- GIIN: What were the goals of Lok Capital's first fund, which invested primarily in microfinance institutions?
- Vishal Mehta:
Lok Capital's (Lok) goal has always been to promote inclusion in India, especially as the country is going through a rapid economic development phase. We want to ensure that the benefits of these economic, social, and political transformations are inclusive. This fund focused on microfinance for a few reasons: first, Lok's founders have backgrounds in financial services and investing in inclusive companies; second, in 2005-2007, when the first fund was being launched, microfinance had already started showing promise of a scalable model in the social enterprise space. These two factors provided us with a good starting point to establish an inclusion-focused platform in India.
- GIIN: Please tell us about Lok's second fund. Why did you decide to invest in sectors outside of microfinance?
Having established some track record, an investment and portfolio team, and a network in the social enterprise space, Fund II was an opportune time to go back to the "why" of our existence. We went back to the drawing board to identify other potential inclusion areas in which a Fund model could work. We wanted to focus on sectors where deal flow exists and where the business models are similar to a microfinance model. We wanted to capitalize on our learning from Fund I and retain our ability to be a value-add investor at the business operations level while diversifying risks in a controlled manner, rather than becoming a sector-agnostic impact fund.
As a fund, we wanted to support enterprises that provide opportunities for low-income individuals and families living at the BoP to gainfully improve their lives and livelihoods. We wanted to help them become economically sustainable via financial services and counter any major income shocks by increasing productivity, enhancing skills, and improving employability via vocational training and education. The fund is also investing in healthcare because our research showed that healthcare is a major cause of income shock to low-income families, and even the most basic health services do not exist for a vast majority at a reasonable level of quality.
- GIIN: What skills developed through the management of Lok Capital Fund I have been transferable to the second fund?
At the core are fund management and portfolio management skills, including (1) raising funds from the right kind of impact-aligned investors, (2) helping portfolio companies perform better, and (3) managing toward exits.
Our ability to raise the first fund with investors that share our goals was an advantage for our second fund. For this fundraise we have also been able to find the right kind of enterprises to invest in, helped by our previous experience developing solid relationships, building our reputation as an investor of choice in the social enterprise space, and having a credible track record from the first fund.
For a fund, the team is of utmost importance. For us, having a core team that has worked together for 6-7 years helps. The core team fully understands and complements each other, a dynamic that only develops with time.
We have been able to help portfolio companies become effective players and demonstrable role models in their respective sectors. We may do this by becoming an active board member, connecting them with government, or assisting in thinking about scale and distribution. Some microfinance investments from Fund I taught us how scaling, distribution, and customer acquisition translate to many other businesses focused on the BoP. Our ability to help portfolio companies with business development, hiring quality senior management, making strategic decisions for sustainable business growth, working on business skills, or helping companies with future fundraising are big advantages. Above all, the exit experiences from Fund I have been useful to demonstrate our viability.
- GIIN: What has it been like to raise this second fund in India in the current financial climate?
If we had known in 2009 that the microfinance crisis in October 2010 would occur, we probably would have modified the timing of the fundraise. We had some early setbacks in 2009 when a few family offices and pension funds we had been in conversations with, and with whom we had invested sizable time and efforts to educate about impact investments, cooled off after the 2008 financial crisis in the West.
Our track record, the quality of enterprises in which we invested in Fund I, and the dedication of our funders to social impact kept Lok in good standing. Three Lok Fund I portfolio companies (microfinance institutions) raised equity in 2011 in India, the peak of microfinance crisis. Barring one, all of the limited partners in Fund I participated in Fund II with a larger commitment, which also made it easier to fundraise. The fundraise took us longer than expected given the crisis, but we are delighted that our investors have shown confidence in us.
- GIIN: What instruments will the second fund use? What types of financial returns is it targeting?
The fund will only use equity and quasi-equity instruments. We are not necessarily looking for the market rate returns that commercial funds are focused on. Our return expectations are largely in line with expectation of our investors, including large development finance institutions like the International Finance Corporation and the U.K.'s CDC Group.
- GIIN: What are your investors' biggest social and financial concerns around making impact investments?
