October 2012

INSIDE VIEW: If the shoe fits…

ShoesSocial impact is no longer a business constraint, it is an objective. The European Investment Fund’s Uli Grabenwarter discusses the implications. Earlier this year, Luxembourg announced its project to work on a corporate structure that, for the first time in economic history, creates a basis for for-profit investors and non-profit social impact-oriented investors to co-exist alongside each other as equally valued funding sources of a company. The landscape for corporate structures around the globe shows numerous attempts for creating corporate structures that suit the development of socially-oriented businesses. However, until today, the unease of financial markets and regulators in dealing with the social component of an investment has confined social businesses largely to the non-profit space. On one hand, investors were assuming that any deliberate social component in their investments comes at the expense of financial return. Public sector regulators, on the other hand, impose restrictions on profit distribution as they are organising the social enterprise sector. Or they impose restrictions on how social enterprises can conduct a commercial activity to prevent any abuse for unethically generating excessive financial returns at the expense of society’s disadvantaged groups. As a result, businesses in the social sector often start as non-profit organisations and, as their activity scales up, have to look for alternative for-profit structures to continue. This is often associated with high legal structuring expense. Not so the project that Luxembourg is working on. There is a perspective for a corporate structure that, from inception, allows for the co-existence of for-profit and non-profit shareholders within the same balance sheet. More importantly, in the intended regulatory framework of this structure, non-profit and for-profit shareholders of a social business mutually depend on each other. Non-profit shareholders need the capital of mainstream investors to scale their business in pursuit of social impact; for-profit investors depend on the achievement of the company’s social impact objectives to materialise their financial return targets. The envisaged corporate structure requires the compliance with the company’s social impact targets as a precondition for the pay-out of any dividend to investors. Any company eligible for this needs to have a social purpose at its core, have predefined quantifiable social objectives, and have the achievements against these social performance targets monitored and audited yearly. The question no longer is whether a company is for-profit or non-profit, but rather how it can achieve best its business purpose, which is to generate social impact. But the biggest breakthrough is the paradigm shift this development brings to the reasoning of financial markets. Financial markets have been criticised after the start of the financial crisis for disregarding the needs of society by placing individual wealth aspirations above the sustainability of our socio-economic system. While this is not unfounded, we need to acknowledge that the incentive for mainstream markets to consider their investments’ impact on society has been limited. Just as much as mainstream market logic favoured the mono-dimensional consideration of financial return at the expense of social interest, social impact-driven companies were equally mono-dimensional in not being able to propose investment models that allowed generating a financial return. In dealing with the fall-out of the financial crisis our creativity needs to increase: if in the beginning of the financial crisis we have taken market developments as another occurrence of built-in cyclicality of financial markets, we have come to the conclusion that this is not about a prolonged bear market but facing systemic issues and systemic change. Our concept of profit generation of the past, which through leverage merely has borrowed value from future generations rather than effectively creating value, is no longer sustainable. Equally, philanthropists around the globe are gaining the insight that social issues are growing at a faster pace than the philanthropic resources available to deal with them. Both ends of the spectrum are, therefore, facing an issue of sustainability, even if it is for diverging reasons. The common denominator is sustainability: of financial returns on business models that ensure the sustainability of our socio-economic system. That is at the core of impact investing, which is not about replacing philanthropy. Philanthropy will always be needed to address issues of society that cannot be solved with market models. Mainstream for-profit investors on the other hand will find in impact investing the perspective of sustainable investment models. Sustainability is the bridge between two historically opposed constituencies in the financial markets which suddenly became connected through the fundamental changes in the market logic. Social impact is no longer a business constraint, it is a business objective. Not only are businesses bound to figure in externalities in their production processes; at the same time, the biggest growth opportunities are observed in the sustainability enabling sectors looking at scarce resource management, energy efficiency and stakeholder value, which overrides the concept of shareholder value. Given the unprecedented macroeconomic conditions, it is increasingly clear that the future of wealth creation will be achievable by investing in the preservation of wealth first. If social impact is a business objective then its concept of being reserved for non-profit companies is obsolete. Rather, we will see the trade-off of for-profit and non-profit investments placed at the level of investors and their decisions. In the future, we will see patrons naturally invest in for-profit business models and for-financial-profit investors consciously investing in social enterprises. Investment performance will extend to the social impact performance of investments with far-reaching changes for our financial market logic: private bankers will become wealth coaches serving the values of their clients rather than fitting them to a predefined portfolio, companies will soon have an impact rating in addition to their financial credit standing, and asset managers’ performance fee will reflect non-financial performance criteria. These are three examples how increased accountability for the social and environmental impact of business activities will transform market logic. The question whether we will all become impact investors may soon no longer be a question of choice. It does not matter whether we consider social impact for securing our financial returns or for capturing new business opportunities, or because we simply care about the most disadvantaged parts of our society. In a world of limited natural resources, of increasing demographic challenges and of an increasing global transparency on unavoidable societal challenges, financial return no longer functions as an isolated concept for measuring economic success. Uli Grabenwarter is head of development, social impact investing at the European Investment Fund ©2012 funds europe

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