Based on the interactive sessions during the ‘Scaling Inclusive Business Investments’ event in October of last year and other conversations that followed, Irmgard Jansen of BoPInc wrote the post below about the challenges to scale IB investments and the need to define a common roadmap.
The opportunity: investing in Base of the Pyramid markets
More than four and a half billion people earn less than eight dollars a day. They are value demanding consumers, resilient and creative entrepreneurs, producers, business partners and innovators. Engaging these groups in sustainable and profitable business is key to improving their livelihood and economic growth. Inclusive business contributes to poverty reduction through the inclusion of low income communities in business processes, both as producers and consumers.
The size of the overall market opportunity for essential goods and services for the Base of the Pyramid (BoP) markets – housing, rural water delivery, maternal health, primary education and financial services – is estimated to amount to $400 billion to $1 trillion over the next ten years (IFC, 2010). This market provides great opportunities for ‘impact investors’. They aim for a combination of social, environmental and economic impact and are willing to accept higher risk and lower returns.
It is becoming clear that there is a ‘missing middle’ between micro finance and the regular financial instruments available to support companies developing products and services for BoP markets. This missing middle is particularly predominant in financing BoP ventures in early stages of development or in the pioneer gap: i.e. the gap in time and money between the formation of the firm and the generation of a positive cash flow. Although this is particularly true for SMEs in the early stages, more mature SMEs face similar challenges. Due diligence costs, servicing costs, transaction costs and retraction costs are usually too high for the size of the investments needed. Impact investors play an increasingly important role for this the ‘missing middle’.
The majority of impact investors are prepared to take larger risks and accept longer tenors, i.e. the amount of time left for the repayment of a loan or contract or the initial term length of a loan. Some of them demand lower financial returns on the condition that the investment will create jobs with good benefits and working conditions and that the investment will have a positive impact on society and / or the environment. In other words: the impact investor actively looks at risk, return and social impact whereas commercial banks mainly take risk and return into consideration. In addition, most commercial investors would not consider any sort of financial investment less than 2 mio Euro’s, because assessing the business, validating the assumptions and going through the due diligence process would take too much time and effort.
Many impact investors consider applications around 500,000 Euro’s. For micro-financers these sums are usually too large and for commercial banks too small. However, the funding requirements of local SMEs as well as local or international business developing innovative business cases, often settle between 50.000-300.000 euro. There is a lack of financial players that move into this investment phase. There is a mismatch between capital and demand which increases the failing rate of inclusive business at an early stage of development, and causes difficulties for investment funds to fill their pipeline.
Source: IBF 2014
Barriers to scaling impact investing in IB
A number of barriers limit the potential of scaling up the number of volume impact investments in IB. These barriers lead to a mismatch between capital demand and supply.
Mismatch between capital demand and supply
To identify potential impact investment opportunities, to conduct due diligence and to complete a transaction much time and resources are needed. Many investors shy away from small-scale opportunities in developing countries because the administrative costs are too high. And as long as the inclusive businesses do not receive sufficient assistance to improve their plans the number of investment opportunities will remain low.
The investment barriers result in a lack of funding opportunities. In other words: impact investors do not receive sufficient numbers of business proposals that meet their investment criteria.
This results in a mismatch between capital demand and supply:
1) There is insufficient capital for the early stages of business development that carries high risks – For the majority of impact investors the risk profile of innovative business models and technology solutions for the BoP markets is too high.
2) Inadequate duration of traditional funding: Traditional funding by banks by means of loans is often impossible for BoP ventures, due to absence of collateral and a traditional tight schedule of repayments. In case of traditional venture capital equity, the expected exit of shares will be on average 5 (3-7) years. In BoP markets it can up to10 years or more. Altogether there is a need for longer term equity and debt capital for BoP development.
3) Inadequate granularity of funding available: Besides the duration of financing itself, the amount of money requested in this early stage is smaller than average. Financial institutions and impact investors tend to move to amounts higher than US$ 1 million and do not serve this particular area, due to an expected low return on investment (RoI).
4) Lack of combination between investment and technical assistance: Oftentimes, inclusive business proposals are not investment ready and would benefit of receiving technical assistance (e.g, business plan improvement, pitch improvement) in combination with investment. However, investment and technical assistance are often not combined. Structures to support Inclusive business are emerging (e.g., Inclusive Business Accelerator) but are too limited in impact yet.
Systemic risk gap
1) Risks Barriers: Enterprises that form the ‘missing middle’ are generally perceived by banks and financial institutions as risky and potentially unprofitable. Furthermore, different – or lack of – incentives, expectations and motivations between investors and fund managers with regard to investing in BoP businesses results in misalignment of financial strategy of fund managers.
2) Institutional Barriers: Countries that appear as ‘donor darling’ do not always provide a suitable investment environment for private capital. Furthermore, the costs of identifying and developing promising investment opportunities is prohibitive for most investors. Another point of attention is the prominence of the informal sector when considering investing in BoP ventures making the valuation of companies challenging.
The immature financial systems in expansion markets represent yet another institutional barrier. There is lack of competition and commercial banks can earn high returns from lending to large public and private entities. This makes it easy to ignore smaller enterprises.
3) Policy and Regulatory Barriers: A regulatory framework conductive to financing BoP ventures is often lacking and sometimes public policy is distorting e.g. limitation in interest rates in a given sector.
4) Skills, Knowledge, Information and Training Barriers: Inclusive business is a nascent private sector approach and often fund managers or financial institutions lack the in-depth knowledge of this approach, the right expertise or instruments to service this segment. Moreover, some entrepreneurs lack the required skills for example in writing high-quality business plans and clearly defining the financial needs. Furthermore, the entrepreneurs do not have a track-record, administrative records nor sufficient collateral. In addition, they lack risk sharing or risk management facilities.
Deals need to be created and this requires a hands-on approach both from the side of investors and from the side of the entrepreneurs. To create scalable investment proposals and generate a pipeline, the conditions in the ecosystem need to be improved. Also, capacity building and technical assistance both at demand and supply side is needed. Investors are generally not willing to pay for this (only).
Source: Scopeinsight and IFC, 2014.
Shared roadmap to overcome impact investment challenges
The challenges in impact investing are becoming clear and can not be solved by individuals or just one segment of the ecosystem. The actors involved – impact investors, inclusive businesses, business consultants and governments – need a shared roadmap including financing mechanisms and adequate business support to reach larger impact in BoP markets.
Relevant mechanisms at the interfaces between the actors need to be explored and developed to foster the benefits of impact investments in BoP markets and the benefits for society at large. The challenges are systemic and therefore systemic interventions are required and solutions should be implemented both on the supply and the demand side of the impact investment market. For example common definitions of good investment opportunities and risks are required and business support services should be further enhanced.