To confront interconnected environmental and social crises, write Yale SOM’s Todd Cort, Juliane Reinecke of Oxford Said Business School, and impact investing expert Clint Bartlett ’17, we must invest in resiliency. That means that impact investors will need to factor resilience-building into their expected returns, especially in the most vulnerable parts of the world.
While it is conventionally believed that the problem lies on the demand side, with not enough projects achieving bankability, we argue that the supply-side mispricing of capital could be the chief culprit.
The role of risk and the blended finance “solution”
It is important to consider the element of risk in the current paradigm of “market rate.” The market rate is the expected return demanded from investors for the risk they are taking. The higher the risk investors take, the higher the return they seek. Assets that yield returns commensurate with the risk taken by investor are considered market-rate returns, or investment grade, while those assets that do not deliver risk-adjusted returns remain unattractive to mainstream private investors—the most significant chunk of global capital.
This market rate (that is, the rate of risk-adjusted return) in the Global South is often high (much higher than in mature economies) because assets (including SME investments) are assumed to be highly risky. Mechanisms designed to lower this rate include a combination of providing technical assistance to de-risk assets or offering financing structures that allow for non-market funders to absorb the risk of market funders. Recently, a form of the latter, “blended finance,” has emerged. Blended finance combines concessional public or philanthropic capital with conventional private/institutional capital in a way that lowers the eventual cost of finance to the targeted asset, thus ensuring that conventional investors do not sacrifice return in the pursuit of achieving impact, and assets are able to access finance at a lower cost.
How conventional finance produces a downward spiral
Why is it important for the asset to create impact outcomes? Because that local system is likely to degrade, possibly sooner than later, as increasingly negative societal and environmental impacts, such as those of climate change, begin to bite harder. When this happens, the societal and environmental voids become starker, more severe, with a commensurate increase in the cost associated with rectifying them.
The local system is then sent into a downward spiral, and the assets tasked with reversing the decline face an ever-growing cost burden to do so. This “local” system can be a village in Uganda, a food system in the Philippines, the Mesoamerican Barrier Reef, or a collection of these, constituting a confluence of tipping points—the avoidance of which is necessary for human survival.
Rethinking “risk-adjusted return” to factor in resilience-building
What is the current market rate? How is it established? Theoretically, the market rate is the return generated by an asset that accurately reflects the risk of that asset—the so-called “risk-adjusted return.” Assets’ risks are a function of their own behaviors and decisions, and of the impact of changes in the system they inhabit. An accurate risk assessment needs to account for this complex interplay between individual asset activities and system factors. Ideally, such a risk assessment should take into account the risk of the asset now, as well as into the future, and shift as the risk changes.
Measuring resilience building
How can one then link this “survival,” or socially appropriate, rate of return with the current market rate of return? We argue that this could be achieved by measuring resilience and resilience-building. By pricing resilience, and by ensuring that the returns generated by assets are done so by taking into account the necessary cost of creating positive outcomes, these assets bring about more resilient systems, and thus lower risk of all assets in the system.
We must rapidly work on creating better pricing for resilience. Investors can then calibrate the cost of finance, internalizing the price of the far-reaching benefits of system resilience and creating a positive feedback loop. The immediate effect of the lower cost of debt is to ensure sufficient free cashflow to cover the cost burden of creating the resilience outcomes. The second effect is that the growing investment renders the investment environment incrementally less risky. This second effect, in turn feeds back to the first effect. As risk in the market lowers, it creates an increasingly stable environment, and the investments continue to generate profits and sustainable outcomes in the long term.
Read the full article by Todd Cort, Juliane Reinecke and Clint Bartlett / Yale
