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Social Impact Investing

In the 1990s, Jed Emerson advocated the concept of Blended Value for funds, firms, social ventures, and foundations to invest with social/environmental impact, rather than to maximize financial performance. Simultaneously, approaches such as pollution prevention, CSR (corporate social responsibility), and triple bottom line (people, planet, profit or the “three pillars”) began to measure non-financial effects inside and outside of corporations. Until around 2007, the term “impact investment” emerged.

“Impact investments are made into companies, organizations and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investors actively seek to place capital in businesses and funds that can harness the positive power of enterprise.” 

It is necessary to note that impact investing is an investment philosophy; it is NOT an asset class, and it is not confined to any particular investment sector. With that said, impact investing involves the same asset classes as traditional investing and deploys the same approach and research processes. Additionally, the generic risk-return profile of impact investments should be quite similar to their mainstream counterparts.

Investment vs. Expressive Utility

Impact investors seek to satisfy two different types of utility – investment and expressive utility.

  1. Investment utility reflects all of the trade-offs any investor faces between risk and return integral to modern portfolio theory, i.e. achieving the highest return at the lowest risk.
  2. Expressive utility, a term coined by behavioral finance researcher Meir Statman, describes investors benefit from the expression of their ethical values. 

The challenge for investment professionals lies in successfully incorporating both utilities into a portfolio. Expressive utility may seem to be an emotions-driven exercise since the measurement of whether a portfolio ”feels right” to a values-driven investor is so highly subjective. However, such an emotions-driven decision is effectively no different from the risk-return trade-ff integral to creating optimal portfolios, i.e. investors are supposed to know when the level of risk ”feels right” in terms of the loss they might face across different levels on a risk-return efficient frontier.

The Impact Investing Industry

The impact investing industry is young, however, according to GIIN (Global Impact Investing Network) and the Impact Investor Survey, a total commitment of USD 9 billion will be made to impact investments in 2013.

Historically, approximately 70.0% of reporting organizations are in the broad financials sector; at region level, the majority survey respondents are from Latin America & Caribbean, Sub-Saharan Africa, and South Asia. Please note that the absence of North America does not indicate a lack of impact investing activity in the region. Rather, it reflects IRIS (The Impact Reporting and Investment Standards)’s focus on emerging markets.

Social Conversation in The Socially Responsive Investing

I have just talked to a U.S.-based SRI fund management firm which has around 15 years’ record in this space. The firm creates personalized ESG screens for taxed and tax-exempt investors.

Instead of employing a standard social screen, the manager starts the investment process with a “Social Conversation,” as we all agree that socially responsive indexing should reflect the true values and  beliefs of the individual investor. In this sense, the “Social Conversation” is the most effective way to create a customized portfolio.

The firm establishes a set of values in the form of a questionnarie that directly determines which personalized ESG screens will be incorporated into the client’s portfolio:

1) Environment

  • Pollution
  • Environmental Innovation
  • Climate Change
  • Environmental Policies and Disclosure

2) Social

  • Community and Politics
  • Diversity
  • Human Rights
  • Sexual Orientation
  • Workforce

3) Governance

  • Board Oversight and Structures
  • CEO Compensation

After the customized screens are confirmed, target social scores will be assigned. The firm has an objective scoring system to give more weight to better-scoring companies based on the predetermined values.

The Problematic Trend in Impact Investing

  • Institutional investors often need relatively large investment opportunities whereas currently impact investment opportunities are much smaller.
  • Investors and entrepreneurs profit at the expense of communities, and there is “capital gap” for community-run project.
  • Impact is being defined by investors and entrepreneurs instead of beneficiaries; the resulting downside is that there is no credible assurance that the intended positive social and environmental impact will be made.
  • The management fees and carried interest are at times too high.
  • The performance of impact investments is hard to measure as investors lack track record of existing products
  • Since impact investing typically targets an investment horizon of five to ten years, it is more suitable to institutional rather than individual investors. Therefore, by far the majority of impact investments are from developed finance institutions and foundations, not much from private sector
  • Impact investing does not yet have the kind of “ecosystem” needed to support companies as they move from initial idea testing through to scale-up

References:

Accelerating Impact: Achievements, Challenges and What’s Next in Building the Impact Investing Industry” by E.T. Jackson and Associates Ltd., July 2012

Data Driven: A Performance Analysis for the Impact Investing Industry (2011 IRIS Data Report)

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