Co-authored with Jed Emerson of Impact Assets
Earlier this month in the Stanford Social Innovation Review (SSIR), Paul Brest and Kelly Born wrote a very thoughtful piece about the difficulty of achieving real impact alongside financial returns for impact investors. Their thesis was so provocative that over 18 of the world's leading practitioners in impact investing responded by explaining the nature of this financial vs. impact dilemma from their own point of view. The responses show a landscape of honest and diverse experience, but it left the overall impression that the ongoing effort to use investment dollars to achieve both financial and social returns is elusive, with no coherent core of best practice.
This is simply not the case.
For the past two years, the three of us have been engaged in a comprehensive analysis and review of 13 of the most exceptional impact investing funds and foundations who have been on the ground doing this work for many years and achieving their well-defined social and financial goals. The funds invest in over 80 countries across five continents, managing nearly $3 billion in assets earmarked for impact investing and work in diverse areas, ranging from agriculture to education to community development to health.
We are pleased to share that within an extremely rich and diverse set of impact motivations, outcome intentions, financial vehicles, geographies and market conditions, exceptional fund managers share an emerging set of characteristics and strategies. These core dynamics are driving the field forward, past the speed of debate, and delivering the total performance -- financial returns with social and environmental impacts -- that impact investing promises.
With the goal of replacing theory with reality, we have spent two years going "under the hood" of emerging best practice, through hundreds of conversations and access to confidential performance data and will be releasing a set of in-depth case studies on each investor later this fall.
Continuing debates regarding risks and returns within a swirl of varying definitions will prevent impact investing from moving to the next level, as Sonal Shah pointed out in a recent Fast Co interview. Instead, it is time for the hand-wringing regarding what impact investing "is" to stop; we should file it away and refer to it as "Impact Investing 1.0." Monitor Group's seminal 2009 report showed us the signs of progress to look for at a field level, and they are here. The simple truth is that Impact Investing 2.0 has arrived. We have the lessons of those who have done this work successfully for years at our disposal. We should now focus on these emerging best practices and work to bring the field to scale based on HOW they have actually done it. As the Heath brothers point out in their amazing book about behavior change, Switch, by studying what has led to superior performance by a set of outliers, one may often discover practices that can lead others to perform better.
Financially, the returns, generated by our group of funds under study, are diverse. They range from debt funds which promise single digit returns and have never lost their investors a dollar to equity funds that have returns around or above 20 percent, to foundation funds that have delivered concessionary to market rate returns and plowed them back into more grantmaking and investing. Socially, the impacts are as rich as the investment theses that can be imagined -- these funds and vehicles are helping the poor, connecting the disconnected, promoting health, developing housing and improving education.
Before we may emulate the practices of Impact Investing 2.0 and take a leap forward, however, we need to get past the misperceptions that relegate public discussions to a mutually reinforcing vortex of opinion. There are four realities in impact investing we will be describing in detail in the fall, some of which are counterintuitive to the collective guideposts many in the field have being using. Here are two of them, drawing from comments in the recent SSIR debate:
Myth #1: We need to take an all-or-nothing approach to philanthropic and catalytic capital.
Many believe the use of philanthropic and concessionary capital in impact investing subsidizes and negatively distorts markets and should not be present in a healthy for-profit marketplace (the "nothing" approach). At the same time, Brest and others insist on "additionality" as the rule of thumb that counts for what is impact investing (the "all" approach, saying all impact capital should invest only if it increases the quantity or quality of an enterprise's social outcomes beyond what would otherwise have occurred through mainstream sources).
This myth is rooted in debate about what philanthropists need to do to justify their own action in a market. It has legal underpinnings in the U.S. program-related investment guidelines and in the social science literature regarding what "impact" is (a debate to which we are proud to have contributed), which gives it extra weight and importance for those using philanthropic capital for their impact investments.
The debate about additionality is also strangely self-centered around each different capital source's frame of reference. Some philanthropists insist they must be needed for their impact investing to be real ("It's not impact investing unless there is additionality,") and some mainstream capital providers insist the market must not require any non-commercial help to be real ("It's not impact investing unless it's just plain good investing.") The debate is sorely stuck and it is time for us to move beyond short-sighted rhetoric.
Reality #1: Catalytic capital is much more blended, driven by type and provider motivations.
From Additionality to Catalytic. The reality behind the myth is this: The true level of proof varies according to the type of capital one wields -- allowing these differences to flourish has been key to creating successes in the marketplace. We agree with Audrey Choi of Morgan Stanley in the SSIR debate: Additionality may be a relevant consideration for that limited set of investors weighing capital tagged as philanthropic, but for most of the market, it is not.
