A risk-based segmentation for impact investments

‘Impact Investing’. Rarely have two words held so much promise, yet have such a broad scope around what it actually encompasses. For those not familiar, impact investments are generally seen as investments actively targeting social impact alongside financial returns. Depending on the investment, risk-adjusted return expectations can either be market-rate or below market-rate.

While most broadly agree that impact investing is a hybrid between traditional investment ideas and spending by philanthropies & government, there has been little discussion around how to frame these investments based on their risk-return characteristics. Without clear articulation of an impact investment’s risk-return profile, it will be difficult to mobilize the collective capital needed for the sector to grow and scale.
Image Adapted from Sasha Dichter's blog post: Give Impact Investing Time and Space to Develop.

This post serves as an initial attempt to segment impact investments based on their risk-return characteristics. Starting with the GIIN definition of an impact investment — and its distinction between market and below-market rate returns —four general risk-return profiles governing the landscape of impact investments are proposed. It’s worth noting that these classifications are derived looking at impact investments at an individual-level; and not on a portfolio-basis.

1. Luxury (e.g. Patagonia, TOMS, Warby Parker)

These are impact investments in social enterprises that can charge consumers a "social premium" for their goods and services; which would then flow through to the organization’s activities to generate social impact. Whether it’s donating 1% of sales every year, or employing a buy one/give one model (for shoes, glasses, etc), the financing for social impact has to come from somewhere— and because its not from the shareholders, it has to be from the consumers.

The similarity drawn here between these social enterprises and luxury brands are that both rely on the perception of brand value, and the means to afford it. The risks to financial return are clear: limiting mission drift to preserve brand value, and the affordability of the goods/services. To the extent that these social enterprises can successfully keep their core consumers engaged, then: “doing good”, is quite literally “good for business”.

2. Partner (e.g. pay-for-success)

These are investments into specially designed financial vehicles where public, private, and non-profit sector players partner to jointly finance and execute intervention programs addressing social issues.

The private sector (investors) provide upfront capital for the intervention, non-profits execute the intervention program, and the public sector (government) pays a return depending on a minimum level of social impact generated — hence the term "pay for success". The most mature examples of this type of financing are recidivism-reduction social impact bonds (in the UK, NYC, and recently launched in Massachusetts).

From a risk/return standpoint, financial returns are directly linked to the risk of the social impact not being realized. Risks to generating social returns may be a function of factors like: risk of the effectiveness of the intervention methodology, operational risk of the non-profit, credit risk of the government payer etc.

To make the risk/return profile commensurate with investment substitutes, new financial cashflows have to be created (usually by the government), and be sufficient to cover the risks. These vehicles are essentially risk transfer programs from the public sector, with a heavy dose of financial engineering.

3. Venture (e.g. BoP markets, science research)

This is the messiest grouping of impact investments, as the definition of a ‘venture business’ can be broad. The easiest way to recognize these impact investments is by the significant amount of risk associated with individual business investments. Sometimes these risks are not quantifiable.

Just like traditional venture capital, investors are betting on broader macro trends while simultaneously placing lots of bets to get the diversification needed to balance out the portfolio-level risk-return equation. In addition, financial returns may also be disproportionately affected by risks related to a specific geography, political regime, or illiquidity.
Impact investments in the venture category usually target basic societal needs that have historically been the responsibility of the government. Opening this up to “market based solutions” can have advantages in efficiency, but also should be treated with caution. It is imperative here that the mission is preserved — given that many of these organizations will be pseudo-substitutes for government intervention.

4. Catalytic (e.g. philanthropic risk-capital)

Catalytic investments are the use of philanthropic dollars to kick-start opportunities that otherwise wouldn’t exist, or, to balance the risk/return profile for early-stage experimental impact investments.

Given that this capital is “philanthropic”, there are no financial shareholders to report to. As long as social returns are generated in-line with the organization’s mission, then any financial return — be it none, break-even, or even slightly positive, can be seen as a successful outcome.

It will be interesting to see this form of capital deployment evolve as philanthropies experiment with different leverage strategies (vis-a-vis private capital) to maximize “social returns”. Some examples that are worth noting, and their implications, are listed below:
  • Bloomberg Philanthropies —  By taking a first-loss position in the NYC Rikers Island social impact bond deal, Bloomberg has effectively written the first non-profit credit default swap/insurance contract. As more philanthropies start taking these types of exposure, new quantitative risk/capital management expertise will be required.
  • Acumen Fund — By deploying patient capital to catalyze new markets and further investment, Acumen is doing what governments are traditionally expected to do with respect to “infrastructure" investments. With philanthropies not bound to short term cycles (i.e. election cycles), they will perhaps be an increasingly important stakeholder in social impact discussions.
In Conclusion

By framing impact investments in terms of their risk and return characteristics, we can aspire to:
  • Better identify the appropriate funding stakeholders for certain types of risk-return profiles.
  • Better understand stakeholder roles and responsibilities in affecting the numerator or denominator of the risk-return equation.
  • Systematically identify where new data and metrics are required to facilitate the efficient matching of supply (capital) and demand (risks).
Only then can traditional investors comfortably enter into the impact investment space and fulfill the potential that the many of us see in it.


