4.6 Achieving Portfolio Diversification and Double Bottom Line through Investing in Underserved Markets
- Partner closely at the outset– to seek alignment – with investors regarding governance structures, developmental goals and expected financial returns; traditional investors see the benefits of diversifying portfolios by investing with socially-minded investment managers, with the objective of generating reasonable financial returns that are somewhat uncorrelated.
- Impact objectives and metrics should be integrated into the investment process as early as possible; in this way, investment opportunities are framed within the impact objectives, and the fund manager can then seek and select those opportunities most likely to achieve financial targets.
- Corporate governance structure should be conducive to double bottom line investing.
The mission of Small Enterprise Assistance Funds (SEAF) is to invest in and support SMEs as a means of economic growth and development in underserved markets.15 SEAF, a registered 501(c)3 non-profit global fund management group, has carried out its economic development mission by deploying private sector tools, i.e. launching private, for-profit equity funds in Central and Eastern Europe, Latin America and Asia.
By the end of December 2012, SEAF’s historical cumulative committed capital reached US$ 655 million, with more than US$ 470 million in debt and equity investments in nearly 400 companies and 214 completed exits. These businesses have created and/or maintained more than 34,000 jobs, developed the skills and increased the wages of their employees, and raised their revenues year-on-year to become stable economic forces in their local economies. We estimate that every US dollar invested in one of our SMEs has generated US$ 13 for the larger community (see “SEAF – The Economic Rate of Return” for more information on the calculation methodology). SEAF’s investors, a combination of development institutions and private sources, have been able to satisfy both their financial and developmental objectives.
While a non-profit group, SEAF is also an investment adviser registered with the US Securities and Exchange Commission (SEC). This unique structure (described in more detail under “Design and Manage Governance to Make It Easier to Achieve a Fund’s Objectives”) allows SEAF to align its mission of achieving developmental impact with generating financial return to its investors through its network of for-profit funds and their underlying investments in SMEs.
Now on its 32nd SME investment fund, SEAF has had many successes and learned crucial lessons about how to align financial return and social impact. We share four of them below.
Work with Investors Aligned to Your Vision for Change and with Investment Parameters
To meet investors’ expectations, it is critical to work with those that share the same goal of achieving both financial and social returns, as well as the same focus of a particular sector, geography or theory of change.
Our investors rarely work with us for the sole objective of maximizing financial returns, but rather for a variety of fund attributes. On a high level, investors must be aligned with our vision that SMEs can be engines of prosperity and forces for change in challenging environments; they sense undiscovered value in the less mainstream corners of the global economy. On a more tactical level, investors must be comfortable with smaller transaction sizes, since our funds, most of which make investments of between US$ 1 million and US$ 5 million, are off the spectrum for traditional private equity funds. Moreover, given that we invest in less mature companies and markets, investors need to be at ease with the uncertainty inherent in frontier and underserved markets, as well as in working with earlier-stage companies.
Historically, only DFIs, existing for the explicit purpose of leveraging finance to achieve economic development, shared our social impact mission. Over time, local investors who want to participate in the growth of their economies through high-potential, home-grown companies have increasingly invested in our funds. These investors include local pension funds and insurance companies, as seen in our Colombian and Peruvian funds.
Recently, family offices, foundations, forward-looking corporations and individuals have seen benefits in focusing on an otherwise hard-to-reach sector, population or geography. These investors often do not identify themselves as “impact investors”; rather, they seek reasonable and somewhat uncorrelated returns. They also recognize that aligned investing provides some protection against the potential financial risk that less socially-minded investment managers can unwittingly create, as when they pursue profit maximization without regard for social, environmental and other standards.
Integrate Social Impact Metrics into the Investment Screening, Selection and Monitoring Process as Early as Possible
The impact objectives should drive the fund thesis, pipeline generation, investments made and, importantly, incentives of the investment team. The fund management team should be aware of investors’ dual motivations. To demonstrate success, the manager must be able to collect, track and evaluate the data from investments made. Alignment from the beginning makes it much easier to integrate the metrics into the investment process; however, the more specific the targets become, the more difficult it can be to balance the developmental objectives with the financial ones. For example, narrowing the universe of acceptable investments too much may mean that the available investments cannot meet financial objectives. Instead of strengthening the impact, a plethora of very specific and potentially competing metrics can hamper the investment team’s ability to find good investments that meet the criteria. This results in the funding of financially unsustainable investments that meet neither social nor financial objectives.
