Investing for Social Impact Lures Investors

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Nov 2008
New York, United States , November, 17 2008 - The term "community investing" refers to investment options with a strong local or geographic connection. This would include both domestic options such as investing in underserved communities or international options such as microfinance.

Community and proactive investing refers to [socially responsible investing] strategies designed to have some direct, positive social impact stemming from the actual investment.

For many investors, this direct connection between their investment dollars and positive social impact makes community investing an appealing SRI strategy. For example, some investors simply find the tangible nature of a community bank deposit more appealing than the often less tangible benefits of social screening or proxy voting.

Typically, the term "community investing" refers to investment options with a strong local or geographic connection. This would include both domestic options such as investing in underserved communities or international options such as microfinance.

"Proactive investing" is an emerging term that broadly refers to investment strategies outside of social screening that have some positive social impact, compared with conventional strategies. Such proactive investing would likely include many community investments and investments in companies or projects geared around broad, proactive environmental or social themes, such as alternative energy or regional economic development.

In the United States, the political and legal victories of the civil-rights era gave way to the persistence of economic inequality among historically disadvantaged minority populations. Structural barriers were high and extensively limited opportunities for certain segments of the population.

Moreover, the combination of redlining (where banks refused to lend in certain areas because of perceived risks or even regulatory limits) and deindustrialization contributed to severe economic deterioration of many inner-city neighborhoods in the 1960s and 1970s. Loss of jobs in industries such as textiles and furniture manufacturing to lower-wage countries resulted in similar problems in rural areas.

In some areas, local community banks, credit unions and loan funds developed to serve local and often disadvantaged groups or geographies. ShoreBank [Corp.], founded in Chicago in 1973, emerged as an early example of a business model with strong social roots aimed at investing in the local community.

The success of institutions such as ShoreBank at addressing local problems contributed to some of them broadening their business models to address other emerging issues, such as the environment.

Alongside these very locally oriented developments has been the rise of social venture capital — or early stage investments in a broad range of companies that have some strong social aspect to their business models.

In general, the success of the core-community investing models that emerged in the 1960s and 1970s paralleled the development of other market-based businesses aimed at addressing social and environmental problems.

Over this same period, these domestic developments were paralleled by international developments in microfinance. There have been frequent connections between domestic U.S. community development and microfinance, such as ShoreBank's involvement in creating and investing in microfinance institutions around the world.

Microfinance institutions generally share the broad goal of domestic community banks of providing capital to underserved populations to stimulate economic development, from the individual borrower on up.

The past generation has brought some additional trends to community and proactive investing. Two trends that have been particularly important in increasing the breadth of community investing have included the following:

• Large institutional investors have become involved in community investing for such reasons as client demand, competitive returns in local development, regulatory pressure or foundation mission.

The majority of these new institutional investors seek competitive returns across a wide range of community investments, including community development financial institution deposits, private equity and private debt. These institutions may also proactively invest in public stocks and bonds that have a focus on community and economic development.

• The growth of community investing has also been fueled by direct access to capital markets. The issuance of more easily traded bonds supporting commercial or residential mortgages, for example, has allowed certain community development financial institutions to free up capital for further community investing by packaging and selling assets to other investors. These types of securities have also been instrumental in increasing the presence of large institutional investors in community investing.

The success of various community investing models has helped dispel some of the now outdated myths regarding community investing, both in the United States and internationally.

Two of the more widespread myths are:

Myth 1: Poor people and smaller businesses are inherently riskier borrowers than wealthier people and larger corporations.

In fact, the experience of community development financial institutions such as ShoreBank and microfinance institutions such as ProCredit Group in Frankfurt, Germany, are just two examples of companies with stable, profitable business models that lend to poorer borrowers and small businesses. Also, with properly designed lending programs, portfolios of loans to very-low-income borrowers can have loss rates below those [involving loans to] consumers in developed countries.

Myth 2: Financial institutions dealing with poorer borrowers or those operating in disadvantaged areas require subsidies to operate.

In fact, many microfinance and community development institutions are profitable on their own without subsidies. Also, key institutions in the economic development community, such as the Consultative Group to Assist the Poor [of Washington], find prolonged subsidies undesirable:

"Subsidized interest rates generally benefit only a small number of borrowers for a short period. Interest subsidies are an inappropriate use of donor or government funds because they distort markets ... Programs that target specific populations with subsidized interest rates have generally suffered low repayment rates, institutional dependency and limited growth. Clients often view these loans as one-off 'gifts' that need not be repaid."

