The impact investing industry marks another phase in its evolution by welcoming to its ranks deep-pocketed private equity firms like TPG, Bain Capital Management, and most recently KKR. Although the entry of these credible players is welcomed, private debt investment funds (PDIFs) have been quietly delivering good returns and scaling impact for many years. MicroVest’s experience managing PDIFs targeting financial inclusion in emerging markets demonstrates their proven track record. PDIFs continue to be an attractive investment vehicle and highly effective means to foster sustainable economic and social impact. While both debt and equity strategies make needed capital available to meet the United Nations’ Sustainable Development Goals, investors must consider which investment approach most appropriately achieves their impact and financial objectives.
Let’s step back a minute to review important differences between private equity and debt investment strategies. PDIFs issue loans that generate returns to investors from the interest borrowers pay back over time. A prudent debt investor will evaluate the borrower’s cash flows to ensure they can pay the loan and interest. This differs from the private equity model, where investors buy shares in companies with the expectation that they will be able to sell them later at a higher price. A successful private equity investor often will buy shares based on the potential to generate increased cash flow over a set period of time.
When compared to most private debt, the high returns and impact targeted by private equity funds excite investors; however, risks for private equity in emerging markets are often underestimated. Entry valuation risks are heightened because understanding potential partners and growth opportunities is labor intensive. Many funds may struggle between spending to develop sufficient pipeline to be selective, and overpaying for acquisitions from a more limited pipeline. Once invested, exiting in all but the largest emerging markets can be a challenge due to low trading volumes. Thinner markets make IPOs very difficult, hinder expansion of exit multiples, and require dedicated and creative sales efforts to find potential third parties. As such, the realized returns on equity investments may fail to live up to expectations. Private debt, by comparison, may ultimately provide a more competitive return on a risk-adjusted basis once an investor fully considers the exit risk in these markets.
Another distinction between private equity and PDIFs that merits full consideration is their potential social impact. The operational control that comes with a private equity investment may initially suggest more opportunity for an investor to exert influence to shape their social impact objectives, and thus, create lasting change. The scalable impact created by debt investors, however, is often overlooked. Debt is essential for scaling companies that have intrinsic social benefits baked into their business model. And scale means reaching more people in a cost-effective way. Debt financing is also cheaper than equity, reducing the overall cost of capital for the company. In the case of financial inclusion, this enables financial institutions to pass on lower rates to their customers. Lastly, debt also allows companies to invest in essential infrastructure to scale operations and reach more people.
The Global Impact Investing Network’s most recent report confirms that PDIFs have been getting the job done on impact investing. That report identified 116 PDIFs worldwide, mostly investing indirectly in end clients—many of whom are small business owners—through financial intermediaries. They represent about one-third of all impact investor assets under management. The institutions that PDIFs support are responsible for much of the underlying productivity gains in historically underserved communities in emerging markets. This is, in part, because they extend access to important financial tools that open new opportunities for growth. By supporting local financial institutions that cater to the unique needs of their communities, PDIFs help build a financial ecosystem that enables entrepreneurs to more effectively manage their finances.
Beyond these important social development benefits, PDIFs’ targeting entrepreneurs in emerging markets offer an investment asset unlike others currently in the market. Micro, small, and medium-sized enterprises (MSMEs) usually operate in their domestic economy and are not tied to global markets. This explains why MSME loans had lower default rates than traditional corporate debt during the 2008 financial crisis. When the world’s stock markets crashed and wiped out trillions of dollars of equity-derived wealth, the MSMEs that thrived on microfinance loans kept operating, as daily economic life did not stop – small-scale textile workers continued their sewing, bakers continued to bake, farmers continued to grow food for their local communities. In other words, in times of volatility, debt investments may not only outperform emerging market private equity, but can also offer returns uncorrelated to other developed market asset classes.