Impact investing boom leads to verbal muddle

The word has swung into favour in responsible investing circles in the past few years, and is now used by many different players to mean different things. So far this has not led to any tension, but debates over how the word should be used are likely to intensify in the next year.

Until recently, the term “impact investing” generally referred to a variety of investing typically done by small, specialist investors, at small or micro scales. These investments are not in ordinary listed shares and bonds but are often highly bespoke and structured, and seek to achieve specific social or environmental outcomes, such as improving health, education or access to finance in a specific district of a developing country.

Despite the granular nature of this activity, and the fact that it operates in challenging markets, it has now achieved substantial size and makes impressive returns for its end investors. Many of these are either public sector organisations or private individuals with philanthropic motivations.

The Global Impact Investing Network (GIIN), a New York-based NGO, records $230bn of such investments outstanding globally, with an average size of $3m. About two-thirds of the investors seek normal risk-adjusted, market rate returns, a sixth look for returns below, but close to, market rates, and the other sixth just want a positive return.

In the GIIN's latest survey, 98% of 200 respondents said their investments were meeting or exceeding expectations on impact, while 91% were satisfied financially.

Summarising investment performance is complex because there are so many asset types, including private equity and venture capital, private debt, real assets, equity-like debt and even some public equity and debt.

But for example, an October 2015 study by the Wharton School of 32 private equity impact funds that invested $1.7bn, seeking market rate returns, found they made an aggregate gross internal rate of return of 9.2%.

In September 2017, McKinsey examined 48 private equity investments in India, with an average size of $2.1m, and found they had achieved an 11% average gross IRR at exit.

Although the market is still small, compared with the roughly $100tr of global financial investments, it is growing rapidly.

“Last year we gave a call that we were at $150bn in 2016, and could get to $300bn by 2020,” said Amit Bhatia, chief executive of the Global Steering Group for Impact Investment (GSG), in New Delhi, adding that the figure was $240bn now. “This October we are going to up the target of what we are going to get to. We now have a line of sight to much bigger numbers. We believe by 2020 we can deliver the tipping point for the movement.”

The GSG, chaired by Ronald Cohen, the UK private equity entrepreneur, is the successor to the Social Impact Investment Taskforce set up by the UK in 2013 when it was president of the G8.

It has a small staff and works through national advisory boards, which are now established in 18 countries and the EU. They promote the market in their own countries. Three more countries' boards — two in Asia Pacific and one in Africa — are set to join at the GSG’s annual summit in New Delhi in October, and another 15 are working through the approval process, which can take up to three years.

In 2016, Bhatia said, impact investments were estimated to have touched 500m poor people worldwide, or a sixth of the world’s 3bn people in poverty. “We believe it can grow to 1bn by 2020. If we can reach one in three poor by these means, that will be inspiring for others to look at and emulate,” he said.

Meanwhile, in conventional financial markets, “impact” is being used in a very different way. The green and social bond market, where issuance is predicted to top $200bn this year, is thought of by some of its investors as an impact investment market.

The proceeds of these labelled bonds are earmarked to finance or refinance specific projects the issuer is undertaking, enabling the investor to feel its money has been used for those projects. Investors now expect issuers to produce 'impact reports' on, for example, how the wind farms to which a green bond’s proceeds have been allocated have reduced carbon emissions. These are often large projects, being conducted by highly rated financial institutions, which have ample access to conventional funding.

Another impact-related approach is thematic investing, where investors choose an environmental or social theme, such as water security, and invest in companies that they believe are providing products or services that help people with that issue.

The growing interest in impact among mainstream investors is partly prompted by the urgency of climate change, and the creation, which involved almost all world governments, of the global Paris Agreement and Sustainable Development Goals in 2015. The private sector is explicitly called on to help achieve these targets.

As GlobalCapital reported this week, that is necessitating a reversal in recent thinking among responsible investing specialists. For the last few years, they have been urging the idea that considering environmental, social and governance (ESG) factors when investing (known as ESG integration) was justifiable purely because it improved financial risk-adjusted returns. No ethical justification was needed.

The idea of “impact” implies that investors should, by contrast, consider also how their investments affect the world outside their investment portfolios. A growing minority argue that doing so is going to be vital if catastrophic climate change is to be avoided.

“There is an emerging consensus starting to build over how you look at impact and what it constitutes,” said Hans Op ’t Veld, head of responsible investment at PGGM, the Dutch pension fund manager, in Zeist. “Impact is about looking at your portfolio and asking questions about how it influences the world, and how you contribute to the world.”

This was still a bit vague, he said, but investors, especially pension funds, were starting to define it. For example, PFZW, the Dutch healthcare pension fund, had decided on four key themes and was tailoring its investments to them .

“I think that as a starter, as an investor you would want to make conscious decisions on what kind of consequences your investment has on the world," said  Op  ’t Veld. "In general terms, you understand that every investment has an impact on the world.”

This dichotomy between considering ESG factors that are financially material to the portfolio and impact was highlighted this month in a response by the Investment Association (IA), the trade body for 250 UK asset managers, to a consultation by the European Commission on aspects of its Sustainable Finance Action Plan.

