FOCUS NOTE Leveraging Equity Investments to Build Inclusive Financial Markets E quity as a funding instrument is particularly important for the responsible development of financial markets. Through purchasing shares have the opportunity to build the capacity of the investee and contribute to creating the next generation of leaders in the market. in financial services providers (FSPs) and other types of institutions, development finance The investor’s exit decision results in a change of institutions (DFIs) and social investors have three ownership that can potentially change a business’s distinct opportunities to shape market players strategy and how markets develop. A new owner, and in turn influence how markets develop by for example, might have different growth and potentially driving competition, promoting profitability goals for an FSP that could be hard to innovation, improving market efficiencies, creating reconcile with the nature of serving the bottom of demonstration to crowd-in others and ultimately the pyramid segment. Similarly, return expectations better serve customers (Figure 1). can signal what potential buyers should expect and the type of buyers it could attract. Loan repayment, Compared to lenders, equity investors can have a 1 by contrast, does not affect the borrower’s substantially wider choice of investees at the starting ownership; at most it releases any assets that were point, or entry. Because lenders can earn only the used as collateral. Timing considerations are also margin between their funding cost and the interest very different for debt and equity. Lenders require and fees determined upfront with the borrower, fixed maturity dates that are enforced by debt their investment portfolio is limited to companies contracts, while equity investors have at least some with more regular cash flows. In contrast, equity flexibility, depending on their funding sources and can be placed in start-ups, firms with relatively low internal policies, and have to be patient and to try revenues now but with strong upside potential to sell their shares when they have achieved their later. The higher returns potentially available to objectives. equity investors enable them to take more risks and a loss on one investment can, at least theoretically, If equity investors want to maximize their impact, be offset by the gain on another so long as there is they should focus more on how they can engage a sizeable investment portfolio. with their investees to act in ways that develop the market, and use their three leverage points— Equity investors also contribute to these returns entry, governance, and exit—more effectively. by being actively involved in the development and The shift to this broader market lens does not governance of the investee. In contrast, lenders mean that equity investors need to compromise usually can influence a borrower through loan on their investment goals; rather, they can covenants that prevent certain activities or through pursue their interests in ways that also benefit No. 104 providing loans that develop others, such as small the market as a whole. For example, they could April 2016 business lending. Lender influence, however, is invest in a leading FSP that intends to serve a client defined in the loan conditions and does not change segment that is perceived by others as being too Estelle Lahaye during the life of the loan unless the borrower fails risky. By developing this FSP’s management team to perform. Through governance, equity investors and helping it succeed in going down market, the 1 The analysis compares equity with debt for illustration purposes to emphasize the uniqueness of equity’s role. This comparison is not intended to diminish the importance of debt in market development or to ignore the fact that there are a number of hybrid products with a combination of debt and equity characteristics. The analysis also does not address grant funding, although it is also extremely important to institutional development, because the ability to make grants is not unique to equity investors. 2 Figure 1. Equity Investors’ Leverage Points Equity investors leverage points: • Entry: decision to invest in a company • Governance: shaping direc�on and growth of company • Exit: decision to sell shares Examples of market effects: • Demonstra�on • Innova�on & disrup�on • Compe��on • Efficiency Inclusive Financial Market investor has the opportunity to help crowd-in other and decisions are based on a combination of the market players by demonstrating that this particular team, competitive environment, and geographical segment can be served profitably and at scale. scope. For example, Caspian Impact Investment Advisers, a private equity fund manager focused on Considering the broader market requires investors socially responsible businesses in India, sought ways to have a deep understanding of the causes of to apply the expertise gained from its experience in financial exclusion and market barriers that keep microfinance to other challenges facing low-income poor people financially excluded. This knowledge communities. It capitalized on the knowledge and should be an integral part of their approach to work that FSG—a nonprofit organization working selecting investees so that they can determine how on inclusive markets and formerly known as they will add value through their investments— Monitor Inclusive Markets (MIM)—initiated in 2006 how they intend to exercise their leverage points to develop a market-building approach to the lack and become more responsive to these barriers of affordable housing for low-income households (Rosskamp 2014). in India3 as well as its on-the-ground experience to identify a new market development opportunity In financial inclusion, most DFIs and microfinance that investors had not yet considered. By creating a investment vehicles (MIVs) 2 use a thematic financial inclusion fund, Caspian had the possibility approach to equity investing. With this approach, to invest in a new theme and “test” the investor an investor chooses to operate within a specific and investee market, which later developed into a industry and/or geography. Potential investments popular market segment for other fund managers. are examined within the selected sector, (For more information see “Looking Ahead”). 