In the impact investing arena, projects and enterprises with strong prospects for positive social and/or environmental impact may lack a risk-return profile that meets the needs of conventional investors seeking risk-adjusted, market-rate returns.
A study published this week by the Global Impact Investing Network shows how impact investors are using financial guarantees as a credit-enhancement tool to stimulate increased private-sector investment in solutions to a wide range of challenges.
Produced with the support and guidance of the Kresge Foundation, the report shows that guarantees enable investors to gain experience in a new sector, help prove the viability of a business model that generates social impact or facilitate access to capital at favorable terms for nonprofits.
“The use of guarantees is not new in impact investing, but this valuable tool is extremely underutilized,” GIIN’s co-founder and chief executive, Amit Bouri, said in a statement.
“Increased awareness of successful examples of investor collaboration through guarantees — and blended capital more broadly — could help spur much-needed, additional investment into solutions to pressing social and environmental problems. There is an enormous opportunity for different types of investors to collaborate to amplify impact.”
For purposes of the study, GIIN defined a guarantee as either unfunded, in which a third party to a financial transaction promises to pay the investor (or lender) in the event the investee (or borrower) cannot do so; or funded, whereby a third party sets aside capital for the benefit of a financial transaction, which can be used if the investor (or lender) is unable to repay the investor (or lender).
It found that guarantees were especially well suited for foundations that already have experience making impact investments — through mission-related investments and program-related investments — as a way to generate more impact without necessarily requiring current liquidity.
The study focuses on use of guarantees in the U.S. community investing market, which GIIN said enabled greater depth of inquiry within a specific context, but said its findings may also be applicable in other geographies.
The research involved 40 interviews with a range of practitioners and experts, and the compilation and analysis of a database of 58 community investments in the U.S. that involved a guarantee.
The findings show that a wide range of deals in U.S. community investing have involved some form of guarantee, but they have been applied most commonly in affordable housing, community revitalization and community real estate.
The median size of a guarantee is $2 million, and the median fund or project size is $20 million.
The primary guarantee providers in U.S. community investing have been foundations, and the lenders gaining protection have been banks.
The report includes case studies that showcase the use of guarantees and other unique deal structures.
In order to revitalize undervalued Baltimore neighborhoods, Healthy Neighborhoods created two loan pools, partially guaranteed by a group of foundations, totaling $53.6 million over a six-year period. This has resulted in increased home sale prices and numbers of rehabilitation permits issued, and shortened the time homes stay on the market.
The Kresge Foundation provided an unfunded guarantee to support co-lending with the Collaborative for Healthy Communities to expand financing for health care centers in high-need states.
Multifamily Property Improvements to Reduce Energy leveraged a loan-loss reserve from New York City Energy Efficiency Corporation to assist Fannie Mae in incorporating projected energy savings into its underwriting practices. This enabled Fannie Mae to provide larger loan sizes to finance efficiency improvements and develop its green mortgage products.
The MacArthur Foundation provided a standby purchase agreement to ensure a liquidity source for senior investors participating in high-impact, affordable and sustainable housing investments. The agreement assisted the Housing Partnership Equity Trust in purchasing properties worth $244 million as of September.
The study said some barriers remain to the widespread use of guarantees in community investing.
Guarantee transactions, often quite customized, vary widely with specific deal requirements in terms of impact sought, coverage levels and other structural features. This kind of customization creates complexity that discourages greater use of the tool.
As well, transactions involving guarantees often suffer from the difficulty of aligning priorities across multiple parties, which can undermine the tool’s effectiveness.
The study recommended the following steps for taking advantage of the opportunities guarantees present and addressing the challenges preventing their broader use at scale.
First, to streamline structuring, practitioners negotiating guarantees should focus on objectives of the guarantee, type of risk addressed, coverage level, financial return expectations and triggers of and access to the guarantee.
Second, practitioners should consider ways to standardize guarantee terms across larger numbers of investments, whether through funds, programs or other means of pooling guarantee capacity.
Third, sectors including energy efficiency, renewable energy and health care could benefit from the use of guarantees, but have seen limited use of the instrument to date. Guarantees could also be promising in the food industry and to improve access to finance for small businesses.
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