Friday, June 22, 2007

Gapitalists and H.E.R.O.'s

There is a bit of a problem with capitalism.

Well, several problems actually. Nothing fatal, but we have some work to do. If you read my blog regularly, you know I think Hernando de Soto has identified some important flaws with how capitalism has been implemented in the developing world (Mystery of Capital). And Paul Hawken and the Lovinses have pointed out some of the problems flowing from a system that doesn't take into account natural capital (Natural Capitalism). Sen has pointed to the need to look at measuring freedoms in addition to economic factors when evaluating international development (Development as Freedom). Well, I am not in their leagues. And my problem isn't that big... but it is signficant.

This problem has to do with expected returns on investment. Those who work in the area of socially responsible investing or sustainable development or the BOP often talk about Social Return on Investment (SROI) where non-financial business performance metrics are measured and quantified. As an example, if you make a loan to business that employs high school drop outs, you (hopefully) get interest payments and a return of your principal. But you also may get measurable social benefits: less delinquent behavior, less kids going to prison, less drug use, etc. If the interest rate and risk on the loan are perceived to be equal, one assumes that most people will favor the socially responsible investment.

This has attracted capital to "social venture" sector. What used to be primarily donations is starting to shift to debt which allows the capital to be recycled. If you are supporting a venture that will eventually be financially independent, it would be nice to get your money back, so you can lend it to another venture. This is the appeal of Kiva. Loan $50 to a microentrepreneur in Tanzania. Get repaid. Lend to microentrepreneur in Cambodia. Almost as easy as shampoo instructions. Instead of Lather-Rinse-Repeat it is Loan-Repay-Repeat. At the other end of the spectrum, Accumen Fund, GoodCap and others are looking at larger loans to larger businesses working on improving on companies that produce financial returns and social returns.

So what is the problem? Well, as you know, it isn't that I think there is a capital shortage for the social sector. The issue is that there is a gap in our entrepreneurial finance model. Debt is unlikely to be a powerful way to fund social venture start ups. Yet private equity capital wants to earn 25%-35% return if invested in a risky venture (spread over a portfolio, so the actual winners need to return at an even higher rate to make up for the losers). Yes, there are losers, that have a negative return. While investors can identify some of these losers up front (and not invest) a fair number slip through, get funding and don't repay investors. After millions of transactions, the markets have worked out that this type of investment needs to return at that 25% rate to be attractive to capital.

And money put into a non-profit returns -100%. So, the gap is that our capitalist system presumes that a start up returning less than 25% on invested capital cannot (and should not) exist (for my academic and banker friends, don't quibble me with on numbers... I am discussing a concept here). It is a null set. Capital just won't go to these deals. At least not smart capital. Of course, this is not true experience. Companies return much lower than 25% all the time and few private investors get a 25% return over time. Not even Warren Buffet (but he has made over 20% over the years for Berkshire shareholders, which is spectacular). But this ROI rule has achieved mythic status in the investment community.

There have to be many good businesses that simply cannot really return 25%, but produce value to society. Rather than castigate these investors for being heartless, entrepreneurs need to find ways to help them build successful track records investing in this sector, and this is starting to happen. These entrepreneurs are venture gapitalists.

Hybrid financing schemes are emerging, where private capital is pooled with foundation capital. The Gates Foundation is working on this. Simply, if half the money in the pool isn't looking for a return (the foundation donation), then the opportunity only has to return 12.5% to meet the private investors 25% hurdle rate. David Green (of Aurolab fame) recently worked with Deutsche Bank on a similar approach to put together a fund for eye care in Africa. I expect to see more of this synergistic financial partnering between private capital and foundations.

Another approach is to use "other value" to attact capital. For instance, my earlier example of SROI. But we need to push that model- I think we are still in beta test phase on this. Instead of being a bit greener or more socially responsible, what if entrepreneurs build companies that will be truly regenerative? My acronym is H.E.R.O.'s: Human and Environmental Regenerative Organizations. As a system, natural systems have an amazing ability to regenerate. How about capitalist systems? What companies are actually cleaning up the place? Is it possible for companies to actually reduce their eco-footprint as they grow? To make a business of environmental repair? clean water? Providing credit, education or health benefits to chronically poor regions? These are the Blue Ocean opportunities of the next decade. Carbon sequestration, cellulosic ethanol, biomimetic solar systems... Entirely new markets will emerge and entire industries are going to be remade in coming decades (as they have been in recent decades).

This is just getting started, so it will be exciting to see what else begins to happen as "relentless capital" begins to flow and shift to find these areas of value. I foresee some interesting financial instruments emerging. Will we see loans repayable with carbon credits (something Envirofit has proposed to some funders)? Financial returns that vary with social/environmental performance (either positively or negatively)? Syndication of social benefits (remember that derivatives are just stripping out and repackaging separate benefits of financial instruments). So I'd urge BOPreneurs to talk with these new investors and LISTEN. Figure out what they are looking for. Figure out if you can find a solution for them.

A few of those who get there early are going to make a bunch of money and solve some of our environmental and social problems. And, I hope, change the business role models for success. And a lot of others are going to fail. Great system, right? This doesn't bother me, but it seems to bother some people in the social venture community. To paraphrase Mr. Churchill: "capitalism is the worst economic system, except all the others that have been tried." Capitalism isn't perfect and continues to evolve. It is this dynamic that allows us to dream of 25% returns or companies that "clean up" in multiple ways.

I think that the easiest way to find entrepreneurial opportunities is to ask "WHAT SUCKS". This "gap" sucks, and it is an imperfection in the capitalist system. But the next step is important. Who is going to fix it? So go ahead, write your newspaper or congressman (good luck) or... get started on building or funding organizations that change business for good.*

*"Changing Business for Good" is the motto of Bainbridge Graduate Institute. I think its a great, sticky motto. So I am shamelessly using it.


Anonymous said...

I would recommend looking into the industry of Community Development Venture Capital (CDVC). While it is focused on communities and therefore creating jobs for low-income people and developing wealth in distressed communities, it is an example of double bottom line investing that is unknown to many.

Bopreneur said...

Good point, Mr. Anon. Perhaps you would like to post some links to your favorite CDVC's.
REDF also has a lot of good material on SROI- look at their free publications at