There is an old Portuguese saying that you cannot expect the sun to shine on the threshing floor while it rains in the turnip fields. Some are just as doubtful that impact investors can simultaneously deliver market returns and measurable social impact. The harder investors pursue social goals in sectors where commercial capital is absent, they argue, the more likely financial returns will suffer.
Others disagree. In June this year, Cambridge Associates released a report showing impact investment funds with combined assets of $6.4 billion had returned almost 7% after management fees. Jessica Matthews of Cambridge Associates said: “There’s a view among some investors that impact investing necessarily entails a sacrifice in financial return. This data helps to show that is more perception than reality”. Or as ClearlySo, a UK impact advisory firm puts it: “there’s no impact see-saw“.
Impact investing is still a young industry with diverse players, operating in multiple sectors and following varied approaches. Organisations like the Global Impact Investor Network (45% of whose members say they target below-market returns) are gathering the performance data. But it will take time before sufficient evidence emerges to allow a meaningful taxonomy of return expectations for different types of impact funds.
AgDevCo invests in the agriculture sector in Sub-Saharan Africa, focusing on early-stage businesses that are starved of capital. To date we have backed 45 SME businesses and committed $60m. There’s little doubt that investing in agriculture can deliver a high social pay-off. But what level of financial returns should we expect?
There are data points from outside the impact investing community. The development finance institutions (DFIs) have been investing in emerging markets including agriculture for fifty years or more (maybe impact investing is not as cutting edge as some like to think).
- The UK’s CDC specialised in agriculture investments during the period 1950 – 2000. A recent research paper concluded that only a third of investments generated financial returns above an “acceptable commercial level” of 12%. However, in many cases where CDC lost money, the business it supported went on to become sustainable operations which created significant positive social impact and delivered commercial returns for later-stage investors.
- The IFC has published returns data on more than 300 exists from SME businesses (across all sectors). Investments above $2 million delivered good financial returns and an acceptable level of write-offs. However, investments below $2 million were generally not profitable and write-offs reached 20-30%.
- Members of the European Development Finance Institutions (EDFI), an association of bilateral DFIs, report that only 5% of new investments made in 2014 were in the agriculture sector, whereas agriculture makes up at least 25% of GDP in most developing countries.
We draw two tentative conclusions. Firstly, in developing countries agriculture does not appear to offer financial returns that are as attractive and/ or requires more patience than other sectors such as financial services, infrastructure and manufacturing (otherwise DFIs would be more heavily weighted towards agriculture). Secondly, for investments below one or two million dollars, financial returns are likely to be lower, if not negative, and the risks of business failure are significantly higher. However, as companies mature they should be able to generate better financial returns, so graduation to commercial capital is a real possibility.
AgDevCo’s experience to date is more or less in line with this. With an average investment size of below $1.5m, we are expecting to recover our invested capital and make a modest contribution to our running costs. As we expand and balance out the portfolio with some larger investments, we anticipate moving towards profitability. In the meantime, part of our operating costs will continue to need grant funding.
What does this mean for the prospects of attracting more commercial capital into the agriculture sector? The need in developing countries is huge, perhaps $83 billion annually per the FAO.
Given the high risk-low return characteristics of agriculture in developing countries, and the fact that most opportunities are at the smaller end of the spectrum where returns can be swamped by transaction costs, it is unlikely the sector is going to attract large volumes of commercial capital any time soon.
The good news is that innovation is driving new investment approaches which offer a way of leveraging commercial capital into these difficult markets. Blended finance models are a sub-category of impact investment approaches. They mix public, philanthropic and private capital in ways that compensate investors for risk-taking where there is the possibility of high social returns.
Although there are only a few active blended finance investment funds targeting agriculture, the concept may be reaching a tipping point. The World Economic Forum is backing the approach. The Canadian government is promoting a new virtual marketplace called Convergence to encourage private and public funders to blend their capital, creating more financially attractive, high-quality deals. Nick O’Donohoe of Big Society Capital, a pioneer of impact investing in the UK, has recently been appointed as senior adviser on blended finance at the Bill and Melinda Gates Foundation.
My Portuguese colleague tells me only her grandparents’ generation still use the threshing floor proverb, which no longer resonates in a modern economy. If impact investing embraces blended finance, it may get to the point where the old debate about impact versus financial returns also becomes obsolete.