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Allocating to Impact Investments - how this looks in reality

November 2, 2018

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Allocating to Impact Investments - how this looks in reality

November 2, 2018

It has been 7 months of rich, hands-on learning, and my understanding of impact investing development has grown much more nuanced and personal. 


Which is why I would like to discuss this topic in much greater depth - it is another fundamental topic that has come up consistently with practitioners across the value chain, and one that is crucial to align in order for functional investment. 


In this (very long) post, I explore this topic from basic concepts to implications for practical implementation:

  • How impact investing looks in terms of risk/reward

  • Are risk perceptions justified

  • How to manage impact investments within a portfolio

Pivoting Investments to Impact


One of the most common starting points for any discussion on impact investing is on potential assets of influence. This bull case scenario hypothesises that, if we can unlock investment dollars towards impact, we can dramatically increase the assets devoted to advancing social or environmental causes (beyond existing philanthropic portfolios). 


Investments are driven by risk-reward - Fear and Greed, if you will - a decision balancing the probability and magnitude of loss and profit. In a commercial world, there is a functioning funding curve that ensures larger risks are compensated with higher rewards. Incentives are aligned and decisions are justifiable and quantifiable.


One reason ESG investing is the most practical and compelling "pivot" for most investors is that ESG investing can be seen as a risk reduction by avoiding poorly run companies and those vulnerable to external shocks. This makes the additional cost of incorporating environmental, social or governance factors into your existing fundamental analysis, and potential implementation and technical risks, worthwhile. 


But how about Impact Investing in the way it's mainly understood - early stage investments into private startups or projects that directly address bottom-up challenges?


The Startup Financing Cycle


Consider this classic illustration of the startup financing cycle:



At each stage, 

Consider an impact investment proposal. This is a for-profit company that promises to do well by doing good. Generally speaking, this is perceived to be greater risk than normal venture capital investment. This is because:

  1. Liquidity concern

    The startup investment value chain is a deep, developed global market where there are entrenched networks and backstop procedures. From a textbook standpoint, this is skin-in-the-game risk-sharing - from angel to accelerator/incubator to venture capital to private equity, each investor is compensated for the risk they take by the next investor, at a higher valuation. This pass-the-parcel process is established, and because there are a lot of players at each segment, there is some reassurance on an "exit" for the risks each investor takes. 

    Contrastingly, the social investment value chain is extremely nascent, and there is low consistency in the sectors, region or development stage of companies that each investor focuses on (or excels in). The historical record of exits is also extremely poor. 

    Without visibility on likely exits, social enterprise investments present extremely inhibitive risks on liquidity.

  2. Flexibility concerns

    Profit-maximisation is a common and intuitive company goal that has a long history and track record of success. On a comparative basis, other models such as employment maximisation are more often associated with inefficiencies. The lack of relevant data and track record means that social enterprises are often perceived to have more constraints on the way they do business, and therefore may be more vulnerable to both internal and external shocks.  

  3. Visibility (of Outcome) concerns

    Many social or environmental outcomes are complex and difficult to measure. As such, by introducing multiple goals into the business model, the outcome becomes less visible or quantifiable. This raises the risk for investors especially for those that are managing external assets. 

This means that an investor would have to embrace projects that appear to be higher risk, in exchange for less visible returns. This fundamentally goes against the grain of normal investment decisions.


Are social enterprises really higher risk?


First, let's remain in the realms of comparing impact investments to traditional startup investments. As outlined above, there are clear reasons for the perception that social enterprises are different, and carry higher risk. 


That said, what are we comparing them to?




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