Last week, Ben Elberger wrote an insightful post about the need for more social impact investing on the equity side of the equation. There is certainly a need to find investment models that would attract mainstream commercial investors to the impact investment world. But there is another crucial bottleneck that Ben has not addressed: options to exit investments or obtain any sort of liquidity are extremely limited, if existant at all. As Next Billion wrote, “exits are a key component of a fertile ecosystem for any asset class. When exits are easy and lucrative, they act like a lightning rod for mainstream capital.” These limited liquidity sentiments were echoed at the Harvard Social Enterprise Conference by panelists from impact investors New Island Capital and the Acumen Fund this past weekend.
How can we solve this bottleneck? With HKS/HBS classmates Jane Silfen, Kunal Modi, and Sonny Kushwaha, we spent the last 2 weeks trying to do just that. We designed ‘The Social Liquidity Fund,” which is described in detail below. This is our proposal for the 2011 JP Morgan International Impact Investing Challenge, taking place on April 8, 2011. Any and all feedback is welcome.
Investment Objective: The Social Liquidity Fund (the “Fund”) is a new platform to generate both financial and social returns by providing liquidity and new exit opportunities for social entrepreneurs, impact investment funds, and social philanthropists.
Asset Class: Loans and Private Equity (up to 20%)
Fund Overview: The Fund will consist of a portfolio of debt and principal investments. The Fund will purchase high-performing, long-term loans from established impact investment funds and will also provide short-term loans secured by donor grants. Up to 20% of assets may be used for strategic investments in for-profit social enterprises, and up to 80% of the fund will be focused on emerging markets (“EM”). The Fund will charge management and performance fees, to be determined. The Fund’s own liquidity is enhanced by the mixed duration of investment vehicles, allowing the Fund to offer a shorter lock-up period—12-24 months, to be determined—than many other impact-oriented funds.
Social Impact Rationale: The Fund’s central investment thesis is that providing liquidity to enterprises with commitments already in place enhances social returns by increasing the operational capacity of early-stage impact investors. This is a win-win-win opportunity that maintains or speeds access to funds for social enterprises, frees early-stage investor capital in emerging markets to more rapidly and efficiently achieve development outcomes, and provides Fund investors with competitive returns. Increased liquidity may also attract mainstream lenders and venture capital to the impact investment space. The EM emphasis is driven by the opportunity for higher social returns and the belief that passive investing offers attractive risk-adjusted returns in an EM environment.
Market Opportunity: JP Morgan’s impact investing survey estimated current AUM of $2.5 billion. Private debt is the most popular instrument, with an outstanding notional value of $921 million. Despite the growth of early-stage impact investing vehicles, there are no other funds specifically dedicated to increasing liquidity and exit opportunities for these investments. Public offering of impact funds has been proposed as an alternate liquidity source, but listing is an onerous process, and may increase funding volatility, heighten exposure to macroeconomic risks, and encourage mission drift as focus shifts from social to shareholder value.
Investment Criteria, Selection and Due Diligence: The Fund will target high single-digit returns with an average investment horizon of 3-5 years. The Fund will purchase debt held by Global Impact Investing Network members with capital in excess of $10 million and who comply with IRIS disclosure, and will make loans secured by grants from private foundations with at least $50 million in assets. Minimum deal size will be $100,000; maximum deal size will be 10% of Fund assets under management. A precondition for debt purchases will be at least 3 years of prior compliance with financial and social obligations and assumption of prior loan terms.
Principal investments will be made on a strategic basis with preference for established entrepreneurs and enterprises operating in markets with precedence for social impact M&A activity and/or stable public equity markets. Minimum principal investments will be $1 million. The Fund will exclusively offer liquidity to established social philanthropies, impact investing funds, and their portfolio organizations.
For all loans and investments, the Fund will require access to information including, but not limited to, grant and loan applications, historical financial and social performance monitoring, current and projected financial statements, and legal documents.
Critical Risks and Mitigants: The Fund is uninsured and subject to losses due to Borrower and Donor default and principal investing losses. Primary risk mitigants are a 3-year minimum of long-term loan performance, minimum foundation and maximum loan size restrictions, and size restrictions on principal investments. The Fund also assumes the full spectrum of risks associated with emerging markets investments. These risks are primarily mitigated through diversification and investment size restrictions. The Fund may also utilize hedges to counteract currency and inflation risks. A 3-year minimum performance requirement provides a substantial advantage in emerging markets, where the Fund can extract a higher financial and social return without taking on the full risk profile of an early-stage emerging markets investor.
Monitoring and Measuring: A key aspect of monitoring and measuring is sustained involvement from the initial social investors and/or social entrepreneurs. The initial Lender will retain responsibility for social performance monitoring, with impact measured in terms of compliance with initial social return expectations. While meeting Donor requirements for disbursal will be a precondition for grant-backed loans, the Fund assumes responsibility for monitoring Donor compliance. Impact will be measured in terms of value added from accelerated funding. The Fund will assume responsibility for monitoring and measuring principal investments, and will report performance based on triple-bottom line accounting.
 J.P. Morgan Global Investment Research, “Impact Investments: An Emerging Asset Class,” November 29, 2010.