What is a fair rate of return?

Module 1 Prompt: What CST principle(s) and/or theoretical framework(s) speak to you most in the context of the work you do today as a steward of financial assets, or one who is supporting such stewards?

Given our organization’s mission to serve the most vulnerable in society, with a particular focus on women, children, migrants and frail elders, the CST principle of Preferential Option for the Poor speaks most to our work today. 

It is a delicate issue as to when an individual is too vulnerable to be a beneficiary of impact investing, which inherently is defined as some amount of return of capital and/or interest. With our focus on migrants, we often realize many individuals are simply in need of food, medicine and shelter which are best met with philanthropic humanitarian assistance.  

When we believe there is a role for impact investment, we then ask ourselves what is a fair rate to charge? (It is relevant to note here that our “high-impact” investments come from the portion of our investment portfolio that has a capital preservation mandate.)

In the first deep dive session, Felipe shared Seed Commons’ definition of non-extractive finance in which the investor never receives more money back than was created by the borrower using the capital provided. “Borrowers are not required to make interest or principal payments until they are able to cover operating costs, including market-rate salaries.” If I understand the concept correctly, the investor is in essence taking equity risk with a capped upside return; said another way, a lower return for a higher level of risk.

Admittedly, as someone who has been indoctrinated by degrees in classical neoliberal economics, a father who bought me the same Milton Freidman book 3x, a career that began with Wall Street credit training, and an ongoing study towards the CFA, my brain is grappling with what I’ve been told to believe (return reflects risk!) and the possibilities of, and tremendous need for, a new more equitable foundation for finance embodied in this concept of non-extraction.

That said, I have found peace between these two sides of my brain by recognizing that our investment decision is based on risk, return and impact (for my traditional finance brain, our Markowitz’s efficient frontier is now 3-dimensional). We are continually improving upon how to measure and quantify this impact component, but we understand that inherently, to have more impact, however it is defined, this often means taking on more risk or receiving a lower return.

Over the last two years working with the sisters, I’ve developed an appreciation for this approach to impact investing which I believe is best articulated by Rodney Foxworth’s reaction to the notion of doing well by doing good — “Shouldn’t the aim be to do good by giving up more?”

For us, it is ultimately a question of how much we can give up and still meet the financial needs of the sisters we serve. Once these needs are secured, it then becomes a question of how much we willing to give up to push along the impact-axis of our efficient frontier at the expense of risk and return. In reflecting on this question, I continually come back to the question of what is our time horizon? This question then becomes entangled with questions of scale, power-sharing, and legacy.

Scale, because we recognize that the closer you are to a traditional risk-adjusted return, you can likely attract more fiduciarily constrained (or perhaps less enlightened) capital to the issue you are trying to address. That said, perhaps more money that is extractive may not net contribute to more wealth in the communities we aim to support. Power-sharing because inherent in return of capital and interest is the notion that it can be recycled and invested again – by us, at our discretion. However, one could argue if we entrusted our investees enough to invest in them in the first place because they were better positioned than us to realize the change we wish to see in the world, then perhaps they would be better situated to redeploy that capital instead of us? Legacy, because the more risk and less return we agree to, the quicker our capital pool will be depleted and the sooner these efforts, done in the spirit of Mother Cabrini, will be no more. Perhaps this is fine, and we should be less concerned with maintaining our program to perpetuity; however, that is not a decision for me to make.

Don’t have a good conclusion to pull this all together but have enjoyed this exercise. Leaving more questions, musings, links and next steps for myself and the community below

***

In reading more about non-extractive finance, I found these articles to be helpful. Rodney Foxworth’s article is a good read for all:

And for those who have incorporated some form of non-extractive financial terms into their investment portfolios, I’d be curious to hear your thoughts on:

  • How does one determine the value add, or increased profitability, attributed to their capital when there are multiple investors in an organization?
  • How do you incorporate this concept into funds or fund of funds? Do you not invest unless the fund manager commits to ensuring these principals are upheld in their portfolio?
  • Does the investment thus have an undefined maturity date, rather the borrower only pays when profitability is sufficient to make a payment, if not, they have opportunity to pay in the next period and so on until the loan is paid off?
  • When lending to a not for profit that relies on grants/donations to fund a portion of their work, how are these considered in the profitability equation? Rather, some organizations do not aim to reach 100% self-sufficiency, thus their net income inherently incorporates donations. Should we as lenders be repaid by donations or do you only look at the revenue-generating side of the organization?

Action Items – What to incorporate into our work? I realize I am raising more questions than I am answering, but welcome examples from other participants as to how they’ve approached these topics!

  • Liveable Wage: Incorporate (ideally a quantitative) assessment of liveable wage into our due diligence process. Rely on Notre Dame’s Livable Wage tool. How do we develop standards for ourselves when we invest across fund of funds, funds and directs? Across multiple sectors? Across multiple countries? What does social participation look like in different countries, different regions, etc.? For groups who aren’t there yet, how do we support them in the process?
  • Non-Extractive Finance: Incorporate an assessment of the extractive nature of our investments as a way to set a baseline for what rate to charge. Look at RSF’s community discussion model for setting rates. Need to evaluate the potential UBTI implications of doing more equity-like investments where you participate in upside if there is any (revenue-share type of investments).
  • Long-term tenor: Have an internal discussion to push back on the notion that we can only do x% of investments with a tenor of more than 5 years. Do we actually need the money before then? Probably not. Ultimately a risk-impact question. Consider shorter term with option for automatic extension if can’t pay before?
  • Power Imbalances: Reflect on whether there are ways we can give decision making power to those beneficiaries we are trying to support? How do we make this a more equitable power dynamic?
    • Ex. We are launching a pilot portfolio with Mission Driven Finance to provide flexible financing to organizations supporting people on the move. We’re exploring if we can eventually create an investment committee comprised of people on the move themselves to approve the investments instead of us.

Other miscellaneous things I’d like to continue thinking about…

  • False solutions: Where are we assuming we are creating a positive impact but may in fact be creating a negative impact? Lots of landmines in the environmental space. Ryan’s comment re: environmental investments whose economics only work because they depend on carbon credits or the privatization of water, the latter in particularly being wholly unjust.
  • Depth vs. breadth of impact: Is it better to have a $5 million fund that is incredibly high-impact but whose risk-return profile does not attract capital to scale or better to have a watered down $500 million fund that is light on impact?

One thought on “What is a fair rate of return?

  1. Thank you so much for this thoughtful reflection piece. I am appreciating so much the thoroughness which you noted your own training and where that leaves us. The sentence that grabbed me the most was: “For us, it is ultimately a question of how much we can give up and still meet the financial needs of the sisters we serve.”

    A mentor and boss of mine, Chuck Collins gave away his inheritance completely as a twenty something. Many discouraged him and told him to only give up the extra but to keep what he needed. His decision to give it all away was informed by his job organizing residents in trailer park to buy out the landowners to ensure housing stability. He watched them live interdependently and care for each other, holding nothing back.

    I often wonder what the world would look like if self-preservation was less of a priority for institutions and organizations as well as individuals. Investing in a Livable Future suggests that we have a livable present. For many, that simply is not true today. I wonder with you what the balance is to live well together now and creatively live well together in the future rather than some of us being able to live well now and in the future while others cannot do either. I truly want to live as if collective commonwealth could sustain me and yet we are so far from that today.

    Like

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