Why we should take risks on things which are hard.

GIF CEO Alix Peterson Zwane recently gave the Keynote speech at the Yale School of Management Impact Investing Conference. We share here Alix's full keynote address.

We know less than we think we do

I know you’re going to hear from some inspiring and passionate speakers today, and I anticipate thought-provoking discussions on impact investing and innovation. That is great, and it’s much needed. Because I would like to put it to you, to us, that we know less than we think we do. I suppose about a lot of things – but I specifically mean in the case of what sparks light the fire of inclusive green growth and social change.

Sometimes we say – “oh, if only there was the Political Will to get this thing done…” That it’s just a case of bringing together the resources we need, both financial and human capital, to fund and scale up solutions.

But really, as I heard Barack Obama say to an audience of development folks in the last days of his administration: hard things are hard. And we don’t always know what to do to make it less hard. And so change takes time.

That is where innovation comes in. We innovate and experiment not for its own sake, but to make hard things a bit less hard. Whether that means making things politically easier, less costly, or more profitable.

We are here today to talk about the state of the impact investing community and its mission. I’m going to kick off this conversation by reflecting on the role of innovation in impact investing.

Let’s say you agree with me that we need more innovation and more resources for innovation. It’d be wonderful if the tools of impact investing could drive that change and learning. If we can generate new understanding about social change and impact while recycling capital, that could turbo-charge our impact agenda.

Well, this morning, let’s explore that question. I’m going to make the case that it’s through investing in innovation and experimentation that we can achieve outsized social impact and change.

How innovation pays

To do that, I would like to pose a challenge faced by many low-income families in India looking to secure a good education and a better start in life for their children. You may find you are limited by a system where early childhood education either isn’t widely available or isn’t of the highest quality.

And in its place, an alternative system has formed, known as “Affordable Private Schools” - private schools, charging nominal fees to lower income families. However, this system is deeply fragmented and informal, leading to wide variations in the quality of education.

So what can we do about this? What innovations can help lower-income children in these schools to access a high-quality education?

A company called “Chrysalis” has developed an age appropriate, activity-based-learning programme that provides consistency and quality across these Affordable Private Schools. Chrysalis’s flexible, play-based approach seeks to improve the classroom learning environment, teacher and management capacity, and, ultimately, learning outcomes for students in the pre-primary and primary grades.

In 2020, GIF made a $1.6m equity investment to enable Chrysalis to expand its operations and product offering for affordable private schools in India. This included increased digitisation and teacher development and school training initiatives.

Our funding came at a time when the Covid-19 pandemic froze all academic institutions and rurned out to be vital in allowing Chrysalis, and by extension our own fund, to respond to the crisis and adapt their offerings for more home-based learning.

In 2022 alone, we know that Chrysalis helped educate around 250,000 students across 700 schools, of which roughly half can be classified as Affordable Private Schools. This is a really encouraging sign of their efforts to scale and to deliver the programme to the schools and children where it will have the biggest impact.

The Chrysalis model includes their own representatives going into schools to make regular assessments. The data they have gathered suggests that Chrysalis is having an impact. The business has reported a 12% improvement in student engagement, improvements in the overall quality of teaching staff, and increased teacher retention and satisfaction.

This is what the impact of investing for social innovation can look like.

The Importance of Being Humble

The Global Innovation Fund is a non-profit, impact-first, investment vehicle, launched a decade ago by the US and UK Governments.

We have a mandate to invest in innovations with the potential to scale to solve hard developmental challenges for the world’s poorest people. Innovations like Chrysalis, the education business in India I just told you about.

How did we know that Chrysalis was the right innovation to invest in? How did we know that its approach to education would take off across schools in India? How did we know that we would have impact through our investment?

Well, truth be told - we didn't. When we invested, we took real risks.

Now, I am talking to a group of investors here – risk is your bread and butter. The investment question can typically boil down to exploring whether and why you believe that the risk adjusted rate of return exceeds your hurdle rate.

However, the problem we are solving as impact investors is a more complicated one. Let me explain. We, collectively, are not just in the profit maximizing business. For us, given our initial budget, we want to maximize our impact.

So, we want to back impactful innovations, for sure. But we also want to back innovations that scale – you need that for impact. This means that we want to back innovations that can figure out their business model, make money, and grow.

And, yes, we want to eventually exit. Then we can recycle our capital and generate MORE impact.

This isn’t wholly different from a traditional venture capital approach to investing; making investment decisions based on rigorous evidence, adopting a staged approach to funding, and taking smart risks, which, like a venture capitalist, we can do by pooling risk across our portfolio.

The difference is that starting point. For us it is about the impact first and financial returns as a means to that end. It’s a more complicated problem to solve. It might require data not available in financial models because we need to evaluate for impact.

It might require more patience than we typically would have with traditional funds. There may be trade-offs between impact and scale, or the pace of scale. As I said before, hard things are hard.

And, an honest impact investor also needs to be humble. We need to be humble about the limits of our understanding about what is going to work and what is not going to work.

And sometimes when we test out what we think might work, we actually discover other things which we had never considered! This is what the Nobel Prize winning development economist, Michael Kremer, has referred to as the ‘virtuous circle’ of evaluation and innovation.

This is the idea that an experimental result can uncover hidden factors, thus suggesting new directions for intervention and evaluation. And with patience, this can continue to unfold and unfold.

Limitations with investment vehicles and pricing risk

So why isn’t there more impact-first capital flowing to international development?

I would suggest that the current approach to development finance, including much impact investing for development, is not fit-for-purpose to address the needs of companies and entrepreneurs today. This comes down to two main limitations: First, the right kind of investment vehicles are not always available. And second, the existing vehicles do not always price risk correctly.

