A deep dive into the world of impact investing
By: Dama Sathianathan
Tags: Impact Measurement, Esg, Venture Capital, Impact Investing, Technology

TL;DR: Impact investing is maturing and some exciting things are happening.

In June 2021, for the second time running, I held a Masterclass (for lack of a better word) on Impact Investing for the latest cohort of Future VC, a programme run by Diversity VC to encourage more people from underrepresented communities to enter the venture capital (VC) industry. So in the spirit of opening up VC, here’s my deck from the Future VC class as well as an accompanying longer blog hopefully demystifying the world of impact investing.

As I was updating my deck from last year, one thing became apparent. More VC funding is available for impact-driven startups in Europe compared to the previous year. It’s wonderful to see the sheer amount of European funds that have emerged in the last year alone, all dedicated to impact one way or another — with the likes of Pale Blue Dot closing an €87M fund to invest in tech companies tackling the climate emergency, Revent in Berlin with an initial close of €20M backing ‘for profit, for purpose’ startups, Remagine in Berlin securing €24M, providing high growth, impact-led startups with revenue-based financing and more. In general, the impact investing industry spans various asset classes and has seen incredible growth over the last few years. But personally, the massive growth of the sector in early-stage VC is by far the most exciting development. Especially when more and more founders are looking for value-aligned investors to add to their cap table because it matters who is on your cap table. And thankfully, there’s no shortage of impact VCs now.

Still, many don’t actually know what impact investing is and often peddle quite a few misconceptions. Before we dive deeper, let’s address the 🐘 in the room. ESG is all the rage right now, especially in the VC industry. ESG investment is set to grow rapidly, and that’s great. We need more companies and VCs to get their house in order and care about doing the right thing across the environmental, social, and governance domains. VCs in particular need to step up when it comes to considering the broader risks to human rights violations. This report from Amnesty USA highlights that none of the world’s top ten largest VC firms have sufficient human rights due diligence policies in place.

It’s also important to highlight that a screening process that’s merely focused on avoiding harm (often referred to as ESG risk management) or that might benefit stakeholders (often referred to as pursuing ESG opportunities) doesn’t always result in net-positive outcomes. On the other hand, impact investors are driven by the motivation that it is not enough to only avoid harm in investment decisions. Instead, impact investors make the conscious decision to use capital to contribute to solutions. With a multitude of pressing social and environmental problems from the climate crisis to insecure work, to increasing poverty and racial inequality, and more, we actively need to invest in purpose-driven companies looking to drive positive outcomes for people and planet.

At BGV, we believe technology plays a big part in addressing these challenges, which is why we’re focused on investing in tech for good companies driving both purpose and profit at scale. That’s not to say that technology is the magical formula to all our problems. Despite being a strong advocate for #TechForGood, we try really hard not to further the narrative of tech solutionism — and if you’re unfamiliar with the concept, read this brilliant article from Evgeny Morozov.

“Why would a government invest in rebuilding crumbling public transport systems, for example, when it could simply use big data to craft personalised incentives for passengers to discourage journeys at peak times?” In the Guardian, from Evgeny Morozov, “The tech ‘solutions’ for coronavirus take the surveillance state to the next level”

Many of the issues we’re faced with stem from a long legacy of systemic discrimination, inequality, and racism and won’t be solved by tech. But we can explore how tech innovations can significantly contribute to better outcomes for people and planet in spite of it. Let’s face it — the world is f***ed. The latest Sustainable Development Report 2021 highlighted how the COVID-19 pandemic and resulting economic crisis is a setback for sustainable development everywhere. Last week’s IPCC report is a stark reminder that the climate crisis is rapidly getting worse. That’s why we need to be more conscious about the investments we make. What impact investors aspire to do, regardless of whether an investment is into a tech company or not, is to ensure that the investments we make today have a material effect on important positive outcomes for underserved people and the planet.

In a world where billions (yep, BILLIONS) have been deployed in Europe in 2021 alone (during a pandemic and economic crisis, I might add) to ensure consumers get their arrabbiata sauce in less than 10 minutes, investors need to understand how their deployment of capital will be judged by others (history has its eyes on you). For further reading on this topic, read this op-ed in Sifted from Johannes Lenhard.