2 According to CGAP’s MIVs Disclosure Guidelines, MIVs are independent investment entities that specialize in microfinance, with more than 50 percent of their noncash assets invested in microfinance. They are either self-managed or managed by an investment management firm and are open to multiple investors. MIVs may issue shares, notes, or other financial instruments. 3 MIM, an economic development consulting firm, initiated a donor-funded project in 2006 to develop a market-driven response to the lack of affordable housing for low-income households in India. Its analysis showed that construction of apartments for this market would be a profitable business. 3 A relatively new approach to equity investing Equity Investment and Its in financial inclusion is thesis investing . In this Three Leverage Points approach, an investor elaborates an intellectual foundation about a specific theme. The thesis will This section analyzes the three points at which include a concrete set of problems or opportunities, equity investors have particular leverage—(i ) entry, a particular view of how the world will look in the (ii ) governance, and (iii ) exit—and how they can use future, and a specific set of factors that need to this leverage to contribute to market development be addressed to get there. The investor will then as well as the success of their specific investee. attempt to structure investment activities around the thesis by either identifying existing companies Entry: A Wide Range of that fit into the investment thesis or helping Investment Opportunities create new ones that can take advantage of an identified opportunity. Based on a system-level The broader range of potential investees presents understanding of the most significant impediments an opportunity for equity investors to influence for financial inclusion, Omidyar Network (ON), market development. There are three broad types for example, developed three theses around of firms in which equity investors can invest, each possible solutions: (i ) reduce the cost of reaching playing a different role in how markets evolve underserved populations in emerging markets by (see Figure 2). promoting the digitization of the retail front-end of financial services delivery; (ii ) disrupt the high cost Market innovators . Sometimes individuals 1.  of risk assessment for billions of consumers with no and firms create new products or services in or little credit history using sophisticated analytics ways that the market does not expect. While of alternative digital footprints; and (iii ) deliver a their business model is not fully developed complete suite of financial products and services to and tested, innovators can potentially disrupt unbanked and financially underserved consumers an existing market or create a new one. Equity by scaling technology-driven innovations. ON has investors play a particularly catalytic role in subsequently made a number of equity investments, providing capital to innovative businesses, both directly and through funds, in start-ups that which are typically too risky or do not yet have are building mobile-based delivery infrastructure in sufficient regular cash flow to attract debt several regions. 4 funding. Furthermore, often new, sparsely staffed businesses require significant support As impact investing continues to gain traction, DFIs and expertise that an equity investor can bring and social investors have a unique opportunity to to develop the innovations into sustainable use their equity funding instrument to contribute businesses. Prominent examples of innovators further to the development of financially inclusive in the financial sector are companies involved markets and achieve sustainable impact. In this in the delivery of digital financial services (DFS) context, this Focus Note seeks to explore how it by leveraging information and communication can be done by articulating (i ) the three leverage technology and distribution networks. points of equity investment; (ii ) the challenges for Market scalers. Businesses with a proven business 2.  investors to exercise their leverages effectively model are well-positioned for significant expansion and possible solutions; and (iii ) areas that require in underserved markets and/or lower-income further consideration. segments. Although the model itself is no longer 4 ON seeks to create impact at the sector level, beyond the level of individual institutions, by making both direct for-profit investments and nonprofit grants. For each sector in which it invests, ON develops a system-level understanding of the most significant impediments and a set of investment theses around possible solutions. ON’s sector-level understanding in financial inclusion led to applying a three-pronged approach to (i) make catalytic investments in early-stage, technology-driven companies that can demonstrate the success of innovative, market-based solutions; (ii) advance sector learnings and knowledge dissemination with a view to inform both policy and product and service design; and (iii) support relevant regulation and policy changes that promote more inclusive financial systems. Although many investors do not have the resources to make grants and support market development as extensively as ON, its approach provides a concrete example of how to apply a market development perspective making decisions about individual investments. 4 Figure 2. Spectrum of Investment Opportunities Low revenues Higher revenues and profits and profits Market Scalers • Proven business model • Opportuni�es to expand scale in underserved markets and/or lower-income segments • Effect on market: demonstra�on, increased compe��on Market Innovators • Unproven business model • Opportuni�es to disrupt exis�ng players with new product or service • Effect on market: demonstra�on, increased compe��on Market Infrastructure • O�en start-ups with unproven business model • Opportuni�es for private businesses to provide key market service • Effect on market: improved efficiency Source: Adapted from Bannick and Goodman (2012). considered risky and of uncertain profitability,5 in providing these services. Investment in such expansion entails risks of its own because it tests businesses could contribute to improving the management and operational capacity as well as market’s overall efficiency. Often, these companies market demand in different segments. Investments are start-ups that can benefit from capital infusion in financial market scalers can contribute to as well as expertise that equity investors can demonstration effects and increased competition bring to launch the product to market. But not in markets. Microfinance institutions (MFIs) are all investments in market infrastructure businesses an example of investees that have often proven automatically optimize market development. For themselves as market scalers in the financial sector. example, a private credit bureau open only to Market infrastructure businesses. One of the 3.  