The significant amount of foreign aid, philanthropy, and even remittances flowing from the developed countries to the emerging markets (much of them targeting the Base of the Pyramid -BoP), has renewed interest in measuring the impact these that investments generate.  Straight-forward metrics as such the Total Capital Disbursed or the ratio of Administrative Expense versus Capital Disbursed are not longer enough.

Investors’ interest in optimal asset allocation adds to the ethical pressures other stakeholders have to optimize the “bang” of “help dollars” aimed to the poorest of the poor.

            A wealth of money, brains and institutions are focused on the investment efficiency issue. Their approach feeds on two distinct sets of knowledge: the program evaluation tradition and classic financial project evaluation.

Philanthropy, welfare and social investment

            Philanthropy and social investing at a large, societal scale is a relatively recent development in human history.

First, Philanthropic investing occurs in wealthy economies: it requires societal savings big enough to be disposed trough it. This was a situation mostly off-limits for the European nations prior to the Industrial Revolution. Second, on the political side, social and philanthropic investing benefits from the existence of a representative government, for the most part inexistent in the western hemisphere until 18th century (England abolished slavery in 1772, Russia abolished serfdom in 1861) When the citizenry and middle class gained a voice in the state matters, the care of the less fortunate gained space in the political agenda as a government issue.

            In the U.S., large-scale social policies and interventions during the nineteenth and twentieth centuries were financed by the U.S. taxpayers. This wave of public financing called for public scrutiny of the results and this, in turn, required a systematic, scientific program evaluation approach. Funds from the fiscal budget went to respected universities to develop a large part of the social science as we know them today -disciplines based in the scientific method. Social Sciences, once considered the poor daughter of the unlikely marriage of Philosophy and Science, and with the pragmatism of William James as a backdrop, became a Scientific endeavor, and an empirically oriented-discipline.

The rise of program evaluation

            All this funding aimed to resolve questions of impact: Did the intervention actually work at all? Did the intervention or policy have the impact predicted? If it worked, how did it work?  Is there a cause/effect relation? Were other factor implicated? How this intervention compares with others?

            Sophisticated, complex, and expensive research methods were used to increase validity of the answers and to attempt to isolate the causal variable. The famous random double-blind clinical trials became the golden rule of validity. It was possible to compare two –or more- of projects or programs, and, based on their evaluations decide which was more efficient. (For example, what’s best for the same population: $1000 invested in give-away mosquito nets or $500 invested in nets and $500 invested in training on their use?

The “Randomistas”

            Isolating causality is a major goal of science, and the new social science disciplines were no exception. B.F. Skinner wrote that his goal was to describe, understand, predict and control human behavior… which would be achieved by the use of appropriate research methods and a detailed understanding of causality.

            The complexity of the social scenario, where isolation of independent variables is extremely difficult due to the nature of the subject -humans- made experimental designs like the Random Clinical Trial (RCT) elusive for Social Scientists (Developmental Psychology, given its most common subject –single infants and animals- has benefited the most from the RCT as a method.) On the other side of the spectrum, Sociology and Economics have just recently been able to use the RCT with some degree of success, with special emphasis in Microeconomics research. The nascent fields of Behavioral Finance (Nobel 2002) and Mechanism Theory (Nobel 2007) will likely benefit from the RCT as a research method as they evolve.

            The research methods used in Economics have gravitated towards the less attractive outcome of correlation, instead of causality and Finance has used the well known “discounted cash flows” analysis and techniques to assess and compare alternative capital allocation alternatives.

A tale of entrepreneurship, interest rates and project evaluation.

            In 1490 when Columbus was given venture capital to finance his adventure, the court advisors didn’t consider how the presumptive future gold payments would fare against the current investment: gold today and gold tomorrow were for all practical purposes, the same. Interest was banned by law and church. Selecting among different projects was subjective since there was not a proven technique to rank projects with different durations and different benefits (cash flows). The decision was left to the judgment of the Queen, but not for long.