Traditionally, wealthy countries have had two tools at their disposal to fund international development; aid agencies that fund through fee-for service contracts and development finance institutions (or DFIs) that make private equity-like debt and equity investments.

Both will continue to be critical and necessary elements in the development landscape. But their approaches to financing to tackle today’s development challenges have their limitations and suggest an important space that strategic impact investment could fill.

The need for innovative finance is particularly acute in higher-risk, fragile places. DFIs have been reticent to take risks on early stage, innovative ventures in these settings, instead looking for tested deal flow that they are more confident will deliver returns.

This creates what is often referred to as the “pioneer gap”. What this means in practice is that the entrepreneurs behind these innovative ventures may have been able to scrape together enough resources to understand the market need, develop a value proposition and demonstrate early proof of concept.

However, where the challenge comes for these entrepreneurs is accessing the funding to validate their idea and transition their innovation to a scalable model. The pioneer gap can quickly turn into a chasm for entrepreneurs.

And this is especially the case for those who are not only trying to sell into a market, but who are also trying to build the market they aim to sell into, which takes time and money.

This creates a large unmet demand for patient, risk-tolerant capital in fragile places. To address this and to help mobilize additional sources of capital, it is vital that we look at how new creative tools in the development finance toolkit can be deployed and think about what this means for impact investors.

We need to be thinking about the creation of new investment vehicles, focused on development impact, which can support innovations at all stages of their journey to scale.

Such new investment structures must offer a variety of financial instruments to meet entrepreneurs’ needs; offer extended investment horizons to account for the time required to achieve social impact, and be explicit about return expectations that consider social as well as financial returns.

Put simply, we need a new way to measure and reward both social and financial returns with flexible, blended finance structures. Structures which meet entrepreneurs where they are for the markets they are selling to.

I believe this is where impact-first, impact investing capital comes in. There has already been some thinking on this: Nancy Lee at the Center for Global Development think tank, for example, has suggested something called a “stretch fund”.

This pooled investment fund would work together with traditional multilateral development banks and development finance institutions to address existing market shortcomings.

It would “stretch” the capital of existing DFIs by expanding the spectrum of investments in which DFIs can participate; and by taking on high-risk tranches to open up more DFI investment opportunities.

There is no reason that the impact investing community could not come together to create such a vehicle, perhaps specifically for climate investing, for example. If this community could develop a successful track record with this approach, it could add to the case for a stretch fund, backed by a DFI or MDB, at a much bigger size.

But it is not just about having the right kind of investment vehicle: it is also about pricing risk correctly.

Changing how we think about risk

Another innovation in GIF’s portfolio is Mr Green Africa, a tech-enabled plastics recycling company disrupting the current informal and exploitative plastic recycling sector in Nairobi in Kenya.

The business offers an in-house, end-to-end process for recycling, purchasing directly from waste pickers, some of society’s most marginalized people. It is committed to an ethical supply chain with wage premiums, uniforms and training, and then sells the recycled materials directly to multinationals, such as Unilever.

Back in 2019, when GIF first came into contact with Mr Green, the business was raising for its Series A round but facing challenges with investors’ perception of risk. Unfortunately, this is commonplace in sub-Saharan Africa, where investors, particularly foreign ones, typically perceive risk to be high.

This perception may be rooted in information asymmetry, as emerging markets sometimes lack the tools and information investors are accustomed to in developed markets, such as large public equity markets, investment track records, or credit rating agencies.

This perception can also simply come from an aversion to the unknown. Lack of understanding of market conditions and regulatory regimes are mis-classified as certain risks.

However, with Africa’s young and growing population and vibrant entrepreneurship, the continent could be poised to become an engine of growth. Unless investors begin to price risk appropriately, global economies may miss out on tapping into a strong, burgeoning workforce, and Africa misses out on much needed development and growth opportunities.

Distinct from real or less-real political or regulatory risk, risks related to environmental, social and governance (ESG) conditions can be legitimate concerns. This was certainly the case with Mr Green Africa.

There were concerns about petty (or not so petty) corruption that perhaps could be addressed with improved financial controls. Could Mr Green Africa confidently address challenges like child labor? Traditional waste picking and recycling is notorious for struggling with both of these issues. Indeed, that is what motivated this innovation!

So Mr Green struggled to attract capital. But part of being a good impact investor is pricing risk appropriately. And an impact investor puts impact first with scale and sustainability as a means to an impact end. How does that change how we think about risk?

Well, here is how we thought about our investment in this case: we knew what we were getting into, the potential for real impact, for waste pickers seeking dignified jobs, and for climate–mitigating methane emissions in landfills. We were also facing ESG risk and the potential for funds misappropriation in a context where a lot of cash is used.

GIF invested in Mr Green Africa in its Series A round in 2019. We worked closely with the company on an ESG risk mitigation plan, including filling gaps in their audit function, setting up an external whistleblowing hotline, and helping with implementing health and safety measures.

Last year, Mr Green had a successful Series B funding round. GIF did not participate. We had played our part by derisking and crowding in capital. It’s a great example of how to derisk companies through strengthening their business models and their approach to ESG.

Be humble. Be open. Be brave.

For those of you here today who are looking to pursue a career in impact investing in international development, I would encourage you all to challenge yourself to take on the hard things in our field. Perhaps I’m looking at the founder of the stretch fund here, right now!

To successfully innovate, we need to be humble. We need to be comfortable with the idea that we don’t have all the answers about what works, and we need to be open to failure.

We need to have the right structures in place to support innovation, particularly in high risk, fragile places. And if those structures don’t exist, we need to build them.

This approach can lead to lasting benefits at a real and meaningful scale. At GIF, we have deployed approximately $100 million into the innovations we have backed, but we have contributed to $1.7 BILLION in social value creation.

Let’s be humble. Be open. Be brave.

And let’s take smart risks on hard things.