World population is estimated at 6.8 billion people, of which close to two billion live in poverty, 925 million are undernourished, 2.6 billion lack basic sanitation, about one billion can't read a book or sign their name and 443 million school days are lost each year due to water-related illnesses. Yes, the percentage of population living in poverty has been substantially reduced in recent decades, but China alone accounts for most (close to 90 percent) of the world's poverty reduction since 1981. What's more, staple food prices are increasing, while income inequality is rising: the poorest 40 percent of world population account for five percent of the world's income, and 80 percent of the world's population live in countries where income differentials are widening.
On the environmental front, global CO2 emissions have risen by 20 percent since 1997, with no post-Kyoto agreement in sight and the 2012 deadline fast approaching. To ensure global temperatures don't rise by more than 2°C above pre-industrial levels, G8 countries would need to cut their emissions by 80 percent by 2050, which translates into investments of $1trn a year, of which $475bn is transfers to the developing world to help it adapt to climate change. Furthermore, the Kyoto framework does not cover deforestation, which is responsible for some 13 percent of CO2 emissions.
Impact finance seeks to address these imbalances by providing an expanding universe of profitable investment opportunities to investors, yielding double or triple bottom line returns.
Public sector needs the private sector
The world is progressively recovering from the financial crisis and a two percent contraction of the global economy in 2009. But the rising debt and need for budgetary cuts faced by most OECD governments has effectively shifted much of the burden of sustainable development funding to the private sector.
Total net official development assistance (ODA) from the OECD amounted to $122bn in 2008, representing 0.3 percent of the combined Gross National Income (GNI) of OECD donor countries. It fell short of the 2010 target of 0.36 percent of GNI to stay on track with the Millenium Development Goals (MDGs), let alone the 0.7 percent of GNI required in order to achieve the MDGs by 2015.
Private sector mobilisation is therefore essential to complement the development efforts of the public sector. According to 2008 data published by the Hudson Institute, private giving to developing countries reached $34bn from the US and $15bn from 13 other countries including most of Western Europe. That same year, remittances to developing countries totalled $325bn (World Bank), and foreign direct investments to developing and transition countries amounted to $735bn (UNCTAD 2009). In fact in 2008, says the Hudson Institute, “Global philanthropy, remittances, and private capital investment accounted for 75 percent of the developed world's economic dealings with developing countries.”
Investment industry reengineering
With $111trn in global assets under management worldwide as of December 2008 (BCG 2010), the capital market pool is too large a resource to be ignored by sustainable development proponents. Some 6.3 percent of these global financial assets are invested in socially responsible investments (SRI), while more than 800 signatories managing $22trn subscribe to the concept of sustainability, broadly endorsing the United Nations Principles for Responsible Investment. Yet most of the actual practice focuses on doing little or no harm, and rarely provides the opportunity to measure the precise social and environmental impact of investments. Impact finance may be a good response to this quandary. It presents financially appealing investment solutions across asset classes, and funds viable and often scalable solutions for microfinance, affordable healthcare, education, alternative energy, and sustainable agriculture. As Bridges Ventures noted in 2009, “the sector stands poised both to address significant social and environmental issues and to chart a new course for the financial services industry to reclaim its stature as an engine of social and economic upliftment.”
Impact finance market
Impact finance was valued at $50bn in April 2010 by the Global Impact Investing Network (GIIN), which expects it to grow to $500bn by 2014. According to another forecast, “Over the next five to 10 years, impact investing could grow to represent about one percent of global assets under management” (Monitor Group 2009). But more recent data indicates impact finance may encompass financial assets worth up to $297.2bn already.
In December 2009, CGAP numbered 91 active Microfinance Investment Vehicles managing $6.2bn, a 25 percent growth over 2008, predominantly composed of mostly de-correlated and low-volatility Fixed Income, with an average return of USD Libor +250 bps in 2009. The ranks of microfinance borrowers have increased by 91 percent per year from 2004 to 2009 (Intellecap 2010), reaching $40bn in gross loan portfolios, and 2.5bn adults still don't have access to financial services (McKinsey 2010).
Community investing in the US was valued at $41bn at the outset of 2010. As for sustainable agriculture, fair trade sales were valued at $4.2bn worldwide in 2009, a 15 percent growth over 2009 (Fairtrade Labelling Organisation 2010).
As for sustainable agriculture, fair trade sales were valued at $4.2bn worldwide in 2009, a 15 percent growth over 2009 (Fairtrade Labelling Organisation 2010). Regarding carbon finance, another impact investment segment, CDC identified 96 carbon funds with a total capitalisation of $16.2bn, in Equity and Private Equity vehicles mostly, while UNCTAD estimated FDI flows into renewables, recycling and low-carbon technology manufacturing amounted to $90bn in 2009. The global carbon market is worth $122bn, mostly thanks to the EU Emissions Trading Scheme (The Economist 2009), with an additional $163bn from green subsidies (New Energy Finance 2009).
