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Solving the Puzzle of Responsible Exists in Impact Investing

26.03.2018Hannah Dithrich, Research Associate, The Global Impact Investing Network (GIIN)

This blog was originally published on the Center for Financial Inclusion (CFI) website.

A responsible exit lays the foundation for long-term impact, and requires considerations as early as due diligence

Impact investors are motivated by two primary objectives: to generate a financial return and to create positive social or environmental impact. But how do they balance these dual goals throughout the investment process, and specifically at exit? It’s no easy feat.

Investors must consider what happens to impact when they exit an investment. For example, if a company received critical capital and resources from an investor, will it still be equipped to succeed and continue its mission when that investor exits? What if an investor sells her shares to a more commercially-minded buyer who deprioritizes the company’s impactful or sustainable practices?

In financial inclusion investments, the possibility of mission drift after exit can have real implications for impact. For example, if a microfinance institution is acquired by a firm with little experience with underbanked customers, it could increase loan sizes beyond what clients are able to pay back, ultimately leading them into cycles of debt. Impact investors seek to mitigate such risks by exiting their investments responsibly.

A 2014 paper called The Art of the Responsible Exit in Microfinance Equity Sales, by CFI and the Consultative Group to Assist the Poor (CGAP), explored the topic, outlining four decisions that microfinance equity investors can consider: i) the timing of their equity sale; (ii) buyer selection; (iii) governance and the use of shareholder agreements; and (iv) how to balance social and financial factors across multiple bids for their equity. Later this spring, the authors will publish a follow-on paper with guidance for all financial inclusion investors, beyond just those of microfinance institutions.

This year, the Global Impact Investing Network (GIIN) published Lasting Impact: The Need for Responsible Exits, a study that draws insights across sectors and asset classes that can be applied to financial inclusion investments. To produce this report, my colleagues and I interviewed over 30 leading practitioners, and found that investors plan for a responsible exit even before the investment is made. They lay the foundations for long-term impact throughout all stages of the investment process, from due diligence and capital structuring to exit.

During pre-investment due diligence, investors seek out companies or projects that present few risks to mission drift down the line – such as those with inherently impactful business models and those whose founders have a strong commitment to impact. They note that companies with impact ‘baked in’ to their business models face few tradeoffs between financial and impact objectives, so are unlikely to deviate from their mission. The question of ‘whom to exit to’ is key – echoed in CGAP and CFI’s paper – and investors note that they consider this during due-diligence, looking at likely exit options, which often depend on companies’ plans for growth. Annie Roberts of Open Capital Advisors noted that “if the planned exit for a given business is to a large strategic [buyer] that might not share the same impact motives, the investor takes this into account when deciding whether to make the investment in the first place.” CGAP and CFI’s paper also notes that investors typically “plan their exits before they enter”.

Once ready to deploy capital, investors can structure investments to help the company grow sustainably, without jeopardizing impact. Return expectations and structuring aspects like repayment timelines or holding periods and ownership stake in the company can all form part of a responsible exit strategy. For example, while equity investments can allow for more active involvement, they also tend to have relatively short time horizons (a 3-4 year holding period for a typical 10-year fund, for example) and growth expectations that could lead companies to prioritize expansion over sustainable practices. Debt investments, on the other hand, can be structured with flexible repayment schedules that avoid the pressure for rapid growth. Tying some portion of payments to revenue can free up needed cash for companies with variable cashflows, while also enabling investors to participate in a company’s success.

Investors can also use shareholder agreements and other structuring documents to solidify the company’s mission. Grassroots Capital’s concept note on “’Hardwiring’ Social Mission in MFIs” shows how anti-dilution clauses, dual share structures, and golden shares can help preserve a company’s integrity or keep key decisions in the hands of mission-aligned founders. CGAP and CFI’s paper echoes this, with the example of Aavishkaar-Goodwell’s exit from Equitas. Equitas had a majority independent board (which could reject share sales resulting in over 24 percent ownership), shareholder agreements that set a cap on ROE, and commitments to donate 5 percent of its profits to charity. These governance clauses helped create a “self-selecting pool of potential investors”.

During investment, investors can instill positive practices and corporate governance policies that will last through changes in ownership. For example, investors can work with company management to improve governance policies like adhering to SPI4 standards, which assess an institution’s social performance, in the hopes that sound practices will continue through changes in ownership.

The exit itself, of course, is also key. Whether exiting through a strategic sale, to a financial buyer, or through an IPO, investors can seek to exit at a time when the company is at a stable stage in its growth, and can benefit from another investor’s capital or resources. For example, the GIIN’s paper profiles LeapFrog Investments, which felt it was time to exit its investment in a Ghanaian life insurance company called Express Life once it saw the company growing steadily and in need of growth capital beyond what LeapFrog could provide.

When it comes time to exit, though, how do investors know if they’re selling to a follow-on investor that might later take the company in a different direction? CFI and CGAP’s paper highlights the importance of buyer selection, and the GIIN report shows how investors identify buyers that are aligned with the company’s business model or mission. For example, LeapFrog seeks buyers that recognize the commercial value in serving low-income consumers, as well as the impact inherent in these business models. It sold its stake in Express Life to Prudential Plc, which sought to establish a presence in Africa and understood both the value proposition and the impact created by providing critical financial services to low-income consumers.

This research can guide investors – those focused on financial inclusion and those targeting other themes – in sourcing, structuring, managing, and exiting investments to optimize for long-term positive outcomes. As the industry continues to mature, investors will further develop strategies for responsible investments and responsible exits that result in lasting impact.

To read more on the GIIN studies about Africa, you can download the landscape of impact investing in Southern Africa, East Africa and West Africa.

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About the Author

Hannah Dithrich conducts research at the Global Impact Investing Network (GIIN) to fill critical knowledge gaps in the industry and improve practitioners’ approaches. Hannah is a former Fulbright Scholar to Malta where she worked with the United Nations Refugee Agency, and has extensive background in microfinance at Grameen America and in research at a boutique fund of funds focused on emerging markets. She holds a Bachelors of Arts degree in International Relations from Pitzer College.

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