Is ‘Place-based’ investing a crisis response strategy for Impact Investors?

From the Covid-19 public health crisis to its subsequent economic downturn and rising protests against racial inequality in the US, the past few months have ignited impact investors to review their strategies both at the portfolio and deal levels. One particular conversation that Toniic and the Impact Terms teams have observed on the rise concerns “place-based investing”. We’ve been internally discussing the scope of what “place-based” means and struggled to hone-in on any fixed definition and strategy. In the spirit of the collaborative and curated approach of the Impact Terms Platform, we decided to extend an invitation to experts in our network to develop a better understanding of what “placed-based investing” means to them, what their place-based investment strategies include, and how they are empowering people disproportionately affected by the recent events, most notably ethnic or racial minorities.

This article is based on the most insightful inputs we gathered from our friends at five US-based organizations, including Blueprint Local, IFF, and Mission Driven Finance.

  • What does “place-based” investing mean?
    All 5 organizations define place-based investing as a focus on communities:

“Long-term investing consistently and systematically in communities with the goal of encouraging an inclusive economy” – David Robinson Jr., Blueprint Texas

“Investing with a geographic lens in addition to other impact goals, and building an interconnected portfolio of companies that reinforce each other and the power of community” – David Lynn, Mission Driven Finance

“Long-term commitment to a community; ensuring capital and development decisions are made at the invitation of and in service of community.Yi Wei, IFF

“Investing in local communities over time – investing with folks who know the community, are part of the community, and investments that help build wealth in local communities.” – Executive Director of a large US Foundation

  • What are the investment strategies they are deploying?
    Most focus on building wealth in local low-income communities.

Mission Driven Finance uses debt and debt-like structures in the sectors of education, health, jobs, and community development.

IFF helps non-profit organizations own their real estate, which in turn gives them more control over staying in place and stronger programmatic outcomes.

Blueprint Local/Blueprint Texas targets whole neighborhoods (as opposed to one-off deals) and focuses on undervalued assets and companies that have the potential to grow and reinvigorate neighborhoods.

  • Is there a focus on empowering people disproportionately affected by economic and racial disparities?
    Most responded that they are committed to continuing to provide capital to underserved communities and organizations unable to access affordable capital from traditional sources. One organization, which is currently adjusting its strategy, will be specifically targeting opportunities in Black communities.

We are interested in further developing this article and invite you to collaborate with us. Please share comments in the section below or reach out to our team to expand on this topic. 

Catalytic Capital

In essence, catalytic capital is investment capital (debt, equity, guarantees, etc) with which the investor accepts reduced financial expectations in order to bring about a greater social or environmental impact.  Lowered financial expectations refers to not only higher risk or lower return profile, but also a longer liquidity window or subordinate position in the investment structure than a more conventional investment. Other terms for this type of capital include concessionary capital, patient capital, and flexible capital, among others.

Catalytic capital fits in the middle of the spectrum of capital, which demonstrates a gradation of investor return expectations, from 100% loss (a grant) through commercial returns at rates set in accordance with conventional financial benchmarks that do not price in “externalities” (conventional equity investments). It can work to fill critical gaps for social entrepreneurs, particularly in early stages of development. It can also encourage third-party investment that may have not been otherwise possible (e.g. a development finance institution taking a subordinated position to entice private investors). 

Tideline, an impact investing consulting and research firm, warns: “Capital willing to accept disproportionate risk and/or concessionary returns is in short supply and can have market-distorting effects if not deployed appropriately. Evaluating potential positive and negative impacts of catalytic capital (including its built-in financial concession and the activities it supports) is essential to its effective use.”

See also:

Would you like to add to this article? Do you have examples of how to deploy catalytic capital appropriately? Please reach out to the Impact Terms team about contributing.

Additional Resources:

Re-Thinking Corporate Governance in the context of COVID-19 and crisis bailouts

This article and all the articles tagged Tactics or Ideas are opinion articles and therefore only reflect the view of the author. 