Impact investing is attracting all types of investors: 19 European pension funds have disclosed microfinance investments of $555m (OnValues 2009), and Toniic, the US impact investment club, will launch its European chapter in 2011. Toniic was co-founded by RSF Social Finance, which since 1984 has provided social enterprises with $200m in loans, and the KL Felicitas Foundation, which has pledged its entire endowment to impact investing.
Impact finance hurdles
According to a recent survey by AlphaMundi Group, this new investment approach still faces a number of hurdles: a short history, a lack of standardisation and access to information, insufficient investor awareness and product benchmarking, liquidity constraints, and a more comprehensive regulatory support are all challenges being progressively resolved by the industry.
Further findings reveal that most impact finance asset managers specialise exclusively in this new type of investment, using debt and PE/VC instruments to fund deals of $1m on average (AlphaMundi 2010). They can broadly be assigned to two categories, the first composed of impact finance pioneers with at least six years of track record and $100m or more in assets, the second made up of new market entrants with less than five years of experience and under $20m in assets. Only half of the interviewees disclosed their financial performance, which on average was superior to five percent per annum for debt instruments and 10 percent per annum for PE in 2009. Half of the managers charge at least two percent management fees, and additional performance fees of 20 percent on average with a hurdle rate of six percent or more, to cover the costs of due diligence which typically takes three months from deal identification to disbursement, and of monitoring and reporting thereafter. Leveraging resources through co-investment could be a solution to reduce transaction costs, but only a small minority had ongoing co-investments at the time of the survey. All the interviewees invest directly into projects or impact enterprises, while half also invest through funds. The regions of greatest interest for the foreseeable future include Asia ex-Japan, Africa and Latin America. Interestingly, most impact finance managers expect microfinance to be supplanted by sustainable agriculture and alternative energy as the primary sectors of impact investment.
With regards to impact measurement, less than half of the interviewees used systematic measurement processes, and in most cases they do so in-house with a customised methodology. About half impact finance asset managers believe it would be useful to establish industry-wide label for impact investing, to catalyse market growth and facilitate fundraising, and 75 percent of them would be willing to contribute data to enable such a label should it exist. Fundraising is the second largest driver of cost for impact finance managers, after the expenses of investment screening and monitoring. Like any new industry, a majority of interviewees think it necessary to broaden investor awareness and appeal through special tax incentives, and AlphaMundi is now working with leading stakeholders across countries to secure sufficient regulatory support and crowd in the private sector.
Regulator support
Regulator response to this emerging investment approach is eclectic. According to the Council of Europe, 40 percent of its Member States have initiatives related to ethical finance, but only 20 percent have created a legislation supporting this type of activity. At the European Union level, three initiatives related to ethical finance are still pending approval, related to the need for companies to publish social and environmental assessments in their annual reports, and to the need of pension funds to disclose their ethical investment policies. More specifically, in the Netherlands, a 1995 directive on green investments paved the way for both revenue and capital gain tax rebates for sustainable, cultural, social, microfinance or developing country investments. In the UK, pension funds must integrate sustainable investment principles in their investment charter since 2000, and in March 2010 the government pledged $120m (£75m) to create a Social Investment Wholesale Bank in 2011. In the future, the bank may channel dormant assets to social enterprises in the UK and abroad. In Norway, the leviathan Government “Petroleum” Pension Fund was established in 1990 and currently manages $450bn and holds one percent of global equity. The Petroleum Fund has adopted new ethical guidelines and a green investment program in 2010. Belgium incorporated a private investment company in 2001, BIO, to channel €346m to date to SMEs and microfinance institutions (MFIs) in developing countries. BIO also provides grants and guarantees. Similarly in Switzerland, the government established the Swiss Investment Fund for Emerging Markets in 2005, which has channelled more than $400m to SMEs in 30 developing and transition countries to date. In Italy, the central bank supported the establishment of Banca Popolare Etica, which today manages a sustainable finance portfolio of €645m in savings and €601m in loans.
In turn, Banca Popolare Etica co-founded the European Federation of Ethical and Alternative Banks association. More recently in the US, the Obama administration announced the launch of a new funding facility for MFIs with an initial capitalisation of $150m in 2009, and gave a strong endorsement to the establishment of a Global Impact Investing Rating System (GIIRS). Last but not least, in Luxembourg a consortium of institutions, including the European Investment Fund, Banque de Luxembourg and Ernst and Young, presented a series of policy recommendations for the government to adopt supportive measures for the growth of impact finance in Europe as of 2011.
Impact finance outlook
The outlook for the growth of impact finance seems to hold much promise. The public sector needs private sector funding to co-finance the sustainable development solutions the world requires. It is imperative that we as a global human society adapt before certain tipping points are reached, be it in environmental degradation, hunger and illness or loss of human life, or inequality, poverty and failed states.
Impact finance complements the array of ODA, philanthropy and FDI instruments for development, and unlocks new sources of capital by blending financial returns and social incentives. As the numbers attest, both institutional and private HNWI investors have already begun including impact finance products in their investment portfolios, across private equity, equity and debt, and thereby contribute to the sector's growth and emerging standardisation.
Tim Radjy is CEO of AlphaMundi Group. For more information www.alphamundi.ch
