Innovative Finance vs. Impact Investment
The main differences
This is a question I get a lot. For the uninitiated to the impact jargon, it all sounds more of the same. If the finance world has been very good at something, it is the repackaging and rebranding of financial products. So it is no coincidence that the general public has become a bit wary when a new word pops up, that in the end turns out more of the same.
Innovative Finance and Impact Investment are more than a financial product though. These are different concepts, or even better, different views on how to deliver impact. Depending on your background, you would probably feel more comfortable within one of these realities. Rarely would one person embrace both at the same time. Even though both views do co-exist. But for persons that live within their own concept of Impact Investment or Innovative Finance it is important to understand one another in order to consider collaborating in the future.
Below I will try to highlight the biggest discrepancies between Innovative Finance and Impact Investment from my perspective.
Closing the Impact Gap
In an open market there is room for lots of overlap, duplication and fragmentation. It all depends on your risk and reward model that determines what works for you. If the risk reward trade off is balanced, you got yourself a winning formula. But what happens when you need to include Impact in your model as well? Now there is different ways to look at your problem here. You can either identify Impact as a financial challenge or as an efficiency challenge. What is your main driver when you think of closing the Impact Gap? Is in your opinion the lack of Impact in the current models a consequence of matching impact investors with entrepreneurs focussing on impact? Or do you belief that the current model does not account for impact because it is not well equipped to recognize impact? Hence the difference between the Efficiency Gap and the Financial Gap.
- Efficiency Gap
From the perspective of Innovative Finance you take a couple of steps back to the problem that is in front of you. You look at the bigger picture and determine if this is perhaps the symptom of a bigger underlying problem. A problem that requires more than allocation of capital but requires coordination amongst stakeholders. Wicked problems that are entangled in complicated ways in society. Eventually it might require updates in public policies, regulation, and principles in considering the identification, measurement and reporting of impact. In the end the actions under the intervention would need to be evidence-based, measurable, lead to closing the gap on the sustainable development goals (‘SDGs’) and not have material adverse consequences on other actors in society.
2. Financial Gap
In the world of Impact Investment the impact gap can be a lot narrower, as it does not require involving other stakeholders or alignment with policies. You look at it from a financial perspective. Can you solve the problem in front of you with a decent return? This allows you to select from the SDGs like a buffet. As the impact investor you focus on the business of your Investee (ie. the social entrepreneur) and he picks the SDG’s that best fit his business model. You might keep track of how many beneficiaries you are reaching and pick a couple of the almost 200 existing indicators as measuring sticks for your impact success.
Type of Actors
There is a difference in which actors are perceived in an Innovative Finance setting compared to Impact Investment. This is mostly a choice which is often driven by a financial incentive. Considering stakeholders in your impact model, might provide a better overall picture, but this requires additional evaluation tools that affect the financial return on the project. Not including stakeholders under the Innovative Finance concept is not conceivable because of the Efficiency Gap that has to be considered (see above).
Referring to actors in the Innovative Finance as stakeholders has a leveling out effect. Not one actor is above or below the other. All are affected by the intervention/investment in their own way. It is the task of the facilitator of the intervention to identify what impact is expected at the specific level of the stakeholders. Stakeholders include the direct beneficiaries, people in their community, all the way to regulators and policy makers.
In an Impact Investment world it is mostly about matching the Investor to the Investee. Most Impact Funds have spend significant time on developing their own unique Theory of Change. A model that stands out and resonates with investors that want to allocate part of their wealth to Impact. This can, at times, also create unexpected barriers on the side of the Investee.
If you, as a social entrepreneur, are the square peg surrounded by the round holes of impact investors, you will have a hard time to find a match. This ’square peg, round hole’ syndrome is idiosyncratic for Impact Investment. The mismatches are often blamed on exterior effects like ‘lack of pipeline’ or ‘bankability of projects’.
Solving the Problem
What is the problem you are trying to solve? What is your definition of the problem? Who is asking? Something that’s a problem to you would not necessarily result in a problem to me. Innovative Finance is able to bring stakeholders together around big hairy problems that require a long term strategy in order to solve. Within Impact Investment however it would be possible to deliver impact by exploiting a tactical advantage as the solution.
