Learnings while conceptualising a marketplace for impact bonds
A few tactical considerations and issues have come up while conceptualizing a thriving marketplace for impact bonds in India/global (as on September 2023). These are
- Unclear funder archetypes: It is unclear who exactly is the right outcome funder archetype (government, corporate funders, multilaterals, DFIs, HNIs/UHNIs, individuals) and who will be the right risk investor (commercial banks, DFIs, foundations, corporate donors, individuals) for impact bonds from long-term and at scale considerations. Currently, service providers and intermediaries are reaching out to all different types of outcome funders and risk investors to fund their proposed impact bonds. It’s important to realize that each segment has very different incentive, risks, appeal, concerns, and compliance/regulation requirements. As a result, solving the impact bond financing marketplace problem at a general level is not useful/ineffective. Such a marketplace, if it exists, will require work to identify the right segment for outcome funding and risk investment, and then to rigorously build a strong case customized to unlock it including integrating technology, compliances, processes, and capability around it. So far, impact bonds are anchored and launched by a few global players, not representative of the real segments expected to be unlocked.
- Non-alignment of conceptual market players with local legal entities: The market terms such as outcome funder, risk investor and service provider need to be mapped with different legal structures and given the inter and intra-fund flow restrictions.
- High transaction setup time and cost: In the current form of impact bonds, the transaction design, fundraising, negotiation, and evaluation are highly costly and time-consuming. Thus, to seed platform with live impact bonds raising funds requires lot of pre-work in transaction design, feasibility studies, financial modelling, consortium formation and other tasks. There is no one-size-fits-all approach, or in other words, there is no universal transaction design or evaluation template yet that will work for different types of players, interventions, and jurisdictions. For a few templates that are open, specific data on compliances, outcome definition, costing and benchmarks is missing.
- Unlikely for money to flow through the platform: Given the high-transaction size transactions, unclear funder archetype, lack of encompassing underlying financing vehicle, and compliance complexity – it is unlikely that money will flow through the platform in current form/fashion in which impact bonds are designed and executed.
- Can enable fundraising but only indirectly: The platform, upon listing all the possible/interested outcome funders and risk investors can at best enable discovery and matchmaking for service providers and other impact bond intermediaries/anchors with potential/interested funders. This direction will be tough to monetize sustainably. Fundraising for impact bonds right now is bespoke with multiple roadshows, long negotiations and rounds of pitching.
- Consortium-driven market with strong institutional barriers: The impact bond market in India is driven by a small group of anchors and market builders with mainstream segment leaders yet to catchup in terms of unlocking their pools of capital. The role that these anchors and market builders have been playing is advocating impact bonds to potential outcome funders (donors and governments to give outcome-finance vs traditional donation) and to risk investors (to finance a non-profit). While outcome funding is considered a huge bottleneck due to multitude of reasons such as lack of a strong evidence/rationale for impact bond outcome financing versus traditional donation (the added cost, time, complexity, program to non-program cost ratio – are not justified), unresolved compliance issues, ideological objections (relating to investor making money off their contribution), lack of awareness and know-how on structuring and managing such transactions and a few others. Similarly, risk investors are not willing to lend to a non-profit or a social enterprise. Risk investors are anyway conversative in financing a commercial venture, lending to a non-profit given the lack of data on their track record, perceived mistrust, poor understanding of the nature of risk (outcome achievement risk versus simple operational risk), compliance issues and others – are existing barriers to be crossed to unlock their pool of capital towards impact bonds.
- Cross-region regulatory, compliance and jurisdiction issues: Financing impact bonds with outcome funders or risk investors from different region will be difficult due to different compliance issues. Such issues are unresolved at local region level (let’s say within India), whereas cross-regional fund flow only adds more complexity.
- Unresolved legal and compliance issues: Despite a few impact bonds being done, the contracts are mostly private. Even if these contracts are made public or a standard template is made of them, it is unclear how that will move the market if a similar contract development/negotiation process is still required to be undertaken, to develop multi-stakeholder contracts every time with a new transaction. The templates may serve as reference and may reduce drafting hours. But the legal and compliance problem is still unsolved, and we are far away from standardization of contracts to be mainstreamed and accepted as status quo by all stakeholders (just like we have for loan, term sheets, SHA, SAFE etc.). This problem is also unresolved because the right archetype to financing impact bonds as outcome funder or risk investor is not identified rigorously and because the first few players/pioneers of impact bonds (international foundations, DAFs and institutions) are not the same as the larger segment of market that is expected to be unlocked. Thus, the case of the highly customized contracts coming out of these initial few transactions being able to set new standards or move the market (invite new players) is unlikely.
- Unresolved fund-flow/vehicle structure: For a marketplace to move money, it needs to have the right legal structure and an effective financing vehicle to lend to each stakeholder. Most impact bonds either require setup of SPV or require custom fund-flow arrangement – until this is resolved, it will not be possible to scale/replicate such transactions if each require such cumbersome undertaking.
[b]Conclusion:[/b]
Impact bonds in current form are time consuming, costly and complex, making them harder to scale and replicate. It also means that even if we are able to do a few impact bonds, it would make us better at doing them, pushing us towards a consulting/servicing business, as each transaction will require bespoke consortium formation, negotiations, fundraising, contracting and transaction management again and again, with us being able to do the same thing again with less cost and time until a threshold. Use of platform will be mostly limited to drive internal efficiency and external communication, and less so to aggregate supply and demand. This, if executed well, at best will make us the best advisors and
deal makers/brokers in the market. However, the scope and scale of value creation (financial and non- financial) will be bounded and will be slow. Driving large ticket sized deals/program financing may have its own value (financial and non-financial), but a few large transactions per year may not enable the much-needed systemic change by unlocking new results-based capital for promising deserving social enterprises and non-profits. It will mostly be an adverse selection approach, wherein we would tend to pick the best and the top non-profits and social enterprises, and structure transactions around them.
Thus, this leaves two options with us. First, to either accept the status quo/ways of past and today to do impact bonds in a similar/slightly modified version and become a force of market and nature to push them into being and aim to maximise the number of transactions and $ value per transaction over the next few years. With this approach, we will be able to do a few transactions i[s]n [/s]this year, growing steadily thereafter. The second approach is to go against the grain, [s]and[/s] look for the first principles, destroy and unpack the conventional way of doing impact bonds, ask a lot of questions and reconstruct a new way to finance outcomes by democratising access to finance that is merit-based, an equitable distributive mechanism, and has high impact per dollar value. This may involve a few experiments, patience and rigor.
We choose to do the latter. The underlying reason behind this choice is a realisation that given limited resources, one can either die scaling and replicating the unscalable and un-replicable, or one can create something that is inherently scalable and replicable and then let it take its [s]own[/s] course. The latter requires creation of a seed that will be placed in today’s socio-economic-techno-regulatory context of the world, whose forces will lead the seed to fruition, sparking an irreversible change in the ways of doing things, beyond which the world will never be the same, and the old ways appear to us as non-obvious. Having said that, there is still a case for outcome-based financing but maybe not for impact bond financing.
Feedback to us, in order to unlock new capital towards outcomes, we need to focus on the following:
1. Identify the first principles and recreate a robust theory of changes
2. Clearly define the funder archetype segments (for both outcome funding and risk investment) and put the right GTM in place
3. Solve the underlying financing vehicle and related compliance issues to enable movement of funds
4. Formalise and curate the transaction interface and tie the loose ends at both ends
5. Disintermediate other actors using technology and standardisation to reduce time, complexity and cost – legal, evaluation, design, fundraising