By Simon Miller
During the past two decades socially responsible investment (SRI) became a buzzword in the City. Investment firms and pension funds were keen to demonstrate their credentials in ethical investment.
Since then, SRI has dropped out of the limelight but recently a variation, impact investment (II), has come to the fore.
Not that it is the same thing. Many see SRI as seeking to minimise negative impact rather than creating a positive social or environmental benefit. Broadly speaking, the term II has come to be defined as the active management of capital investments to attain a level of financial return, together with the creation of social and/or environment impact.
The market is attracting both private wealth managers as well as institutional investors such as banks and pension funds. Investments range from basic needs such as agriculture and water to basic services such as education, health and even financial services generally targeting the broad base of the economic triangle.
In September 2009, JP Morgan, Rockefeller Foundation, and the United States Agency for International Development launched the Global Impact
Investing Network to accelerate the development of an effective impact investing industry.
However, according to Jed Emerson, executive vice president of Impact Assets, there is a lot of discussion about how to even measure the popularity of II, or indeed whether companies are really engaging in II.
Speaking to Financial Risks Today, Emerson comments: “There are
complications around language because when you ask people if they are doing impact investing, a lot people say yes and then you have them describe what sounds more like SRI or fundamental investing that’s informed by sustainable finance perspective. So the definition problem makes it hard to engage in who’s doing what?”
Why companies and individuals are looking into this market is open to question. Cynics claim that with the reputational battering investment funds and banks have had over the past three years it is a convenient way of making money while ‘looking good’.
It is a charge that Emerson disputes: “I was at a meeting with an institutional investment group and they did a survey of their clients and no one really understood what [II] was. But when asked that if it was possible to invest for financial performance with a level of social impact would you be interested in that product, over 50 per cent said yes.”
He continues: “For the early adopters there is nothing about this that is ‘greenwashing’. Their motivation is about helping gain access to capital to help business. It is very clear and focussed and they are very clear on the risk aspects.”
Despite cynicism over the motivation for II, it is clear that it offers new alternatives for channelling private capital for social benefit.
According to a JP Morgan report, Impact Investments: An emerging asset class, the returns potential is vast - with potential profits over the next ten years ranging from $183 billion (£114.2 billion) to $667 billion from an invested capital of between $400 billion to nearly $1 trillion.
“With increasing numbers of investors rejecting the notion that they face a binary choice between investing for maximum risk-adjusted returns
or donating for social purpose, the impact investment market is now at a significant turning point as it enters the mainstream,” says the report.
According to Emerson unlike traditional investors, impact investors will be looking at even greater active management of their funds.
In his white paper, Risk, Return and Impact, Emerson argues that at the level of overall investment strategy, “for many impact investors there is a commitment to maximising the total performance (financial and extra-financial) of the portfolio”.
He continues: “While many traditional investors would state they invest in an active manner, for the impact investor this action is focused upon not only attaining a level of financial return, but social and environmental impacts as well.”
Again, unlike traditional investment, II does not see risk/return simply as a matter of pricing in risk - i.e. the riskier the investment, the greater the return.
For overall strategy, many view II as a broad strategic investment with allocations being specifically assessed with an eye towards how it may contribute to the financial and impact performance of the total portfolio under management.
Emerson quotes an impact investor who said he was responsible to
maximising the total impact of his entire portfolio “regardless of how we decide to allocate our capital into specific, individual investments”.
“In considering risk and return for impact investing, these investors understand it is less a question of whether one is a ‘finance first’ or ‘impact first’ investor than a strategic consideration of risk and return the investor makes,” says Emerson.
Indeed, it is this 3D model as espoused by Brian Dunn, formerly with Aquillian Investments, which looks at impact on top of the traditional risk/
Emerson writes: “When viewed in this light, investing and the performance potential of capital are viewed within a holistic framework wherein investors are not asked to embrace an artificial trade-off between doing good and well but rather assess various investments with regard to their real or potential performance across three axis of simultaneous blended value creation.”
For some, II is seen as an asset class. JPMorgan argues that an asset class is no longer defined simply by the nature of its underlying assets but “rather by how investment institutions organise themselves around it.”
The financial services company sets out four characteristics which have materialised in II, therefore justifying it as an emerging asset class:
• Requires a unique set of investment/risk management skills
• Demands organisational structures to accommodate this skillset
• Serviced by industry organisations, associations and education
• Encourages the development and adoption of standardised metrics, benchmarks, and/or ratings
However you define II, like all investment, there are a number of risks involved which will be familiar to all investors: liquidity; manager; and fund development risks. What makes II substantially different to other investments is that by its very nature, II has to make an impact. The whole raison d’être of II is to make a difference so what may be a peripheral concern for the traditional investor, becomes one of the key issues.
According to Emerson, impact risk speaks to the possibility that what may first be viewed as a ‘good thing’ may actually end up being ‘not so good’.
