Cracking the Code of Impact Investing

As compelling as the concept of impact investing has become, many investors still remain stymied in their efforts to put capital to work addressing social and environmental challenges.

Some barriers are obvious, like the shortage of investable products. Despite numerous studies showing increasing client demand, and the addition of the likes of BlackRock, Bain Capital, State Street Global Advisors, and UBS, fewer than one-third of the world’s largest 50 investment managers are active in impact investing.

Other barriers are less obvious, like the ongoing difficulty for investors to navigate impact investing easily and efficiently. Navigation barriers result from deficient market scaffolding, including the lack of agreed-upon product categories and underdeveloped performance benchmarks. As a result, the extra effort required to move from interest to action in impact investing can sap investor enthusiasm and confidence. The ramifications are significant:

• Slow entry. New investors are struggling to enter the market. Barclays recently reported that, while more than half its clients are interested in impact investing, just 9 percent had actively engaged for lack of “knowledge, guidelines, or frameworks.”
• Inefficient market matching. Investors and investment managers pay a real price for the inefficient, bespoke efforts required to identify aligned counterparties who have similar objectives.
• Inappropriate impact expectations. The risk grows that investors will walk away if impact performance expectations are unmet in the absence of frames that more clearly establish appropriate objectives.
• Market gaps. The current market provides too little visibility into where capital might be most needed, leading to a lack of appropriate investment across the risk/return spectrum (the challenge identified by practitioners as most limiting to the growth of impact investing).

After studying how a wide range of groups are describing impact investments, we believe impact investing needs a simple, widely accepted “impact classification” system that helps investors readily match their financial and impact objectives to the right products. Our new working paper, “Navigating Impact Investing, the opportunity in impact classes,” describes how this new classification system would help crack the code of impact investing for investors and advisors, as well as enable researchers to compare like investments, including for the purpose of understanding the relationships between impact and financial performance.

Asset classes are a great analogy. By bundling similar financial risk and return characteristics, asset classes provide tremendous benefits by allowing investors to build the most appropriate investment portfolios. They are not definitive (no one asset class is guaranteed a specific financial return), but they provide basic scaffolding that allows for diversification and performance benchmarking, and have helped create an intermediary market infrastructure for financial markets, by allowing for specialization and organization.

Impact classes may provide the answer on the impact side of the ledger—by providing a mechanism for clustering investments with similar impact characteristics across asset classes, sectors, and public and private markets.

In the same way investors first decide they want to invest in public equities before selecting the best stock or mutual fund, investors’ decisions about their preferred approach to generating impact within an issue area of interest should precede and inform their choice of vehicle and service provider. An impact investor may decide she wants to invest in something that is high risk but has direct impact on low-income populations, or in something that is already scaled effectively to build it out further. These objectives could be linked to different impact classes.

Designing impact classes

To be effective, impact classes will need to be limited in number, easy to understand, and objective, which is a high bar when investors are seeking idiosyncratic impacts that span dozens of social and environmental interest areas.

That’s why current attempts to categorize the market by theme on the one hand (for example, by sectors like health, education, and housing), and business model on the other (for example, by investments with particular “place,” “process,” and other characteristics) are necessary, but not sufficient.

Our own research over the last year—an extensive literature review, over 50 expert interviews, and numerous meetings with leading practitioners, supported by Omidyar Network—suggests that, rather than categorizing on the basis of theme or business model, the best approach to designing impact classes needs to include foundational elements that underlie the investor’s strategy and theory of what will change as a result of deploying capital. We have identified three promising building blocks:

1. The role of impact investing capital: There are a discrete number of reasons why a market might need impact capital. For example, an investor may prefer to invest primarily in pioneering efforts that develop new and untested business models, or alternatively in scaling proven, impactful solutions in more mature markets—each of which are valid and compelling purposes.
2. The type of impact evidence: Impact investment managers provide different types of evidence to investors, from inputs to outputs, outcomes, and eventual impacts. This building block serves as a good proxy for the specificity of the impact an investor is targeting. For an investor with very focused social or environmental goals, more evidence is likely required to demonstrate progress toward these objectives.
3. Market and beneficiary characteristics: Three factors arose repeatedly in conversations with practitioners: the extent to which the people, places, or systems targeted by impact investments are vulnerable; the extent to which the investment market is relatively new, emerging, or subject to systemic challenges; and the extent to which capital provided to an investee plays an essential role in making the impact possible.

Next Steps

While the impact class concept needs further refinement, diverse stakeholders agree the design process is worthwhile. We have engaged an expert advisory group for this effort, including pension fund managers, investment managers, foundations, family offices, wealth advisors, investment banks, and academics. Following a convening of 40 global participants held at Blackrock’s offices in New York in February 2016, we surveyed the group and found that, of 27 respondents, 80 percent wanted a “broadly accepted framework for categorizing the many ways in which funds/intermediaries create impact through investment.”

About three-quarters also agreed impact classes would help in the sorting process needed to make individual investments and portfolio allocations, and that impact classes would help advisors and their clients arrive at impact objectives. We also see others adding fuel to the idea of portfolio maps or grids that are very similar to this idea.

It’s important to note impact classes are not about creating yet another complicated framework in impact investing. While we need to build impact classes on robust foundations, the end result ought to be surprisingly basic. As a result, market entry should become easier, matchmaking more efficient, objectives more transparent, and capital more available for multiple purposes. Indeed, as one participant at the February meeting remarked, classification in impact investing is inevitable. The question is whether practitioners want to shape the effort or prefer to have the categories imposed from outside.

We hope that others will join the conversation at a site we’ve just launched to help engage the larger community in reviewing the ideas in our working paper. We think it’s time to address the thorniest challenges in impact investing by creating common classifications of the impact that investors are trying to create.

Read more stories by Ben Thornley & Cathy Clark.