Demystifying Impact Investing
By: Phil Price
Tags: Impact Investing, Philanthropy, Venture Capital

From a new 100 million people entering extreme poverty due to COVID-19, to the growing climate crisis, to the myriad challenges the ocean faces, to name but three themes, the sheer scale of these issues is evidence that opportunities for impact investing only continue to expand. Indeed, as renowned VC investor Chamath Palihapitiya recently hypothesised:

Solving humanity-, or perhaps even life-itself-, scale problems and making a cool trillion dollars in the process is exactly the clarion call the world needs to attract the best talent and the required capital to make it happen. But what is impact investing precisely?

The Origins of Impact Investing

To understand impact investing, you have to start with philanthropy. Etymologically, philanthropy means “a love for humanity”, was coined 2,500 years BC by its use in the Greek myth of Prometheus Bound. Examples can be traced back to three millennia before Christ to Babylonian laws which decreed punishments for the strong who abused the weak, whilst other ancient examples can be observed in Catholicism, Islam and Judaism.

An early modern example is the Foundling Hospital, the first ever children’s hospital for street-dwelling orphans built in 18th century London. In America, industrialists such as Andrew Carnegie and John D. Rockefeller, who made their vast fortunes in the booming 19th century economy from steel and oil respectively, devoted their later lives to philanthropic causes. Carnegie financed over 2,500 libraries and ultimately gave away 90% of his fortune, whilst Rockefeller invested huge sums in medicine, higher education and scientific research.

This legacy of philanthropy permeates the understanding of impact investing which, formulated less than 15 years ago, is a mere newborn in comparison. Defined as investments which look to generate positive social, environmental and financial returns, impact investing is still to this date sometimes confused with philanthropy, perhaps in part because both Carnegie and Rockefeller were poster-child capitalists turned world-renowned philanthropists.

A Diverse Investment Spectrum

Remarkably, the concept of socially responsible investing has been around for almost a century, with the 1928 Pioneer Fund using the model Socially Responsible Investing (SRI) and a negative screen or “do no harm” approach to avoid investments in the alcohol, tobacco, gaming and arms industries.

More recently, Environmental, Social and Governance (ESG) investing, with companies graded in these 3 areas allowing investors to be more proactive and allow for positive screening. ESG analyses how companies manage more responsibly their relationships with its stakeholders — human capital, product liability, social opportunities, climate change, the environment, corporate governance, — yet this does not stop ESG managers investing in industries such as oil and gas.

Whilst SRI and ESG focus primarily on public markets, impact investing is focused on private markets and looks to drive social or environmental change through the very product or service offered. It is investing for impact, with each dollar invested looking to drive outcomes. Social businesses, applying traditional financial terminology, are those which generate triple-bottom-line profits, where there is a net profit from a financial, social and environmental angle.

Along with the two extremes of conventional profit-seeking finance and conventional philanthropic non-for-profit donations, SRI, ESG, impact investing, among others such as venture philanthropy, make up a diverse investment spectrum, offering differing financial and social return profiles to investors.

Sonen Capital 2019 Impact Report

Here’s a second chart from Bridges Ventures:

Businesses On This Spectrum

Not all companies can generate the same type of returns, and that’s fine.

For example, if your business is one that doesn’t have a clear route to profitability, this likely means that you will rely heavily on donations to survive. At this end of the spectrum, you’re more focused on philanthropic donations and grants.

If your business is early stage or maybe has a model which doesn’t completely finance itself through sales, then venture philanthropy or concessionary capital will be a better fit. If your company has a clear strategy to reach profitability and scale, or is already on that route, then you’re the right kind of candidate to reach out to impact funds seeking market-rate returns.

When approaching an impact investor, understanding what their return expectations are and how this fits with your business is crucial. As an entrepreneur, it’s key to have the self-awareness of where your company sits on the investing spectrum and, as a consequence, what is the right capital type.

Investment Instruments

Another important issue is the alignment of appropriate capital for both companies and investors. Traditional debt and equity financing structures often fail to meet the needs of early-stage social enterprises as well as investor return requirements. Equity exits are in many cases unlikely or can’t offer the classic 10x demanded by traditional VCs, whilst standard debt can be too onerous.

This has led to investors being creative, creating self-liquidating instruments through structured exits which don’t rely on a sale to another fund (a secondary sale), to another company (M&A), or a public listing (an IPO). Indeed, to fight back against this “unicorn-only-style” traditional VC investing, the impact community has defined the “zebra”, investable companies which aren’t traditional VC candidates.

Structured exit a derived from company performance, examples of these contingent payment structures including revenue-based or cash-flow-based debt, self-liquidating equity, and the demand dividend.