Democratizing science philanthropy

An important trend has been emerging in the area of scientific research funding. In recent years, there has been a notable increase in the share of private philanthropic support for the sciences. For those who aren’t familiar, this is more commonly referred to as “science philanthropy”. Deep-pocketed philanthropists fund large-scale efforts to further our understanding of things like the human brain to various types of cancers. A recent study by MIT researchers estimate philanthropic contributions to be at least 30% of total research funding at the top US research institutions.

While this type of funding is vital for science in times of government cut backs and fierce political debates, concerns around these types of large-scale funding chasing only the “popular, well known” science research topics leaves more to be desired.

Enter the era of crowdfunding.

As crowdfunding proliferates across a number of applications – from creative projects to life-saving medical treatments, it shouldn’t surprise anyone that this is also being tried for scientific research. While straightforward in its mechanics, the inherent bottom-up and community-centric qualities of crowdfunding present two enormous opportunities. One, it gives everybody a voice to become a patron of science, and two, it encourages all scientists to tangibly communicate the importance of their research to the broader public to garner support.

Because crowdfunding inherently creates a system that channels a large number of small donations to specific research efforts, it presents a framework that mirrors that of traditional science philanthropy (which is more top-down). While crowdfunded donations are comparatively tiny, and may only be enough to fund smaller “seed” projects, we miss out on the larger potential if we focus only on the dollars and cents. Aside from the obvious benefits of helping to fill the research funding gap, crowdfunding for science creates something that’s much more valuable – that is, the voices and attention of the broader public putting their money where their mouth is.

Once crowdfunding for science matures along a similar trajectory as that of other crowdfunding verticals, we should begin to see many unique communities pop-up around a gamut of scientific topics. Often times these are not the same topics you’d normally read or hear about in the mainstream media. Successfully crowdfunding a research project will be as much about the intrigue and potential for discovery, as about education and communication of the research’s value to society.

How traditional science philanthropists respond to the science crowdfunding phenomenon will be the most interesting to observe. As a more diverse set of research questions are illuminated through the crowd, the cost of sourcing this wider array of research projects drops substantially. Traditional science philanthropists may choose to use these communities as possible “signals” to inform and diversify their funding allocation decisions – also bringing back an element of the patron-scientist dynamic from the days of Galileo and the telescope. Whether they choose to use this information to devise new matched funding structures, for research lead generation, or for something else all together, there are many opportunities to be innovative.

Through crowdfunding, the profile of a science philanthropist can be re-imagined to encompass virtually anyone. By coordinating and combining the voices of the many, with the resources of the few, there is the potential to create a new method of science philanthropy. This type of integration leaves me optimistic that scientific discoveries can be accelerated – perhaps, where least expected.


Note to self: A reflection on New York

Everything about New York City fascinates me. Wander to any part of the city and you’ll find unique collections of structures and landscapes – each with their own story to tell. From the city’s central jungle to the surrounding concrete jungle, there’s always something new.

Moving to New York City two years ago, I already knew that I’d like it, I just didn’t realize that I’d fall in love with it.

While it was a bit overwhelming at the beginning, I quickly learned to appreciate that living here meant taking everything that the city had to offer and boiling it down to a set of things that worked for me. While New York is big enough to have almost everything, the one thing it doesn’t give you is time. The fluid nature of the city and its people means that nothing ever stays static. For this reason, everyone’s New York story will be different.

For me, my story started with a simple walk along the Hudson River during Thanksgiving 2011 (when I was an intern in the city). Escaping from the crowd of the Macy’s parade, I managed to make it to the water, and for no particular reason, just started walking along it.

Maybe it was the fact that it was a beautiful sunny day, or because it was one of those rare moments when you’ve got an entire piece of the city to yourself; whatever the case, that walk convinced me that I needed to be here.

Returning a year later to work full-time, I started to see different aspects of New York, and felt a sense of “being home”. Starting my new job, I met a ton new people who came to become my new family. Days were spent food hunting (for the best ramen, best burger, best pizza, the best “you-name-it”), seeing galleries/museums, and strolling through the city. Nights were spent bar hopping, hanging out on rooftops, or just simply hanging out.

The silliness of being young while also forming lifelong friendships was a big part of my story’s narrative. It was nice to know that you never had to really plan to find something interesting – rather, something interesting usually finds you. About a year in, I was surprised to find a sense of stability in such an inherently transient environment.

Though, as with many things in life, change comes when you least expect it. Faced with the prospect of leaving, I can’t say that I’ve tried everything that New York has to offer, or that I am “ready to leave”. That said, I understand the reality that every story has to have an ending. For mine, I’ve thought quite a bit about what it would be – coming to realize that there is really only one appropriate answer: “To be continued…”