Patient Capital in an Impatient World
Brian Trelstad, Class 12
"Water, water, everywhere,nor any drop to drink."–Samuel Taylor Coleridge,The Rime of the Ancient Mariner
More than 1.1 billion of the world's people lack access to reliable sources of drinking water. The poor quality of the water that is available to drink is a humanitarian crisis with more than a million children dying every year from diarrheal diseases attributable to poor water quality and lack of basic sanitation facilities. The United Nations sees this as such an important public health problem that one of their eight highly publicized Millennium Development Goals seeks by 2015 to halve the number of people without sustainable access to safe drinking water and sanitation.
A handful of entrepreneurs are looking at this problem through a different lens: opportunity. They see an immense, untapped market waiting to be captured with innovative water treatment and distribution businesses. There is literally a "fortune at the bottom of the pyramid" according to C. K. Prahalad, the business strategist who wrote an influential book by that title. By developing radically less-expensive products and services designed specifically for low-income consumers, innovative new business models can deliver social value in a financially sustainable way.WaterHealth International (WHI) is one of those companies: Founded in 1996, WHI uses an ultraviolet water treatment technology developed at Lawrence Berkeley Labs to build community scale water purification systems. The entrepreneur, Tralance Addy, had grown up in Ghana and was impatient to see a world where every child has access to clean water. In 2004, the company approached Acumen Fund, a U.S.-based social investment fund, to help finance their India market expansion. Acumen Fund joined with the International Finance Corporation, the private equity arm of the World Bank, and Dr. Anji Reddy, a successful Indian entrepreneur, to commit a total of $2.6M in new equity.Over the next two years, as the opportunity became more attractive (and the challenges of executing became more daunting), the company sought to raise $11M in capital. They turned to two investors—a strategic investor and a clean tech venture firm—who had clear fiduciary responsibility but also had the insight to see the disruptive potential of meeting a huge and underserved market in a new way with WaterHealth's technology.As the more traditional commercial investors came into the company, they questioned Acumen Fund's potential value as an investor. Acumen Fund only had a small ownership stake in the company and seemed more enthusiastic about building the low-cost water sector in India than pushing for a large financial return on its investment in the company. As a result, during the negotiations, Acumen Fund lost a board seat and became a relatively passive investor over the next few years.As for many early stage companies, the story does not end with this round of finance; to understand how and why Acumen Fund re-engaged, it is useful to consider a broader perspective on this story and others like it.
New Investors, New Strategies
Over the last decade, a new breed of venture capitalists, like Acumen Fund, has emerged. These so-called "impact investors" seek to combine financial returns with social impact by using the tools of venture capital to make principal investments in private, high-growth companies that have the potential to deliver some measurable social or environmental benefit. Building on the success of microfinance in demonstrating the commercial viability of an overlooked asset class, patient capitalists believe that you can achieve a commercial or quasi-commercial return and outsized social impact by betting on innovative entrepreneurs addressing underserved markets. For the social investor, the exciting growth opportunity is not a company's valuation, but the liters of clean water delivered, the cases of malaria prevented, the tons of CO2 emissions averted, the lives changed.
With several hundred million dollars raised in the last few years, social investors are a growing and influential phenomenon, but are still a relatively small part of the global capital markets. While social investors share a desire to do more with their capital than simply maximize financial return, there are as many differences among social investors as there are differences across venture capital funds. Some take product risk, others avoid it; some are stage-specific, others invest across company lifecycles. Some are shrewd investors; some are not. And the commercial versus social orientation of funds is all over the map, in large part driven by the source of capital.This article outlines the rise of the social investors and touches on a number of key points where they diverge from traditional profit-maximizing venture investors. Professional venture capitalists may disagree with the fundamental assumptions of social investing—that you can do well and do good—but it is important to understand what role social investors play in the venture capital ecosystem.Some venture investors may view impact investors as soft, perhaps even more uncharitably, as "dumb money" (Acumen has often been asked by co-investors why we did not just make a grant to struggling companies in our portfolio). However, venture capitalists risk ignoring impact investors at their own peril: these new fund managers can be a great source of deal flow, co-investors who bring experience in underserved or emerging markets, or more patient capital that is willing to assume a higher risk for lower returns. Understanding the diverse motivations, strategies and styles of this rapidly growing segment will become essential for traditional venture capitalists over the coming decade.
