What exactly is impact investing?
Unlike other types of sustainable investments, impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return (GIIN). Therefore, it must contain four key elements:
- Intentionality: Impact investments intentionally contribute to social and environmental solutions. This differentiates them from other strategies such as ESG investing, Responsible Investing, and screening strategies.
- Financial Returns: Impact investments seek a financial return on capital that can range from below market rate to risk-adjusted market rate. This distinguishes them from philanthropy.
- Range of Asset Classes: Impact investments can be made across asset classes.
- Impact Measurement: A hallmark of impact investing is the commitment of the investor to measure and report the social and environmental performance of underlying investments.
Types of impact investing
Impact investing can be categorized based on the investor’s preference and motivation to prioritize either financial return or impact. Financial first investors seek to optimise financial returns with a floor for social/environmental impact. This group tends to consist of commercial investors who search for investment vehicles that offer market-rate returns while yielding some social/environmental good.
Meanwhile, Impact first investors seek to optimise social or environmental returns with a financial floor. This group uses social/environmental good as a primary objective and may accept a range of returns, from return of principal to market rate. This group is willing to accept a lower than market rate of return in investments that may be perceived as higher risk in order to help reach social/ environmental goals that cannot be achieved in combination with market rates of financial return.
Both types of investors could also work together in the so-called, layered structures. These layered structures are created when the two types of investors work together, combining capital from Impact First and Financial First motivations, blending different types of capital with different requirements and motivations. In these deals, Im- pact First investors accept a sub-market risk-adjusted rate of return enabling other tranches of the investment to become attractive to Financial First investors. This symbiotic relationship allows Financial First investors to achieve market rate returns and Impact First investors to leverage their investment capital thus achieving significantly more social impact than they would if investing on their own [2].
In reality, pension funds and institutional investors are typically financial first investors as they are normally bound by strong fiduciary duties, limiting their ability to play in Impact First investments. Other sophisticated investors such as ultra-high net worth individuals and foundations or philanthropies generally have greater flexibility in their investment mandates, hence being able to participate in impact-first investments. However, investors could create a diversified portfolio of impact investments across platforms (financial first or impact first) and asset classes to generate market-rate return with desired impact outcomes.
Similarly, public equities tend to be less focused on impact as stock prices are usually valued using short-term horizon, as compared to private equities with the flexibility to focus on long-term impacts. Green bonds and debts are however becoming increasingly popular as an impact investment with long-term sustainability targets, as Chile is set to launch the world’s first sustainability-linked sovereign bond which is tied to its commitment to reduce absolute CO2 emission and advance renewable energy development [3].
Why impact investing?
Do good and do well Impact investors have diverse financial return expectations. Some intentionally invest for below-market-rate returns, in line with their strategic objectives. Others pursue market-competitive and market-beating returns, sometimes required by fiduciary responsibility.
According to GIIN survey, respondents also report that portfolio performance overwhelmingly meets or exceeds investor expectations for both social and environmental impact and financial return, in investments spanning emerging markets, developed markets, and the market as a whole.
Private equity is the most commonly used instrument in impact investing, deployed by over 75% of impact investors that responded to the GIIN’s most recent Annual Impact Investor Survey. The third largest asset class in impact investing in terms of asset allocations, it accounted for about 19% of global impact investing assets under management (AUM) as of the end of 2016. Depending on market type and target returns, investors reported average gross returns expectations ranging from 4.9% to 16.5% for 2016 vintage equity investments4, which is within the range of market-rate returns.
Besides, private debt is the largest asset class in impact investing, accounting for about 34% of total impact AUM according to the GIIN’s 2017 Annual Impact Investor Survey. The survey also found it was the second-most commonly used asset class, with over half of respondents indicating some allocations through private debt. On average, gross returns expectations of vintage debt investment range from 2.7% to 9.2% depending on whether the investment is in a developed market or emerging market and whether the investor is principally seeking market rates of return or concessionary returns.
Case study on whole portfolio approach
The KL Felicitas Foundation (KLF), first established in 2000 to support growing social enterprises, began allocating its portfolio to impact investments in 2005. By 2014, 99.5% of the foundation’s portfolio was allocated to impact investments. Its impact investments target a wide range of sectors, including community development, financial services, health, food and agriculture, energy, and water, and are made across multiple asset classes. KLF’s impact portfolio is allocated globally, with a focus on Africa, India, and North America.
Returns were calculated as a function of all income from inception through 2013 using the Modified Dietz methodology, which time-weights cash flows on a daily basis to value quarterly performance. Returns were then analyzed net of fees and transaction costs by asset class, excluding investments in real assets and private equity due to their early stage in the investment lifecycle. Its overall impact portfolio generated 3.0% p.a. net of fees, compared to its benchmark which generated 2.5% p.a. The table below also includes additional detail on performance by asset class within its impact portfolio.
Therefore, it is definitely possible to do good and do well (achieving market-rate return) at the same time. Sometimes, impact investors would even prefer to have lower financial returns in exchange for greater impact achievement within the investment timeframe. From the whole portfolio case study, impact investing is proven feasible and flexible in terms of asset allocation to determine an optimum level between impact generation and financial return.
Lower cost of capital
Some research have concluded that impact investing is capable of lowering the cost of capital for issuers due to the existence of green premium, especially in the bond market.
