Note: This article originally appeared in the December 15, 2011 issue of Responsible Investor
Tomato, Tomahto, Potato, Potahto: what does “impact investment” mean to you? Although most agree on the high level goal of protecting people and planet while generating profits, numerous approaches to achieving these objectives are creating confusion and constraining the growth of impact investment. Like emerging markets, impact investment is a theme within which varied strategies and asset classes can be pursued.
In the past, we all accepted single line returns – financial – as the only possible investment objective. Today, we have the option of pursuing multiple-bottom-line (MBL) returns. But what does that mean for investors and what are they key obstacles to pursuing an MBL strategy? Broadly speaking, these obstacles relate to strategic clarity and economies of scale.
The desire to do good – or to do well by doing good – has created numerous MBL practice areas or sub-themes that offer different risk-reward value propositions, including: corporate social responsibility (CSR), environmental, social and governance (ESG) screening, ethical investment (EI) screening, socially responsible investment (SRI) screening, social enterprise, social capital, venture philanthropy, social venturing, sustainable finance and impact investment. Convergence and consolidation are to be expected, but finding strategic clarity and a reasonable path forward in the present is both necessary and feasible.
On an aggregate basis, two distinct schools of thought have emerged around MBL investing. The first, following Rockefeller Foundation’s taxonomy, segregates impact investment into “finance first” versus “social first”. The former seeks primarily financial returns with a little something extra on behalf of social equality or the environment. The latter pursues social and environmental goals first and looks to add a layer of financial returns as icing on the cake. “Finance first” investors see the uncertainty around evolving industry benchmarking standards for environmental, social and governance (ESG) targets and opt to use known financial benchmarks as primary drivers, relegating ESG to a secondary role. “Social first” investors emphasize the human and planetary impact of a potential investment, with financial returns as a secondary driver.
In a recent Forbes magazine interview, Luther Ragin of Harvard’s Kennedy School noted: “the continuing challenge of a traditional investor mindset that views the simultaneous pursuit of financial return and positive social and environmental benefits as inherently contradictory or even unwise. It is a paradoxical position, coming often from those who otherwise embrace market-based, private sector solutions.” The concept of Blended Value put forth by Jed Emerson provides a useful counterpoint to the “finance first vs. social first” paradox. This alternative school of thought acknowledges that we can and should look at the ESG impact potential of all investments. Alternative thinkers see “impact investment” as an opportunity to design innovative products that incorporate social values and responsible stewardship of the environment alongside profitability targets.
Where you fall on the spectrum between these two schools of thought can guide how impact investment fits within your overall investment strategy. If you believe that all investment should bring some element of ESG alongside financial performance, you can achieve blended value returns within any and every asset class in your portfolio (see Impact Investing Across Asset Classes) for further insights).
Alternatively, you can allocate a defined percentage of total portfolio to one or more impact sub-themes, leaving your core portfolio strategy unaltered. One important sub-theme focuses on finding market-driven solutions to serving and improving quality of life for the large consumer market at the “base of the pyramid” (BOP). These investments tend to be early-stage, emerging markets ventures, with an entirely different risk and return profile than listed SRI and ESG instruments.
Becoming an impact investor does not, however, mean that you must include BOP risks in your portfolio. Defining and implementing an appropriate impact strategy for your organization may mean hiring new advisors and gradually realigning your portfolio around multiple bottom lines. You do not, however, have to accept a single (financial) return anymore. Specialty advisors like R. Paul Herman’s HIP Investor (Human Impact + Profit), Ron Cordes’ Impact Assets and others offer “next generation” information, advice and product access to accredited investors. Cordes notes that a major obstacle for impact investment is the “lack of awareness among the financial advisor/wealth manager community who are truly the “gatekeepers” for the $ 37 trillion of investor capital held by US households” and looks to provide full spectrum knowledge to this community.
Alongside strategic clarity, two additional obstacles are worth noting, both relating to economies of scale. Investment and asset managers with experience in EI, SRI and ESG products and efficiently sized operations are no longer difficult to find. As you move closer to the BOP end of the spectrum, established managers are scarce and, as a result, product offerings are few and far between. This new manager risk, combined with the lack of a transparent and appropriate ecosystem, tends to constrain scale, with a correspondingly negative impact on efficiency and effectiveness.
Traditional approaches to new manager risk limit the size of a first fund, without adjusting standard fee structures. The result is likely to be riskier than a larger, less resource-constrained, fund with alternative risk mitigation features. For example, does emerging markets risk make deal pricing look too low? Consider political risk insurance (PRI) tools that take this risk out of the equation. 2012 will see the launch of at least half a dozen “Impact Investment fund of funds” hoping to address new manager risk by providing anchor capital and launch support, but more is needed to move from niche to mainstream.
Developing an impact investment ecosystem is key for this “niche to mainstream” transition. New impact product offerings typically lack the size and trajectory needed to support a public offering. Much as NASDAQ emerged in the 1960s to provide a transparent, affordable way for smaller, newer firms to access public markets, today impact investment needs a specialized marketplace. Platforms that can provide affordable access and effective oversight of smaller MBL instruments and enterprises, like Mission Markets, have made significant headway in this regard but themselves lack access to growth capital. Investing in financial services firms catering to impact investment offers an interesting private equity play for sophisticated investors.
Sorting through the hype and exuberance surrounding impact investment can be challenging, but failing to do so – and remaining focused on financial returns alone – means forgoing additional upside from social and environmental returns. With public concern about water, energy and social justice on the rise, MBL investing is poised to enter the mainstream. As a responsible investor, you can choose to help lead this transition or follow along, but either way, impact investing is here to stay.
Managing Director, One Planet Ventures (Lauren.OPV@gmail.com)