Impact Investing

The Responsible Hand: Overcoming the Shortcomings of Impact Investing

For impact investing to truly harness the power of the market, we need to directly align shareholders’ value with both social impact and profit.

Despite all the hype around impact investing—allocating capital to businesses that generate both a positive social impact and a financial return—there is little evidence of its effectiveness. Impact investing, like any resource allocation mechanism, can be truly effective only if it has the following components: direct incentives to motivate impact, direct incentives to achieve impact efficiently, and clarity on the suitable trade-off between the promotion of economic and social returns. These are necessary conditions for the market to guide efficient resource allocation, but current instruments within the impact investing arsenal all suffer from the lack of one or more of these components. An idea that emerged out of the Massachusetts Institute of Technology in 2011 provides a theoretical solution to the challenge: Socially Responsible Equity (SRE), a concept that Nobel Laureate Amartya Sen says “shows considerable originality and imagination.”

SRE is a form of corporate ownership in which shareholders can collect only a portion of the current and future cash flows. The level of measured social impact by the corporation determines the size of this collectible portion. In other words, impact controls the percentage of the profits available to shareholders that is distributed as dividends. First presented at the 2011 European Business Ethics Network Annual Conference in Dublin, SRE was viewed to have much applicability for enterprises that can both internalize enough financial returns to secure market rate investment and make a huge positive impact on society.

If there are no direct incentives for maximizing social impact, such as linking investment returns to the amount of impact, impact is bound to be limited, especially in the long run. Currently, flexible-purpose corporations or benefit corporations allow managers and directors some legal freedom from the demand for maximizing profits. In states like California, Hawaii, Maryland, New Jersey, New York, Virginia, and Vermont, executives of benefit corporations can make decisions that shun profit-maximizing options as long as they can justify them with social benefit. The fiduciary duty of these directors to create social impact is limited to passing some minimum threshold set by some third party certification process. These institutions and their associated profit distribution rules do not incentivize these managers and directors to think more “aspirationally” about creating a very profitable company that drives the greatest possible impact—there is no financial motive for increasing social impact. Furthermore, the organizational drive for social impact can vary over time and depending on board members. It is prone to the shifting passions and motivations of incumbent managers and directors. The value of a corporation to its owners must be tied directly to the amount of impact it generates (in addition to profit). SRE achieves this goal by making distribution to shareholders contingent on impact.

Then there is the issue of efficiency. While investors in Pay for Success and Social Impact Bonds are incentivized to pick grantees that can deliver impact, they are not directly incentivized to pick ones that can do so in the most cost efficient manner. Also, these instruments can be effective in accomplishing short-term social goals, such as reducing the recidivism rate of a particular cohort of former inmates, but neither induces grantees to invest, longer term, in on-going social goals. One strength of the market is that it forces corporate efficiency by rewarding profit making; it cuts unnecessary costs, yields highest-factor productivity, stimulates investments, and reduces waste. Just as conventional corporate ownership does, SRE gives corporations every reason to operate efficiently and profitably in the long run. While incentivizing impact, SRE ensures that the value of ownership is still critically dependent on profitability. Sen comments that SRE could be very useful in “getting the market to take note of broader goals—that is, broader than self-centered profit maximization—…to reconcile the pursuit of social objectives, without losing the dynamism that goes with the market mechanism.”

Social enterprises often bring together two types of investors: those who primarily seek social impact and those who primarily seek financial return. Many advocate a blended value approach, or ask enterprises to adopt the double or triple bottom line. These often end up creating a daunting task for managers who are left to determine what the right “blend” should be. Shareholders may all place different relative weights on social impact and financial returns, and the set of owners might change as shares change hands. The information asymmetries, ambiguities, and instabilities around what the “correct blend” for shareholders is will generate obstacles to efficient corporate governance, as well as other inefficiencies. SRE removes these issues by directly stabilizing and stipulating the balance between profits and social impact that constitute shareholder value.

SRE provides a method by which impact investing may fully leverage the market’s ability to efficiently drive social impact, and its practice will be a great mark of progress.

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  • BY Thien Nguyen-Trung

    ON March 14, 2012 04:41 AM

    Dear Alex,

    I really like the idea of socially responsible equity and fully agree with your assessment that blended value approaches have the weakness of leaving too much undefined and ambiguous (or at best: highly complicated!). By forcing managers to make highly subjective decisions between what is the “right” blend, we do not even know what efficiency could look like for these invesments.

    However, I do have a few concerns with SRE that even after I reviewed your original paper I was not able to address. I would be curious to hear how you plan on resolving these issues with SRE. The following questions may best capture them.

    1) Who is the main beneficiary for SREs - social enterprises or corporations?