The Rise of the Social Investor
All investors, to some extent, are impact investors. Google has changed the world. So has Genentech. Venture-backed companies that scale to serve hundreds of millions and alter the landscape of health services, energy or technology have reshaped the world we live in, often for the better. The scale of the potential impact is usually an important part of the logic which drove the ultimate financial return. No one who invested in Google really cared about search for its own sake; they cared that search would solve the problems of millions of people, and that millions of people spending time on a simple website could somehow be monetized. And that those cash flows would make the investors really rich. Really, really rich.
So what differentiates social investors from traditional investors? We define a social or impact investor as someone who, in addition to the financial return on their investment, also and perhaps equally considers the social or environmental return when making investment decisions. They will sometimes, but not always, consider a lower economic return for potential social or environmental impact. There are several rationales for this approach—some are mission driven (e.g. poverty alleviation, environmental impacts), some are government sponsored (e.g. the International Finance Corporation, Norfund), and some are driven by regulatory frameworks, such as the Community Redevelopment Act in the United States. Consider the "spectrum of capital" in Figure 1. While it presents a simplistic trade-off between (non-risk adjusted) financial return on one axis and (non-risk adjusted) social impact on the other axis, it is useful as an orientation to the world of impact investing.
Figure 1. A Spectrum of Capital.Author's image.
Traditional profit-maximizing investors exist on the far left of Figure 1, trying to make as much money as possible for their investors. Benchmark and Sequioa have a fiduciary responsibility to their limited partners to maximize the return on their investments. Whether the general partner cares about the social impact of their investments is secondary to their need to generate an internal rate of return (IRR) that is superior to their peers in the same asset class. New funds like Kleiner's pandemic fund, or the new generation of clean technology funds, or the success of emerging market funds like Zephyr might imply that traditional venture funds are inching further to the right on the social impact axis in search of blended value,1 but what is more likely is that they are fundamentally spotting market imperfections or disruptive new opportunities that will have significant financial returns and that may also be able to save lives, reverse climate change or rebuild the economy of sub-Saharan Africa in the process.At the other end of the spectrum are traditional foundations, whose grants generate a reliable –100% IRR. Some foundations, particularly newer ones, have waded into the space of "venture philanthropy," using the tools of venture capital to make grants in high-growth social ventures. These foundations and venture philanthropists often support social enterprises and innovative nonprofits that can generate fees for service to cover some of their financing needs. Funders like Draper Richards Foundation, New Schools, or New Profit use venture capital methods of high-engagement philanthropy, milestone based "term sheets," and intensive management assistance to help scale these effective social programs. Some are stage-specific (Draper Richards for seed), region-specific (Venture Philanthropy Partners in Washington, DC) or issue-specific (New Schools in education).Some of the nonprofits and social enterprises that these foundations fund, like Visionspring or College Summit, have used the techniques of venture-backed companies to raise money: developing a business-like prospectus and taking the team on a "road show" to "investors" (really donors). These organizations are moving up from the bottom right of the chart into the world of impact investing, but much like a venture fund will always seek to maximize financial return, a foundation that gives grants or a social enterprise that seeks them, no matter how much business parlance they throw around, primarily cares about maximizing social return.2In the middle is everything else. This messy world of "impact investor" includes for-profit funds, nonprofit organizations, government-sponsored funds, domestic funds, global funds, technology funds, IP funds, you name it. It also includes, somewhat confusingly, the financial managers of foundation endowments. Most investment managers at foundations strictly adhere to their fiduciary responsibilities to grow the endowment as aggressively as possible. Remember, the benefactors of most foundations are no longer living, so the only way to grow the asset base is to successfully invest the corpus and grow it. At some progressive foundations, however, like the Rockefeller Foundation or the FB Heron Foundation, we are seeing more risk-seeking investments within their endowments, using "Program Related Investments" (PRIs) and "Mission Related Investments" (MRIs) to achieve modest financial returns more aligned with their grant making missions.3How is a venture investor to tell where on the spectrum of capital an impact investor might fall, whether they care more about financial or social return, and how to treat them as a co-investor? What follows are a few important characteristics of impact investors that can help illuminate their motivations and anticipate their actions.
Types of LPs Supporting Impact Investors
The first and most important question to ask of an impact investor is their source of capital. There are very few social investment funds that have moved a material amount of purely commercial capital; the risk return trade-off in many of the markets just doesn't compute yet. The more commercial the source of capital, the more likely the fund managers will act like commercial managers. Conversely, the more philanthropic the source of capital, the more unpredictable the fund might be in working with traditional investors. Below are a few major categories of sources of capital, from the most to the least commercial, and the types of funds they typically prefer.
