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The demise of impact investing

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A careful analysis of the decade gone by will highlight the evolution within the impact investing sector. The expansion of this sector has spurred industry experts to hold counter viewpoints – a faction that believes that the changes have been positive while the others opine that the “impact” of impact investing has diminished over the years. Despite this dissonance, industry leaders can cohesively echo that the changes within impact investing have definitely been fundamental in nature.

So, what have been the proponents for change within the sector? As an investor with close to two decades of managing funds, the last seven years of impact investing have been far more challenging than my first seven years in traditional private equity. The reason why private equity may seem like an easier path to tread is because PE/VC investments offer complete clarity on the objective and its end expectation. Fund managers have no option but to walk the talk.

Now when we were to discuss managing funds within impact investing, the granularity and the clarity of the objective, approach and expectations, in my opinion, have faded over a period of time. This would largely be due to the fact that today several impact investment funds are operating very similarly to that of private equity funds. As a fund manager with early days exposure in traditional PE/VC and then the shift to impact investing – comparing the value add between both strategies is inevitable for me.

The difference in approach with traditional PE/VC and Investments which is now blending in together often compels one to question the actual progress of impact investing.

Impact Investing and its initial day challenges:

Impact investing has witnessed a see-saw journey. If one were to look back at the initial days of impact investing, we will notice that there have been two great shifts within the sector.

Firstly, there was no proven model of impact investing beyond the financial inclusion sector. It is only in the last decade or two, that a lot of money has flown into the financial inclusion sector which has led to the growth of the sector by leaps and bounds. Due to this prodigious influx of capital, one can argue that there was no further need for impact investing money going into this sector. However, the investment opportunities within the sector offered a very appealing risk-reward ratio which led to the continuance of capital flow.

This approach had an adverse knock-on effect. As the saying goes, “Too much of everything is bad” – the over-deployment of capital over a period of time, led to lower social returns on investments. It also decreased innovation within the sector as the focus was to mime the strategy that is making money.

This over-deployment of funds now has led to several districts in India that are now under the heated district category. By heated districts, we mean areas that have more than 10 microfinance set-ups operating in one single district. This has led to several scams being unearthed in the sector due to the demand for higher growth than what is sustainable.

These sequences of events are, perhaps, the aftereffect of the significant shift in focus. At present, the focus is no longer to venture into the districts which are under-served or innovate on the products side to meet the needs of the BoP population – which is the original premise for social impact.

Secondly, the shift from philanthropic investing to impact investing in other sectors was still at a nascent stage. During this phase, there was a huge pool of grant funding or capital available for investment opportunities in other sectors. This was considered as project financing. The not-for-profit evaluation lens were applied while considering investment opportunities. Although the intent was in the right direction, the discipline that an investor should follow was missing, which led to scalability and exit challenges.

The teething problems led to the belief that the sectors like agriculture, healthcare, education etc. could not generate good returns or offer a favorable exit. However, there was a strong demand that the impact funds focus on sectors beyond financial inclusion.

The mainstreaming of impact investments

Although the above two challenges were significant, investors treaded this challenging journey with hope. Gradually, over a period of time, the challenges started to fade away as investors (LPs and GPs) started to adopt a different technique. Investors became more disciplined in their approach, and the funds began looking at other sectors beyond financial inclusion. This partial shift in approach led to a spurt in funds available for the impact investing sector.

The impact investing sector started to see significant traction, leading to traditional PE/VC raising money under the impact investing banner. One would argue that the objective of the sector was achieved when such development happened. Unfortunately, the development led to newer challenges which impacted the whole thesis of impact investing negatively.

The traditional PE/VCs started attracting more money than the impact funds in the space. On its own, such development would have impacted the impact sector positively. However, these investors were focused on investing in larger deals within the space which was non-existent beyond the financial inclusion sector. Therefore, once again, money started pouring into the financial inclusion sector, as otherwise, a hockey stick growth was not possible by investing in other sectors (or the perception was that it is not possible).

The second shift that the sector witnessed was the complete focus on technology deals. When the traditional PE/VC funds entered the impact investing space, they started focusing heavily on technology-led companies. This shift was primarily because traditionally, venture capitals have focused on technology deals to generate above-market returns for their investors. This technology-focused play led to an overnight shift in the type of companies that could attract capital from impact investors (or the traditional PE/VC funds operating in the space). But then, didn’t we still have traditional impact funds focusing on social enterprises? I would argue here and say not really.

The second shift put massive pressure on the impact funds as they were now competing with the traditional PE/VC funds for raising money from the LPs. There was also significant pressure to generate (or at least promising to generate) above-market returns. Traditional impact funds were now left with two choices:

1. Turn mainstream and focus on technology-backed companies; or

2. Perish, as it is difficult to complete with traditional VC funds without focusing on technology.

Unfortunately, most of the conventional impact funds turned mainstream. The impact sectors changed from sustainable agriculture to agri-tech, accessible education became ed-tech, healthcare became health-tech, and so on. The problem here is not the adoption of technology but rather the investor’s complete reliance on technology.

Where does impact investing stand presently?

The initial days of impact investing certainly held potential, but the momentum was short-lived. As the sector was still in its infancy, there were no ground rules laid that helped investors towards smooth navigation. This led to a weak foundation. Additionally, investors had no benchmark to define and measure impact. It wouldn’t be wrong here to say that perhaps investors within the sector perhaps jumped the ship too soon.

What the sector needs now is for investors to put up a fight, challenge the status quo, guide the sector for everyone’s benefit and sustainability. The mad rush towards valuation will destroy everything sooner than later. The need of the hour is to come together, brainstorm, and put in place an appropriate fence around impact investing. Then maybe one day, the mainstream capital will follow the impact investing way and not the other way round.

The author, Arvind Agarwal, is Co-Founder and CEO at C4D Partners. The views expressed are personal