- The Social problem solver
Innovative Finance would be better positioned to assist in creating transitional pathways that solve wickedly complicated social problems. Innovative Finance is often faced with modeling to solve a problem that has no clear solution yet. It is more of a journey of discovery towards social innovation.
2. The Technical problem solver
Whereas Impact Investment is better equipped to solve technical problems that have a clear risk, return, impact profile. Again both worlds are not mutually exclusive as they could definitely collaborate on solving problems together. But it would be important to understand that their perspective on problem solving is different.
Form of Steering
A vantage point not often taken when talking about Impact Investment or Innovative Finance. It goes back to what type economic model you belief in. Do you belief in Adam Smith’s invisible hand and expect markets to correct themselves and that public goods are born out of a collective self interest of market participants. Or is there a level of multilateralism which Prof. Jeremy Rifkin would refer to as biosphere thinking?
To put it more crude; do you belief that the Paris Climate Accord was signed by 195 self-interested parties or by stakeholders with a common belief that climate change is real and requires collaboration to be reversed.
Under Innovative Finance there would be a transition model where long term consensus amongst stakeholders leads to transition pathways that result in change in society. It requires a shared long term vision. Let’s stay with the example of climate for a second. Everybody need clean air. It does not matter where you stand on the political spectrum, the color of your skin, nationality, trade deficits, religion or gender. We all need clean air. This is how innovative finance is able to rally stakeholders around the same topic.
Under impact investment there is a strong belief in the competitive model where only the winners are rewarded. It is fair to assume that all social entrepreneurs want to achieve impact. But only a small percentage will get funding for the work they do. Scaling impact investment to deliver a positive impact to Global Public Goods (like Environment, Health, Education) is challenging. Either the economic incentive will vanish over time as access becomes universal or the impact is reduced as the ‘public good’ only is available to the happy few. This is a balancing act.
Duplication, Overlap, Fragmentation
Ok, it is fair to mention that Risk and Opportunity are often 2 sides of the same coin. Still, depending in which world you live (Innovative Finance or Impact Investment) your sentiment might be tilted to one of them.
If you operate in an Innovative Finance world, you have a strong belief in collaboration, learning from each other and scaling proven projects. These are all key to solving large social problems. Having projects randomly duplicated, projects overlapping existing ones, or even worse, splitting up successful projects, you consider that a risk from the perspective delivering impact. Preferably all stakeholders involved follow the pre-determined transition pathways that should result in the expected impact. If the available flavors are Order and Chaos, in innovative finance you would choose Order over Chaos any day.
From an impact investment perspective, having these inefficiencies in the market place, is regarded an opportunity. Businesses with comparable impact focus but different business models can be filtered down by the impact investor to the one with the highest social and economic return. Given these imperfections Impact Investment is better equipped to benefit from the ‘chaos’ of the market place.
Type of Culture
What type of culture you belief is more conducive to deliver impact? Is it the individualistic or collectivist culture? Is the individual important, or should he/she be selfless and doing what’s best for society? Obviously there is some nuance here. Not one society would be entirely self-centered or selfless. Still difference in culture is a relevant discrepancy when talking about Innovative Finance and Impact Investment.
Innovative Finance can best be characterized as an ecosystem. The actors in the ecosystem belief in the interdependency towards each other. Even actors that are on top of the food chain know that they should not ignore the efforts of the worker bees, as a lack of them might have grave consequences for the entire ecosystem.
2. Binary system
You are either the Investor or the Investee. Are you buying or are you selling? This requires a different mind set. It is transactional. Closing the deal. Winner takes all. Survival of the fittest. Obviously this is rather black and white. Still not uncommon.
Innovative Finance is not better on delivering impact than Impact Investment, or vice versa. It simply is a different view on impact. And depending on the project/business both, the Innovative Financier and the Impact Investor, could both be working together.
Do you share the above or do you believe that there is more to it. Please let me know.
first published on LinkedIn, February 24th, 2019