A Guide to the Different Forms of Impact-backed Finance
by Marta Maretich, Chief Editor @mmmaretich
Impact investors have put capital behind mission-driven finance providers since the earliest days of the social investing movement. Now the industry has grown and diversified to offer a wide range of finance provision models and approaches for investors to back.
Microcredit was one of the earliest forms of social impact finance and it remains one of the best known. The idea of lending as a way to improve the lot of the poor goes back to the origins of finance, but its modern version was crystallized in the 70’s when early advocates like Muhammad Yunus began to experiment with using finance provision as a tool to lift communities out of poverty.
Microcredit involves making small loans available to poor people, especially those traditionally excluded from access to bank loans, through programmes designed to meet their particular needs and circumstances. Loans are usually small and short-term. Collateral is often replaced by a system of collective guarantee groups whose members are mutually responsible for ensuring that loans are repaid. Alternatively, borrowers may find one or two personal guarantors. Often these are respected local community leaders.
Microcredit is designed to give borrowers an alternative to traditional informal forms of credit such as moneylenders, pawnshops, loans from friends and relatives. Crucially, it’s designed to keep vulnerable borrowers out of the clutches of exploitative lenders, such as loan sharks.
In important ways, microcredit is the mother of the diversified social investing sector we see today. Many of today’s leading social investors, including Ashoka and Accion, cut their financial teeth on microlending, using philanthropic money to establish lending programmes as a way to further their social missions. Microlending sowed the seeds for what has become an explosion of social investing innovation as more and more organizations turn to finance provision as a way to extend their reach and multiply their impact.
The term microfinance can refer to a range of financial services including loans, credit, savings, insurance, money transfers, remittances and other financial products.
In the field of social investing, these services have traditionally been targeted at poor and low-income communities, often in emerging markets, with the aim of making them affordable for people who don’t have access to mainstream providers. Many microfinance institutions have developed their models to combine philanthropic support with finance, providing capacity building grants, training and market-building activities along with capital and credit.
According a recent GIIN/JP Morgan survey, this picture of microfinance is still fairly accurate, but it is changing fast. Increasingly, for-profit finance providers are entering the sector in places like India and sub-Saharan Africa and the practice of microfinance is being rolled out in to serve customers in developed countries, too. This suggests that the microfinance model is both flexible and sustainable, and that it can be adapted to encourage a variety of beneficial outcomes in many different contexts.
Microfinance is not without its critics. There are those who feel that it threatens traditional philanthropy and fails to recognize the complex causes of poverty. Recent years have seen cases of fraud in the microfinance world: in 2011 an international scandal in the Indian microfinance market threatened to discredit the burgeoning industry. All this has led to calls for better regulation by national governments and sparked efforts by the social investing sector to establish standards for responsible microfinance practice.
Nonetheless microfinance has seen a real boom in the years since early adopters began to branch out beyond microlending and there are signs the industry is maturing. The Microfinance Information Exchange (MIX), on online a platform, now collects and validates standard financial, operational, product, client and social performance data from institutions across the globe.
Meanwhile, microfinance continues to gain popularity and attract new players to the marketplace with commercial banks like Citi now getting involved. This makes sense, since some of social finance’s greatest success stories are now coming out of the microfinance sector in the form of a string of profitable exits for impact investors like Bamboo Finance, Triodos and Lok Capital.
Just as microlending led to microfinance, microfinance has paved the way for what might be called growth finance. In growth finance, providers offer financial services resembling those available through mainstream financial providers to customers in underserved markets. For example they may make bigger, longer-term personal loans or provide commercial credit facilities to growing businesses. In each case, services are structured in a way that makes them accessible and affordable to the client base.
Growth finance recognizes the fact that certain market sectors, especially those in poor communities and emerging economies, still don’t have access to mainstream finance even when they rise above the rock-bottom base of the pyramid. While microfinance is well equipped to meet the needs of the very poor, growth finance offers a way to support individuals and communities as they increase in prosperity and build more robust economies.
Growth finance also offers a way to extend vital financial services to impact businesses as they scale up and face the challenges of what’s been identified as the “pioneer gap“; the tricky mid-stage of growth where philanthropic financial support dries up and mainstream support remains out of reach. Recognizing this, many active microfinance institutions are extending their services to offer growth finance options to their markets. For example, seasoned social lender Root Capital is now preparing to offer more loans as well as larger, longer-term loans and other services to meet the changing needs of their rural client base.
The goal of impact is, of course, to build businesses and markets that are robust enough to one day attract finance from mainstream providers. Recent exits offer some evidence that this is already happening: Leapfrog, an impact investor in financial services companies in Africa, recently sold its stake in the Ghanaian company Express Life to FTSE 100 company Prudential.
This exit is another promising sign that the impact model can deliver, yet there is still much work to be done before all global markets have access to finance through mainstream providers; and some may never get there. For this reason, impact investors continue to play a key role in capitalizing businesses that offer the right kind of financial services for developing markets and underserved communities. But what does the future hold for impact investing in financial service providers?
To find out, see part three of this series: The Future of Investable Social Finance. Or read part one, Why Finance is (And Always Has Been) an Important Sector for Impact Investing.
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