    You argue fundamentally that we have an incentive issue. That managers need more tight alignment in return for impact. I agree with this. However, this addresses perhaps only half of the problem.

    The other half is a supply-side issue: we need to find enough social enterprises that can generate the profits to even pay dividends. Kevin Starr from Mulago Foundation put it nicely in his last SSIR article where he argued that revenue is not equal to profits.

    While most social enterprises are capable of generating revenue indeed, this does not accrue to all that much profitability at the end of the day. I would argue that only a handful of social enterprises worldwide fit this profitability standard at which point SREs would help align managerial incentives for greater efficiency and consistency in program delivery.

    If you buy this argument, we should probably look at corporations and the monetization incentive for CSR activities. In that case, companies based on SRE will require managers to do their best to return money to shareholders from (social/sustainable) practices usually not designed for profit in the first place.

    2) What happens when you mix SRE shares with traditional equity shares?

    The reason traditional equity works is that all shareholders have the same profit-making motive in common. Once you start issuing SRE shares in addition (assuming you would suggest to replace not all equity shares but only some with these), presumably the “do-good” investors will expect social return from the same managers who also have fiduciary duty to produce financial returns for their other normal investors.

    From point 1) above, if you agree that is, we probably cannot find many activities that can BOTH achieve high social return and high financial return. The former costs money that takes away from the latter, in the most simple expression.

    How would you propose managers to deal with this dual obligation sustainably? Milton Friedman would not be happy, I presume.

    3) Is the attempt to tie social impact to financially-oriented behavior through this system the best long-term solution?

    The way I understand SRE’s main premise right now is that they are meant to give a better FINANCIAL incentive to managers and shareholders to produce social impact. Like I caution frequently, this premise may run into a larger issue that we are not fixing: why do we try so hard to keep playing by the conventional ballgame by assuming financial incentives are the most important?

    The bolder question and effort would be: why are we not trying to make social impact motivation INTRINSICALLY the end goal for someone to invest in a company (those who care the most are obviously not investors but philanthropists)?

    Hence, why can’t we orient ourselves towards “impact expected for dollars invested” market places? I’d answer: because the money is currently not there yet. When all is said and done, SREs still operate in a “dollars expected for impact created” world that has been tough to crack.

    Those who care about the dollars never find enough dollars in social enterprises. Those who care about impact don’t care much about the dollars anyway and find plenty of existing philanthropy or ESG fund options to go with.

    Trying to convert the dollar-seekers from the capital markets is super hard as long as they do not see the INTRINSIC (not financial) value of impact and keep expecting to have their cake and eat it a la “double/triple bottom line” rationale.

    4) What will you do to prevent “capital flight” once a corporation re-issues shares with SREs?

    In other words, I am pretty sure that if I put money in company making widgets and I expect to earn money out of their widget-making activities, I may expect them to focus their resources on widget-making instead of branching off to all kinds of social impact activities (that still must be defined in each instance by the way) - which all cost money and are not always compatible with the goal of producing widgets profitably.

    Note that we have instances of the two occuring simultaneously (profitable impact) quite infrequently, to the best of my knowledge. Thus, what happens if shareholders essentialy dump Good Company X’s SREs to put money in Company Y that will make them more (and easier) profits?

    To conclude, what I hoped to convey here is that while SREs address the incentive issue for managers, they do not offer a solution on how to generate PROFITABLE social impact that is required to please today’s capital market place you are hoping to engage. Again, since you mentioned the term “social enterprise” a lot, I assume you are targeting them with SREs. In that case, the chance of creating high profits through social impact is even lower than with traditional for-profit corporations.

    Remember, REVENUE generation alone is what makes something a “social” enterprise. Achieving competitive PROFIT levels is a completely different ballgame that few can participate in by today’s standards, no matter what shareholder or bond instrument is utilized and no matter our excitement about social enterprises.

    That all said, I think SREs is a quite interesting concept that deserves to be taken further in pilot implementation, but would argue that more work needs to be done around (1) whether it’s designed for (CSR interested corporations or social enterprises), (2) what type of investor base you are trying to speak to and (3) how exactly you expect most social enterprises of today to generate greater profits than they are already working hard to achieve in the first place.

    Thanks again for the contribution and looking forward to hear more about SREs and their hopeful conversion from theory to practice in the near future.



  • Gabriella Garcia, PhD's avatar

    BY Gabriella Garcia, PhD

    ON March 26, 2012 01:02 PM

    Alex, congratulations on a very innovative idea. SRE does resolve a lot of the incentive issues that plague impact investing.

    I do agree with Thien that implementation will be a tough nut to crack.

    Could you comment a bit of what potential implementation of SRE would look like? Also, can you compare it with new corporate forms like benefit corporations?


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