13. Impact Investing

Dr. Falko Paetzold Managing Director, Center for Sustainable Finance and Private Wealth, University of Zurich

History and Definition

The concept of impact investing developed out of “blended value” in the 90s in the US, wherein thought leaders together with different organisations sought options to merge financial returns and philanthropic efforts. The term “impact investing” was coined during such a conversation convened by the Rockefeller Foundation in 2007.

The Rockefeller Foundation then initiated the Global Impact Investing Network (GIIN) in 2009, an association that by 2017 had established itself as a global network of over 200 organisations active in impact investing, including asset owners, asset managers, and service providers. One of its key outputs is an annual survey to collect information on volumes and trends within the impact investing space. As of 2017, the 208 respondents to the annual GIIN survey managed USD114 billion in impact investment assets. 1

GIIN defines impact investing as investments made into companies, organisations, and funds with the intention to generate social and environmental impact alongside a financial return. Depending on investors’ strategic goals, impact investments can be made in both industrialised and developing markets and deliver a range of financial returns, from market-rate to belowmarket rate (see Figure 14).

Further, a set of core characteristics helps to distinguish impact investments from other types of sustainable investing:

Intentionality refers to investees that, through the core activities of their business, specifically intend to achieve a positive social or environmental impact. Examples include health care services for underserved populations, education technologies, or social housing.

Measurability refers to the commitment and ability to measure and report the social and environmental outcomes of investees’ business activities. This is done through systematic setting of social and environmental goals as well as performance metrics, monitoring, and reporting processes. The GIIN provides a standardised set of impact performance metrics through the IRIS 2 metrics catalogue. IRIS metrics, as well as other impact measuring frameworks, are widely applied by impact investors and funds globally. Building

Figure 14. Differentiating Impact Investing Based on Regional Focus and Expected Financial Return

Financial Return Market

Below Market Region

Industrialised

Products focused on industrialised economies that generate competitive returns Developing

Investments for Development Products focused on developing economies that generate competitive returns

Products focused on industrialised economies that require a below market return

Products focused on developing economies that require a below market return

Source: Swiss Sustainable Finance (2016).

upon the catalogue of IRIS performance metrics is the GIIRS rating system. GIIRS is a standardised, externally verified rating framework that is applied by many impact funds and investors.

Range of return expectations, regions, and asset classes. Impact investments cover a range of asset classes, from real estate (e.g., social housing), to fixed income (e.g., consolidated portfolios of micro-loans), to private equity/debt (e.g., clean tech in Germany). However, the majority of impact investment opportunities are based in developing markets in the form of primary-market investments and private equity/debt, venture capital, and real estate. This is due to the intentionality and measurability characteristics outlined above (and additionality, described next). These characteristics are less feasible in secondary markets and in listed equities in particular, where shares are sold from one investor to the other and the impact of deployed investor capital is more difficult to measure.

One aspect not mentioned by GIIN but to which advanced impact investors also pay close attention is the additionality of their investment capital: actively seeking to optimise the catalytic effect that the deployed capital has. These impact investors invest in funds, firms, or projects that would not have been realised were it not for that particular capital being deployed. Examples include anchor investments into first-time funds, or directly into the fund management companies themselves, or into such novel investment structures as social impact bonds (SIBs). Other examples include investments into particularly underserved (i.e., capital-starved) technologies, populations, or markets. An example would be a sanitation-infrastructure developer (technology) focused on rural bottom-of-the-pyramid farmers (population) in Rwanda

Figure 15.

Sustainability Focus

Financial Risk/Return profile

Impact Investing in the Spectrum of Sustainable Investment

Traditional Investing

No explicit consideration of ESG and impact

Sole focus on financial risk/return Exclusions

Sustainable Investment Approaches

Best-inClass, ESG Integration

Voting & Engagement Thematic Investing Impact Investing

Avoid negative impact & mitigate ESG risks. Align investments with personal values.

Pursue ESG opportunities

Actively pursue positive impact

Actively select investees solving a social/ environmental problem

Philanthropy

Sole focus on environmental/ social positive impact

General baseline expectation of market-rate financial risk/return

Below market rate risk/ return No financial risk/return objective

Source: Illustration by author. 3

(market). Put differently, allocating capital into over-subscribed funds or projects that attract sufficient mainstream capital would be less interesting for these investors, who would rather aim to allocate their capital into funds or projects where their capital would be additional.

As such, investors can consider impact investing as the investment approach within the spectrum of sustainable investment approaches that is closest to philanthropy in terms of the focus on achieving a positive impact while still aiming for the full range of financial risk/returns, depending on investor preferences (see Figure 15).

Social and Environmental Impact Topics

Solutions to environmental or social challenges historically are obtained through public services or through philanthropy. Impact investors, however, aim for business models that deploy market-based solutions to social or environmental challenges.

As such, a key societal contribution of impact investing is to develop market-based solutions for many themes that historically were closed for the capital streams from investors that seek, at a minimum, the return of their capital.

