22 February 2021
Private sector participants are increasingly joining their peers in the public sector in providing finance that marries impact with investment returns. Ranajoy Basu and Priya Taneja of McDermott Will & Emery explain
Environmental Finance: Let's start by defining our terms: what do we mean when we talk about social impact finance?
Ranajoy Basu, partner, McDermott Will & Emery: Broadly speaking, it is any structured financial solution which aligns with the implementation of the UN Sustainable Development Goals (SDGs), and which aims to create a positive impact, whether in environmental or social terms. So one bucket includes, amongst others, green energy, clean water, environment and climate change. The other bucket relates to, amongst others, social sustainability, health, education, skills and entrepreneurship. It involves either domestic financial solutions or, what we specialise in, global cross-border impact finance solutions. Delivering a positive impact (and related measurement and reporting) plays a central theme in impact finance transactions. The Operating Principles of Impact Management defines impact investing as "investments made into companies or organisations with the intent to contribute to measurable positive social or environmental impact, alongside financial returns".1
Crucially, the impact element is specifically measured and reported on so that the economics of the transaction are directly linked to the positive impact delivered. Confusingly, impact bond transactions are not necessarily bonds in the traditional capital markets sense: they are not debt instruments and, for example, they can't be traded (yet!). However, we do see certain jurisdictions, such as France, where impact bonds are capital markets securities. More recently, we have seen 'blended finance' transactions include (very effectively) a combination of grants and debt instruments.
EF: What does a typical impact bond transaction look like?
Priya Taneja, counsel, McDermott Will & Emery: Investors provide capital to an intermediary, whether a corporate or an NGO, which wants to make an intervention to create impact, such as educating girls by building schools in remote villages. The intermediary builds and runs the school (either directly or through third-party service providers), and the intervention and its outcomes are monitored – in this case, the grades achieved by the girls and/or general retention rates of the students over a certain time period – by an independent evaluator. The investors then earn a return based on the outcome. Investors are paid for success by Outcome Payers.
If the Outcome Payer is a government body, such a transaction would tend to be called a social impact bond, but if it's a charitable or philanthropic organisation, it would be called a development impact bond.
Examples include the alliance between UNICEF and the Education Outcomes Fund (EOF), aimed at delivering SDG 4, in setting up a joint structure in relation to an outcomes-based model for EOF's underlying education programmes in various jurisdictions.
Another is the Utkrisht Bond, which aims to reduce the number of mother and baby deaths by improving the quality of maternal care in Rajasthan's health facilities, the impact of which is intended to reach up to 600,000 pregnant women by improving care during delivery. This could lead to up to 10,000 lives being saved over a five-year period. The "Educate Girls" impact bond aims to improve learning outcomes for more than 20,000 children in some of the remotest parts of Rajasthan in India. And the International Commission on Financing Global Education Opportunity's establishment of a finance facility (the International Finance Facility for Education (IFFEd)) to enhance financing initiatives for education in low-income and lower-middle-income countries. In its initial phase, this innovative approach is estimated to unlock $10 billion in new funding for education from the international community.
EF: What sort of organisations have been tapping the market? What are they using impact finance for?
RB: The social impact market emerged from the development finance world, from institutions such as the World Bank, the Asian Development Bank, government agencies such as USAID and global foundations. However, it is encouraging to see that the sector is now attracting a very wide variety of participants from both the private and public sectors.
What has changed? Two things drive participants in the market. One is the SDGs. These involve some very ambitious objectives, which in many jurisdictions are backed by legislation – and it's no longer just development institutions that will be responsible for achieving those targets. This effort has become a partnership between the public and private sectors.
The second is a realisation that these two sectors need not be divorced from each other in the type of transactions that they can do. There is a realisation that private sector participants can still be profitable at the same time as having a very positive impact with the structures that are available to them.
EF: What does the investor base look like, and what is the appeal to buyers?
RB: What appeals is the impact element. They are driven by the big change – how are we changing the world? It is two-fold; being part of the journey of change, but there is also the return element. You can have investors who are impact first, and other investors who are driven by the return.
EF: How has the market been growing in recent years?
RB: The Brookings Institute has tracked 193 social impact bonds and 13 development impact bonds since 2014. These bonds have raised more than $400 million in up-front capital, and have supported some 2.6 million beneficiaries.
EF: What are the challenges in structuring social impact bonds?
RB: At a very high level, there is confusion about the terminology and a lack of consistency, not just in reporting, but also in documentation. We're involved in a number of initiatives to address this, including with the Government Outcomes Lab at Oxford University, which is developing a template document for outcome funding. A lot of terms used in social impact come from the development finance world, so they don't necessarily resonate with capital markets investors.
There are also challenges directly linked to the nature of the transaction, which remains bespoke and can involve high transaction costs. First, social impact takes time to deliver, to measure and to report, but all three elements are critical for the funding structure. Second, from an investor or asset manager's perspective, unlike commercial transactions, you can't easily unwind these transactions, because you have very vulnerable populations involved, especially on the social sustainability side. There are very complex governance mechanics regarding restructurings or any factors which adversely impact the life of the transaction. Covid is illustrating this. There are some very broadly drafted force majeure provisions. In education, for example, how do you measure impact when children are not able to attend school due to lockdowns?
