According to the definition of the International Finance Corporation, impact investing is a deliberate allocation of capital by investors that, in addition to financial returns, also has measurable positive social, economic or environmental effects. [1]
This can be seen as a positive, strengthening investment trend that raises hopes of mobilizing the trillions of US dollars needed to finance the achievement of the UN's 17 sustainable development goals. An increasing number of investors are taking these and other goals as a reference to show the relationship between their investment decisions and the impact they have.
Features of Impact Investing
Since the term is still relatively young, there is no uniform definition so far. According to the study "Impact Investing: Concept, Areas of Conflict and Future Perspectives", this term only refers to direct equity and debt investments in the sense of private equity and private debt, since secondary market transactions on the stock exchange only cause the shares to move to another portfolio. [2] Nevertheless, the authors see three crucial commonalities that connect different definitions:
• Achieving a financial return
• Generation of a positive, non-financial effect (Impact)
• Measuring and reporting on this impact
In this general article on impact investing, we focus on the term in a broader sense, which includes, in particular, investments in the stock market.
The paper "Creating Impact: The Promise of Impact Investing" additionally names three essential characteristics in which impact investors differ from others: [1]
The intention is articulated to achieve a sustainable goal. For this purpose, the results pursued by the investment are identified and it is stated who will benefit from them.
The investor follows a credible thesis that describes how the investment contributes to the achievement of the intended goal. In this way the investor makes a contribution, which can be both financial and non-financial.
It is measured how the declared intention and the contribution made are linked to the improvement of the sustainable results of the company in which the investment is made. The measurement system allows the investor to assess the level of expected impact in advance, and then to continuously monitor progress, take corrective action if necessary and assess the results afterwards.
The principles described are considered to be crucial building blocks of a robust impact management system. They can be implemented both at the level of a fund and for the entire company.
Source: International Finance Corporation / The World Bank (2019), Investing for Impact, Operating Principles for Impact Management, p. 4
SRI and ESG
The two terms Socially Responsible Investing (SRI) and Environment, Social, Goverance (ESG) are closely linked to the later emergence of impact investing. Elisabetta Basilico has compiled the study "Impact Investing 2.0: Not Just for Do-Gooders Anymore" for the portal alpha architect, which classifies these two concepts. [4]
One of the origins of the term Impact Investing therefore comes from the Rockefeller Foundation. There, Anthony Bugg-Levine used the term in 2007 for investments with more than one return target, where the capital invested has a more direct effect than with only loans, grants or subsidies with low ,or no, return expectations. The first tangible concept was SRI, which developed from purely ethical investment principles and consisted mainly of filtering out certain negative criteria in investments (for example, weapons, alcohol, gambling, tobacco, child labour, environmental pollution and animal testing). This later developed into a broad understanding of environmental, social and corporate policy (environment, social, governance, ESG for short). Instead of simply filtering out negative criteria, the focus here is on actively searching for desirable factors. These include compliance with human rights, positive working conditions, environmental protection, energy efficiency and product safety.
What about the returns?
In the past, it was often assumed that companies that achieve positive non-financial effects have a corresponding yield disadvantage. This expectation could be justified, as studies have shown, for example, that the disreputable "sin stocks" did offer a yield advantage. However, this is not the whole story. For in 2017, the study "Sin Stocks Revisited: Resolving the Sin Stock Anomaly" showed that the effect can be explained by exposure to certain classic factor premiums. [5]
Nevertheless, from a theoretical point of view there should be a (small) negative effect if certain shares are neglected. This is because in the objective of maximizing the return for a certain risk, limit the possibilities and can only result in an equally good return in the very best case as without any restrictions. However, it is much more likely that a lower expected return will result for the same risk. At least that is what Cliff Asness of AQR Capital argues in his paper "Virtue is its Own Reward: Or, One Man's Ceiling is Another Man's Floor". [6]
The logic behind it is as follows: No matter what individual investors do or don't do, the market as a whole must clear itself. Each share must be held by someone. If some players now decide not to own any more "bad" shares, then these must be held by the remaining investors. In order to give them an incentive to do so, however, the corresponding shares must promise a higher return. Under otherwise equal conditions, the prices must therefore be lower. Investors already invested in sin shares experience in this view thus price losses. At the same time, however, the expected returns for the future increase if one assumes that fundamentally nothing has changed.
Positive change through cost of capital
This effect can even be the source of the positive change that sustainable investors are aiming for. Because the higher expected returns of the sin shares represent at the same time the discounting factor and/or the capital costs, with which such projects - purely theoretically - are calculated. If we assume that fundamentally nothing has changed and that the same cash flows are still generated, this leads to a higher number of imputedly unprofitable "sin projects". As a consequence, less of them should be implemented. This would achieve the positive change that sustainable investments are striving for - caused by a shift in the cost of capital.
