The State of Financial Performance in Impact Investing, Part Two
Even as impact investing moves into the mainstream, the perception—whether true or imagined—of a financial trade-off remains a barrier. We at Threshold Group are often asked by first time impact investors: will I have to sacrifice financial return for impact?
Our answer? Not necessarily.
Here we explore the evidence showing that we need not sacrifice financial returns to generate positive social or environmental impact.
In part one of this two-part series, we focused on public market investments and why they can sometimes perform better than their mainstream counterparts. Part two discusses private markets and what all of this means for the newly minted impact investor.
Impact investing also comprises private market solutions. These private equity and private debt investments address social or environmental challenges often by supporting sectors, geographies or populations that struggle to access traditional capital. Because these investments operate outside the mainstream, many managers and advisors lack the experience to effectively evaluate them, dismissing them as too risky or too difficult to underwrite relative to their potential financial return.
Fortunately, we are beginning to see aggregate data suggesting that impact investment funds can achieve competitive returns:
- A 2015 study by Cambridge Associates and the Global Impact Investment Network measured the financial performance of 51 private impact investment funds launched between 1998 and 2010 against 705 regular commercial funds. The impact funds spanned multiple themes but all targeted typical market rates of return (15% for private equity and venture capital and above 10% for mezzanine funds). In aggregate, impact investment funds launched between 1998 and 2004 – those that are mostly realized – outperformed funds in the comparative universe. Over the full period (1998-2010) impact funds returned 6.9% versus 8.1% for the comparative universe but in these cases, many had yet to be fully realized.
- In 2015, The Wharton Social Impact Initiative analyzed 53 impact private equity funds, assessing 170 underlying investments that were designed to seek market rate returns. These investments produced a 12.94% IRR, exhibiting near identical performance to the study’s selected benchmark, a spliced Russell Microcap/Russell 2000 index.
- From 2000-2010, the International Finance Corporation (IFC) invested $2 billion in 124 emerging market private equity funds. The IFC is the private sector branch of the World Bank and provides investment to encourage economic development in emerging markets. In aggregate, these funds achieved an internal rate of return (IRR) of 19.7%, outperforming benchmark returns of 14.2%.
There is also data showing that in some cases, the perception of risk may be greater than reality. For example, in the U.S., community lenders are often perceived as higher risk because they invest in non-profits that lack collateral or small businesses that serve low-income communities. And yet well-managed community lenders can point to decades of performance on par with their traditional counterparts. For example, the Opportunity Finance Network assessed 209 community development finance institutions (CDFIs) and found an average net loan loss rate of 1.5%—on par with FDIC-insured institutions.
It is important to acknowledge that impact investments – like traditional investments – can and will fail. And there is no doubt that further research on the financial performance and risks of private impact investments is critical. But for those who are looking to impact investing in the near term, we point to this early evidence that it is possible for impact investments to achieve competitive returns.
What does this mean for the newly minted impact investor?
Our view is that there is mounting evidence that ESG and impact investing – when executed thoughtfully by managers with appropriate experience – can have a compelling financial role within a portfolio. And yet, despite this early evidence we must reiterate that research remains nascent and that impact investments can pose unique risks and nuances.
One nuance is that while many impact investors pursue market rate returns, there are many others who are willing to accept below market returns. The fact that impact investing spans both concessionary and market rate returns has made many would-be impact investors unsure that they will be able to access impact investments that also match their risk and return preferences.
Another consideration is that while we often discuss impact investing as a standalone category it in fact extends across asset classes and sectors, with each adding its own layer of risk and return characteristics. For example, an impact investment in the form of a short-term loan to a small business should likely have a lower risk profile than an impact investment in the form of a venture capital investment into an early stage medical research company.
Likewise, different sectors pose different risks. We’ve seen this play out in the clean technology sector, where the first generation of investments into capital light software companies performed relatively well while investments into capital intensive hardware, materials or chemical companies failed spectacularly. These considerations make it very challenging or near impossible to discuss impact investing as its own category.
In addition, impact investing involves risks including, but not limited to:
- the early stage of development with impact investing managers often having a more limited track record relative to their mainstream peers;
- the complicated regulatory regimes that are often intertwined with many impact sectors, such as clean energy or affordable housing;
- reputational risks as well as the very real risk of mission drift and impact failure;
- challenges associated with “blended finance” investments that creatively combine private, public and philanthropic capital to achieve a specific risk/return profile; and
- “green washing” which involves asset managers using the term “impact” as a marketing strategy rather than a true investment strategy.
In an industry defined by complexity and information asymmetry, manager skill and thoughtful manager selection remain essential. At Threshold Group, we have purposefully built an investment team spanning traditional finance, impact investing, policy, environmental science and academia in order to help our clients better navigate these complexities.
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Impact investments are investments made into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending upon the circumstances. Impact investors actively seek to place capital in businesses and funds that can harness the positive power of enterprise. Impact investing occurs across asset classes, for example private equity / venture capital, debt, and fixed income.
Impact investors are primarily distinguished by their intention to address social and environmental challenges through their deployment of capital. For example, criteria to evaluate the positive social and/or environmental outcomes of investments are an integrated component of the investment process. In contrast, practitioners of socially responsible investing also include negative (avoidance) criteria as part of their investment decisions. Threshold Group makes no representations or guarantees that any specific investment opportunities will meet such goals of impact investors or impact investments.
 Cambridge Associates. Introducing the Impact Investing Benchmark. June 2015.
 University of Pennsylvania. Wharton Social Impact Initiative. Great Expectations: Mission Preservation and Financial Performance in Impact Investing. 2015.
 International Finance Corporation. The Case for Emerging Market Private Equity. January 2013.
 Opportunity Finance Network. 20 Years of Opportunities Finance: 1994-2013: Analysis of Trends and Growth. November 2015.
 Gaddy, B., Sivaram, V., O’Sullivan, F. Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation. An MIT Energy Initiative Working Paper. July 2016.