Impact investments, made with an intentionality toward the SDGs, has been estimated to have crossed USD 1 trillion in assets globally.
However, this growth has been skewed toward sectors such as financial services, agriculture, and clean energy, together accounting for 55% of asset allocation.
A successful partnership of seasoned impact investing stakeholders to support first-time fund managers could catalyze the much-needed diversification of SDG financing at scale.
By Arun Asok, Strategic Lead, Private Capital & Impact Investing, Abt Associates
Impact investments, made with an intentionality toward the SDGs, has been estimated to have crossed USD 1 trillion in assets globally. However, this growth has been skewed toward sectors such as financial services, agriculture, and clean energy, together accounting for 55% of asset allocation. Further, the growth in private investments is also skewed toward more developed emerging markets. Despite the 70% increase in foreign investments in SDG-related sectors in developing countries in 2021, a strong rebound from the early pandemic lows, the share of 46 Least Developed Countries (LDCs) in these investments dropped from the already modest 19% in 2020 to 15% in 2021.
In line with the leaving no one behind (LNOB) promise of the 2030 Agenda for Sustainable Development, it is imperative to diversify SDG financing into underinvested sectors and geographies. Identifying such investment opportunities requires local and diverse fund managers who are closer to the businesses and understand the nuanced operational challenges. As forecasted by CDC Group and Blue Mark, diversity will be a cornerstone to the future of impact investing.
Most of these local and diverse fund managers are raising their first funds and face similar hurdles as the companies they intend to support – limited access to private capital and fewer investors who understand the underlying business models. To address these challenges, we need a multi-pronged market creation approach.
1. Strategic allocation tilt by asset owners: Asset owners need to make a paradigm shift in their analysis – from a disproportionate focus on investment track record of fund managers to an intentional focus on operational expertise. Further, an affirmative tilt such as a diversity lens or a thematic tilt such as a climate lens is required to ensure equity in the manager selection process. The Due Diligence 2.0 Commitment is noteworthy in how asset owners and other stakeholders commit to shifting their due diligence process to incorporate track record alternatives.
Development finance institutions (DFIs) have been at the forefront of this change. Abt Associates manages the Investing in Women (IW) Program through AUD 102 million commitment from the Australian Government and seeded eleven gender-focused investment funds in Southeast Asia primarily through first-time fund managers. IFC has historically supported first-time emerging market funds, and they have outperformed follow-on funds and industry benchmarks.
Among the private investors, Seedstars Capital recently launched as an investment platform to invest in emerging and diverse managers addressing the SDGs with local expertise. Capria Ventures has supported diverse fund managers with various instruments, including investing in the fund management company itself.
However, large private asset owners are yet to make significant strides in supporting local and diverse fund managers.
2. Technical assistance: Identifying investment opportunities in underinvested sectors and geographies poses a significant drag on the limited resources of these fund managers. Technical assistance is therefore required in areas such as fundraising, risk management, and gender and climate lens incorporation.
The Asia Natural Capital Design Funding Window, funded by RS Group and managed by Convergence, aims to support the design of funds with an intentional focus on natural assets, an underinvested sector in climate financing. 2X Collaborative, an investor body furthering gender lens investing, is in the process of creating 2X Pioneer Funds Accelerator Facility, to provide technical assistance to first-time women-led funds.
While there are several technical assistance facilities for underlying investments, there are few that target the needs of the fund managers.
3. Innovative financing: Emerging market investment risks are disproportionately higher in underinvested sectors and geographies. Innovating financing tools such as blended finance – public capital acting as a first loss protection for private investors – can significantly de-risk these investments. For example, The BUILD Fund, an SDG-focused debt fund for the LDCs (of which the author of the article was the fund manager), raised over USD 50 million of first-loss capital from UN Member States and development institutions. Abt Associates’ IW program also implemented a blended finance strategy to further gender lens investing through local fund managers, leveraging private funding to the tune of five times the public funding.
Further, for first-time fund managers without an existing balance sheet, investment warehousing support can be catalytic. Holding initial investments on the investor’s balance sheet can enable fund managers to demonstrate investment track record prior to fund launch.
4. Rethinking the asset management model: With smaller fund sizes and significant operational requirements, first-time fund managers are limited by the standard 2% management fees. They need customized fee models such as a) a cost-plus or a fixed fee model or b) a higher percentage of management fee that can be clawed back from the carried interest upon fund liquidation.
Carried interest, the primary financial incentive in fund management, needs rethinking. Traditionally linked only to financial milestones (a standard 20% of the profits generated by the fund), this incentive needs to incorporate impact milestones as well. This is imperative for underinvested sectors and geographies to ensure incentives are aligned with the long-term impact objectives of localization and diversity.
Further, the impetus for localization and diversity should reflect in the composition of the investment committees – the ultimate decision-making body – by ensuring higher local and diverse representation.
Finally, longer fund life or open-ended fund structures, as opposed to the standard ten-year life of a fund, are required to align with longer payback periods in underinvested sectors and geographies.
Tipping point: Market creation through partnerships
These large structural changes in the asset management industry, while much needed, will be a slow and incremental process. Meanwhile, local fund managers continue to be resource constrained, losing out on the opportunity to make significant advancements toward the achievement of the SDGs. In line with SDG 17 (partnerships for Goals), stakeholders in the impact investing industry could come together to bridge this gap.
Just as successful entrepreneurs have set up venture capital funds and accelerators to invest in and mentor early-stage businesses, DFIs, foundations, and mature impact investors should partner in the creation of emerging market fund-of-funds and knowledge-sharing platforms dedicated to supporting first-time fund managers with capital and technical assistance. The early success of impact investing, especially in microfinance, acted as a catalyst in attracting large asset owners and exponentially scaling up SDG financing. A successful partnership of seasoned impact investing stakeholders to support first-time fund managers could catalyze the much-needed diversification of SDG financing at scale.