For practitioners in the world of social-impact investing, a number of questions come up time and again: How do we define a social investment? How do we define social enterprise? and How big is the market and should we define it as an asset class? The question that comes up most of all is Do we believe that making an investment with the intent of creating impact necessarily leads to a risk-adjusted return that is lower than a purely financial investor would expect? Or in other words, Does impact investing require investors to “trade off” social return against financial return, or is it in fact a “free lunch” that allows investors to optimize risk-adjusted returns at the same time as they generate positive social value?
The article by Paul Brest and Kelly Born is by some margin the most coherent attempt yet to consider this question. In the January 2013 survey of impact investors by J. P. Morgan and the Global Impact Investing Network, Perspectives on Progress, 65 percent of respondents indicated that they were seeking market-rate returns. If Brest and Born are right in saying that they are “skeptical about how much of the impact investing market actually fits this description,” then at best these investors are going to find it very difficult to find suitable investments, and at worst they are
facing disappointing financial returns.
So is the authors’ skepticism justified? Broadly speaking, I believe it is. In my view the vast majority of impact investors projecting market-rate returns fall into one of four categories.
- They are in fact earning a market-rate return but only because there is subsidy in the capital structure. For example, large US banks are increasingly describing their lending to Community Development Financial Institutions (CDFIs) as impact investing. Without wanting in any way to discourage this activity, I would point out that the CDFIs receive significant subsidy through government grants and tax credits, and the banks that lend to them rely on that subsidy to earn their return.
- They are confusing absolute return with risk-adjusted return. Projecting a 15 percent return for a microfinance equity fund may seem like a reasonable absolute return, but it is not close to what an appropriate risk-adjusted return would be for early-stage investments in some of the least developed markets in the world.
- They focus on returns from individual investments rather than returns on the entire portfolio. The extraordinary returns to the original shareholders in Compartamos do not prove that a portfolio of microfinance equity generates commercial risk-adjusted returns.
- They confuse projected returns with actual returns. Risk and return data are scarce in the impact investing world, and the projected returns of an investment manager rarely match actual returns.
I particularly find Brest and Born’s notion of investment impact helpful. They are correct in suggesting that for impact investment to have impact it has to be “additive,” and although it is easy to argue that concessionary investments are additive, it is much more difficult to do that with non-concessionary investments.
Is it ever possible for the impact investor to earn a market return? Are there ways in which being an impact investor gives a competitive advantage over mainstream investors that allow the impact investor to optimize financial and social return?
The authors identify a number of frictions that may impose barriers to what they describe as socially neutral investors but may provide some competitive advantage to socially motivated investors. Some of these frictions—such as small deal size, limited exit, and governance issues—are true of any investment portfolio that focuses on smaller companies, particularly in emerging markets.
The authors also describe a skepticism and inflexibility that can create an unintended bias among mainstream investors. The following is a gross generalization, but I am going to make it in any case. If you go into any mainstream bank, investment manager, or private equity firm in Europe or the United States you find the same people: hordes of MBAs from the same schools investing with people they know and like, in places they visit and in businesses they can relate to. This homogeneity among investors has unintended consequences.
New business models that create social value through the people they employ, the products they produce, or the areas in which they locate tend to find it difficult to attract capital. Because impact investors start from a different point of view, they go places, meet people, and see opportunities that the mainstream investment community misses. It may be possible, as David Chen notes, for them to “see something that you don’t see.”
I share the conclusion that it is critical for impact investors who are providing concessionary capital to provide clear measurable metrics that demonstrate and support the impact they are creating. Those, however, who seek to provide non-concessionary capital also need to demonstrate evidence of impact, but they must in addition be able to articulate their investment impact, and that means a clear articulation of why normal commercial investors are missing the opportunities that they are pursuing.