In addition, there is emerging evidence that community investing strategies may have some surprising advantages over conventional in-vesting activities.

Some of these advantages are:

Faster growth. With microfinance assets projected to grow at 30% over the next 10 years to approximately $250 billion and with community development financial institutions expected to grow at twice the rate of commercial banks in the United States, community investing presents investors and depositors with significant growth opportunities.

Broader Diversification. Within microfinance institutions, for example, there is emerging evidence that institutions that lend to poorer borrowers may not be as hurt by adverse macroeconomic trends as more mainstream institutions. This evidence includes a recent study that looked at the returns of microfinance institutions versus banks in developing countries over economic cycles:

"Our empirical tests generally show very low exposure of microfinance institutions to general market movements, suggesting that microfinance portfolios may have useful portfolio diversification value."

With mounting evidence, these myths are beginning to be replaced with a more accurate and balanced view that also reflects some of the unique, positive financial characteristics of community investing. Done properly, many community investing activities can be accomplished with profitable, stable, growing business models.

For investors and depositors, this equates to a combination of competitive returns and positive social impact.

INVESTING STRATEGIES

In considering your community investing options, it is important to know some of the constraints. A major consideration is whether you will be considered an accredited investor. Simply put, being an accredited investor means that you have some combination of high income, high net worth and a high level of knowledge of investing that allows you to make certain types of investments that are not typically available to the general public.

The rationale, as articulated by the Securities and Exchange Commission, is essentially to protect the vast majority of unsophisticated investors from investing in relatively higher-risk investments that also would tie up their money for long periods of time (sometimes as long as 10 years).

This logic also explains why stock and bond mutual funds are mainly invested in securities that can be valued every day and can be sold relatively easily with few restrictions.

The types of investments available only to accredited investors typically have very high minimum investments and might include a wide range of funds or shares or other alternative investments, such as private-equity funds and private real estate funds. Importantly, these types of investments typically come with many restrictions and caveats.

The result is that most individual investors looking to engage in community or proactive investing will be limited to low- and moderate-risk investments such as community bank deposits and specialized mutual funds investing in related securities. Accredited investors can engage in these and higher-risk private investments as well.

OPTING FOR THE COMMUNITY

While community investing offers a wide range of options, many of these options have two fundamental limitations that will apply to many investors:

The investment option has very high minimum balances and is only available to accredited investors who meet certain criteria, thus eliminating many potential investors. The investment option is structured to provide the investor with below-market-rate investment returns.

One way around one or both of these limitations is simply to have your community investing assets included as part of another account or fund. This could include, for ex-ample, investing in socially screened stock or bond funds with small allocations to community or proactive investing. This occurs in many of the funds from the specialized SRI investment firms, such as Calvert [Group Ltd. of Bethesda, Md.] and New York's TIAA-CREF.

In addition, some conventional funds have small allocations to community and proactive investing programs.

Certificates of deposit, savings accounts and checking accounts in local community development banks or credit unions are probably the easiest way for individual investors to engage in community investing. Importantly, these deposits typically come with federally backed deposit insurance and often with competitive returns commensurate with this low level of risk and comparable to similar deposits at conventional financial institutions.

Within the United States, these local institutions are often considered under the broader label of community development financial institutions — an official designation of the [Department of the Treasury] meaning mainly that their primary mission is geared toward local economic development in underserved communities.

These types of deposits generally have provided a combination of competitive returns, positive social impact and broad appeal to investors.

"Deposits into community development banks and credit unions, at market rates, for part of a cash allocation are an essential component of the continuum of mission-related investments that maximize economic and social/environmental performance," according to a recent report commissioned by TIAA-CREF and released by the Calvert Foundation of Washington.

MICROFINANCE INVESTING

Microfinance is the provision of financial services, such as loans to low-income borrowers. This type of community investing often occurs in developing countries through microfinance institutions.

With wide historical roots, the recent history of microfinance can be traced in several directions, though the founding of the Grameen Bank by Dr. Mohammad Yunnus in Dhaka, Bangladesh, in 1976 was certainly an important development. Dr. Yunnus' model for microfinance initially involved lending very small amounts (typically under $100) to poor women.

The initial goal of Grameen was to break the cycle of poverty (low income leading to low savings leading to low investment) and underemployment. Loan proceeds were generally used to support "viable income-generating activities — simple processing such as paddy husking, lime-making, manufacturing such as pottery, weaving and garment sewing, storage and marketing, and transport services."

