Impact Investments

The role of the financial system in society has evolved and asset owners, asset managers and banks are now expected to be able to allocate financial flows supporting important social, environmental issues, and transition to a net-zero economy. Investors and asset managers can seek a balance when it comes to considering their impact on society and the pursuit of profit, but they need specialized guidance to do this.

Impact investing means that investors want to achieve some sort of change in the outside world on top of financial returns, focusing investments in a specific way.

  • Intentionality is a key characteristic of impact investing. Investors target specific outcomes.
  • These outcomes need to be measurable. Impact investments focus on outcomes and quality, rather than just outputs and quantity. This helps protect against social/greenwashing.
  • Impact investments can provide investors with market-rate financial returns.

To elevate impact, some investors may choose to share knowledge and connections with investee companies, accept below-the-market return, offer first-loss capital, or take additional complexity to structure financial products.

Another important feature of impact investing is additionality. Effects of investments and investment allocations won’t happen in the normal course of events in the future or wouldn’t have happened in a counterfactual scenario in the past.

The global impact investing market is growing and is estimated to be $2.3tr globally. The growth is driven by long-term evolution of investment preferences and changing perception of importance of factors in social development and role of investors.

The growth is particularly proclaimed in the US and UK, as these are two markets where companies, both multinationals and SME depends less of debt financing from banks and have much broader access to capital markets compared to the continental Europe. This create an opportunity to reallocate capital to support development of important social issues.

In the United Kingdom particularly impact investing market is estimated £58B in 2020 and currently represents around 1% of total UK AUM. There is however a headroom for the rapid growth, as research suggest a strong tailwind to increase allocation to the impact investing up to 4% of the AUM in the UK.

For investors to play an even greater role in solving social and environmental problems, impact management must be integrated with financial management.

Beyond screening, few investors or lenders actively optimize both impact and financial performance simultaneously. There is a method that enable investors to go further by actively optimizing for both impact and financial performance in portfolio construction.

Additionally, impact-financial integration enables investors to communicate all dimensions of their goals and performance internally and externally with greater clarity and transparency.

  1. First, the investor and asset owner need to understand what it wants to do with it’s money. That’s all defined with strategy-type approach, defining what sort of investment purpose the organization or investor have, their financing strategy, availability of financing and what element of investment contribution can be made.
  2. Then we need to understand what is “impact”. Impact management is the process of identifying the positive and negative impacts that people and the planet, and then reducing the negative and increasing the positive. To make it more manageable, “impact” has 5 dimensions – what, how much, who, contribution and risk.
  3. Looking into the universe of the possible investment opportunities with impact, there are multitude of instruments that has been developed that can match different type of risk, impact and return combinations at different time horizons.
  4. It’s one thing to understand impact, risk and financial return at investment level, and the other thing is to implement optimal allocation to optimize three these parameters. Modern practice give us a solution – which is based on interpretation of classical CAPM (Capital asset pricing model). Once we’ve build an impact measure, we may construct the universe of all possible portfolios with combinations of impact, risk and financial return. Each point is a portfolio of investments. And we may define the impact frontier – which is the line defining the maximum achievable combination of these three factors. This is actually a three dimensional space and at the diagram below we see a two-dimensional projection. The actual investments we pick into the portfolio are the investments as close to the impact frontier as possible. But it’s not possible to cross this line.

Different types of investors may want to pick different portfolios. Pension funds may want to construct portfolio closer to the top left side – with fiduciary duty pension fund more concerned with financial return, but still want to do some impact. And some sort of foundation with possible philanthropic intentions may choose portfolio closer to the right bottom part of the curve (As close to the curve as possible). Both option are optimal and leave no impact, or return on the table.

So what we can do to put the theory into practice?

  1. First, there are three approaches to measure impact – target, impact rating and monetization framework. The impact rating is the most popular. That is the weighted sum of impact indicators that collectively cover multiple dimensions of impact. Weights reflect importance of impact to stakeholders that experience them and investors’ impact priorities. Even among a set of possible investments already screened for positive impact, ratings can help investors to identify the investments with greatest expected impact.
  2. Second investors need to choose what is the measure of financial return. That is slightly variate among different part of financial industry. Some investors measure return in multiples, other in IRR, some other in monetary value.
  3. Third, there is a systematic way to analyze relationships between impact and financial return. In some segments the relationships may be positive, in some negative and in some no correlation at all. Then you as an investor have some sort of legacy portfolio you are living with. This portfolio is probably far from optimal from impact / return optimal line. So you want to improve it. It means to analyse which investments you may want to ditch, with investments you want to add and how these decisions will change position of you portfolio.
  4. And then of cause there are expected impact and return and realized impact and return. So you want to build analysis how you portfolio changes over the time and how much it different from what was expected. And of course you want to build a comprehensive system to screen any new opportunity to once it arrives over all measures.

An the way you handle investment can also differ and is part of the investment strategy. Investors may want to be relatively passive, signaling, trying to collect data and avoid harm. Some type of interventionalist investors may want to engage and contribute substantially, even with non-controlling stakes. And then some investors may be much more ambitious, trying to grow market or building controlling stake and actually becoming a “strategic investor”.

There is another approach to impact investing, which is focused to implementing impact at a specific place, which is a natural desire to some investors. They want to understand they contribute to regions or communities.

But that is also a model that may greatly benefit to pension plans, particularly to local government pension plans. Current and future pensioner are living in a particular space. And pension plans have long term assets. That is a great match to develop local areas and match investments with long-term liabilities. A few non-governmental bodies (sponsored by UK government) have developed a quite efficient framework to channel investments to what these local communities need the most – housing, SME support, energy, infrastructure, regeneration.

I can help to establishes impact investing front-to-back, enabling new impact investment products, developing idiosyncratic impact investing strategy, taking into consideration particular preferences of investment community and key stakeholders.

Please contact me if you wish to discuss creating a practical approach for impact investing:

  • Proprietary impact investment ratings and monetary-based impact measurement frameworks, taking into consideration custom element and preferences of different investors
  • Operationalizing impact investments tightly integrating with portfolio management
  • Supporting with specific issues around impact reporting and disclosures

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Dr. Tymur Khusainov
Sustainable Finance and ESG Consultant