What is impact investing, anyway?
It is becoming increasingly apparent that private enterprise can play an important role in solving critical social and environmental challenges. Investors realize that these companies can have a meaningful impact on the world while delivering financial returns at the same time, enabling investors to “do good while doing well.” This has given rise to a large, growing movement known as impact investing.
Impact investments are investments made into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investments provide capital to support companies aiming to solve some of the world’s greatest challenges. Typical sector targets for impact investment are: sustainable agriculture and development, affordable housing, affordable and accessible healthcare, education, microfinance and financial inclusion, and clean technology.
My interest in impact investing stems from a variety of personal and professional experiences over the past couple of years. The initial spark was lit when I heard Sir Ronald Cohen speak about the subject around two years ago at an event in Israel (he believes social impact investing will be the new venture capital). I have also been inspired while watching my good friend Caroline Klatt leave corporate America in order to launch her own impact driven startup, OhSayNation, leading me to reflect on how my activities could be more impact oriented. Lastly, on a professional level I have had the opportunity to be an observer on the board of directors of two great impact companies (ReWalk and Neverware), and recently had the privilege to attend this year’s first investment committee meeting of the Wharton Social Venture Fund, OurCrowd’s new partner for impact investing. This series of events has left me more excited than ever to expand my knowledge of impact investing. Here is what I have learned so far:
Fundamentally, an impact investment must be impactful. In other words, an impact investment increases the quantity or quality of the enterprise’s social outcomes beyond what would otherwise have occurred without the presence of the impact investor. This is known as additionality.
The Global Impact Investing Network defines the core characteristics of impact investing as follows:
- Intentionality — The intent of the investor to generate social and/or environmental impact through investments is an essential component of impact investing. This is in contrast to socially neutral investors who are indifferent to the social consequences of their investments and whose sole mandate is to maximize financial returns.
- Investment with return expectations — Impact investments are expected to generate a financial return on capital and, at a minimum, a return of capital.
- Range of return expectations and asset classes — Impact investments generate returns that range from below market (sometimes called concessionary) to risk-adjusted market rate.
- Impact measurement — A hallmark of impact investing is the commitment of the investor to measure and report the social and environmental performance and progress of underlying investments. Impact measurement helps ensure transparency and accountability, and is essential to informing the practice of impact investing and building the field.
Do impact investments generate solid financial returns?
To elaborate on #3 above, not all impact investments have the same financial objectives, and so it is important to differentiate between different impact investing strategies. According to the CASE Foundation’s Short Guide to Impact Investing, the following are 3 of the major approaches:
- Blended strategies. Some investors are willing to take lower financial returns, or perhaps higher risks for an expected return, in order to have impact. They consider the “blended” social and financial return.
- Market rate, with impact. These investors look at these investments like any other, with the expectation of market rate return, but then filter for social impact as well. Ironwood Capital, for example, is a mezzanine fund that invests more than 50 percent of its fund in women- or minority-owned companies or in companies located in low to moderate income areas.
- Impact alpha. A growing number of investors are making the case that “impact” may represent a fundamental insight that the rest of the market doesn’t yet fully value, raising the possibility of market beating returns. These investors reject the tradeoff between social impact and financial return — rather than seeing returns or impact they see returns from impact. If the businesses succeed they can deliver financial and social returns at scale.
So does impact investing work if you are not willing to compromise on financial returns? According to the data, yes.
In terms of public equities, there is a lot of data to compare the performance of companies that are seeking both a financial and social return with those that are purely financially motivated. One piece of evidence cited in a July 2013 report from UBS is a landmark 2011 Harvard Business School study that demonstrated that from the early 1990s to 2010, companies that incorporated the needs of various stakeholders and took a broader view of ESG [environmental, social and governance] risks outperformed the companies that did not by a wide margin, and they also experienced lower volatility. The UBS report goes on to summarize that an “enormous amount of academic research has been published about the financial performance of sustainable investing funds over the past several years. The literature concludes that sustainable investing strategies perform about in line with market benchmarks.”