Investors’ interests in specific impact themes vary depending on investors’ background, organisational set-up, and mandate. Banks deploy surveys and interviews to explore the interests of their clients. 4

Figure 16. Investors’ Planned Change of Capital Allocation for 2015 by Impact Themes

Energy Food and Agriculture Healthcare Education

Financial Services (excluding microfinance) Housing Microfinance Water and Sanitation Information and Communication Technologies Infrastructure Manufacturing Habitat Conservation Arts and Culture –10 0 10 20 30 40 50 60 Decrease Begin to Assess Maintain Increase

Note: Ranking by number of respondents who choose “increase”. Source: Saltuk, Y., & El Idrissi, A. (2015). Eyes on the horizon. J.P. Morgan & GIIN.

70

Investors’ interests change over time. A survey by J.P. Morgan and GIIN in 2015 showed that the impact areas that received most interest for further allocations were food & agriculture, health care, education, and, since 2015, energy. Microfinance, a cornerstone of impact investing, is the only area where some investors planned to reduce allocations (see Figure 16).

A perspective on the focus of funds on specific impact topics can be gained through analysis of ImpactBase, the database managed by GIIN of more than 400 impact investing funds. Funds in ImpactBase indicate which of six impact themes they cover (one fund can cover multiple themes): Access to basic services, access to finance, employment generation, environmental markets and sustainable real assets (SRA), green technology, sustainable consumer products, and other themes. As per 2017, access to finance was the most prominent impact theme covered by impact investing funds. The theme includes mostly micro-finance and lending to small- and medium-size enterprises (SMEs). Access to basic services, the second most prominent impact theme, includes mostly solutions providing access to health care, education, clean energy, water, and sanitation.

In terms of allocation of capital across markets and themes, roughly half of AuM are deployed in developed markets (with social housing in the US playing a significant role), while half of AuM are deployed in developing markets (in particular in energy and microfinance) (GIIN, 2017).

Figure 17.

Percent 100 90 80 70 60 50 40 30 20 10 0

Performance Relative to Expectations

Impact Performance n = 200 Outperforming In Line

Financial Performance n = 202 Underperforming

Note: Number of respondents shown below each bar, some respondents chose “not sure” and are not included. Source: GIIN (2017).

Financial and Impact Performance

The majority of impact investing funds target the delivery of at least marketrate returns. This allows them to fully cater to the majority of investors, who equally expect market-rate returns. 5 Most impact investors are satisfied with the financial performance as well as the impact performance of their impact investments (Figure 17).

Data regarding the achieved financial performance of private debt/equity impact investing funds are still rare. Two studies, published by Wharton (2015) and GIIN/Cambridge Associates (2015), indicated that impact investing funds produce attractive financial returns and funds that outperform the benchmark exist. Both studies had small sample sizes (Wharton: 53 funds; GIIN/Cambridge: 36 funds) that differed in their characteristics from the market benchmark. However, their findings suggest that investors, depending on their preferences, do not need to compromise their financial return expectations. For example, micro-finance funds offer diversification of assets across millions of lenders in developing or frontier markets. This provided attractive and stable returns throughout the last financial crises and the current low-interest-rate environment (see also chapter 13.2 on microfinance).

Conclusion

With regard to financial risk, impact investing can provide diversification opportunities through engagements in populations and regions that offer largely uncorrelated returns relative to mainstream capital markets. Considering their core objective of actively seeking to contribute to positive social and environmental change while at a minimum aiming for return of their capital, impact investments represent a growing market for investors with a strong motivation to create continuous impact through their investments.

Further Reading

• Battilana, J., Kimsey, M., Paetzold, F., & Zogbi, P. (2017). Vox Capital:

Pioneering impact investing in Brazil. Harvard Business School Case 417–051. • Gray, J., Ashburn, N., Douglas, H., & Jeffers, J. (2015). Great expectations: Mission preservation and financial performance in impact investing.

Wharton Social Impact Initiative of the University of Pennsylvania. • Matthews, J., Sternlicht, D., Bouri, A., Mudaliar, A., & Schiff, H. (2015). Introducing the impact investing benchmark. GIIN & Cambridge

Associates. • Mudaliar, A., Schiff, H., Bass, R., & Dithrich, H. (2017). Annual impact investor survey. Global Impact Investing Network (GIIN). • World Economic Forum. (WEF). Impact investing: Primer for family offices.

Available at: weforum.org/reports/impact-investing-primer-family-offices.

Endnotes

1 Mudaliar, A., Schiff, H., Bass, R., & Dithrich, H. (2017). Annual impact investor survey. Global Impact Investing Network (GIIN). 2 https://iris.thegiin.org/. 3 Partly adapted from Barby, C., & Goodall, E. (2014). Building impact-drive investment portfolios. In From ideas to practice, Pilots to Strategy II. World Economic Forum. 4 UBS, for example, in 2011 reported that many of its clients were interested in supporting SMEs (especially clients with an entrepreneurial background) and that Asian clients tend to focus on their home; the bank subsequently launched products that were focused on this combination. The UBS & Harvard Kennedy School study From prosperity to purpose: Perspectives on philanthropy and social investment among wealthy individuals in Latin America (published in 2015) identified the same home bias for UHNWIs in Latin America and subsequently launched related products. 5 See Mudaliar et al. (2017).