In the United States, financial institutions are often compelled by Community Reinvestment Act requirements to invest in distressed communities and have thus invested in social investment funds. For example, Bank of America's Capital Access Fund is a limited partner (LP) in Pacific Community Ventures, a fund that invests in job creation in distressed communities in California.
Pension Funds and Screened Funds
These funds are looking to diversify their risk and fulfill the social obligations of their clients and members. Funds like Calvert are primarily invested in community housing (which often receive tax credits to generate competitive risk adjusted financial returns), while pension funds sometimes wade into clean teach or more progressive funds that foster innovation in new sectors.
There are a few funds that have raisedtens of millions of dollars fromhigh-net-worth individuals who are expecting commercial returns. Some of these funds are aiming to deliver "microfinance" like returns in the low teens; others are promising commercial returns.
High-net-worth individuals are often the sole capital sources of social investment funds. The Omidyar Network, Legatum, and Gray Matters are examples of funds that have been founded and capitalized primarily by one high-net-worth individual. The investment teams are driven to maximize financial returns, but often have the flexibility to take higher risks and can therefore be unpredictable at times. Another such single LP fund is the Aga Khan's Fund for Economic Development, which focuses on economic development in regions where Ismailis live: Central Asia through South Asia into East Africa.
There is a range of "development finance institutions," most notably the International Finance Corporation. The IFC and its many regional and national counterparts (e.g., the Inter-American Development Bank, NorFund in Norway) are largely private equity players who primarily seek financial returns but who are also interested in social impact through the economic development of their investments.
Foundations can make grants or invest in funds using PRIs. E+Co, an energy investment fund, was launched with a grant from the Rockefeller Foundation in 1994 and has raised other foundation, government, and individual contributions. PATH's new health venture fund was seeded by a grant from the Gates Foundation. Itis important to know whether the foundation wants its money back, or not. Obviously, a fund backed with grant funding in search of fostering innovation will be more risk seeking.
There are some funds that have raised significant amounts of capital from diverse pools of individual donors, but not many. The philanthropist as "LP" is an unusual case, but Acumen Fund, for example, has raised about $100M in individual contributions, coming from both individual and institutional donors contributing from $10,000 to $5M, with the "partnership" typically being a $100,000 contribution over 3 years. In Acumen Fund's case, the donors are not expecting their money back, so are not traditional LPs, but instead are hoping to catalyze social change through their contributions
As one navigates the field of impact investors, the source of the capital is probably the strongest predictor of their behavior along the spectrum of capital (Figure 1).
Fund Structure and Economics
After the LP composition, the fund structure and economics are the next most important differentiating factors and probably the most difficult to synthesize. Many social investment funds are closed-ended limited partnerships, with offshore structures that aim to optimize the taxes on investment returns for their LPs. They will act like typical investors: savvy at doing deals, aggressive at maximizing returns and not so different from a typical venture fund manager. Some funds are evergreen,4 quasi-government agencies with the ability to navigate restrictions on foreign direct investments (helpful in markets like India that restrict capital flows into and out of the country). These funds are risk-averse but commercially savvy, and often bring considerable experience and resources to nontraditional investment or turbulent economic situations. Finally, a minority of funds are evergreen non-profits: tax exempt institutions that can make commercial investments without having to deliver commercial returns to their investors or employees. These are the wild cards: hard to predict their actions, more motivated by social impact than financial returns, and often far more entrepreneur-friendly (if there is little money at stake, why go through the pain of firing a management team?).