banks would not be as good for the market as one key elements to building inclusive markets is to that allows participation by all types of lenders. have an infrastructure in place that supports and By providing strategic guidance and expertise, improves their overall efficiency. In the financial equity investors can also work with the market sector, it typically includes information platforms, infrastructure business to ensure that it has a credit bureaus, rating agencies, collateral positive effect on the market. registries, and electronic payment platforms. Policy and regulation usually influence whether Governance: An Influencing market infrastructure is provided by the public Voice in the Boardroom or private sector, and it is often a role played by public sector actors and NGOs. But there are also Ownership rights are the leverage point that equity opportunities for private businesses to engage investors can use to add value throughout the life 5 Market scalers are typically companies that developed and rolled out a product, validated its profitability, and had adequate organizational and management systems to bring the business to scale. For investors, these businesses present less risk and potentially attractive returns. 5 of the investment. Equity investors directly impact place, however, if the successes (and failures) are corporate governance by maintaining shareholder well documented with relevant information and rights, including the possible right to nominate one widely shared with or otherwise observable by the or more board members. The board of directors in market (see Box 1). A company’s success can also turn makes decisions about the investee’s strategy contribute to market transparency, to the extent and selects and oversees the management team that the management and board permit information that implements that strategy. Governance and about the company, its products, and its financial support for business development more generally performance to be readily available. from equity investors is particularly important for market innovators and market infrastructure Effective corporate governance can contribute to businesses to help develop/prove sustainable other development objectives, including explicit business models. 6 commitments to responsible business practices, such as adopting the Client Protection Principles7 Careful selection, participation, and strategic or the Universal Standards for Social Performance guidance of board members in the business can Management, 8 which are prominent in the influence market development. Companies in microfinance sector. which the board of directors effectively supervises a capable management team have a higher likelihood Investees may also contribute to market of achieving their objectives. These objectives, development by other means than running a such as developing an innovative business model successful business, for example, by helping to or scaling a proven business model, can have an found or lead an industry association, being active impact on the market by creating a demonstration in data platforms, or contributing to research and effect, crowding in others including new investors, surveys that generate useful market information. and/or influencing the competitive environment. The board of directors and shareholders can encourage these leadership roles rather than Caspian Impact Investment Advisers did more seeing them as diverting management time and than identify investees, for example. Through resources from the core business. active governance, it shared its microfinance and mortgage expertise to help housing finance Exit: Key Signals to the Market companies develop their business models on a sustainable basis, and several of Caspian’s An investor’s decision to sell its shares and investees were able to attract second-round the resulting change in ownership can have a financing from new investors. Accion’s Venture profound impact on the investee’s future; the way Lab—a global investment vehicle that provides it exits can also send important signals to other seed capital to financial inclusion start-ups— market players. The ideal exit for a DFI or social supports the day-to-day operations of its investees investor is one that validates the objectives of through active governance to maximize chances of the investment: the investor will have achieved success. It is also uniquely positioned to connect its its financial and other objectives, and the new investees with Accion’s in-house technical experts buyer will be committed to further develop the and the broader financial inclusion community. investee’s mission. This positive outcome provides encouragement for investors and business owners Effects on the market, such as demonstrations that that are already in this market or are considering pave the way for others, are more likely to take entering it. 6 ON has observed that the human capital costs of working with early-stage businesses can often exceed the financial costs (Bannick and Goodman 2012). 7 The Client Protection Principles are the minimum standards that clients should expect to receive when doing business with an MFI. For more information, see http://www.smartcampaign.org/about/smart-microfinance-and-the-client-protection-principles. 