In 1494 Venice was one of the busiest trade ports in the world, connecting Europe with the Middle and Far East. The accounting challenges posed by such complex international trade, along with the familiarity of algebra (imported from the Middle East) and the Greco-Roman mathematical knowledge provided the foundations for the Venetian Lucca Paccioli’s cornerstone achievement: “Summa de arithmetica, geometria, proportioni et proportionalita”. In his treatise, he presented the modern accounting methods, and provided significant contributions to geometry. But most important he, the notions associated with the discounted cash flow including the concepts of Internal Rate of Return (IRR) and Net Present Value (NPV), likely the most used metrics in the field of financial project evaluation in the last 500 years.

The merits of the Net Present Value were immediately recognized by investors worldwide: it allowed them to compare different exclusive projects, regardless of their size (whether big and small), with different durations (days, years), with different benefits over time (upfront versus delayed benefits) in a systematic, quantitative way. It allowed ranking different projects in order of interest under one single metric. Finally, the world could compare apples to apples. The world would never be the same.  In words of the revered philosopher of sciences Thomas Kuhn, it was a Scientific Revolution, changing the paradigm of capital allocation models.

            With this method, Finance has achieved a major feat: it has generated a standard, agreed-upon set of procedures and techniques to compare different capital allocation projects and rank them (further refinements of the NPV approach have permitted comparing projects that are non-exclusive, projects subjects to capital rationing, or potential gains to be obtain upon success of prior phases –e.g. Real Options-).

Evaluating social investments, 2008

            As of July 2008, I have found close to 40 different initiatives and methods to assess/prioritize social investments. The shadow of the two traditions discussed cast over these initiatives: the lab-like sophistication of the program evaluation discipline and the sharp financial approach.

Evaluating program evaluation

            The program evaluation approach is particularly useful when the policy maker/investor faces the dilemma between two or a limited set of interventions and a limited set of populations: Here, prior program evaluation can illustrate the decision making process with unmatched clarity.

            Unfortunately, the Global Social Investor faces a much more complex dilemma: multiple disparate interventions in disparate latitudes with different durations and different benefits. The investment options are globally limitless and present dilemmas like: is it better to invest in malaria nets in Mali, or in a microfinance project in Nepal? As much as the social investor acknowledges the value of program evaluation, this method does not provide information that will allow investors to rank global alternatives of capital allocation.

            The question still holds: How can we decide if the dollar invested in microfinance in Nepal is more “effective” than a dollar invested in malaria in Mali? Which will provide more “bang” from each unit of input? The problem becomes clear; this is a problem of capital allocation optimization.

Adding a “social line” into the Balance Sheet? Triple bottom line?

Paradoxically, many of the new impact assessment efforts try to provide a framework for measurement while also relying on the assumption that much of the impact “cant be measured”. The rationale might go something like this: “how can we put a price on a human life! (…or whatever other outcome we are targeting). Human life is invaluable, and thus, a new set of measures should be put forward. The balance sheet of social enterprises should have a “social impact” line.”

            The problems with this approach are several. First: we are doing social and philanthropy investing because we think it is valuable. If it is valuable, why are we resistant to value it in the way we tend to value other assets: that is through the social convention of price? Consider that: the U.S government has a “statistical price of a human life” metric agreed upon for years now. Can we do the same for, let’s say, our Mali citizens using bed nets?

            Second: we want to measure it but we do not want to use the standard measurement techniques.  This approach presents a totally different challenge -not only we want to provide a plausible, and credible measurement to rank different investment alternatives; we also want to create a new knowledge paradigm. Certainly a daunting task with no minor intellectual pretensions! Unless we find our own twenty-first century Lucca Paccioli, is unlikely that a new revolution of knowledge in metrics will occur anytime soon.

