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Capital impact for SME fund managers

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17 March 2015

Over two-thirds of SMEs in emerging markets lack sufficient access to capital. Specialised SME investment funds are increasingly stepping in to fill this financing gap. By financing and nurturing SMEs, these fund managers often realise positive social and/or environmental impacts alongside a financial return. Measuring these extra-financial effects is called impact measurement. Doing so has several benefits for investors: better access to capital, an enhanced reputation and a basis for better business analysis. However, measuring impact is no straightforward exercise. This article identifies the four main challenges in impact measurement faced by SME fund managers, and provides potential solutions.

Small coffee business Ashoka -Root Capital

Photograph: small coffee business, Ashoka – Root Capital

Financing and nurturing the ‘missing middle’
SMEs are fundamental to diversified economic growth. However, according to IFC data up to 68 percent of SMEs in developing countries are unserved or underserved financially. They are too small for traditional bank financing and too big for microfinance. Hence the commonly used term ‘missing middle’ to describe SMEs in developing countries.

This finance gap is increasingly filled by investment funds that specifically focus on SMEs. Their number increased steadily over the past few years, and combined assets under management are currently exceeding USD 1.3 billion. In addition to financing, SME fund managers actively support invested companies to professionalise and grow – for instance by helping family-run businesses introducing good governance standards.

Financing and nurturing this underserved segment has transformative potential. This means that SME funds not only generate financial returns, but also realise positive social and/or environmental impact. Some funds specifically focus on these impacts, and include social and environmental objectives in their investment strategy. If these fund managers want to concretise these realised extra-financial returns, they have to estimate or calculate the effects of their investments. This practice is called impact measurement.

Why impact measurement pays off
Impact measurement generates several benefits for fund managers. For starters, it opens the door to limited partners (LPs) with capital earmarked for impact investments. Impact investment is on the rise, but so are the expectations regarding measurement. In addition, quantified impacts help fund managers in better communicating their added value to stakeholders, such as governments and local communities. This improves their reputation.

But most importantly, impact measurement enables an investor to help steer a portfolio company towards both financial and sustainable success. Impact measurement improves performance monitoring, as it provides an investor with the opportunity to track key performance indicators (KPIs) that go beyond the traditional financial norms. On this basis, investors are able to assist invested companies designing social and environmental strategies – and track a company’s progress towards set objectives.

Given these benefits, why is impact measurement not already common practice among SME investors? Well, simply because it is no straightforward exercise. Investors have to jump some hurdles when implementing a framework for impact measurement. Four challenges are most pressing here.

The hurdles in impact measurement
A first general challenge is that there is no standard way to measure impact. Potential social and environmental impacts differ per company, and they therefore require tailor-made measurement approaches. Fund managers do not have to start from scratch though. A useful starting point is IRIS, a catalogue of standardised impact indicators developed by the Global Impact Investor Network (GIIN). This catalogue helps in selecting what to measure, although some indicators leave room for interpretation. What are for instance considered green building practices? In addition, there is the question of attribution: to what extent is there a causal relationship between a fund’s investment and a particular effect? These judgments can lead to different depictions of fund-level impact, which in turn may lead to discussions on the legitimacy of results.

A second challenge is the divergent requirements of LPs. The development finance institutions, family offices and other institutional investors which dominate the investor base often demand reporting on different indicators. Where one LP expects the fund manager to deliver detailed job data, another is focused on gender issues, while a third expects data on CO2 emissions. This drives fund managers to report on impacts that may not always be fully relevant to portfolio companies and increases the burden of data collection and reporting.

Related to this is a third challenge: the collection of factual, verified and current data from invested companies. Senior management of SMEs in emerging markets may sometimes be reluctant to collect and deliver the requested impact data, as they may not see the added value of monitoring certain metrics. This is particularly the case if requested metrics do not make any business sense in their eyes.

And ultimately, often the most pressing challenge simply is fund economics. Due to the lower average ticket size, SME funds have to execute a high number of deals. This leads to a relatively high level of human effort and transactions costs. After investment, SMEs require more nurturing to successfully grow their business compared to larger companies. This puts pressure on both fund team members and the available financial resources. Measuring impact requires some financial and human capital, and it might not be a top priority for fund managers with scarce resources.

Harmonisation, practical support and cost-effectiveness
Tackling these challenges is not easy. There are however actions that can be taken by different parties involved to alleviate them.

Firstly, LPs and the wider impact investment community should work further towards harmonisation of metrics, definitions used and reporting requirements. A major result in this field was an agreement among 25 development banks on the harmonisation of definitions, units of measurement and reporting standards for 28 core indicators from 12 different sectors, which was concluded in 2013. This should be continued to both ease the burden on fund managers and provide more clarity to the wider public.

Secondly, there should be more support available to SME fund managers who want to get started with impact measurement. This can be in the form of training, guidance on a basic impact measurement system and tools for measuring impact. Some DFIs already provide technical assistance in the field of impact measurement, while the GIIN will start a training course on impact measurement this year.

Thirdly, fund managers should try to keep collecting data from invested companies as relevant to their business and cost-effective as possible. This can be done by clearly explaining their rationale to invested companies right from the start, and agreeing on indicators that make business sense for the company. To keep costs low, they should leverage technology for data collection and take advantage of the catalogues and tools industry organisations provide. They should also consolidate impact results into one fund-level template that is transmitted to all LPs.

These measures will help SME fund managers to better steer capital towards a combined financial, social and environmental return. And make their life easier.

Source: Steward Redqueen

Matthijs de Bruijn is a consultant at Steward Redqueen, a consultancy firm specialising in impact and sustainability. He advises financial institutions in emerging markets on development impact and ESG management.

Sara Tabre Collier is an impact investing specialist at GroFin Capital, one of Africa’s largest SME impact investment funds. She is global strategist and social entrepreneur, with 10 years of experience working with MSMEs and social enterprises in emerging markets.

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