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The “Missing Middle” and the Growth of Social Enterprises

Aleem Walji's picture

SOCAP (via amsterdam.wordpress.the-hub.net)Every fall at Social Capital Markets (SOCAP), the who’s who of impact investing and social enterprise convene in San Francisco to network and share stories about topics like market-based solutions to poverty, social stock exchanges, and just how much capital is waiting to be deployed to solve the world’s toughest problems. It’s inspiring to be sure, especially the growth in the number and diversity of participation. It’s no longer the sole domain of Ashoka, Skoll, and Schwab who have paved the way for so many others. Today, mainstream Banks from Europe to Asia, fund managers, and wealth advisors are sending a signal that doing good and doing well is a more enlightened form of capitalism.

But behind all the feel-good energy and promises that impact investing will be a $50 billion industry by 2020, there are gaps in the story line and challenges that we must confront as a community. First, there is no clear definition of an impact investor. The industry brings together those who are primarily driven by a financial bottom line (finance first) with those who are seeking to optimize a social return without making a loss (impact first), and finally grant makers who are aiming to improve the efficiency of philanthropic capital (largely foundations). Their world views are different, their expected returns are different, and how they use the same vocabulary (e.g. impact, viability, and sustainability) varies widely.

(via: blogs-images.forbes.com/rahimkanani/files)

The Need for Flexible Capital

Rather than seeing these three groups as adversaries, there is an opportunity to see them as allies. Early evidence suggests that even the most successful social enterprises (enterprises with a primarily social mission) require flexible capital in early stages. This capital is hard to source and requires time horizons of at least 5 to 7 years. Commercially viable enterprises wishing to reach last mile customers or test new business models often require concessionary terms to take such risks. And finally, enterprises providing public goods precisely because of government or market failure need access to public or philanthropic funding to plug holes in public service delivery systems. This last group is the least understood in my view. For Government, this is precisely where innovation is most needed and deploying the right mix of public and private capital and incentives can drastically improve the delivery of basic public services, particularly to the poor in underserved regions.

Conferences like SOCAP bubble with enthusiasm for market-based solutions aiming to generate above average, risk-adjusted returns and simultaneously serve the needs of the poor. Unfortunately, there is much more money chasing this category of deals than there are mature, finance-ready enterprises. But much can be done to develop a pipeline with targeted capacity building, mentoring, and the heavy lifting that many investors don’t have the time nor patient capital to support. Investor syndicates that are prepared to share origination costs, due diligence, and sequence capital according to business needs could do much to thicken this pipeline and accelerate deal flow.

Understanding Local Market Conditions

SOCAP Attendees - via: triplepundit.comTo illustrate, the Development Marketplace (DM) has supported social enterprises for more than a decade. The program has provided early stage seed capital to 1200 + enterprises globally with a pool of $60 million. Most social enterprises attest that this is the hardest money to place and without it they would have never moved beyond ideation. The challenge for Development Marketplace winners, however, lies in next-stage financing or growth capital. What happens when you’re ready to expand operations and reach more customers? You’re still off the radar of most banks and you’re too big for microfinance. Moreover, equity markets are nascent in most developing markets, and the type of capital you need generally requires investment horizons of 5 to 10 years. The few impact investors that do exist sit thousands of miles away, and probably don’t know you exist, and have minimum deal size thresholds that are much larger than the need of most early stage enterprises. Often, growing social enterprises need a combination of grant, debt, and equity, and crave insights from local business angels at least as much as capital.

Should this be surprising to anyone active in the parallel universe of commercial investing? Investors primarily source locally, find like-minded people to invest with, aim to reduce diligence costs, and seldom “fund and forget” their pipeline. Start-ups know that all money is not equal and want investors who bring attention and know-how as well as capital. Being situated 5,000 miles away from investments makes this difficult. Yet most impact investors do exactly that and know little of the underlying conditions in the markets in which they try to invest.

