Do No Harm: Subsidies and Impact Investing
Part IV in Omidyar Network’s case for a sector-based approach to impact investing.
Priming the Pump for Impact Investing
Omidyar Network makes the case for a sector-based approach to impact investing.
In our third article, we highlighted the biggest gaps in capital supply for impact investing. While money is flowing reasonably well to “scalers,” where investors expect high financial and social returns, money is less readily available for industry infrastructure and for early-stage innovators—especially in markets that serve the most disadvantaged.
One of the critical and contentious questions that impact investors often face—especially when investing in early-stage innovators—is about the role of subsidy. When, and in what circumstances, is subsidy appropriate?
Investing in the Gray Space
Certain forms of subsidies are more controversial than others. It appears widely accepted, for example, that grant capital can and should be used to build industry infrastructure. Governments and foundations alike, for example, have regularly funded basic research in diverse fields such as agriculture and medicine.
What’s less clear is when and how financial subsidies—whether in the forms of grants or concessional debt or equity—should be given directly to for-profit innovators and scalers. The April 2012 Monitor report, “From Blueprint to Scale: The Case for Philanthropy in Impact Investing” describes the practice of giving grants to for-profit organizations as a classic approach for building the pipeline of inclusive businesses in challenging markets. We applaud the exhortation to invest earlier in the innovation lifecycle. But we believe it is also important to conduct a thorough examination of the risks and benefits of subsidy in these situations. We would also point out that the appropriateness of subsidy is strongly influenced by the nature of the market being served: subsidies may be necessary to kick-start firms serving the very base of the economic pyramid, but are less essential—and potentially harmful—when directed at firms serving those with significant disposable income.
Finally, it’s extremely important to note that subsidy is not the only way to kick-start for-profit sector development, even for lower-income consumers. At Omidyar Network, our focus on developing deep sector and geographic expertise frequently leads us to price risk differently than generalist or geographically remote investors. A high percentage of our investments are in businesses that we believe—against conventional wisdom—have the potential to generate strong financial returns. Such willingness to question more conservative perceptions of risk is a major way that impact investors can accelerate the growth of new industry sectors. And in many cases, this approach can give impact investors a competitive advantage in finding promising profitable new business models that don’t necessarily require subsidy.
The Risks of Firm Subsidy
Many strong market advocates cite the following potential risks of investing in a lower-returns business, whether with grants or with concessional for-profit capital:
1. Preventing a Level-Playing Field for Competition
In well-functioning markets, return-seeking capital will flow to the firm that develops the best value proposition and business model for its target market. This tends to ensure that the firms that serve their customers best will be the ones that grow. If one provides subsidized capital or grant capital to one for-profit entity, but not all of its potential competitors, then one risks undermining the discipline of the market, thereby destroying rather than creating customer value.
We directly encountered this question in our recent work on mobile money. We know of several instances where funders have tried to kickstart the sector by giving a large grant to one leading mobile money player but not to its competitors. Is this the right thing to do? Does it distort the market and prevent robust competition? Are there better ways to use subsidy—such as funding multiple players or investing in sector-wide infrastructure? We have ongoing internal debates on this topic.
2. Limited Direct Scale
Only highly profitable businesses, it is argued, will ultimately generate the cash flow and raise the capital necessary to scale up and have massive direct social impact. Low (or no) profit businesses may also be unable to attract the talent required to innovate and grow. Subsidizing a business with no prospects of operating at scale is therefore simply an inefficient use of capital.
3. Compromising the Promise of the Impact Investing Industry
Impact investing will succeed only if investors are able to demonstrate strong investment acumen and the ability to work constructively with entrepreneurs to grow strongly profitable, scalable businesses. If impact investing becomes the domain of low financial and low scale expectations, many may question the fundamental impact investing premise that businesses generating social impact also can earn strong returns.
The Positive Uses of Firm Subsidy
Of course, there are also circumstances in which the potential benefits of directly subsidizing a for-profit business may outweigh the risks. The following are counter-arguments to the risks described above:
1. Spurring Market Development
It is all fine and well to complain that subsidies may distort markets, but what if there is no market to distort? In some cases, subsidies are going to firms that are trying to create an entire new market and are willing to take risks that no other entity is willing to take. In general, the more disadvantaged the population being served, the lower the prospects for profitability and the lower the risk that a subsidy will be market distorting.