Unlike a venture capital fund, it can be hard to define the size of a social investment fund, which can make it hard for traditional investors to understand how much of an appetite the impact investor has for new or follow-on investments. Some use traditional fund terminology (e.g., amount raised, capital deployed), and some are more aggressive and talk about "capital mobilized"—the money they have catalyzed by making direct investments. Others are more conservative and only talk about the investment dollars disbursed that sit on their balance sheets.But no matter how you analyze it, most impact investors are relatively small players. Most funds seem to be in the $50-$100M range. The Kellogg Foundation just announced a $100M fund to invest in job creation initiatives in the United States and South Africa. SNS Real had a 50M Euro water fund. The larger funds, in the $1B+ range, are typically development finance institutions like the IFC, which has an $8B portfolio invested globally. Smaller funds, like the Google.org/Soros Economics Development Fund/Omidyar Network SME Fund, are often geographically targeted and stage-focused; in this case, they have raised a $15M fund to invest in small and medium enterprises in India.Even the largest funds (except for the international finance institutions) can rarely invest more than a few million dollars in any given company. The average investment size varies widely, but most social investment funds seem comfortable investing $1-2M per deal, willing to double down to twice that amount, but usually unable to help carry a deal through to a public offering or lead larger rounds. Some can do investments as small as $50,000 to $250,000, but for most funds, the transaction costs of anything less than $500,000 become hard to justify.5Few if any of these funds operate with the classic 2 and 20 economic structure6 of the typical venture capital fund, in part because it is really hard to define their financial returns, and in part because of structure or investor profile. For some of the single LPs, there are no general partners (GPs), just employees who typically don't share in the upside of the fund. Some of the funds with multiple limited partners have taken higher management fees (3 to 4%) to reflect the higher costs of finding and structuring social investments. The nonprofit funds often have affiliated management assistance or business development arms that can provide grant-funded consulting and business support that can cost up to 20% of the invested capital. Some of the funds will offer fixed returns to investors (sometimes with first-loss provision from subordinated investors who get to share in the upside), while a handful offer the traditional 80% of the carry to their limited partners.Given the diversity of fund structures and sizes, it is important to look closely at each impact investor's structure to learn about the relevant time horizons and to see if the staff is compensated in a way that is consistent with a more traditional fund. In the WaterHealth case, the Acumen Fund team had more incentive to see the rapid scale-up of water systems and the development of other competitors to prove the case that community water is a viable business model, while the investors at Sail were interested in the financial return. These priorities can go hand in hand, but in some cases the difference in emphasis will be enough to create tensions among investors that are important to trace back to their structural roots.
Investment Strategies and Return Expectations
The final dimensions of differentiation from traditional venture capital are the investment strategies and return expectations. Social investment funds can use any combination of investment structures: debt, equity, preferred shares, guarantees, and even revenue participation or royalty structures. Some funds will seek to do whatever best supports the business at its current stage of development. Again, the types of investments used will depend on the fund's capital source, the fund structure, and the time horizon for return expectations. Investment structures are most often driven by the exit options available in the local markets. In some markets and asset classes, there is little liquidity for privately held companies. There are limited options for strategic buyers and the public equity markets are nascent.
As a result, some social investors favor debt or preference shares (where allowed) or will only invest in markets with more vibrant capital markets or in sectors where acquisitions are possible. Others are willing to take risks on the exit. Acumen Fund, for example, worries first about whether the company can become viable with positive cash flows, and then thinks about exit options. Return expectations vary widely and are dependent on the same factors: LP, structure, time horizon, and exit options. At the more commercial end of the spectrum, investors are expecting 25 to 30% IRRs, while some funds will be fine with a multiple of 1x, or simply the real return of principal.A fund's investment strategy is often articulated as its "theory of change," or why it believes the world will be a better place because of its investments. Most are less disciplined than their for-profit venture colleagues at defining a clear investment thesis; the sector is still nascent, and opportunism abounds. There is a less well-defined track record for investment performance, and little evidence (yet) of consistent social impact. Most social investment funds seem most comfortable with seed or early stage investments. Few have the resources to be later stage or so called mezzanine investors (unless the fund invested in an earlier round), and they would rather hit the social home run by getting in early. Funds are often explicit about geographic focus (Africa and India are recent favorites) or issue (global public health is a hot sector, as are renewable energy funds). Some will do multiple issues in single geographies (Aavishkaar in India), others will do single issues in many countries (E+Co), and some funds are issue and geography agnostic.
Investment Teams, Decision-Making, and Value Addition
The investment professionals at social funds come from diverse backgrounds, but many do not have principal investing experience prior to joining their funds. Some come with significant private sector experience (consulting, product management), and are excited about the opportunity to support new venture creation in the context of social change. Very few come for the money.