But without further ado, let’s dive deeper into the world of impact investing.

What is impact investing?

To put impact investing into context, it’s always good to remind ourselves that all investments have impact — both positive and negative. The most common definition for impact investment derives from the Global Impact Investing Network (GIIN), which defines impact investments as investments “made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” The very nature of this definition allows it to focus on an investor’s approach to investing rather than the membership to a specific asset class.

‘Impact’ in impact investing is broadly defined as any meaningful positive change due to specific actions. Intentionality plays a significant role in the impact investing world, both in terms of investors’ intentions to allocate capital to drive better outcomes and assessing founders’ motivations and ambitions to start and run a business that has purpose at the core of it. Impact investors seek a financial return, albeit across a whole returns spectrum running from below-market-rate to risk-adjusted market rate. But perhaps the most distinguishing characteristic is impact measurement, dubbed the hallmark of impact investing, signalling the commitment of investors to measure and report on the social and environmental performance of portfolio companies.

However, it’s worth noting that not all investments promoting sustainable development are classified as impact investments. Take investments in electric vehicles as an example. A traditional VC, Investor A, might invest purely because of the expected financial returns, as the electrical vehicle market is growing rapidly and adoption is promoted and supported by regulation. On the other hand, Investor B, who is an impact investor, lists the potential for a massive reduction in carbon emissions as one of the main motivations to invest and has the critical intent to deploy capital to drive positive environmental outcomes, but also seek significant financial returns. Is one investment approach better than the other? Perhaps. Perhaps not. But you can pretty much assume that the impact investor will demand a higher degree of accountability from the company to evidence and measure the environmental outcomes than the traditional investor unless they have a strong ESG mandate.

Sizing the market

Impact investing is a rapidly growing field, and the impact investing landscape has gradually become more prominent over the last decade. According to GIIN’s 2020 Annual Impact Investor Survey, the full impact investing market size is $715 billion, covering the assets under management (AUM) of over 1,720 organisations globally. The IFC estimated investor appetite for impact investing to be as high as $26 trillion, of which nearly $5 trillion (19%) is in private markets, involving private equity (PE), non-sovereign private debt, and VC. The market offers great potential, and new investment opportunities and vehicles are emerging to finance and support impact-driven founders enabling founders and investors to pursue both impact and profit as they become inextricably linked.

The industry has undoubtedly witnessed significant shifts from consumers and investors alike, who increasingly want to put their money where their mouth is. Research into consumer trends from Zenogroup’s Strength of Purpose Study (2020), Deloitte (2019), and many others suggest there are increasing shifts in consumers’ purchasing behaviour towards purpose-driven businesses and brands they trust to do good. Simply put, people want to buy products and services from companies they perceive to do good and drive social impact.

“Purpose-driven companies witness higher market share gains and grow three times faster on average than their competitors, all while achieving higher workforce and customer satisfaction.” Deloitte, Purpose is Everything, 2019.

On the investor side, research suggests that individual investors and limited partners (LPs) increasingly care about the social and environmental impact of the companies and portfolios they invest in. For example, Atomico’s 2020 State of European Tech Report suggests that 45% of LP respondents to the survey require their GPs to report on their portfolio’s social and environmental impact, and 41% are considering implementing this requirement. Arguably, demographic shifts and generational wealth exchange have also meant that more and more individuals are increasingly interested in impact investing. For example, a 2019 study from Morgan Stanley suggests that more than 8 in 10 US individual investors now express an interest in sustainable investing. And we see this shift in consumers with attempts to democratise and open up investing through impact investing platforms like Tickr, who say that 90% of their users are investing for the very first time.

