In their article Paul Brest, Ronald Gilson, and Mark Wolfson make a critical distinction between value alignment (aligning one’s investments with one’s values) and social value creation (deploying one’s investments to increase the social value created by the recipient enterprise). What separates the two is investment impact—whether the investment itself adds in amount or nature to the financing that the enterprise could otherwise obtain.

An individual investment either has or does not have investment impact. By contrast, investment funds, and the general partners that manage these funds, need not limit themselves to investments that all have, or do not have, investment impact. The authors touch on this possibility, and I believe it is where the majority of the untapped potential of impact investing lies—and also much of the confusion.

In their search for deals, impact investors are likely to come across a range of opportunities, some of which offer potential for value alignment and some of which offer potential for social value creation. Fund managers can create more value at less cost by pursuing both goals via a hybrid strategy.

Particularly in nascent sectors and challenging business environments, a hybrid strategy fits the nature of the market opportunity better than either strategy alone would. Enterprises in such contexts are likely to have multiple financial needs, some of which can be met in local financial markets, and some of which cannot.

For example, Root Capital extends loans to small and medium-sized agricultural enterprises, the smallest of which typically lack access to finance. If those enterprises positively impact smallholder farmers, then our working capital loans to those enterprises create social value. As these enterprises grow and gain other sources of finance, the investment impact of our working capital loans declines, but we might offer additional long-term loans for factory construction or farm renovation that do have investment impact. And then if there were a macroeconomic or agricultural shock that causes other lenders to exit the market (as has indeed happened), our working capital loan would have investment impact again.

At the extreme, to achieve a portfolio in which 100 percent of investments create social value would require an investor to forgo investing in any business that has other options. As an agricultural lender, this is not feasible given the long-term nature of our client relationships, the variability in number and size of loans that create social value from year to year, and assets under management and a cost base that are both fixed in the short run.

For Root Capital at least, the question is not whether to aim for 100 percent value alignment or 100 percent social value creation. The question is: with how much of our portfolio can we go beyond value alignment to social value creation? What are the expected costs and the expected impacts of doing so? And can we find investors and donors that are willing to provide the required amount and blend of grant and investment capital?

For fund managers that pursue a hybrid strategy, confusion arises from two sources:

• It is difficult to know what constitutes a ‘good’ financial return for investments that offer investment impact. Some investments that have investment impact offer risk-adjusted market-rate financial return. Most do not, and there is no performance benchmark for those that don’t.
• It is difficult to know what portion of a fund’s investments have investment impact. It is rarely reported externally, or even tracked internally. Root Capital will begin publishing the proportion of our loans that have investment impact on our website in 2017.

As a result, it is difficult for external parties to tell whether “concessionary” impact investment funds are achieving enough impact to compensate for their below-market financial return, versus simply making poor investment decisions or operating inefficiently. Root Capital’s recent article in the winter 2017 issue of Stanford Social Innovation Review, “Towards the Efficient Impact Frontier,” represents one effort to address these challenges and bring greater transparency to the economics and the impact of concessionary impact investing.

My colleagues and I at Root Capital couldn’t agree more with the authors that “the field [of impact investing] can only grow responsibly if individual investors, impact investing trade associations, and fund managers are candid with themselves and others about the conditions necessary for real impact.” Specifically, impact investors should be transparent about how many of their investments have investment impact. But this is not the same as saying that all investments in a fund should.

Concessionary impact investors such as Root Capital should not shy away from the fact that not all of their investments have investment impact, and for good reason. Purity is difficult to achieve in practice. Nonconcessionary impact investors should not shy away from the fact that few of their investments have investment impact, and for good reason. Value alignment is nothing to be ashamed of.

Lastly, the authors reference in passing an idea that frequently comes up in these discussions, namely tying compensation to social impact as well as financial returns. While supportive in principle, in practice I am wary of incentives for investment impact, because it is often self-reported by necessity. The managers of the investee enterprise, and the investment officer of an impact fund, are the only ones with direct knowledge of the additionality of a given investment. Even to them, it may not always be clear what alternative financing options the enterprise has. In turn, external investors must rely on the fund manager to accurately aggregate and report what the investment officers have self-reported.

Perhaps in time definitional standards will emerge for various types and degrees of investment impact, alongside third party auditing of it. In those circumstances, incentives for impact might make sense. But until then, a better strategy is to rely on intensive screening of fund managers to ensure that their impact objectives are aligned with those of the asset owners; ensure that those fund managers have tools and processes for implementing those objectives; trust them to self-report investment impact as best they can; and don’t give them a reason—such as compensation heavily tied to financial return—to deviate from those social objectives or to misreport investment impact.

Read the rest of the responses.