6 Reasons Why Impact Investing Aligns Venture Capital with Startup Ecosystems

Put these six factors together and you've got a formula for investors to fund companies that invest in their cities with the help of their governments and the endorsement of their citizens.

It took 25 years to recover from the Wall Street Crash of 1929 and during that period of self-reflection, investors (i.e. owners of stocks and shares) realized a pretty fundamental weakness in their approach: they weren’t analyzing profit.

Such an oversight obviously seems absurd now, but for more than a century “investable” businesses that were trading on the stock market, were all permitted to run their own accounting systems, if they had any at all. It seems crazy to think that “accounting is a modern invention” but, yep, the standardized system of “Generally Accepted Accounting Principles” (GAAP) invented in 1936 is still less than a hundred years old.

That’s the backstory of venture capital that Sir Ronald Cohen, esteemed Egyptian-born British businessman and founding partner and former chairman of Apax Partners, opens with in his book, Impact: Reshaping Capitalism to Drive Real Change. As one of my summer reads from this year, I recommend the book to anyone interested in social entrepreneurship, but if you’re more of a watcher or a listener, this discussion with the RSA hits all of the major talking points in the book. 

The Impact Investing Symposium is taking place on Friday, November 12th, 2021 at Washington University in St. Louis.

Wanna learn more about Impact Investing? Tune-in to this Virtual Event!

Urgent Needs In Our Darkest Hour

Although recent memories of the global social unrest may now be dimming into a general sense of pre-pandemic panic, let’s not forget that uprisings didn’t come from nowhere, nor were they simply responses to tragic news events. They were responses to economic, gender and racial injustice: arguably, citizens in democratic countries all over the world were responding to the “impact” of Capitalism itself.

Cohen, who published the book in 2020, says the collective soul-searching induced by the pandemic echoed the wake up call to investors of 1929. Speaking somewhat hopefully, he believes that the COVID-19 post-pandemic period will see an acceleration towards transparency on the impact that our whole economic system creates.

“In 1929 after the Great Crash, investors sat up and said, “Have we really been investing in companies without measuring properly the profit they make?” Of course, it led to the generally accepted accounting principles four years later when legislation was passed in the United States, which was then followed across the world and to the use of independent auditors. 

And I think today… investors are sitting up and saying, this time, “we’re only investing in companies on the basis of the profit they make with no transparency on the impact companies are creating.””

Can Benevolent Capitalism Really Work?

It’s worth noting that critics would argue that Cohen’s evangelism constitutes a passionate defense of Capitalism rather than a solution to its excesses. Asheem Singh, Director of Economics at the RSA brilliantly illustrates the objection with this analogy (which is itself inspired by critic of philanthropy, Anand Ghirardaras, author of another excellent book, Winners Take All):

“Do we really want to give the keys to the Fire Truck to the arsonists who started the fire?”

The crux of the counter-argument is that if we can trace the roots of economic crisis and environmental catastrophe to capitalism, why would we trust “capitalists” (aka investors) to propose a solution? It is a fair argument that deserves more consideration, but let me put it aside for now to at least hear Cohen out and his proposal to “reshape capitalism to drive real change.”

In this interview, Cohen doesn’t get drawn too far into debating the merits or weaknesses of various systems of government and political ideologies, and instead frames the entire situation we find ourselves in as extremely urgent. He says we need companies to address the critical challenges society faces as governments cannot solve them on their own, in a timely manner, especially in light of rising unemployment and government debt.

What is Impact Investing?

He evangelizes Social Impact Bonds (SIB) —also known as a PFS (Pay for Success) in the US— is a financial instrument tested in the UK and US on issues like prison recidivism and chronic homelessness during the early 2010s. Social impact bonds link non-profits, corporations and governments together into an investment vehicle that funds projects for the “public good.”

Social impact bonds mean governments can promise performance based returns to investors based on targeted metrics measured and managed by nonprofits. The key economic system mechanic that impact investing rests on is managing the dynamic of incentive and risk, so social impact bonds are designed to offer variable returns that are payable depending upon the attainment of specific and measurable social outcomes being achieved over a fixed term.

