USAID and Partners: The Efficient Impact Frontier – New Tools to Allocate Capital for Impact
Caption: Musasa, a coffee cooperative in northern Rwanda, is among the hundreds of businesses that benefit from the work of Root Capital, an agricultural impact investor.
Root Capital, like many impact investors, operates in the gray area between traditional philanthropy and mainstream commercial markets. As a mission-focused lender, the organization serves the financial needs of small- and medium-sized enterprises—a Fair trade coffee cooperative in Uganda or an association of women quinoa producers in Bolivia, for example.
These businesses have outsized potential for impact: they help farmers earn higher and more stable incomes, provide them with access to new markets, and unlock opportunities for formal employment. Like all entrepreneurial ventures, they need reliable access to capital. However, because these businesses operate in remote areas and have limited track records, they are often seen as too risky by commercial banks. Recognizing this opportunity, Root Capital has financed the growth of more than 600 high-impact agricultural enterprises since 1999.
The economics of investing in these businesses—and in the agricultural sectors of frontier markets more generally—means that Root Capital’s portfolio does not generate the type of risk-adjusted, market-rate returns that many other impact investors would expect. Most of the organization’s loans, which range from $50,000 to $3 million, fall into one of two categories: either they yield a negative financial return and thus require a subsidy, or they yield a positive but below-market return. Critical to Root Capital’s investment strategy is its ability to cross-subsidize loans in the first category with revenue earned from loans in the second category. The organization also relies on other forms of subsidy, such as philanthropic donations from individuals and grant funding from over one hundred institutions, including the U.S. Agency for International Development.
But how do hybrid impact investors like Root Capital allocate their philanthropic and investment funding in the best possible way? And how might donors know exactly how much of their grant funding (versus investment) is needed to achieve specific impact goals?
To date, investors haven’t been able to answer these questions with a high degree of confidence. They have lacked tools that quantitatively and comprehensively take into account the financial, social, and environmental factors that underpin investee performance. Frameworks abound, but hard data on the intricate relationships between financial return and impact are scarce, even a decade after the term “impact investing” was first coined.
Root Capital’s article “Toward the Efficient Impact Frontier,” which appears in the Winter 2017 issue of Stanford Social Innovation Review, seeks to bring data to bear on the challenges faced by impact investors and those who provide grants and investment capital to them.
Their approach is inspired by a concept used in mainstream capital markets: the efficient frontier. Introduced by Nobel Prize-winning economist Harry Markowitz in 1952, the concept refers to a set of portfolios, each of which offers the greatest possible return for its associated level of risk. In a world in which there is a tradeoff between risk and return, the concept of the efficient frontier helps investors strike the right balance.
What if investors could extend the efficient frontier of risk and return to include a third dimension: impact? A portfolio of investments on the “efficient impact frontier” would offer the greatest possible level of expected impact relative to the expected risk and return.
By plotting risk-adjusted expected return of each of its loans on one axis of a graph, and expected loan impact on the other, Root Capital is able to integrate all of the factors that it needs to consider when deciding which loans will best achieve its desired impact. Likewise, plotting the aggregate impact of all of the loans in the portfolio on one axis, and the total grant funding required to support those loans on the other, provides a way to track progress and set goals for the portfolio as a whole. Today, the organization is beginning to use this method to improve its processes and decisions around loan approval, capital allocation, and portfolio goal-setting.
By adopting and adapting concepts like the efficient frontier, impact investors and donors can make more informed and precise decisions when allocating their capital to support social enterprises and mission-driven businesses. As impact investing continues to move into the mainstream, these tools can provide the transparency and the accountability that impact investors need in order to set realistic goals to increase impact, financial returns, or in some cases both.