Impact investing has never been more popular nor more in peril. The field is wracked by confusion over basic principles, dubious practices that invite cynicism, and biases against large companies. If more clarity is not brought to the movement, it risks a hard fall.
The stakes are high, and the world does not have a surplus of money or time to spend. Achieving the Sustainable Development Goals (SDGs) by 2030 requires $5 to $7 trillion annually.
Impact investing can help, but only if properly harnessed. A handful of pervasive problems are responsible for most of the trouble:
- Muddled thinking about appropriate rates of return that saps resources and exacerbates in-fighting among practitioners.
- Questionable theories of impact that spawn confusion about the character and quality of evidence to demonstrate impact, even managing to obscure the value of conventional investment and economic growth.
- Unwarranted sidelining of global and large regional companies that could provide necessary operational and financial resources.
To overcome these challenges, impact investors should follow three guidelines.
1. Anchor Impact Investing to Market Returns
The highest calling of impact investing is to increase the amount of capital being invested in places, companies, products, and services that have significant social benefits. Mobilizing private capital flows is made exponentially more difficult if impact investors are not aligned with conventional investors, who seek market returns.
As a consequence, impact investors should not be providers of concessionary capital. Impact investors should rather focus on growing competitive markets by aligning with market players who make decisions based on the likelihood of an investment achieving market rates of return. That likelihood (risk) informs the investment’s price, which is the signal markets use to efficiently allocate resources. Impact investors should not want to change the financial structure of an investment with a subsidy, as that would mask an investment’s true price and encouraging investors to make investments they would otherwise avoid. On the scale of billions—let alone trillions—of impact-investing dollars, this can be disastrous, particularly in the smaller economies of developing nations, where help is most needed. It can result in the wrong factories getting built and the wrong businesses getting support—a waste of financial resources and a missed opportunity to achieve social gains.
Rather than run the risk distorting markets, the unique and differentiating mission of impact investors is to build better, more competitive markets by investing non-concessionary capital in businesses with potentially large social benefits, such as reduced income inequality or slowed global warming. Those socially beneficial goods and services—be they rural roads, solar panels, seeds, or medicines—are, after all, the “purpose” of businesses. Impact investors equally understand, as Martin Wolf writes in his review of Colin Mayer's book Prosperity, that “profit is a condition—and result of—achieving purposes”. Comprehending this is critical to impact investors’ ability to leverage their own investments with that of conventional investors.
Providing concessionary capital (subsidies) is the job of governments and their agencies. They decide when it is in the public interest to subsidize private enterprises; they choose how it should be done in the most cost-effective way. Blended finance is the term of art for governments determining the right mix of direct subsidies, guarantees, tax relief and exemptions, or improved enabling environment—code for the collection of regulations, laws, and public bureaucracies with which businesses operate. By virtue of their authority to tax and spend, governments have the standing to make these determinations. Impact investors do not.
The risks of misallocations if impact investors do not anchor themselves to market returns are serious.
The risks of misallocations if impact investors do not anchor themselves to market returns are serious. Without a fiduciary-like focus on achieving market returns for their clients, fee-charging intermediaries—advisers, investment bankers, gatekeepers, and asset managers—effectively receive a license to underperform and rationales for doing so. Just look at estimates of the scale of impact investing: $250 billion to $22.9 trillion. The range reveals the wildly divergent definitions of asset ownership, asset allocation, and investees that meet credible criteria. The finance industry is left free to scramble to create specialized “impact” products, which often charge higher fees. Beware of advisers who solicit a client’s preference between financial returns and social impact, especially in light of the difficulties of accurately measuring the latter. Such requests should invite skepticism, not trust. They contribute to a frothy, do-good enthusiasm that is not grounded in well-tested, professional investing principles.
In fairness, earning market returns is not easy. Many businesses, and even whole sectors, don’t. It is sadly true, as Mara Bolis and Chris West point out, that many enterprises impacting poor people in the global South earn in the low single digits. But that is a problem to be solved, not accepted. Still, too many impact investors surrender to concessionary business models before the fight for market returns is ever joined. They offer a plethora of rationales to justify accepting concessionary returns, arguing, for example, that subsidies are necessary because impact-oriented businesses take a long time to become financially self-sustaining.
But accepting concessionary returns is a declaration that one is not actually an investor—impact investing is investing, after all. Impact investors should instead think of themselves as factor investors, who pursue attributes (or factors) of an asset class that identify opportunities for reliable, outsized market rates of return. The factor premiums, as they are called, go by terms such as value-growth premium, momentum premium, illiquidity premium, credit risk premium, and volatility premium.
