Over the last five years, impact investing—an investment approach that intentionally seeks to create both financial return, and actively measured positive social or environmental impact—has gained tremendous excitement and buzz among academics, governments, and philanthropists. However, most investors have been careful not to get too excited about an investment approach that creates a potential constraint on capital.
Last month, the World Economic Forum (“the Forum”) gathered some 50 senior executives across sectors at its New York offices to discuss impact investing in conjunction with the release of its new report, “From the Margin to the Mainstream: Assessment of the Impact Investment Sector and Opportunities to Engage Mainstream Investors.” More than 10,000 people downloaded the report in the first two weeks, and it was used as a baseline for discussions among the delegates of the G8 countries. Yet it is important to keep in mind that interest does not equal momentum and that for impact investing to have the transformative effect many people expect and hope it will, we have much to do across sectors and stakeholders.
One year ago, we at the Forum started our research with a simple hypothesis: Investors are increasingly interested in allocating capital to create measurable social impact, but they face a number of hurdles when they attempt to do it. Over the course of the year, we sought to determine the biggest challenges that these investors face and identify recommendations for addressing them. Our ultimate hope was that more large-scale pension funds, insurance companies, sovereign wealth funds, and other asset owners would begin to adopt this emerging investment approach. We identified many constraints on asset owners and found that most of these arise from one of four broad challenges:
- The ecosystem is still in an early stage. As a result, there is confusion about what financial returns investors should expect from impact investments. We asked more than 50 executives from US-based pension funds if they thought that impact investments generated financial returns. Only 60 percent did. However, we analyzed all of the impact investment funds in ImpactBase (an online database of impact investment funds and products) and learned that 80 percent actually target market returns. This disparity between asset owners and asset managers about financial returns is well founded, given the diversity of experience among impact investors. We also learned through our research that while 38 percent of impact investment funds have more than a 3-year track record, 41 percent do not have a track record at all.
- Deal sizes are relatively small. We learned that direct investments in social enterprises or impact businesses are historically around $2 million. A quick analysis of all the traditional, private equity growth-capital deals in 2012 reveals an average deal size of approximately 20 times that amount. Given that impact fund investments are typically much larger than $2 million (median impact investment fund size in ImpactBase is about $60 million), asset owners will look to invest through funds as opposed to direct. However, our analysis shows that, on average, even investments into impact private equity funds are significantly smaller than most asset owners are willing to make.
- Impact investments are difficult to fit into traditional portfolios. Asset managers follow conventional finance models (for example, Modern Portfolio Theory) when making investment decisions. They also often organize their teams by asset classes. In this construct, we learned that investment professionals are not really sure where impact investments belong. Impact investing is an approach that crosses asset classes and involves making investment decisions based on non-financial metrics; this complicates the investment decision-making process for asset owners.
- Measurement of “social returns” is not easy. While significant progress has been made in measuring, reporting, and scoring social returns (thanks to B-Lab, GIIN, and other systems), asset owners are not accustomed to measuring non-financial metrics, as it often requires a long-term commitment to measurement and can thus be costly. Similarly, measuring the social returns of an investment can be complex. Evaluation of a counterfactual – or put simply, evaluating the social or environmental outcomes had the investment not been made – is an activity that many asset owners are not privy to.
Given the challenges described above, it may appear that our attempts to make impact investing become more mainstream are bearish. But quite the opposite is true. By identifying the main pain points, we can prioritize activities and more effectively delegate resources to address them. These challenges are not insurmountable. In the report, we outline recommendations for different participants—including governments, philanthropists, impact investment funds, impact enterprises, and intermediaries—to overcome these challenges. It will require focused collaboration, but with implementation of these recommendations, our hope is that impact investing will move just a little closer out of the margins and into the mainstream.