Impact Investing

By: Wesley Chan

The Challenges of Investing In Social Enterprises:

1) Tackling complex partnership and capital structure

The capital structure of social enterprises (SE) is not as straightforward as mainstream commercial
businesses. Hence, it creates many potential conflicts of interest to navigate around. The share
capital of a SE who just starts out usually consists of grants, subsidies and commercial investment
capital. Therefore, the SE has to account for the multiple stakeholders or multifaceted financial
transactions. The main stakeholders involved are usually the government, charitable bodies who
supply the donated capital, and on the other hand, venture capitalist and impact investors tend to be
investors of commercial capital. The two different types of capital have different expectations: social
returns and financial returns respectively (for impact funds, a mixture of both returns). In most cases,
this will most evidently result in disputes.

2) Reinventing a new approach to collaboration

In view of the first challenge, to make the complex capital work, social enterprises need to become
effective at collaborating with capital donors and governments. They would have to take into
consideration the primary interest of the different donors. However, this is far from simple. In the case
of the government, its interest is to maximize public good and social outcomes. As long as this is
fulfilled, regardless whether a social enterprise is profitable is of no significance to them. We can
examine how proprietary information is treated differently to illustrate this point. Donors seek to place
the intellectual property an enterprise creates (technology, practices and process innovations) into
the public domain as quickly as possible so as to create social impact. In contrast, most private
investors want to maximize the financial return brought about by this proprietary information by
creating high barriers of entry around it. This creates tension between both parties and as a result,
the social enterprise is stuck in the middle.

3) Active role in investee business model

Social enterprises that are in need of capital are usually small and relatively complex. Larger proven
business models are usually not in need of additional capital. As a result, impact funds often invest in
start-ups and this trend is likely to continue, especially in underdeveloped countries. In general, social
enterprises usually face many struggles in their early stages, refining their business model could take
years and they might not have the expertise or resources to carry out the changes. Therefore, in
order to improve the profitability of these SEs, impact investors need to support the investees in
implementing basic processes and systems. However, impact funds might find this aspect
challenging, as they themselves also might not have the financial resources and skillsets to properly
support the enterprises.
Overcoming These Challenges:

1) Separate social enterprises that can absorb investment capital from those needed to be
supported with grants and subsidies.

The key here is to refrain from financial ill discipline by avoiding investing in hyped-up growth stories.
It is necessary that impact investors remain grounded and acknowledge that not all social enterprises
will be success stories. Social enterprises that are just starting out usually require time and patience
to refine a sustainable business model. Given this, many SEs require funding or highly concessionary
capital to buy them time to sharpen their business model. One possible solution is to adopt a ʻlong
term investingʼ mentality that recognizes investeesʼ need to experiment with their business model. A
buy and hold strategy is applicable in this context, as impact investors need to be patient to realize
their returns. Also, structuring investments to phase in capital over time is essential in many cases to
manage risk.

2) Arrange for hybrid capital structures to decrease risk (focus on a high margin of safety):

The nature of social enterprises is that their business models are unorthodox and usually require time
and patience to refine. Hence in their experimenting stages, impact investors should expect a
compromise on returns. One possible way to mitigate investment risk is to utilise hybrid capital
structures and get comfortable with early stages investing that SEs require. Impact investors can
structure their investments via debt or equity or a hybrid of both. For instance, instead of having the
usual traditional equity ownership, impact investors could come up with different financial instruments
that allow them to cover their downside should the investment in the SE not be successful. They can
also arrange for no strings attached assistance from government or strategic investors. For example,
a social enterprise, Dial 1298 for Ambulance secured in-kind support from a U.K trade association,
U.S hospitals and secured ambulances that are donated from the government to fund the initial
stages of their businesses.

3) Changing the traditional way of operating an impact investment fund

SEs are inherently different from mainstream businesses. They take longer to scale and require
substantial support like financial and consulting in its early stages. Therefore, from an investor
perspective, a different investment model is needed. The 2 and 20 management fee structure for a
typical hedge fund does not work well. The 2% management fee limits how funds can provide
technical support as the 2% are also used to cover the essentials of running a fund like salary, rental
and other administrative costs. A solution to this is to reduce the 20% carry over a certain return
threshold that the private equity gets to keep to about 10-15% and instead, charge a higher
management fee in the range of 5%. The impact fund can also raise donor capital that can
supplement management fees. Finally, a typical private equity firm distributes all profits after 7 years,
this forces funds to liquidate their investments in SEs before they take off. Usually a typical business
needs 7 years or more to achieve stability, and the time frame would even be more for a SE. Hence,
impact funds should operate more like a value fund where it sees itself as a strategic partner instead
of a passive investor, and also have a longer time horizon in view of its investments.