Impact investors using the factor approach have an obligation to clarify the attributes of impact investments that they believe will achieve premium returns. This is not as hard as it might sound, especially for impact investors who believe that there is no trade-off between financial returns and social benefits. As Black Rock’s Andrew Ang explains, factor premiums “work precisely because investors understand that [they] are the rewards for being willing to endure the associated losses in bad times.”
2. Reboot Impact Measurement
The most common complaint about impact measurement is the lack of agreement on indicators that could be standardized across investments within a sector, let alone across sectors. The more profound problem is the expectation that an observed change in an indicator can be reliably attributed to a particular investment or company.
Impact investors sincerely want to know that their investments “make a difference.” They are attracted to the idea that the financial and social benefits of an investment would not have occurred without their participation, a concept known as additionality that thought leaders such as Paul Brest have described. If impact investors cannot demonstrate additionality, then many people argue that the foundation of the whole impact investing project gets shaky.
Impact investing has backed itself into a corner because it's difficult to test whether a change in an indicator can be reliably attributed to an investment or company.
Impact investing has backed itself into a corner because it's difficult to test whether a change in an indicator can be reliably attributed to an investment or company. Doing so at scale is often impossible because rigorous testing involves establishing an experimental or quasi-experimental design with a counterfactual. Often, impact investors end up relying on bad science. They count the number of hours children spent exercising, the number of meals delivered, or other metric that is too often loosely based on a complex theory of change with no credible way to verify connections between impacts and a company’s actions, products, or receipt of a specific investment. This is a recipe for disappointment that over time will increase the already pervasive cynicism about “greenwashing” or “impact washing.”
The impact investment community needs to reground its work in the values of conventional investing or economic growth that focuses on problems of extreme poverty, corrosive income inequality, and climate change. The focus also needs to shift to a regime of corporate disclosures linked to a company’s audited financial accounts. These disclosures would be derived from the intrinsic, core operations of a firm using the metrics of conventional investing. They rely on macroeconomic assumptions about how markets work and how they can be made to work better to maximize long-term, inclusive, sustainable wealth creation, rather than short-term profits. To be clear, an expanded set of corporate disclosures would not provide reliable estimates of impact.
This does not mean an impact investor should never rigorously test for a set of promised benefits. It's appropriate to do so if a business claims a product will solve a particular problem. But many, if not most, businesses do not produce products or services that directly or materially impact the poor or reverse global warming. Rather they directly increase the wealth of stakeholders (employees, suppliers, and shareholders) and mitigate environmental damage by reducing carbon emissions.
For the most part, impact investors should content themselves with disclosures that provide information on the following:
- Returns to all stakeholders in a company, not just shareholders. When a company sells a product, some of the revenue flows to employees, senior managers, suppliers, contractors, creditors, and, via taxes, governments. Is wealth being shifted to shareholders at the expense of contractors, direct employees, or a supplier's workforce? In other words, what are the returns to labor in addition to returns to capital? Reducing inequality of income within and across countries is at the heart of impact investing.
- Compliance with environmental, social, and governance regulations most relevant to the company’s operations. While we are all negatively impacted by flouting these regulations, it is the poor who disproportionately bear the costs of, for example, dirty water and unsafe work environments.
- Estimates of threats to the company’s value coming from negative externalities. Examples of risk-increasing threats include the depletion of reserve stocks of forests or fisheries, bribery of politicians and regulators, and underrepresentation of women and minorities.
- Estimates of positive externalities, spillovers which increase the value or reduce the risk of the company. For example, a logistics company targeting urban clients inadvertently benefits rural communities because overall market fragmentation is reduced.
- Estimates of the consumer surplus created by the company when selling product or services directly to the poor. A surplus is created when the price paid is less than the maximum price that the consumer might be willing to pay. That surplus is valuable, especially to poor consumers, and it serves as indirect evidence that the company is avoiding unfair, deceptive business practices. Transparently disclosing product pricing and market share information is further evidence.
Impact investors may not be happy to settle for what are largely accounting and valuation exercises. However, these approaches will get more traction than non-verifiable, non-credible claims that a particular benefit is attributable to a company or an investment.
