The key to moving more capital? Impact Investors must understand the “Financial Supply Chain”
May 01, 2018
Unpacking the impact capital markets
In our strategic plan, we highlighted two ecosystems that we see emerging within the impact investing field: one rooted in and driven by philanthropy (“philanthropy-plus”) and the other grounded in and serving the capital markets (“impact capital markets”). These ecosystems are distinct but often conflated, resulting in confusion and limiting opportunities for productive debate and partnership in the impact investing space.
The first ecosystem, “philanthropy-plus”, is being built to augment philanthropic-oriented activity that is focused on addressing a specific challenge or population. This includes using a broader array of financial tools with an organization’s grant budget to bring more sustainable solutions to bear on traditional challenges.
The second ecosystem, “impact capital markets”, is actively trying to shift the behavior of the traditional capital markets (public and private capital markets) to finance scaled solutions to social and environmental problems. This work is no less couched in mission, but is working to match the needs of communities with the needs of the markets to move capital through existing infrastructure. Put another way, the purpose of the impact capital markets is not to exist as a stand-alone alternative to traditional markets, but to serve as a bridge to traditional capital markets, where appropriate.
Within the impact capital markets, an alternative financial supply chain has emerged to support the capital needs of mission-driven businesses and their markets, which can’t typically access financing from traditional investors. This supply chain includes a wide range of activity, roles, and players working under the impact investing umbrella to achieve their financial, social, and environmental goals. We hope this piece—and the framework included—help to organize the array of work happening around us.
A financial supply chain is the sources and types of capital that are available to a business at different stages of development, from seed to mature.
Traditional capital markets: financing the familiar
But first, we need to understand why the traditional markets aren’t meeting the needs of mission-driven businesses. In short, the markets are built to fund the familiar. Typical businesses can tap traditional capital to the extent that they can be evaluated against the existing standards, templates, and procedures that traditional investors use.
A mature business can go to the public capital markets to issue debt or sell shares in its business. Similarly, a private business can apply for a loan from a commercial bank or sell equity in their business to venture capital or private equity investors. All along the financial supply chain, from early stage to mature, there are a variety of institutions and investors that are willing to provide capital to businesses and models they understand and can price according to the risks they understand. When new sectors (e.g., off-grid solar), new customer segments (e.g., low-income populations in Latin America), or new business models (e.g., on-bill energy efficiency financing) emerge they often do not fit into standard templates or operational boxes that traditional capital providers use, and they make it difficult for capital to flow.
Traditional markets are just that—traditional. To benefit from their strengths, we need to meet them where they are until their systems can understand and accommodate the benefits of multi-faceted returns (social, environmental, and financial) that mission-driven businesses offer.
The alternative financial supply chain: funding the misfits
The financial supply chain serving mission-driven businesses needs to be more patient, flexible, and creative than the one used by traditional capital providers. This new financial ecosystem must balance the customized needs of mission-driven businesses with a desire to, over time, grow them to conform to traditional markets so they can access capital with greater efficiency and scale. Thus, impact investors must understand the unique challenges and strengths of mission-driven markets and their barriers to accessing traditional capital so they can create an effective bridge between the two.
Businesses that impact investors finance are typically ones that have been rejected by traditional markets for being “too different”. These businesses are challenging the status quo, often disrupting current systems that are not fully or equitably serving certain populations or the planet. Microfinance institutions, beginning with groups like Grameen and FINCA, challenged the system that said the poor couldn’t repay loans. Affordable private schools, like the ones our borrower Varthana finances in India, are challenging the way education is provided by bringing high-quality education to low-income student populations.
With creativity from the impact capital markets, these mission-driven businesses and the markets they represent can mature through the financial supply chain; they can grow in budget, revenues, and profits, and over time establish a track record of performance, repayment, and returns. The gap between real and perceived risk decreases and, as they mature, businesses can start to go directly to traditional markets. The markets can now understand and price the risk of the business appropriately; the once unfamiliar starts to become recognizable.
Not all businesses will, or should, reach this stage though. Some will fall off the supply chain or stall, some may have different objectives that don’t prioritize growth, and some will continue to require some form of subsidy to operate. But we have seen a world full of exciting solutions to complex social and environmental challenges that can and should advance to traditional markets.
Knowledge [about the financial supply chain] is power
So what is included under the hood of the impact capital markets? We have created a framework (download below) that starts to segment and define the various, wide-ranging activities.
Understanding this financial supply chain is empowering for both impact investors and the organizations they support. By focusing on where investors can play a role—which depends on the capital they have, the risk/return profile they seek, and the markets in which they have interest—they can understand how to engage effectively and collaboratively for impact. And through this process, as a collective, we can tackle the tremendous social and environmental challenges that require urgent action.
If you're interested in downloading the financial supply framework, please provide your name and email.