Toward a better future: the value of impact investing

February 2020  |  COVER STORY  |  FINANCE & INVESTMENT

Financier Worldwide Magazine

February 2020 Issue

Burgeoning trend or a flash in the pan? Whatever the sentiment, the value of impact investing is an issue that has generated considerable coverage and discussion in recent years.

Defined by the Global Impact Investing Network (GIIN) as “investments made by companies, organisations or funds with the intention to generate positive, measurable social and environmental impact along with a financial return”, impact investments can be made in both emerging and developed markets – targeting a range of returns from below market to market rate, depending on investors’ strategic goals.

The GIIN’s ‘2019 Annual Impact Investor Survey’ – which features the views of organisations with impact investments worth approximately $239bn – highlights five key findings it suggests “demonstrates the increasing scale and maturity of the impact investing industry”. First, the market is diverse. Second, the impact investment industry continues to grow and mature. Third, impact measurement and management is central to investors’ goals and practices. Fourth, overwhelmingly, impact investors report performance in line with both financial and impact expectations. Finally, impact investors indicate commitment to developing the industry.

“Impact investing enables investors to achieve financial returns according to their risk and return preferences, invest in alignment with their values, and contribute to social and environmental solutions,” says Sapna Shah, managing director at the GIIN. “Impact investing also allows investors to differentiate themselves competitively and provides a path to cater to growing client demand for aligning business with personal values. Investors from around the world and in every segment of the financial industry are entering this market – from large pensions to banks, foundations, family offices and smaller, impact-focused fund managers.”

Moreover, in impact investing parlance, there are two types of impact investors: ‘finance first’ and ‘impact first’. “Depending on whether impact or finance is the main motivation, investors will select projects with different returns – both financial and in terms of impact,” explains Diane-Laure Arjaliès, assistant professor, managerial accounting and control, general management and sustainability at Ivey Business School. “Impact investing addresses a need that was not previously fulfilled – whether at issuer or investor level. It is the financing of projects that trigger positive change and generate financial returns.”

In the experience of Lucinda Gregory, investment research and guidance manager at The Share Centre, the majority of these projects “provide capital to address the world’s most pressing challenges in sectors such as conservation, renewable energy, sustainable agriculture, microfinance, and affordable and accessible basic services, including healthcare, housing and education”.

The GIIN’s 2019 ‘Sizing the Impact Investing Market’ report estimates that over 1340 organisations manage $502bn in impact investing assets (predicted to reach $1 trillion by 2020). Yet, while pervasive and maturing, for Rehana Nathoo, founder and chief executive of Spectrum Impact, the growth of the market is a less fascinating trend compared to the diversity of impact investing investors. “In 2010, when some of the first surveying began, investors largely consisted of one or two development financial institutions using a mix of capital to help seed the market,” she recalls. “Today, investors are active across investor type and asset class, and the increase in number of deals, year over year, demonstrates that investors are finding a pipeline of opportunities to meet their financial and impact targets.

“Investors’ goals depend greatly on the change they want to see,” she continues. “Impact investing, at its core, is not a new ‘way of investing’. It is a new purpose of investing. It is behaviour change. It works with the traditional markets to be more intentional, explicit and future-oriented when we think about utilising investment for a dual purpose. Just like in traditional investing, impact investments require a similar consideration of trade-offs across risk, return and liquidity. They also add ‘impact’ to that important calculation.

Instruments

Private debt, private equity, public equity and real assets are among the most popular instruments for making impact investments. Furthermore, an impact investment instrument should meet both general partner (GP) and portfolio company financing needs, have a clear process for its deployment and imply a strategy for ultimate exit.

“Any kind of financial product that aims to make an impact alongside financial returns could potentially be adopted for impact investing,” says Ms Arjaliès. “Of course, such instruments must aim to produce value in the real economy – not nurture speculative behaviours. Derivatives, for instance, would be difficult to use for impact investing. For now, most impact investing vehicles take the form of impact bonds or venture capital type of funds in the form of equity holding, convertible debt or debt. But there are currently many initiatives that might expand the type of instruments currently in use, for instance conservation impact bonds that use blended finance models.”

Indeed, investors have been demonstrating an increasing appetite for bonds issued to fund sustainable projects. “Green bonds are fixed interest instruments which exclusively assign proceeds to finance projects in sectors such as energy efficiency or water management, while social impact bonds (SIBs) invest in listed bonds issued by organisations that support key social themes, including employment and housing,” observes Ms Gregory.

One such bond, available later this year, is the Rhino Impact Bond (RIB) – the world’s first financial instrument working toward the conservation of a species at the risk of extinction. “The RIB will transfer the risk of funding conservation from donors to impact investors by linking conservation performance to financial performance and looks to boost the black rhino population by 10 percent globally,” explains Ms Gregory. “This is an exciting innovation that will surely grab the attention of investors.”