“For example, the controversy regarding palm oil harvesting for bio-fuels or job creation that acts to accelerate the movement of people out of rural areas and into already challenged urban centres,” he writes.
JP Morgan agrees, arguing that critics may claim that II “exploits poor people for the sake of profits”. It adds: “Some impact investment business models, especially those employing high-volume, low-cost approaches are able to drive financial return and social impact together with impact and profit correlated as the business expands. But it would be naïve to believe that these two imperatives are never in tension.”
“The question is it appropriate, at the end of the day, to make money from vehicles that are trying to advance some level of intentional social impact? To me it’s an odd question. People are basically saying that they are much more comfortable with this black and white idea of we can make money wherever we like with no consideration of social or environmental value,” says Emerson.
Another area of risk is measuring and reporting. Unlike other investments into the emerging markets, conditions can make accurate pictures of the impact an II is having harder to detail. While all investments can have reporting difficulties on a fiscal basis, the impact investor will want to see how his investment is working in the field. With difficulties in measuring social and environmental impacts, many investors may be exposed to an inaccurate assessment.
“In practice, measuring social performance is complicated, expensive and can be subjective, so impact investors have supported the development of standard and social measurement frameworks,” says the JP Morgan report.
As a result, the area has seen the introduction of the Impact Reporting and Investment Standards (IRIS) which aims to standardise reporting and
create industry benchmarks while the Global Impact Investing Rating System will utilise IRIS definitions and other data to assign relative values to social performance.
Again, a feature that may not arise under more traditional investment is
social enterprise risk. Although this type of risk shares some traits with the traditional enterprise risk, it is viewed through the lens of social commitments and orientation.
Emerson says: “In addition, social enterprise risk would consider what a likely range of outcomes will be as they relate to not just a successful execution of the business, but also whether it will create the stated and desired social and/or environmental outcomes projected.”
With the field that II is working on, there is also the issue of subordinate capital risk and, simply put, does reliance on grants or other subsidies and their additional complexity lead to better results or impact on the outcomes of any given investment strategy?
Another area that Emerson explores is the issue of perceived risks. For many, the idea of investing in certain areas of Africa for example, or in non-profit organisations is of deep concern due to the misperception that nonprofits are operated poorly, have few underlying assets to secure the debt and carry significant reputation risk to the investor. But Emerson argues that this is often just perception rather than the reality.
“As one investor commented: ‘They may not have a ton of assets to secure their debt but they can point to 20 years of consistent bill paying and sound credit management. Why wouldn’t I want to invest in that?’” he writes in his report.
The country that a company invests in can also be an issue, be it political unrest or sovereign debt issues.
The JP Morgan report cites an example of political risk where a company is disrespectful of community culture or it is seen to be competing with
initiatives already attempting to deliver the same product or service. In 2008, local politicians in Pakistan were encouraging borrowers to withhold repayments on their microfinance loans, feeding into a more general “borrowers’ revolt” in that region.
“Given the sensitive nature of the services provided, in many impact investments, businesses must recognize that they are dealing not just with
customers but with citizens who can mobilise political opposition to collateral collection or debt payments. If the company fails to manage these kinds of risks, the financial performance of the company and the investment will suffer,” says the report.
However, it is unlikely that there will be liquidly traded credit default swaps (CDS) to hedge against this for II. In addition, shorting bonds or equity is unlikely to be possible. According to JP Morgan, the best protection against credit risk is likely to be a thorough due diligence process both at the time of investment and throughout the investment holding period.
As events have seen in Greece and the Middle East, countries themselves can be risky propositions. Whether through a sovereign default or political instability, this can have a significant effect on II.
Responsible Research’s briefing note, Issues for Responsible Investors by Marco Arosio, points to events in Thailand where the country lost all its GDP growth in Q2 and Q3 2010 due to the riots there.
Although hedging country risk is possible though sovereign CDS, the required size may be too large to make sense for II and, in the case of Thailand, Arosio writes that it is hard to quantify the damage actually done to II.
He adds: “Nonetheless, given the nature of the sectors employed to achieve impact, the real harm might be considerably lower than losses suffered by traditional asset classes.”
Yet, even though different territories offer differing challenges to investment, it can also be where the greatest impact can be had. As Arosio puts it: “Countries that present the biggest barriers in these areas often offer the biggest opportunities for social and environmental impact.”
Although you can argue over its status as an asset class If risks can be overcome then II looks like it can take its place among other investment vehicles.
However, Emerson warns that people need to understand that II is still an emerging area and you cannot just sign a check and get a statement every quarter.
“People need to go into this with their eyes open. But, having said that, there are still hundreds - if not thousands of investors - that are doing pretty well in this space,” says Emerson. “Just like SRI practices have moved into the mainstream so in five to 10 years II will not be some outlier. It will continue to have an impact and it will continue to grow.”
If Emerson is right and returns can be matched with the promised social
impact to the benefit of indigenous populations, then this investment may indeed impact fuller on the minds of institutional investors and grow, despite what cynics may say.