The global financial crisis has a created both financial burdens and social burdens for governments in many developed countries. We had the chance to catch up with Michael McMillan CFA, Director, Ethics and Professional Standards, CFA Institute – USA and speak to him about how government can best support social finance projects, how projects can attract investment and the future of social finance and social impact bonds. Michael McMillan was a presenter at the 2013 Social Finance Forum in Australia. Informa will be launching the inaugural Social Finance Summit in the UK this year.
The global financial crisis has a created both financial burdens and social burdens for governments in many developed countries. Governments must now grapple with years of overspending, growing debt, and widening budget deficits. As a result, “austerity” has now become the “mantra” of public officials. At the same time, however, governments must also deal with higher unemployment, low or no economic growth, greater poverty, and increased homelessness. Unfortunately, government efforts to reduce their financial burdens, through a reduction in spending (especially, on social services that benefit the poor and underserved), have only exacerbated their social burdens.
The current period of fiscal consolidation represents an opportunity for collaboration between the public and private sectors. In the private sector, social entrepreneurs are developing projects which benefit complement and supplement government products and services. In the public sector, government officials are increasingly turning to social entrepreneurs to provide: 1) services they have not be able to provide; 2) services that they can no longer afford to provide; and 3) services that they believe the private sector can provide more efficiently and/or effectively. By doing so, they are also hoping to attract more private capital which less their own financial budget.
Public-Private-Partnerships represent the best way for government to support social finance projects and for social finance projects to support government. PPPs enable governments to leverage their own funding by encouraging private sector investment alongside their own to address societal issues such as: high unemployment, poverty, recidivism, and inadequate, housing, education and welfare.
The public sector’s support of social finance projects is based on two realizations: 1) that the reward structures in government often encourage the pursuit of projects/activities which often conflict with a wise use of resources; and 2) the cost of government supplied services to the economy is more than either the size of the associated tax bill or the level of budget expenditures implied. They also include the cost of tax and regulatory compliance as well as additional costs associated with greater taxation and regulation.
Social finance projects are able to address these issues because the decision they are characterized by a voluntary exchange that is coordinated by prices. As a result, only those projects which are mutually agreed upon by both buyers and sellers will occur. In other words, while government projects are based on “majority rule”, social finance projects are based on mutual agreement, which means that there are no winners and losers. This also enables social finance projects to be conducted with a higher level of efficiency than government projects. Social entrepreneurs are incentivized to get the most value for the available funds and/or the largest possible benefit for a given level of cost. With the support of the government, their goal is to: 1) more services (benefits) at the same cost; 2) the same service at a lower cost; or 3) more services at a lower cost than similar services provided solely by the government.
Sustainable growth requires participation from all economic strata within a society, i.e. “a rising tide lifts all boats.” However, many government programs and policies are either not specifically designed to help the poor or under-served or do so in a costly and inefficient manner. Therefore social finance projects designed to education, employ, house, and improve the health of those at the “bottom of the pyramid” should stimulate and sustain growth in the overall economy and benefit everyone.
In addition to encouraging and participating in more PPPs, governments are changing their policies to reduce barriers to entry and stimulate growth in this area. For example, some governments are specifically licensing social finance funds (projects) to invest for impact and are providing them with subsidies to do so. Other governments are providing tax credits, guarantees or other sector oriented mechanisms. Some governments have created working groups to examine how they should enhance their policy support, while others are creating offices which will oversee social finance, impact investment markets. Changes in government policy and greater support have resulted increased the flow of private capital into these projects.
In summary, there are a variety of ways that governments are supporting social finance projects and social entrepreneurs are supporting government activities. The key for success of these initiatives is having an engaged government that is committed to addressing the social needs of the poor and underserved, is open to outcomes based contracting, and is willing to pay if agreed upon social outcomes are achieved.
As a general rule, I don’t believe that philanthropic organizations should guarantee social impact bonds. Investing involves risk, i.e. no risk no return. Investors who choose to investment in social impact bonds, should be well aware of the risks before they invest in them, just like investors who invest in traditional fixed income instruments. Risk encourages and stimulates innovation which what the basis of social finance and impact investing is based upon. Although guarantees will insure financial returns, it does not to enhance social returns.
The purpose of philanthropic organizations is care for nourish, and develop social enterprises and projects. They should donate funds or not donate funds to a project, not to guarantee others investments in a project. There is a risk that if philanthropic organizations guarantee social impact bonds, the focus and objectives of the project may shift from generating social returns to preventing financial losses.
I do believe, that may be an opportunity for the government to provide guarantees to certain projects if they do not succeed. Securing and structuring government guarantees of social impact bonds in certain circumstances may be appropriate as a risk reduction technique because it may assuage investor concerns regarding risk and at the same time open access not only to sources of capital but to a wider range of investors.
The primary way that social finance can attract a wider range of investors by better aligning the different and often complex priorities and objectives of the 3 stakeholder groups involved in social finance 1) the investors (providers of capital); 2) intermediaries (receivers and distributors of capital); and 3) social enterprises (end users of capital).
