Both impact investing and traditional philanthropy are on the rise after the decade-long economic boom following the Great Recession. But when does an impact investment make a bigger difference than a grant?
The question is far more complicated than simply evaluating whether an impact investment can be profitable while doing good, suggests new research from Benjamin N. Roth, a Harvard Business School assistant professor in the Entrepreneurial Management Unit.
“This idea that you're increasing your impact by leveraging capital, that making investments rather than donations helps you reach more companies, that's too simple because it ignores the cost on the firms you’re supporting,” says Roth, author of the new working paper Impact Investing: A Theory of Financing Social Entrepreneurship.
Decisions on how best to support social and environmental entities can shift billions in capital. Today, annual impact investing—which seeks to further social and environmental causes as well as generate profit for the investor—tops $500 billion, with 69 percent directed at non-public companies, according to a 2019 survey from the Global Impact Investing Network.
Decisions on how best to support social and environmental entities can shift billions in capital.
Traditionally, philanthropic organizations make donations, not investments. Yet, some 41 percent of large foundations make investments, alongside their traditional grants, to further their programmatic goals. The Bill and Melinda Gates Foundation has made frequent use of investments in the form of “program-related investments” to support its social and environmental goals.
How can an entrepreneur trying to do good evaluate the best form of support to pursue?
Roth recommends those holding the purse strings consider these questions:
Is the organization’s cause worth subsidizing for the indefinite future? If yes, then a grant may be the way to go, Roth’s research suggests. In contrast, if the organization may one day reach a point where it will be sustained on its own revenue, and where it will no longer reinvest all of its revenue toward high impact opportunities, then an investment may allow the financier to reallocate funds to other purposes.
Does the company have opportunities to expand its profitability at little cost to its social mission? If yes, an investment may empower the firm to exploit these profitable opportunities, and the investor can channel the profits to other productive uses. In this sense, making an investment rather than a grant can help a firm more effectively combine its profit and mission motives and expand its total impact.
As an example, Roth uses Husk Power, a company he previously examined in an HBS case study, that provides prepaid power plans to poor urban and rural communities using energy derived from rice husks and solar power. Its model benefits both poor populations and the environment.
Husk thrives because of its base in both urban and rural areas. It also has a side business: turning the discarded husks into incense to create more revenue.
If an investor feels the cost of the stray business—the incense sideline for example—isn’t a good use of capital, then the impact investor can take the profit back and invest the capital elsewhere, perhaps in a different company. Another common reason to pull capital could be that the company’s management wants to take profit for themselves in the form of higher compensation.
Recycling capital
Making an investment rather than a grant allows financiers “to essentially recycle capital,” Roth says.
“When the companies you are supporting aren't going to put their marginal dollars to good use, you can take them back.”
Relative to donors, impact investors may also push Husk Power to grow its business and increase profitability. For example, if Husk Power were to raise its prices, it may generate more profits. If doing so would also exclude some of Husk Power’s most vulnerable customers, then a donor might discourage the move.
However, an investor (who is by definition a partial owner of the firm) places higher value on Husk Power’s profits. The investor may therefore empower Husk to make this change. By channeling these new profits to another productive use, the investor may expand Husk’s total impact.
Roth cautions that his analysis does not offer a complete view of the many ways in which investments and grants differ. Many subtleties will complicate the calculus of deciding whether an investment offers superior impact to a grant.
However, the analysis illuminates some of the core tradeoffs at play and, hopefully, will enable a more informed discussion about the role that impact investing can play in the broader philanthropic landscape.
About the Author
Rachel Layne is a writer based in the Boston area.
[Image: kertlis]
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