By Uli Grabenwarter, Head of Strategic Development-Equity at the European Investment Fund
Social impact investing has made it to the forefront of the debate about financial markets and how they can more responsibly serve the sustainable development of society. In June 2013 the G8 Summit in London identified impact investing as a possible means to overcome major societal challenges at national level, in dealing with the aftermath of the global financial crisis, and also as a means of addressing global social disparities.
The emergence of impact investing has set in motion actors along the entire chain of social action, from philanthropists to charities and foundations to social sector organisations, NGOs, public sector actors, social sector financial intermediaries and asset managers and, last but not least, the emerging community of social enterprises.
At the core of the debate among those various stakeholders is no longer the question of what precisely is to be understood by social impact investing, even if differences in the definition of this market space continue to exist. Consensus has emerged that social impact investing seeks to realize concrete societal objectives and requires transparency and accountability from the various actors along the social value creation chain.
Impact metrics that drive decision-making
The debate has therefore moved on to the means of ensuring transparency and accountability, which ultimately converges in the requirement for meaningful social impact metrics. Also in this area of impact measurement, substantial progress can be noted despite the still prevailing disagreement on specific impact metrics to be used. Whatever system and metrics approach is taken, stakeholders increasingly agree that the relevance of performance indicators for a specific social action must not be sacrificed for the sake of a pretended comparability or aggregation of social impact performance across various projects, activities or sectors.
An important sign of the progress in this debate is reflected in concrete examples where impact metrics go beyond being mere tools for transparency and become genuine drivers in economic decision-making and the related distribution of financial value:
- First investment vehicles have been launched where the financial performance incentive for the investment manager is linked to social impact performance metrics alongside the financial performance;
- New corporate structures that link the pay-out of dividends to shareholders to the social performance of the business have entered the legislative process;
- And an increasing number of payment-by-results structures such as social impact bonds are using social impact metrics for defining the payment streams between a commissioner of social services, the executing social sector organisations and an investors community providing the funding.
Moving on from metrics to pricing social value
This extended use of social impact indicators in the economic decision-making and performance-monitoring process has revealed a new dimension that so far has not been addressed in a conclusive way: the pricing of social value.
If social action moves away from a philanthropy-based funding approach (where impact metrics at best serve the monitoring of efficient capital allocation in pursuit of a given social goal) and enters the space where social impact becomes the substance of economic trade, the question of how to attribute economic value to social impact becomes central.
The debate on this topic has so far been largely avoided. Social-impact-inclined stakeholders such as philanthropists, charities and foundations have dodged it, possibly because it feels ethically uncomfortable to attribute financial value to social benefit. The basic assumption in a socially focused mind-set is that social value is beyond the notion of money.
On the other hand, stakeholders seeking the benefits from social service delivery (such as commissioners of social impact bonds) were happy to avoid a debate on the pricing of social value because doing so resulted in cost savings, offering an easy and not to say cheap way to propose social value in lieu of financial return to investors investing for social purpose. Under the pretext of a new form of investment return concept, investors were invited to look at the combined return of social outcome and financial profit rather than just at financial profit alone.
The true cost of failing to price social value
This thinking may well be what we aspire to in terms of a new financial market logic, but in order to arrive at this ideal, it must be accepted along the entire social value creation chain. If one looks at the cost structure of payment-by-results instruments, for instance, it cannot be ignored that the financial return component paid to investors in social impact bonds issued to date is marginal compared to the fees incurred for the structuring, placement, monitoring, performance management and other costs associated with these instruments.
It is strange to observe that investors in the social impact space are urged to look at their combined return aggregating social and financial value creation when other stakeholders in the ecosystem still refuse to do so.
How else can we explain that the pricing of social value used in social impact bond structures is still almost exclusively based on the cost structure of the social sector organisation delivering the underlying social service and largely dismisses any fair financial return expectations of investors funding such activity?
The viability of a social impact bond structure, at least from the perspective of the public sector commissioner, is still predominantly judged on the cost savings potential for the state budget rather than on the social value it creates. Isn’t it counter intuitive that we accept it when “traditional” markets trade goods and services at their market value (rather than at a price equivalent to the cost incurred by the supplier) yet fail to apply a similar value-based logic when contracting social goods and services?
A cynic might say that public sector commissioners who adopt such cost-based approaches are looking for investors who are ready to submit to double taxation. Having paid a first layer of tax on income with which the public sector was supposed to provide a given social service in a welfare state context, investors then shoulder a second layer of tax by incurring an opportunity cost in being asked to forgo an appropriate risk-adjusted return on their investment. If that’s the case, the approach is not only questionable from a political point of view, it is also potentially counterproductive to the development of the social impact investing space.
Finding new alliances between the public and private sectors
With the fallout from the financial crisis affecting state finances, it has become clear that the concept of the European-style welfare state cannot be upheld in its pre-crisis shape. If we want to maintain the concept of community solidarity we must find new alliances between the private sector and the public sector in the delivery of social services.
This shift in social service delivery requires a new understanding of the various stakeholders in their respective roles, including that of the public sector. The public sector can no longer be a tax-funded provider of social services but needs to embrace a new role as a market participant in a social impact market. Being a market participant, however, requires that public service commissioners move beyond considering only the cost of a good or service and instead accept the idea of paying for its value.
Of course, the debate about what exactly is the value of a social service is ongoing, as is the debate about what counts as a “fair” return for social impact bond investors. But the principle must be accepted that (i) execution risk, (ii) the risk on outcomes and (iii) the funding of social services must all be taken into account when determining the return structure of social impact focused financial instruments. In other words, if we accept that the cost of capital for a social sector organisation is part of the “production cost” of the good or service it delivers, linking this to common sense market logic can’t be too big a leap to take.
The benefits of pricing social value
It appears that the public sector hasn’t fully comprehended the spectrum of opportunities it can leverage by taking this step: By allowing social value pricing that enables a fair remuneration of investors in social activities, the public sector, through the superior efficiency of private social sector organisations, will unleash a great saving potential in providing social services. Additional economic and social benefits can also be realised by capitalising on the generally prevention-based approach of social sector organisations as opposed to the symptom-driven reactive approach to social issues in a public-sector welfare state approach.
But the strongest argument for the public sector to accept its new role is in the scaling potential for this new form of public-private partnership. Unaddressed societal issues grow at a faster pace than the philanthropic money available to cure them. Hence, new funding sources are needed to address these challenges. In the absence of new philanthropic resources and in the light of a virtually disappearing margin of manoeuvre in public finance, the future of our welfare state system depends on the ability to attract private sector investment into this space.
Such a shift is unlikely to happen by converting the institutional investing community into philanthropists. However, the increased consciousness in financial markets of the need for a social equilibrium as a prerequisite for economic prosperity offers an opportunity for a new economically sustainable welfare state concept. At this very moment there are important choices to be made by the public sector on how to assume its role at the interface of the key stakeholders in the social impact investing space. These choices will prove decisive for the scale of the social impact investment space going forward.
We have spent decades blaming the financial markets for their lack of responsibility towards society by mono-dimensionally focussing on financial return. Now that financial markets are finally starting to comprehend social impact as an integral component of economic life by accepting economic risks linked to social outcomes, we cannot respond to the dawn of this new market logic by an equally short-sighted and mono-dimensional attempt to shift responsibilities for no reward.
There is a wealth of insight to gain from impact investing when defining a new financial market logic if we stop procrastinating in the perceived contradiction between financial return and social value. If the wisdom of dividing financial return from social benefits has left us with the 2008 crisis as a result, we might as well take our chances and try an approach that seeks to reconcile the two going forward.