            On the more practical side: this approach might have serious consequences as the efforts in creating new metrics could be counterproductive given that mainstream society is reluctant to “buy” them and, therefore, the philanthropic effort fails to attract even more resources, due its lack of credibility and reporting transparency.

            Finally, since these approaches are far from compliant with GAAP regulations, even in the most successful endeavors, they will be off-balance sheet for ever. Not good if we are planning on growing the initiative trough financing from where financing comes: the highly overseen, regulated, “rulefied” competitive capital markets.

Metrics 2.0: Muhammad Yunus meets Milton Friedman.

            The existence of economic outcomes (both good and bad) outside the main enterprise is not a new idea in the field of Economics, and is called “economic externalities”. A closely related concept is the Social Enterprise – the idea that through process and product innovations there is money to be made providing the Base of the Pyramid and, at the same time investors are served with market comparable returns.  

            From the Global Social Investor perspective regardless of our intention (creating social enterprise, positive externalities, or simply alleviating suffering) the issue is one Optimal Capital Allocation.

            A successful metrics framework would be increasingly effective if it has widespread credibility among the society at large. Any approach involving “esoteric” metrics has a double challenge: creating the metric and convincing the rest of society of its validity.

            Building on the shoulder of giants, a successful framework for Capital Allocation Optimization might gain more traction if -informed by the program evaluation advances-  builds on current financial standards on project evaluation (NPV, IRR) and capital allocation optimization.

            How would this approach include all the soft issues (human lives saved, or increased education access for woman, or village income lift)? A credible approach would require computing at market prices –in money, old fashion style- all the externalities, benefits and liabilities generated by the initiative and consolidating them into a pro forma financial forecast to be discounted to the present.

If we value them, let’s count them proudly. Your accountant friends will love you, and you certainly will be able to generate more resources for your philanthropic initiative.

1. – The Dollar Devaluation

Either because of their inability to attract financial managers skilled in FOREX hedging and/or their inability to access the derivatives market, smaller-scale investors (a bracket made up for the most part by social investors and philanthropists) have seen their “helping power” significantly eroded. Some actors, losing their advantage as the dollar devaluate have been unable to keep operational costs at bay and have been forced to “go out of business”, as they become a sub-optimal solution and other organizations with stronger currencies are now doing the job.n Last months Federal Reserve’s interest rates decrease will likely keep the dollar at the current low prices for the foreseeable future.

2. – The Financial Markets Crisis

On the funds sourcing side, the worldwide “deleveraging” of the financial markets and  the feverish debt sell-off experienced in the last months made investors (both return and socially motivated) even more risk averse, and liquid capital even more scarce.

The planned new regulation for the financial markets currently in the works in the U.S. congress is likely to obliterate the liquidity levels we experienced in recent years (e.g. the planned requirement for trading houses to keep a leverage level at the 10 to 1 ratio, significantly below their 33 to 1 of shops like Bear Sterns just six months ago). The cash dry-up will affect Social Investing just as it is affecting the Private Equity sector, whose size and quantity of deals is close to one third below what they were in the same period in 2007. Given the inertia of the government and grant making processes, we will see the effects of the funds drought in the first semester of 2009.

Adding to these complications, the momentous rally of commodities and food prices, the rising worldwide inflation, and an impending U.S. recession lay a gloomy outlook in the emerging economies. In short, more help will be needed and fewer dollars will be available.

3. – Global Trade

The thorough implementation of the Washington Consensus ideas pushed worldwide tariffs down by more than 15% in the last 20 years. As a consequence, emerging economies have growth significantly, fueled by the possibility of selling their goods into developed markets. However, the successes of these policies have not come without some caveats.

First, the Gross Domestic Product (GDP) computes economic output and inflation but not the dollar depreciation. Since GDP is denominated in dollars, a GDP increase does not necessarily mean a real increase in economic output, or purchasing power. (Oversimplifying for illustrative purposes, Thailand might have increased their GDP by 25% since 2000, but that is a 0% real economic output, if we input 25% dollar depreciation). 

