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What will become of impact investing?

The concept of “impact investing” has suddenly become one of the hottest topics in the world of finance. New investment funds are continually springing up that claim they operate according to their own version of impact investing. Meanwhile, in the international financial press, the word “impact” is often being used to refer to ESG investments (i.e. companies that factor in corporate commitment to environmental, social, and governance issues as investment targets). But what actually constitutes an impact investment?
We shared some reflections about the ongoing evolution in this industry with Luciano Balbo, founder of Oltre Venure and one of the first impact investors in Europe, who in 2014 helped set up the Impact Investing Lab at SDA Bocconi.
Impact investing emerged around 20 years ago, mainly as an advanced model of philanthropy and venture philanthropy, with the aim of pursuing financial and social returns through new scalable business models. The ambitious objective was to supersede the net dichotomy of profit vs non-profit, with investment targets that generated more patient and sustainable financial returns. So impact investing centered on the search for positive solutions via investment models (primarily following a venture capital approach) which could respond to the needs of society at large, and not only its most vulnerable members. From this viewpoint, targets of impact investing in its original form were the so-called “social impact enterprises” (SIEs).This expression was used to differentiate these companies from traditional social enterprises, both due to the business model itself (which aimed to combine the two types of returns in a single impact value proposition, which was at the same time commercially viable) and because of the gap in the demand which SIEs intended to meet, encompassing more than solely those in greatest need.
Till a few years ago, the sector was very small and off the radar for the most part, intently focused on generating impact business models in certain benchmark niche sectors, such as for instance microcredit for aspiring entrepreneurs who were not bankable; access to low-cost, high-quality health services; training and job placement for certain segments of the population who needed more assistance (young people, migrants, the disabled). According to the Global Impact Investing Network, today the numbers show a constant upward trend in the market (about +20% per year), with over 1700 active organizations and around 800 billion dollars in value. If in the past these organizations were the creations of foundations and international agencies (Development Finance Institutions), today the sector is more and more populated by asset management companies that invest with a for-profit rationale. The crucial question we need to ask is whether or not behind these numbers there is actually any real additionality, in other words, innovative solutions capable of making a bigger impact with respect to existing models. In fact, the real risk is that impact investing could lose its fundamental characteristics and simply become a way to refocus traditional venture capital. According to the report, “The State of European Tech” compiled by Atomico and Orrick, today more than 20% of the VC investments in Europe are channeled into what they call “purpose-driven tech companies.” An additional risk is that impact investing could represent a version of ESG investing, a place where investors go who want to avoid the trap of green washing or impact washing, or who intend to tap into the potential returns linked to business solutions that are in some way associated with Sustainable Development Goals.
But if we take a closer look at startups financed by impact investment funds, we can’t help but have some doubts, among the cattle ranchers using organic feed, or the bicycles producers who want to support the clean energy transition.
Today more than ever before we need courageous entrepreneurs and investors. And they need to look at the niche markets that have needs that neither the public administration nor the traditional market nor philanthropy are capable of responding to. The solutions would come in the form of business models that can be financed and developed with impact approaches and then possibly scaled up with impact capital, but with an eye to the secondary market.
The questions that up until a few years ago fueled the debate on impact investing seem to have become irrelevant today. There were three main threads running through this debate. Additionality, that is, the conviction of those we might call “purists,” who held that impact investing should concentrate on targets that can develop solutions that have yet to be invented, instead of putting money into existing business models. Financial returns, that is whether priority should go to financial over social returns and, more generally, if the true social additionality should intrinsically determine lower financial returns, at least in the short term. (This discussion later led to the emergence of two sub-categories: impact first and finance first.) Finally, measurement of the social impact as the true substance of what impact investing is, to preclude investments based on all talk and no action. In this sense, many metrics have appeared to measure impact, but clearly there is no such thing as a single unit of measure that everyone will agree on. So, although the aspiration to measure impact is fundamental, the truth is that the sector is exposed to forms of interpretations of impact investing that are quite broad.
In the beginning, the impact investing was driven by the idea that a “value chain” of actors could be built to identify and realize new impact solutions. Essentially, this would consist of entrepreneurs who aimed to contribute with new solutions to the needs of the community; investment funds (i.e. intermediaries) who backed them; and asset owners who opted to allocate part of their resources to this activity, even if that meant accepting lower or longer-term financial returns. Till today, the sector’s small size has made is impossible to assess the true impact. But one thing is clear. The high level of sector financialization begs a big question: can business models underpinning impact investing keep their DNA intact when they go from the seed/startup phase to start scaling up?
Here is Balbo’s answer to this question: “Let’s start by saying the impact investing is one of the biggest success stories in the world of finance. All of the sudden, in the last two years, the finance industry has embraced this concept, turning it into an actual cultural takeover. Today all the investment fund managers are putting together impact funds, in particular in private equity, funds that invest in established companies. So the additionality objective has disappeared, and they’re replacing it with metrics that make impact investing an extension of ESB investments. The lexicon of the industry has changed too. We’re no longer talking about entrepreneurs, or impact enterprises, or social innovation companies; instead it’s the investors who find interesting companies from a financial viewpoint, and then they apply their own social metrics. As a result, the aim of developing new models primarily oriented toward making a social impact is dissipating, and instead, the tendency is to identify social impact with already-existing firms.”
Basically, the industry is seeing explosive growth precisely because the concept of impact investing is a tremendously attractive, powerful one. It’s mobilizing countless institutional investors who need to include this type of investment in their portfolios, at a time when the word “sustainability” is trending. What’s happening, albeit with different numbers, is not unlike what occurred with ESG investments, which are at the center of the debate in recent months with respect to the credibility of the stated commitment of the companies who ostensibly embrace an ESG approach. In this context, even investors who are firmly convinced of the original idea of impact investing run the risk of their DNA mutating, and being swept up and thrust toward models that have little to do with the concept of additionality. The reason for this is that the funds that promise impact with higher returns, at least in the short term, have the potential to raise more capital.
Many economists, the likes of Hart and Zingales, are asking themselves whether maximizing welfare can serve as a substitute for maximizing market value. The signals from today’s market are fairly ambivalent, with regard to impact investing, corporate sustainability and ESG approaches. This observation was also corroborated recently by Harvard researchers investigating the real commitment of companies that are riding the wave of these new trends with their ostentatious declarations.
Legislative initiatives are underway to more effectively regulate ESG investments, and pressure is mounting from various think tanks such as Ronald Choen’s (one of the founding fathers of impact investing) in terms of measuring impact weighted profit. All this will inevitably serve to help create a clear differentiation between what actually creates additionality and promotes change, and what is a socially compliant or purpose-driven.