The relationship between impact investing mechanism design and social value creation

Impact investing is growing in acceptance and adoption within the Western, neoliberal framework. Investors are increasingly seeking a combination of social and financial returns from their investments, rather than just one or the other. Both a symptom and consequence of this trend is the design of new financing mechanisms which aim to better enable investors to generate blended social and financial value. Such mechanisms include social impact bonds, income-contingent loans, and combined credit and insurance. However, empirical evidence shows that these mechanisms have been beset by problems. Many have low take-up rates, and those that are adopted rarely generate social value to the degree intended. Why is this? Unfortunately, the existing academic literature provides limited guidance. For while individual investment mechanisms have been researched in isolation, they have not been researched collectively at a conceptual level. This is partly attributable to the underdeveloped nature of the social finance field, and partly due to the divergent treatment of investment mechanisms within the incumbent literature. Different impact investment mechanisms are situated in different pools of academic literature, with each discipline having distinctive terminology, research methodology, geographic focus, types of investors, and types of investees.
This dissertation begins to address this gap in the literature by researching the design of impact investing mechanisms collectively, at a conceptual level, and in an interdisciplinary manner. Specifically, the dissertation asks the question: “How does the design of impact investing mechanisms affect the creation of social value?” This overarching question is answered by focusing on a specific class of impact investments – investments that are in individuals, that aim to improve productivity, and that involve contingent repayments. Given the interdisciplinary nature of the research, a mixed-method approach is employed.
To better understand why the existing literature fails to explain the relationship between mechanism design and social value creation, bibliometrics research is undertaken of two corpora – one with 500 publications from social finance and one with 500 publications from development economics. Keyword co-occurrence, pairwise publication similarity, and citation analysis reveals there is a key missing link in the academic literature which stems from the differing approaches of the two fields and the negligible interaction between them. This missing link is between the aggregate financial value that arises from an investment and the financial return that accrues to a specific investor.
To understand the role this missing link plays in the relationship between mechanism design and social value creation, each of the five main existing contingent-repayment impact investing mechanisms are modelled using theoretical microeconomics. It is proven mathematically that none of these five mechanisms can sustain the first-best in equilibrium. There are two underlying reasons for this: first, a lack of social value creation for a given investment expenditure, due to suboptimal investment selection, quantity and/or effort; secondly, a lack of value capture for a given social value creation, due to suboptimal value attribution and/or an inability to appropriate attributed value. These reasons for why existing mechanisms fail to maintain the first-best correspond to the two main ways that mechanism design affects social value creation. Importantly, the latter of these two relationship pathways – value capture – corresponds to the missing link discovered in the bibliometrics research. In other words, the ability of investors to translate financial value into financial return is determined by the factors of attribution and appropriation. Those are the prerequisites for the internalisation of positive pecuniary externalities from investments.
Given the above, a Unified Fundamental Model of Impact Investing is developed to complete the impact investing cycle. This theory construction brings together all the different impact investing mechanism designs, as well as related topics (such as social impact measurement, capital recycling, and social impact definitions), into a single, consistent framework. It conceptually unites numerous previously siloed concepts, resolving ambiguities in the process, and laying the foundation for further research.
This theory construction, together with economic modelling, points to three additional intermediate ways that mechanism design affects social value creation: via social impact measurement, via the alignment of social and financial returns, and via constraint adherence. These three intermediary relationship pathways are investigated in a nuanced way via qualitative methods, with primary data obtained from 141 detailed survey responses by impact investors and 19 semi-structured interviews with key stakeholders. This data reveals both impact investor practices and perceptions, thereby enabling us to identify where practices and perceptions diverge. It is discovered that there are seven properties which impact investors believe a measure of social impact should possess, four stakeholder constraints which restrict the ability of stakeholders to adopt mechanism designs, and two practical constraints which limit the extent to which a mechanism design can operate as intended. Combining these with the three components of social value creation (selection, quantity and effort) gives 16 first-best properties. It is discovered via logical deduction that for a mechanism design to satisfy all these sixteen properties simultaneously, it necessarily requires investment by a private investor, enforcement of repayments by the government, and appropriation of value in the form of taxation revenue. These precise characteristics needed for a first-best mechanism are the precise characteristics that correspond to a gap in the impact investing landscape, as shown via gap analysis. This result motivates research into this implied modified mechanism design as an extension.
The relationship between mechanism design and social value creation for the specific implied mechanism, termed Tradable Income-Based Securities (TIBS), is then researched. This is done by identifying and evaluating the concerns of key stakeholders regarding the mechanism design. Sixteen concerns were raised by at least three interviewees, with the concerns evaluated on the basis of validity and importance. As part of this, it is proved via microeconomic modelling that TIBS can maintain the first-best in equilibrium where existing mechanism designs do not. It is also shown that this implied mechanism enables a new method of measuring social impact, termed Discounted Expected Marginal Impact (DEMI), that satisfies the seven first-best measurement properties where existing approaches (such as SROI) only satisfy a subset.
Further contributions of this research include: determining the conditions under which capital recycling is socially optimal; discovering an advantage to aligning social and financial returns that has not been identified in the literature to date (namely that when there is alignment, financial tools can be used to obtain first-best social impact properties by obtaining the equivalent financial properties); proving that if investors maximize their own measured social impact, this does not necessarily maximize aggregate social impact; formally distinguishing between the oft-conflated concepts of ‘social value’ and ‘social impact/return’; and discovering a way to objectively reveal the expected effectiveness of potential investments ex ante, thereby enabling selection of the most effective investment, knowledge of the counterfactual, and measurement of marginal social impact.

Keywords: Social Finance
ISAs
Social Impact Measurement
Social Change
Social Impact
Healthcare Finance
Microeconomics
Forte
Social Ventures
Role of Government
Theoretical Microeconomics
Double Bottom Line
Social Return On Investment
Social Value Creation
Social Impact Bonds
Microinsurance
SIBs
Nat Ware
Cost Benefit Analysis
Nathaniel Ware
Economic Growth
Impact Investment
Poverty Alleviation
Pay for Success
SROI
Development Economics
Impact Investing
Social Value
Trickle-Up Economics
Pay by Results
Mechanism Design
Outcomes Based Contracting
International Development
Income Share Agreements
Social Enterprise
Public Private Partnership
Financing Of Return To Employment
Triple Bottom Line
Outcomes Based Contracts
Impact Evaluation
Social Impact Investment
Education Finance
Pay for Results
Advisor: Gollin, D