8 The Universal Standards for Social Performance Management, adopted by the Social Performance Task Force, provide a set of management standards to help guide these actions for all MFIs pursuing a double bottom line. 6 Box 1. What can investors do to create demonstration? Demonstration is an important part of building inclusive information that shows that a company is profitable markets and creating impact. It is about testing and does not typically include sufficient detail for an proving the validity of a new business model, product, outsider to assess and replicate the results. or any other type of innovation to stimulate other market Sharing relevant facts to demonstrate that results are actors to adopt a new type of behavior. Firms can indeed achievable is paramount. The type of information will have ripple effects on the market such as (i ) inspiring vary from case to case, but it will often be centered on copycats, (ii ) generating a competitive response from overturning assumptions. For example, if market actors existing businesses, and (iii ) focusing attention on generally perceive a particular client segment as too previously unidentified market shortcomings (Kubzansky risky for credit, sharing information on the innovator’s and Breloff 2014). So, by investing in and working closely loan portfolio quality could correct the misperception. with different kinds of firms, equity investors have the If a new business philosophy is introduced as a way to opportunity to create demonstration. better serve clients, such as customer centricity, client However, showing that something works in practice survey results and repeat transaction data might be or correcting an inaccurate market perception doesn’t helpful to make the case for such practices and the always happen because of an investment. Often, when returns they can generate if adopted by other market results are not well known or the reasons for success are actors. So, the type of information to share is less about not clearly understood, other actors are less likely to the methodology for achieving the results, which is learn, adopt, or even enhance their existing practices. usually proprietary information, but more about Information plays an essential role. Impact investors showing evidence that they are achievable. need to have a deliberate plan for how knowledge Active dissemination is another key ingredient to about the demonstration will be transferred to demonstration. For example, Accion’s Venture Lab others. This starts by defining upfront what is puts an emphasis on proactively sharing its investees’ being demonstrated. It could include proving the stories, successes, and even failures. Staff do not viability of a specific product, a specific process, an simply ensure that information is made available; they organizational structure, or a business philosophy, actively monitor media hits and industry “buzz” to such as responsible relationships with clients. assess how the information is being disseminated Impact investors also need to make sure that relevant (Breloff and Khosla 2014). information is extracted. Although businesses Finally, impact investors should determine whether typically produce a variety of marketing and product the demonstration effect has been achieved. Has the information, this information is not necessarily proof of concept been established that the company designed to provide convincing evidence of the is able to attract new investors? Are other businesses viability of a new product or approach. Even financial copying the innovation? If not, why not? Exiting investors need to carefully consider four key to the company in terms of strategic direction, strategic decisions (Rozas 2014): specialized expertise, and growth capital. With what conditions and mechanisms: Putting 3.  When to sell: The desired timing and avenue of 1.  provisions in shareholder agreements might help exit should be part of an investor’s decision to codify and reinforce the business’s mission and invest. These plans and preferences should be social commitment. However, it can also send an discussed with the other equity investors and the important signal to potential buyers who may be MFI’s management. put off by such provisions. The legal enforceability Who to sell to: Investors need to weigh two 2.  of such shareholder provisions varies widely from key issues when considering potential buyers. one jurisdiction to another, and this approach First, they need to ascertain to what extent the would work only if the majority of investors buyer is a like-minded investor that shares a support these commitments. commitment to a business’ stated mission and At what price: Exits that are unprofitable or are 4.  can be trusted to “stay the course” over time; seen to have failed in other ways create warning this point is particularly important for FSPs with a signals for other investors. Extraordinarily strong social commitment. Second, they need to profitable exits risk creating unrealistic consider how the potential buyer can add value expectations as well as undesirable headlines.9 9 Exits also have a very practical impact on existing investors, who typically have to value their investments on a regular basis for reporting to their funders. Recent exit prices play an important role in the valuation process. 7 Challenges for Impact Furthermore, it takes a lot of work to identify these Investors to Exercise Their investees: Accion’s Venture Lab reviewed over Leverage Effectively 1,000 applications to invest in 21 companies. Often impact equity investors are small companies with For equity investors to succeed in leveraging a limited number of staff, located in developed their investments to develop the broader market, countries. Thus, they are usually predisposed they will need to shift the way they work in ways toward identifying market scalers. that might be challenging for some. This section explores these constraints and discusses emerging This mismatch between the capital most needed solutions. for market development and what is being offered is linked to the equity investors’ structures. Entry: Responding to Market Needs Private equity model more suitable for large To date, most impact investors have focused investments. This model is often used to diversify their efforts on developing market scalers. For investments by pooling funds with other investors example, more than 90 percent of the assets to work with experienced fund managers and under management for impact investing is