By Ranajoy Basu
Impact finance heralds a new frontier for finance: one in which an investor’s drive for financial return is coupled with a key motivating factor (commonly referred to as the “double bottom line”) to generate and maximise a social impact. This innovative and growing market of bringing together public and private sector funding for targeted social interventions aligns with the scale of funding required to achieve the United Nations’ 2030 Agenda for Sustainable Development, which provides a common pathway for a better and more sustainable future by identifying seventeen global sustainable development goals (“SDGs”).
The International Finance Corporation, part of the World Bank Group‚ has created a new framework of nine principles to bring greater transparency‚ comparability and rigour to the impact finance market (the ‘Operating Principles for Impact Investing’). Sixty fund managers managing over $350 billion in assets have signed up to these principles. The Impact Investing Institute, an independent non-profit organisation (supported by the UK government) is also one example of a recently established taskforce which aims to accelerate the growth and improve the effectiveness of the impact investing market in the UK and globally.
There has also been an exponential growth of consumer and general public interest in impact investing. A clear message is being delivered‚ especially from millennials: corporates need to be more socially responsible. As a result‚ many forward-looking companies are responding positively to this consumer-led demand‚ with one example being the Beyond Meat post-initial public offering performance.
This article aims to explore the spectrum of impact investing, its various forms and structures‚ and the challenges as well as opportunities for investors who are looking to participate in this what is now truly emerging as a mainstream asset class.
What is “impact investing”?
Impact investing is “an approach used by investors to harness the power of their investment capital to actively contribute to improvements in people’s lives and the health of the environment.”1 What differentiates impact investing from other forms of investment is the positive social or environmental impact that the investor seeks to achieve, alongside its financial return. This includes both ‘finance first’ investing‚ which looks to achieve a social impact while generating competitive financial returns‚ and ‘impact first’ investing‚ which looks to achieve a social impact while accepting lower financial returns.
It is this duality in social and financial return, that sets apart impact finance from traditional finance structures at one end of the spectrum‚ that target competitive risk-adjusted financial returns with no expectation to enhance social value, and philanthropic funding at the other end, which addresses social impact with the expectation of full capital loss.
Within the impact finance space, however, exists a myriad of impact investing structures. This reflects both the lack of consistency in approach in impact investing and‚ perhaps more so‚ the level of innovation within the market space. Impact investing structures include, amongst others:
- Results-based financing instruments that enables investors to finance development or other social programmes for the achievement of specific target outcomes
- Green or environmental, social and corporate governance (“ESG”) bonds that are capital market issuances enabling investors to finance climate-related or other social projects backed by the issuer’s balance sheet
- Funds financing solutions that blend public‚ private and grant funding which can be leveraged to generate additional funds
Although more commonly associated with developing markets, some of the greatest innovation in impact investing structuring emanates from developed markets. The Royal Bank of Scotland’s recent bond issuance under its green‚ social and sustainability framework is the first by a British financial institution, which it said would boost lending to small firms in disadvantaged areas.
A further example of a unique impact financing structure relates to an investment facility for education, which is being set up to deliver improved multilateral development bank financing in the education sector. The international finance facility for education (“IFFEd”) aims to unlock significant new funding for education from the global community. The funding will be used to fill a gap in the international financial architecture where currently lower-middle-income countries are unable to mobilise sufficient funding to achieve SDG 4 (i.e. to ensure inclusive and equitable quality education and promote lifelong learning opportunities for all).
The appetite for results-based financing instruments such as government-backed social impact bonds (“SIBs”) has been growing since the first SIB launched in 2011 by Peterborough Prison. That SIB raised £5 million from 17 social investors to fund a project with the objective of reducing recidivism rates of prisoners who had served custodial sentences of up to one year. Development impact bonds (“DIBs”), the close cousins of SIBs backed by non-governmental entities, have seen a concomitant rise in popularity, with the first DIB being launched in 2014 aimed at reducing the gender gap in education in rural India by increasing the school attendance of girls. SIBs and DIBs (which, confusingly, do not necessarily include an issuance of ‘bonds’ at all) seek to channel money to projects with a positive social impact while only providing a repayment or return to investors once the desired results have been achieved.
While there are several ways of structuring the contractual framework of a DIB or SIB, the basic concept involves a risk investor providing upfront capital to an intermediary in order to achieve pre-agreed target outcomes for the benefit of a specified target population. The intermediary acts as a project manager by coordinating and managing the ongoing implementation of the project and brokering relationships between the key transaction parties. The service providers execute the actual intervention and coordinate with the intermediary on the implementation of the project. An independent evaluator is engaged to evaluate and confirm whether, and to what extent, the success metrics, as agreed between all key stakeholders at the outset, have been met. To the extent that such target outcomes have been achieved, the outcome funder will make a payment to the risk investor commensurate with the extent to which the target outcomes have been achieved. Depending on these outcomes, the risk investor may receive more or less than its initial investment in the DIB or SIB. A simple impact bond structure is outlined below:
DIBs and SIBs transfer the risk and upfront capital commitment required for social impact projects from governments and philanthropic organisations (who may already be too thinly stretched, as well as being constrained by bureaucratic red tape) to private investors that have broader investment capabilities and greater appetite for risk. It also means that, unlike traditional philanthropic activity, it measures actual ‘outcomes’ rather than just ‘inputs’.