3. Leverage the Power of Big Companies
Impact investors are increasingly skeptical that the prevailing social enterprise paradigm—venture capital, incubators, and small businesses—can tackle wide-ranging problems in far-flung places, where a daunting complexity impedes “fixes” in the sectors most critical to the poor, namely infrastructure, health, agriculture, and logistics.
However, they fully appreciate the many challenges to investing in underperforming sectors in low-income countries: it's hard to meet requisite payback periods or break-even benchmarks; the required investments are big and inevitably have high transaction costs due to their complexity; and there is the reputational risk of operating in poor countries with fragile government institutions and unpredictable regulatory regimes.
Take the agriculture sector on which the poor most depend. It requires arable land, extensive roads, irrigation, high-quality inputs tailored to multiple microclimates, mechanization, transportation, networks of skilled smallholder farmers, some larger farms, food processors, reliable low-cost power, access to markets, food sanitation and safety standards, trade regulation, different types of financing, insurance, and good weather. These elements need to come together to profitably deliver harvests to consumers.
Larger regional and global companies, not small ventures, can handle such complex undertakings. They have the production capacity and skills to manage the scope and scale of these investments profitably. They are well-placed to acquire and scale new technologies as well as the innovative business models essential for success in low-income countries (LICs) and low- and middle-income countries (LIMCs). They have the reach, through trade and global supply and value chains, to address problems of market access and inconsistent regulatory implementation. They have the scale to handle the high marketing and first-mover costs to reach bottom-of-pyramid market segments. They have excellent access to short- and long-term financing at the lowest available rates, as well as internally generated capital.
Larger regional and global companies, not small ventures, can handle such complex undertakings.
Finally, for all their risk aversion and attention to short-term quarterly earnings, large and regional corporations may best appreciate that underlying long-term trends favor higher returns in emerging and frontier markets over the coming decades. They know that conventional, lower-risk routes to profitable growth are shrinking, if not exhausted.
Also, the payoffs to disruptive innovation have never been more evident. If a company can become a large-scale, low-cost producer through a first-mover advantage, rapid growth is possible and the rewards get big enough to justify the risks. We should all hope so. The world’s poor are trapped in failing or missing market segments in the sectors on which they most depend, agriculture and health, which in turn are dependent on infrastructure and logistics.
Alphabet, for example, requires that each of its investments—its “bets”—addresses a significant, real-world problem rooted in unmet basic needs, such as food, housing, sanitation, clean water, or transportation. Through Sidewalk Labs, Alphabet is designing inclusive new cities around the world. At Softbank, the sheer size of its investments necessitates tackling systemic problems. Uber has become a last-mile transportation solution. Ping operates as an online healthcare and medical platform. Amazon, J.P. Morgan, and Berkshire Hathaway have announced that they intend to sort out the economics of US healthcare for their own employees and then presumably for others.
These are not standard investments to penetrate a particular market or update an existing product. They are long-term, bigger investments targeting specific social benefits that have proved elusive, such as improved health outcomes at lower cost. It is worth noting that these opportunities arise as often from government failures as from market failures. In either case, these investments are not based on convoluted or tenuous theories of change, but on specific product or service solutions.
Of course, there are the one-off successes of smaller firms, such as the mobile-payments firm bKash in Bangladesh and the solar-power company M-Kopa in Kenya. But many innovations still need to be integrated into larger businesses to achieve meaningful scale and realize their potential. The Kenyan company M-Pesa, for example, is an impact investing success story, both in terms of consumer uptake and benefits to the poor, but it took the resources of Safaricom and Vodafone. Without that muscle, the shallow and fragmented capital markets of low-income countries doom a high percentage of smaller startups. While technology has helped some sectors leapfrog ahead, many sectors such as agriculture and infrastructure need more than apps. That has been difficult to accept for many technology-loving impact investors.
Amid these challenges and opportunities, impact investors are noticing the advantages that global and large regional firms have over smaller firms in low-income and fragile countries.
Amid these challenges and opportunities, impact investors are noticing the advantages that global and large regional firms have over smaller firms in low-income and fragile countries. They see the number and scale of successes of emerging-market entrepreneurs, such as Carlos Slim in Mexico, Aliko Dangote in Nigeria, and Jack Ma in China. These entrepreneurs have catalyzed development—with its associated positive social impacts—in their countries by building huge, productive companies that compete globally. What the businesses have in common is an attention to demonstrable basic needs and market signals that give rise to high uptake and fast growth. For example, Center for Global Development recently summarized the evidence of companies in Kenya, Columbia, and Chile that rapidly built out—within 18 months—complete value chains for horticulture and vegetable farming. These so-called export superstars are “born big, start out as highly productive firms and grow fast.”