focus on specific investment objectives. In financial invested in “post-venture” or scaling stages inclusion, this model is mainly used with MIVs, which (J.P. Morgan 2014). A similar situation exists in provide approximately 60 percent of the equity financial inclusion, with the majority of DFI and MIV funding to FSPs. 12 The compensation structure funding going to FSPs serving the lower-income of an equity fund consists of a management fee segment and whose business model has been based on the fund’s size and a “carry” formula proven a long time ago.10 In contrast, there is an for sharing profits between investors and the fund increasingly widespread view that investments in manager.13 Consequently, there is an incentive to market innovators as well as market infrastructure create large funds with a relatively small number of businesses are insufficient; yet such businesses less demanding investments. In contrast, innovative can also make significant contributions to building or market infrastructure businesses typically require more inclusive markets. 11 relatively small investments and considerable hands-on support—hence the equity fund model With limited revenue or high costs, the entry does not necessarily create strong incentives for decision for start-ups and the investor’s risk/ investing in these types of companies. return trade-offs are different than for scaling businesses. Identifying the right business model A variety of efforts are underway to make this for market infrastructure businesses can be even model more conducive to financing start-ups. The more challenging because of the public good role high costs of identifying and working with small they often have, and not all forms of services can investees have been addressed in some funds by be easily commercialized. Even if these businesses providing grants and larger management fees to the are able to generate revenues, profitability may not fund manager. Some funds address the high risks even be achieved and investors may need to make by including first-loss coverage with an investor or a long-term commitment. For an equity investor, grant donor who agrees to bear first losses in an this means placing less emphasis on capital gains investment. Changing the compensation structure (which is rare). is another plausible adaptation, although not 10 It is important to note that comparing investment figures for market innovators, market infrastructure businesses and market scalers is not straightforward, because market scalers by definition typically require more funding. Furthermore, it is impossible to know whether more funding for market innovators and market infrastructure businesses would actually result in a larger number of successful businesses. 11 This topic is discussed extensively in Koh, Karamchandani, and Katz (2012). 12 Estimate based on the 2014 CGAP Funder survey and 2014 Symbiotics MIV survey. 13 Management fees vary from 1.5 to 3 percent; management fees of 3 percent are typically for small funds of under $50 million. Management fees are typically reduced by 25–50 basis points after the investment period has ended. The carry formula is typically 80 percent for the investors and 20 percent for the manager. 8 one that was adopted by any funds covered by Accion Venture Lab that foster experimentation this research. For example, the management fee and promote new business models through could be increased so that managers have a higher active investing and governance. Comparing operating budget and can better respond to the the performance of these alternative investment needs of start-ups, quickly adapt to ever-changing structures with innovation-focused private equity market conditions, and attract human capital with funds could help investors continue to refine the the appropriate expertise. A variation on the optimal approaches for financing innovation. theme of adapting the fund manager’s incentives is the initiatives taken by some investors to divide Governance: Be an Active the carry into a financial and a social component Owner and Align Interests (GIIN 2011). This approach not only compensates fund managers for higher risks, but also can focus Most DFIs and social investors recognize the attention on the market development outcome. importance of governance to affect change at Some of these initiatives could also be applied to institutional and market levels. Although they have funds that specialize in market scaling investments dedicated substantial resources to improving the as incentives for expanding their willingness to take technical skills of board members, even the most risks, such as expanding proven business models to experienced board member can fail if the investors new geographies and products. have not created conditions for effective governance. In fact, recent evidence in microfinance suggests that DFIs have limited appetite for risk. In addition to DFIs and social investors are not fully capitalizing on working through funds, DFIs also have an option to the opportunity to use this key leverage point and take direct stakes in businesses. As publicly funded strengthen FSPs’ governance (McKee 2012). institutions, DFIs’ mandate is to provide longer- term capital to the private sector for investments Integrating market development considerations into that promote development. Their investments are the governance process is even more challenging best placed where private investors fail to invest than the well-documented challenges of corporate sufficiently because of real or perceived risks. governance more generally. Shareholders and the board need to agree on objectives, appropriate In financial inclusion, DFIs have demonstrated that metrics, and assessing progress. Unless the investors the risk associated with financing MFIs is lower than have explicitly agreed among themselves on market previously perceived, thus attracting more private development or other objectives and can give clear capital to the sector. Now that private capital has been guidance to the board, it can be extraordinarily crowded in, DFIs seem well positioned to contribute difficult for board members to resolve these issues to filling the gap in supporting the next generation on their own. This can be particularly tough in scaling of