For impact investors, this is the age of exuberance.
The global impact investing market reached $715 billion of assets. Research indicates that sustainable and responsible investments are outperforming their peers. The Business Roundtable and the World Economic Forum have recently committed to the same principles of social and environmental accountability that impact investors have long embodied. The fiftieth anniversary of Milton Friedman’s article, “The Social Responsibility of Business is to Increase its Profits,” was commemorated with dozens of articles trumpeting the fall of shareholder primacy and rise of stakeholder capitalism.
But in the fight to reform capitalism, idealism and cynicism travel in pairs.
Many in the financial world have greeted the happy talk of “doing well by doing good” with significantly less enthusiasm. Warren Buffett has remained skeptical of the growing focus on environmental, social, and governance (ESG) metrics. As his long-time partner Charlie Munger summarized, “I like our way of doing things better than theirs and I hope to God we never follow their best practices.” The venture capitalist Marc Andreessen famously concurred in his assessment of B Corps, which are companies that seek both financial return and social benefit. “I would run screaming from a B Corp,” he said. “The split model makes me nervous and I don’t think we would ever touch that. It’s like a houseboat. It’s not a great house and not a great boat.”
This summer, the US Depart of Labor proposed a new rule reminding pension funds of their fiduciary duty: maximize financial returns, not social or environmental impact. Any focus on ESG cannot come at the expense of investors. Hence the question: Is there necessarily a trade-off between profit and impact? Between generating prosperity and holding companies accountable for what they do to society and the environment?
This is a question we get all the time. We’ve helped build impact investment funds at Bain Capital and Two Sigma. Our friends in traditional finance have spent their careers maximizing a single goal: financial return. With impact investing, they say, we’ve added a second goal: social impact. We went from maximizing a single-variable equation to creating a dual-variable one. Investors must—must—give something up in order to do good, the logic says. Otherwise, traditional investors would already be targeting social impact in their quest to maximize profit. — Michael O’Leary and Warren Valdmanis
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In the nascent field of impact investing, not everyone will make money. But even the most experienced and cutthroat investors don’t make money all the time. How are we to know when poor returns are due to prioritizing impact, making bad investments, or suffering bad luck? It’ll be many years before generalizable, long-term data on impact investment funds are even available. And so the suspicion grows that you can’t both do well and do good—at least not through impact investing, at least not as a general rule.
We’ve noticed that almost everyone who invokes the trade-off argument is talking about a trade-off with profit—that is, profit as it shows up on the income statement each year. But approaching the discussion this way stacks the deck, because all investments—whether in R&D or marketing or in a more environmentally friendly supply chain—cost cash today. The harder question is how to measure the benefit.
For that, we have to wade a bit deeper into a key financial concept: the valuation multiple. For the uninitiated, consider this your crash course in corporate valuation. We’ve spent our careers obsessing over it, but we’ve boiled it down to its essentials. Let’s take a company everyone knows: Coca-Cola. Is it a good idea to buy a share of Coca-Cola today?
The financial markets have been more volatile this year, so let’s look back at 2019. At the beginning of 2019, the share price of Coca-Cola was $45. Ownership of Coca-Cola is divided into 4.3 billion shares, so the total equity value of the company was $196 billion. So far, so good.
Is this a high or a low valuation for all of Coca-Cola? In finance class, you learn a technical answer: you project all the future cash flow that Coca-Cola will ever generate and then discount that cash back to the present according to both how far in the future it is and how risky it is. If this sounds hard, you’re right. We can’t reliably predict next quarter’s earnings, much less cash flows decades in the future. Investors, like all people, avoid doing hard things. Luckily for them, there’s a shortcut.
Let’s compare the share price to the annual earnings that Coca-Cola generated the year before. Coca-Cola’s share price at the beginning of 2019 was twenty-two times the previous year’s profit per share. This is called a valuation multiple, and—here’s a little secret about the financial world—it’s how almost all investors think about valuation. Rather than tediously calculating the company’s future growth and risk, they just say that a share of Coca-Cola is worth twenty-two times its earnings.
Is that high, low, or just right? Let’s compare it with PepsiCo. PepsiCo’s valuation multiple at that time was nineteen times its earnings. If you knew nothing else about these companies, you’d say that it would be cheaper to get a dollar of earnings by buying PepsiCo than by buying Coca-Cola. PepsiCo looks like a good deal, all else being equal.
Of course, there’s the rub: “all else being equal.” In reality, PepsiCo and Coca-Cola are very different companies, with different growth rates and risk expectations. Until we make a judgment on those, we just can’t say whether Coca-Cola or PepsiCo is a better investment.
Congratulations, you passed Intro to Corporate Valuation.
Now let’s try a valuation experiment: What would happen if Coca-Cola reduced the amount of sugar in its sodas to improve the health of its consumers?
It could lose profits if its customers were to eschew the new recipe. But let’s say younger consumers prefer healthier products and prefer buying from corporations that care about their health. As these consumers age and become a larger part of the market, Coke’s decision to lower the sugar content in sodas could be a significant draw. This could improve Coca-Cola’s long-term growth. Further, let’s suppose that the government creates a sugar tax in the future. In that case, Coke’s reduction in sugar would also reduce its exposure to this risk. Both higher future growth and lower future risk should improve Coca-Cola’s valuation multiple.
So is there a trade-off for Coca-Cola between providing a healthier product and creating long-term value for shareholders? Is it a good idea or a bad idea for Coca-Cola to cut the sugar content of the drinks it produces? Though the short-term impact on earnings is more tangible, the long-term benefits to the valuation multiple are immeasurable—not necessarily immeasurably large, just immeasurable.
We started this section with the challenge all impact investors are hit with: Don’t you have to give up return in order to have impact? Isn’t there a trade-off? Here’s the answer: Yes. Of course there’s a trade-off. All investments require a trade-off between a certain, measurable expense today and an uncertain, immeasurable return in the future. The question should be whether that trade-off will be worth it—whether running a company to maximize both impact and return could end up creating more return than running a company to maximize return alone. The question is whether, over the long run, financial return is a goal best achieved when you don’t aim at it directly and obsessively.
Impact investing isn’t a surefire way to make money. No investment strategy is. But the most common criticism of impact investing—that it aims to achieve two things instead of one and therefore must involve concession on one or both dimensions—is based on outdated economic orthodoxy.
Fortunately, the financial world is starting to change. Andreessen, who’d said he run screaming from a B Corp, has since begun investing in them, in some cases alongside other impact investors. We used to joke that impact investing would not exist in fifteen years. If returns were bad, it would gradually fade into obscurity as a niche financial solution to narrow philanthropic problems. If returns were good, everyone would adopt the impact approach and the distinction between it and regular investing would become meaningless. The jury’s still out, but our money’s on impact.