Impact Investing in Asia
A 2019 study by the Global Impact Investing Network (GIIN) [KS1] estimated that there are over 1,300 organizations managing over $502 billion in impact investing assets globally. The GIIN’s annual impact investor survey (Mudaliar et al. 2019) observed that assets allocated to Asia, specifically South Asia, East Asia, and Southeast Asia, have increased considerably among its 4-year repeat respondents (GIIN, 2019). Of the $37.1 billion managed by these correspondents in 2014, $5.9 billion was allocated to Asia. The figure grew at a compound annual growth rate (CAGR) of 21.6%, reaching $12.9 billion in 2018. This growth was significantly faster than the 16.5% CAGR experienced by the total assets under management (AUM) by the survey correspondents, and second only to the Middle East and North Africa region. Other optimistic signals, aside from the growth in AUM, point to the narrowing of the knowledge gap between capital providers and impact investors, and a growing proportion of capital deployed through private impact investors instead of development finance institutions.
The literature on this topic has focused on a few areas. Some researchers have looked at the relationship between asset managers’ integration of environmental, social, and governance (ESG) factors into their investment decisions and the potential financial returns from these investments. Others have explored the implications of accounting for these nonpecuniary returns on corporate financial performance. More specifically to impact investing, a recent paper by Barber, Morse, and Yasuda (2019) studied if impact investors are truly motivated by the potential generation of positive social and environmental impact, as opposed to other causes such as portfolio diversification or social signaling. The results from these studies have been promising, displaying a non-negative or positive effect of ESG integration on pecuniary investment returns and a willingness to pay for generating positive social and environmental impact.
As we seek to increase impact investing activity, it is likely that further progress will be constituted by scaling existing activity as well as bridging the gap between untapped sources of demand and supply of capital. The diversity of sociocultural and economic environments in Asia denies the possibility of an effective broad-based solution. It also necessitates innovation in designing new processes to encourage capital flow for impact investing activity. In this brief, we explore a type of impact investing which is relatively unusual compared to the private equity form that it normally adopts.
A Case of Crowdfunded Impact Investing
Music Securities, Inc. (MS) was started in December 2000 by Masami Komatsu, its founder chief executive officer (CEO). From his time as a musician in his college days, Komatsu knew the importance of funding to sustain a living. He realized that it takes money to make music. At the time, musicians needed to associate themselves with a major record label to obtain the necessary funds to produce albums. If a record company provides the funding, it assumes all the risk—and consequently the rights as well, so musicians have to make the kind of music that the company wants. That is when he learned that there is no creative independence without economic independence.
Komatsu created MS as a financial institution that ensures economic independence for musicians. It started as a small music fund that raised ¥860,000. It was a one-man operation: Komatsu put together contracts, signed artists, negotiated with investors, produced compact discs (CDs), and marketed and promoted them. His efforts paid off and resulted in returns of 13.3% to investors who received a portion of the CD sales. The company took a significant step toward expansion by developing Securite in 2009, a platform for crowdfunded investment funds that was not limited to funding music ventures.
Although its investment approach would have changed drastically with this expanded scope, MS maintained its social mission by adopting a set of investment criteria targeting both financial and nonfinancial returns. These investment criteria include (i) strength of business model, (ii) expected financial return to investors, and (iii) social and environmental returns. Ten years after its inception, Securite has created over 850 funds for more than 570 companies in various fields, including the Securite Disaster Area Support Funds.
These were created in the aftermath of the Great East Japan Earthquake, which hit on 11 March 2011, killing about 18,000 people and causing damage amounting to ¥16.9 trillion ($144 billion). Komatsu felt devastated as he closely followed the developments of the catastrophe. The government had budgeted ¥25 trillion for financing the rebuilding over 5 years but faced difficulties utilizing the capital effectively. According to Japan’s Reconstruction Agency, less than two-thirds of the planned amount each year was spent because of weak coordination with local groups in the affected areas. The government’s slow response disappointed the thousands of business owners in dire need of financing after the loss of business and personnel in the earthquake. Komatsu wanted to use the unique financing scheme that he had created to help these victims get back on their feet. Shortly after, MS set up the Securite Disaster Area Support Funds to support companies in earthquake-hit areas.
