Impact investing is gaining traction among both large and small investors and entrepreneurs. Angels, private equity firms, and banks are expanding beyond their traditional markets and exploring deals that could generate financial returns, while also having a positive environmental or social impact. Some previously niche industries - such as clean tech, natural food - are moving toward the mainstream. While both investors and entrepreneurs are embracing this trend, they are having a hard time connecting.
Why? In my experience, it is a limited understanding by both parties on the opportunities of impact investing, the risks, and the realities and nuances of each other's worlds.
Many investors say they have trouble finding good quality deals; they're too risky, difficult to scale, and are mired in confusing definitions of business models (for-profit vs. non-profit vs. hybrid) and impact investing itself (impact vs. SRI vs. ESG vs. sustainability). At the same time, for-profit impact enterprises ("investees") are getting more attention but are having trouble securing funding.
It's like dating. A good match can be very successful, but it is difficult when you know what you want but just can't find the right person, or when you are not sure what you want and end up with some not-so-great options. In impact investing, the trial and error process for both parties takes a lot of time and money. It can lead to poor quality investments, higher perceived risks, frustration, and in some cases, no investments at all.
In my work with investors, including through the International Finance Corporation (IFC/World Bank), and with for-profit investees, building their "investor-readiness," I've gained perspective on each party's needs and common pitfalls. A few lessons stand out:
Evaluating and choosing impact deals is complicated. As with any investment, investors need to understand the investee's business model and potential risks before making an investment decision. The riskier the deal profile the costlier the capital. Risk assessment of impact investments is tricky because of the sector's relative infancy, its heterogeneity, the variety of measurement and reporting approaches, and the limited information on lessons learned.
In addition, most investors do not have an impact investing track record and vague terminology makes it hard to sort through potential options and choose what's right for them. There are also industries, geographies, and business models that are less risky than others so painting all impact deals with the same brush can lead to an over- or under-assessment. All of these factors affect the categorization of the deal's risk profile.
What can investors do to help make their process easier?
- Build their internal capacity. Increase investment staff's awareness and expertise to help them better understand impact investing and the various risk profiles.
- Offer a range of investment options. Don't offer a "one size fits all" deal structure. Typically this isn't the best way to support both the finance and impact goals of an impact investment.
- Set up impact-related systems. Set up systems to collect impact evaluation, monitoring and reporting data according to the investor's impact strategy and goals.
- Apply lessons learned. Analyze data regularly to identify patterns and understand what worked and didn't work and why.
- Collaborate with external parties. Work with industry experts, strategic partners who have complementary geographic, technical, or market expertise.
For-profit impact investees are unique. Their goal - to address an environmental or social issue and have a profitable business model - is not easy. The ones that will thrive are the ones with effective business models, who know how to approach investors, and who know what factors are critical to their business.
What can investees do to improve their funding chances?
- Target the right investors. They need to understand and articulate their company profile (e.g., Is this a startup? What is the target market? What impact does the business want to make?). Knowing these answers will help them target the right investors. For instance, angel investors will be best for some investees while others will be better served by a bank.
- Address key risks for investors. Address two sets of risks: those that are common to all businesses (such as business model, team composition, competitiveness, etc.) and those unique to the impact sector (e.g., how incorporating environmental & social factors will affect the revenue model; how to measure and report impact). Example: A biomass energy company was providing electricity to underserved populations and approached an investor for funding. While the business was compelling, it had not secured a reliable biomass fuel supply or done a comparative analysis to its competition. The deal was rejected because the company did not address its key business risks.
- Ensure the pitch tells the right story. Lead the pitch with the business arguments. Then show how incorporating environmental, social impact will support the business. Example: A sustainable coffee company focused most of its investment pitch on how the coffee would improve the lives of farmers and reduce environmental impact. It did not provide information about the increasing demand for coffee in its target market, how its coffee met gourmet quality standards, or its plan to get environmental certification, which was proven to yield a price premium. These oversights led to it being rejected by the investor.
- Clearly show returns, impacts. Showing financial returns over time is important for investors. Additionally, investees need to be clear about which specific environmental, social metrics they will focus on (e.g., CO2 reduction, job creation, access to energy) and their approach to measuring, monitoring, and reporting the impacts.
These are some of the key factors that can help both investors and investees understand each other's needs and concerns and lead to more productive conversations. Addressing the real and perceived differences in incentives, interests and constraints will give both parties a better chance of finding the right match.