Why Impact Investing Might Collapse and How to Stop It

(Photo by iStock/peeterv)

Impact investing is an opportunity for public and private money to support emerging markets that lack the capital needed for growth and poverty reduction, but the foundations are wobbling. Collective delusion about the true impact of investments has the potential to undermine a vital instrument for global development. The current paradigm of linear, simplistic cause-and-effect models for impact risks distorting markets and directing capital toward investments that may not be effective.

We’ve seen this before. The crisis of confidence in voluntary carbon markets was caused in large part by buyers realizing they were not getting the non-financial return on their investment that had been promised, with the result being an 87 percent reduction in the price of credits across a two-year period.

If we keep pretending that investments generate impact when, and in ways that, they don’t, then we are a few high-profile critiques away from a similar crisis of confidence. To improve, it is important to understand the current practice, its limitations, and then to examine how a systemic approach more reflective of real-world dynamics can improve capital allocation, management, and measurement so that impact investing can realize its potential.

How We Pretend Investments Create Impact

Impact means many things to many people, but the Sustainable Development Goals (SDGs) are as good a place as any to start. Despite the documented flaws in impact investing, including in the pages of SSIR (Viglialoro et al, Bildner, Foroughi, Starr), and attempts to change things, standard practice remains that 1) asset managers identify a pipeline investment within their target IRR range and other fund parameters such as sector, 2) the “impact team” attaches the work of that company to an SDG and develops an impact thesis, which is used to support the investment decision, 3) the activities of that company or firm are then measured to assess impact. In the middle, approaches range from activist investors to passive investors, but typically the activism relates to financial performance or compliance, particularly in relation to ESG and reporting.

For example, we invest in an agro-processing factory, which grows and employs 10 new people, and we report on 10 new jobs created. Or we invest in a new digital financial services (DFS) product, which reduces travel time for users and onboards 100,000 new customers, contributing to many SDGs. Or we invest in a home solar company, which sells units to one million households and increases access to clean energy.

From a measurement standpoint, there are, of course, issues, including the methodologies and veracity of this data, and there have been numerous attempts to address these challenges. But this is not principally a challenge of measurement—that comes later. It is more a challenge of the mechanics of how investment generates impact, where the industry has a significant blind spot.

How Investment Actually Creates Impact

Firms exist in markets. These markets include customers, suppliers, competitors, regulators, and other formal and informal functions, networks, and behaviors that influence their success or failure. The true impact of an investment is based on how it affects a market and not only how it affects a firm. To critically revisit the examples from above:

• The 10 workers at the agro-processing factory used to work at a factory next door. That factory has now closed as they couldn’t get a commercial bank loan, and your concessional capital has undercut them.
• The DFS company onboarded these users, but they didn’t have access to information about how to use the products. The merchant side of the transactions didn’t catch up, so the accounts went unused.
• Consumers bought the home solar units, but there was no maintenance service. The units broke, and it was in the company’s best interest not to do repairs and instead, sell more units. So, consumers were ultimately poorer when they purchased replacements.

These examples demonstrate how current practices do not capture actual and additional impact in negative scenarios, but the same is possible in a more positive light:

• The agro-processing firm used the money for technology that was new to the industry. As the firm became more competitive, competitors emulated this innovation and also grew. The 10 jobs created in the firm were complemented with many more jobs in competitors and in the increasing number of commercial and smallholder farms required to service the industry.
• The DFS company built a use case that resulted in infrastructure investments in rural areas. These infrastructure investments led to many more use cases, which contributed to the SDGs, including education and health services delivered over the same network.
• The home solar units had far greater utility to smallholder farmers who were able to introduce cold storage and increase their revenues from the harvest.

To summarize, this is what we need to know to understand true impact:

• Impact additionality: What would have happened without our investment? What was the net effect on the impact indicators of our investment when considering other relevant actors across the market system?
• Financial additionality: Why was our capital needed? What other sources of capital were available? What impact did our investment have on these other sources of capital, for our portfolio company, and for others in the market?
• Management additionality: Was there anything else, outside of capital, that contributed to impact as a result of our investment?
• Sustainability of changes: Were any practice changes that did occur and contributed to impact performative as conditions of our investment, or did they persist after these conditions expired, the debt was repaid, or we exited our equity position?

How to Practice Impact Investing to Create Systemic Impact

A growing number of investors are exploring the use of a systems lens to generate impact. Systemic impact through investment means achieving a defined additional net impact for a defined group of people in a defined context because of an investment that was made and the way it was managed. Additionality has to consider the counterfactual of other changes in both the financial and real economy systems, while net impact has to consider the “beyond the firm” positive and negative consequences of the investment on its buyers, suppliers, competitors, service providers, and others in the enabling environment.