Corporate governance is the framework of rules and practices by which a board of directors ensures accountability, fairness, and transparency in a company’s relationships with all stakeholders (financiers, customers, management, employees, government, and the community.  Corporate governance framework consists of (i) explicit and implicit contracts between the company and the stakeholders for distribution of responsibilities, rights, and rewards; (ii) procedures for reconciling conflicting interest of stakeholders in accordance with their duties, privileges, and roles; and (iii) procedures for proper supervision, control, and information-flows to serve as a system of checks and balances (business dictionary)

The COVID-19 context, a global and painful health and financial re-shift, presents an opportunity for implementing greater incentives towards broader stakeholder engagement. The restructuring of portfolio holdings presents such an opportunity – as financial restructurings take place, corporate governance restructurings are also possible and should be on the table.  Diversification of thought and perspectives makes for better risk mitigation and thereby better financial and non-financial results. The current context presents an opportunity to explore different corporate governance structures including, steward ownership structures.

The response to the 2008 financial crisis was mostly significant-sized bailouts and financial restructurings, and one could argue, not enough of non-financial restructurings.  When corporations emerged from the negative impact of the crisis they indulged/engaged in significant share buybacks. This crisis is showing us that such a strategy has delivered questionable value for stakeholders as we witness market volatility and lower share prices.  We can all agree that big shocks – climate, conflicts, pandemics, and financial, have become more frequent so there will not be as much time between this and our next crisis. The Great Depression was the last major global event before 9/11 caused a seismic dislocation. Since 9/11, however, we have been experiencing global-level shifts with greater frequency. 

Currently, more bailouts are underway, and it is likely that after the crisis is over and profits soar again, we will see more share buybacks.  Is it time for rethinking crisis restructurings away from just financial considerations? Are we well placed to push for consideration around governance frameworks that create the necessary “infrastructure” for informing how entities are run with all stakeholder interests accounted for? As the shocks that require restructurings and “bailouts” become more frequent, should operating frameworks be structured to include inputs from a diverse set of players?  Is it time to ask that any corporation that wants a share of restructuring and bailout funding be required to, over a period of time, transform its ownership/governance structure to one that enables more diverse opinions? In private markets investing, particularly in impact investing, are financial and governance restructurings a minimum response given investor focus on delivering financial and impact returns.

Is it time to implement more ownership structures like steward ownership, as mentioned above, to help protect more diverse stakeholders in normal and pandemic times? Steward-ownership refers to a set of legal structures that instill two core principles into the legal DNA of a business: self-governance and profits serve purpose. These structures ensure that control (voting rights) over the business is held by people inside the organization or very closely connected to its mission. Voting control in steward-ownership forms is not a saleable commodity. Profits in steward-ownership are understood as a tool for pursuing the company’s purpose. After paying back capital providers and sharing economic upside with stakeholders, the majority of profits are reinvested in the business. Steward-ownership forms include an asset-lock, which prevents the proceeds from a sale from being privatized.  This structure aligns decision making power with active stakeholders close to the business, instead of remote investors or shareholders. 

We pose these questions to invite expert thought pieces of examples of structures and case studies from different jurisdictions (see our style guide).

“From now on, it’s in the best interest of our management to put our social mission first, even if that means slowing down our growth. Everyone working in the company is incentivized, first and foremost, to make decisions that benefit not just the owners of the company, but all other stakeholders, the environment, and society at large. After this change, we can finally—confidently— say that our company will always be a force for good in society.”: Juho Makkonen, Sharetribe Co-Founder and CEO 

Covid 19 is a lesson in why alternative investment structures are needed

This article and all the articles tagged Tactics or Ideas are opinion articles and therefore only reflect the view of the author. 

Covid-19 is teaching us many lessons that take the form of “that thing we used to do, or that idea we used to feel safe thinking, turned out to not be that good an idea after all.”  Covid 19 is teaching us the value of resilience and flexibility.   

Companies that need cash and wish to borrow to survive the crisis have no idea when their cash flows will once again become predictable.  Companies that thought they had predictable cash flows and have borrowed against those predictions are now stuck with fixed payments they can’t meet.  

The core problem with traditional debt for social enterprises is agreeing to fixed payments against variable revenue streams, negotiated early in a company’s life when revenue is most unpredictable.  Many enterprises in the countries where Covid-19 lockdown measures have been implemented are going to fail. It’s not true that “no one saw this coming.” Covid-19 specifically, yes; but unpredicted swings in revenue early in the life of a company?  Both foreseeable and foreseen.  