Innovations and market trends
A SIB or DIB may be used to fund innovative and untested interventions, therefore appropriate due diligence of the funding mechanism, the implementation framework and the evaluation process needs to be undertaken to reduce the risk of potential pitfalls when the actual project is implemented on the ground. Where there is a lack of underlying baseline performance data, which makes it difficult to evaluate and measure the success of the social impact and hence calculate the financial return, pilot projects can be undertaken to measure the baseline against which the results of the social impact can be evaluated. Such pilot projects are increasingly being utilised to help fine-tune the proposed intervention to provide further assurance of the success of the project for investors. A properly designed SIB or DIB can allow innovative concepts, which would otherwise never have even been tested, to be implemented with little or no track record whatsoever.
Although green and ESG bonds are typically done through debt issuance and most funding of SIBS or DIBs is done by way of grant funding, a recent innovation in the impact finance sector is the use of privately placed or publicly issues listed bonds and securities to raise funding for results-based SIB or DIB structures. Driven by the need to increase the scalability of impact investing (the funding gap to meet the SDGs is estimated to be USD 2.5 trillion annually), participants in the sector are increasingly developing structures involving debt issuances to access loan or capital markets for funding. While this introduces additional costs and takes time to launch, the goal for market participants is to establish SIBS or DIBs that can be marketed to institutional investors much like any capital markets offering. From an investor perspective, this approach allows funding to be channelled into the social impact directly, taking risk solely on the success of the intervention, unlike investors in ESG or green bonds who must take issuer credit risk by de facto purchasing corporate bonds.
An interesting market trend is the establishment of funding vehicles to aggregate funding either at the risk investor, outcome funder or issuer level. Although such an approach introduces additional complexity and incurs higher costs (due to, for instance, the need for specialist advice in relation to the management of the fund as well as tax and regulatory law), it could lead to cost savings over the long term if the fund is set up as a programme to enable participation in multiple SIBS or DIBs. For example, funding vehicles which provide for funding streams from different impact investments to be compartmentalised supports the scalability of SIBs or DIBs, driving demand and increasing standardisation in structure and contractual documentation. Funding vehicles at the outcome funder level reduces the cost of funding for participation in SIBs or DIBs and also allows greater sized SIBs or DIBs to be issued.
Whether it be in relation to businesses engaged in the delivery of ESG products or services, or in the context of an impact bond, the core governance structure responsible for the manner in which capital is used is arguably the backbone of successful impact investing. A strong governance model is one in which financial resources are managed with a view to maximising the value of the social impact while balancing the efficient and responsible use of capital. Impact investors will require transparency and appropriate checks and balances in the form of, for example‚ corporate finance policies and strategies‚ steering committees‚ budgeting of capital deployed and the strict measurement and reporting of any impact achieved. It is common‚ for example‚ for impact investors to restrict the ability of the business or project manager of any impact bond to raise any further funding for a particular intervention‚ in order to prevent an inefficient allocation of capital relative to the social impact.
Can you really make money while doing good?
A key challenge for the impact finance market is dispelling any perception that investments that generate both financial return and social impact are mutually exclusive. This includes the work required to educate the financial sector‚ including investors‚ financial professionals and policy-makers, as to the potential and proper use of impact investing. Despite the lack of a globally accepted definition for or approach to impact finance‚ measuring the extent of the social impact is already a fundamental requirement for impact investors. As a result of this‚ the use of impact finance for the sole purpose of public relations is becoming increasingly harder.
Methodologies designed to identify, measure, track and report the wider benefits of the social impact is a key requirement of any impact investment. From a documentation perspective‚ this means that it is vitally important to have clearly defined and measurable success metrics in place. Impact investors should be particularly careful that underlying documentation clearly defines the parameters for the actual outcome or impact and also outline a reporting system for various stages of the project upon achieving key milestones. The level of information can significantly vary between projects and jurisdictions and this is one of the biggest challenges in achieving consistency of data. The provision of clarity in reporting between different projects will ultimately help build investor and market confidence.]
About the Author
Ranajoy Basu is a partner in Reed Smith’s Structured Finance group and the head of the firm’s Social Impact Finance group. He is widely recognised as one of the world’s leading impact investment lawyers. He regularly advises on complex, cross-border social impact finance structures, including social and development impact bonds, renewable energy, “green” structured finance transactions and other capital market solutions in the social impact space.
As a true pioneer in adaptive sustainable development and impact finance, Ranajoy has made a significant contribution through structuring impact bonds and other cutting-edge impact finance solutions. Ranajoy is one of the lead architects of the International Finance Facility for Education (IFFEd), a ground-breaking financing mechanism designed to deliver funding for the education of millions of children around the world and target the United Nations Sustainable Development Goals for Education (SDG 4). He also advised on the Educate Girls Social Impact Bond, the Utkrisht Bond and more recently advised The British Asian Trust on the world’s largest impact bond for education. Ranajoy is extremely passionate and driven to create a positive social impact around the world using the law and finance as an instrument of innovation.
1. GIIN, “Core Characteristics of Impact Investing”, available at https://thegiin.org/assets/Core%20Characteristics_webfile.pdf.