A natural destination

Category: Asia, Global
By Heda Bayron*

India’s impact investment sector is coming into its own

Impact investments are described as investments that are committed to generating and measuring a social and environmental impact alongside financial return. They represent an evolution of socially responsible investing, which historically was focused on avoiding socially problematic businesses (e.g. tobacco) rather than making a positive difference. A survey by J.P.Morgan and the Global Impact Investing Network (GIIN) released in May 2014 says global impact investment commitments are expected to increase 19% or by US$12.7 billion this year. South Asia and East and Southeast Asia are among the top three regions where investors say they will be boosting impact investment commitments. The survey respondents represent a total portfolio of $46 billion in impact investments, of which around 20% are invested in the two Asian regions.

India is considered a natural destination for impact investing, largely due to the enormous unfulfilled demand for social and economic services in the country. Intellecap, an India-based advisory firm focused on social enterprises, estimates US$1.6 billion of capital has been invested in more than 220 impact enterprises across India. In the past, impact investing in India has focused largely on microfinance, drawing international development finance institutions and large foreign foundations. In recent years, capital has flowed into other sectors such as agriculture, health services, energy, and education. Last year saw the launch of the first rupee-denominated impact investing fund put together by Incube, Charioteer, and Unitus Seed Fund, signalling greater domestic investor interest.

“India is extremely vibrant in this sector. As you know, India is generally an entrepreneurial place, but it is specifically an entrepreneurial place in social business and impact investing,” says Narayan Ramachandran, CFA, co-chairman of Unitus Capital, an impact investment-focused investment bank. He is a former head and lead portfolio manager of Morgan Stanley’s global emerging markets and global asset allocation teams and the US investment bank’s former India country manager.

Unitus Capital estimates that impact equity investments accounted for 23% of overall private equity transactions in India last year, worth US$390 million. Impact equity investments are expected to grow 30% this year. The financial services sector saw the highest deal activity, followed by agribusiness and healthcare. This trend is consistent with the J.P.Morgan/GIIN survey results, which showed that planned global impact investments going forward will target food and agriculture, healthcare, and non-microfinance financial services, in that order.

We spoke with Mr. Ramachandran about the potential of the impact investment sector in India, the challenge for entrepreneurs, and why social impact bonds may not be the best solution. The following is an edited interview:

What should investors know about impact investing? How is it different from investing in private equity, for example?

Narayan Ramachandran: There are similarities and differences. The similarity, of course, is that the principles and methods by which you investigate the investment are broadly similar to that followed in private equity (PE). The difference is that, one, there has to be substantial impact so as an investor you have to come with some interest in impact. I don’t think it works if investors are only interested in financial return as is the case for investors in venture capital. But if they are interested in impact of some kind then this type of investing allows the discipline of venture capital to apply itself on businesses that seek to better society in some way. But there is another difference, and this is that they may have to be more patient because impact investing is often much smaller in size certainly than private equity but possibly even venture capital, and because this is a new and evolving arena, there’s not a huge track record of exits. In standard venture capital or private equity investing, exits are made in the capital markets through IPO, trade or strategic sale or secondary sales to other PEs. While some of this has happened in impact investing, it is only just beginning. We don’t yet have a long list of companies that have been sold in subsequent rounds to different and new kinds of investors.

How would you describe the returns of the exits that you’ve seen so far in India?

The results we’ve seen so far, particularly in the microfinance segment, have been spectacular. They’ve actually beaten commercial investments. But that’s because the pricing structure of financial inclusion business models has permitted a return on assets of approximately 3% or more. Financial inclusion investments are often different from others because there’s a balance sheet involved. If the balance sheet gets funded and is successful, then typically it will be quite impressive as indeed they have been in microfinance. In, say for example, SKS [Microfinance], Equitas, and Janalakshmi, the original impact investors have exited with cash-on-cash multiples that range from 5x to 20x.

Operating impact businesses have really only been invested in over the last five-to-six years. There, the record is a little sketchy. Not sketchy in the sense of poor returns, but because they have not had the time to become mature businesses that allow exit.

Development financial institutions have traditionally funded these areas. Where does capital for impact investing in India come from?

It’s not entirely true that only development finance institutions funded microfinance. For instance, private players did fund microfinance even as early as ten-to-12 years ago. I really think we have to separate microfinance from this because it is an industry that is now debatably ten to 12 years old and therefore, has gone through the cycle of development funding, then private equity and then exit. In the other areas, everything from dairy farming to healthcare, development finance institutions after 2008 have been rather lethargic. So in the last five years all of the ones I’m talking about have only, by exception, been funded by development finance institutions. They have been funded mostly by dedicated players in impact investing. I would say, if you have to characterise non-microfinance investments [over the past five-to-seven years], the source of the money has been predominantly European, from all three categories: institutions, family offices, and ultra-high-net worth individuals, and primarily through dedicated impact investment funds or through intermediaries such as Unitus Capital in Asia.

Have you seen financial innovation happening in impact investing – in deal structuring, for example?

It’s too early for that. If you’re talking about structuring of these equity deals, they haven’t gotten ultra sophisticated and I actually think that’s positive rather than negative. The principle has been, let’s invest and let’s make sure the business succeeds. Success is measured both by the ability to execute the business plan, and to grow large enough and interesting enough for an exit. The debt market in emerging markets is very regulated, and therefore, with debt, in a structure or otherwise; entering into these markets has been complicated. India, for example, has very strict entry-exit regulations for debt and therefore, anybody who does debt has to come through very specific gates. This has restricted the full flow of innovation. Some development financial institutions like the Overseas Private Investment Corporation (OPIC), which have their own restrictions, have created some onshore, offshore structures that facilitate the movement of money but that’s more again a way to comply with regulation rather than anything that’s fundamentally helpful to the investment itself.

What are the challenges for investors?

Not beyond the normal. I would say there’s very little difference in the challenge of investing in regular private equity versus impact investing. The biggest challenge is the market/ business plan challenge, which is, if you invest in something, can it grow big enough and profitable enough for you to have a range of exit options? Because any return to the shareholder must eventually mean exiting the investment, even if you allow for a longer period for which the investment is held. Opportunities for exits can come from growing the business large enough for regular folks to be interested in and maybe having a special way of transacting these investments in such a manner that a price can be discovered, even when you are halfway through the process.

How can impact investment attract more capital?

The issue is, at the moment, you have something like this (impact investing) and it acquires an ecosystem, jargon, and complexity of its own. That really doesn’t serve a purpose. I think the challenge is; we don’t need a complex carving out of impact investing. We need impact investing to coexist with regular investing.

The support of impact investing around the world needs to come to small businesses in such a manner that they are helped, facilitated and nurtured to grow into bigger mainstream businesses rather than create a large impact business, which mainstream investors are not interested in. A different way of saying it is that impact investing is not a parallel path; it is a stepping-stone to mainstreaming a particular kind of investment.

And therefore, I actually think the idea of social impact bonds is less useful than the idea of equity, because equity is risk capital. If you give social impact bonds, what you’re saying is: “You take the risk, I’ll give you the fixed-income structure”. And that’s unhelpful to any small firm, but particularly to small firms trying to mainstream themselves from the impact sector. In the US and the UK they have spoken about that as one major solution. In really targeted and specific areas such as affordable housing it could have value. One of the recent businesses that Unitus raised money for was a low-cost eye examination company that produces devices that give you a three-in-one check of your eyes. I don’t see much value for a social impact bond in something like that. They need equity to make their device cheaper and to market in other emerging markets.  

* Heda Bayron is a communications specialist at CFA Institute in Asia Pacific.