market innovators. A few DFIs are supporting investments, when a new, less developmental innovation with DFS through equity investments. They investor joins an existing shareholder group that often invest in early/growth stage companies that may not share the same vision for the institution. already have an initial track record with an investment size of $2 million to $5 million. Although they often A closely related question is to define the appropriate provide patient capital, their incentive structure balance between what is good for the investee and doesn’t encourage a higher risk appetite to invest in what is good for the market; important trade-offs such seed and early-stage companies, and they are prone as time and financial resources need to be discussed to disburse larger amounts of money either with large and agreed on. An example of a governance challenge direct investments or through funds. is provided by a board decision that the company’s CEO should create and lead an industry association to DFIs could develop other investment structures that contribute to the market’s development. This decision better suit the needs of innovative businesses. They raises questions about how to estimate the various costs and other large direct investors, for example, could to the company’s business and the potential benefits create innovation investment labs similar to that of from the industry association, so that the trade-offs can 9 be assessed. The board should also consider how it will will inevitably suffer. There is also a disincentive for assess the CEO’s success in creating the association early exits, even for successful investments, because and what it would do if the CEO were not successful. the fund’s fee structure is based on assets under Achieving agreement on these types of issues can be a management. A related question is how to time an significant challenge for a board of directors. exit when there are attractive financial returns and disappointing impact performance or vice versa. Governance is such an important leverage point that it is important for equity investors to try to agree Many funds have flexible maturity dates in practice, among themselves on their objectives for the investee because investors can extend the life of a fund. But this and provide a clear mandate for the board. This also creates a shrinking management fee for a fund would include their expectations for how much and with only a few remaining investments. Adaptations in which ways the investee should seek to contribute could be made to the fund structure to facilitate exits, to market development for financial inclusion; such as establishing longer-term and/or more flexible these expectations could also be embodied in a fund maturity dates to give fund managers more time shareholders’ agreement, as well as requirements for to work productively with their investees. reporting on financial inclusion initiatives and results. Shifting the focus on investor returns from exit to Exit: Often Deciding under ongoing dividend payments could be another approach Nonoptimal Circumstances to help with the exit decision. This model would reduce the pressure on exits and provide investors with more Exits can have an enormous impact on the investee time to work with their investees; although, it would and market development, and yet they are typically also reduce the ability of the investees to reinvest their the leverage point over which the equity investor profits for the benefit of their clients.14 has the least control. The optimal exit from a market development perspective is one in which the new investor That said, even if an investor has the possibility is committed to the investee’s mission and contributes or flexibility to work with its investees within a new resources, such as funding, experience, and ideas, longer time frame, staying too long can crowd to the next stage of the investee’s development. out potential new investors. The decision to work with investees for longer terms requires careful But when to exit can be a challenging decision. The balancing among what is needed for the business ideal timing is when the investor concludes that its and encouraging investors to enter a market. objectives have been accomplished, there are suitable buyers, and market conditions are appropriate Another challenging exit decision is to whom to sell for obtaining a fair exit price. These conditions do the shares. Social investors often put considerable not always correspond with the time frame for the effort into ensuring their right to select responsible investment and can result in exits that are not optimal buyers and sometimes require commitments from the for the investor, the investee, and/or the market. buyers to support the investee’s mission.15 However, if the choice of buyers is limited and there is no The private equity fund structure is a factor that can timing flexibility, the investor’s options are limited as affect the timing decision. Although these funds often well. Public listings are a potential solution for large have extension options, the deadline for returning investments in countries with developed securities funds to the investors creates a maximum investment markets, but these conditions are rare. Such exits also term. If a fund’s maturity date coincides with create challenges of their own related to the dispersed negative economic conditions, its exit possibilities ownership structure and the impact on governance. 14 For a summary of an ongoing project to research the use of dividend payments and other approaches for achieving liquidity see de Callejon and Campbell (2015). 15 Potential buyers can sometimes be discouraged by the right of first refusal conditions that investors sometimes use to protect themselves from sales by another investor to a buyer that is not acceptable to the remaining investors. These conditions can have the unintended effect of discouraging attractive buyers (as well as unattractive buyers) who do not want to go through an entire due diligence and negotiating process only to learn at the end that some of the existing investors will exercise their first refusal rights. 