A changing financial ecosystem
Several trends are disrupting the traditional funding sources relied upon by many non-governmental organizations (NGOs). Some government donor agencies that fund NGOs have threatened to sharply cut their budgets. At the same time, liquid global capital markets and a greater risk appetite among financiers has expanded the landscape for private financing flows to include social and environmental programs - for example, the growth of green bonds and SDG-linked equity funds. In relative terms, private foreign direct investment flows, remittances, and philanthropic giving far exceed the flow of official government aid to developing economies.
With this confluence of trends, many donors and philanthropists are thinking more like professional investors. Private sector donors are becoming more sophisticated, and many are seeking better value for money and returns on investment in terms of social outcomes and expecting NGOs to be more accountable and transparent than ever.
Similarly, public sector donors and social investors are looking for new ways to leverage their limited funding with blended (public-private) finance vehicles that augment declining public dollars with private funds.
A changing development ecosystem
The work of non-governmental organizations (NGOs) - protecting the environment, helping the sick and needy, preserving arts and culture, is by nature unprofitable. Traditionally, NGOs rely on the goodwill and generosity of others to cover the costs of their activities through grants and donations. Today, unfortunately, NGOs find that such traditional funding sources are often insufficient to meet growing needs and rising costs. In addition, restrictions imposed on many grants and donations, along with the uncertainty of these funds over time, make it difficult for NGOs to do long-term planning, improve their services or reach their full potential.
When the costs of an NGO’s core activities exceed the inflow of grants and donations, it is forced to either reduce the quantity and/or quality of its work, or to find new sources of funds to cover the difference. Reaching out to new donors with innovative fund-raising approaches is usually the first step. Redesigning program activities to include cost recovery components, whereby the beneficiaries or clients of the NGO pay part of program costs, is a second approach. A third alternative is for the NGO to make money through commercial ventures.
The impact of the Covid pandemic has been enormous particularly on the NGO sector. Not only are their traditional funding sources now directed to new emergencies – but in the short to medium term – their survival is threatened by a complete lack of donor funding. This is because traditional funders of the NGO sector are facing their own challenges – for instance – profits have declined and therefore corporate social investment or grant funding is less. Traditional overseas development agencies are focusing on their own countries and as such have less resources to send around the world. In addition, funding practices are changing, and funders are now looking at more sustainable funding mechanisms. This means that NGO’s will also have to consider new sources of capital to ensure their survival into the future. One of these are impact investments.
Impact investing has become a widely used and popular term over the past few years. Impact investing is characterized by three aspects specifically:
- Intentionality: Every investment has some positive impact: creating jobs, making products cheaper, etc. In impact investing, achieving a pre-defined goal is part of the investment’s objective. The impact is not just a more-or-less random by-product of an existing portfolio of assets. It is selected because it generates a certain impact.
- Measurability: In impact investing, data are collected to quantify the positive impact of the investment. This can be supplemented by case studies. Different frameworks can be applied, for example, the Impact Reporting and Investment Standards (IRIS) of the Global Impact Investing Network or the Impact Management Project’s dimensions of impact framework that focuses on who is impacted, in what way, by how much, and its contribution to impact and risk.
- Return: While the notion of impact investing is generally related to investments that repay at least the principal amount of capital, the space covers the whole scope from philanthropists and program-related investors willing to accept concessionary returns, to market-rate returns.
Private investor capital differs fundamentally from traditional donor funding streams because it requires NGOs to pay investors returns, the principal and interest in the case of a loan, or a share of the profits in the case of an equity investment. And this requirement to ‘pay back’ resources have significant implications for NGOs.
Implications for NGOs
To adapt to a parsimonious and return-driven market for donor resources, many NGOs have taken a fresh look at their funding models. Some have seen this as an opportunity to add impact investing to their operations by pivoting towards activities that have social and environmental impact (doing good) while generating financial returns (creating value).