Initially, though loans were made to individual borrowers, those borrowers were typically part of a lending group that also guaranteed the loans. Microfinance spread rapidly in Bangladesh through Grameen and through two other Bangladeshi microfinance institutions: ASA International and BRAC International in Dhaka, Bangladesh. Largely driven by these three, the penetration of microfinance in Bangladesh has reached the highest level in the world (35% of the poor population).

Microfinance also developed in other parts of the world, often through the assistance of such international microfinance foundations as Accion International [of Boston], [Foundation for International Community Assistance International of Washington] and through internationally oriented development banks such as the International Finance Corp. [part of the World Bank Group of Washington], FMO NV [of The Hague, Netherlands], and KfW [in Frankfurt, Germany].

Foundations such as the Omidyar Network [in Redwood City, Calif.] and DOEN [in Amsterdam, Netherlands] have also been instrumental in promoting microfinance through grants and investments.

With the United Nations declaring 2005 the Year of Microcredit and Dr. Yunnus winning the Nobel Peace Prize in 2006, the field of microfinance received significant attention. The reason for the high profile seems primarily to be its effectiveness as a development tool that is also commercially viable and self-sustaining.

In this sense, microfinance stands out as one of the few economic development tools that has proved both scalable around the world and effective at alleviating poverty.

The effectiveness of microfinance as a commercial economic development model has been widely studied. In 2005, the Grameen Foundation USA in Washington published a summary of the wide-ranging research on microfinance. Its conclusion states the following:

"Does microfinance work? This review of the literature provides a wide range of evidence that microfinance programs can increase incomes and lift families out of poverty."

As an investment option, however, microfinance presents few pure plays that invest solely in microfinance, are easily available to investors, and provide competitive returns.

Accredited investors can consider options from companies such as Microvest of Bethesda, Md., a specialized microfinance investment company.

GREEN INVESTING

Green or environmental investing has become a widely popular term with no clear definition.

Thus, it is worth noting that there are environmentally related investment options within all three SRI strategies. For example, some environmental issues, such as climate change, can be [affected] by shareholder activism (to encourage carbon emissions reporting) or social screening on environmental issues (to invest in companies with stronger environmental track records).

Finally, there are proactive investment options such as sector equity funds investing in alternative energy, water resources and pollution control.

However, the proactive or community investments in this area have a number of limitations for most investors: The stocks or funds geared toward sectors such as pollution control and water resources tend to be sector funds with higher levels of risk than broadly diversified portfolios.

This higher level of risk stems mainly from technology risk (that the underlying technologies do not work), regulatory risk (that regulations required to compel users to adopt the technology are not passed into law or are not enforced) and simply having very narrow investment strategies. Consequently, these funds often do not fit easily into the asset allocation process.

Importantly, these types of sector funds cannot be counted on to outperform the broad stock or bond markets over long periods. While underlying trends such as high energy prices may be strong, the financial benefits stemming from these trends do not necessarily accrue to investors in these types of funds and stocks and are inherently difficult to predict. The rapid growth of the Internet, for example, has created massive wealth, but sometimes not where investors expected it.

From the perspective of environmental impact, many investors may simply be better served by making shorter-term personal investments (in better insulation for your house) or considering insured deposits with community development finance institutions with a strong environmental focus (such as ShoreBank Pacific or New Resource Bank) than trying to consider sector fund strategies.

In addition, investors can focus on the other two SRI strategies with an added eye on the environment. In short, while environmentally oriented investing does present opportunities for investment and positive environmental impact, most of the investing options are currently more appropriate for large institutions or highly knowledgeable accredited investors.

SOCIAL VENTURE CAPITAL

Social venture capital involves providing investment capital (debt or equity) to early-stage companies with business models offering a combination of financial returns and positive social impact.

I consider it a proactive investing strategy because it is capital that is seeking direct [effect] on social problems.

In 1992, a group of high-net-worth, socially minded investors got together to form Investors Circle [of San Francisco] — a network of investors in young companies who are "using private capital to promote the transition to a sustainable economy."

Because of the focus on early-stage companies and on social factors (inherent in "sustainable"), it is one of the earliest organizations to be linked with the term social venture capital.

Investors Circle evolved from an informal network to include two annual SVC conferences that featured a select list (picked by the IC board) of young companies with a strong social or environmental aspect in their business models.

Companies were typically quite young and needed new investors to fund prototypes, commercialization or general working capital needs.



Source : Investment News
 

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