Despite the success of global and large regional corporations, co-investing with them still strikes many impact investors as a fraught proposition at best. The lack of public trust and cynicism associated with big business is significant, in many cases deservedly so. Yet the Edelman Trust Survey 2018 found that in 21 out of 28 markets, 52 percent of respondents said they trusted businesses more than governments, versus 43 percent reporting they trusted governments more than businesses. And 72 percent of respondents gave their own employer the highest possible trust score.
So what would it take for impact investors to co-invest with global and large regional corporations? For one, all of the players need to understand that “fixing” an underperforming sector will require a set of complementary investments—think project finance, not venture capital. Secondly, impact investors must package their relevant market and policy experience with sufficiently large amounts of capital on terms that are attractive to global companies.
Once these concerns are addressed, investors can begin to design and market test the investment products, platforms, or structured finance vehicles that can aggregate impact investor interest. Here are some basic ground rules to guide their planning:
- Investments must reach the poor, increasing their resilience. There are many different forms this could take. In power infrastructure deals, for example, the traditional focus is on the terms of the offtake agreements for water or electricity, negotiated with a government. Then the government sets retail and wholesale prices, and builds the last-mile connections to inner-city households and rural communities. Were impact investors involved, last-mile connections and retail metering would be part and parcel of the overall agreement.
- Investments must fill gaps in the market ecosystem or value chain. Take agriculture. In that industry, physical infrastructure—irrigation and roads—is critical. So is market infrastructure—aggregators and brokers who connect sellers, processors, and buyers. And don't forget the development of small farmers' skills, the supply of inputs such as seeds and fertilizers, the presence of value-added processing such as juicing and threshing, and the use of climate-resilient crops.
- Investment terms must be fully published in real time to facilitate public consultation. This will increase the risk of surfacing rival offers from competitors, but the benefits of public bidding outweigh the costs. Investors need to lead on transparent procurement rules. There cannot be extensive “business confidential” information, let alone side agreements. This is the price of having reputable co-investors, both local and foreign.
- Investments in fragile or low-income countries will frequently need to include the costs of creating a competitive enabling environment, which includes protections like property rights or other public goods. Investors of course prefer to be able to charge for any and all possible benefits of a product or service, but impact investors should accept or even seek positive spillover effects, such as literacy or health benefits provided to workers. Shouldering these costs, which in other contexts might be considered government’s responsibilities, is part and parcel of a prudent, long-term investment strategy.
Even with an agreement on co-investment principles, impact investors will find it challenging to offer terms that will make them indispensable partners. The ability to do large and long-term deals, and take early losses, will play in. But equally important will be impact investors’ willingness to invest reputational capital. Linking their name to an investment provides comfort to regulators who will have to approve of deals. The presence of high-reputation impact investors signals that the public’s interests have been taken into account, which lowers investment risk for commercial co-investors. Corporations, for their part, will need to agree on management, exit terms, and, often, rigorous impact measurement when specific benefits or social outcomes are at the heart of the business proposition. Broadly speaking, they need to demonstrate that they are prepared to take on the risks of longer-term commitments to address widely recognized social needs. They also need to follow best practice accounting practices around shared costs and intercompany transactions.
With the right agreements in place, global and large regional corporations may play the critical role in reaching the SDG goals by 2030. That's a surprising scenario, but it reflects the structure of the global economy, which has been regularly creating wildly successful “unicorns” while leaving behind the poorest of the poor.
Come Together Now
If impact investing continues to drift along with muddled ideas about rates of return, impact indicators, and large regional and global companies, it will invite more cynical responses. It will also fall short of its potential in financial markets, where reputation is critical. And if it keeps attracting financial resources without demonstrating its effectiveness, it may be responsible for a large-scale misallocation of capital on the basis of well-meaning intentions.
The world does not have the surplus of money or time to spend on conflicting ideas about rates of return, measurement, or the importance of large companies. We do not have anything to waste if we want to achieve the SDGs by 2030. We will not get a do-over if we miss our opportunity to address climate change. Freshwater aquifers will not replenish themselves. No generation that grows up in poverty can reverse time and live a life of proper nutrition, education, and wellbeing. Today, and for the generations ahead, we need to ensure that impact investing is clear in purpose, grounded in the facts, and pursued with the highest possible efficiency.