PT: The third challenge is the size and depth of the impact bond market and whether there are enough investment opportunities. We asked participants at a conference last year whether there was a lack of capital, or a lack of projects to invest in: the answer was very much the latter.
RB: There are also challenges relating to the scaling of social impact transactions. Because you're evaluating the performance over a period of time, what is being targeted is actually quite specific. This means that transactions often don't lend themselves to scaling, even if you have an unlimited amount of funds. There are exceptions: Covid has been a great example of impact finance transactions which are being structured at a global scale – for example, if we consider what GAVI, the Vaccine Alliance, is doing with its Covax initiative aimed at equitable access to vaccines – but these exceptions (such as the Education Outcomes Fund, The International Finance Facility for Immunisation or the International Finance Facility for Education) are few and far between.
EF: What should investors consider when evaluating transactions?
RB: Investors tend to look at four things: One, where is the money being used, how much money is required, and what is it being applied to if it's a use of proceeds model? The second is with implementation. How much risk is involved? How is it measured? The third thing is that investors want complete clarity over the return proposition. They want to understand what, during the life of the transaction, can disrupt the implementation model and the measurement evaluation, and how that affects their return on investment.
Finally, and this is a critical issue, is how much control they have during the life of a transaction. It's a bit of a 'balancing act' during the negotiations. You don't want the project to be so investor-orientated that the service providers are so constrained with restrictive covenants and reporting obligations that it becomes very difficult for them to actually carry out the intervention. You need to ensure that the investor's money is being used properly for the objectives of the project in order to maximise returns, while also ensuring that project governance is not too burdensome and service providers have the flexibility they need to adapt on the ground.
Early transactions tended to be structured on a full 100% risk basis – so if the project didn't achieve 100% of its outcomes, the full investment would be lost. We're now seeing much more structuring coming to the market, with milestones in the form of specific outputs included in the contracts.
Impact bond structure, parties and documentation
EF: How are blended finance approaches being applied to social impact finance?
RB: Blended finance is representative of the coming together of different actors – public, private, philanthropic, donor-based and return-based. The beauty of these transactions is that you can marry up all of these different sources of funding to ultimately deliver a positive impact. Classic examples include development impact bonds, educational impact bonds, and recent ones such as the rhino conservation bond.
Essentially, it's a way of sharing the risk. You can structure the capital stack in such a way that the grant funding takes the first loss piece, and the returns-based model is used as a catalytic component to scale the volume of funding (or a blended combination of both elements). You can structure transactions differently, so that not all of the risk is on single investors or sponsors. Recent transactions have shown one can successfully aggregate capital (and consequently spread the risk particularly in first time interventions) both at an investor and sponsor level. There are various 'back-to-back' structures being put together to achieve risk participation and scale of funding.
For example, the Quality Education India development impact bond was the first transaction to use an aggregated model to attract funding at both the outcome funder level as well as the investor level – so you have numerous investors standing behind the core investor, and numerous sponsors involved. Each transaction has a slightly different risk profile.
EF: How did the sector perform in the face of the Coronavirus pandemic?
RB: While many sectors have contracted during the pandemic, the impact finance sector has gone the other way. This is one of the most encouraging factors around the sustainability of the sector. Over the last 12 months, there has been exponential growth, not just in relation to Covid-related funding, but also to other issues, such as clean water, renewables, climate change. These issues are not going to go away overnight.
The coronavirus pandemic has tested the sector, but it has shown that this sector is extremely resilient, despite all of the disruption. There is a genuine drive by both the public and private sector to address some of the social interventions around the world at the moment. We only see it increasing over time. The road ahead is definitely a busy one for impact investment.
EF: What developments do you anticipate in social impact finance over the coming year?
RB: There are three things to mention. As an industry, there are numerous organisational activities underway. For example, HSBC, in collaboration with some of the leading banks around the world, is fostering a 'Fast Infra' project to catalyse infrastructure financing around the world. There's the Coalition of Impact Investors, co-ordinated by the Red Cross and others to bring together the investor community to try and grow the sector. There are various working groups, including legal groups such as the International Impact Lawyers Working Group. There are organisations at the government or sponsor level, such as the GO Lab at Oxford.
But also what's interesting is that there are rapid developments underway to ensure greater clarity, clearer reporting and the standardisation of documents.
The third thing is that people are now very acutely concerned about protecting the growth in the sector. There are ratings being developed of impact measurement, and organisations which are looking at monitoring the impact evaluation aspects of transactions. From a regulatory and governance perspective, there's been a great deal of activity to address a lack of definition and clarity around some of the terms used in the market. One has to be careful about this because, in any growing market, over-regulation can stifle innovation.
Finally, in the last few months we've seen that not only has the number of transactions increased, so too has their average value. The market is not without its challenges and, overall, it remains quite fragmented. However, what is emerging quite rapidly is an appetite for supporting these types of transactions at scale.