBs are different from livelihood-sustaining small businesses, which start small and are designed to stay that way. Second, unlike many medium-sized companies, SGBs often lack access to the financial and knowledge resources required for growth.

ANDE’s research convincingly argues that SGBs can and have played a preeminent role in driving economic growth by “creating jobs, paying taxes, purchasing from local suppliers, and selling to local and global distributors.” Beyond simply improving economic growth, SGBs are force multipliers, expanding access to critical goods and services amongst the ‘base of the pyramid,’ linking local communities to the global market, and empowering often marginalized groups. This improving entrepreneurial ecosystem tends to be more sustainable and innovative than other forms of economic growth. In fact, SGBs have encompassed 60% of jobs and 50% of GDP in the US and an even larger share in emerging markets.

The perceived massive potential for the private sector to boost investments in emerging market SGBs, however, has not materialized. BlackRock Impact illustrates why: despite (or maybe because of) having over $200 billion in assets under management, Blackrock Impact devotes only a small fraction of its funds to what the GIIN would define as impact investments. The majority of its assets are screened investments (SRI, effectively) or investments in a small number of Environmental, Social, and Governance (ESG) funds. These allocations lean heavily toward larger and more established, usually publicly listed firms that can achieve a risk-adjusted market rate of return, which predominantly lean toward developed over emerging markets.

This definition of impact as an expanded version of SRI has the benefit of encompassing a wide variety of investments and attracting quite a lot of positive attention and discussion, especially with younger investors who are about to inherit great wealth. My colleagues and I have had many conversations with asset allocators at mainstream wealth management firms or family offices who talk about their clients wanting their investments to be more meaningful than just producing a solid risk-adjusted return on capital.

Impact investing, however, has not necessarily been a good thing for emerging markets. A partner at a $50 billion asset manager based in the Mid-Atlantic region, which is developing an impact investment program, told us most of his investors are interested in doing something locally:

There are enough things broken in Baltimore, with the Chesapeake, inner-city schools, the arts and healthcare, that we don’t really need to look overseas for something to fix.

Impact capital mostly ameliorates the status quo, but doesn’t change it


Developed markets account for roughly half of the $113.7 billion in impact investments, according to the 2017 benchmark survey from the Global Impact Investing Network. While the emerging markets field is growing in general — with sub-Saharan Africa in the lead, developed markets will likely maintain their lead over emerging markets.

There are substantial differences between emerging markets and developed markets in terms of the investee’s stage of development and sector.

Of the assets going to emerging markets, there is a clear and growing focus on growth stage businesses (47%). That may bode well for the development of job and economic growth-creating SGBs over the long-term.

Slightly less than half is being invested in mature or publicly traded companies, which, while important, are not the net generators of jobs. There appears to be a strong preference for Private Debt (62%) over Private Equity (27%) in emerging markets. But this may not be as clear as it seems – 42% of global Private Debt went toward microfinance. Given the predominance of microfinance in emerging markets, it is likely that a significant portion of emerging market’s Private Debt is going toward microfinance.

That means small and growing businesses are still relying on Private Equity investments. In general, equity investments are not conducive to SGB growth. Equity requires an exit. Most emerging markets lack liquid markets and the mechanisms for traditional exits (trade sales or going public events). SGB, in emerging markets, also tend to be multi-generational. As one lawyer who does significant work with SGBs in emerging markets recently told us:

“Equity is like a partnership. If I am a mid-sized business owner, the last thing I want is another partner. I probably already have my cousin, my aunt, my mother and three brothers in the business. I don’t need someone else telling me what to do.”

The news doesn’t get much better when we break the investments down by sector. The 40% of investees in microfinance are not a small and growing businesses, and are unlikely to be able to scale dramatically, if at all. Beyond microfinance, it is not clear to what extent the remaining 60% of AUM is being invested in small and growing businesses versus other entities that may not share SGBs’ scalability in terms of job creation and economic growth, regardless of their level of impact.

Indeed, the more one digs into impact investing, the less capital is actually directed toward potentially game-changing sectors and the small and growing businesses within emerging markets that are key to these states’ economic development. Instead of helping to drive a new generation of small and medium-sized goods and services providers integrated into global supply chains, much of impact investment appears to be directed toward efforts to ameliorate the status quo, not change it.


While the expectation of a return is implicit in any impact investment — otherwise it is a grant — the rate of return can range widely. BlackRock Impact, for example, invests only a small portion of its capital in what could be called impact investments. And even that is focused on liquid, market-rate of return providing investments. While there may be some market-rate- producing SGB investments in emerging markets, they are neither the majority nor particularly liquid. Consequently, it is unlikely that BlackRock Impact has invested in many emerging markets SGBs, if it has at all.

Within emerging markets at large in 2017, 60% of investors sought risk adjusted market rate returns. One-quarter expected close-to-market returns. And 17% simply wanted a rate of return closer to capital preservation. According to a benchmark developed by Cambridge Associates (2016 figures), for equity investments, average emerging markets market rate return expectations were 16.8% and below market-rate return expectations were 11%. Emerging markets Private Equity (PE) and Venture Capital (VC) impact investing funds launched between 1998–2004, have a net IRR of 15.5%. However, more recent vintage funds tell a different, but nonetheless interesting, story.

Emerging market PE and VC funds have underperformed return expectations for over a decade, only surpassing the 16.8% market rate of return expected by investors for funds started between 1998 and 2001.

