Back to Basics - the irony of evolution in Impact Investing
Palladium's Ryan Glasgo walks through the basics of Impact Investing and explores the motivations that drive these types of investments.
Recently, I met with a large, sophisticated foundation to discuss opportunities for collaboration. The first question from across the table was: what is Impact Investing? The inquiry didn’t stem from naivety, but rather from the desire to understand what angle I (and vicariously, my firm) took in approaching the topic. My response was likely typical. Rather than negotiating variations, I stuck with an inclusive answer:
“Impact Investing is an investment strategy that actively seeks to achieve both financial returns and social or environmental objectives”
The follow up question was slightly provocative, yet valid, given the convoluted state of the industry today: “So, under your definition, a fund investing in water efficiency technology in Singapore while simultaneously seeking to maximize returns could be classified as an Impact Investing fund?”
“Correct,” I said, “as long as the fund is actively measuring water savings as an environmental objective, their target rate of return is irrelevant.”
This brief exchange, although simple and straightforward, highlighted the continuing opaqueness and confusion around target rates of return within Impact Investing. This despite the industry’s best attempts to evolve and, in some cases, begin consolidating with influential and clearly commercial financial institutions (e.g. Goldman Sachs’ acquisition of Imprint Capital, an impact investment asset manager with more than $550 million under advisory as of the acquisition).
On reflection, the conversation also highlighted additional insights with respect to the evolution of impact investing:
1) As the impact investing industry becomes increasingly diverse, a simple, common definition remains crucial.
Under the Global Impact Investing Network’s (GIIN) original definition, there is little room for confusion: Impact Investing is based on intentionality – it is neither a negative screen, nor simply an ESG (environmental, social and governance) overlay. The explicit intention of an impact investment must be to achieve a social or environmental impact in addition to a financial return. Although GIIN doesn’t explicitly state that measurement of social or environmental impact is required, the industry has evolved to consider this measurement as implicit as the measurement of financial returns. As a result, without an existing comprehensive regulatory body, the industry is forced to self-regulate and the onus falls specifically on sophisticated high net worth and institutional investors to navigate diverse product offerings and classify them accordingly in order to avoid market confusion.
For example, Blackrock’s new iShares Global “Impact” Exchange-Traded Fund (ETF) would not fall under the category of an Impact Investment under the existing industry standard. This is because the investment mandate stipulates that the fund seeks to track an index composed of “positive impact companies that derive a majority of their revenue from products and services that address at least one of the world's major social and environmental challenges as identified by the United Nations Sustainable Development Goals.” In order to understand the intentionality of the fund, it’s worth noting that in the time that this blog was in development, Blackrock’s wording for the fund has been updated from its previous description that underlying companies “may drive positive change” aligned with the Sustainable Development Goals. While pedantic, the original use of the word ‘may’ in the investment mandate, was telling. There is presumably no active measurement component, therefore, it’s not Impact Investing – simple, right? Furthermore, SDG #9 is ‘Good Jobs and Economic Growth’. What ETF couldn’t argue alignment with this at a high level (or any long-only fund for that matter)?
However, just because Blackrock’s new ETF doesn’t fall under the category of an Impact Investment, doesn’t mean it’s not worth considering for a portfolio or allocation aligned with ESG or Responsible Investing goals. Assuming an investor would be willing to forgo the fact that ETFs were originally designed to access market correlated returns (i.e. beta) at low fees and specialised ETFs may not make sense in the first place, at first glance most of the companies in the top ten holdings do appear to align with SDG #9 and beyond (examples include public companies in health care, education and electric vehicles as of March 15, 2017 ).
As always, the challenge is to dig deeper than marketing terminology in order to fully understand an investment strategy. As large financial institutions and asset managers increasingly seek to create products with an “Impact” component, this challenge will become increasingly difficult. GIIN’s simple definition and a common market consensus around measurement of both financial and social returns are useful to refer to as a starting point for comprehension, rather than as determining factors.
2) Impact Investing cannot become a standalone asset class – the approach needs to remain an investment strategy overlay.
Due to the variations in financial return targets, impact measurement, investment vehicles and fund strategies, Impact Investing neither can, nor should become a standalone asset class. As a subset of Responsible Investing, the industry must develop across asset classes, rather than as a burgeoning asset class of its own. The initial goal of Impact Investing was to think differently about empowering entrepreneurs and underserved populations. Let’s not forget this. However let’s extrapolate this to achieve new and increasingly bold social and environmental objectives globally.
Rather than conflating Impact Investing into a niche style of private equity in emerging markets or venture capital in developed markets, it is necessary to equate Impact Investing to an investment strategy, or overlay. A similar approach, for example, to an ESG screen which seeks to monitor specific changes at the investee level prior to staggered capital injections (often through establishing Key Performance Indicators that management teams are accountable for prior to the next capital outlay). If we agree that Impact Investing is a strategic overlay, rather than a separate asset class, it will help to avoid market confusion and dilution of the industry based on existing market stereotypes.
3) Target (and actual) financial returns can and should vary dramatically between funds with diverse investment strategies.
Impact Investing has previously been synonymous with lower financial returns. This is due to the fact that many impact funds (and investors) are willing to accept increased financial risk and potentially lower returns in exchange for the prospect of higher social and environmental impact. However, this is not a mandatory component of Impact Investing. Yes, some impact-oriented funds will adhere to the ‘patient’ capital approach, where internal rates of return are inherently lower due to the time-bound nature of this financial measurement. But other fund managers will seek to achieve above-market returns with investment theses that directly correlate social and environmental stewardship with increased financial returns. Again, when deciding where to allocate capital, institutional investors must become sophisticated enough to understand the differences in investment strategies, just as they would for an emerging markets-focused ESG fund versus a U.S. centric private equity fund that adheres to the UN’s Principles of Responsible Investing.
Furthermore, the industry should embrace all Impact Investing strategies where target financial returns vary dramatically. As an example, Palladium’s recent research that mapped the landscape of the Impact Investing market across South and Southeast Asia identified four distinct categories of Impact Investing funds across the spectrum of financial return. In addition, aid agencies, where baseline alternatives are 100% write-offs through grants or allocations to their respective Development Finance Institutions, may seek to target a 0% real return or even negative financial returns in order to catalyse and leverage 3rd party capital through tools like blended finance or guarantees. Foundations and family offices may also be willing to accept lower returns in exchange for mission-aligned (or value-aligned) investment strategies. Even pension funds are beginning to interpret their long term accountability to stakeholder beneficiaries as a potential opportunity to align portfolios with long term societal and environmental benefits – a resulting reallocation to impact investing would likely require a rebalancing of respective portfolios in order to achieve target financial returns. The diverse goals of these asset owners and the investment strategies that logically stem from them are equally valid, and should be viewed as such by industry stakeholders.
To date, the growth of Impact Investing has largely stemmed from a reaction to historical economic affairs: a short-sighted, singular focus on financial returns and economic growth as predominant indicators of success, rather than long-term societal and environmental progress. Instead, Impact Investing originally represented a pragmatic desire to support and empower entrepreneurs that seek to tackle poverty and other ‘wicked problems’ on a global scale. As the industry continues to evolve, consolidate and refine frameworks, it’s important we keep these original goals in mind. The ultimate objective should remain to support entrepreneurs, companies, industries and fund managers that seek to tackle global problems. At the same time, Impact Investment strategies can and should continue evolving using myriad approaches across asset classes, geographies, sectors and target financial returns.