How Securite Works
Small and medium-sized enterprises (SMEs) have long had difficulties accessing financing for two reasons. First, their reach to financial institutions depended on the geographical distribution of these institutions. While businesses in city areas had easier access to financing from banks and venture capital, it was harder for businesses in rural areas because of the smaller number of financial institutions in the region. Second, approaches to get that financing were limited, because most financing was executed by companies pursuing financial returns who did not see funding SMEs as profitable enough from an economic viewpoint. Securite, through its empathy-based financial inclusion, moderates both problems. As an online platform, Securite can offer financial mobility as individuals can invest from anywhere and at any time. It also enables individual investors to undertake empathy-based investments, taking into account not only the financial return but also nonfinancial returns from the investment. Letting investors choose which business they want to invest in is how MS delivers its unique value proposition. Furthermore, MS provides funding to numerous unlisted companies to which investors would typically lack access. For investors, the platform offers fresh investment opportunities, and for business operators, this is a novel way of raising funds.
Securite is an internet-based investment platform that integrates several functions such as payments, blogs, online stores, due diligence, monitoring, and auditing systems. It connects individuals to businesses and makes it easier for entrepreneurs to raise money through social media contacts, friends, and other individual investors registered to the platform. The unique financing scheme of MS—seeking funds from retail investors over the internet and then distributing a certain percentage of the revenue from the business to investors—is compliant with the Financial Instruments and Exchange Act of Japan. More recently, this approach has been referred to as investment-based crowdfunding.
Financing through Securite is unique because it is neither equity nor debt in a traditional sense—and its uniqueness paved the way for its success. Individuals are entitled to receive a certain percentage of the revenue from the business, but they do not own equity of the company nor do they have voting rights. There is no obligation to pay back the funds, unlike loans. Returns are based on the result of the business, and the investors bear losses if the sales of the business do not reach the target. Investment returns include gifts from the enterprise to investors, which could total up to 20% of the initial investment amount. For instance, if an investor were to invest $200 into a sake brewery, the average financial return would be 2.75% along with a bottle of sake worth $40, taking the total return to roughly 22.75%. While empathy is what drives investors, the return on investment is strictly based on the risk profile of the enterprise and its business plan.
MS only acts as an intermediary between investors and business operators. Investors transfer money to MS, who first stores the investors’ money in a trust account and then disburses the money to business operators once the fundraising process is complete. Likewise, returns from business owners are first transferred to the trust account before they are disbursed to investors. A diagrammatic depiction of this process flow can be found in the appendix.
MS generates revenue by charging a fee to both business operators and investors. Investors pay 5%–10% of the amount committed as a handling fee. For instance, when investors pay ¥10,800, MS takes ¥800 as their fee and provides the business operator with ¥10,000 as an investment. Business operators pay up front approximately 10% of the amount of funds raised as the fund origination fee. MS uses that money to conduct due diligence, create web content, solicit investors, and cover the cost of attorneys for legal reviews. If needed, it also provides support for formulation of business plans. The amount of the initial fee depends on the quantum of work involved.
The company stresses effective deployment of raised capital, and their services do not end with the funding cycle itself. In fact, its approach includes supporting the businesses post funding to effectively utilize the capital raised, for example through consulting, and to deliver returns to investors. Business operators also undergo an annual voluntary audit by MS’s certified public accountants. Information from the audit is disclosed to investors, and the audit expense is ¥100,000 annually. Commissions are the primary source of earnings for MS, while returns are passed onto investors.
As mentioned previously, MS introduced the Securite Disaster Area Support Funds after the Great East Japan Earthquake. A fine example is the fund for Yagisawa Shoten, located in the city of Rikuzentakata-Shi in Iwate Prefecture. Established in 1807, the soy sauce manufacturer has a history that dates back 200 years. MS created two funds for them: one for ¥100 million and one for ¥50 million. As many as 4,248 people invested in the fund, raising the largest amount of money through crowdfunding up to that time. And the money was used to rebuild the Yagisawa Shoten factory. The company was also able to capture customers because all of the investors became stakeholders. Numerous people expressed the belief that the presence of the fund created a supported community, and this became a rising force to rebuild the business.
The “half-investment, half-donation” model of these disaster relief funds is both unusual and symbolic. The smallest unit of investment was ¥10,500, of which ¥5,000 were a donation, ¥5,000 were an investment, and ¥500 were fees to MS. The model was put in place because MS realized that the damaged businesses were not in a financial position to offer competitive returns. Despite the risk of losing half of their money even if the investment was successful, 39,200 investors put a total of ¥1.1 billion into 38 companies that were affected by the earthquake. The success of this model highlights the phenomenon of empathy-based financial inclusion.