Second, research sponsored by the World Trade Organization (WTO), suggest a worrisome positive correlation of within-country inequality and trade liberalization. The United Nations GINI index, designed to measure inequalities within the countries, suggests a widening gap between rich and poor in some emerging economies that successfully implemented trade liberalization policies.  An illustrative example of this phenomenon of steady growth and increasing inequality is Chile. Chilean’s often praised macroeconomic figures reveal a sustained growth of nearly 6%, on a compounded annual basis over the last 20 years, and a noteworthy reduction in extreme poverty levels now similar to those of  developed economies. At the same time, it ranks in a distressing tenth place among the most asymmetrical income distributions in the world.

4. – Food For Thought

Looking forward, the cost-conscious, impact-oriented international social investor and policy maker might want to consider the following suggestions:

 (a) Policy makers and practitioners should encourage the use of non-speculative derivatives to hedge FOREX risk both trough managerial education and regulation aimed to increase smaller players’ access to the derivative markets in emerging economies (b) In order to preserve their “helping power”, social investors might invest in the U.S. or in countries that present positive historical correlation with the dollar, like Mexico and Central America. Opportunities to help in countries where the dollar is still powerful abound (Honduras, has 21% of its population living with less than $1 a day and 44% with less than $2) (c) Organizations designed for sustainability are in better position, particularly if their funding strategy combines U.S. funding with local currency sources (local philanthropy) or local revenues (social enterprises) (d) Macroeconomic metrics such as GDP must be paired with microeconomic data, in order to understand intra-country disparities in wealth.  That way, for instance, some of the poorest population in Chile would not be left outside the “radar screen” only because Chile’s macroeconomic success.

Given this wealth of relationships Miami seems to be ideally located to play a pivotal role as a meeting point where big American Venture Capital meets Latin American entrepreneurs. This hasn’t happened yet.  The root cause of this is two pronged: At the hemispheric level, entrepreneurship in Latin America faces significant challenges regarding their human capital utilization, the capital allocation processes, the social cost of failure and the economies of scale required for the Venture Capital model to work. At the local level Miami haven’t been able to provide the “ecosystem” required to foster economic development trough innovative enterprise.

Wasted Human Capital: Latin American societies are extremely stratified. A good proxy of this stratification is the GINI index, used by the United Nations as measure of inequality of income distribution, in which Latin American countries fare dramatically (8 of the 15 most unequal countries in the world are located in Latin America). As a consequence, the same “selected few family names” share powerful positions in economic, political and legislative positions for generations. One big family name has senators, judges, and board members sparkled across several generations in several of the most prominent institutions. Social mobility is scarce; the “American Dream” is just a dream when it comes to Latin America.

As a significant percentage of the human capital of these nations are excluded socially, they are also excluded from education opportunities, and therefore, are unable to participate in an entrepreneurial ecosystem with their knowledge. Social mobility is a pre-requisite of a healthy entrepreneurial environment. It allows people from all walks of life, from all backgrounds, from all knowledge arenas access to the commodity capital is.

Sub optimal Capital allocation: Social mobility is also the prerequisite of optimal capital allocation. In an environment where the best ideas never come to light because people don’t have a chance, investors  look for returns elsewhere exporting capital in the form of foreign accounts, offshore private banking and the like. Mid and big enterprises attract most of the local capital, leaving nothing for high-risk / high-return endeavors and the positive economic externalities innovation brings. This sub optimal financial structure prevents higher growth rates fueled by innovation. For investors to get optimal returns, the economic ecosystem must allow the brightest of the brightest to arise from the shame of social exclusion.

Macroeconomic disadvantages. Cash strapped emerging companies might not overcome their own revenue volatility anywhere in the world. One bad season might wipe the company altogether. If we add the effect of the endemic macroeconomic volatility of Latin America’s economies the challenge is daunting.  Even worst: both (company and market volatility) tend to be highly correlated, amplifying the effect of each other.

