The ‘missing middle’ is still missing

Professor Ingrid Burkett and Professor of Practice Alex Hannant consider the need for social finance and blended value funds, as part of a series of impact investment provocations.

Provocation #3

We’ve got it backwards. Many of the biggest opportunities for preventative intervention and impact exist in emergent spaces. But much of the current appetite for impact investment is in comparatively “de-risked” and “ready” propositions.

Finding ways to catalyse emergent opportunities was intrinsic to the original purpose of the impact investing movement and we must not lose sight of it. What if we re-frame these spaces as opportunities for transforming markets and finance to match the impact we are seeking to create? And if impact really is a common goal, how should that change the supply / demand relationship?

We need to align the supply and demand of impact capital

If you’re a not for profit, community service or social enterprise seeking to deliver great outcomes for people and places, then chances are, you are juggling resources from a range of sources.

Running a “for purpose” organisation or business in the current environment increasingly requires managers and boards to become familiar with blending grants, contracts, donations and investment to make their business models work and deliver impact. The demand for a range of capitals to support impact has grown over the past two decades. However the supply of capital (though subject to much hyperbole) has not adequately matched the demand.

The result has been an impact capital market that is skewed towards certain kinds of capital for certain kinds of returns and therefore limited ranges of purpose. So investors are screaming for pipeline development, saying they are ready to invest at scale; suggesting that for-purpose organisations need to change their appetite, grow their readiness and account for their impact.

Meanwhile for-purpose organisations and social enterprises are seeking a more diverse range of capital offerings; capital structuring that benefits their constituents not just investors; and a scale of investment that matches their capacity to deliver real impact in alignment with their purpose.

When it comes to impact investment what is evident is a mismatch between supply and demand (see figure 1), or the “quality” of demand being largely a construct of supply side interpretation.

Figure 1: There is currently a mismatch between supply and demand in impact investment.

There is no doubt that impact investment has grown in Australia – in 2018 almost $6 billion was identified under the banner of impact investment and this has continued to grow. However, it also needs to be said that 96 per cent of this investment was directed at environmental outcomes. 

Yes, this is crucial given the critical nature of climate change, biodiversity decline and extinction rates, but these are also areas where often established markets (and financing) are in operation.

If we want to be serious about impact, we are going to have to get serious about articulating what this impact actually is – and what the different kinds, intensities, nature and intent of impacts are across the increasingly diverse field of impact investment.

Equally, we are going to need to become much more attuned to the relationship between financial instruments and their potential to unlock and deliver different kinds of impacts in order to really start to align and better match supply and demand in Australia.

To emphasise this point, most of the significant growth in impact investment is at the intersection with mainstream capital markets, where impact can be pursued and incentivised without requiring concessions on financial returns.

This primarily relates to sectors and opportunities where societal need and market opportunity overlap, such as renewable energy and health, or asset backed investments that promise to retain and appreciate in value regardless of their proposed use.

Figure 2: Impact Investment in Australia (RIAA + CSI, 2018).

However, impact investment continues to experience headwinds where propositions intervene in areas of market failure and are unable to generate commercial returns. This basically results in “impact” being an investment preference rather than a commitment to advance genuine reform.

This is a fundamental flaw that needs to be addressed, as many of the biggest opportunities for preventative intervention and impact exist in emergent spaces, and finding ways to resource these opportunities was an intrinsic part of the original purpose of the movement.

Rather than determining these spaces as concessionary or uncommercial, which is pejorative and implicitly creates silos, a more constructive narrative may be to re-frame them as challenges for market and financial innovation. All markets are constructed and, at the basest level, simply reflect an agreement on what is considered valuable and how newly created value is quantified and exchanged.

It follows that many “uncommercial” opportunities reflect our current inability to accurately appraise and reward the value being created, or the potential value that stands to be unlocked.

Figure 3: The missing middle in the Australian Landscape.

The missing middle needs a resurgence of social finance

This points to what could be seen as a “missing middle” in the Australian landscape (see figure 3). In this space sit both those arenas where the mismatch in supply and demand are most acute for impact investment, but also those areas that could better be served by “social finance”.

Though in Australia the field of social finance has largely been subsumed by the growth of interest in “impact investment”, we argue that, in fact, we need to reconstitute this as the larger field, in which impact investment sits (rather than the other way around).