10 Finally, if an investor sells to a buyer who does not their resources to outsource market research. Not only share the objectives of the other investors, it can would this reduce research costs, but it also would give create a challenge to maintain the initial mission of investors a shared information base for consultation. the investee. Tag-along rights 16 can protect existing Impact investors could also commit to sharing investors from having to work with an incompatible new information about problems and lessons learned from investor, but they weaken the market demonstration failures. While this is sensitive information that has and crowding-in impact of the investment. A right of to be managed carefully, the market development first refusal option could turn out to be impractical if 17 benefits of sharing the information could be extensive. the potential new investor is able to pay a higher price than an existing investor can afford.18 Engaging with regulators and policy makers can also make important contributions to market development. Looking Ahead While individual investors often lack the time or resources to do so directly, and their efforts to do so The practical potential for impact investors to use can be perceived as self-serving, coordination can help their leverage in ways that result in more inclusive bring together the collective views of investors and financial markets is exciting and capitalizes on ensure that their practical experience is shared. their experience working with individual investees. However, to ensure effective implementation, As referenced earlier, Caspian Impact Investment additional work is required to overcome the Advisers was able to leverage the work that FSG/ challenges discussed in this Focus Note. We see a MIM started in 2006 to test the investee market for number of specific areas that warrant further efforts. affordable housing in India. FSG/MIM worked closely with key stakeholders, including donors, investors, Coordinate with Other and over 600 housing developers, to develop and Investors and Stakeholders promote the concept.20 With growing interest, FSG/ MIM helped the first developer get started, including Markets are in constant flux and impact investors don’t selecting a site and incubating an affordable finance necessarily have the adequate capacity and physical mortgage provider, among other initiatives. In parallel, presence to understand and respond to changing Caspian raised funding to invest in this sector through needs quickly. Therefore, the more stakeholders its India Financial Inclusion Fund. It made several coordinate by sharing information and working investments, including in the company incubated cooperatively, the greater the likelihood of success. by FSG/MIM, to provide mortgages to low-income The ideal scenario is for stakeholders to create a borrowers and played an active governance role. collective view about financial inclusion impediments FSG/MIM eventually worked with the government and a shared commitment and plan for resolving them. on housing policy issues and publishing state-of-the sector reports to share industry information; Caspian In cases where this scenario is not feasible, a less has consistently contributed to these reports and demanding but also important form of coordination shared its views on affordable housing policy issues. is information sharing. This could be done through The work of FSG/MIM, Caspian, and others to develop existing structures, such as industry associations, the affordable housing market in India has had a country- or market-level facilitators, 19 or by working positive impact. More than 80,000 low-income homes closely with other impact investors. A practical example have been purchased in India. Not only have several of of information sharing would be for investors to pool Caspian’s investees attracted second round financing 16 Tag-along rights give a minority investor the right to join the transaction and sell his or her minority stake in the company when a majority shareholder is exiting. 17 The right of first refusal permits existing investors to acquire shares before a third party buys them. 18 One topic that merits further consideration is the incentive structure for investment advisers who manage the exit process, which is typically related to the final sales price. This compensation structure clearly provides incentives for the adviser to focus on price at the potential cost of other factors, even if the price is not the seller’s primary concern. 19 An independent actor that is close to the market and thereby able to monitor market developments on an ongoing basis. 20 FSG/MIM’s work is described in Koh, Hedge, and Karamchandani (2014). 11 Box 2. Tracking indirect impact Impact investors have been focusing on measuring knowledge that can benefit the market and have the development impact of their investments to potential spillover effects. ensure accountability and to track progress. Important Accion Venture Lab is currently experimenting with milestones have been recently achieved with the several approaches for tracking indirect impact of creation of social performance metrics (e.g., Impact its investments in start-ups and creating information Reporting and Investment Standards, Global Impact to contribute to a sector-wide discussion about this Investment Rating System, Social Performance topic. These approaches include the following: Indicators for Microfinance, etc.). Investors are able to report on the direct social impact of their investees, • Defining alternative pathways to scale, by such as the number of women or low-income highlighting the first mover’s role in a final successful households served by their investees. outcome. Yet, another form of development impact deserves • Making efforts to raise awareness and monitor further attention by investors: indirect impact of “buzz” to measure awareness and influence. firms that can have ripple effects on the market. • Focusing on the sector as well as the firm, by Kubzansky and Breloff (2014) have identified three measuring sector-level outputs in addition to indirect impacts: (i ) inspiring copycats, (ii ) generating firm-level outputs and laying the groundwork for a competitive response from existing businesses, understanding the possible links between them. and (iii ) focusing attention on previously unidentified • Tolerating