High social cost of failure. Unlike American were entrepreneurship is praised, and where the example of a founding father being broke several times before it “struck it rich” is well known, Latin American entrepreneurs pay a high price if they fail.  Failure looms in the family for generations, stringent bankruptcy laws have few clauses protecting the failed endeavor, and social ostracism is the norm in a stratified society where nobody wants to be seen with the failed entrepreneur.

The Sciences dilemma: Scientific research provides the backdrop where many new innovations came from, Unfortunately, sciences research absorbs significant amount of resources and do not relate directly to any cash flow producing business and therefore is extremely difficult to justify politically. This difficulty is even more pressing for cash strapped countries with “hot” social needs. This is the policy dilemma: on the one hand basic sciences investments are necessary to produce innovation and wealth in order to “enlarge the economic pie”; on the other hand those same resources are needed to fight current pressing problems as starvation and the like. 

Economies of scale (1): Venture Capital is a financing industry that has violent statistics; out of 9 financed companies 6 will fail, 2 will generate moderate returns and 1 will be the next big bang.  In order for the Venture Capital industry to exist, a multi billion dollar market must be readily available to be tapped on by a billion dollar company. Unfortunately, there is only a few multi billion sectors in Latin America: Agribusiness, Mining, Telecom, and another couple more. Furthermore, historically there is not a lot of companies that have grown at the pace Venture Capital requires for the model to work. In short, Latin America faces a scale problem. The only way we can scale is using  multinational Pan American approach.

Economies of scale (2): The pan American strategy has challenges in itself: Brazil and Mexico have a different languages providing natural barrier of entry to the retail operators.  Legal barriers arise in most of the sectors Financial services, energy, telecom And so to scale the becomes difficult.

The Entrepreneurial ecosystem issue in South Florida:  Following professor M. Porter ideas, there is a need for at least three elements to arise simultaneously in order to generate a real Entrepreneurial cluster: there must be a critical mass of interconnected competing business, financing must be available, and academia must be present providing sciences, innovation and professionals. The vicious circle present in South Florida doesn’t help: the lack of companies deters VC’s of having a real presence in Miami, and at the same time, the University does not have a strong output of professionals that might be feeding the nascent companies. The ecosystem is not here.

The current global inflationary spiral has prompted the IMF chief to alert about the consequences it has for the poorest of the population. In his latest statements, Mr. Strauss-Kahn follows classical western economics thought: the poorest fifth of the world population make wages in the local currency, and in inflationary environments their wages are adjusted at a slower pace than price rises, eroding their purchase power over time. The higher the inflation rate, the slower is the wage adjustment. On top of that, the classical economic thinking goes, the poorest segments of the population don’t have the inflationary hedges richer people have like moving their assets to gold or other less inflation-sensible assets class.

This line of thinking has two central assumptions: First, there is an asset the owner cannot dispose immediately (e.g. “frozen” savings in the bank, wages to be paid at the end of the week and/or other accounts receivables); second the asset is denominated in the national currency being devaluated due to inflation.

This set of ideas are extremely compelling in the developed economies where most of the population is wage-earning employees (unemployment rates have been around the 8% average the last 50 years) and poverty is a marginal concern (“endemic” poverty in the G7 countries is less than 1% of the population, mainly as a consequences of other concomitant factors –e.g. mental health, physical handicap, substance abuse )