The promise of an impact-investing approach for NGOs is to provide a new funding stream that diversifies them away from the problems of more traditional sources of finance - donations and grants for example. Currently most NGOs live on the `cliff-edge' as their financial resources are awarded for a fixed period and then drop off, leaving them with the perennial issue of finding new funding sources. They are also at the mercy of the changing tides of fashion as donors or philanthropists decide to shift strategies or just move on, leaving the recipient organization either underfunded or struggling to find new sources of finance. Impact investing offers the prospect of enabling NGOs to plan ahead with a more diversified pool of resources.
However, the change in funding strategy also requires NGOs to provide greater transparency and accountability to their investor partners.
Impact investing presents a range of distinct challenges to NGOs.
- The NGO must understand what comparative skills and roles it can play in the impact investing ecosystem. Whether as a facilitator in the deal origination process or a co-creator of new innovative pilot programs, the NGO should match the role with its existing capabilities or a future state.
- There is the question of what risk-reward tradeoff is most suited to the NGO. Some may opt for a riskier strategy of making direct investments, while others prefer a more conservative role as a service provider. Each, however, entails changes in the underlying business model, issues of legal structure, consideration of financial solvency, and efforts to increase transparency and accountability - based upon verifiable results and implementation fidelity.
- It is important to identity who are the partners that complement your skills and can fill gaps in the ecosystem that present barriers to successful project implementation.
- Consideration should be given to whether there is a willingness and capacity to restructure the organization - operationally and/or legally, to be fit for purpose.
- NGOs need to have the business models and cash flows that are necessary to pay fair returns to investors. NGOs typically limit their use of private investor capital when they use it at all – to investments in independent social enterprises with a ‘double-bottom line’ where they rely on income or equity generated from the enterprise to pay investors back. However, there is opportunity for NGOs to diversify their use of private investor capital to invest in other aspects of their operations.
- NGOs need to have the appropriate management capacity, culture, and financial and business skills to successfully implement these business models and engage with investors.
- The rate of the return paid to investors is determined by assessing the risks associated with the investment. Generally, the greater the risks, the greater the return an investor will demand for a commitment. Given the requirements to use private investor capital, NGOs should only do so when the additional impact generated by using the capital is greater than the costs associated with using the capital, i.e., the required returns. NGOs must determine if the impact they can generate with the capital warrants the associated costs relative to other possible sources of funding.
- Longer-term, the use of private investor capital could result in additional revenues for the NGO that can be used at the NGO’s discretion to deliver more impact. Investments in income-generating assets could result in an ongoing stream of revenues for the NGO beyond what needs to be paid back to the investor. Similarly, investments in new and cutting-edge projects could later attract additional donor funding to areas that were previously too risky to fund.
Towards a new paradigm
Currently there are several efforts underway to design and implement financing mechanisms that can bring impact investors and NGOs together. These include social and development impact bonds, low interest loans for advanced procurement of health products, and low-interest housing and community development loans.
They also include advance purchase commitments to motivate the development of drugs and vaccines for diseases that disproportionately burden low-income countries, and donor guarantees and first-loss agreements in investments in social businesses, as well as other examples.
When correctly done the promise of impact investing can create additional sources of revenue and greater opportunities to expand and scale impact. However, the shift from engaging solely with donors to engaging proactively with the impact investment ecosystem requires a clear strategy, strengthened delivery capabilities, and a solid grounding in data analytics to track and respond to outcome indicators. When NGOs meet these challenges and are equipped to succeed, they can scale the impact of their work and attract the long-term investment they need to grow and thrive.
Reana Rossouw is the owner of Next Generation – a management consultancy that focuses on social innovation to create shared value, sustainable development and impact assessment. In addition, she created the Investment Impact Index™ - a dedicated impact management and measurement practice that assist social and impact investors with impact strategies, impact management plans and performance frameworks, impact measurement, verification and reporting. Examples and case studies, articles and research reports can be found on www.nextgeneration.co.za and www.investmentimpactindex.org.