Written by Paul Asel, Partner, NGP Capital
Impact Investing is a hot market. Long the domain of development finance institutions, impact investing has moved mainstream, with the likes of Bain Capital, Calvert, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, Temasek and Texas Pacific Group now offering impact fund alternatives.
Impact investing, an investment strategy that seeks to generate financial returns, while creating a positive social or environmental impact, has grown 17% annually the past five years to $715 billion assets under management involving 1720 firms according to a 2020 survey by the Global Impact Investing Network (GIIN). Impact investing now accounts for 7% of all private investment assets under management according to McKinsey.
Yet the growth of impact investing has aroused much skepticism. In “Is ‘impact investing’ just bad economics?,” Philip Demuth argues that impact investing muddles financial and charitable motives, leaving any investment wanting on both measures. Instead, he advised that investing is left to financial managers, while charities focus on donations. Others worry about ‘impact washing,’ spurious investor claims of social impact without supporting evidence, a temptation that increases as governments impose ESG (environmental, social and governance) mandates. According to McKinsey, more than a quarter of assets under management operate according to ESG principles.
Even in the current investment market, our analysis shows that climate change and other global issues are getting the attention of the world’s entrepreneurs and investors. As is evidenced by the fact that investment in companies who identify with one or more of the UN’s Sustainable Development Goals (SDGs) has more than doubled over the last two years.
The rise in investments in purpose driven startups is being seen across the world’s major markets and extends far beyond the fiefdoms of impact investors – as new partnerships between the world’s investors and a new generation of entrepreneurs create new and innovative solutions to the world’s problems, and large institutional investors require their investment partners to report on ESG and add SDG-relevant measures to their investment activities.
Economic Merits of Impacting Investing
Dismissing impact investing altogether, as Demuth does, is bad economics. Impact investing, like effective financial investing and charitable donations, require nuanced judgment and intellectual rigor. When thoughtfully administered, impact investing applies sound economic principles that accomplishes investment and charitable objectives more effectively jointly than when pursued separately.
Microeconomics is a balancing act. Production optimizes where marginal cost and marginal productivity intersect. Consumption optimizes where price equals marginal utility. Manufacturers maximize production by balancing capital and labor. Consumers maximize utility by balancing work and leisure and allocating discretionary spending across a basket of goods. Similarly, impact investing seeks to optimize financial and social mandates by balancing these objectives across an asset portfolio.
Financial economics describes an ‘efficient frontier’ as the optimal expected return for a given level of risk. As shown in Exhibit 1, investors require a higher return on an illiquid, risky venture capital investment than a liquid, low risk government security or bank deposit.
Exhibit 1: Efficient Frontier and Market Rates of Return
The efficient frontier framework applies to impact investing by associating required financial return with a given level of social impact. A pure financial investment requires a risk-adjusted market rate of return independent of social impact. A grant requires high social impact to compensate for foregone financial return.
Impact funds offer a middle path between these two extremes. They seek to do good while doing well offering financial returns while delivering positive societal impact. Financial and social objectives are not mutually exclusive. Conscientious financial investment contributes positively to society. Venture capital has brought life changing innovations, economic growth, prosperity, and employment wherever it has flourished. Financial returns and social impact are often mutually reinforcing. No activity can do good if it does not do well: underperformance is unacceptable to donors and investors alike.
Impact investing involves real tradeoffs. Surveys indicate that 67% of impact investing assets under management are deployed for risk adjusted market rates of return. The other 33% accepts concessionary returns while seeking to return capital. As Exhibit 2 shows, concessionary returns may be economically efficient if an investment provides sufficient additionality through social benefits that could not otherwise be achieved through financial objectives exclusively.
Exhibit 2: Efficient Frontier for Impact Investing
Impact Investing Advantages Relative to Grant Funding
Grant funding addresses social needs in the non-profit sector where market friction obstructs for-profit initiatives. Sources of market friction are manifold. Public goods, externalities, knowledge spillovers, low-income markets with limited ability to pay, high transaction costs, frontier markets with political uncertainty, institutional constraints and regulatory uncertainty are just a few of the market frictions that many worthy non-profit organizations address.
Yet not all activities fit neatly into a bifurcated world of financial investment and social goods. Two by two matrices have intellectual appeal, yet such a bipolar world would be bleak. Impact investing thrives in the more nuanced world in which we live.