There is an alternative, but it’s been practiced only at the fringes.  This global crisis presents the opportunity to reconsider how we structure early stage investments.  For the many companies in trouble, Revenue-Based Finance (RBF) approaches are among the most promising ways to restructure debt to assure repayment in the long run.  Little has changed about the long-term prospects of most of these companies; yet many have total uncertainty about near-term revenues. A return to revenue growth is likely, but the timing is completely unknowable.  This type of situation is a perfect recipe for the use of RBF.

For new financings, the benefits of RBF have never been clearer.  If a crisis can quickly slow the economy once, it will happen again — why not design our financing structures for flexibility and resilience?  Revenue-Based Financings are investment structures that link the returns to the investor with a company’s revenue. This type of structure is in the interest of both the social enterprise and their investors.  There are many ways to structure RBF and you can learn more about structuring options at impactterms.org  

Because the payments due to investors from RBF structures vary with company performance, they are designed to handle exactly the kind of stress and uncertainty we are seeing in this crisis (and others like it in the future). A company that borrowed using an RBF structure, instead of traditional debt would not be forced to make payments that they can’t afford but if they miss put them in default. Its action also saves the investors in the company. Yes, the investors’ returns will likely decline as payments get pushed to the future, but that’s a much better problem than losing their whole investment.

One investor using RBF both for restructuring and new investing is Capacity Capital, a new fund investing financial and social capital into small revenue-generating growth businesses, especially the overlooked and underestimated.  For example Capacity Capital recently made an investment in RentSons, a company that helps people link up with “helping hands”. Rent Sons had a mix of existing debt obligations that, as is common in debt structures, did not offer the company the flexibility they needed to manage downturns in the business cycle.  They now have the flexibility they need thanks to Capacity Capital restructuring those old debts and providing new financing in a combined RBF financing.  

Through a new RBF investment they are providing RentSons additional growth capital and restructuring their old debn

For investors and companies that have used traditional debt and are facing likely default, this is a great time to consider restructuring the debt using an RBF structure.  When the timing of cash flows is uncertain but the company’s prospects are still strong, the traditional option is equity. However, the investor has to believe they will one day be able to sell that equity.  By restructuring into an RBF structure, the company can have the flexibility they need to recover, and the investor can have a realistic path to recovery and profit.  

It will take some time before we have enough perspective to look back and draw final conclusions from this experience, but one clear lesson we can learn today is the value of flexibility and we can put that lesson to work today by using Revenue-Based Financing and the other alternative investment structures featured on ImpactTerms.org 

Social Enterprise

A social enterprise is typically understood to be a for-profit business or a business within a non-profit organization that has a specific social or environmental mission included in the business plan. U.S.-based Social Enterprise Alliancel defines social enterprises as:  “Organizations that address a basic unmet need or solve a social or environmental problem through a market-driven approach.”

This definition is left intentionally vague, as it must cover a wide variety of approaches and structures. Some operate within traditional structures and follow traditional exit paths, whereas others opt for alternative structures

See also: 

Would you like to add to this article? Please reach out to the Impact Terms team about contributing.

Footnotes:

  1. Social Enterprise Alliance

Revenue Based Financing

Revenue Based Financing is the most popular form of contingent payment structures and is often used as an alternative exit structure.

Revenue Based Financing structures are contingent payment instruments that dedicated a percentage of revenues as the source of returns to investors.  The structures are typically designed to stop paying investors when the investor has received the negotiated target return. Typically, that negotiated return is expressed as a multiple of the initial investment.  For example, investors seeking a 3X return target that has invested $100,000 would receive their share of revenues until the investor has been paid $100,000 X 3 = $300,000. It’s important to note that the investors return on capital will depend on the timing of the payments – and thus will depend on the rate of revenue growth.   The same 3x return target will have a much better return on capital if the company has fast revenue growth compared to the same company if it experiences slower revenue growth.

Revenue Based Financing can either be set up as debt or equity structures depending on the local laws.  When using equity they are typically Redemption Based Exits in that the issuer is obligated to repurchase the equity from the investor at a specified premium.  In Revenue Based exit Structured as debt, the payments to the investor are treated as a mix of interest and principal payments.

Key Considerations for Deal Structuring

Legal and Accounting Considerations

Complexity

Complexity is an important consideration when seeking the most appropriate capital for a company.  If the needs for capital are appropriately met with traditional structures then using traditional structures will likely reduce transaction costs and investor reticence.

