The flawed theory of change of impact investing

I have been struck by how much the entire thesis behind impact investing and start-up innovation for development has been built on a narrative which is deeply questionable. 

The most important thing is that the entire impact investing/grant making world has just blindly borrowed a narrative from the venture capital (VC) world which is deeply questionable for the context and issues of  development and bottom of pyramid markets. Interestingly, even for the regular VC world, this narrative may be relevant for a small sliver of economic activity amenable to technology interventions.

Two arguments in this regard

1. The innovation and VC world works on the belief that there are plug-and-play ideas which can "meaningfully address, or even disrupt, persistent and intractable development challenges that impact the lives of millions of poor". Further, these innovations can arise from the most unexpected places through entrepreneurial brilliance, and all investors need to do is keep a look-out for such innovations. They will suddenly spring up and then just seize them. This belief comes from the tech-innovations of the last two decades which have been abruptly disruptive of existing markets and transformed our lives. 

But this has little basis in the real world of addressing persistent and intractable development challenges. There are hardly any such sudden or quickly impacting innovations possible for these problems. 

Making even a small dent on any of the big problems of the world - poverty, gender inequality, poor learning outcomes, malnutrition, traffic congestion, cleanliness and sanitation, low agriculture productivity, pervasive informal markets, unaffordable housing, low productivity SMEs, credit constraints among poor and SMEs, maternal and child health problems, access to clean water (say, low-cost borewells) and electricity, cost-effective menstrual hygiene products etc - is most unlikely to have a flick-of-a-switch solution. They require persistent effort over a long time. We need solid enterprises/companies, than those built on the vapour-ware of ephemeral growth and valuations. 

Just try to think of such plug-and-play innovations that have addressed persistent development challenges at scale in the last 20 years which have come through the VC approach to financing. The only things you could perhaps think of are products - eg. pharmaceutical drugs or a high yield variety seed - which large legacy companies are best placed to provide. Even simple innovations (which one would think are ripe for disruptive change and VC funding models) like telemedicine, digital literacy and skilling, biometric attendance monitoring in schools/hospitals, credit-worthiness assessments for poor/SMEs, agriculture extension using ICT, labour market matching for low-skill jobs, data acquisition and management systems for utilities/SMEs/government systems, market access for SMEs, informal market aggregation, early warning systems on natural disasters/pests etc have proved elusive despite countless efforts. In all these cases, all the technologies to address them have been around for years.

As to the popular tech-innovations of the last 25 years, which have formed the basis for the VC financing, they have almost completely been confined to four areas - smart-phones, aggregation and market making (or platforms), data analytics, and cloud. They have their basis on the ICT break-throughs, all which in turn have emerged through public finance. 

2. The second is the belief that we can scatter the money around among several promising entrepreneurs and in a finite time (3-5 years) some will hit the jackpot with both returns and impact (the so-called "innovation funnel"). There is an associated belief that the entrepreneur too can similarly diversify by spreading himself out in many geographies simultaneously even before they have figured out their business models. 

This too is very naive in its understanding of both the problem or market failure that is being sought to be addressed and the nature of the market itself. With a regular market innovation, the entrepreneur can just release the product or solution and it will diffuse into the market. But with development innovations, aside from numerous market frictions, we invariably need to change very entrenched behaviours and create demand among the most price sensitive and demanding of consumers. 

This is hard, almost building the ship while sailing in the harshest sea. It requires entrepreneurs who need to hunker down in a geography to build their teams, business models and stabilise their unit economics, establish their value proposition to their customers, and thereby build the foundations of a company (and not mere vapour-ware valuation by acquiring customers through discounting). 

An associated idea is that of the "valley of death". There is surely a valley of death for any entrepreneurial venture. But unlike the mainstream narrative, the valley of death is not a short one (the "fail fast" belief). For the reasons mentioned above, these entrepreneurs need to work on their businesses for a long time to establish and set themselves up on the pathway to scale. The differentiator between success and failure in almost all these areas we are interested in is hardly about some technological disruption, it is about fitting the available technology into the market in question in a commercially sustainable manner. That just requires time and effort to establish the value proposition. 

This is as much true of less-tech innovations (a smart/pre-paid water meter or low cost sanitary pads) as it is of more-tech (labour market matching or fintech or Edtech) innovations. Each one of these are virtually building whole markets afresh in the most hostile and inhospitable of environments. They cannot afford to spread themselves into multiple geographies (their bandwidths are limited) and their valleys of death are much longer (even ten years or more). They need to hunker down, de-risk their models, stabilise unit economics, and demonstrate value proposition to their price-sensitive customers.

For those who profess the value of evidence in the development world, it is therefore important to look at the evidence of these entrenched but (evidence-free) narratives and re-build their mental models of impact investing.

So what's an alternative approach?

Two points to consider. One, instead of believing that great innovations to meaningfully address persistent development challenges will spring up suddenly from somewhere, funders and policy makers should focus on strategic prioritisation and guidance into areas/sectors most likely to throw up innovative companies. A "picking winners" approach without actually picking winners! More on this in forthcoming posts. 

Two, there is a need for patience and focus on building companies. This requires a level of portfolio management which entails rolling-up the sleeves and getting into the trenches along with the entrepreneur. It demands very active portfolio support to build promising companies engaged in areas where meaningful impact is likely over a long-enough period of time (often even with multiple equity write-downs).

Also, we need to bear in mind that outside of microfinance, the world of commercially viable impact investing track record is almost barren. Like with all industries and commercial sectors historically in their evolution, impact investing too will learn and revise its path in the years ahead and become humbler and more nuanced and perceptive. But it will atleast have to wait the end of this current reckless credit cycle.

If you are investor or philanthropist looking for instant gratification with both impact and returns, then development challenges is unlikely to be the right place.