Understanding Impact Investing

The following text is an excerpt from a larger report. Available upon request.

Until early 2000s, investors have historically drawn a clear distinction between their investment activities and philanthropy. Recently, the impact investing industry is growing rapidly. The idea of impact investing came about from Christian ministries in the United States in mid-1700s when moral responsibilities of commercial enterprises came up against profiting from slavery, and boycotts.[1] Investors saw that “impact” based portfolios were much less affected by the 2008 financial downturn, and found that impact investment was a method to mitigate short-term risks for long-term value creation.

According to the Global Impact Investing Network (GIIN), a nonprofit organization dedicated to increasing the scale and effectiveness of impact investing across funders, it defines it as “investments made into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact Investing includes investments that range from producing a return of principal capital to offering market‐rate or even market‐beating financial returns…Impact investors actively seek to place capital in businesses and funds that can harness the positive power of enterprise.”[3]

The following section will provide an overview of the consensus around impact investing, spectrum of risks acceptable when compared with traditional investing, as well external benefits when adopting the model.

1.1 What is impact investing?

Impact investing is quite simple. It attempts to solve our social problems by mobilizing capital. While traditional investments lie on the spectrum without regard to social impact, philanthropy does not regard financial returns.

Impact investing lays in a space where financial returns grow with impact. Impact investing can expect financial return or choose to accept a lower return. Investors and funders would have a range of expectations based on the risk continuum of financial and impact returns.

Impact investing ideally has the following mechanisms:

  • It is value-aligned: Transactions are mostly private debt or equity investments. There are publicly listed impact investments, but they are categorized under a screened socially responsible investment, in which investors seek to minimize negative impact than a proactive positive impact. An investor’s intention to have a positive social or environmental impact through investments is essential.
  • It has impact returns: The model of the business should be designed with intended effect on the target population may be much broader than the consumers. Values should be ideally integrated into the business model.
  • It has financial returns: Impact investments are expected to generate a financial return on capital or, at minimum, a return of capital. Range of return classes and expectations: Target financial returns that range from below market (sometimes called concessionary) to risk-adjusted market rate, and can be made across asset classes, including but not limited to cash equivalents, fixed income, venture capital, and private equity. [4],[5]

These investors operate across multiple business sectors, including agriculture, water, housing, education, health, energy and financial services. The impact objectives may vary such as mitigating climate change or providing assets for poor people. It can also take the form of different finance structures, such as debt, equity, or other like social innovation bonds. According to the Rockefeller Foundation and J.P. Morgan, they provide capital, expect financial returns to business designed with the intent to general positive social or environmental returns.

Impact investors could range broadly across sectors and objectives – private wealth managers, commercial banks, pension fund managers, boutique investment funds, companies and community development finance institutions. Essentially, there exist the funders (government, foundations, family offices, high net worth individuals, and other socially responsible investing) that fund impact investing intermediaries (microfinance institutions, social banks, social venture capital/private equity firms, and pension funds) that invest in social enterprises for beneficiaries.

1.2 Different Approaches to Impact Investing

The idea of impact investing and how to allocate capital based on different approaches have diverged over time. Asset classes can be clustered according to the way investments would deliver financial return by the approach that they take. As illustrated by the below frameworks, impact investments are intended to align with an investor’s preference.  In the impact investing spectrum, one end has the traditional investing mechanism and the other philanthropy and can compare the extent of impact and risk in an impact portfolio. The categories in organizing impact portfolio to determine level of impact, moving from less to more integral impact, are the following:

