The following article is about an innovative new impact fund being tried by some brand new graduates of the Presidio MBA program. As the “Six Dynamics” report by Cathy Clarke, Jed Emerson, and Ben Thornley points out, (Good Capitalist – Issue #25) the social capital market is characterized by a high degree of financial innovation as people try to practically and proactively deliver social and environmental impact and still take home an appropriate financial return.
We are making a space in this newsletter for innovative ideas looking to become a reality. The bias will be for practical new instruments that might work given existing cultural, political, and economic realities in particular places. If you have a new concept that you think meets that standard, send them to firstname.lastname@example.org. We will be gathering to talk about those ideas at SOCAP13, September 3rd through 5th in San Francisco. We are also looking for volunteer editors who would be interested and eager to work on this project.
Picture this: a $300M fund providing equity and debt expansion capital to positive-impact small businesses, boosting local economies while generating market-rate income returns to investors. Not just accredited investors … any investors. Sound good? It can be done, via a business development company (BDC). If you’re not familiar with BDCs, you’re not alone.
A BDC is essentially a way for private investing to go “public”, with the added benefit that BDCs were specifically structured for investing and building in small, private companies. It’s a US structure, part of the Investment Company Act of 1940, and has been around since 1980. BDCs have a unique set of features that align nicely with impact investing:
- A BDC is a closed-end fund with an indefinite life, and no need to redeem shares. The investment portfolio can be structured for the long-term – enabling alternative exits, such as through preferred stock income – rather than relying on a sale that might not further the portfolio company mission.
- As a public company, the BDC can be listed on an exchange, providing the ability for investors to sell if their investment needs change.
- BDCs are expected to at least offer strategic guidance to portfolio companies, either directly or through co-investors.
- BDCs can raise additional investment capital through offerings or leverage.
- BDCs must meet compliance requirements and provide quarterly reporting.
These compliance standards are more costly than running a private fund, so investing at scale is required. Our estimates for a future Eupraxia BDC figure breakeven and generating income distributions at around $100M, and a 7% annual income distribution and 1% expense ratio at $300M.
We intend to construct equity / royalty / debt financing packages to suit venture expansion needs, and in a way that pays back over time. Each portfolio company will be required to select and report on their primary impact metric, using IRIS (Impact Reporting & Investment Standards). Not bad for investors who want income with their impact.
We at Eupraxia Capital plan to use the BDC structure to align incentives of investors, management, and investees. One key to this alignment is the internally-managed structure of the BDC. In an internally-managed BDC, the management company / team is part of the BDC itself, so management costs are integrated in the cost structure of the fund, and staff incentives are typically equity in the BDC. This aligns management incentives with investors as we all benefit the same way from the income generated from investments.
Externally-managed BDCs tend to have management fees and incentive payment structures along the lines of the 2-and-20 structures of private equity funds, with corresponding incentives to generate realized investment gains from the portfolio, which may not be aligned with needs of the portfolio companies or impact investors.
We see BDCs as a tool to open a new pathway in impact investing – both for its ability to drive capital at scale, and for its ability to open more investing opportunities to the average investor.
By Elizabeth Krueger, Eupraxia Capital