The IA was only addressing proposed rules about what investors should be required to report on. It was not arguing that investors should not consider the impacts of their investments.

Nevertheless, it stressed very strongly that “sustainability risks” should not be thought of as “risks to environmental sustainability” but as “risks to the economic sustainability of an investment which derive from environmental, social and governance concerns”. 

The IA said this view was “vital” and “of great importance to investors”.

“They want ESG integration and that’s where they want it to stop,” said Wolfgang Kuhn, a former bond investor and now fellow at ShareAction, a responsible investment NGO in London. “ESG has been integrated. All that means is that any risk which is somewhere in those ESG dimensions has been explicitly called risk, and everyone is happy with it."

He believed the IA was worried that the way the Commission used language about ESG integration and real world impact could be confused, because it often was in market discourse. "They are worried that someone might force them to report on impact, or target impact, which is not what the conventional asset manager wants,” Kuhn said.

Although he thought this was a very conventional view, Kuhn applauded the IA for at least “trying to clear up the confusion”.

At the same time, the Principles for Responsible Investment organisation is beginning to push investors to consider the real world impacts of their investments.

There are thus at least three meanings of “impact” being used in the responsible investing world. One is impact investing in the sense of highly targeted investments outside mainstream markets. A second is investments within mainstream markets, where the investor chooses shares or bonds of organisations that it believes will achieve a positive outcome in the world. And the third is in a more analytical sense: that every investment of whatever kind has an impact — the sum of its effects on the real world.

“If, as I just read, Nestlé is taking too much water in Vittel and the good people of Vittel don’t have enough water, that is an impact, and Nestlé as any company should follow their impact and make sure that on average it’s not negative, or that if it is, at least they report on it,” said Kuhn.

Nestlé has denied it is overusing the water source.

Some investors, such as PGGM, believe they should consider such impacts; others do not. 

Like Op 't Veld, Kuhn argues that investors should consider a third dimension when making every investment, besides risk and return, namely impact, which can be positive or negative.

“We don’t have a better word than ‘real world impact’ for the third dimension,” he said. “‘Impact’ is the best word, I’ve thought about it. If we talk about ‘impact’, we shouldn’t just focus on the positive impact, because avoiding the negative impact is as important. Why not see the two as a continuum?”

He recommended using the term “good impact” for investments that specifically target social outcomes.

The PRI pointed pension funds towards this kind of thinking in a document published in April called How to Craft an Investment Strategy, but has not yet become forthright and explicit in its guidance.

“It doesn’t make sense to say to 2,000 signatories ‘we’ve changed our mind and now you have to do something different’, but this is the next stage in the journey,” said Kris Douma, director of investment practices and engagement at the PRI in London. “We are trying to bring more investors on board but it’s not an obligation. But in the next 10 years, it’s the objective of the PRI to bring more investors on board for that third dimension.”

Douma said considering impact could be traced back to the preamble of the Principles for Responsible Investment themselves, created 12 years ago, which says “we recognise that applying these Principles may better align investors with broader objectives of society”.

“That was always the intention; we are becoming more explicit about it,” he said. “Also, the broader objectives of society are quite vague, but the Sustainable Development Goals are not vague. For the first time, the global community has identified a plan for the sustainable development of our society and that is making that broader objective of society more explicit.”

The change in the PRI’s thinking was first evident in a document published last October on Investors and the Sustainable Development Goals, then in the April publication, and thirdly in a large, 112 page Impact Investing Market Map, published last week.

Kuhn said he was disappointed that the Market Map appeared to have backed away from the call to consider impact , positive or negative, when making all investments, which he had welcomed in the April document.

Instead, the report focuses very much on “impact” in the sense of mainstream investments that seek to achieve a good outcome. It is intended as a guide for mainstream investors that are starting to think about their impacts and want to find investments with good ones.

In the next year, the area where there is likely to be most contention over the term “impact” is between this sphere, which wants to brand itself as having impact, and the more dedicated and specialist impact investing promoted by the GSG and GIIN.

“Absolutely, the word ‘impact’ is misused,” said Bhatia. “I think it is the right word, and it will take greater education around the world that there is an impact continuum.”

Bhatia’s proposed resolution of the confusion is to use “impact” as the umbrella term for the whole responsible investing spectrum, but to divide that range into three parts.

The first — which he calls “A” for “avoiding harm” — is conventional ESG investing, in which the investor avoids pernicious companies and protects itself from risk. This often does not lead to very ambitious outcomes. “If you look at most ESG equity indices, the top holdings are Apple, Amazon and Alphabet,” Bhatia said.

The “B” section, or SRI impact investing, was investments that “benefit all stakeholders”, he said.

“Think of a mobile phone company in rural areas [in the developing world] that allows money transfers, or infrastructure being built in rural areas,” he said. “It may not be targeting the poor or vulnerable but the important by-product is prosperity.”

