Can Impact Investing Avoid the Failures of Microfinance?

///Can Impact Investing Avoid the Failures of Microfinance?

Can Impact Investing Avoid the Failures of Microfinance?

The impact investment industry is growing rapidly, a fact that many of us in the field celebrate. In 2010, J.P Morgan projected up to $1T in investment would be deployed this decade — which would make impact investing twice the size of official development aid to the world’s less develop countries (as defined by the United Nations), presuming historic levels of aid stayed constant since 2010. Many of us are starting to envision a day where we can drop the “impact” moniker and just assume that investments take into account social and environmental factors.

But are we scaling the right model? How do we make sure that the blossoming impact investment movement — especially as it starts to supplant traditional aid — actually leads to improvements in outcomes for the people and communities it is supposed to benefit?

Impact investors over the past decade largely focused on proving that impact investments could achieve a “market rate” or above return profile. Making something wildly profitable will of course attract the attention of financial markets, and thus increase the chances it will scale effectively. Often, however, the elements that make something profitable work counter to those that maximize positive social impact. So it’s important to recognize that if we expect to expand impact investment based primarily on its profitability, we should expect to get just what we set out to create: a tool that has maximized profit over impact.

In my view, the pursuit of scale must be accompanied by a litmus test to make sure we are equally scaling impact, in a way that is both accountable to and transformative for beneficiary communities. Impact investing can learn from the history of microfinance — the provision of debt and other financial services to the poor — an industry that was at a similar stage 15 years ago. In that case, the industry achieved financial scale, while impact at scale was largely left behind. Fortunately, impact investors have the opportunity to think more creatively over the next decade, as long as they learn from past mistakes in microfinance.

Lessons from Microfinance

There are two major debates in particular about microfinance that are relevant for the impact investment industry. First, does microfinance help people, and if so, how much? Depending on who you talk to about microfinance, it is either the solution to global poverty and deserves to be included in the basic list of human rights, or it’s a complete rip-off of the global poor that only serves to concentrate more resources in the hands of the wealthy. A long line of studies has been unable to conclusively prove the point for either side. Still, the question is important to ask.

Second, should microfinance make money, and if so, how much? One school of thought held that, for microfinance to scale and attract and maintain commercial capital, it needed to show that it could achieve market rates of return. Others believed that, if it was truly a social intervention, perhaps it shouldn’t make money beyond enabling institutions to sustain themselves, especially if the owners of those institutions are primarily wealthy people outside of the communities being served.

If our starting place in defining successful scale-up is a certain expected return for the investor, then the tail is likely to wag the dog in terms of the financial services offered and who ultimately benefits. For example, many microfinance institutions have promoted loans far more than they have promoted savings, as loans produce much higher margins — and in the case of some less scrupulous institutions, people have been flat-out prohibited from opening savings accounts if they are not taking out a loan as well. Prioritizing profitability over impact can also lead institution to provide activities and services according to which ones are most profitable, rather than which best support poor people and ultimately eliminate poverty.

Scaling microfinance through financial market adoption became the predominant preoccupation and ambition for the industry before the questions of “Does it actually work to reduce poverty, and under what circumstances does it work best?” were fully answered. The assumption became, “Microfinance works, so let’s scale it” without acknowledging how scaling through the prioritization of profits could change the nature of the industry and have consequences for the people being served.

Read more at Harvard Business Review