In this post I address three key challenges in SVC:
- Investment impact protections and asset-locking provisions, which provide deal certainty for investors by providing a guarantee that assets will be used to create impact;
- SROI/EROI metrics, which are used to quantify social and environmental returns on investment;
- Investor familiarity, prudently pointed out as a concern in another answer to this post by my colleague Alex Brug.
Before addressing them specifically, however, I would be remiss to fail to point out Everett Rogers’s early work, Diffusion of Innovations, which identifies five characteristics of innovations that influence their adoption or rejection. The characteristics of diffusion are as follows. First, complexity or simplicity (is it difficult to understand or use); second, compatibility (is it readily assimilated into the target population’s activities); third, relative advantage (is it an improvement on the previous generation of the product/service); fourth, trialability (is it easily experimented with, if so at what cost, and can it be implemented incrementally); and finally, observability (is the innovation observable and easily communicable to others). As Zoe Wong, President of the Social Enterprise Association at Cornell University, points out, DOI principles are applicable to the feasibility and success of the impact investment movement.
I now turn to three key challenges which will determine whether the impact investment financial innovation will become diffuse.
First: investment impact protections and asset-locking provisions. “Asset Lock” is a term that has co-evolved with a British social enterprise legal entity, the Community Interest Company. An Asset Lock, in that sense, is a provision in the CIC Articles of Association (equivalent to the Charter or Articles of Incorporation for an American Corporation), which is designed to ensure that the locked assets of the CIC are used for the benefit of the community. More generally, asset locking provisions are essential to providing investors with the certainty that their impact investment will indeed be used to create an impact, and not, for example, invested by the target entity in a tobacco farm or sweat shop – or any other non-impact-oriented purpose. A distinction of the British Asset Locking concept is that use of locked assets for the benefit of the company’s directors, employees, or service providers will be considered to contradict and violate the asset lock. “The community benefit requirement and asset lock require a CIC to precommit to social goals and irretrievably dedicate a substantial part of its assets to their pursuit.” For our purposes here, it will be sufficient to say that, in order for impact investment to become widespread in the United States, the investment and entrepreneurial communities will need to develop financing agreement and target entity provisions which will provide certainty for investors in their intent to have their funds be used for projects that are aimed at creating public benefit. Until such provisions become standardized, or principles for the construction of those provisions are created, there will be increased uncertainty and therefore increased transaction costs associated with impact investments, and such investments will be deterred therefore.
Second: Defining return – the challenge of constructing efficacious mainstream metrics. This concern speaks directly to Emerson DOI principle number 5 (observability). A recent open letter to the SEC Chairman advocates the adoption of GIIN’s Impact Reporting and Investment Standards (IRIS) to facilitate deal certainty and comparability. GIIN’s impact measurement and reporting standards allow investors to assess the impact of their investments in the same language, saving time and resources when evaluating social enterprise investment targets.
Third: Investor familiarity– the need for process familiarity and low transaction costs. Speaking directly to Emerson DOI principle number 1 (simplicity/complexity), a key concern of investors is deal process certainty and familiarity. GIIN was established to enhance efficiency within the impact investments market by standardizing and promoting the sharing of information. Investors will also be made more comfortable with the impact investing framework through the launch of B Lab’s GIIRS – Global Impact Investment Rating System which includes Pioneer Investors who have explicitly declared a preference for GIIRS-rated funds. Pioneer Investors include JP Morgan, Prudential Investments, RSF Social Finance, the Rockefeller Foundation, the Annie E. Casey Foundation, the Skoll Foundation, Calvert Foundation, and the WK Kellogg Foundation, among others. As increasing numbers of private equity and investment banking firms adopt uniform standards, and as the standards are used over an increasing timescale, investors will come to understand impact investment principles and appreciate the deal certainty offered by the metrics. In addition to achieving standardized asset-locking provisions in financial instruments mentioned above, the progressive adoption of standardized metrics will increase investor familiarity and confidence in the impact investing sector.
Zoe Wong prudently points out the relevant network effects of the impact investing movement, wherein increasing numbers of social enterprises will attract increasing numbers of impact investors, and vice versa. She turns to Easley and Kleinberg, “Networks, Crowds, and Markets: Reasoning About a Highly Connected World” and its discussion of market tipping points for explication of the network effects tipping point concept:
If impact investing is to reach its tipping point, it must reach point z′ in the figure above. She writes, “If the proponents of impact investing succeed in getting the population’s expectations for the number of impact investors above z’, then they can use the upward pressure of demand to push this number to the stable equilibrium at z′′. On the other hand, if the population’s expectations are even slightly below z′, then the downward pressure is likely to drive impact investment activities to 0. The value z′ is essentially “the hump [that the impact investment sector] must get over in order to succeed” and become mainstream. However, it is difficult to come to a conclusion on whether or not impact investing is in fact at this tipping point.” the current average costs of impact investing are higher than those of traditional investing, the impact investment movement needs to achieve greater deal familiarity and enhanced standardization of metrics and asset locking provisions to lower transactional costs, in order to reach the tipping point.