Five 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]

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

Learn more:

[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

Infocentral: Impact Investing

Generalities.
Technologies.
Networks.

What Makes an Investment “Impactful”?

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.

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.”

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.

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.

Impact Investing in Asia

Asia has felt so far away but is less new to me now. With the help of family, friends, and gracious hosts, I learned tremendously. I breathed in secondhand smoking, met my mentors at the Asia Venture Philanthropy Network (AVPN), ate Ya Kun Kaya Toast, met with friends from Temasek a sustainability fund, and went surfing with family friends. Here is what I learned:

Asia is complex. The impact investing ecosystem is still at its early stage. The government is allocating capital through green bonds or lending mechanisms, but there are only a handful of investors or family offices devoted to the field. Korea has an advantage of its thriving entrepreneurial ecosystem and growing corporate and government initiatives, but from what I learned, Hong Kong and Singapore may need more pioneers to build upon the existing ecosystem and contribute to a cultural shift.

I thought I could be helpful with my experiences in the U.S., but I ultimately felt like taking language from the States perhaps is not the most effective, as they reflect a more Western mainstream attitudinal approach. Network or platform based country-specific initiatives were more effective in attracting private investors, banks, and policymakers for long-term sectoral engagement.

With the protest happening, I kept thinking these populist trends in ethnic, political, or religious divides draw parallel to other countries and trickle down to the Southeast Asian market. Impact investing began after the financial crises that it did not ride with the plunge. Institutionalizing impact investing across asset classes also translate to asset diversification effectively hedging geopolitical and environmental risk for long-term value creation. I’m so grateful for the insight and advice and for new friends who fiercely pioneered through the Asian market.

Moving Toward Value-Based Financial Systems

(Originally written: 11.13.2018)

I’ve been thinking cross-culturally about finance institutions and how we can reinvent the modern systems in a value-based investing approach.

The growth of finance made civilizations possible, as the role of finance and institutions – money, bonds, banks, corporations, helped urban centers to expand and cultures to flourish.

Finance was at key moments of history as different apparatus, as products were developed and reinvented in the course of history. Finance innovations emerged to solve economic problems of time and geography. An example – a religious institution like Templar that became a legal system in Europe to adjudicate disputes and rights became a theoretical foundation for Europe’s unique financial architecture. While its extensive geographical network provided for an easier transfer of money through space, Templar dissolved. Its distribution of wealth made it a political target, a loss of its original mission.

Chinese financial system was different from the Greco-Roman to be more nimble – the political context determined its solution. For Europe, its reliance on capital market lies in the fragmentation and weakness of medieval states.

Finance markets and political context today coexist and complement, but the past gives us lessons on how we can risk share and adapt variations of the tools to different kinds of societies. Discoveries of financial solutions led to its civilizations most important achievements – writing, mathematics, how we save and invest, and how to harmonize global economy. It also created problems like slavery, imperialism, and other crises.

Financial thinking in a modern economy is difficult – as crashes and bubbles always take people by surprise – and I think it is because we rely too much on specialized tools from legal arguments to modern portfolio theory. As we move toward a collective global civilization with a greater proportion of the population in complex societies, finance needs to keep up.

The market is driven by spontaneous, mutual hope, often irrationality or optimistic dream. Businesses play a game of skill and chance, where it relies on average results of many investments through ebbs of hope and cold calculation. A large portion of it depended on spontaneous optimism than mathematical expectation.

Gambling investors based on hopes of new technologies enabled technological progress. Companies that harness the spirit – enable the markets to overcome the financial inertia – a force in the economy. The market sentiment that often holds the economy back because of irrational fears, managed correctly with public expectations, could become a force for good.

The risk in individual investing is often inside us – how well can we ride out plunges and the market – how much experience do I have or confidence do I have and go against the current? Could I make a lot of money? Can I rely on my willpower to endure the probabilities and consequences?

Progress is based on optimism. Good innovation can be celebrated where modern economies reward activities that create value than extract them. The shared values – where creating of value can be more collective – based on a dynamic division of labor focused on problems that 21st century are facing – can be more sustainable and preliminary to an economy where we create value than extract them.

It’s an essential thesis that optimism has and continues to drive financial markets and fund economic growth, and that optimism can be tied to higher motives and collective goals.

Translating Risk for Social Impact

“Successful private equity needs macro-economic and micro-economic factors. These include political stability, sophisticated capital markets, corporate governance, strong entrepreneurial structure, and proper benchmarking. Other factors include fragmented markets, low competition, and comparability of funds.”

— Markus Ableitinger, Director of Capital Dynamics

(Originally written: 10.12.2018)

Businesses did not begin to champion social impact or corporate social responsibility until they were truly faced with understanding counter risk to global operations – the effects of environmental, social, and governance in networked operations and stakeholder management. They saw that portfolios with “impact” or ESG indicators have outperformed those during the 2008 downturn, and found impact investing as a method to mitigate short-term risk for long-term value creation. Essentially then, risk tolerance becomes to what extent do we want our dollars to be philanthropic and the type of risk to a portfolio, climate, technology, etc., are equivalent to the opportunity of innovation in the portfolio companies.

However, there is substantial lack of language of risk mitigation in impact investments or studies of political determinants of venture capital investments. Yet, VCs include political stability among the important determinants of receiving VC funding.

The supply of VC comes from the share of risk capital provided by private investors. Along this line, the macro factors are mainly general economy, technological opportunities, entrepreneurial environment, and political risk.

Markus Ableitinger, Director of Capital Dynamics says, “successful private equity needs macro-economic and micro-economic factors. These include political stability, sophisticated capital markets, corporate governance, strong entrepreneurial structure, and proper benchmarking. Other factors include fragmented markets, low competition, and comparability of funds.”

Moreover, venture capitalists and investors are growing in Singapore taking advantage of the country’s political stability, highly educated workforce and strategic location. Despite the fact that micro, macro and even legal determinants of VC financing have more or less been analyzed; changes in political stability of countries have received little attention.

VC investment intensity is the total value of stocks traded, the significance of IPO in a fixed effects model, GDP growth (GDP) as well as inflation, labor market rigidities, and some of the political risk variables – investment profile, socioeconomic conditions, corruption and other determinants.

Given the increasing frequency and intensity of political/economic crises, a more systematic method of measuring political risk and evaluating its impact on market prices is required for emerging markets. Businesses can successfully mitigate and manage macro-political risk in emerging markets with targeted preventive investments into portfolio companies.

For instance, with Khashoggi, the United States is about to sanction specific entities and France and others could also back sanctions, which would affect countries with commercial deals with Saudi Arabia and have a certain number of days to wind down the activities depending on the products being sanctioned – that would translate into – from relying exclusively on export products to opening up domestic companies and technologies less variable to political activities.

For VCs, where we’re concerned with risk in maintaining profits, sustaining economic growth and protecting investments from market fluctuations, we have to manage threats in regulatory relationships, overall legal environment, and geopolitics critical to smooth operations.

Today’s environment requires innovation by companies by both sensing and understanding these risks and in adapting risk management to include networked-based models of information sharing. Each area of risk management is becoming a strategic value for an enterprise, and must be mainstreamed into the entire organization’s value proposition – beyond philanthropy and the CSR paradigm.When portfolio companies are scanned for threat and vulnerability for types of risk, we’re also able to measurably predict the role of companies with business processes that can conduct mitigation potentially as a supply chain partner. We can effectively then incentivize companies for mergers and acquisition, monitor its capacity for IPOs, and others – by geopolitical prediction.