Many of the alternative exit structures are new, are not well understood by many practitioners, and have less clarity about their tax, accounting, and legal merits than traditional exits.  These complexities can add costs and slow the transaction process.

Equity vs Debt

It’s important to understand that just because a security is labeled as “equity” or “debt” does not mean that the local tax authorities will accept that label.  It is common for tax authorities to have procedures to reclassify securities based on their economic structures.  Any reclassification could significantly change the economics of the security and/or increase the difficulty of accounting and other compliance elements.

We recommend any investor or entrepreneur seeking to use an alternate exit structure seek professional advice on the tax implications with a specific focus on reclassification risk.

Usury Laws

When an alternative exit uses a debt structure or a structure that could be reclassified as debt issuers must be careful that the nature of the contingent payments don’t violate local usury laws.  Usury laws are laws that set a maximum interest rate on debt payments.

What is interest vs principal?

When an issuer pays an investor some return on a debt structure it needs to be clear to both parties what portion of the payment is interest and what portion is principal.  This distinction is important because generally the return of principal is not taxed but the interest is subject to taxation.

Traditional investment structures calculate the principal and interest portions of a payment using near-universally accepted amortization tables.  With many alternative exit debt structures it is not clear how to create an amortization table that is accepted by the local tax authorities.

For example, consider a debt based alternative exit where the source of returns is a fixed percentage of revenues until the investor receives 3 (three) times their initial investment (a revenue based contingent payment).  If the investor invested $100,000 then when the transaction has completed its duration the investor will have received $300,000 in payments of which $100,000 has to be treated as return of principle and $200,000 has to be treated as interest..  If the first payment is $10,000 – what portion of that is principal and what is interest?  It might make sense to call ⅓ principal and ⅔ interest.  It also might make sense to call the entire $100,000 of payments principal and then all the rest interest.

While it is possible that your local tax jurisdiction will not have clear rules, it is more likely that they do have rules for properly apportioning principle and interest because not having those rules would have made it easy for investors to take advantage of their absence and create investment structures that are intended to delay, defer or avoid taxes.

Complicated accounting requirements

Some tax jurisdictions solve the above referenced question of apportioning interest and principle by imposing complicated tax accounting methods that can be burdensome to administer and may even create tax disadvantages to the investor.

For example, in the United States the law (26 CFR § 1.1275-4) requires contingent payment instruments to be treated as if they were not in fact contingent using the Noncontingent bond method. In addition to the added complication, this often has the negative consequence of requiring, in the early years of an investment, the investor to pay tax on income they will not receive until the later years of the investment. This article goes into more detail on taxes and revenue-based or other similar contingent payment instruments in the US – we highly recommend reading that article if you considering these structures in the US.

Distribution rules (eg re dividends and Board approval)

Local lay may have rules that need to be carefully considered when using equity instruments for alternative exits, especially when using a dividend as part of the structure.  Traditionally dividends may need to be authorized by the board and their may be restrictions on payment if the issuer does not have retained earnings.

Downside Protection

Traditional investment structures have clause for when the investment does not perform or when the company is forced to restructure or close.  The order in which creditors and investors get repaid in those cases is one of the negotiable features of term sheets but is generally based on the overall structure of the transaction with debt having higher preference than equity.  To the extent that an alternative exit has an economic structure that is different than its legal structure (eg a debt based exit that offers equity returns) the parties need to consider the appropriate downside protection.

Considerations by Legal Jurisdiction

The key questions that you need to ask to figure out what exit structures work in a given local legal system:

  • Do the tax authorities have rules for reclassifying debt as equity (or vice versa) – that is, is it possible that designing a debt instrument that pays variable payments (eg revenue based) would be reclassified as equity
    • if those rules exist you may need to create an equity structure
    • if those rules don’t exist then,
      • how are contingent payment debt securities taxed and accounted for.
        • how is each payment split between the return of principle vs interest? (need to know for investor and issuer – may not be the same)
        • are there rules that force contingent payment debt instruments to be accounted for in a way that may create phantom tax (in the US, for example, you have to act as if the payments were non contingent and create an amortization schedule and make tax payments based on that schedule – not just on what each payment ends up being)
    • Could designing an equity structure with mandatory redemptions be reclassified as debt
      • if yes this loops back to the questions re debt payments above
      • if no then equity with mandatory redemption contingent on (revenue %) is an easy option

Additional Resources