In the past, you might have come across asset owners thinking investing in impact violates their fiduciary duty because it doesn’t maximise risk-adjusted returns (think pensions who manage millions and millions of individuals’ retirement savings). But nowadays, asset owners see the threats to the long-term value of their assets and the wellbeing of their clients, critically due to climate change (again, we’re f***ed, if we don’t act). More and more asset owners see clear benefits from integrating impact, ditching the trade-off mentality regarding investment performance pursuing purpose and profit. A 2020 survey from Cambridge Associates found more than half of the respondents, with the majority being foundations and endowments, taking active steps towards sustainable or impact investing. Many increasingly recognise how the state of the world affects their responsibility to beneficiaries and are adopting new interpretations of fiduciary duty. For instance, this group of pension funds is working on practical steps to integrate sustainability into investment practice, realising that climate change threatens the fund’s ability to uphold its fiduciary duty. Clearly, we should all ask ourselves what world we want to retire into. We can ensure that asset owners, especially stewards of long-term capital like pension funds, actively use their capital to drive change. And BGV’s recent acquisition by Connected is one of hopefully many more emerging examples celebrating this shift in VC.

Impact measurement, the hallmark of #impinv

Translating intent into action is perhaps the most significant advancement in the maturing sector with increasing levels of sophistication in impact measurement and management (IMM) practices. Robust IMM practices certainly help founders in various ways. Adhering and setting standards helps founders crucially protect their purpose early on, validate their product or service and create an impact-driven fundraising narrative, as impact investors raise the stakes in their due diligence. All this applies to general partners (GPs) as well ;)

Impact measurement seems complex, but it really isn’t (though I work with a bunch of people who love this stuff as much as I do — so I’m definitely in my own little filter bubble). There are different methods available, and this guide from Best and Harji at Purpose Capital provides helpful context for the various processes to measure and manage impact. Generally, impact investors have many resources to work from, which can be distilled into principles, frameworks and standards that provide guidance on setting impact objectives, measurement and reporting on impact performance. According to the GIIN 2020 Survey, the most commonly used frameworks were the UN Sustainable Development Goals commonly referred to as the SDGs or Global Goals (73%), the IRIS Catalog of Metrics (46%), IRIS+ Core Metrics Sets (36%), and the IMP’s five dimensions of impact (32%). Most investors in the sample (89%) use a blend of three tools, systems or frameworks to measure and manage their impact, with only a small proportion using proprietary methods.

Figure from GIIN 2020 Survey showing the use of tools, frameworks, and systems, by purpose

Let’s look at some of the various IMM tools that help investors translate intention into impact results.

Principles: In the impact investing space, various sets of principles serve as the foundation for broad rules and best practices for the industry. They differ from frameworks and standards, as they more often than not communicate intent and might require a public commitment strengthening accountability in the space. Relevant examples include the UN Principles for Responsible Investment (UNPRI), which launched in 2006, and the IFC Operating Principles for Impact Management, commonly referred to as the Impact Principles, established in April 2019.

Frameworks: Frameworks are specific methodologies that translate impact principles and intent into practice. Examples include the UN SDGs and the IMP’s five dimensions of impact. Though, as someone who previously worked in advocacy for a civil society organisation involved in the consultation process for setting the indicators, I’d like to point out that the SDGs might provide a strategic blueprint for prosperity and peace for people and planet. Still, they left out some of the most marginalised communities. For example, considering that a large proportion of UN member states still criminalise homosexuality and being queer, it’s no surprise that the goals largely leave out targeted provisions for the LGBTQ+ community. This guide from Stonewall International provides substantial insight into the challenges faced by LBGTQ+ folk across all 17 goals. It suggests practical actions to ensure any progress made towards the SDGs also meets the needs of LGBTQ+ individuals. Overall, alignment with the SDGs is relatively easy to demonstrate, but translating alignment into action requires more than a big vision. And to measure net-positive impact, we need more. And that’s where standards come in.

Standards: Standards refer to taxonomies or a set of core metrics applied to specific verticals and sectors. Standards help determine the type of data you want to collect and measure to validate and evidence your impact, and mitigate impact washing. Examples include IRIS+ Core Metrics Sets, the SDG Compass linking the SDGs to the Global Reporting Initiative’s (GRI) Sustainability Disclosures, B Impact Assessment and many more.

