Social impact versus financial return? It’s time to embrace blended finance

There is an old Portuguese saying that you cannot expect the sun to shine on the threshing floor while it rains in the turnip fields. Some are just as doubtful that impact investors can simultaneously deliver market returns and measurable social impact. The harder investors pursue social goals in sectors where commercial capital is absent, they argue, the more likely financial returns will suffer.

Threshing - Boris Kustodiev (1908)

Others disagree. In June this year, Cambridge Associates released a report showing impact investment funds with combined assets of $6.4 billion had returned almost 7% after management fees. Jessica Matthews of Cambridge Associates said: “There’s a view among some investors that impact investing necessarily entails a sacrifice in financial return. This data helps to show that is more perception than reality”. Or as ClearlySo, a UK impact advisory firm puts it "there's no impact see-saw".

Impact investing is still a young industry with diverse players, operating in multiple sectors and following varied approaches. Organisations like the Global Impact Investor Network (45% of whose members say they target below-market returns) are gathering the performance data. But it will take time – possibly five years or more – before sufficient evidence emerges to allow a meaningful taxonomy of return expectations for different types of impact funds.

AgDevCo invests in the agriculture sector in Sub-Saharan Africa, focusing on early-stage businesses that are starved of capital. To date we have backed 45 SME businesses and committed $60m. There’s little doubt that investing in agriculture can deliver a high social pay-off. But what level of financial returns should we expect?

There are data points from outside the impact investing community. The development finance institutions (DFIs) have been investing in emerging markets including agriculture for fifty years or more.
• The UK’s CDC specialised in agriculture investments during the period 1950 – 2000. A recent research paper concluded that only a third of investments generated financial returns above an “acceptable commercial level” of 12%. However, in many cases where CDC lost money, the businesses it supported went on to become sustainable operations which created significant positive social impact and delivered commercial returns for later-stage investors.
• The IFC has published returns data on more than 300 exists from SME businesses (across all sectors). Investments above $2 million delivered good financial returns and an acceptable level of write-offs. However, investments below $2 million were generally not profitable and write-offs reached 20-30%.
• Members of the European Development Finance Institutions (EDFI), an association of bilateral DFIs, report that only 5% of new investments made in 2014 were in the agriculture sector, whereas agriculture makes up at least 25% of GDP in most developing countries.

We draw two tentative conclusions. Firstly, in developing countries agriculture does not appear to offer financial returns that are as attractive and/ or requires more patience than other sectors such as financial services, infrastructure and manufacturing (otherwise DFIs would be more heavily weighted towards agriculture). Secondly, for investments below one or two million dollars, financial returns are likely to be lower, if not negative, and the risks of business failure are significantly higher. However, as companies mature they should be able to generate better financial returns, so graduation to commercial capital is a real possibility.

AgDevCo’s experience to date is more or less in line with this. With an average investment size of below $1.5m, we are expecting to recover our invested capital and make a modest contribution to our running costs. As we expand and balance out the portfolio with some larger investments, we anticipate moving towards net profitability. In the meantime, part of our operating costs will continue to need grant funding.

What does this mean for the prospects of attracting more commercial capital into the agriculture sector? The need in developing countries is huge, perhaps $83 billion annually per the FAO.
Given the high risk-low return characteristics of agriculture in developing countries, and the fact that most opportunities are at the smaller end of the spectrum where returns can be swamped by transaction costs, it is unlikely the sector is going to attract large volumes of commercial capital any time soon.

The good news is that innovation is driving new investment approaches which offer a way of leveraging commercial capital into these markets.

Blended finance models are a sub-category of impact investment approaches. They mix public, philanthropic and private capital in ways that compensate investors for risk-taking where there is the possibility of high social returns.

Although there are only a few active blended finance investment funds targeting agriculture, the concept may be reaching a tipping point. The World Economic Forum is backing the approach. The Canadian government is promoting a new virtual marketplace called Convergence to encourage private and public funders to blend their capital, creating more financially attractive, high-quality deals. Nick O’Donohoe of Big Society Capital, a pioneer of impact investing in the UK has recently been appointed as senior adviser on blended finance at the Bill and Melinda Gates Foundation.

My Portuguese colleague tells me only her grandparents’ generation still use the threshing floor proverb, which no longer resonates in a modern economy. If impact investing embraces blended finance, it may get to the point where the old debate about impact versus financial returns also becomes obsolete.

Chris Isaac is a founding Director of AgDevCo, a social impact investor in the African agriculture sector. He is speaking on blended finance approaches at the Convergence “Blended Finance for Agriculture” conference in partnership with Citi and UNEP in London on Friday 20th November 2015.

LAFCo agri-loan facility now open for business

CAPE TOWN (June 3, 2015) — KfW, the German Development Bank on behalf of the German Ministry of Economic Cooperation and Development (BMZ), along with AgDevCo and Root Capital, today announced the launch of the Lending for African Farming Company (LAFCo). The company will finance agricultural enterprises throughout sub-Saharan Africa to enhance local food security and stimulate inclusive economic growth in the region.

Announced at the 2015 Grow Africa Investment Forum during the World Economic Forum on Africa, LAFCo aims to increase smallholder farmer productivity and incomes through better integration in local and regional agricultural value chains, and improved access to formal markets. With an anchor commitment from KfW, using funds from the German government, and additional investment by AgDevCo, which initiated the project with the support of UKAid, LAFCo will accommodate the working capital needs of agricultural enterprises. It will be managed by Root Capital and will provide lines of credit and other flexible debt products in amounts of up to $4 million, denominated in both U.S. dollars and local currencies.