The economic principle of money velocity illustrates the advantages of impact investing. Money velocity measures the number of times currency is used to purchase goods and services during a given period. A supermarket with weekly inventory turns will have 26x higher money velocity than a car dealership with semi-annual inventory turns. Increased money velocity produces higher economic growth all else being equal.
Impact investing involves return of capital than grant funding, which involves a single use of donor capital. Donor capital is gone once deployed, while impact investing capital, even when deployed at concessionary rates, uses capital multiple times. Capital can be recycled five times with an 80% return of capital including administrative expenses and ten times with a 90% return. A 100% return of capital may be redeployed indefinitely, and profitable returns offer a growing source of committed capital.
Fundraising for impact investing can be a tough sell despite its evident advantages over grant funding. Jacqueline Novogratz, founder of Acumen Fund, observed the challenges of pitching impact investing: “It never fails to amaze me how people seem comfortable making grants for purely charitable purposes, so they experience a 100% loss of their money and are equally comfortable investing in hopes of seeing financial returns of 10-20%, even if they risk losing a portion of principal. Yet these same individuals will often not consider investment that results in negative returns of 10-20% that creates outsized social impact. Between pure charity and pure financial return, there is an unexplored space with tremendous opportunities for innovation, social impact and lasting change.”
This comment highlights the distinction between a two pockets versus one pocket investor. By separating financial investments and charitable contributions, two pocket investors commit capital at the far edges of the investment range in Exhibit 2. Impact investing apportions capital along the continuum offering a range of financial returns with social impact.
The entry of top tier investors into impact investing suggests attractive financial returns and market demand among one pocket investors. As Exhibit 3 shows, impact investors report 10-18% median equity returns and 7-10% debt returns across developed and emerging markets according to a 2020 survey by the Global Impact Investor Network. Median concessionary discounts for below market versus market rate investors are 10-20% for lenders and 40-50% for equity investors.
Exhibit 3: Impact Investor Reported Rates of Return
Impact Investing: Additionality and Demonstration Effect
The growth of impact investing fulfills a supply side market opportunity for socially responsible investing. Yet impact investing may simply drive valuations up for financial investors if they compete for the same investments. Impact investing fulfills a demand side need only if there is additionality: it adds value that financial investors could not provide or invests in overlooked sectors where market friction exists.
As noted earlier, market friction abounds. Impact investing addresses many of these gaps in the market. Investors systemically overlook frontier markets due to limited liquidity, political uncertainty, institutional constraints and exit options. As a result, 50% of the world population receives just 5% of global private investments and represents just 0.4% of global market capitalization. Investments in public health, education, energy, agriculture, the environment and community enablement involve public goods with positive externalities that benefit many in society beyond the innovator. Over 40% of the world adult population are unbanked ignoring wealth at the bottom of the pyramid due to small transaction sizes and imperfect information. Without government support through patent protections and funding for basic research, the private sector systematically underinvests in research as scientific breakthroughs involve knowledge spillovers that no single entity cannot fully capture. Acknowledging the importance of externalities, Nobel Prize winner Paul Krugman lamented, “the stuff that I stressed in the models is a less important story than the things I left out because I could not model them, like spillovers of information and social networks.”i
Impact investing at its best attracts mainstream capital into previously overlooked markets. The International Finance Corporation was an early investor in leading emerging market mobile operators such as Airtel in India, MTN in Africa and Orascom in the Middle East accelerating mobile adoption across emerging markets and attracting private investment. Microlenders Grameen Bank in Bangladesh, SKS Microfinance in India, BancoSol in Bolivia demonstrated profitable small lending to unbanked borrowers attracting bank competition and over $152 billion of capital to an overlooked sector. MPesa in Africa, Alipay in China and PayTM in India have created robust mobile payment systems that have bolstered the digital economy in their respective markets and spurred emulation across other emerging markets.
Impact investing has risen to the top of the agenda for many of the world’s top investors and corporations. Blackrock, the world’s largest investor with $7 trillion under management has put sustainability at the top of its investment strategy. The World Business Council for Sustainable Development is a coalition of 120 international companies united by a shared commitment to the environment and to the principles of economic growth and sustainable development. Individual and corporate investors alike share a common consideration: where does your capital sleep at night. Impact investing is dedicated to the view that we sleep better when our capital is prudently seeking financial returns, while pursuing socially responsible objectives.
Ultimately, it’s clear that the era of binary differentiation between impact and non-impact is coming to an end for investors and entrepreneurs alike. Our research shows that a startups’ purpose and impact matters to all investors, and that tallies with what founders are telling us.