Social finance, according to the Said Business School in the UK, captures a much broader range of “instruments, hybrid funding models and structured deals blending various types of capital… that includes conventional financial assets of debt and equity, but also includes grants and bespoke asset types such as quasi-equity or upside revenue participation bonds.”

It is a much broader framing than “investment” (for example, it includes granting and consumption like instruments), and, as a result, offers a more diverse range of financial instruments that can be deployed to address complex or “wicked” social issues such as place-based disadvantage.

It is a reconstitution of the social finance field that will enable us to more effectively realign the current mismatch between supply and demand.

There are already a number of ways to recognise the value of outcomes – let’s explore them more

To fill the missing middle, it will be important to keep exploring ways to recognise the value of outcomes via reliable payments, and create market mechanisms that enable promising interventions to be tested and effective ones to scale.

In this, the voluntary carbon markets (especially approaches such as Plan Vivo) may provide a better blueprint than impact bonds. Certainly, to enable broader adoption of outcomes-based payments:

• compliance costs need to come down;
• impact producers need to be better enabled;
• demand for outcomes needs to be cultivated (through multiple means); and
• extractive industry building needs to be constrained.

We should also explore where the required level of evidence best sits on the efficacy-accuracy continuum, and consider what other proof points can work alongside measurement to enable effective interventions to be resourced efficiently, in proportion to their maturity and performance.

Another way to develop opportunity in this missing middle, especially in relation to hybrid enterprises, is to calculate and separate the additional liabilities associated with delivering the impact aspects of a business model – the “social costs” of creating blended value.

REDF has developed a “double bottom-line” accounting mechanism that is both transparent and easy to implement, and makes it relatively simple to appraise the underlying viability of any given impact enterprise by distinguishing the nature (impact related or straight-up commercial) of revenues and costs.

This enables both entrepreneurs and investors to distinguish between a bad business, and viable business encumbered by the additional costs of tackling market failure. If the latter, it then provides distinct propositions for both funders who are primarily interested in impact (who can underwrite the social cost), and investors who require a market rate return.

Conceptually, at least, it would be straightforward to establish a “blended value fund” that underwrites the social costs of high-potential impact enterprises using this accounting model (unlocking opportunities for market-rate investment), with the co-benefit of also driving better practice around accounting and reporting.

There are a number of other promising approaches being advanced to fill the missing middle. On a small scale it is interesting to see the (Australian-based) Impact Investment Group’s new loan vehicle, designed to help start-ups focus on their impact. In this facility, repayments are based on the start-up’s revenues (turned up and down depending on their capacity to repay), while interest rates will be tied to the level of impact they achieve.

A promising response at a higher level of capital intensity (required for asset-backed and large-scale systems interventions) is the Catalytic Capital Consortium (C3), which was launched in 2019 by the MacArthur Foundation in collaboration with the Rockefeller Foundation and the Omidyar Network. C3 will constitute a significant investment in direct finance and support of intermediaries who will be able to unlock significant amounts of investment through backing high-potential and high-performance impact-first actors.

“The real story is about the value of patient, flexible, equity-like capital for high-performing non-profits.” – Debra Schwartz, managing director of impact investments at MacArthur

There is a huge dividend for governments in these approaches, and perhaps a considered investment case could be prepared and socialised as part of pandemic recovery measures.

A final point to consider is the degree to which the conventional supply / demand relationship is a contributor to the missing middle, and needs to evolve.

Re-framing this relationship from one of shared risk and mutual gain, to one of shared purpose and complementary capacity, changes the nature of this relationship from one of negotiated prospecting to one of generative partnering – the pursuit of stakeholder value over shareholder value necessitates more than an additional set of metrics. It requires different relationships, that put common outcomes above respective inputs, and function in more equal ways.

This article is part of seven provocations from The Yunus Centre which aim to promote dialogue, and contribute to new thinking about the potential for transformational impact investment in Australia, New Zealand and the wider Asia Pacific region.

The purpose in the “We need to talk about Impact…” series is to ask some of the hard questions to interrogate how we can reshape impact investment to ensure that we are actually transforming outcomes for people, places and the planet.

See also:

Impact investment needs to stretch horizontally not just vertically

Sleeping giants: Generating impact in place through anchor investment