2. Catalyzing Other Models of Scale
While tapping commercial capital markets may make it easier for firms to scale and directly touch millions of customers, it is not the only way for for-profit organizations to contribute to impact at scale. As noted in the previous blog post, some firms will have their biggest impact by contributing to indirect scale. These firms can pioneer an innovative model that will be improved by subsequent actors who may indeed be able to generate strong returns. There are also firms that generate a low return but provide critical industry infrastructure. Investors who consider both sector value creation AND firm value creation, may find it catalytic to invest in these kinds of businesses.
Additionally, it is important to note that different firms have different capital requirements. Some “low-capital-intensive” firms, particularly those that make use of technologies such as the Internet and mobile, can scale on their own without having to tap commercial capital markets.
3. Creating a Pipeline for the Impact Investing Industry
It’s worth noting that many of the firms having the biggest impact on disadvantaged populations have indeed benefitted from some form of subsidy. According to the Monitor group, most of the businesses serving the base of the pyramid in India benefitted from subsidy in their early years. M-Pesa, the widely recognized innovator in mobile payments, was launched with a grant from DFID, the UK development agency. And microfinance, which remains the single most prominent example of a high social impact sector serving primarily the poor, benefitted from more than a billion dollars of subsidy before reaching commercial viability. In sum, in certain markets, there may be no chance of making impact investing a high returns business without first using subsidies to prime the innovation pump.
We would not rule out the possibility of a fourth scenario in which a socially impactful industry sector has a steady state in which there are medium returns and high impact. This, too, remains a subject for internal debate and perhaps fodder for a future blog post.
First, Do No Harm
At Omidyar Network, our ability to deploy all types of capital, from grants to commercial investment capital—and everything in between—has caused us to think carefully about what type of capital to use in which situations. We are reticent to invest in low returns businesses, lest that lead us down the path toward limited scale, sloppy investing, diminished expectations, and potential market distortion. Nevertheless, we do feel that there are instances when it is worthwhile to invest in a business even though it may be unlikely to generate a strong financial return. There really is no simplistic “yes” or “no” answer, but rather a complicated and nuanced set of conditions under which different types of investments can play a complementary role in sparking sectors. We think the impact investing sector would be well served if it moved beyond the simple “is subsidy good or bad” formulation and toward a more nuanced, inclusive and ultimately more impactful approach.
Generally speaking, the biggest determinants of whether we will consider below market returns tends to be the income level and size of the market that the entrepreneur is trying to serve. For example, in 2008, we made a concessionary equity investment in BRAC to deliver microfinance services in Liberia and Sierra Leone because they were serving a small, extremely poor, war-torn population. (We also gave a grant to their sister NGO that gives livelihood training to poor rural women to enable them to take advantage of the small loans they receive.) Not surprisingly, organizations providing goods or services to the extreme poor are much more likely to require subsidy than those serving the next level up.
Market distortion tends to be a bigger risk in large markets, with multiple players, serving relatively affluent populations. We find that impact investors can sometimes lump the vast majority of developing world customers into a very broad definition of “base of the pyramid” without appreciating the vast differences in disposable income and purchasing habits across segments. (There is an excellent overview of segmenting the BOP by Harvard Business School Professor Michael Chu.)
In sum, we believe that impact investors should adopt a “do no harm” credo with respect to the use of subsidies. Before subsidizing a for-profit firm with grants or concessional debt or equity, impact investors should ask themselves several questions:
1. Am I slanting the competitive playing field by favoring one firm over another? Even if there is only one incumbent, will a large grant dissuade others from entering the market?
2. If I do not expect market rates of return on my investment, do I believe that this firm can meet at least one of the following conditions:
- a. Scale on its own or with additional grant funding without needing follow-on rounds of commercial financing;
- b. Eventually refine its business model, so that it can tap commercial capital down the road;
- c. Create a significant demonstration effect, thereby advancing or even catalyzing an entire sector;
- d. Provide an important public good for the industry as a whole.
Innovative firms, whether supported by subsidy or not, play a central role in sparking entire new sectors for social change. But they do not always control their own destiny. Of course, government and politics have a critical role to play. A firm can win in the marketplace and still fail if it does not carefully consider the impact that it has—not only on its customers but also on entrenched economic interests and on the politicians who consider themselves to be advocates of the disadvantaged. And government also can play a hugely catalytic effect in creating entire new sectors. We turn to this issue in our next article.