The complexities of social finance

Finance is a fascinating field of research. It’s the only field where you can just add multiple layers of complexity.

Imagine you are a songwriter and own the rights to a variety of popular Mongolian songs. Every time, someone streams your music, you earn a fee. One day, an entity offers you to buy all your future royalties for $450,000. The entity also purchases a library of Bolivian, Austrian, and Swedish music, creating a diversified portfolio of music royalty streams, which they acquire for a total of €25 million.

The entity now packages them into asset-backed securities. These are then sold to institutional investors for €30 million. Now, someone believes that Austrian folk music is highly overvalued and wants to profit from this insight. She would need to borrow these securities and sell them to profit once the value of the securities are declining.

I am not aware of any liquid markets for royalty streams, but it shows the value of the financial markets. Artists can sell their future revenue streams, which hold significant value for them. The analysis of markets helps to find the right prices for securities. It also helps individuals to own a diversified portfolio of assets.

Now let us move to something with significant social value: the financing of impact enterprises.

One reality is that the field of impact finance is at least three-dimensional, encompassing risk, return, and impact. Some are sharing this three-dimensional graphic but it is just an illustration as no one really knows the relationship between impact and return as well as impact and risk. The curve should also include negative impact as well as negative returns.

However, we see all sorts of combinations of these three dimensions. Some are aiming for higher impact but lower returns and for some it is the other way around. Obviously, capital owners have a preference for certain combinations. A foundation or wealthy individual might prefer a higher impact, while institutional investors can only invest in funds offering market-like returns. This is also shown across multiple studies like the recent GIIN survey (“Sizing the Impact Investing Market in 2022”).

The following figure shows illustratively the alignment of funds with the preferences of the capital owners as well as the return potentials of the investees.

There are other complexities as well. Investors might benefit from so-called capitalization schemes. One of the biggest schemes is managed by the European Investment Fund (EIF) and provides large anchor investments to funds. They are typically in the range of €10–20 million. Munich-based Ananda has received €15–20 million for their fourth fund, while the Zagreb-based FeelsGood Social Impact Fund I received a committment of €15 million.

This means that public authorities can help build the market by providing capital to financial intermediaries.

There are also guarantee schemes which can help banks to give loans to impact or micro enterprise. The European Investment Fund (EIF) has signed 163 guarantee contracts across 31 countries and this funding is expected to enable over EUR 2,854.7 million for micro-enterprises and EUR 1,440.0 million for social enterprises. Across all portfolios, these guarantees support 162,208 micro-enterprises and 6,709 social enterprises. These numbers are impressive and have been very important for the development of the sector (check out this study I have been involved in for my details).

The next level are the grants impact enterprises receive to conduct their work. It is estimated that there are 186,000 foundations in Europa which give an estimated €54,5 billion per year. On average, each of these foundations provide €300,000 per year in funding and the majority of the funds will be grants for certain projects.

The number for the public authorities will be much larger, although it is hard to estimate the total numbers. Germany spends around 26.7% of its GDP on social expenditures. Obviously, areas such as education, pensions, family allowances or unemployment are responsible for a large part of these numbers. However, there are also budgets for impact enterprises to deliver services.

One of the issues is that there are might be conflicts between these contractual agreements and the capital structure. For example, these grants typically prohibit double funding and thus restrict the entrepreneurial flexibility. In addition, there are often clauses which restrict the use of the funds for financing costs (part of my doctoral thesis covered these potential conflicts of interest).

In recent years, we have seen an increase in the number of outcome-based contracts. Since the introduction of the first Social Impact Bond in 2010, which linked social goals with financial returns, various new financing instruments have emerged.

These include Ebola bonds, which should fund responses to outbreaks, Green bonds with penalties for missing sustainability targets, and Catastrophe bonds to offset disaster-related losses, showcasing the increasing blend of finance with social and environmental objectives.

Nowadays, we see interesting new developments. Social Impact Incentives are a financial instrument which pay a premium for the achievement of social impact. Rikx are a platform which allows companies to buy units of social impact. Alphabet, Meta, Shopify and Stripe have committed over $1billion to purchase permanent carbon removal by establishing a platform called Frontier. The platform enters into prepurchase agreements and evaluates carbon removal technologies for long-term impact and scalability based on their permanence, minimal land use, affordability, substantial capacity and commitment to environmental justice.

The figure above shows different layers in social finance and there are at least three conclusions I would like to share.

These options give financial supporters much more strategic flexibility. Institutions such as foundations can guarantee loans, capitalize funds or give out grants. Companies can enter into pre-purchasing agreements with impact start-ups working on relevant topics. Wealthy individuals can provide capital to impact investment funds.

This complexity does not exist to enrich investors but to build an impact finance market and help to create social value. That is a nice change to my first job in investment banking.

The social finance market started in the early 2010s with the launch of the Social Business Initiative (SBI) and grew since then. Given that there is still a lot to do we can expect to see more innovation in this field.