Presenting the investment, Jenny Scharrer, senior project manager of KfW, commented: “The barriers to improving food security and alleviating poverty are numerous and complex. By investing in LAFCo and supporting the businesses that work with smallholder farmers, KfW is seeking to demonstrate new and innovative approaches to development finance. Guided by the shared values and impact philosophies of its sponsors and manager, LAFCo will help fill a critical financing gap and support the equitable and inclusive growth of this sector.”

The new collaboration comes at a time when the need for capital is increasing for agricultural businesses throughout the region. However, many of these enterprises are unable to access sufficient financing from commercial banks or other financial institutions. Beginning immediately, LAFCo will provide debt financing to a wide range of agricultural enterprises, including cooperatives and private businesses. Lending activities will take place across sub-Saharan Africa, with a particular focus on Ghana, Kenya, Malawi, Senegal, Tanzania, Uganda and Zambia.

“The potential of Africa’s agricultural sector has attracted significant interest from equity investors, but the day-to-day financing needs of businesses are often overlooked,” explained Chris Isaac, director of investments at AgDevCo. “We’re delighted to partner with KfW and Root Capital to help African entrepreneurs and farmers access the capital they need to grow profitable businesses. Investment in agriculture means higher incomes, more jobs and increased food security.”

According to the Alliance for a Green Revolution in Africa, sub-Saharan Africa is home to 60 percent of the world’s uncultivated arable land. Despite its production potential, Africa’s crop yields are between one-third and one-half of the global average, and more than 200 million individuals are chronically undernourished, the majority of them living in rural areas. To help address these challenges, LAFCo will finance agricultural enterprises that purchase crops from smallholder farmers, or that provide them with yield-enhancing products, such as seeds and fertilizers, and related services.

“If Africa is to meet the challenge of sustainably feeding a rapidly growing population in ways that also contribute to poverty alleviation, reliable access to finance is essential,” said Nate Schaffran, senior vice president of lending at Root Capital. “With 15 years of experience in lending to agricultural enterprises, Root Capital is honored to manage LAFCo and help catalyze a broader financial market to benefit Africa’s smallholder farmers.”

Beginning with a first close of $15 million in committed funds, LAFCo aims to become a leading provider of capital for businesses operating in Africa’s local and regional agricultural value chains. The innovative “blended finance” structure of LAFCo, which combines public and philanthropic funding with private capital, will allow it to serve parts of the market that are generally not being served by commercial banks or other financial institutions.

LAFCo was developed with the support of Dalberg Global Development Advisors and in collaboration with the Grow Africa Finance Working Group. Founded jointly in 2011 by the African Union, The New Partnership for Africa's Development (NEPAD) and the World Economic Forum, Grow Africa works to increase private-sector investment in agriculture and accelerate the execution and impact of investment commitments.

Additional legal and structuring advice was provided by Innpact, Norton Rose Fulbright South Africa Inc. and BLC Chambers

Blended finance can unlock agriculture potential in Africa

Africa is growing faster than any other continent. It has a middle class which is set to triple in size by 2030. Private equity investment deals reached $8.1 billion last year, with investors betting on financial services, consumer goods and property. Diversification of investment activity from extractives holds promise for higher job creation and broader based growth.

But the agriculture sector lags behind, despite its enormous potential. Food imports are already running at $35 billion annually and could double over the next decade. African farmers’ yields fall well below global averages. Per the latest UN statistics, the number of undernourished people continues to rise (from 175 million in 1992 to over 220 million today).

The need for private investment and expertise to help unlock the potential of agriculture is widely recognised. Farming is a business that requires an entrepreneurial approach and plenty of risk capital, whether at the smallholder level or for large mechanized farms. The sector will not achieve take-off if reliant on public sector support and hand-outs, which has been a tendency in the past.

The problem is that private capital is not reaching the agriculture sector, for three main reasons. Firstly, logistics costs are high, mainly because of weak infrastructure. Secondly, agriculture is inherently risky and requires specialist and locally-adapted knowledge. Thirdly, most agribusiness investment opportunities are small and early-stage, which makes due diligence and transaction costs prohibitive.

So what is to be done? One approach is to wait. The policy environment is improving; roads, telecommunications and power networks are reaching the most remote areas; a highly skilled African diaspora is returning home; capital markets are becoming more sophisticated. The best opportunities should rise to the top and private investors should be able to find them.

However, in AgDevCo’s view, it may take ten years or more before the agriculture sector matures to the point where it can attract sufficient volumes of commercial investment. In that time 122 million young people will have entered the workforce, according to a recent McKinsey study. Without investment in agriculture it is unclear whether Africa can create enough jobs to take advantage of its “demographic dividend”.

Blended finance funds are a possible solution. These hybrid fund structures combine public, philanthropic and private capital. The non-commercial capital acts as a first loss cushion, with the objective of leveraging larger volumes of private finance into markets where risks are high and financial returns uncertain, but there is the possibility of major positive social impact.

These types of funds have an ability to invest with new entrepreneurs and early-stage businesses, allowing them to build a track record, which should help them access later rounds of commercial capital. By making smart investments, blended finance funds aim to demonstrate that the cost and risks of operating in certain markets are not as high as some investors might think.

With agriculture investment in Sub-Saharan Africa estimated as being 11 times more effective in reducing poverty than investment in any other sector, a blended finance fund focused on SME agribusinesses could make a major contribution to food security, economic growth and poverty reduction, while demonstrating that agriculture can be a profitable business.

WATCH THIS SPACE: with international partners AgDevCo will be announcing a new blended financing facility for African agriculture at the World Economic Forum Africa meetings in Cape Town on 3 June 2015. More details will follow soon . . .