In partnership with local governments and financial institutions, MS has rich experience in managing funds, having raised more than ¥8 billion in total. The company measures its own success by the number of funds it operates and the number of enterprises for which it provided funding. Between 2012 and 2019, the number of funds grew 15-fold from 56 to 840. Another measurement of success is the number of financial institution partners. MS is creating a business ecosystem (Securite-Local Bank Ecosystem) that makes it possible for business operators throughout Japan who need funds to meet each other: a fee-based business matching service. Starting with Shiga Bank in 2010, MS has now forged partnerships with more than 69 financial institutions. Through this ecosystem, MS can conduct business matching for more than 150 companies a month.
MS also measures social and environmental impact using both qualitative and quantitative metrics. With respect to the qualitative method, MS has adopted the United Nations Sustainable Development Goal targets and also evaluates how the business plan of SMEs could create a positive social impact for achieving these goals. For example, Maruyama Coffee, one of the businesses funded through Securite, pays in advance for premium coffee beans to farms, which in turn do not need to borrow money from financial institutions that charge high interest rates. Over the long term, coffee farms can buy fertilizer and equipment using the advance payment, which allows them to produce more high-quality beans and sell at a higher price. The entire economy of the area could benefit once it becomes famous for high-quality coffee beans. Children, who would previously work on coffee farms, could now go to school instead and earn more in the future.
MS does not have a definite principle to calculate impact via a quantitative method. One way to calculate impact could be through social impact bonds (SIBs), which is a type of performance-linked outsourcing agreement. One such example is the SIB introduction fund, which was implemented in collaboration with Hiroshima Prefecture and six local governments in the prefecture to promote colorectal cancer screening in the area. The individual investors who invested in the fund via Securite will receive financial returns based on the payment from the local governments, which will be calculated using the rate of increase in the number of people who take the cancer screening tests.
The Future of Crowdfunded Impact Investing and Policy Recommendations
MS with the crowdfunded impact investing model it employs has broken fresh ground by creating a unique type of empathy-based investment and unlocking new sources of demand and supply. However, the viability of the model, although successful in deploying ¥8 billion of capital for 570 companies, remains to be validated across a broader coverage of industries and sectors.
As the world prepares to deal with more complex challenges, large corporations and investors too face the pressure to act responsibly toward their stakeholders. In fact, the world is now realizing that governments and philanthropists alone cannot lead the fight against acute problems such as climate change and poverty. Businesses and investors must also play a part, considering the economic resources at their disposal.
Impact investing or investing to create positive environmental or social benefits along with financial returns has become more popular in the past two decades. As impact investors taste success, considerably more investors are willing to make the jump, or at least incorporate impact enterprises in their portfolio. MS, therefore, is an important pilot case for other investors to take the leap. But there is still a long way to go, and streamlining and clarifying policies as well as government incentives can play a big role in shepherding people toward impact investing. It is therefore essential for the government to provide tax incentives, clarify that impact investing does not violate an asset manager’s fiduciary duties, and create a conducive environment for impact investing.
Offering tax breaks to investors on earnings that accrue from their impact investments is one way to catalyze investments in the impact space. On the demand side, tax incentives could augment the existing capital that is being invested in the industry; on the supply side, it could expand the pipeline of investable projects. If a mismatch in the risk return profile is keeping investors away from impact enterprises, then tax incentives can prod investors toward this asset class. To make a case for these tax incentives, advocacy organizations must approach lawmakers and explain to them how impact investing is filling a void left by the government and that it goes a long way in helping organizations that were devoid of finance. The government can also undertake a cost–benefit analysis to ascertain whether the benefit that accrues to it via impact on the ground is worth the fiscal pressure due to forgoing of tax revenue.
Numerous investors around the world have noted that impact investing, because of its risky nature, may be violative of their fiduciary duties. Fiduciary duties refer to the standard of care that asset managers owe their clients. After the 2008/09 global economic crisis, regulation mandated asset managers to steer clear of certain asset classes. Some investors are therefore unclear if impact investing is one such class. It is thus imperative for experts in the field to formulate guidelines that clearly state that impact investing is not violative of an asset manager’s commitment to their clients and then approach the government for enactment.
While the capital deployed represents a fraction of a region’s total and faces similar difficulties with tracking social impact, the innovation and value generated by MS is undeniable. As we tackle the challenge of understanding and adapting to the heterogeneity of Asia, we hope that more innovative models will surface to match the varied and shifting needs of investors. Such innovation, together with changing mindsets and greater collaboration between stakeholders, will surely contribute to a significant advancement in impact investing.
[KS1] This has been co-authored by Anant Kapoor, Bihong Huang, Liang Hao and Dave Jia Xuan Luo