different data at different innovation market shortcomings. stages, because impact will be reflected in different The challenges with these indirect outcomes are that ways throughout the life of a project: for example, a they often are unpredictable and difficult to discern start-up going from no clients to 1,000 may suggest even after the fact. However, if they can be identified, a bigger impact than a larger firm adding 1,000 they can also create opportunities to generate customers. Sources: Kubzansky and Breloff (2014) and Breloff and Khosla (2014). from new investors, affordable housing finance in can also collaborate with specific providers to India is now perceived as a market with potential. ensure that their services better respond to needs and providers are able to monetize their offering. Collaborate to Strengthen Market Infrastructure Develop Market Development Metrics Although the specific characteristics of infrastructure Measuring impact is one of the biggest challenges investment can make it impractical for many impact when it comes to embedding market development investors, market infrastructure is too important for objectives into equity investment strategies. Impact the sector as a whole to ignore. Those that cannot investors need not to be clear on what market impact invest directly should seek other ways to ensure they are seeking to achieve but also on how it can that the appropriate infrastructure is created. be measured and analyzed to determine whether a specific investment decision really did contribute to These activities may include working with industry a market development outcome (see Box 2). associations to identify infrastructure needs and bringing these needs to the attention of Given the challenges associated with measuring the appropriate actors. DFIs could consider the impact of individual investees, assessing market- example of the International Finance Corporation level impact is more complex. Nonetheless, there (IFC), which has fostered the development of credit are emerging efforts to define broader market-level bureaus and collateral registries by providing measurement principles and standards, and investors advocacy, grant funding, and expertise.21 Investors can benefit from and contribute to these efforts.22 21 For information on IFC’s Credit Bureau Program see http://www.ifc.org/wps/wcm/connect/REGION__EXT_Content/Regions/Sub- Saharan+Africa/Advisory+Services/AccessFinance/Credit+Bureaus+Program/ 22 CGAP is currently working with funders and industry experts to develop innovative and more complete ways to measure inclusive market development. For more information see http://www.cgap.org/topics/impact-and-measurement. 12 Organizations Interviewed Fund Manager Compensation with Social and Environmental Performance.” December. Accion’s Frontier Investments Group Accion’s Venture Lab J.P. Morgan. 2014. “Spotlight on the Market: The Grassroots Capital Management Impact Investor Survey.” New York: J.P. Morgan, Omidyar Network 2 May. International Finance Corporation (IFC) Overseas Private Investment Corporation (OPIC) Koh, Harvey, Ashish Karamchandani, and Robert Katz. 2012. “From Blueprint to Scale: The Case for References Philanthropy in Impact Investing.” Monitor Group in Collaboration with Acumen Fund, April. Bannick, Matt, and Paula Goodman. 2012. “Priming the Pump: The Case for a Sector-Based Approach Koh, Harvey, Nidhi Hedge, and Ashish to Impact Investing.” Washington, D.C.: Omidyar Karamchandani. 2014. “Beyond the Pioneer: Network, September. Getting Inclusive Industries to Scale.” Deloitte Touche Tohmatsu India Private Limited, April. Breloff, Paul, and Rishabh Khosla. 2014. “Measuring the Indirect Impact of Market Innovators.” Stanford Kubzansky, Mike, and Paul Breloff. 2014. “On Social Innovation Review, 4 March. Innovators and Pinballs.” Stanford Social Innovation Review, 3 September. Burjorjee, Deena, and Barbara Scola. 2016. “A Market Systems Approach to Financial Inclusion: Guidelines McKee, Katharine. 2012. “Voting the Double for Funders.” Washington, D.C.: CGAP, September. Bottom Line: Active Governance by Microfinance Equity Investors.” Focus Note 79. Washington, Burnham, Bill. 2005. “Deal Flow Is Dead, Long Live D.C.: CGAP, May. Thesis Driven Investing.” Burnham’s Beat blog, 25 May. www.billburhham.blobs.com. Rosskamp, David. 2014. “Typology of Venture Investing.” 17 November. www.drosskamp.com. de Callejon, Diana Propper, and Bruce Campbell. 2015. “Innovative Deal Structures for Impact Rozas, Daniel. 2014. “The Art of the Responsible Exit Investments.” www.bluedotlaw.com/wp-content/ in Microfinance Equity Sales.” Forum 9. Washington, uploads/2015/08/ProjectSummaryApril2015.pdf. D.C.: CGAP and Center for Financial Inclusion. El-Zoghbi, Mayada, and Kate Lauer. 2013. Shahnaz, Durreen, Robert Kraybill, and Lester “Facilitating Market Development to Advance M. Salamon. 2014. “Social and Environmental Financial Inclusion.” Focus Note 86. Washington, Exchanges.” In Lester M. Salamon, ed. New D.C.: CGAP, October. Frontiers of Philanthropy: A Guide to the New Tools and Actors Reshaping Global Philanthropy GIIN (Global Impact Investing Network). 2011. and Social Investing. New York: Oxford University “Impact-Based Incentive Structures: Aligning Press. No. 104 April 2016 Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org The author of this Focus Note is Estelle Lahaye. The author who shared their own experiences and insights. The author would © CGAP, 2016 would like to thank Gail Buyske for her important contributions also like to thank the following colleagues who reviewed the to the paper, including her thought partnership and support Focus Note and provided invaluable input: Mayada El-Zoghbi, throughout this project. The author would like to thank staff Frederik Jan van den Bosch, Deborah Drake, Louise Moretto, at IFC, Accion’s Frontier Investments Group and Venture Lab, Kate McKee, Olga Tomilova, Erin Scronce, Anna Nunan, and OPIC, Omidyar Network, and Grassroots Capital Management Barbara Scola. The suggested citation for this Focus Note is as follows: Lahaye, Estelle. 2016. “Leveraging Equity Investments to Build Inclusive Financial Markets.” Focus Note 104. Washington, D.C.: CGAP, March. ISBN 978-1-62696-076-3 UKa from the British people