Overcoming the challenges to social impact investing

Partner Content: investing in local social impact projects in deprived areas of the UK is challenging for both asset owners and investment managers. Andrés Senouf from Temporis Capital looks at options for the LGPS including the use of ‘catalytic funding’.

Photo: Shutterstock

Funds that are part of the Local Government Pension Schemes (LGPS) are keen to invest in projects that have a demonstrable social positive impact on local communities throughout the UK. Levelling up is a focus for the UK government, but the LGPS is struggling to allocate significant capital to investment strategies with a social impact in local communities.

At the same time, impact-focused fund managers have found it challenging to propose proper levelling up strategies that offer attractive returns to their limited partners (LPs).

Most local projects in deprived areas in the UK are small: such infrastructure and real estate projects (including schools and community centres) typically require investments of £1m or less. The execution of a strategy focused on local projects is challenging, as sourcing and investing in a small infrastructure or real estate project requires nearly the same amount of time, effort and due diligence as investing in a large project.

Yet, in order to deploy £100m, a fund will typically need to source, close on and manage 50 to 100 assets, which is a costly enterprise.

The execution of a strategy focused on local projects is challenging, as sourcing and investing in a small infrastructure or real estate project requires nearly the same amount of time, effort and due diligence as investing in a large project.

What’s on in 2022? Room151’s LGPS Events

Unattractive returns

When it comes to returns, these projects tend to need very low-cost financing to be financially viable. Developing broadband networks in rural areas, for example, is expensive but will serve fewer users than in suburban areas, negatively impacting revenue potential. This dynamic makes achieving breakeven more difficult.

The issue for general partners (GPs) becomes: how can we deliver the appropriate risk-adjusted returns for investments that achieve true social impact but are also costly to execute and struggle to deliver robust stand-alone financial returns?

The bottom line is that investing in local social impact projects in deprived areas of the UK is challenging for both asset owners and investment managers.

Asset owners will typically need to accept lower returns from investment in these projects. For the LGPS, such lower returns can conflict with the goal of delivering a spread of 2% to 4% over inflation over the long term to members. This problem is compounded by the fact that inflation rates have reached highs unseen in the UK since the 1980s.

Asset managers have been asked by the LGPS to deliver strategies to help with the levelling up objective but will struggle to do so without the necessary resources and expertise to undertake the origination, screening, structuring, execution and management of large portfolios of modest-sized investments. This is costly and works against the objective of generating attractive financial returns for the LPs.

The bottom line is that investing in local social impact projects in deprived areas of the UK is challenging for both asset owners and investment managers.

Interim strategies

One way to achieve more attractive returns for such investments is to include catalytic funding in these types of projects. Such funding, also known as concessional funding, is typically provided by foundations or by development financial institutions that are willing to accept below-market risk-adjusted returns on some of their investments.

For example, these investors may accept the first loss (riskiest) risk of a project or a portfolio of projects at a low expected return to unlock the rest of the capital needed to make the projects feasible. In that way, investors like the LGPS can invest equity into small local social impact projects at more attractive risk-adjusted returns.

Such blended finance (combining catalytic funding and private capital) has been around for a few years (often used for emerging market projects or portfolios), but the providers of catalytic or concessional finance are not easy to find. The UK Infrastructure Bank would likely be an appropriate candidate to provide such funding.

In the meantime, GPs can deliver attractive strategies that will impact socially deprived areas by developing larger projects in these areas while delivering positive impacts during the development process. This strategy constitutes more of a top-down approach, where the manager looks for additionality by developing new projects that offer appropriate risk-adjusted returns and providing local social benefits in the project design and/or through economic sharing/grants from project revenue.

The bottom-up strategy, where asset managers originate small projects in deprived areas with low risk-adjusted returns, needs to have further backing from the government and its financial development institutions to unlock more investment capital and resources for such targeted opportunities to deliver social impact.

Andrés Senouf is head of distribution at Temporis Capital.

—————

FREE weekly newsletters
Subscribe to Room151 Newsletters

Room151 LinkedIn Community
Join here

Monthly Online Treasury Briefing
Sign up here with a .gov.uk email address

Room151 Webinars
Visit the Room151 channel