Again, the structure and economics of the fund will dictate how active or passive the investment officers are, and how the fund makes decisions. More commercial funds are often more passive investors, with smaller, centrally located teams that can't sit on boards or provide intensive management assistance. But these funds can make decisions internally (and sometimes very quickly). The more socially-oriented funds have distributed global teams and will actively help structure the business opportunity pre-investment with formal technical assistance or business development programs. These funds often complement their less experienced investment teams with very seasoned external investment committees, which can often take time to iterate through major changes to terms or deal structures. The larger the fund, and the more socially oriented its mandate, the more convoluted the investment (and credit risk) committees can be for decision making.A final distinguishing characteristic of impact investors is that they often bring more than capital to the table. All venture capitalists aim to deliver non-monetary support to their portfolio companies beyond board service: senior level hires, near-term business development leads, or back-office functions like finance and accounting. Some prominent social investors, like Root Capital or E & Co, raise additional grant capital to run business development programs that train early stage entrepreneurs in financial management or assist with the business planning process. Others, like the IFC, have the capacity to provide extensive technical assistance grants that help their investments refine or improve their business model. Acumen Fund has launched a prominent fellows program that places high-potential emerging leaders with ten of our portfolio companies each year, working on the strategic priorities of the senior management team.
Impact Investors: Reasonable Returns
When WaterHealth International was looking for a fourth round of financing in 2009, the company reached out to all of its existing investors. When the board and new management team met with Acumen Fund to present the company's strategy, including plans to expand into new geographies, they began to realize the value that we might be able to add as social investors. Our co-investing relationships with a number of large development finance institutions, our experiences in the markets they were looking to enter, and our access to philanthropic capital to support new product research and development (we had a partnership with the Gates Foundation and IDEO to support innovations in water distribution and storage) were all of immediate, near-term value to the company. In late 2009, our investment committee approved a follow-on investment and WHI agreed that it made sense for Acumen Fund to rejoin the board.
Impact investors are here to stay. There is too much evidence that combining social or environmental criteria with a disciplined approach to principal investing generates real change and sufficiently attractive but perhaps not-quite risk-adjusted commercial financial returns. The Rockefeller Foundation's Global Impact Investment Network is looking to build the infrastructure for the sector, particularly in emerging markets. Even traditional large foundations like the Bill & Melinda Gates Foundation have recognized the need to use a wider range of tools to generate positive social change through "creative capitalism" as Bill Gates has called it.Savvy venture investors should not dismiss impact investors as mere philanthropists, dumb money, or a passing fad. Within the next ten years, it is likely that nearly every venture capital fund, including IT, health, or clean tech, will have at least one company in its portfolio that has been partially financed at some stage by an impact investor. In part, patient capitalists exist to enable higher-risk lower return businesses to a point where the commercial markets can invest.Impact investors are part of an emerging asset class that can generate serious deal flow, test new ideas, or expand into new markets, and in the process contribute to solving some of the most intractable environmental and social problems of our time; certainly a reasonable return on investment by most measures.
Brian is Chief Investment Officer at Acumen Fund, a non-profit global venture fund that uses entrepreneurial approaches to solve the problems of global poverty. Before joining Acumen, Brian spent four years at McKinsey & Company as a consultant in the healthcare and non-profit practices and as an editor of McKinsey Quarterly. Earlier in his career, Brian was at Stanford's Center for Entrepreneurial Studies. Earlier he co-founded GetActive Software in Berkeley, CA (acquired by Convio in 2007). Brian holds an AB from Harvard College, a Master's from UC Berkeley in city and regional planning, and an MBA from Stanford.
1 Jed Emerson has written extensively about Blended Value and SROI; links can be found at http://www.blendedvalue.org/.2 I have chosen to plot traditional philanthropy well short of the social impact "frontier" because of the challenge of objectively quantifying social returns; placing it in the middle seemed like the appropriate place to express "median social returns." To be fair, given ten-year venture returns, philanthropists should probably be plotted closer to the middle than the top of the graph. I have written more about the challenges of measurement and social enterprise in "Simple Measures for Social Enterprises," in Innovations: Technology, Policy, Governance 3, no. 3 (2008).3 For more on PRIs and MRIs, see Rockefeller Philanthropy Advisors' new report on "Philanthropy's New Passing Gear: Mission Related Investing."4 Put simply, an evergreen fund is one in which returns are reinvested on an indefinite basis, with no fixed date for repayment of the limited partners. In a for-profit evergreen fund, investor redemptions may be defined on a clear basis (e.g. after 8 years you can take out 5% per year, etc.). In a non-profit evergreen fund, the capital remains in the fund in perpetuity with no investor redemptions.5 Note. Many social investment funds, including Acumen Fund, rely heavily on pro bono support from law firms, so the full transaction costs are often clouded by the generosity of these firms.6 Venture capital funds typically charge a 2% administrative fee and the general partners keep 20% of the return after returning the initial principal to the investors.