So-called impact investors — providers of capital to businesses that solve social challenges while generating a profit — are the current rage in economic development. U.S. President Barack Obama’s Office for Social Innovation and Civic Participation recently convened more than 100 practitioners to discuss how impact investing could be unleashed in the United States and the developing world. The United Nations Foundation and the U.S. State Department have launched a $50 million public-private partnership to promote clean cooking stoves in poor countries. In the United Kingdom, the Netherlands, and France, development agencies are looking to reposition some of their funding to businesses serving the poor.

According to the World Bank, roughly 1.4 billion people live in extreme poverty (earning less than $1.25/day), and 2.6 billion in moderate poverty (less than $2/day). More than a billion of the moderately poor — a number that exceeds Africa’s total population — live in South Asia. Can impact investing do more to reduce global poverty than so many previous efforts, all of which have struggled to have any impact at all?

Impoverished populations desperately require lighting, fuel for cooking, affordable and accessible health care, clean water, elementary education, and financial services. Government programs to supply these needs are plagued with corruption (by some estimates 50-70 percent of all welfare spending in India is stolen) and unable to provide quality services. Moreover, large companies have been unable to serve these populations’ needs, because to do so would require them to reinvent their existing business models around new product, distribution, and pricing paradigms.

This type of disruptive innovation usually comes from entrepreneurs. But entrepreneurs face daunting barriers, such as inadequate logistics, lack of consumer financing, poorly trained workers, consumer distrust of new technologies, high-cost marketing channels, backlash from existing merchants or moneylenders, and under-developed regulation.

Surmounting these business challenges is an expensive and slow process, and new ventures require many years to become cash-positive. As a result, commercial providers of debt or equity cannot get the high returns and quick exits that they seek.

When both governments and markets fail, impact investors can stimulate change. Microfinance — its advent, rise, and recent crises — shows how.

The microfinance industry began in the 1980s in Bangladesh with the nonprofit Grameen Bank and BRAC Bank. Donors soon helped launch other microfinance institutions in Mexico, India, Peru, Indonesia, and many African countries, where they could offer loans at 25-30 percent interest rates — well below traditional moneylender rates of 60-100 percent — and still generate strong profit margins. Today, the microfinance industry serves about 150-200 million borrowers around the world, and has grown rapidly by securing access to several billion dollars in equity financing.

Banco Compartamos in Mexico and SKS Microfinance in India illustrate impact investors’ catalytic role. Both started as NGOs (following the Grameen model) and received millions in grant money from development institutions to start lending operations. They also got access to low-cost lending from government banks and multilateral institutions such as the International Finance Corporation (the World Bank’s commercial-lending arm) and the U.S. Agency for International Development.

Within a few years, as their loan books began to grow rapidly, Compartamos and SKS created for-profit businesses that were owned by their respective NGOs. Subsequently, they raised equity capital from investors seeking to make a social impact — Compartamos from Accion and the IFC, and SKS from Unitus, Silicon Valley venture capitalist Vinod Khosla, and an Indian government development agency.

An initial public offering in 2007 followed for Compartamos, valuing the company at $2.2 billion. SKS raised more equity from investors such as Sequoia and Odyssey Capital, before going public on the Indian stock exchange in 2010, raising about $358 million at a valuation exceeding $1.6 billion. Impact investors’ support eventually led to flows of commercial capital — both VC funding and IPO investors — into Compartamos, SKS, and many other microfinance institutions.

Despite these successes, however, microfinance has struggled recently in India. Credit histories cannot be shared, because a credit bureau is just getting started. Moreover, an appropriate consumer-protection code and a nationwide regulatory framework are still lacking.

Not surprisingly, some have sought to exploit the poor as a result, which has put pressure on the authorities to “do something.” Unfortunately, this often results in inadvertent harm. For example, the Andhra Pradesh state government passed a restrictive ordinance making it difficult for microfinance institutions to recover their loans from their clients. As a result, many institutions had to write off much of their loan portfolios and take heavy losses, sending shock waves through the industry and the investor community — and causing the poor to suffer.

The lesson is that markets simply cannot work without accompanying public goods and high-quality government supervision. Although impact investors can lay the groundwork for commercial investors, they must also work in unison with government authorities to ensure well-functioning market systems. Only when such systems are firmly established will the poor be able to participate in today’s vast global economy.

Tarun Khanna is director of the South Asia Initiative at Harvard University, a professor at Harvard Business School, and a member of the board of SKS Microfinance. Jayant Sinha is managing director of Omidyar Network India Advisors. © Project Syndicate, 2011.

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