The Types of “Deals” Government, Nonprofits and Venture Capitalists Can Strike

The not for profit consultancy that Cohen founded, Social Finance, defines social impact bonds as, “a public-private partnership which funds effective social services through a performance-based contract.” To understand how social impact bonds work in detail, you have to read the book, where Cohen cites an example that Social Finance invested aimed at causing a reduction in prison reoffending rates in the UK.

17 charitable foundations and the Rockefeller Foundation in the US raised $6.7M to fund nonprofits working with prisoners at the Peterborough jail, a small city of ~200,000 people in the UK. The deal was that if the reoffending rate had not dropped by 7.5% (relative to a control group) after five to seven years, then the investment would not be repaid; but if the project was successful, the British Government would repay the initial investment including a variable interest rate that increased with the reduction achieved.

According to Cohen, “the Peterborough SIB achieved a 9.7 per cent reduction in the number of convictions, and paid investors 3.1 per cent a year on top of their capital.” 

The Win-Win-Win Impact Loop

The “impact” trick for Cohen though is not simply the return on investment based on effective results. It’s also the fact that the government investment in the Peterborough jail project still effectively cost 50-70% less than what the state would have spent on law courts and prisons. 

Plus, all the nonprofits would be able to secure future financing to continue their work. Meanwhile the charitable foundations gained returns that could immediately fund more impact investments in other areas.

Measuring the Impact Economy

Ultimately, whether financial instruments such as Social Impact Bonds or Pay for Success contracts can make a difference rest upon whether we can agree upon ways to measure “Impact”, to the same degree of accuracy, reliability and stability that investors currently calculate “Risk” and “Return.” 

Cohen imagines a future “Impact Economy” in which all parties collectively participate in a series of measurable practices that cut across all sectors of the economy, laboring under a philosophical methodology that seeks to continuously create incentives for change, while de-risking investment in change. 

He envisions impact metrics touching every part of society, such that public companies will produce “Impact Weighted Accounts,” in much the same way that nowadays, since the Wall Street Crash of 1929, companies seeking investment are expected to accord to Generally Accepted Accounting Principles —or risk jail. 

He also argues that impact weighted metrics don’t need to be realized and agreed all at once either, but can be developed as part of a constant work in progress around policy reform, much like new accounting requirements like Sarbanes Oxley were put in place after the Dot Com Bubble.

He believes that such metrics will mobilize public sentiment to invest in stocks according to new measures of environmental impact, job creation and other metrics that evolve from the Impact Economy. Cohen says that, as a solution, “Impact is Practical,” and we can measure these things now. 

Six Reasons Why I Think Impact Investing Could Work

What makes me excited about impact investing is that, in my opinion, it plays to the strengths of all parties involved.

1. It puts nonprofit organizations to use in a way that is best suited to what they do best: directing funding to the right places and areas of need.

2. It puts venture capitalists to use in situations they are most comfortable: calculating risk and aligning incentives developing innovation.

3. It puts local government to use in the way it is most effective: de-risking investment projects and promoting innovation.

Impact investing also provides useful safeguards against the typical problems that beset innovation when performed by just one sector, rather than all three:

4. It mitigates a problem that has besieged nonprofits around cyclical funding, which often means nonprofits spend more time chasing their next funding sources than delivering on their promises.

5. It mitigates the problem that venture capital often creates incentives to work against the government rather than with them, while also centering a collective approach rather than social power, as a core principle of the investment strategy.

6. It mitigates the problem of government falling foul of bottomless investments and increases their risk appetite to address social issues.

Put these six factors together and you’ve got a formula for investors to fund companies that invest in their cities with the help of their governments and the endorsement of their citizens.

Certainly, there’s a lot more to the discussion than I have covered here, but my main goal is to get you thinking about alternative approaches to investing and entrepreneurship and pursuing causes that matter to you. If I’ve done that, then mission accomplished!