Impact investing grows up: from intentionality to additionality (Part 3/5)

Falko and Harald discuss the current state of impact investing: where we are, why we’re here, and where we need to go. They draw on recommendations that commentators made as far back as 2012, and introduce new frameworks that help investors who are looking for “additional impact” to identify the most effective tools. 

This is part three in a series of five articles. In part one Falko and Harald argue that a shift in focus is needed in impact investing: from the strong emphasis on intentionality and identity – which requires asking: “can this impact investment be attributed to me?” – to an emphasis on additionality and systems – which requires asking “how do we ensure adequate funding of needed solutions to global problems?” And: “how do we effect the system change that is often needed for this?” In part two they dig a little bit deeper into their CC2 concept: "Causing Change That Wouldn’t Otherwise Occur." This is not to coin a new phrase, but to explain why there might have been more attention to pinpointing the "change" element, than the elements "causality" and "additionality". They also discuss the implications for impact labels - can we develop labels that capture causality and additionality? - and for monetization of impact - can we put dollar values on the generated impact? Part four can be found here and part five here.

For this series they lean heavily on a series of articles published by Stanford Social Innovation Review, that are referenced throughout the text, and four academic papers co-authored by Falko. These sources are also listed at the bottom of this article.

Part 3: “Impact & Returns go hand-in-hand” & the SDG Venn Diagram

In this article we analyse a phenomenon that, paradoxically, has rallied a great number of investors to the impact investing cause, but at the same time poses a significant barrier to it reaching its full potential: the “impact & return go hand-in-hand” narrative.

It asserts that investors aiming for impact don’t need to forego financial return or, in other words, can generate good returns and impact at the same time. We could mention hundreds of examples of fund managers, advocacy groups and individual investors referencing this narrative, to demonstrate this thinking is so widespread in the impact investing community that it is often taken as a fact and is rarely questioned.

In the paper “Between impact and returns: Private investors and the sustainable development goals”, Falko and co-authors find that high net-worth “investors invest more capital into SDGs where they expect higher financial returns” and confirm that “both impact and attractive financial returns are expected”. One investor interviewed for the research commented, “I'm tired of hearing people say there has to be a sacrifice in return. I know it could be done with market rate.” Another said, “what the space needs is just data and proof… dispelling this myth that there's a trade-off between impact and financials.”

However, we’ll argue here that this narrative simply doesn’t hold up – first by seeing what the SSIR articles referenced in article 1 say about it, and then by reasoning through it, linking to the solutions required to close the SDG funding gap and the type of financing that it requires.

What do our SSIR authors have to say about this?

• Brest & Born: “Although it is possible for impact investors to achieve social impact along with market rate returns, it's not easy to do and doesn't happen nearly as often as many boosters would have you believe.”

• Bildner: “To be blunt, the data is in: Few problems have been truly solved by impact investing, and returns have been nominal at best… And yet, the noise in the funder ecosystem remains fixated, some would say obsessed, on the notion that it’s possible to achieve both market returns and full social returns… The more aspirational the impact goal, the harder it is to achieve market returns.”

• Brest, Gilson & Wolfson: “It is also possible for non-concessional impact investors to affect the outputs of firms while still earning a risk-adjusted market return through private market transactions by taking advantage of private knowledge or special expertise that they or their fund managers possess. However, non-concessional investors’ claims to have value-relevant private information should be viewed with healthy scepticism.” 

• Starr: “Fully unsubsidised clean water for really poor people? Essential services to millions of one-acre farmers? Saving lives from the most common diseases? Forging new distribution channels? Forget it—you’re not going to make any money. These represent profound market and government failures.”

It seems a clear verdict: while it isn’t disputed that investors can find opportunities where impact and return go hand-in-hand, these commentators agree that doing so is much harder than conventional wisdom holds, and that they are few and far between. To understand where these commentators are likely coming from, have a look at the Venn diagram below.

