5.4 Role of Governments

Impact investments focus on social challenges and issues – such as healthcare, education and poverty alleviation – that are typically addressed by governments; thus governments can play a critical role in mainstreaming impact investing.⁹³

Recommendation 1: Provide tax relief for risky or early-stage investments in which public benefit is created, but below-market returns are generated.⁹⁴ Government has the unique ability to catalyse investments in sectors that create public benefit, but that potentially result in below-market returns. These investments will likely be avoided by investors unless there is a tax incentive or regulatory provision that improves the economics of the deal. As an example, in June 2013 the British government announced tax relief to encourage private investment in social enterprise; details have not yet been released but the relief will be introduced into the 2014 finance bill.⁹⁵ While tax incentives can help direct capital, a key implementation challenge relates to the classification of “social impact”. In order for this recommendation to be effectively implemented, a universal definition for social impact would need to be understood and a legal form for impact enterprises would need to be developed. For example, in the United States, a division within the Securities and Exchange Commission or Internal Revenue Service would need to be established that regulates the impact enterprises that comply with or meet certain impact standards.

Recommendation 2: Cautiously revise regulations that restrict willing capital into impact investments. In certain instances, regulation can restrict capital from being invested into impact investments. Relevant revisions to these regulations can thus open up new sources of capital flow. For example, many US-based private foundations do not make programme-related investments (PRIs) – introduced in Section 3.2 – for fear of the tax penalization incurred as a result of making “jeopardy investments” or investments made in an imprudent way that risk a private foundation’s ability to carry out its charitable purpose.⁹⁶  In April 2012, the US Treasury expanded the types of investments that could be considered PRIs and listed new examples to clarify types of qualifying investments.⁹⁷ These revisions have the potential to direct significantly more capital from private foundations into impact enterprises. The history of venture capital provides another example of how revisions to regulations could open up new sources of capital. Prior to 1979, pension funds were quite limited in how much capital could be allocated to venture capital because of the Employee Retirement Income Security Act (ERISA)’s prudent-man rule.⁹⁸ In 1979, the US Department of Labor revised the regulation to allow pension fund managers to allocate capital to high-risk assets, including venture capital. To illustrate the impact, in 1978, pension funds supplied just 15% of the US$ 218 million allocated to venture capital. Just 10 years later, in 1988, pension funds supplied 46% of the US$ 3 billion allocated to venture capital.⁹⁹ Although further changes ERISA’s rule with respect to impact investing are unlikely, revisions to restrictive regulation can be a tremendous way to increase allocation to investments that create social and environmental value.

Recommendation 3: Help de-risk the ecosystem through innovative funding mechanisms. Given the early stage of the impact investment sector, there are three ways government can play a critical role in helping to reduce uncertainty:

First, government can provide a fiscal safety net for funds by providing guarantees as a means to underwrite financial performance. The New York Acquisition Fund is one such example. It provides loans to developers committed to creating and preserving affordable housing in the five boroughs of New York City, but the loans are structured in a way in which The City of New York, together with leading foundations, provide capital to guarantee the investments made by a consortium of banks, thus reducing the banks’ exposure to risk.¹⁰⁰  

Second, government (or a development financial institution) could take a subordinate position in a layered-structured fund. Layered structures help private and institutional investors move beyond making only small allocations to impact investments. For example, the Deutsche Bank Eye Fund allows certain investors – in this case, international development agencies – to take subordinate positions in an effort to attract mainstream investors into the fund. The fund successfully raised approximately US$ 15 million to invest in sustainable eye hospitals that serve the poor.¹⁰¹ 

Third, government could set up a pool of capital and provide anchor funding for market builders, first-time funds and early-stage enterprises (this is most relevant for governments of developed economies, and would likely be established within a country’s development financial institution). The United Kingdom provides an exemplary example of how this recommendation has worked well in a developed country. In 2012, the Financial Services Authority approved the creation of Big Society Capital, an independent financial institution that leverages unclaimed assets in dormant bank accounts in order to provide access to capital to organizations that are building the impact investment market in the United Kingdom. In its first year of operation, Big Society Capital committed £56 million to 20 different impact investment intermediaries. In the United States, the Overseas Private Investment Corporation provided US$ 285 million to finance six new impact investment funds with the aim of offering anchor financing so that the funds could raise more than US$ 875 million from mainstream investors.¹⁰² In the context of frontier markets, there is a need for government-funded capacity building funds for technical assistance programmes to help investees become more investment-ready. For example, the Government of Ghana’s Venture Capital Trust Fund provides investment capital and technical assistance to small and medium enterprises, helping them become more investment ready for commercial capital.¹⁰³