Philanthropy and the practice of grantmaking traditionally have been very separate from traditional investing in both culture and approach, but the emerging field of impact investing invites a productive collaboration between these two disciplines. Indeed, in an increasingly resource-constrained world, the ability to drive more impact investments into the communities and issues we care about is imperative. In the paragraphs that follow, we will explore how family foundations, philanthropic institutions, and public funders can use their grants strategically to unlock future impact investments in social businesses and socially driven business models that are either too risky or not ready for investors seeking financial returns.
In traditional capital markets, there are clear roles that different investors play in the sequence of financing for organizations as they move from seed stage to later stage. In the impact investing field, the role and needs of investors at different stages follows a similar though less clearly defined path. The relatively recent proliferation of socially driven business models makes it challenging for many to identify opportunities that are ready for investment or that have enough of a track record to provide confidence in their future returns. While such an environment provides investors with opportunities to be creative with financing, it also requires increased transparency and communication from investees, funds, and intermediaries to accommodate different risk and impact profiles within the same deal or investment opportunity.
In many cases, the work of innovative socially driven business models may be accelerated by combining various types of impact investment capital, in effect "stacking" capital that requires a financial return with capital that does not in order to "buy down risk" or otherwise make a deal happen that philanthropy or market rate investment alone would not be able to achieve. Because grants do not require repayment or a rate of financial return, they can be used more flexibly in certain transactions. For example, grants may be used to provide guarantees, fund a loan loss reserve, or serve as flexible lending capital, each of which may be needed in order to leverage or attract capital seeking a return. Coordinating grants with investment in this way may not only reduce the risk associated with particular transactions, but also can support socially driven financing models, thereby enabling impact investment opportunities that might otherwise not be possible.
When blending grants with loans, grant providers and impact investors should coordinate in advance to determine the best use of the grant capital. If a lender is evaluating a loan to a weak borrower, an aligned grant can be helpful in serving as a buffer, or loss reserve, for the loan. But a grant to support programming and capacity building to the same organization, while important, probably would not sufficiently reduce risk enough for an impact investor.
Another situation in which philanthropic capital may play a catalytic role for investment capital is when transactions or borrowers are not ready for capital that is seeking a financial rate of return. In many such cases, the borrower may lack a credible business plan or may have a socially driven business model that is not well-tested or proven in the mainstream market. This is certainly the case for many high-potential social ventures that won't be ready for investment capital until they have reached a certain scale or established reliable revenue streams, yet require initial funding to prove and develop their model. In these cases, grant funds may also serve as effective seed capital to incubate "investable" opportunities and unlock capital from later stage impact investors, support new ideas that are not mature enough to generate investor returns, and/or build capacity and scale social ventures.
However, regardless of how creative one is, the reality is that some social ventures will never develop into businesses that can service debt or generate a return on equity, while others simply have not invested in the metrics and evaluation activities needed to validate their model to impact investors. Grantmakers can involve impact investors early on in their due diligence process to help identify and support organizations that have a higher potential of developing into investable business models. And they can work with impact investors to structure their grants in ways that attract future investment by incorporating the kinds of evaluation metrics and performance requirements that will satisfy the due diligence needs of impact investors.
Driving increased coordination between grantors and impact investors will require additional efforts to bridge these two cultures. Within foundations, the grantmaking and investing sides of the house have generally been kept separate from each other. Part of the solution for unleashing the power of market-rate capital to generate good at the community level lies in cross-training individuals from these disciplines, as well as shifting organizational culture toward understanding and embracing greater collaboration among staff.
Making the best possible use of every single grant dollar is particularly important in today's fiscally constrained world. Aligned grants can be critical to unlocking impact investment capital, thereby stretching the dollars available to the communities and issues we care about — regardless of where we sit in the capital stack!
The above article was adapted from "From Grants to Groundbreaking: Unlocking Impact Investments," an ImpactAssets issue brief by Amy Chung of Living Cities and Jed Emerson.