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Finding the Right Type of Financing for Impact Enterprises

Elizabeth Boggs Davidsen — Manager, Multilateral Investment Fund, Inter-American Development Bank

Large-scale affordable housing projects, wind farms, and small-scale diagnostic health clinics are just some examples of the wave of impact enterprises that have been emerging over the last decade, seeking to address social and environmental needs in addition to making profits. The unique characteristic of these impact enterprises is the expectation of a net positive social or environmental benefit, whether through their product or service, or in the way they create value for the communities they serve. Some may be extremely profitable; others may more closely resemble non-profit organizations. What most of them share is a difficulty in finding capital that aligns to their needs and enables their growth.

Since impact enterprises are recognized for employing unique business models, shouldn’t their financing options follow suit? This hasn’t traditionally been the case. Consequently, impact enterprises continue to seek financing through established pathways, such as early-stage equity financing from private equity venture capital. As it turns out, however, most of the capital directed to impact enterprises is focused on low-risk investments and on business models that are already proven and ready to be brought to scale. The Global Impact Investing Network (GIIN) reported that there were over US$114 billion assets under management for impact investing in their 2017 Annual Impact Investor Survey. Yet, for an estimated 70 percent of impact enterprises that are in early stages or pre-profitability, there is little appropriate risk capital available. This lack of capital across the risk/return continuum is a challenge for the impact investing community and for entrepreneurs that have yet to unlock their potential as powerful agents of social change.

Financing gaps also persist because banks and other debt providers look for strong audited financial statements, even cash flow projections, and require collateral to offset loan risk. This contrasts with many promising impact enterprises which have revenue inconsistencies, lack collateral, and have business models that have few comparators and are often unfamiliar to banks. These barriers, as well as high transaction costs, also inhibit access to capital.

Development finance institutions and other impact investors are now innovating to develop and implement new solutions that go beyond traditional equity and debt.

The problem for impact enterprises goes beyond finding capital – It’s about finding the right type of financing. The good news is development finance institutions and other impact investors are now innovating to develop and implement new solutions that go beyond traditional equity and debt, and that are better suited to the variety of business models and markets in which impact enterprises operate. This emerging marketplace of new financing models is the subject of a report recently launched by the Multilateral Investment Fund (MIF) of the Inter-American Development Bank Group in partnership with Transform Finance and the Rockefeller Foundation entitled, Innovations in Financing Structures for Impact Enterprises: A Spotlight on Latin America. The report provides a rich overview of 16 alternative financing structures to support early and growth-stage impact enterprises, including new ways to use grants as seed capital, how to align financial incentives to impact outcomes, and different ways for financial intermediaries to structure funds.

Three examples of interesting models featured in the report:

  • The team at Adobe Capital manages the Adobe Social Mezzanine Fund I, a US$20 million fund that has invested in seven early-growth impact businesses in Mexico in the healthcare, education, low-income housing, and alternative energy sectors, all with a clear path to profitability. Rather than favoring equity capital, the fund mainly uses mezzanine debt and structures their loans as revenue-based loans with flexible schedules and a grace period, including a broad prepayment option without penalty.
  • Enclude’s Variable Payment Obligation (VPO) in Central America is designed to benefit both impact enterprises and commercial banks eager to expand their small business loan portfolio. The model targets entrepreneurs otherwise deemed too risky and applies an innovative underwriting methodology that centers on cashflow, rather than traditional collateral. Through variable repayment terms tied to revenues generated by the impact enterprises, the VPO provides repayment flexibility to the enterprise and aligns the incentives of both parties.
  • The MIF’s reimbursable grant structures provide startups with a risk-sharing mechanism that incentivizes experimentation with business models that have a compelling social or development impact. These grants target companies that are beyond prototype and ready to launch a commercial pilot. As the grant maker, the MIF´s primary goal is to help bring to market disruptive technologies addressing social issues. A reimbursable grant removes the risk to the entrepreneur by having no financial cost or interest rate unless the enterprise succeeds. A second type of reimbursable grant the MIF has piloted are those with discounts based on achievement of targets, or “Don’t Pay for Success”. In these models, the reimbursable grants are originally treated more like a liability, with a pre-set expectation that the grant will be reimbursed. This financing is provided to an intermediary organization working to accelerate early-stage impact enterprises. The grants are linked to predefined impact targets for the intermediary organization and the underlying enterprises. If targets are met, the intermediary organization is not required to reimburse the grant, thereby aligning incentives of the grantor and grantee.

Building on examples such as these, the main takeaway from this study is that continued innovation and broader adoption are needed to increase the flow of capital for impact enterprises. The models that are presented from Latin America have tremendous portability to other regions and the recommendations that conclude the study provide a way forward, including fostering the systemization of structures; socializing success stories; increasing familiarity of new structures among entrepreneurs, investors and fund managers; exploring new policies to remove bottlenecks in the provision of capital for early and growth-stage impact enterprises; and perhaps most importantly, coordinating efforts.

In short, the impact investing community can go further together, and in the last several months this momentum has produced additional partnerships to explore new and innovative funding alternatives under the leadership of the Omidyar Network, World Bank, Dutch Good Growth Fund and the Global Impact Investing Network, all focused on filling the capital gap facing impact enterprises. After all, with about 70 percent of impact enterprises left on the financing sidelines, there is tremendous opportunity to disrupt financing in this sector, just as we expect these companies to disrupt the status quo with their innovative solutions to pressing societal challenges.

This piece was originally published on the Multilateral Investment Fund’s blog and reposted with permission.

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