Are Microfinance and Impact Investing the same thing? How are they different? While the terms are often used interchangeably, there are significant differences between these two different types of investment; this article will cover an overview of both the similarities and the differences between both.
Micro-financing can be traced back to the 1800’s and Lysander Spooner, who wrote about the benefits of providing loans to the poor. Impact investing is a newer idea, but both started as small movements that have now grown considerably in popularity over the past 30 years, on-boarding large financial institutions and banks and changing the way we view finance for the poor and vulnerable.
Starting with Definitions
Microfinance (also known as microcredit) has been defined by Investopedia, as a “type of banking service that is provided to unemployed or low-income individuals or groups who otherwise would have no other access to financial services”. This broad definition covers a wide range of financial services; microfinance is often an ethical alternative to using loan sharks, but can also be a way to raise money from multiple funders (crowdfunding), or pay for utilities such as solar power.
Impact investing has been defined by the Global Impact Investing Network as “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.” Again, a broad definition that covers a wide range of investments, but notably focuses on investment in a company, organization or fund.
Debt Investing vs. Equity Investing
Anyone lending microcredit or making an impact investment is taking some calculated risk in exchange for either charging interest (more common), or taking some equity in the company, whether it exists now or is being built. The amount of risk taken is variable, and the location and the size of the investment plays a big role.
For investments into individuals in developing countries (microfinance), while the investment amount may be relatively small, the geographical, and political risk can often be quite significant. An example of this may be loaning $2,000 USD to an individual in the West Bank, Palestine, who is looking to purchase a new shop to expand his grocery business.
Investments in funds, companies or organizations (impact investing) can also be risky. However, they are usually large amounts into companies that have a proven financially sustainable business model. Returns can be lower than in traditional venture capital or debt funding, making the due diligence process even more pertinent.
Where In The World?
Both impact investment funds and microfinance companies exist all around the world. While traditionally microfinance has more offerings in developing countries, microcredit platforms like Kiva now list borrowers in the United States, though their focus is certainly more on less economically developed regions such as Africa, Asia, and Eastern Europe.
Impact investors are spread throughout the globe, in both developed and developing countries, with some social impact investors focusing exclusively on one country (such Big Issue Invest in the UK), or on a region (such as BlueOrchard in Asia and East Africa). In developing countries, many impact investors are investing in smaller organizations that include microfinance organizations, while in developed countries, impact investors focus on solutions that serve vulnerable sectors of society.
At Lendahand we focus on social impact investment opportunities in developing countries because our mission is to help eliminate global poverty. By focussing on building up the financial systems in these countries, our goal is to build sustainable means of financing for entrepreneurs willing to work to provide a better future for their countries, communities, and families.
Helping Others vs. Helping Them Help Themselves
Impact investors usually invest into funds, companies or organizations, but not in individuals directly, though the organizations in which they invest are providing services to vulnerable and disadvantaged members of society.
Microfinance organizations invest directly into individuals, providing them with the capital to upscale their business, investing in utilities such as solar power, or saving for a larger, profitable item (the typical image being the idea of a family buying a cow).
These differences mean the size of the investment also varies. Within impact investing, organizations may be looking for $10,000 or $1 million, and fund managers often focus on providing a ticket size of the investment. Organizations that are looking to borrow large amounts of money will need more proof that their business model is sustainable and they can take on the debt.
Microcredit, as is in the name, is smaller amounts of money, usually around $1,000 that go directly to an entrepreneur or individual. It would be incredibly costly and highly impractical for each individual investor to conduct due diligence on the investee when lending such small amounts of money. That’s why microfinance contributions are often made through a crowdfunding platform, such as Kiva, or Zidisha.
Finally, public attitudes to these two types of investments have been somewhat different.
A Workable Solution
Microfinance has been lauded as one of the “most promising and cost-effective tools in the fight against global poverty”. Bono noted that “give a man a fish, he'll eat for a day. Give a woman microcredit, she, her husband, her children and her extended family will eat for a lifetime." While there has been criticism of microfinance platforms, including that it’s an effective form of political control, it riddles people with unsustainable debt, and ultimately adds to poverty, microfinance has enabled millions of people to access basic financial products who were previously permanently excluded from the financial systems.
While impact investing has received praise, and hope for the future; “the Millennial generation is transforming investment, and capitalism itself”, many skeptics believe there is not yet enough evidence to prove that it is a sustainable form of finance, often arguing that governments are helping to subsidize investments, making it cheaper than it would be without that intervention.
As demand for both continues to grow, I expect there will be more overlap. In the end, if it’s having a positive, intentional impact on those that deserve it most: does it matter what we call it? As long as we're sustainably helping create a better world together, I think we're doing a pretty good job.