The contrasting situation in emerging economies

Emerging economies offer a sharp contrast, characterized by unemployment and sub employment rates of above 70%; poverty levels above 40%; a significant portion of the economic activity being informal outside of any state monitoring and taxing. In these latitudes, the poorest fifth of the population likely do not earn regular wages, and live mostly out of locally transacted goods and services. Three salient characteristics of this markets can be pointed: (a) a significant part of the transactions are barter or cuasi-barter transactions: agents tend to operate through simple “mental accounting” in two “ledgers”: accounts receivable from their neighbors and accounts payable to their neighbors. Minimal or no cash is involved and the transaction is denominated in terms of the goods to be exchanged: (e.g. one pound of rice for two pounds of coal). Since there is no cash involved, and their transaction is not indexed to any currency, the accounts payable/receivable act as a natural hedge against inflation (b) these tend to be rural settings without much connection with the global economy. (Furthermore, Development economists tend to agree that it is the lack of trade and linkages with other economies what keeps these regions poor). As a consequence, a global inflationary spiral is irrelevant, since the linkages with the global economies are not there. Whatever happens in the world, for good (development) or bad (inflation), is not necessarily happening there. For instance, while a country can import inflation trough their need to import increasingly expensive oil, this small village’s dramatic isolation isolates them from development and inflation. Finally, (c) Transactions are remarkably small, as the market agents have not savings capability being theirs a subsistence economy (single serving soups are a best seller in Mexico and India, based on the consumers’ ability to pay for one at a time, and their inability to purchase and store large packages). This lack of assets implies that the poorest of the poor don’t have anything to get depreciated trough inflation! Inflation is a concern of those that do have something to be depreciated, like the blue collar’s worker savings in the U.S. bank or his devalued paycheck at the end of the month. In the absence of assets, paradoxically, the concerns on inflation also disappear.

The significant contribution of Microfinance

Microfinance has played an important role in the poverty alleviation efforts the last there decades. Capital fuels the machines of economic growth: As the micro entrepreneurs increases its productivity thanks to micro credits, the local economies grow and trade with other geographies become real. These improved economic conditions lift micro-entrepreneurs while making them more vulnerable to inflation. The micro-entrepreneur’s illness of the childhood are gone, but now they are exposed to the illnesses of the grown up’s. How? (a) Barter transactions recede and the influx of capital increases the amount of economic activity being transacted in the local currency, witch is loosing purchasing power as time passes by. The micro-entrepreneur “cash cycle” becomes a significant hurdle. The cash he gets from sales after his economic activity is performed might not be enough to pay for supplies for the new cycle of economic activity, a couple of days or weeks after (b) Linkages with the global economies make them prone to inflation import by the way of an increase price of supplies now imported from other villages at the national or even international level. Worldwide prices do impact them now. (c) The increase in their savings capacity makes the risk of any savings in the form of assets denominated in the local currency to depreciate.

These three elements: transactions being nominated in local currencies, new linkages with the global economy, and increased savings generate a new scenario for the micro-financed entrepreneurs which are for the first times exposed to the global macroeconomic trends.

Is there anything to be done?

The efforts of the Microfinance institutions face a new challenge. Their success or failure is now associated with the global economy. For the microfinance institutions to succeed, they need to add to their tasks not only the provision of capital and financial literacy, buy provide the ailments to the global economy maladies. This is a major undertaking.

The expansion of financial services to the poorest brackets of the population have seen an enormous expansion in the latest decade as significant publicity was gained after Mr. Yunus’s Nobel award. Deutshe Bank has suggested that this is a $250B market, and new financial products have been slowly released (investment banks have invested in BoP securitized debt, climate insurance has been rolled out, etc.) Microfinance institutions might want to explore the use of inflation hedging mechanisms either via embedding them in their loans or as a standalone offering. The explosive boom in global derivatives trading might provide an interesting field where experience might be “imported”.

Sustainability of the Microfinance organizations

On the supply side, microfinance institutions face their own share of problems. As their loans for the most part are fix interest and not indexed to the inflation, in an inflationary environment they will get payments in devalued currencies and thus, their might experience net loss. Depending on their managers ability to generate inflation risk hedging strategies they will fare this inflationary period with success, or simply will be forced to reduce their capital base and take significant write off from loans that are underperforming in real terms. Nothing big banks have not seen lately.