  • Responsible: Also known as Socially Responsible Investing (SRI), this approach involves the negative screening of investments due to conflicts or inconsistencies with personal or organizational values, non-conformity to global environmental standards, adherence to certain codes of practice, or other such binary impact performance criteria. ‘Responsible’ captures investment activity that may proactively contain a social or environmental component in its strategy.
  • Sustainable: Sustainable investments move beyond a defensive screening posture, actively looking for investments that are positioned to benefit from market conditions by integrating Environmental, Social and Governance (ESG) factors into core investment decision-making processes. This can include corporate engagement, innovations, and new markets that are recognized as a path to growth, with positive social and environmental benefits, such as, for example, alternative energy.
  • Thematic: Thematic or mission investments have a particular focus on one or more impact themes, such as clean water or deforestation, and work to channel investment allocations in those particular directions. These are highly targeted investment opportunities, in which the social or environmental benefits are fully blended into the value proposition of a commercially positioned investment.
  • Impact-First: Investments that seek to optimize a desired social or environmental outcome, without regard for competitive return. They are open to trading off financial return for more impact where a more commercially oriented return is not yet available.
  • Non-Impact Investments: Investments made for the sole purpose of financial return, without any explicit consideration given to the social impact of the investments.
  • 100% Impact Investment: The intentional commitment by asset owners of 100% of their assets to positive social and/or environmental impact.

To navigate the following strategies, the report recommends adopting an incremental philosophy to explore opportunities in the program that builds upon the internal capacity, investment functions, and existing relationships. For instance, mission related investments are “financial investments made with the intention of furthering a foundation’s mission and recovering the principal invested or earning financial return.”  Socially responsible investing focuses primarily on (negative) social   screening and proxy activity in public equities, while mission-related investing is a proactive approach in use across asset classes.[7]

1.3 Why should I start impact investing?

Impact investing is no longer a niche market. As more investors are interested in exploring impact, they are seen as a simple mechanism with expected financial return and an approach to impact.

Impact investing can offer the following opportunities when pursuing impact investing:

  • Banks, pension funds, financial advisors, and wealth managers can provide client investment opportunities to both individuals and institutions with an interest in general or specific social and/or environmental causes.
  • Institutional and family foundations can leverage significant assets to advance their core social and/or environmental goals, while maintaining or growing their overall endowment.
  • Government investors and development finance institutions can provide proof of financial viability for private-sector investors while targeting specific social and environmental goals[8]

McKinsey & Company looked at financial returns for impact investments on 48 investor exits between 2010 and 2015 and found that they produced a median internal rate of return (IRR) of about 10 percent. The top one-third of deals yielded a median IRR of 34 percent, clearly indicating that it is possible to achieve profitable exits in social enterprises. The below figure shows some evident relationships between deal size and volatility of returns, as well as overall performance. The larger deals produced a much narrower range of returns, while smaller deals generally produced better results. The smallest deals had the worst returns and the greatest volatility.[9]

            Source: McKinsey & Co., 2018

Below is a figure of respondents who report that portfolio performance overwhelmingly meets or exceeds investor expectations for both social and environmental impact and financial return, in investments spanning the market as a whole.

Performance relative to expectations:

Source: GIIN, 2018.

 References


[1] Jacen Greene, An Introduction to Impact Investing https://impactentrepreneurs.wordpress.com/2012/04/16/an-introduction-to-impact-investing/

[2] Jane Finkelman, Kate Huntington, Impact Investing: History & Opportunity, https://www.athenacapital.com/wp-content/uploads/Impact-Investing-History-and-Opportunity.pdf

[3] GIIN, 2018 GIIN Annual Impact Investor Survey,  https://thegiin.org/assets/2018_GIIN_Annual_Impact_Investor_Survey_webfile.pdf

[4] GIIN, What you need to know about impact investing, https://thegiin.org/impact-investing/need-to-know/#core-characteristics-of-impact-investing

[5] J.P. Morgan, Impact Investments: An Emerging Asset Class, https://thegiin.org/assets/documents/Impact%20Investments%20an%20Emerging%20Asset%20Class2.pdf

[6] NPC, Investing for Impact: Practical Tools, Lessons, and Results, 2015. https://www.thinknpc.org/wp-content/uploads/2018/07/KLF_Investing-for-impact_FINAL.pdf

[7] Heron, Expanding Philanthropy, Missionrelated Investing at the F.B. Heron Foundation, https://www.heron.org/sites/default/files/Expanding_Philanthropy_Mission_Related_Investing_at_the_FB_Heron_Foundation.pdf

[8] GIIN, Impact Investing Guide, https://thegiin.org/assets/documents/GIIN_impact_investing_guide.pdf

[9] McKinsey & Company, Private Equity and Principal Investors, https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/a-closer-look-at-impact-investing