The blue circle represents all projects and activities that the world needs to achieve the SDGs. Picture the SDGs in their multi-coloured variety – no poverty, zero hunger, clean water and sanitation, climate action, etc. – and imagine all of the programs and efforts that must go into meeting them: building and running schools, sanitation programs, reducing maternal mortality, getting food to hungry millions who can’t pay for it. If you literally want to do this exercise, go to the SDG text and scroll through the many sub-goals, and you’ll get an idea of the vast to-do list encompassed by this blue line.

The other circle contains all activities undertaken globally by profit-seeking corporations. These activities have in common that they involve products or services that people are willing to pay money for; that this money is sufficient to induce corporations to engage in delivering them in order to generate profits; and that profits are attractive enough for investors looking for a good return on their investment.

The part of the picture that the “impact and return go hand-in-hand” investor is obviously interested in is the overlap – and the two circles do overlap as the SSIR quotes above suggest. However, this investor should also ask these questions:

How much do they overlap? 

How big of a role can profit-seeking corporations play in eradicating extreme poverty? In ensuring the poor get access to property? Ensuring the poor have access to safe and nutritious food? Strengthening the prevention and treatment of substance abuse? Getting all youth to achieve literacy? You get the idea – while there are areas where companies can play a role, there is a vast number of areas where solutions won’t generate any revenues, let alone profits, any time soon. You can even argue that the more impactful the activity is, the less likely it is to provide an attractive return.

How much impact can be found in the overlap? 

The investor identifying corporations active in the shaded area but should also be aware that: 

1. The impactful activities are already taking place! Does the investment further facilitate these activities? In other words, is your investment “impact-alignment” or “impact-generation?” To answer this question it’s important to know if the investee company is listed or privately owned, and how constrained its access to capital is. 
2. These activities apparently yield a return (otherwise the corporation wouldn’t be active here) – will the companies undertaking them have difficulty in attracting capital? This is what Starr has to say: “Investments that provide a big return don’t count: the market will take care of those, and we don’t need conferences to get people to put money into them.” 

And note that these issues (1) and (2) are also two of the key elements in our CC2 model – investments that Cause Change That Wouldn’t Otherwise Occur – if the investment in the impact company does not cause the impactful activity to take place or to scale up, and if the activities would occur anyway, because they already yield a profit, how impactful can we really claim our investments to be?

Incidentally, we think the overlap between the circles is small: in the bigger scheme of things most of the hard work in addressing SDGs will need to be done by governments, NGOs, philanthropy etc. – simply because these activities won’t generate any revenues or profits, today. As Brest & Born say, “Although we do not reject the possibility of earning market-rate financial returns while achieving social impact, we are skeptical about how much of the impact investing market actually fits this description.” Starr says, “impact investing creates the illusion that traditional business models can solve big problems in places where poor governance and huge market failures are the rule.”

But even if you believe the overlap is large, does it matter? The companies in that space are already generating good returns – financial markets may not be totally efficient, but they certainly operate efficiently enough for that not to be kept secret long. It can be interesting to identify companies operating in this area of overlap, to determine what specific contribution they are making to SDGs, for example. But we argue that it is much more interesting to determine what circumstances allowed that company to engage in these activities in the first place.

Was there a technical innovation, or a government or philanthropic intervention (such as a grant or a subsidy), that made this possible? We discuss below what investors can do to increase the size of the intersection of the circles, because that is where we believe the really impactful outcomes may be found.

Listed companies

Also a word on listed companies in this context, because many funds promise to deliver impact by allocating to publicly traded companies. We feel investors should be wary of these promises. Brest, Gilson & Wolfson say, “When can investments or divestments in public capital markets have impact by affecting the behaviour of investee firms directly through purely financial mechanisms? The answer is, virtually never.” 

Why? We think there are three reasons:

1. For the most part in these secondary markets, your ‘investment’ isn’t going into a company allowing it to do impactful things with your money; the money is going to whoever sold you the shares.
2. It’s true that buying and selling of shares sends certain signals to companies, and at sufficient scale this trading may influence the cost of capital (making it easier to obtain capital to be impactful) and the share price (giving executives incentives to deliver impact as this is part of their variable compensation). However, unless done on a very large scale these tend to be extremely weak signals and there are other, much more powerful signals and incentives driving executives’ behaviors.
3. This reasoning assumes that listed companies can make large contributions to the SDGs; however, as argued above there are many, many SDG solutions that do not generate revenues, and where listed corporations cannot play any role, except at the margins.