For impact investments in private companies, the data is not as readily available for analysis but there are numerous bright data points:
- Sonen Capital and KL Felicitas Foundation (KLF) reported that over the course of seven years, performance of the investments in KLF’s Return-Based Impact Portfolio was essentially on par with benchmarks in four asset classes — cash equivalents, public equity, hedge funds, and fixed income. Overall, KLF’s investments overperformed in some asset classes some years and underperformed in other years, but generally, yearly net returns from KLF’s impact investments rose and fell with the market.
- Impact Assets, CASE at Duke and Insight at Pacific Community Ventures conducted research on 12 successful Impact funds with varying financial return objectives, ranging from low yield credit to above market return private equity. One of the funds profiled in the report, is Elevar Equity, a $94 million private equity fund that delivered a 21% net, realized IRR to its investors — in line with the high return hurdle of other succesful PE funds.
- Tabreez Verjee of Uprising conducted a study that looked at the top 100 VCs which had altogether invested in 7,061 companies. Of those companies, 362 (or 5 percent) met criteria which qualified as Impact companies. Verjee compared the overall performance of these 5 percent with the remaining 95 percent of the sample pool. The data showed the following for the Impact companies: (a) these companies (5 percent) were responsible for generating 10 percent of the overall revenue of the sample pool; (b) over 6 years, their collective revenue grew by an impressive 146 percent, from $47 Million to $139 Million; (c) they registered 21 percent higher revenue per employee than the non-impact companies; (d) they attracted 3.7 times the number of Twitter followers per capita as non-impact companies.
- Unicorns ($1+ billion startups) are necessary for any entrepreneurial ecosystem to truly flourish, acting as role models for the next generation of entrepreneurs. DBL Investors, a $225 million impact investment firm in San Francisco, invested in SolarCity, now the largest solar installer in the country, up 413% since its IPO a little over two years ago and now worth $5.8 billion. DBL earned a handsome multiple on its investment in SolarCity and attributed its investment to being impact-focused: “We saw the opportunity early, that traditional investors would not have seen.”
One hypothesis for why impact-oriented ventures may outperform their profit-maximizing counterparts along both social and financial metrics is the social motivation of the entrepreneurs. As Mark Straub of Khosla Ventures has explained, it’s often much less about the business plan and much more about the extraordinary people who are driven to maximize impact through a business model that happens to generate profitable return.
Obviously a key reason for being engaged in impact investing is the social and/or environmental return-on-investment. How to measure the non-monetary impact is a topic that has been widely discussed and is beyond the scope of this post. I suggest this whitepaper written by the Global Impact Investing Network as a good place to start on the broader topic of impact evaluation. The whitepaper frames the importance of impact measurement to the growth of the industry as follows:
“Impact measurement is central to the practice of impact investing and vital to the growth of the impact investing market. Measurement demonstrates the social impact that these investments are having, which further legitimizes the practice. Without it, effective impact investing could not occur. Effective impact measurement generates value for all impact investment stakeholders, mobilizes greater capital, and increases the transparency and accountability for the impact delivered.”
Experienced investors are accustomed to having financial metrics with which to measure company performance. Similarly, impact investors need tools to provide the basic market infrastructure for monitoring the “impact” dimension of impact investing. Major strides have been made in this area and the 3 primary tools in use today are IRIS, PULSE and GIIRS (read more about those tools here).
With over $4.4 billion of impact investment today, the market is expected to continue to grow as more and more data becomes available on the financial and social returns to investors. Anecdotally, OurCrowd’s first exit out of our portfolio of 50+ companies at the time was ReWalk, a fast growing impact company helping paralyzed people walk again. I do not know whether or not that was a coincidence, but I for one will be paying extra close attention as impact investors (hopefully) share their returns in the coming years and shed more light on various impact investing strategies.
If you have prior history with impact investing, I would love to hear about your experiences in the comments section below.