Achieving systemic impact starts with asking what is not working, how, and why, to assess whether and which financial and non-financial investments can address those issues. Next, asset managers develop targeted investment strategies and work alongside the investment to influence the behaviors within and beyond the portfolio company.

We use lean systems as a term for the approach to deliver systemic impact that prioritizes the most efficient ways in which systemic impact can be delivered. The lean systems approach is grounded in pragmatism, practicality and has been piloted across the last eight years, building on several decades of learning in international development practice. The approach is not about setting impossibly high standards for measurement. Although with infinite resources, you can do infinite things. Rather, it’s about using this lens to help make more impactful decisions across the investment lifecycle.

Crucially, a lean systems approach is also aligned with the incentives and capabilities of the asset owners, managers, and portfolio companies. Owners are choosing to invest in impact rather than maximizing return. They need to know that this impact is happening, but lack the time, resources, or, in some cases, the technical knowledge to make such an assessment; they cannot take on the responsibility to source, manage, and measure for systemic impact themselves.

Managers are operating in a competitive environment—competitive for pipeline and for capital. They cannot afford to drive up overheads with excessive additional processes. Adopting and arguing for systemic impact with investors should make asset managers more competitive (for pipeline and for capital) as organizations that can demonstrate genuine and larger-scale impact, if the approach is operationalized correctly.

For portfolio companies, taking impact capital can often be burdensome, performative, and compliance-heavy. A critical tenet of the lean systems approach is that impact is not the concern of the portfolio company but of the asset manager. Notwithstanding ESG risk mitigation measures, managers should invest in a company because of the way its success addresses systemic constraints to a given development impact. The company should focus on doing what it does—more and better. Investing this way, greater impact equals great financial return, benefiting portfolio companies, managers, and owners.

Adopting a lean systems approach results in substantive but not necessarily expensive changes across the investment lifecycle—better sourcing, better management, and better measurement. Here’s what that looks like in practice:

Better Sourcing

Adopting a systemic view of impact results in better sourcing of investments that generate genuine, additional, sustainable impact. Understanding how pipeline companies fit into the markets in which they operate and how an investment might simultaneously address some of the constraints of both the company and the market allows asset managers to make better investment decisions.

• Investment and impact strategy is informed by market analysis, not solely financial analysis and ESG screening alone. Market analysis identifies the key capital and non-capital constraints affecting the investees’ ability to achieve the targeted developmental impact, required changes in service delivery or market behavior for lasting change, and then subsequently, the most effective way to deploy capital and non-capital support. This analysis can be done at the level of a country, sector, or individual investment. It helps to contextualize the impact pathways—linking the cash and non-cash investments in a causal chain to different outcomes—in a more holistic manner.
• Assessing impact pathways during pre-due diligence and due diligence is more comprehensive and focused on maximizing value creation as opposed to risk mitigation. Due diligence goes into identifying systemic risks and opportunities in the supply chain, service delivery related to key supporting functions, social norms, and formal regulations that affect the investment’s likelihood to deliver impact.
• Financial and impact additionality considerations are prioritized. Asset managers collect sufficient information on other sources of capital and the need and relevance of that specific investment to assess financial additionality. And the potential value addition of the asset manager is assessed in the context of impact KPIs at baseline and historical growth to meaningfully assess impact additionality.

Better Management

Taking a systemic view of impact should help asset managers know what kind of inputs are required to ensure maximal financial and impact returns. In some cases, there is an important role here for blended finance. Technical assistance is often used at a very linear, simplistic, and firm-centric level—writing documents, ensuring compliance, and conducting market research. Adapting this support to be consistent with a systemic view of impact can enable relatively small investments to catalyse impact. These may be investments that are perhaps beyond the risk appetite of an asset manager or portfolio company, but support more widespread adoption of innovation. However, the way in which a lean systems approach facilitates improved investment management is not limited to technical assistance facilities. It is geared toward ensuring that any way in which an asset manager supports their portfolio company, in addition to the provision of capital, is aligned with maximizing the impact return. Examples of practical differences include:

• Investee support and technical assistance focused on maximizing value creation in the market, not improving internal systems (e.g., financial management, governance, inclusivity in leadership, internal policies) of the portfolio company only. While those can contribute to improving the capacity of the portfolio company to deliver impact, that link is rarely validated.
• Explicit recognition of the roles of the asset manager in value creation efforts. The investment agreement should not burden the portfolio company with performative tick box exercises, but meaningful activities in line with the impact pathways, implemented jointly.
• The asset manager and the portfolio company engage with beyond-the-firm market actors relevant to the specific impact pathways. This can include suppliers, service providers, regulators, or membership organizations, depending on their specific role in achieving the intended systemic impact. For example, a portfolio company that is a food processor might lobby government to lower the import tariff on fertilizer, even though this is not an input they use, as it is important to smallholder producers who are critical to their profitable and impactful theory of change. This is not an activity that directly benefits the firm and certainly not preferentially over their competitors, but it does, if successful, make economic sense for the firm at the same time as generating impact throughout the supply chain and the supply chains of others in the sector.