As Brest, Gilson & Wolfson wrote on this issue: “It is virtually impossible for investors to affect the outputs or behaviour of firms whose securities trade in public markets through the financial mechanisms of buying and selling securities in the secondary market. Socially-motivated investors who would like to make ESG standards the norm must join forces with consumers, employees, corporative activists, and regulators.” Also: “The socially-screened mutual fund industry should be regarded as offering investors a value alignment strategy, not an impact investment strategy.”

In other words, fund managers promising impact through listed equity should make it very clear they are offering “impact-alignment” – customers might feel good about being associated with impactful companies but should know that otherwise their investment doesn’t ‘do’ anything – there is no, or only very weak, “impact-generation”. In other words, in our CC2 model, to the extent there can even be Change, it will virtually never be change That Wouldn’t Otherwise Occur, and Caused by these investments.

Implications

What are the implications from this article for those investing for impact? 

• The vast majority of interventions needed to meet the SDGs cannot (yet) generate revenues, let alone profits, so are not investable. Starr says, “When we look at the world of impact investing through this lens (making the poor a lot better off), we find remarkably few for-profit ventures that both reach our target population and have the potential to become viable business enterprises. (…) There’s 10 times the risk profile of a standard US venture deal without the same potential upside.”

• The universe of opportunities offering both impact and return is very small. Bildner says, “It’s simple: While there is demand for impact investments that create full market return and true social impact, these simply do not exist at scale.”

• We should be sceptical about propositions promising both impact and return, and even more sceptical if they promise higher than market-rate returns, especially if propositions relate to secondary markets investments.

• The bigger the impact you want, the more concessions you’ll need to do on your return requirement. If you’re not a concessional investor, you’ll need to work with governments, development banks or philanthropists to derisk the investment for you.

Our arguments lean heavily on those of a number of commentators who – in a set of articles published by the Stanford Social Innovation Review (SSIR) – have started making similar observations as far back as 2012, but that we feel have been overlooked. We want to bring them back to the current debate and they are therefore referenced throughout our articles:

• Sectors, Not Just Firms; Do No Harm: Subsidies and Impact Investing and Government Matters (2012), By Matt Bannick & Paula Goldman (“Bannick & Goldman”)

• The Trouble With Impact Investing: P1 / P2 / P3 (2012); Kevin Starr (Part 2 with Laura Hattendorf (“Starr”)

• When can impact investing create real impact / Unpacking the Impact in Impact Investing (2013); a long and shorter version of the same article, Paul Brest & Kelly Born (“Brest & Born”)

• How Investors Can (and Can't) Create Social Value (2016); Paul Brest, Ronald Gilson and Mark  Wolfson (“Brest, Gilson and Wolfson”)

• How to Overcome ‘Warm Glow’ and Other Barriers to Effective Impact Investment Decisions (2020); Matthew Lee & Jasjit Singh (“Lee & Singh”)

• Impact Investing Can’t Deliver by Chasing Market Returns (2023); Jim Bildner (“Bildner”)

We picked these from a much larger universe of articles on impact investing because they best encapsulate how to think about its moving parts, but also to show that smart advice on impact investment has been available from the early days, and that we can be more effective by heeding it.

This article is also based on insights from four papers that Falko co-authored together with other academics in recent years:

• Between impact and returns: Private investors and the sustainable development goals (2022); with Timo Busch, Sebastian Utz, Anne Kellers

• Do Investors Care About Impact? (2021); with Florian Heeb, Julian Kölbel, Stefan Zeisberger

• Unlocking the black box of private impact investors (2021); with Sarah Louise Carroux, Timo Busch 

• Wealthy Private Investors and Socially Responsible Investing: The Influence of Reference Groups (2021); with David Risi, Anne Kellers

Finally, in writing this series, we have greatly benefited from conversations with Paul Brest, James Gifford, Robert Boogaard and Jonathan Harris.

illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.