In the $3 billion cross-section of the market we studied -- including four funds that manage assets, in whole or in part, through nonprofit charities -- philanthropic capital is almost never the only capital being deployed and very few that deploy it hold additionality as a threshold rule. Most importantly, these impact investors have moved beyond additionality to the notion of catalytic participation in a broader marketplace of players. Being able to leverage mainstream capital into your carefully chosen investments creates important opportunities to deliver more impact, period.
As for the commercially-incorporated funds, additionality is simply chimeric. A private sector asset manager can step in wherever and however she chooses and is not beholden to prove additionality, either as a pre-investment rationale or as a post-investment proof-point. Additionality, as the threshold investment argument, does not reflect the reality that impact investing at the fund level is primarily thematic and that impact is imbedded by these high-performing managers a priori in a sector-oriented strategy. In this case what matters most is the sector or sub-sector itself and its inherent disconnectedness from mainstream capital markets (health, community development, affordable housing, education, rural development in India or China, etc.). And this is above and beyond the fact that proving additionality with rigorous evaluation across portfolios of these sizes is impractical, to which several of the SSIR respondents alluded (Ignia, Morgan Stanley and GIIN).
In short, catalytic capital unleashes other impact investing capital, serving as an instrument for generating immense social value. It does this by sustaining, de-risking, signaling, seeding and aligning with high-performing impact investing strategies, whether through grants, guarantees, concessionary or cornerstone investments. Catalytic capital may be, but is not always, philanthropic and the burdens of proof are actually much more flexible outside of the philanthropic envelope. This is a good thing and a sign of market maturity. While some portion of investments, by some dedicated investors, might be spot-tested for "true," counter-factual-based impact, the market as a whole need not be constrained and in reality it is not.
Myth #2: Impact investing is either, "financial-first," or, "impact-first."
The common lexicon in the marketplace is that you are one or another kind of investor. "Impact-first," means you work with an impact floor where impact intentions are your knockout criteria for an investment and financial concerns are secondary. "Financial-first," means you work with a financial floor, where market-rates of financial return are non-negotiable, and impact concerns are secondary.
Reality #2: Impact investors attend to financial and impact objectives differently throughout the lifecycle of an investment -- and both "types" of impact investors do it in exactly the same way.
Impact is defined by capital motivations. What our research has shown us is that impact is ultimately defined explicitly and early on by a fund, accounting for the motivations of its capital providers (limited partners, the lenders in a debt fund or the governing body of a foundation or charity and so on). The exceptional fund manager finds ways to blend these motivations in ways that bring a cohesive and aligned set of capital and impact expectations to a deal, a fund or a market. We have examples of all three in our study.
Mission first and last. It is also clear that establishing an embedded strategy and structure for achieving impact prior to investment is at the core of successful impact investing. This enables all funds to have a predominantly financial focus during the life of the investment. And knowing that impact is in a fund's DNA, all parties (LPs/investors, investees and the fund itself) are able to move forward with the investment disciplines akin to any other financial transaction, confident that mission drift is unlikely. They will then return at the end of the investment to assess the impact achieved according to the strategy that was embedded at the beginning. Bridges Ventures calls this making sure its investments are in "lockstep" with the mission. And despite the fact that it has funds achieving market rate equity returns, its focus on mission first is not different from low-interest social enterprise lender RSF Social Finance, which assesses the mission of the venture as a threshold criterion and then applies rigorous financial discipline to determine the credit worthiness of borrowers.
We believe that this impact investing lifecycle -- which was common across all funds in our study and is a theme we refer to as, "Mission First. And Last," -- holds the key to the much more sophisticated, blended approach to value creation in the 2.0 era of impact investing, as it clarifies how successful funds actually behave with regard to the pursuit of their objectives. As recent debates have shown, in order for our field to grow we need analytical tools based in actual practice-level research. We must recognize the solutions already being put to use by leading practitioners around the world and not constrain them with theories that might be both outdated and ungrounded in the actual reality of impact investing.
Check out the hashtag #impinv2.0 to follow our tweets this week and beyond.
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Jed Emerson is co-author of the book, Impact Investing: Transforming How We Make Money While Making A Difference, and a long time actor in sustainable investing and social enterprise. He coined the term Blended Value and has written extensively on the pursuit of financial returns with social/environmental impact. He is Chief Impact Strategist with ImpactAssets and Senior Advisor to three family offices executing "all in" impact investing strategies to asset management.