“No one line of inquiry and evidence is going to tell you everything. IMM should help you ‘manage forward’ to improve your impact over time, rather than just look back at what impact has occurred.” Steven Godeke & Patrick Briaud, Rockefeller Philanthropy Advisors, The Impact Investing Handbook

Depending on your fund’s investment thesis and asset class, standardisation might seem like a Herculean task. It can also reduce the precision of information conveyed about how exactly portfolio companies are achieving transformational impact. Aggregating information into one value doesn’t always capture the complexity of the impact achieved. For example, at the end of 2020, BGV’s portfolio companies positively impacted 17 million lives. But who are the 17 million people? Some were refugees and internally displaced people using Chatterbox to gain access to decent work, where otherwise they might not have earned an income due to their displacement. Some were young women who swapped clothes to reduce the excessive amount of clothing going to landfill through Nuw. And some were people accessing vital health services during a global pandemic with DrDoctor. No one line of evidence will tell you everything, which is why it’s important to always leave enough room for qualitative methods to highlight impact stories. Regardless of how you structure your IMM practice and deliver platform support for portfolio companies to report on specific metrics and outcomes, it’s important to remember that this is an iterative process that will eventually change and evolve.

Impact alignment in the investment process

Impact alignment in the investment process is possible at various stages. If you are an investor or someone looking to start investing in impact, I hope the resources and questions to ask yourself will help.

Investment and portfolio strategy: What is your fund’s investment thesis? How does it align with your investment model? What else in addition to capital can you contribute?

See examples here from Bethnal Green Ventures, Future Positive Capital, and Kapor Capital. BGV, for instance, mandates that a company embeds their social and/or environmental mission into the articles of association to ensure no mission-drift occurs as companies scale, similar to Obvious Ventures World-Positive Term Sheet. Incidentally, this is also one of the first steps a company has to undergo to certify as BCorp. We’re also conscious about the contribution we can make to our portfolio companies aside from providing capital. At BGV, we run a 12-week acceleration programme to help founders build and launch their tech for good businesses and provide further platform support to our portfolio teams. 34% of our portfolio companies believe that without BGV their product or service would not have existed today, and a further 50% believe that without BGV they would not have been as far along in taking their product to market. So if you’re setting up a fund, consider not only the capital you provide but also what type of non-financial support can help founders level the playing field in making their business a success. Take into account what value-add you can provide, especially if you’re supporting first-time founders navigating the murky world of investment or founders from marginalised communities, who often lack the networks to raise capital. At a minimum, your fund’s investment strategy and approach should clearly link intent to asset selection, which in turn is based on a credible investment thesis. The Impact Investing Handbook by Steven Godeke & Patrick Briaud is an excellent resource that takes you on a step by step journey to adopt an impact lens to your fund structure, approach and portfolio management.

Investment screening and due diligence: How do you screen deals for impact? How do you validate a company’s impact?

This is probably one of the harder ones for VCs, especially if you’re a fund at the earlier spectrum of early-stage investing (btw early-stage is a stupid, ambiguous term). At BGV, we initially screen investments based on whether they broadly align with the impact outcomes we seek in the world — A Sustainable Planet, A Better Society and Healthy Lives. We have a few dedicated questions at various points in the pre-investment and due diligence phases that are sector-agnostic but can be tailored to the respective businesses. Norrsken VC provide a really good example of how they screen for impact and sustainability at various stages of the investment process. Needless to say, that it is much easier to screen for impact the more mature companies are. But it’s often incredibly hard at the earlier stages because founders might not consider themselves to be purpose-driven or impact-driven. Thus, a screening process that ensures alignment with the impact outcomes you seek and clearly articulating your thesis is essential.

Investment management: How can you help founders understand how to measure impact effectively? How do you manage a fund’s impact performance?

There are numerous standards and measurement frameworks, and many more ESG frameworks are currently in development. It’s important to note that a different level of evidence might apply depending on the company’s maturity. Nesta’s Standards of Evidence is a helpful framework to assess at which stages we can expect varying levels of confidence as to how a company’s intervention has a positive impact.

For tech for good ventures, we also need to ensure founders and investors understand the potentially harmful (un)intended consequences of products and services. Doteveryone’s Consequence Scanning Toolkit and Omidyar Network’s Ethical Explorer are toolkits we use as part of our programme to help founders early on to think about responsible tech development and build a mindset where thinking about unintended consequences is not abstract. Instead, it’s focused to help founders assess risk levels and prevalence and what potential mitigation strategies they can deploy. We’ve also started reporting on our portfolio companies’ impact risks that arise from trying to mitigate and avoid possible consequences. My brilliant colleague Yumi, who leads on BGV’s insights and operations, shares guidance here on how to assess your portfolio’s risks of unintended consequences and examples of how BGV’s portfolio companies validate their impact in this blog. Crucially, you should consider applying the same rigour to ensuring accountability to impact targets and reporting results in the same way investment professionals do for financial performance.