These caveats are particularly important with investments made in smaller and often less mature markets. In the end, the team must seek opportunities that are sound and sustainable, yet conducive to the social impact that investors desire.
Ideally, the investment professionals should see that achieving the developmental objectives also factors into their compensation. Unfortunately, this is all too rare for two reasons: first, it is not easy to devise the right balance of incentives; and second, even aligned investors are frequently most comfortable remaining with traditional incentive structures based on financial return. No basis exists to create incentives geared to anything other than financial performance if the fund manager does not develop and deploy metrics for evaluating agreed social and developmental outcomes (e.g. job creation, wage growth or sector-specific metrics related to providing basic services or health outcomes).
In the end, rigorous impact measurement and evaluation methods can play a significant role in successfully balancing financial and social returns, so long as both are measured and the incentives do not tip the scale too far in one direction. One example is a scale of financial incentives that increases as long as sufficient progress is made in achieving both social and financial returns.
We have also adapted and implemented a stakeholder-benefit methodology that quantifies the net benefit to the local economy of investments made in emerging-market SMEs. We calculate the multiplier effect of investments through in-depth case studies of representative portfolio companies. Using a cash-flow model, the multiplier effect considers the financial return of an investment plus additional external social returns (see Figure 10 and “SEAF – The Economic Rate of Return”).
By gathering more than just deal-specific financial data, we are able to tell the story of the investments and make the case to an increasing number of stakeholders about the positive role that SME investment can play.
Figure 10: SEAF Economic Rate of Return
SEAF – The Economic Rate of Return
Since 2004, SEAF has conducted 20 in-depth case studies to assess and report on impacts beyond the scope of the indicators included in the portfolio-wide data survey. The case studies allow us to conduct an overall quantitative analysis similar to an assessment of an investment’s financial performance. The detailed information collected from site visits and interviews is quantified in dollar terms and incorporated into a cash-flow model of the company that is used to calculate two impact measures: an investment multiplier and an economic rate of return (ERR).
By adding the social impacts to the cash-flow model for the company in each case study, SEAF is able to calculate the multiplier effect of investment for each company. To calculate a net economic benefit/cost ratio, SEAF considers the value of financial and social cash flows and the value of the total amount invested into the company. This figure includes returns to financiers (the owners, SEAF and other financiers) and the impacts on other stakeholders, and is net of the amount invested.
For the 20 cases conducted to date, every dollar invested into frontier-market SMEs has generated, on average, an additional US$13 in the local economy. The calculation is based on a 0% cost of capital (i.e. discount rate). With a 10% discount rate, the figure is US$6. Use of various discount rates (a valuation methodology used in finance) allows investment managers to consider potential impact results in line with how they assess expected financial performance.
Case study methodology
SEAF quantifies the development impact of each portfolio company using a development impact model adapted from the economic department of the International Finance Corporation (IFC) (“Assessing Development Impact”, by Frank J. Lysy, International Finance Corporation, 20 October1999). This model measures the economic impact on each group of stakeholders affected, either directly or indirectly, by the investments in the company. SEAF calculates the present value of net cash flows generated for all stakeholders and divides it by the present value of the dollars invested over the life of the company; this provides the additional dollars generated in the local economy per dollar invested.
The model is based on the recognition that not all of the impact or value of a market transaction is reflected in price paid. Such effects beyond the price paid are variously referred to as externalities, public goods or consumer surplus. In the case of the impact of or value derived from investing in SMEs, some impacts, whether positive or negative, are not captured in the returns to financiers. These excess values – the aggregated value to all members of the economy – must be added to the SME financiers’ net profits for assessing the investments’ value to the economy as a whole. The overall value represents the total development impact resulting from the investments. The stakeholders potentially impacted by investments are broken down into the following categories: financiers, employees, suppliers, customers, competitors & new entrants, producers of complementary goods & services, local community, national governments.
The model is built using data from the company, including financial statements and market statistics, and makes extensive use of information gained through stakeholder interviews. The model is based on 10 years of cash flows (usually from inception of the company and projected cash flows) and a terminal value. Results from the model are expressed as internal rates of return (IRRs) and present-value net benefit/cost ratios calculated at various discount rates. Both are in real terms, as the cash flows used in calculations are in constant US dollars. The benefit of calculating figures in real terms is that the reader may select the discount rate thought to be the most appropriate for risk without having to consider inflation (also making it easier to compare case studies).
