Early-Stage Startups: Closing the SDG Gap and Locking In Above-Market Returns

NEO MOOKI, the chairperson of the Botswana Stock Exchange (BSE) argues that by supporting impact-driven start-ups in their early stages, impact investment returns will improve over time. If the sector succeeds in this approach, she believes we could potentially see a future where generating positive impact is linked with achieving above-market returns.

There’s a growing awareness across the investment world that private capital has a key role to play in meeting the estimated $4.2 trillion funding gap required to achieve the Sustainable Development Goals by 2030.

Investors are becoming more socially and environmentally conscious, particularly since the pandemic which highlighted to many, the inextricable connections between human and planetary health. 

As a result, there’s growing global awareness regarding the relative importance of climate change, biodiversity loss, and other global environmental and social challenges. But it’s climate change that’s now dominating most of the impact investors’ pipelines. There is continued growing global concern over rising greenhouse gas emissions. There is a consensual agreement throughout that current policies aren’t enough given that science suggests we’re on track for 2.8°C warming by the end of the century. That means more impact investment is needed. 

The final COP27 agreement stated, “$4-6 trillion p.a. needs to be invested in renewable energy until 2030 – including investments in technology and infrastructure – to allow us to reach net zero emissions by 2050”. $4-6 trillion is multiples of the current entire impact investment sector, so there’s no arguing the fact that climate change will be a key impact investment theme for many years to come.

With these tailwinds building, many investment managers are increasingly investing to generate impact. The impact investment sector’s assets under management have more than doubled since 2019. But these asset managers aren’t committing capital out of the goodness of their hearts. For example, some common benefits of impact generation include improving market opportunities, stronger competitive moats, enhanced brand-names, and better stakeholder relations for companies.

And of course, the business case for impact has been proven. There is the big carrot: it’s becoming more common to create impact while generating market-rate returns. A 2020 GIIN study showed that most impact investors now target market rate returns, and 68% have met or exceeded those financial expectations. So the era of concessionary capital dominating the impact investment world is over.

That’s leading to greater impact investment inflows from the mainstream investment world. However, the bad news is that despite these positive sector developments, access to capital remains challenging for impact-focused start-ups in the pre-market rate of return phase. These start-ups are not benefiting from the strong inflows seen across the impact investment sector.

During my recent trip to Botswana, I caught up with a few entrepreneurs with start-up businesses aiming to deliver returns at all three levels: people, planet, and profit. From my experience, many impact investment managers are young and thus don’t have the track records asset owners and consultants are searching for.

So, there’s often a fundamental lack of trust when these young managers propose impact investment opportunities with higher risk profiles. This dynamic leads to a relative lack of interest in startups. In fact, about 90% of the $1.2 trillion of impact-focused global capital targets market rate returns.

This is where the discussion gets really interesting. If we define impact as “material change in the world that would not have happened otherwise”, the real impact of investing in the market-rate return bucket of impact-focused opportunities is arguably marginal. After all, impact investments that generate market rates of returns would have attracted capital in the traditional investment world anyway. That means there’s minimal additional impact being created by those impact investments.

This begs the question: Are impact investors who only invest in opportunities that generate market rates of return really generating additional impact? Or are they simply positioning themselves to take advantage of impact as a helpful fundraising thematic – are they just asset gathering? This was a theme discussed in a session in Monaco last week at the Super Investor conference.

There was a consensus in the session last week in Monaco that, this challenge is surely at the core of scaling up impact generation and meeting the climate transition goals over the long term. Even in the traditional investment world, it’s long been understood that successful investment opportunities generally need three progressive types of investment over time: 

1. Grants which are used to shore up business cases, 

2. Concessionary debt and equity to fund the development phase, and 

3. Market-rate debt and equity once a business is positioned to meet those investment expectations.

This is hardly rocket science. So why is it so challenging for impact-focused start-ups to attract enough free and cheap money to cross the desert to reach the river of real money? With this question in mind, let's consider the journey undertaken by a typical start-up. A start-up is initially funded with equity and cheap debt.

Then for some who had to face COVID, growth momentum was stunted by a once-in-a-generation global pandemic. For these start-ups, it was almost too much for the business to bear. Crossing the desert is brutal, and the concept of impact sometimes feels to management as though it is a mirage during challenging times. If you are lucky enough, you emerge out of the desert to hit the river of market rate return funding – however, the desert is full of skeletons of companies that couldn’t make it.

The key learning from this example is that the challenges of launching a start-up are extreme and often unforeseeable. As a result, most start-ups need support from investors to make it through. So, if the impact investment world is going to amplify impact through innovative business models, it needs to be ready to support early-stage investments through the challenging start-up phase.

It’s great news that there’s a large and growing pool of capital available for impact investments that generate market rates of returns. But if the impact investment sector is going to significantly scale up from the current 1% of global AUM towards what’s needed to achieve COP’s renewable energy and transformative technology goals, the sector’s start-ups need to be recognised as valuable R&D which will become key growth drivers. 

This is about taking a long-term view as well as generating additional impact beyond what the traditional investment world is already achieving. By helping impact-focused start-ups get off the ground, impact investment returns will also benefit longer term. If the sector gets this right, we may even be on track for a world in which impact generation becomes associated with above-market returns. One can dream.