The Missing Middle

Increasingly, we are seeing branches of social investment funds open in Africa and Asia using local staff and seeking local syndicates who understand markets and how to mitigate risks, in addition to seeing opportunities where others see challenges. But there is much more to do. Social enterprises start small and can’t absorb the minimum capital sizes many funds impose. The “missing middle” is wide and the majority of entrepreneurs we’ve seen through the Development Marketplace need 50-200K to improve their financial systems, management team, governance, and business model. They need flexible capital and a variety of capital types. They would welcome repayable grants and convertible debt. They are starved of working capital and need better ways to smoothen their cash flow. And they are prepared to wean themselves off grants as they mature as enterprises.

DtM's Director of Product Development, Elizabeth Johansen, discusses Design that Matters collaborative design approach. (via: designthatmatters.org)Are investors ready to listen better to the needs of small and growing social enterprises? Do we as a community of investors see the disconnect between the supply and demand for capital in most of the developing world? If we do, we can figure out how to generate a more investable pipeline and use concessionary finance in more targeted and strategic ways. We can then differentiate between business models that are best suited for commercial investors, those that present opportunities for double-bottom line investors, and those that are suitable for governments to support as a means to increase efficiency in providing public goods to the poor.

The World Bank and its Development Marketplace program are primarily focused on this last category and is positioned to use competitions and in-country networks to surface innovations in providing public goods to poor populations. Rather than being concerned only with commercial viability, the DM is searching for delivery models that are financially sustainable, efficient in providing basic goods and services to the poor, and capable of scaling up to address systemic challenges in public service delivery. But it can’t be done alone. Solutions will require flexible capital from a number of public and private providers, replicable and/or scalable business models, and regulatory regimes that encourage rather than inhibit innovation in service delivery.

Comments

Submitted by Anonymous on
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This is an important piece, as it zooms in on the keyhole we need to turn to unlock additional support: blended capital mechanisms bringing $50K - $200K investments to recently 'ready' social enterprises. These are innovative firms operating in underserved regions who are too small for development bank funding and need some pre-financial development to become investor-ready. Investors need to gain confidence that these firms will be successful - then blend their capital support in a way that better aligns with the growth phases of the social enterprise. We collectively have some ideas... time to get to work -

Submitted by A Walji on
There is much we can do in this space and hoping the DM can help catalyze action. If we can build the infrastructure, perhaps others will use the roads to get more done for worthy social enterprises poised for growth.

Excellent article and one we'd echo very strongly here in the UK - seed grant funds available and a growing amount of social vc investment, but there's a serious gap in the angel space. At UnLtd we are experimenting through the Big Venture Challenge programme (@bigventurechall on twitter) to incentivise business angel investors to look at social venture prospects - through providing a top quality cohort of ambitious social entrepreneurs, due diligence the investors trust, and match funding to reduce the risks. It's looking promising - less than 2 months from announcing the 25 candidates, they are already drawing in new angel investors who have never made a social investment before. There is also work in the UK on tax and regulatory reform to incentivise high risk early stage social investment - including an NCVO working group led by John Kingston. Pipelines need to be continuous to work. Angels are a key part of a well functioning system.

Submitted by A Walji on
Glad to see that UnLtd is taking a lead in the UK in mobilzing Angels investors to support enterprises. We need to mobilize angel networks in developing markets as well. As John Kohler points out most early stage money to support social enterprises in developing markets is coming from Europe and North America. This trend must change if these markets are going to take-off. Local investors are much better positioned to support national enterprises. What can we do to catalyze local angels in Africa and Asia?

There is still a disconnect between rising entrepreneurs in the third world and first-world capital, no matter how well intentioned. We need more organizations that act as "bridges" for these capital flows. Kiva was only a leader of what need to be many organizations sourcing capital to entrepreneurs in need in the third world. And let's not forget, the purpose here is to solve the world's worst social problems, and make a profit too.

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