In the view of Ms Nathoo, the choice of investment instrument very much depends on the asset class, with some impact investors suggesting that impact investing is its own asset class. “We disagree,” she says. “The typology of ‘asset class’ – and its alignment with traditional investment classification – is very important to maintain. Asset class connotes an acceptable level of risk, return and – most importantly – liquidity based on investment type. Impact investments range in those considerations.

“You can have something risky and something that is not,” she continues. “Something that is liquid and something that is not. We believe that you can find impact investments in almost every asset class. A decision on the right investment tool to pursue should, firstly, be a decision on the right asset classes to engage in. What we are really asking is for investors to be clear about their risk, return and liquidity peferences. Once that is made clear, there are impact investment tools to meet all of those needs.”

Challenges

The challenges associated with impact investing are numerous – from getting the balance right between delivering a strong return to investors and ensuring the community or issue the investors are attempting to resolve receives adequate funding to establishing a viable mechanism for measuring success. At the same time, investors also need to remember that impact investments perform like other investments and may not achieve their targeted returns.

Among the challenges respondents to the GIIN’s 2019 survey noted were: (i) appropriate capital across the risk/return spectrum; (ii) suitable exit options; (iii) sophistication of impact measurement and management practice; (iv) high-quality investment opportunities (fund or direct) with track record; (v) common understanding of definition and segmentation of impact investing market; (vi) government support for the market; (vii) data on investment products and opportunities; (ix) professionals with relevant skill sets; and (x) research on market activity, trends, performance and practice.

“There has been an increase in demand for transparency and measurement – both to understand how investments are performing as well as their intended, and unintended, consequences,” says Ms Nathoo. “Impact investing is not much different. In its 13-year history, the industry has also needed to evolve, greatly, to be more inclusive, more accessible and more transparent. Though the size of the market and number of players suggests that the trend is still on the rise, a commitment to better measurement and transparency suggests that we are reconnecting to the rigour needed to differentiate this investing from other types.

“The biggest challenge, as well as opportunity, is that of standardising measurement,” she continues. “Much of the criticism in impact investing is about the inability to measure. That is incorrect. Frameworks exist that continue to sophisticate measuring the impact – both outputs and outcomes – of investment activity. But without standardised use of those frameworks and an ability to compare performance, we are not saying much in terms of best practice. That is a real opportunity to build transparency into a set of investment practices that do not often exist elsewhere in private markets.”

Another issue is the potential for companies to ‘greenwash’. “Impact investing is privy to the same concerns over ‘greenwashing’ that other responsible investing strategies have been facing recently,” notes Ms Gregory. “The wish to capitalise on the growing demand for responsible products has seen some organisations promote products falsely. Standardisation within the industry of what constitutes a socially responsible investment (SRI), environmental, social and governance (ESG) or impact product would be a huge help to the retail investor, but it is not a straightforward task.”

Despite the challenges, there is confidence that solutions are within the grasp of investors. “The industry is still growing, and experienced practitioners are actively working to generate solutions to these challenges,” says Ms Shah. “For those new to the industry, do not start from scratch where work has been done before you. There are many resources available, including research, tools and existing systems that can help investors articulate their impact strategies, and measure and manage their impact performance against their objectives.”

Outlook

As the industry and its investor portfolios scale and mature, the general consensus is that ever-increasing numbers of investors will turn to the impact investing market in the years to come as a way of generating value beyond solely return on investment (ROI) considerations.

“Previously, responsible investing was seen by many in the industry as a niche strategy,” says Ms Gregory. “However, in recent years, we have seen a significant shift in investor interest. Investors are recognising that new ideas are required in order to address some of the largest societal and environmental challenges facing mankind, and because of this impact investing is gaining traction. Demographics such as millennials require more than just the superficial return of investments and want to align their profits with their principles.”

In Ms Shah’s view, demand for impact investing will only increase over time, with investors becoming more sophisticated in their practice. “We see more and more signs that public expectation on the very role of the financial markets in society is changing, and with this a greater demand for options to invest according to one’s values. For example, research shows that younger generations demonstrate a greater interest than their predecessors in aligning all aspects of their lives with their values.

“As these generations begin to inherit and achieve their own personal wealth, investment options will have to adapt to these interests,” she continues. “We have also seen business leaders across the globe recognising the business significance of investing with social and environmental considerations. The traditional view of the investment industry is falling short of where the world is headed, and financial services firms that want to be successful in future markets need to make an investment in these capabilities today.”

Equally optimistic as to an increase in impact investing is Ms Arjaliès, not only because it makes economic sense to invest in projects that have a positive outcome on society, but also because financial returns are difficult to extract in conventional products. “As the world is moving to passive investing and the number of companies publicly listed decreases, investors will have to search for value in places that have been neglected so far,” she says.

While questions remain regarding the impact, benchmarking of investment products and financial viability of projects, impact investing is generally viewed as a burgeoning growth area – a win-win scenario for those companies that possess a positive social, environmental and financial outlook.

© Financier Worldwide

BY

Fraser Tennant