Over the past 20 years, the universe of social enterprises and investable social opportunities have grown, which has allowed them to be described and compared along a variety of dimensions. There are now social enterprises and opportunities in: 1) developed as well as emerging markets and within those markets in various regions and countries; 2) various industry sectors – food/agriculture, healthcare, education, housing, energy, information technology, water and sanitation; 3) with different objectives – social vs. environmental; and 4) different stages of development –start up, venture capital, growth, mature private companies and mature public companies.
As the universe of social enterprises and opportunities has grown so has the variety of financial instruments and products that intermediaries have been offering to offer to investors: private equity, private debt, mezzanine financing, indemnity bonds. In addition, many intermediaries are taking traditional approaches to venture capital and private equity investing and modifying them so that they are more appropriate for impact investing and impact investors. With the growth in both social enterprises and financial instruments financial advisors and wealth managers are better able to match individual investment opportunities or funds with different investor types, profiles and risk tolerances. The standardization of product offerings as well as a lowering of transaction costs should also attract a wider range of investors, particularly smaller (retail) investors. This should facilitate the movement of investable capital from more traditional investment into impact investing products and instruments. Intermediaries have already begun to the segment the impact investor market along a variety of dimension: time horizon, return objective, risk tolerance, mission, values, etc which has made it easier to match impact investment opportunities and products to different investors.
Investors need to be in sync with investees in terms of understanding their mission, objectives, and business model. Investees need to be more in sync with investors in terms of being open to becoming partners with investors in delivering both social and financial returns. Over the past 20 years, the universe of social enterprises and investable social opportunities have grown, which has allowed them to be described and compared along a variety of dimensions. There are now social enterprises and opportunities in: 1) developed as well as emerging markets and within those markets in various regions and countries; 2) various industry sectors – food/agriculture, healthcare, education, housing, energy, information technology, water and sanitation; 3) with different objectives – social vs. environmental; and 4) different stages of development –start up, venture capital, growth, mature private companies and mature public companies. This should attract with different risk-return profiles, particularly smaller (retail) investors.
Performance, from both a social as well as a financial return perspective, is a key factor in attracting a wider range of investors. Impact investments need to be benchmarked, so that investors can compare their returns with other impact as well as nonimpact investments. This should ultimately enable impact investors to either
1) Specify a required rate of return and then search for investment opportunities that are expected to offer the most impact at that rate; or
2) Specify an expected impact level, and then search for investment opportunities with the highest expected return, given that impact level.
The current environment is an opportune time to pique investor interest in social finance and impact investing. The global financial crisis and resulting scandals, have made investors examine more closely the strategies that corporations are employing to generate revenues and profits. Investors have become more proactive in questioning the environmental and social practices of the companies in which they are investing. In addition, they are questioning the underlying and fundamental purpose of many investment products and strategies.
The financial crisis has also made those entering into the work force rethink their careers and personal goals. Many no longer want “just” a 9 to 5 job” or simply to be rich. Instead, they want to do something that is meaningful that will have positively affect their local or the global community. As a result, many of the “best and brightest” business school graduates are looking to work for non-traditional firms and organizations. They still want to be venture capitalists, entrepreneurs, and private equity financiers, however, there ultimate objective in these roles and is to improve society instead of solely making themselves and their clients risk.
Equally, as important, investors are realizing that the private sector may be better able to deliver social services and address such issues as poverty, poor education, and high unemployment more effectively and efficiently than the government. Market and outcome based projects and programs have shown that they can provide: 1) the same services at a lower cost; 2) more services at the same cost; and in many cases more services at a lower cost.
Social finance/impact investing is simply one more stage in the development and growth of “values investing.” From socially responsible investing, to corporate social responsibility, ethical investing, sustainable finance, and microfinance, investors recognize that the objectives of earning (generating) a social return (having a positive social/environmental impact) and a earning a financial return are not mutually exclusive and do not represent a zero sum game. Instead it is possible for them to use their investable capital to address societal ills, while still saving for retirement or their children’s education. In addition, they have a better understanding of the risk-return continuum involved as well as the spectrum of social investing: philanthropy, blended investments, and market return project.
Globalization of financial markets has given investors a broader perspective of the world made it easier for them to invest in undercapitalized regions and sectors.
Social Finance organizations and Funds are also becoming more savvy in marketing to investors and are ready to compete with other investment opportunities for capital. These organizations have become more transparent by providing the type of data that investors as well as outcome metrics that are both measurable and objective.
I believe that social finance represents the future of finance. Social finance like traditional areas of finance is driven by innovation in products and services, business models and technology. Many of the same people who have been attracted to traditional areas of finance because of innovativeness will also be attracted to social finance. Social finance, like corporate and behavioral finance, should be included as part of the curriculum in business schools.
An important step in the evolution of social finance and social impact bonds will be the development of secondary markets where social impact bonds and other impact investment products can be purchased and sold by investors. Creating a liquid market for impact investments would not only attract more capital it would attract a wider range of investors.
Are you interested in learning more about social finance? The inaugural Social Finance Summit will be held on the 12th and 13th November in London. For more information about the event, visit the conference website.