Despite the rapid growth of impact capital worldwide it is yet to fully address many critical needs. According to the Global Impact Investing Network (GIIN), “appropriate capital across the risk/return spectrum” is a significant challenge facing the impact investing market as it is constrained by the requirements and expectations of mainstream finance.
Addressing capital gaps left by mainstream capital, catalytic capital plays a crucial role in impact investing. Catalytic capital is investment capital provided by development finance institutions and government agencies, family offices and foundations, which is more risk-tolerant, concessionary, patient, and flexible than conventional capital.
To better address capital gaps, so that investors and advisors can develop sound strategies to address them, they need to be better understood. Work by the Catalytic Capital Consortium (C3) has identified capital gaps across the market to help investors see these gaps in much deeper and clearer ways. C3’s work has identified a diverse array of capital gaps — some of which are already being met by catalytic capital — as well as dispelling many myths around them. Writing in the Stanford Social Innovation Review, Harvey Koh addresses five myths that are preventing catalytic capital going where it is needed.
Myth #1: Gaps only occur in poorer, less economically developed parts of the world
It is often assumed that capital gaps are exclusive to impoverished, less economically developed regions. While these areas do face significant challenges in accessing local capital, flourishing economies and sophisticated financial sectors are not protected from the emergence and persistence of capital gaps.
The presence of gaps across diverse domains underscores that conventional impact investing falls short of meeting the widespread need. And before capital gaps can be addressed, it is imperative they be recognised and address these capital gaps comprehensively on a global scale.
Myth #2: Gaps are pretty easy to spot—just look for the absence of capital on offer to potential investees
One might assume capital gaps are marked by the absence of available capital. In many cases that is true, but in other cases capital is available but not in the amounts, and on terms and conditions appropriate to the investee.
Consider African SMEs that can’t put up the collateral required by mainstream lenders or who are offered finance at unaffordable or damaging terms. They may be discouraged from applying for capital due to unfavorable terms and conditions or believe that the application would be approved.
So while capital is available, it doesn’t match the needs and constraints of enterprises. As such, very little ends up flowing into those areas.
Recognising the identifying features of capital gaps is essential to accurately spot them — even those that are less obvious, and in areas of need that superficially appear to be served are not passed over.
Myth #3: Gaps stem from weaknesses on the part of potential investees, not anything to do with investors
There’s a misconception that capital gaps are solely the fault of potential investees, rather than investors, but recognising issues on both sides is crucial to addressing capital gaps.
The prevailing power dynamic sees the investor perspective having greater legitimacy, while views of investees can be overlooked, if even given an airing at all. Some enterprises and communities are simply labeled “hard to reach” without the necessary questioning of why investors are “reluctant to serve”.
Closing gaps — such as the lack of diversity among asset managers — requires efforts from both investor and investee sides. While investees aim to inspire and support diverse teams, asset owners must recognise the issue, understand that diverse managers perform well, and adapt due diligence approaches so as to not systematically eliminate diverse managers from the selection pool.
Capital gaps can result from misalignments between investors’ knowledge, attitudes, requirements and expectations, and investees’ profile, situation, values, and wider context, which drive their needs and constraints.
Pinning the problem on investees alone is inaccurate and profoundly unhelpful in trying to resolve the issue. Recognising issues on both sides as being parts of the problem is needed to address capital gaps.
Myth #4: The gap faced by innovative solutions is greatest at the outset and gradually narrows as they scale.
While some capital gaps are expected to persist in the long run (structural gaps), others might narrow or even close over time (transient gaps).
Transient gaps typically occur around novel solutions, models, markets, mechanisms, types of actors, etc. that carry a high degree of “early-stage risk,” and lack the track record and proof points required to be acceptable to mainstream finance. One might expect that these gaps are greatest at the outset and then progressively narrow, advancing linearly towards an eventual “graduation” from the need for catalytic capital.
However, reality does not always bear this out, and real-world scaling journeys often involve expansion into new areas that bring greater risks and/or costs. It is not unusual for second funds to require more catalytic capital, not less.
Myth #5: Attitudes and values are not relevant to the discussion of capital gaps
It is true that many capital gaps are driven by “hard,” tangible, objective factors, such as enterprises being too small or not sufficiently profitable, or they lack track record, or are exposed to economic or political risks.
However, capital gaps can also open up because of misalignments in attitudes and values between supply and demand.
Consider an Indigenous community where wealth is not only defined as financial success but as social well-being, community health, or environmental connection. Mainstream investors’ lack of understanding and acceptance of this can lead to capital being offered in ways and on terms that do not align with community norms, or to capital not being offered at all due to perceptions that working with the community is too difficult or costly.
Moving forward
The research and analysis by C3 is already helping catalytic capital investors identify capital gaps in much deeper and clearer ways. These investors are becoming more effective in how they articulate their strategies in response to both transient and structural capital gaps.
But there is much that remains to be done. Catalytic capital investors still need more effective, integrated tools and practices to guide strategy and deployment based on robust analysis of capital gaps.