JOHANNESBURG – Smartly-designed innovative finance mechanisms can attract bigger or new sources of capital to investment opportunities that previously couldn’t access this type of money, but it is no panacea.
This is the view of Carlijn Nouwen, partner at strategy and policy advisory firm Dalberg, who says while there is a buzz around innovative finance solutions in the impact investing space, it is no silver bullet.
“It requires really clearly thinking through incentives and risks, while designing [solutions] for that. Hardly ever can you pull an innovative finance product off the shelf and just apply it in a different setting and assume that it will work,” she says.
The Global Impact Investing Network defines impact investing as “investments made into companies, organisations, and funds with the intention to generate social and environmental impact alongside a financial return”.
Innovative finance seeks to use all available financial and philanthropic resources to fund those organisations, people and projects that optimise social and environmental impact alongside the financial returns, adds Aunnie Patton Power, innovative finance lead at the Bertha Centre for Social Innovation at the University of Cape Town.
Nouwen says due to the buzz around innovative finance, many investees believe they will have a much easier time accessing money, but that is not necessarily the case. It will depend on what the investee can give the investor in return – and about the joint ability to align incentives and bring goals of all actors closer.
Designing innovative financing mechanisms that can be applied successfully is about addressing the risks associated with the investment.
“We can’t just keep going out and telling people ‘it is less risky… you should put money in’. We actually have to think about how do we design mechanisms that not only reduce risk but transfer risk,” Patton Power says.
While matching investors and investees – even in the traditional investment space – can be challenging, it may be even harder where investors have had a negative experience with impact investing in the past.
Mark van Wyk, portfolio manager at Mergence Investment Managers, says asset consultants (who advise pension funds on investments) have memories like elephants. If they have lost money with impact investing once, it doesn’t matter how or where it happened – impact investing will be regarded as a high-risk investment.
He says it is incumbent upon all industry players to ensure that platforms are sustainable.
Nouwen highlights that amongst other applications, innovative finance can be used to mitigate real or perceived risks in investments. She profiles four applications where innovative finance solutions can be used as tools to address particular risks.
- Where the risk of losing money is high
- Where the perceived risk is high, but the actual risk is lower
- Where the investment faces a risk that can’t be controlled by the investee, but may be insured
- Changing the risk to something palatable for the investor
While there is a lot of perceived risk associated with impact investing, there are also real risks some investors are not willing to stomach.
Traditionally these types of opportunities were sequenced – philanthropic capital and/or a grant was used first and once proof of concept was confirmed, a new road show commenced. This is a very time consuming process that is potentially inefficient for investees as they are put on hold every time they want to access capital from a new source.
Increasingly blended finance instruments are used in such instances – investors come together from the outset, their requirements and money are pooled and the average profile suits the investee.
Nouwen cautions that this is not something that can be “ordered off the menu” but has to be tailored to suit particular needs. However, investors don’t have to change their return expectations or risk profile – they can find other sources of capital in order to ensure the mix is palatable to the investee.
Investors often shy away from these types of investments.
Nouwen says in such instances a guarantee can be a great instrument as it creates a safety net for the investor – if the investment goes south, the investor can get his money back.
Philanthropic funders are often looking to leverage their funds and are less willing to give grants to one particular project anymore.
“A guarantee is a wonderful way of doing that because as long as it isn’t called upon, you can keep using that money,” she says.
Nouwen says insurance companies increasingly step into this market to provide a bespoke insurance product to cover a risk that would otherwise prevent a deal from happening.
One example is humanitarian agencies like the Red Cross – when disaster strikes, they employ capital immediately and deploy donor program funding or raise funds in the weeks to follow. Many of these agencies hold millions of liquid capital on their balance sheets because banks aren’t willing to provide working capital.
Yet, experts are fairly confident that the Red Cross would be able to deploy and raise money from donors and funders, as it is one of its core capabilities.
Nouwen says insurance companies can insure the risk that the Red Cross would not be able to raise funds when disaster strikes and because it is able to put a price on that the premium is much lower than the total amount on their balance sheet. Against this background a bank may be willing to provide a regular working capital loan to the agency, which frees up millions on its balance sheet for its regular operations and programmes.
The advantage of this mechanism is that it comes into action a lot faster than a guarantee. It can take a couple of years for a guarantee to pay out and banks will likely not be comfortable with that, she says.
Nouwen says that in some cases, an innovative finance tool can be used to shift the risk from something an investor is not willing/ able to bear to a different type of risk that an investor is able to bear. An example is an advance market commitment, which is a tool where a buyer of a yet-to-be-developed product promises to buy it when it is finalised.
This is used in the pharmaceutical industry. If there was a vaccine against HIV/Aids or an effective treatment for Ebola there would be a market for it. In its absence however, pharmaceutical companies facing a decision to invest have a really difficult time, as they need to invest significant resources upfront without knowing who their customers will be if they are successful.
By putting an advanced market commitment (a tailored declaration defining exactly what requirements the product needs to meet) in place, the risk is changed from one where the pharmaceutical company invests without knowing if anyone wants to buy it, to one where the company knows that they have to be first to market. The pharmaceutical company still doesn’t know if they would be able to sell it if they invest (a competitor may be faster) but they know that if they are first, there will be a market. The need of having to beat their competitors to the market, is a very well-known risk to them as that’s core to their R&D capability and processes; a risk they’re able to price and decide upon running, Nouwen explains.
Ultimately, developing a successful innovative financing tool is about understanding what risks the parties are facing and designing a solution that tackles these challenges in a way that aligns incentives.
“You don’t have to throw philanthropic money at it to make it more attractive. Just make sure that you align the incentives and the player actually does what they are best at,” Nouwen says.
* The speakers participated in a panel discussion at the recent Southern African Impact Investing Network (SAIIN) Conference.
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