Whilst each instrument has its benefits and is tailored for each company, generally they are reliant on generating positive cash flow, which means they aren’t adequate for those companies which are in an early stage or that have little prospect of reaching financial breakeven.

Be aware that there are other types of investment instruments out there other than equity or debt. Just because your company doesn’t fit in the VC-backable pigeonhole doesn’t mean you can’t generate good returns for investors, so be prepared to be creative.

Defining Impact

The products or services of these social businesses are specifically designed to tackle specific social and/or environmental issues. Naturally these issues are wide-ranging, in many cases aligned with the United Nations’ 17 Sustainable Development Goals (SDGs), touching on areas such as poverty, health, education, gender, energy, economic growth, climate action, and sustainable production practices, among others.

Additionally to a traditional investment thesis, impact funds have an impact thesis. These vary significantly, focusing on specific goals which are relevant to the fund’s context and geographical focus as well as the investment team’s expertise. For example, access to education and building new infrastructure are key in developing countries, whilst reskilling populations for the future of work or repurposing existing infrastructure are more relevant in developed nations. Another example, this time from an SDG angle: life below water is more relevant to island-nation Madagascar whereas life on land is key to landlocked Mongolia.

There are varying levels of impact, which can be understood as breadth and depth. To comprehend this, it’s key to recognise that not all impact is born equal. As an example, it’s not the same offering someone a financial product (e.g. a bank account) for the first time, as it is integrating them into a global value chain with fair trade pricing, as it is transferring them share ownership of a profitable company over time. These different types of impact — consumption-, income-, and asset-based — will naturally have very different breadth (some are much more scalable than others) and depth (some will impact more greatly in the income-generation and asset-building of beneficiaries).

Finally, and perhaps most importantly, who is finally going to execute on this impact mandate is the entrepreneur. To have a clear perspective that there is a commitment to achieve this mission, and avoid mission-drift, investors look for mission-alignment with the entrepreneur.

In short, impact investors will look for fit as to the type of impact, as well as its breadth and depth, and who is trying to achieve it. Impact investors scrutinise these as much as they do the company’s financial potential, just like traditional investors. Don’t skimp on either.

Measuring Impact

The same way that a traditional company will report on operational and financial metrics, social businesses also report on their impact metrics. In general, greater metric definition will help you, stakeholders and investors to understand more deeply your business and its impact.

There are two types of metrics. On the one side, standard off-the-shelf metrics. Perhaps some of the best known and comprehensive are IRIS from the GIIN. It provides a wide array and various cross-sections, whether you are linking by SDG, impact category, among others. GIIRS is another option.

On the other side, there are custom metrics. Whilst using one of the standardised sets above may be sufficient, perhaps they don’t quite capture exactly what impact you are generating with the business, so a custom metric can be more relevant to your particular context and intervention.

It’s worth mentioning that there’s no one metric better than another; a regenerative commercial forestry company will likely have very different metrics to those for a technology platform focused on empowering blue-collar employment opportunities, for example. Choose those which are right for you.

The same way that traditional investors demand the company file detailed financial reports, companies must be prepared to be as rigorous in their impact metric reporting too. This isn’t a nice to have. These North Star metrics ultimately are a key motivational factor for the company’s founders and stakeholders.

Returns In Line with Traditional Investments

It’s worth remembering that, from a returns perspective, impact investing sits at the midpoint of the investment spectrum, where financial returns, in some cases market-rate, can be made alongside generating significant positive social &/or environmental ones too; you don’t need to be concessionary in one to gain the other.

Inevitably, many question whether that’s even viable. Whilst philanthropic or “concessionary” capital (capital which looks for below-market-rate returns) exists, which is indeed required for some projects, investing for impact doesn’t necessarily reduce financial returns. Indeed, ESG funds outperformed the S&P 500 during COVID-19, and Morgan Stanley data show that returns are the same as traditional investments whilst offering the benefit of lower risk.

Morgan Stanley — Sustainable Reality Report

For impact, performance data from the GIIN show that impact investments have delivered returns on par with similar funds with no environmental or social objectives.

This explains the explosive growth in assets migrating away from traditional investing. Whilst global capital markets including equity and bonds sum to around USD 200 trillion, ESG assets as of 2020 are now USD 40.5 trillion. Still small in comparison, impact investing assets have also grown rapidly, with USD 715 billion of assets as of 2020 according to the Global Impact Investing Network (GIIN).

In Summary

There are many types of investors, all looking for different types of social and financial returns, potentially with an interest in very specific verticals or industries. As for the impact investing industry itself, it has matured significantly, innovating in instrument types and refining the definition of what “doing good” means, and has proven it can generate market-rate returns.

Perhaps Chamath’s hypothesis that the first trillionaire will be made in climate change isn’t as brazen as it might have first sounded.