Lessons Impact Investing Can Learn From Microfinance

01/29/2013 03:03 pm ET | Updated Mar 31, 2013

While the underlying approaches are older, the term impact investing has recently created new buzz and attracted a growing followership. I'm very excited about this. It seems to indicate that more people have come to a conclusion that I share after 20+ years of privileged insights into motives and decision making across public, private, and social sector entities: Combining a higher-order purpose with the discipline of private sector financial sustainability has the best shot at solving many of today's pressing societal challenges.

As I'm following the reporting and publications on this space, there are two related issues that I'm struggling with and that I fear, if not thoughtfully addressed, might ultimately harm the positive brand emerging for impact investing. The field can benefit from some of the hard-learned lessons from the three decade-old experience of investments in microfinance institutions, which in 2012 constituted still by far the largest share of impact investing -- estimated to be one third of total new commitments and two thirds of outstanding total in developing countries.

My first issue has to do with return measurement. I get the financial return part. Any entity that operates under market principles must create a valuable offering to, and get paid by, its customers in the consumer market; it pays its suppliers in the product market and its employees including management in the labor market; the excess of revenues over expenses is profit, which the enterprise can choose to reinvest or dividend out. Whatever you think ideologically -- and of course there are also market imperfections and information asymmetries -- financial returns on debt or equity investments (or total shareholder returns in the case of publicly-quoted companies) are measures conceptually consistent with a broader market economy paradigm and a summary indication that value has been created.

Social and environmental impact returns are qualitatively different and essentially in the eye of the beholder. In the early years, investors in microfinance institutions thought that simply reaching disadvantaged segments such as women and poor people was a sufficient indicator of impact. Only later did they start realizing that financial access did not automatically mean improving people's lives, and that at the minimum client protection principles, if not social performance objectives , needed to be in place. More recently, rigorous impact assessments have helped the field understand what type of financial access is beneficial to what type of customer segment and why, which in turn is leading to better product design and offerings.

The efforts that the impact investment community is pushing with respect to impact indicators in other areas such as education need to learn from this evolution. To use an analogy, for example, it's not enough to just count heads of kids in social and private sector elementary schools in developing countries; investors through their governance influence need to also ensure that the education the kids get is truly a good investment for the typically poor families who make real long-term sacrifices to pay school fees.

The second issue is on return expectations. In a recent JPM/GIIN survey, 65 percent of impact investors said that they seek market return for their financial investment. This investor segment I find less inspiring. Wouldn't anyone want to have market returns and social returns on top for good measure? Or, from market development perspective, if market returns were available, wouldn't plentiful commercial capital flow in anyhow?

The microfinance investment community demonstrated that philanthropic capital was necessary to prove a concept and attract new sources of capital and talent to an area where no market existed before. Microfinance investors also learned that you can't conceptualize away potential tradeoffs between social impact and financial returns pointing to the long-term. They have come around to ask themselves questions such as: how do we find the right entrepreneurs with whom we durably share impact and financial objectives at the outset? Once invested and on boards, how do we set and don't set growth targets? How do we incentivize for a profitability sweet spot -- not too little to jeopardize financial viability, but not too high to tempt management to take short cuts? How do we responsibly exit and to whom so that the impact objective remains preserved?

The microfinance community learned some important answers the hard way and is still learning. The broader, emerging impact investment community can only benefit from these lessons.