OK, so Monday wasn’t very funny. I’m not sure today will be much funnier, but we’ll get there eventually.
Monday I stated that most of the things people expect out of a “real market” do not exist in adequate supply and diversity in most corners of impact investing. Today I am going to try to enumerate a few of the key pieces of infrastructure and why we don’t have much of any of them.
Let’s start with investment advisors. Building a portfolio of investments is hard work, one for which most investors have neither the time, expertise, requisite networks nor internal management infrastructure to do themselves. Doing it in impact investing, where you are trying to adhere to a specific set of impact parameters while picking through a small-ish and idiosyncratic set of opportunities? That’s even harder. So, almost everyone is going to need help. They need an investment advisory firm that has expertise in impact investments.
I have friends who run what I truly believe is the best impact-focused investment advisor in the world. Last time I checked, they had over $400m under advisement for 35 clients, each one of whom has a specific set of issues they care about and expect to have a portfolio that matches that issue set. But it’s tough work. Investment advisory work is traditionally one where you collect a bunch of assets and provide all of your clients similar products (tailored to their needs, but drawn from the same pool). By comparison, these friends of mine are providing custom mission specific portfolios and diligencing new products all the time for clients who fall into at least 5 (and probably more like 10) different issue areas. It’s a tough business to manage, because investors have set expectations about what they will pay for advisory services, and it is generally based on a percentage of assets. And those expectations are based on the high assets, low customization approach of traditional asset management. The standard is somewhere between 35 and 75 basis points. Now, take an impact adviser, one who will manage a relatively small mandate with a high level of customization. They still get paid a standard fee on an assets under advisement basis. So that $1,000,000 in that cool fund in East Africa? The one they found, flew 2 staff to Nairobi to meet with for a week, did 2 months of due diligence calls on and for which they now do quarterly investment reviews? They make $7,500 a year managing that (and that doesn’t include the work they did on the 5 funds they decided to not recommend). There won’t be a gold rush into impact advisory services any time soon, not unless the mandates get much larger, the product set becomes much more standardized, or people are ready to actually pay full freight for the services they receive. (By the way, some institutions do pay, many of them have been my clients, and but they are in the small minority, so I am within my rights to complain about everyone else for rhetorical effect.)
Now, if you look past this one firm, into a market where there are allegedly trillions of dollars already being deployed, there aren’t really any other credible shops in the US, past single-person operations that focus on a particular sector or work for just one client. This is a huge problem since, as stated here and earlier, most people and institutions new to impact investing are not ready to navigate it on their own. And don’t get me started on traditional advisors ability to serve this market. That’s a different post. Maybe Friday.
Now let’s talk about fund managers. A lot of my favorites in the impact space, like Core Innovation Capital, were born out of insights from people with deep domain expertise, people who have been working in a certain community or a certain sector. They see an opportunity to deploy capital in their market in a new way that can drive positive change and make a return for investors, so they start a fund. The problem is, usually they don’t have a track record, or at least not enough to appeal to large scale investors. So, they raise the 5 million or 10 million they can from impact investors to prove out the strategy. Fund 1 is underway! Good news, right? Well, sort of. The problem, once again, is that there is an established rule of thumb for what investors will pay a fund manager, a 2% annual management fee and 20% carry. That leaves our new fund with $100,000 to $200,000 a year which seems like a lot of money, but when you realize they have to pay 2 or 3 people and cover operations, back office and legal fees, it’s not that much. Now add to that the fact that they are pioneering a new area – one where they are invariably going to hit some twists and turn and unforeseen bumps in the road? You now have an undercapitalized entity that’s trying to innovate along multiple axes simultaneously, and that is a recipe for an unnecessarily high failure rate. Some people make it, but it feels like we’re setting most of these guys up for failure. Then we investors complain because they’re “not really institutional quality.” I have talked with various impact investors about systematically investing into fund management companies (as opposed to funds) to solve this capacity issue, but to my knowledge no one has done it yet.
So one last piece of middle ware worth talking about. In a mature market, the lives of investors, their advisors and those who are raising capital are made easier by firms that help structure investment products that meet the needs of both owners of capital and seekers of capital. They take a variety of forms, but I’ll call them deal structurers (You can also call them investment banks but that term has some well deserved baggage at the moment) There is a tremendous need, specifically in impact investing, for firms that work with people and organizations with deep domain expertise to develop investment opportunities that meet the needs and interests of impact investors, especially given the structural limitations mentioned above. However, you don’t see a lot of people moving into this market yet. Why?
Well, unfortunately, we are back to our old friend, scale. It can take 2 or 3 years to take an investment opportunity to market, 50% - 90% of what you are working on never comes to fruition, and when you get there it’s usually not a big enough deal dollarwise to make enough money to justify the time investment and all those deals that didn’t work out. There are a few boutique firms, usually a couple of people at a time doing the work because they love it, but there is a tremendous undersupply of this service in the market and I can’t help but think it has to do with the fact that it is hard to see a real business model at the moment.
So, what’s the answer? I realize this post is already pretty long and I burned through my 1 hour per blog post writing limit, so I’ll be coming back to it. In short, we need to admit that much of what’s going on here is sub-scale. We need to find ways to properly capitalize the businesses that are the connective tissue of the market. There are a number of ways to do this – the simplest is to decouple for now the return of the underlying investments from the cost of finding, structuring and evaluating them. If you want to invest $1,000,000 in a Ugandan mobile money business, it might cost you $150,000 to do it right. If you want and need highly trained professionals to do things right, pay them! If you don’t, then don’t. This sounds simple, but it is unfortunately common for investors to nickel and dime vendors on what are still sub-scale, specialty deals. This leads to existing firms cutting corners to stay in business on anemic fees or great people staying out of the business entirely. We can’t build a real industry until we solve this problem.
In another post I’ll suggest some ways to start getting after it.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.