The impact on financiers is measured, with a cash-flow model, as the traditional financial returns that they receive from the company. Using the net financial cash flow, SEAF calculates the IRR to all the financiers of the company, which per the IFC model is called financial rate of return (FRR). We measure the return to all the financiers, including both the investments from the Fund and those from other parties, over the entire life of the company. Next, we evaluate the impact on the other stakeholders (see stakeholder category list) over the life of the company. As with the net financial cash flow, we count the social benefits from inception onwards, including projected years. The net social cash flow is calculated as the premium over the benefit that the stakeholders would receive elsewhere, or would receive if the portfolio company did not exist. For example, the benefit to suppliers is calculated as the net income resulting from the portfolio company minus the estimated net income they would receive elsewhere if the portfolio company did not exist.
SEAF then adds the net social cash flow to the net financial cash flow to calculate an IRR representing the total development impact of the company, or return to all stakeholders, which is the ERR as per the IFC model. Again, the ERR does not represent the economic return from the Fund’s investment alone, but the economic return generated by all of the debt and equity investments in the company, and over its life. Finally, we calculate the net economic benefit/cost ratio, which represents the additional dollars generated in the economy from one US dollar invested. The net economic benefit is the present value of the net financial cash flow and the net social cash flow, and the cost is the present value of all the debt and equity investments in the company and over its life (financing cash flow).
Select Financially Sound Investment Opportunities and Provide Support to Keep Them on Track
Central to SEAF’s investment philosophy is the belief that high developmental impact can only be achieved through financial success of the portfolio company.16 Given that our vehicle for achieving impact is a private-sector company, the SME must be financially healthy to continue delivering on impact objectives (e.g. creating jobs, increasing wages and skills, paying taxes, procuring supplies of inputs, giving customers better value and more choices, and contributing to the fabric of the local community by a variety of philanthropic activities).17
We provide technical assistance to portfolio companies’ management teams to improve their financial and cost controls, source new customers and markets, adhere to relevant quality standards, and access industry experts to advise on operations and expansion strategies.
That said, we monitor and evaluate the portfolio companies to ensure that even the most financially successful investments continue to meet the development priorities of the Fund and provide the social benefits sought through the original investment thesis. This is critical for managing investor expectations given that our investors stipulate ESG norms and development impact in their investment parameters.
Design and Manage Governance to Make It Easier to Achieve a Fund’s Objectives
As impact investing funds move from the donor world to the investment world, they need to seek appropriate business models and develop strict investment discipline and strong financial controls. Several aspects of governance are critical to achieving double-bottom-line performance. At a high level, the legal structure and governance should protect the mission of the organization. On a day-to-day basis, sound governance practices should ensure clear investment policies and processes. Finally, the importance of full accountability and transparency could not be overestimated in giving confidence to investors.
SEAF is structured as a non-profit with a mission-focused charter and binding investment policies that stipulate the scope and target of investments. SEAF’s board of directors ensures the mission is central to charting the organization’s direction. Besides SEAF’s own board, each individual fund’s board and shareholders provide additional oversight and governance necessary to keep the fund manager on track and aligned – both through financial incentives for risk-adjusted investment returns, and from an investment policy standpoint whereby approval is given only to investments meeting the developmental parameters.
We make it a priority to meet all fiduciary obligations to our investors and have developed strong financial controls and reporting. We perform regular valuation of fund investments and provide investors with quarterly reports on their investment status.
Strong focus on its development mission, strict investment discipline and commitment to transparency has enabled SEAF to attract diverse investor base and grow assets under management. SEAF is a SEC-registered investment adviser, which further signals to investors its commitment to prudently manage capital, and with full understanding of fiduciary obligations.
As assets under management in impact investments grow, more fund managers will become registered and regulated by governmental or industry bodies. Meeting regulatory requirements will in turn lead to the further professionalization of the impact investing sector. It is a virtuous circle that starts with the fund manager ensuring appropriate fund governance practices. This eventually will lead to more capital flowing into impact investing.
While the desire to produce both financial returns and development impact can create occasional tension, the challenges of achieving a healthy balance can indeed be reduced by consciously developing an approach and structure that allows an organization to pursue both goals effectively. First, the importance of working with investors who are aligned with the dual mission and take each aspect of it seriously cannot be understated. Second, the investment team must be able to define, measure and incentivize non-financial success. Third, it should be understood that social and development impact flows from financial success when the impact delivery vehicle is a private sector company. And finally, creating a corporate governance structure conducive to double-bottom-line investing can help tie all activities together.