But there is another, simple effect. So far we have assumed that nothing has changed fundamentally. However, if customers prefer sustainable companies, they will receive fundamental support. This in turn also enables better returns on the respective stocks. But only if, in addition to the ecological and social aspects, the processes in corporate policy are also sustainable. This "G" of ESG, governance, is often underestimated in comparison to the other two dimensions. But this criterion plays a particularly important role for investors. The example of Wirecard showed what can happen in the worst case if governance is not right.
There are other, plausible arguments that speak for the long-term advantage of sustainable investments. Gary Antonacci already summarized the most important points in 2015 in the article "Sustainable Momentum Investing: Doing Well By Doing Good". 7] Above all, responsible corporate action - i.e. the governance just discussed - is the basis for good relations with politicians and a positive perception in society. This reduces the risk of being confronted with regulations or pressure from the public, which in turn has a positive influence on the brand perception of customers and thus implicitly fulfills an advertising role. This not only results in potentially higher sales, but also more loyal customers. Suddenly, sustainable investing sounds like a positive upward spiral. And last but not least, it also improves the ability of the respective companies to find and retain talented employees. Ultimately, these and other factors add up to a positive effect on competitiveness and productivity.
Return on investment and impact
The study "Impact Investing 2.0: Not Just for Do-Gooders Anymore" shows that there is a wide range of return expectations for impact investing, which ranges between two extremes: [4]
on the one hand, no or only a very low return (philanthropy), where the focus is actually on the impact achieved, which compensates the investor accordingly
on the other hand, an above-average return (alpha) compared to the market, where investors assume that sustainable investments (should) perform better in general
The chart shows the range of return expectations, divided into four categories, that different groups of investors associate with impact investing.
Source: Lieberman, D. (2020), Impact Investing 2.0: Not Just for Do-Gooders Anymore
In addition to the bandwidth in expected returns, there is also a bandwidth on the impact side. The paper describes the following example: [4]
• low impact: investment in solar bonds to develop new technologies
• moderate impact: energy-efficient conversion of an office building with a focus on community-oriented workplaces in a healthy environment
• High impact: private solar company in Kenya that sells home solar systems to private households in its own country as well as in Tanzania and Uganda; these can replace dangerous kerosene lamps, which were previously the only option for many people
Impact Investing today
The paper also discusses the current status of impact investing. According to various studies, both the investment capital managed under sustainable aspects and the number of funds available for this purpose have increased significantly in recent years. It also defines a concept for the next stage, Impact Investing 2.0, which is based on an understanding of the future importance of significant changes in society, the economy and the environment that other investors do not (yet) recognize. One example of this is investment in companies that are working to make good education available to all people worldwide by improving access to relevant offers and information. [4]
Another example is climate change, which most people agree in principle about. Nevertheless, many investors regard this as a problem that lies far in the future and is not a priority for their current investment decisions. How much one can be mistaken here is shown by a specific consequence of climate change: the increasing risk of a shortage of clean water. The fact that this will not be a dramatic problem just sometime in the future, but already exists today in some countries, was illustrated by the drought in South Africa from 2016 to 2018, when drastic measures were taken to avert a "day zero" in the drinking water supply of the capital Cape Town. An obvious impact investment here would be, for example, investments in companies that develop better water treatment technologies. [4]
Challenges
The paper "Creating Impact: The Promise of Impact Investing", mentioned at the beginning of this paper, describes both the opportunities and the challenges of impact investing. Four essential points are mentioned, which represent a bottleneck for further growth: [1]
Ongoing discussions about whether impact investing achieves higher, roughly equal or lower returns than other investment concepts. The first impact investments came mainly from the field of philanthropy, where low or no returns were accepted. Today, as described above, expected returns are subject to a range, but the largest group - and especially the potential growth market - probably cannot be placated with below-average returns.
Lack of standards on how to manage impact investments in detail in order to achieve real impact. This can lead to "impact washing", i.e. problems with credibility. And this deters investors. One solution could be to implement the characteristics of impact investors described above within a standardised investment process.
Limited comparability of the measured impact across different projects and managers. Unlike financial returns, for which there are many key figures, there are no standardized methods for assessing impact. If industry-wide accepted criteria are created here, this could generate higher investor confidence.
The framework conditions of many institutional investors often do not (yet) support the fact that managers pursue impact targets in addition to financial returns. The focus is still on the return dimension - even if the own investors support impact investing.
According to the study "Impact Investing: Concept, areas of conflict and future perspectives", it is also problematic that the majority of investors have quite high return expectations (as described in first point of the discussion above). Not in all areas can a win-win situation be created that reconciles financial and non-financial goals. This can also result in "impact washing" in such a way that the whole idea is watered down to a commercial marketing vehicle. [2]