For 2011–2014 vintage funds, the return has been particularly poor, -7.93%. In our experience, investors tend to be data focused, and the data around emerging markets PE and VC (the priority for SGBs) is not encouraging: Those that have invested have been disappointed and those that are considering investing, would be ‘fighting the tape.’

If we compare funds by size (smaller or greater than $100 million), it becomes clear that smaller funds tend to significantly outperform lager funds, which may reflect the difficulty of conducting extensive due diligence on or sourcing of the many investments required to allocate an entire large fund to investments like emerging markets SGBs. It could also reflect the lack of a sufficient quantity of investment-ready SGBs in individual countries, requiring the expensive expansion to multiple target countries.


Embracing debt capital might make investors more impactful

Despite the hope that impact investments would provide the necessary capital for emerging markets’ missing middle, only a portion of the wider $2.5 trillion annual funding gap for the Sustainable Development Goals (according to Rockefeller Foundation President Judith Rodin), this summary of our research and experience unfortunately leaves us with a pessimistic assessment of impact investing’s role in the broader development of emerging market economies. The amount of capital needed is just too large.

Relatively poor prospects for large-scale funds, the wide geographic spread of impact investments, and investor’s comparative lack of enthusiasm for early and venture stage firms and, maybe, most importantly, preference for debt over equity, demonstrate that a new approach is necessary to fill the capital gap for SGBs and scalable new enterprises in emerging markets.

Instead of trying to fit a square plug into a round hole — make impact investing a key component of international development — we believe that a broader look at the role and requirements of private sector investors could lead to a more productive conversation.


A simple first step would be to actually ask institutional investors for their thoughts on emerging markets and impact investing. Similar to the concept of Human Centered Design, we believe a focus on Investor Centered Design will be key to increasing the flows of capital toward emerging markets. While many DFIs may get excited about the concept of attracting ‘blended capital,’ the common complaint we hear is that the products they create are too cumbersome and time-consuming to use. As one veteran emerging market investor, who invests across all sectors, asset classes, and geographies said:

“When I was a small fund, I would often try and raise capital from or work with OPIC products. It was a necessary evil. They treated me like a supplicant, its products were clunky and it took forever to get anything done — 12 months to 2 years, which doesn’t fly in the commercial world. As I got larger, I realized, I didn’t need them and had had such bad experiences, I will no longer work with them. They now need me more than I need them.”

We believe that this investor is hitting on one of the basic problems the public sector faces in attracting much of that $218 trillion in global capital: the private sector often has had bad experience with the public sector; the public sector’s products are often inappropriate, complex, and time consuming, and it tends to treat the private sector as supplicants, not patrons. As we learned early on in our careers, whoever has the most capital, sets the terms. Approaching investors through Investor Centered Design would entail working with the investors to pull from them exactly what they are looking for from a product or financial structure. Essentially, asking them what types of products, services, and partnerships they would like to see from DFIs to facilitate their investment into emerging markets’ mature companies and SGBs.


A second key step would be standardization. As a licensed broker-dealer, we, on a daily basis, raise capital for projects in emerging markets across many different geographies, asset classes, and sectors.

The most prevalent issue preventing investors from allocating capital is not that the investment itself is unattractive, but that it is too small to justify the transaction costs, especially as it relates to documentation. For example, without transactions costs, the Internal Rate of Return (IRR) on a $5 million Power Purchase Agreement for a clean energy project might be attractive; however, with legal costs running 1–2 percent of the size of the transaction, there is a general perception that the deal is ’not worth doing.’

Leveraging a new focus on Investor Centered Design, we would encourage stakeholders to put together a series of meetings between investors, underwriters, government agencies, NGOs, and think tanks with the goal of developing standardized documents for various common transactions. By reducing transaction costs through standardization, many otherwise marginal or unattractive projects might produce the returns commercial investors require (whether investors seek market or below-market rates of return). Unlike the BlackRocks and Bain Capitals of the world, which focus on more mature Series C and D investments, the more numerous, smaller impact investment funds could be key to filling the Series B funding hole in emerging markets (building on the growth already seen in Series B or growth-stage financing).


Finally, alongside the standardization of documents, there should be a focus on utilizing the tried-and-true methods for providing capital for SMEs that we see in developed markets, not the least is swapping the focus on equity, where the bulk of Series B investments are presently made, to debt, which is the lifeblood of the capital markets. For example, as is often pointed out in the US, less than 1 percent of companies will ever receive equity investment from outside investors. Also, even quasi-mature businesses with real cash flows and assets often find it difficult to get bank financing.

Yet small businesses do get capital. Where do they go? In a healthy financing ecosystem, small businesses are able to use factoring, vendor financing, revenue-based capital loans, and warehouse lines of credit. Despite this, we find that impact investors too often think like return-maximizing commercial investors. As one founder of an early-mover in the world of impact investing recently said to us:

“I get debt, I just don’t like it. I tend to feel that if I am taking all that risk, I should get the reward and debt caps off my rewards. I like hockey sticks.”

Technically, he is correct: debt is more like a put, with a downward sloping return (you can only make so much, but you can lose everything); equity is more like a call (you can only lose your investment, but the upside can be infinite). Commercial investors need to focus on asymmetries: finding investments where the return considerably outweighs the risk. Impact investors shouldn’t have to.

Indeed, we would make the argument that by promoting these investment asymmetries, and showing that the number of times where the bet goes in the money versus bust, would be a huge boon to emerging market investing. Bond markets only work because defaults tend to be low, repayments high. Microfinance works because of this dynamic. Our experience says that SGB lending does as well. Focusing on debt might make impact investors, well, more impactful.