In the primary market, the pricing benefit can be interpreted by the fact that the issuance of green bonds is still limited today and the demand for green investments is rising. This potential supply and demand mismatch can trigger scarcities and thus a “greenium”. The premium reflects the investor demand for bonds with a green label over conventional bonds, which will encourage project owners to issue green bonds to fulfil their financing needs at a lower cost of capital. In secondary markets, green bonds generally trade at tighter spreads than comparable conventional bonds by very small margins (of 2 basis points or less according to the latest research report from Amundi and IFC focusing on green bonds in emerging markets) [5].
Case study on Tesco’s green bond
Another study on Tesco’s recent issuance of sustainability-linked bonds (SLB) also concluded that it enables Tesco to reduce borrowing costs in comparison to standard debt. While SLBs generally penalize issuers with higher borrowing costs if they don’t meet certain ESG metrics, the research also proved that an instance of coupon step-up does not transform the yield difference from negative into positive. This observation dismisses concerns that investors look for issuers to fail in pursuit of material changes in their carbon footprints [6].
Smarter way of investing
Impact investing is all about a smarter way of investing as it unlocks hidden economic values and efficiencies, while realising undervalued or misjudged investment opportunities.
Case study on Ignia
Ignia, a Mexican Venture Capital firm that invests in businesses that provide products and services to the underserved low income population of Latin America, aims to invest in profitable and scalable businesses that create social impact by achieving systemic change. It believes that there is a strong market for high quality products and services delivered to the poor at affordable rates. Ignia raised an initial fund of about $60MM and has completed 2 investments in the areas of affordable housing and healthcare services and it hopes to have completed 6 investments by the end of 2009.
In 2008, Ignia made a $2MM investment in Premin for its Jardines del Grijalva housing project in Chiapas, Mexico. The homes are being built for families that earn less than $10,000 a year. The idea behind the investment is that small local developers of affordable housing suffer from a lack of capital and large developers seldom go into the South of Mexico or into smaller communities. Consequently, there is a shortage of housing and families are forced to build their own homes. Ignia also identified a microfinance institution that would provide mortgages to families without access to them.
Today, around 1,800 families have been provided access to affordable but quality housing with affordable mortgages since Ignia’s funding. It expects to earn above market rate returns on the project, and believes that generating high returns is imperative in the low-income segment as the market perceives the segment to be high risk and the customers in this segment do not have a lot of choice and so high margins are sustainable [7].
How do we measure impact?
To date, there are different standards when it comes to impact measurement. The International Finance Corporation by World Bank Group has laid out three key impact measurement frameworks, which are based on impact target, rating, and monetisation respectively [8].
LeapFrog Investments, a profit-with-purpose investor, had set out its target-based FIIRM framework that encompasses a matrix of operational key performance indicators (KPIs) to track financial performance (F), impact and innovation (II), and risk management (RM).
Besides, the Partner’s Group (PG LIFE Fund) with the dual mandate of achieving attractive risk-adjusted financial returns alongside measurable, positive social and environmental impact, operates with a rating-based framework. Through all its investments (also outside of PG LIFE), Partners Group aims to drive value creation, which includes helping companies improve the management of material ESG topics such as energy management, health & safety, and diversity. Partners Group has an approach and framework for capturing the impact of these improvements in business practices and sees the PG LIFE framework as an extension of that, by being able to capture the positive social impacts of companies based on their core products and services.
Lastly, TPG’s RISE Fund with the objective of achieving social and environmental impact alongside financial returns has worked with Bridgespan Group to develop an approach to measuring impact that can be used across a diverse set of assets. Their approach builds on earlier contributions to quantifying impact, including cost-benefit analysis, and social return on investment. The basis for their framework is an impact money multiple (IMM) that quantifies and monetizes an investment’s net social and environmental impact on the basis of rigorous, quantitative evidence.
What’s next for Impact Investing?
Impact investing has a key role to play in financing the gap to achieve United Nation’s Sustainable Development Goals (SDGs) around the globe, with increasing interest and capital deployed on sustainable investments.
Consider the widely cited estimate by the United National Conference on Trade and Development (UNCTAD): At the global level, total investment needed to meet the SDGs are on the order of $5 trillion to $7 trillion per year. In developing countries, needs are estimated at $3.3 trillion to $4.5 trillion, with a midpoint of $3.9 trillion. This capital expenditure spans many sectors: hospitals, schools, telecommunications infrastructure, water and sanitation, railways, airports, irrigation, and conservation projects.
Such investments have a long payback period of seven years, at the very least. Investing at this rate, under the assumption that they earn a commercial return— private institutions and households can be expected to invest $728 billion for impact annually ($5.1 trillion over seven years) in private markets—a substantial contribution toward SDG needs. If they earn a sub-commercial return, however, they have appetite to invest $214 billion for impact annually, less than 10 percent of investment needs.
In public markets, the potential is much greater. There, impact investors could invest $3.1 trillion annually ($21.4 trillion over seven years), within the range of what is needed in developing countries today. This implies that investment by public companies—those whose equity is traded on stock exchanges, or who issue debt securities—must play a role if we are to mobilize financing on a scale needed to finance the SDGs [9].
Ultimately, the extent of impact investors’ contribution toward the SDGs depends on two crucial factors:
- whether they can influence the behavior of firms by investing in securities traded in public markets and;
- whether they can earn commercial returns while solving the social, environmental, and economic problems outlined in the SDGs.
