NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

Exits. When an investor recovers the last dollar of debt principal plus interest, or when it sells its shares in a business, 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. As with many economic realities, it’s a bit counter-intuitive: if you want to bring in capital on a mass scale, you have to consider how easy it is for capital to get out.

When Steve Jobs purchased Pixar Animation Studios in 1986 for $10 million, for example, he didn’t know he’d have to spend as much as $50 million in the next ten years just to keep the company alive. Pixar finally turned a profit with the 1995 release of Toy Story, the first ever full-length, computer-animated feature film that launched an industry. The company went public that same year. In 2006, with Jobs still a majority shareholder, Disney purchased Pixar for $7.4 billion in stock equity.

Impact investing may not ever produce exits or new industries on that scale, but that doesn’t negate how easy exits would help amplify impact by attracting more mainstream investors. As patient capital/impact investment pioneer Jaqueline Novogratz recently told Nextbillion.net, “The idea of patient capital is actually starting to permeate into the mainstream institutions.” That journey to mainstream turned a major corner with the Nov. 29 release of Impact Investments: An emerging asset class, a report from JP Morgan. It contains a wealth of key insights into impact investment, including the need for more exits.

Combining with data from The Next Four Billion: Market Size and Strategy at the Base of the Pyramid, the report gives partial yet compelling estimates of impact investment potential at the BoP: potential profits in the next ten years could range from $183 billion to $667 billion; while invested capital could range from $400 billion to nearly $1 trillion. The authors also break down those estimates into five sectors: housing, water, health, education and finance.

Prepared in partnership with the Rockefeller Foundation and the Global Impact Investing Network, the report uses four indicators to define impact investment as a new asset class: the unique skill set required for impact investing; new organizational structures to accommodate a new skill set; the emergence of supporting organizations, associations, and educational facilities; and the accelerating trend toward standardized metrics, benchmarks and ratings.
Asset class definition will tremendously help draw mainstream investor attention to impact investment. As the report notes, “definition was a key catalyst in driving the institutional growth of (hedge funds and emerging market capital) over the last twenty years.” Impact investment could experience the same growth as mainstream investors continually seek to diversify their portfolios, but not without easier and more lucrative exits.

In the impact investment ecosystem, exits are still exceedingly rare. The JP Morgan report surveyed 24 leading impact investors, covering a total of 1,105 investment deals valued at $2.4 billion. Only two survey respondents provided information on realized returns from exits.

Of course, it’s still early. Most current impact investment deals are intentionally medium- to long- term and therefore aren’t yet poised to produce a significant volume of real returns. Expectations have nonetheless attracted a few risk-savvy mainstream investors; India’s Financial Express reported that capital invested in social ventures grew from $150.36 million in 2009 to $404.58 million in 2010, with a growing percentage from mainstream private equity and venture capital. Sooner or later these pioneering investors will need to exit, and the returns they get when that happens will be the deciding factor in keeping impact investment momentum going (or slowing).

Exit returns depend greatly on the type of investment instrument used. For instance, 629 out of 1,105 surveyed investment deals were in the form of debt, which is predictable and relatively safe but not very flexible; exit time and return is usually set from the beginning. While equity is riskier and less predictable, equity’s flexibility means it holds the most potential for lucrative returns. After all, Steve Jobs waited 20 years for the right time to sell Pixar.

The catch? Equity investment runs into the well-known challenge of creating legal business entities in many emerging markets; entities whose shares investors can buy and sell. While local expertise helps to navigate labyrinthine business environments, as a rule cumbersome business registration systems impose a significant barrier to the many new and mainstream investors whose entry would boost the value of impact investment equity sales.

At the same time, weak corporate governance practices in many BoP markets undermine mainstream investor confidence while also threatening to create the next financial crisis. As has happened most recently in U.S. property markets and in India’s microcredit markets, a lack of competent and independent board oversight combined with a flood of investment, accelerates the growth of harmful asset bubbles. Impact investing must not repeat those mistakes and cause another financial crisis.

Healthy, transparent, rules-based competition among new, old, foreign and homegrown investors would dramatically increase the value of impact investment sales when the time is right. Impact investment opportunities do not have to remain limited to impact investors. Paradox is paramount; mainstream investors will flock to where they can exit quickly – toward more useless and harmful bubbles, or, if given the choice, toward the creation of new industries with positive social impact for the base of the pyramid.