The “C” element, corresponding to GIIN and GSG-style impact investing, would mean “contributing to real solutions — taking greater risk, including in private markets, and building new markets where they don’t exist”.

This could mean affordable education, healthcare, water, sanitation, clean energy.

“In this one, you have to be ready to get out of your comfort zone and find new solutions,” Bhatia said. “This is therefore a smaller market, but this is going to be the fulcrum. We want to build an inclusive, impact economy with measurable numbers.”

Up to now, the GSG and GIIN have used a very simple definition of “impact investing” — in the GSG's words: “Impact investment optimises risk, return and impact to benefit people and the planet. It does so by setting specific social and environmental objectives alongside financial ones, and measuring their achievement."

But this does not mention what really distinguishes the impact investing market from, say, buying shares in a large utility that is building windfarms — namely, its off-market, intrepid nature and emphasis on generating change.

“We are going to a lot more clearly define the difference between the impact investment movement and the larger impact movement, which is A, B and C put together,” said Bhatia. “It’s OK to use ‘impact’ for the larger movement, because ESG and SRI also help get us to the Sustainable Development Goals. So we have to build a unifying umbrella.

“But we have to distinguish and hold dear the impact investment space as well, because some of the toughest answers to the toughest problems will be found there. There will be areas where you can’t build scale in a way that public market assets under management can be deployed.”

He pointed to the microfinance movement, which had taken 40 years to develop to its present size, where it now includes some billion-dollar companies.

“It’s important that this is a big tent, but let’s hold dear the nucleus, which is the art that we can convert every social and environmental challenge into an investment opportunity,” Bhatia said.

This sphere is set to grow and attract more institutional money. Already the wealth management arms of big investment banks like Credit Suisse and UBS are involved.

But Op ’t Veld said: “The reality is that when we look at the combined volume of all institutional investments in the world, it’s impossible to do only targeted impact investments and run portfolios that are robust. So large institutional investors will look at impact investments within their portfolios.”

Confusion and friction over terminology are likely to arise, because of the very different levels of ambition and kinds of impact offered by these two sectors. 

The PRI in its Market Map uses the faintly dismissive term “traditional” to describe impact investing of the GSG kind, contrasting this with "a more mainstream approach", which the Market Map is designed to promote, "that focuses on medium and large businesses that deliver products or services to benefit society and the environment". 

This language recalls the way ethical investing approaches were ushered to the sidelines as old-fashioned during the last phase of the PRI's thinking. 

But Douma said there had been no intent to disparage full-on impact investing. On the contrary, he said, the guide’s aim was to help mainstream investors wanting to find investments with a positive outcome, by pointing out to them criteria that were already used by specialist impact investors.

Many of the experts who contributed to drafting the Market Map are specialist impact investors.

Neverthless, the Market Map is squarely focused on "mainstream impact investing", even though this is a nascent activity with very little to bind it together. 

The PRI believes this category has $1.3tr of assets under management, compared with $230bn in "traditional impact investing", $26bn in even more philanthropic "blended finance from international organisations and the private sector" and, at the far end of the scale, $127bn of "grants and non-financial return investments from development financial institutions".

That $1.3tr includes thematic investing and green bonds. This mainstream impact investing comprises three types or levels, Douma said: "One is that you have the intention to make a positive contribution with your investment. The second stage is additionality - it's a complicated one - do I with my investment really add to more sustainable outcomes? The third one is measurement."

But the investments in this category do not necessarily have all three attributes. Thematic investing may not involve measurement, for example; while with green bonds "the intention is to create additionality but there is no guarantee that it's the case," said Douma.

Op 't Veld said PGGM was now trying to measure the impact of its portfolio. "We look in two ways: in a financial sense - what percentage of the portfolio consists of what we consider to be impact investments; and secondly, what is the impact we achieve with that. The first one we are gradually improving in terms of our definitions, but measuring the impact as such is a challenge."

Its assets also include "a mixed bag in terms of impact", said Op 't Veld - "some of their activities might contribute, others might detract from the Sustainable Development Goals. We are trying to get into companies that have an impact element and encourage them to do away with the parts that are inconsistent with that."

Hard core and mainstream impact investing have up to now been largely separate worlds, but they are likely to move closer together. As that happens, clarity on terms, if it can be achieved, will be very helpful.

One important reason is that the targeted impact investing market will seek to attract money from mainstream institutions. Just as pension funds began, decades ago, to start making small allocations to 'alternative' asset classes such as hedge funds and private equity, they may start doing so to impact. Even a very small percentage allocation would multiply the size of this ambitious impact investing market.

But the impact industry's pitch for that money will be clouded and impeded if more pedestrian investment strategies, which also brand themselves as impact, get in the way.

Ultimately, the answer may lie in the third meaning of impact: the real world consequences of every investment. The challenge will be calculating it. 

"Sir Ronald Cohen has mooted the idea that perhaps companies can publish impact-weighted accounts, in additional to traditional accounts," said Bhatia. "We believe markets in the future will value corporations not just because of their profitability but also morality."

From this perspective, Kuhn said: “Every fund is an impact fund.”