Better Measurement

Adopting a systemic view of impact means focusing on additionality, sustainability, and scale. Methods vary and must be right-sized—with bigger impact claims comes a bigger burden of proof. The key, though, is to look beyond the firm and ask the right questions. Practical examples include:

• Capturing changes at the level of the portfolio company and the broader system. This will assess the validity and relevance of the firm-level impact and capture wider positive and/or negative changes triggered by the investment.
• Defining a well-articulated theory of change that establishes a clear link between outputs (i.e., access), outcome (i.e., usage and behavior change), and impact (i.e., benefit). This also shows how the specific activities undertaken by the portfolio company and the asset manager contributed to those changes with measures to assess additionality and attribution. For example, a fund might invest in a mobile money platform, which onboards new users. A systemic theory of change should consider whether they used the platform and what benefits they extracted. What was the impact on the merchants who now had a new customer base and their suppliers, whose sales increased as a result? How were other mobile money platforms and traditional financial service providers affected positively?
• Shifting from relying on self-reported data from the portfolio company and introducing measures of triangulation through secondary resources and engagement with wider market actors. For example, if an investment is made in a country’s first higher-ed e-learning platform in rural areas, the fund may want to monitor whether other e-learning platforms emerge and explore any credible links between the two. Looking at a negative case for the same investment, if the growth and new learners on the platform resulted in an equivalent closure of competitors’ platforms, then the benefit is marginal and not absolute. What do these learners get now that they did not get from their previous platform?

The Systemic Impact Investing Standard

The last thing impact investment needs is another standard, principle, guideline, or norm. And yet, that is what we have created, but knowingly so and with a clear purpose.

The Systemic Impact Investing Standard (SIIS), developed by Agora Global and the Bertha Centre at the University of Cape Town (where the authors work), places systemic impact at its core and is an auditable standard to assess the degree to which an asset manager’s sourcing, management, and measurement are aligned with delivering it. In each area, an assessment is made as to whether the manager’s practices demonstrate the achievement through their initial commitment (purpose), practical steps to operationalize (processes), and evidence that the processes have been implemented effectively (proof):

• Purpose: Defined in, for example, investment strategies
• Processes: How they develop pipeline, manage portfolio companies, and their measurement practices
• Proof: Whether these processes have been implemented and are delivering systemic impact

The standardization work done in the past 10 years in the sustainable finance and impact investing ecosystem has focused on managing environmental, social, and governance risks (e.g., ISSB), providing guidance on how to integrate impact throughout an investment process (e.g. Operating Principle for Impact Management), qualifying impacts in a harmonized way, (e.g., Impact Frontiers) or tackling specific issues such as diversity (2X Challenge) and climate change (TCFD, SBTI). Others have provided measurement guidance with catalogs of harmonized metrics (e.g., IRIS+) or modelling approaches (Joint Impact Model). While the above are useful, there are several issues with their intent and execution that makes them unsuitable for achieving systemic impact. The standards, and particularly the norms, are, by definition, trying to gradually improve broad-based practices. Creating systemic impact requires a paradigm shift and a means of auditing and recognizing those who invest in shifting this paradigm.

Conclusion

We return to our earlier concern: How can the field of impact investing avert disaster? The first step is to be honest about impact. The second is to recognize and operationalize the role that different players have in delivering it. Asset owners need to be judicious in where they put their money to incentivize better delivery. They may also need to accept higher costs, higher management fees, or higher risks, but not in relation to the level of genuine impact being generated. Finally, they may need to play a convening role in bringing other ecosystem players, including in the development of blended finance vehicles, to the table.

Asset managers need to respond to the incentives created by asset owners. They need to recognize their role is not purely fiduciary and, from sourcing through to measurement, adapt their practices to deliver systemic impact. And portfolio companies need to focus on what they do best—creating and growing innovative business models that address development challenges at scale.

We need to change practice—sourcing better, more impactful deals; proactively managing for impact as well as financial performance; and measuring what matters with a focus on additionality and externalities. All of this requires a systemic impact lens, seeing investments and the impact they generate in the context of the systems in which the portfolio companies operate.

Read more stories by Ben Taylor, Zannatul Ferdous & Jason van Staden.