Impact investing has never been more popular nor more in peril. The field is wracked by confusion over basic principles, dubious practices that invite cynicism, and biases against large companies. If more clarity is not brought to the movement, it risks a hard fall.
The stakes are high, and the world does not have a surplus of money or time to spend. Achieving the Sustainable Development Goals (SDGs) by 2030 requires $5 to $7 trillion annually.
Impact investing can help, but only if properly harnessed. A handful of pervasive problems are responsible for most of the trouble:
- Muddled thinking about appropriate rates of return that saps resources and exacerbates in-fighting among practitioners.
- Questionable theories of impact that spawn confusion about the character and quality of evidence to demonstrate impact, even managing to obscure the value of conventional investment and economic growth.
- Unwarranted sidelining of global and large regional companies that could provide necessary operational and financial resources.
To overcome these challenges, impact investors should follow three guidelines.
1. Anchor Impact Investing to Market Returns
The highest calling of impact investing is to increase the amount of capital being invested in places, companies, products, and services that have significant social benefits. Mobilizing private capital flows is made exponentially more difficult if impact investors are not aligned with conventional investors, who seek market returns.
As a consequence, impact investors should not be providers of concessionary capital. Impact investors should rather focus on growing competitive markets by aligning with market players who make decisions based on the likelihood of an investment achieving market rates of return. That likelihood (risk) informs the investment’s price, which is the signal markets use to efficiently allocate resources. Impact investors should not want to change the financial structure of an investment with a subsidy, as that would mask an investment’s true price and encouraging investors to make investments they would otherwise avoid. On the scale of billions—let alone trillions—of impact-investing dollars, this can be disastrous, particularly in the smaller economies of developing nations, where help is most needed. It can result in the wrong factories getting built and the wrong businesses getting support—a waste of financial resources and a missed opportunity to achieve social gains.
Rather than run the risk distorting markets, the unique and differentiating mission of impact investors is to build better, more competitive markets by investing non-concessionary capital in businesses with potentially large social benefits, such as reduced income inequality or slowed global warming. Those socially beneficial goods and services—be they rural roads, solar panels, seeds, or medicines—are, after all, the “purpose” of businesses. Impact investors equally understand, as Martin Wolf writes in his review of Colin Mayer’s book Prosperity, that “profit is a condition—and result of—achieving purposes”. Comprehending this is critical to impact investors’ ability to leverage their own investments with that of conventional investors.
Providing concessionary capital (subsidies) is the job of governments and their agencies. They decide when it is in the public interest to subsidize private enterprises; they choose how it should be done in the most cost-effective way. Blended finance is the term of art for governments determining the right mix of direct subsidies, guarantees, tax relief and exemptions, or improved enabling environment—code for the collection of regulations, laws, and public bureaucracies with which businesses operate. By virtue of their authority to tax and spend, governments have the standing to make these determinations. Impact investors do not.
The risks of misallocations if impact investors do not anchor themselves to market returns are serious.
The risks of misallocations if impact investors do not anchor themselves to market returns are serious. Without a fiduciary-like focus on achieving market returns for their clients, fee-charging intermediaries—advisers, investment bankers, gatekeepers, and asset managers—effectively receive a license to underperform and rationales for doing so. Just look at estimates of the scale of impact investing: $250 billion to $22.9 trillion. The range reveals the wildly divergent definitions of asset ownership, asset allocation, and investees that meet credible criteria. The finance industry is left free to scramble to create specialized “impact” products, which often charge higher fees. Beware of advisers who solicit a client’s preference between financial returns and social impact, especially in light of the difficulties of accurately measuring the latter. Such requests should invite skepticism, not trust. They contribute to a frothy, do-good enthusiasm that is not grounded in well-tested, professional investing principles.
In fairness, earning market returns is not easy. Many businesses, and even whole sectors, don’t. It is sadly true, as Mara Bolis and Chris West point out, that many enterprises impacting poor people in the global South earn in the low single digits. But that is a problem to be solved, not accepted. Still, too many impact investors surrender to concessionary business models before the fight for market returns is ever joined. They offer a plethora of rationales to justify accepting concessionary returns, arguing, for example, that subsidies are necessary because impact-oriented businesses take a long time to become financially self-sustaining.
But accepting concessionary returns is a declaration that one is not actually an investor—impact investing is investing, after all. Impact investors should instead think of themselves as factor investors, who pursue attributes (or factors) of an asset class that identify opportunities for reliable, outsized market rates of return. The factor premiums, as they are called, go by terms such as value-growth premium, momentum premium, illiquidity premium, credit risk premium, and volatility premium.
Impact investors using the factor approach have an obligation to clarify the attributes of impact investments that they believe will achieve premium returns. This is not as hard as it might sound, especially for impact investors who believe that there is no trade-off between financial returns and social benefits. As Black Rock’s Andrew Ang explains, factor premiums “work precisely because investors understand that [they] are the rewards for being willing to endure the associated losses in bad times.”
2. Reboot Impact Measurement
The most common complaint about impact measurement is the lack of agreement on indicators that could be standardized across investments within a sector, let alone across sectors. The more profound problem is the expectation that an observed change in an indicator can be reliably attributed to a particular investment or company.
Impact investors sincerely want to know that their investments “make a difference.” They are attracted to the idea that the financial and social benefits of an investment would not have occurred without their participation, a concept known as additionality that thought leaders such as Paul Brest have described. If impact investors cannot demonstrate additionality, then many people argue that the foundation of the whole impact investing project gets shaky.
Impact investing has backed itself into a corner because it’s difficult to test whether a change in an indicator can be reliably attributed to an investment or company.
Impact investing has backed itself into a corner because it’s difficult to test whether a change in an indicator can be reliably attributed to an investment or company. Doing so at scale is often impossible because rigorous testing involves establishing an experimental or quasi-experimental design with a counterfactual. Often, impact investors end up relying on bad science. They count the number of hours children spent exercising, the number of meals delivered, or other metric that is too often loosely based on a complex theory of change with no credible way to verify connections between impacts and a company’s actions, products, or receipt of a specific investment. This is a recipe for disappointment that over time will increase the already pervasive cynicism about “greenwashing” or “impact washing.”
The impact investment community needs to reground its work in the values of conventional investing or economic growth that focuses on problems of extreme poverty, corrosive income inequality, and climate change. The focus also needs to shift to a regime of corporate disclosures linked to a company’s audited financial accounts. These disclosures would be derived from the intrinsic, core operations of a firm using the metrics of conventional investing. They rely on macroeconomic assumptions about how markets work and how they can be made to work better to maximize long-term, inclusive, sustainable wealth creation, rather than short-term profits. To be clear, an expanded set of corporate disclosures would not provide reliable estimates of impact.