Exit: What does a responsible exit look like?

It’s often hard to influence a company’s impact trajectory for early-stage investors who usually take minority stakes, which are then diluted in future funding rounds, just as the impact and ESG risks grow. For funds like BGV, it means ensuring we have robust processes in place to spot any potential risks and build great relationships with founders to ensure we can support their trajectory to conscious scaling where needed. So what happens if an exit is on the horizon? A growing number of VCs are integrating a sustainability clause into term sheets and shareholder agreements, and examples of responsible exits emerged, most notably from Rubio Ventures. It’s still a relatively unexplored area, so please leave a comment if you come across any other examples.

Debunking myths

So what are these common misconceptions we hear in the impact investing space time and time again?

Myth: Impact investing means compromising on financial returns.

Debunked: No-oh-oooh. Think of profit and returns on a large spectrum with different financial return expectations.

67% of respondents to the 2020 GIIIN Survey principally target risk-adjusted, market-rate returns, with the remaining respondents seeking either closer-market-rate (18%) or below-market-rate: closer to capital preservation (15%). Overall, 88% of respondents reported meeting or exceeding their financial expectations.

More and more impact investors are seeking to invest in companies with apparent ‘lockstep’ — which intrinsically links their purpose to their commercial success. In other words, as impact scales, as do the financial returns for investors. As a result, companies are increasingly aligning their impact in the same direction as their EBITDA. Many studies have proven that you can indeed invest in impact and achieve net-positive impact with significant commercial returns in various settings. For example, this study from the Morgan Stanley Institute for Sustainable Investing reviewed the financial performance of over 11,000 mutual funds from 2004 to 2018 and suggests there is no financial trade-off in the returns of sustainable funds. Instead, investing in socially responsible companies is more profitable than investing in traditional companies. The 2021 Net Impact Report by the Upright Project also suggests that “making a positive impact is definitely not at odds with making profits.”

Similarly, Cambridge Associates and the GIIN launched the Impact Investing Benchmark in 2015, the first comprehensive analysis of the financial performance of market-rate PE and VC impact funds with supporting evidence to the solid financial performance of these funds. The IFC provides further proof that you do not have to trade-off between impact and returns, highlighting that the IFC’s realised equity investment delivered returns in line or better than the MSCI Emerging Market Index from 1988 to 2016. Notable VC examples include Kapor Capital, who in 2019 reported a 29.02% internal rate of return (IRR) and 3x Total Value to Paid In (TVPI), which elevates them to the top quartile of VC firms, and BGV with a 1.9x TV/Cost.

So, let’s ditch this outdated perception of a trade-off between impact and profits and acknowledge that there is a broad spectrum of returns expectations in impact investing. Check out Omidyar Network’s whitepaper “Across the Returns Continuum” for further reading on this topic.

Myth: By virtue of seeking impact outcomes, you’re a good company.

Debunked: Ah hell no.

Theranos, I rest my case.

Just because a company is trying to make the world a better place doesn’t mean they achieve a net-positive impact. The net impact of a company is not only the result of positive impact outcomes but also operational. Good governance, fair, decent and equal work and many more factors play a huge role in helping companies on a responsible trajectory to scale. So where can you start? For any new companies, honestly, try out the B Impact Assessment. It’s a lengthy questionnaire, sure, but it will help you spot the areas where you might need improvement or significant support from your community.

Quibbling over semantics

“Amid so much suffering and injustice, we cannot resign ourselves to the reality we’ve inherited. It is time to reimagine what is possible.” Ruha Benjamin, Race After Technology

We put labels on things to try to differentiate and make sense of things in this world. But sometimes, it really doesn’t matter. Call it impact investing, call it responsible investing, call it value-aligned investing, call it what you want. It doesn’t matter. What does matter, however, is recognising the urgency with which we need to respond to the challenges of our lifetime and for future generations to come and put our money to work.