On the financial side, impact investing is still young, so financial expectations are still being adjusted and formed among investors. In theory some may have a target return in mind, but realize that they won't see it for the next four to five years. I think a lot of people are waiting for the industry to mature to know how to manage their financial expectations in this space. The biggest concern has always been that we operate in a space where the business and impact opportunity can be viewed differently by different types of investors. Unless the company and its promoters have done a good job of unifying investors, differences will emerge among shareholders that could be detrimental. We clearly saw signs of these misaligned expectations in Indian microfinance companies.
On the social side, I think Lok and its investors are fairly aligned in terms of how to have an impact, whether through livelihood organizations, healthcare organizations, or product segments directed at BoP populations. Our understanding of impact in certain nascent areas is still evolving, though the basic fundamentals are the same throughout. For example, in education, the important criteria are quality, affordability, and accessibility. The most simplistic approach could be to understand fees charged as percentage of income for a typical family at the BoP. But what is the quality of the education, and how do we assess the learning outcomes? There's no single answer when it comes to impact and we have been developing specific approaches that are relevant to different sectors and companies. We do not want to limit our social assessment programs to completing checklists and forms. The social and responsible aspects of these business have to be seen in the DNA and culture of the organizations.
- GIIN: Do you have any investors based in India? If not, why do you think this is?
There are technical and practical complexities that make it difficult to raise funding from Indian investors. One is that there are different sets of regulations for domestic and foreign capital investment. Mixing foreign and domestic capital in the same fund is fairly complex from an administrative perspective. Unless the fundraise has a minimum critical threshold of domestic capital, mixing the two is not worth the administrative costs.
We have good relationships with several relevant and interested groups in India, but impact investing is not yet commonly recognized. In future we do believe we will raise domestic capital. Until that happens, we are working with several individual domestic investors who are co-investors in our portfolio companies.
- GIIN: How does Lok Capital work with its partner organization, Lok Foundation?
Lok Foundation is the sponsor of Lok Capital Funds. We see inclusion as not just an economic phenomenon. Lok Capital Funds promotes economic inclusion and Lok Foundation endeavors to provide research, advocacy, and grants to promote social and political inclusion. Practically, we find many initiatives and partners where both the Funds and Foundation can work together, but it is not required.
- GIIN: How do you expect that you'll exit investments at the end of the fund's life? In particular, how will you ensure that the social aspects of these companies are preserved through the exit?
When we are making an investment we spend a lot of time getting aligned with the owner or founder on both a business and a social perspective. As a part of alignment, we try to discuss practical exit scenarios in a five to seven year timeframe. Exit scenarios may include going public, buying back by the company if it generates enough profitability and probable income, or a secondary sale of our stakes to another fund. We have now partially or fully exited around 50 percent of our Fund I companies, so we are generally hopeful about investment exits.
How to ensure that the company's social values are preserved is a tough question. I don't think all of us have seen enough impact investing cycles to have many examples. But some practical learnings thus far are: a) keep the social aspect of the business fully integrated with the operations of the business; b) carefully chose co-investors and future investors so that the business expectations of shareholders stay focused; and c) build the right management team at the companies so that the culture is set before the shareholder base becomes broad . We have found that if we communicate business principles and objectives clearly, most investors realize that if the social mission is compromised, the business will also be negatively affected.
- GIIN: What is most exciting to you about the field of impact investing today?
One aspect that I am particularly excited about these days is the increase in the number of professionals that want to join the social enterprise space. In just the 7-8 years that I have been engaged in this space in India, there has been a significant increase. As a sector, we need to capitalize on this positive social change. As an investor in the space, we feel responsible to be able to provide the "right" capital and advice to this new generation of social entrepreneurs.
A note to readers from the GIIN:
Diversity is a hallmark of the impact investment market, which has attracted traditional financial institutions, pension funds, private foundations, government-funded development finance institutions, fund managers, high-net-worth individuals, and family offices. As a nonprofit organization dedicated to increasing the scale and effectiveness of impact investing, the GIIN aims to bring transparency to this market and to the practice of impact investing. To this end, we believe it is in the interest of the field to share a sample of the diverse viewpoints held by investors who are motivated by social and environmental considerations. The publication of such diverse viewpoints, however, should not be construed as an endorsement by the GIIN of those viewpoints or the individuals or institutions expressing them.