Impact Investing: What is it and why consider it?
Now more than ever, companies are increasingly measured not only by their revenues, but also by the societal impact they have. As a result, impact investing has now become mainstream. The Global Impact Investing Network (GIIN) estimates that the current size of the impact investing market hit $715 Billion in 2020.
GIIN defines impact investing as any investments into companies, organizations, and funds with the intention to generate positive, measurable social and environmental impact alongside a financial return. An impact investor targets a range of returns from below-market to market rate, depending on such investor’s strategic goals. Implicit in this definition of impact investing are two core elements, which are (i) intentionality, meaning the investor’s intention to have a positive social or environmental impact through investments; and (ii) investing with return expectations, meaning the investments are expected to generate financial returns on capital, and in some instances, just a return of capital. In an impact investor’s playbook, impact comes first and financial returns second, and the investor may be willing to receive reduced returns where impact is evident, depending on the strategic goals of the impact investor.
One fascinating thing about impact investing is that it challenges the archaic views that social and environmental issues should be addressed only by philanthropic and government funding and that private capital should focus exclusively on achieving financial returns. Today, the impact investing market offers diverse and viable opportunities for investors to advance social and environmental solutions through investments that also produce financial returns. As mentioned above, impact investors have diverse financial return expectations. Some intentionally invest for below-market-rate returns, in line with their strategic objectives, while others pursue market-competitive and market-beating returns, sometimes required by their fiduciary responsibility. Thus, addressing social or environmental issues and achieving financial returns should not be viewed as mutually exclusive.
Moreover, solving our biggest social problems requires private capital. The United Nations estimates that between $3.3 to 4.5 Trillion per year needs to be mobilized in order to achieve the 2030 Agenda for Sustainable Development. Philanthropic donations and government funding is not enough to meet this need; thus additional private capital, through impact investing, would be required to fill this gap. Therefore, a combination of private investment alongside philanthropy and government spending will be vital to solve more social problems globally.
An Argument for Investing Where the Return Is Social Change highlights that impact investing provides a middle ground for investors, which is a little more impact for a little less return. This differs significantly from the approach of wealthy philanthropists, who give money to nonprofit organizations to bring about social change without expecting any financial return. Even then, this middle ground approach has been greatly criticized on the basis that while the wealthy can take such risks for low returns, most investors cannot. Investors in many of the typical impact funds would not be willing to accept lower returns for riskier investments. Thus, while getting market-rate return is something impact investors are comfortable with, it would appear that a lower return makes it harder to attract other investors to the impact investing industry. In GIIN’s 2020 Annual Impact Investor Survey, most of the investors surveyed pursue competitive market-rate returns, with 67% pursuing risk-adjusted, market-rate returns, and only 23% percent pursing below-market rate returns. It is thus clear that impact investments with lower returns generally narrow the number of investors the impact investing industry would attract.
Impact Investing and Environmental, Social and Governance (ESG) – Any difference?
Another interesting aspect of impact investing is the difference between ESG and impact investing.
ESG refers to a framework used to evaluate a company’s environmental, social and governance risks and practices. The consideration of ESG factors began in the public markets as investors sought a framework to consider risks to sustainability. More importantly, the ESG framework also considers risk factors that do not lend themselves to financial statements but are material to the sustainable operation of a company. Thus, the integration of ESG factors is used to enhance traditional financial analysis by identifying potential risks and opportunities beyond technical valuations.
While there is an overlay of social consciousness, it is important to note that the main objective of ESG valuation remains financial performance. This means that assessments of ESG factors are aimed at helping investors to identify risks that might be material to financial performance. This is materially different from the objectives of impact investing. Impact investing exclusively seeks out companies whose primary products and services are directly tied to a measurable positive social or environmental impact, while also hopefully generating market-rate returns. Thus, the key difference is that impact investing is more focused on the positive social or environmental impact, while ESG typically warrants better financial returns.
In the 2022 Letter to CEOs written by Larry Fink (founder and chief executive of BlackRock), he clarified that the focus on ESG issues does not conflict with making money. For example, reducing a company’s carbon footprint makes the business more resilient in the long term, which is in investors’ interests. Mr. Fink wrote, “make no mistake, the fair pursuit of profit is still what animates markets; and long-term profitability is the measure by which markets will ultimately determine your company’s success.” He also noted that BlackRock focuses on sustainability not because the investors are environmentalists but because they are capitalists and fiduciaries of their clients. The 2022 Letter lends support to the view that the main objective of considering ESG factors is purely to help investors identify risks that might be material to financial performance. Unlike impact investing’s focus on the positive social or environmental impact, ESG is financial performance driven.
Today, the impact investing industry is full of success stories. It is expected that more investors will become optimistic about the industry and think differently about the power of their capital, which would lead them to invest more in impact investments. While GIIN estimates that the current market size of the impact investing industry is $715 Billion as of 2020, it will be interesting to see how much growth the industry will experience in the next decade.
Funmilayo Fenwa is a Corporation LLM candidate at NYU and serves as a Graduate Editor of the NYU Journal of Law & Business. Prior to attending NYU, Funmilayo worked as an M&A and Project Finance lawyer for over three years at Olaniwun Ajayi LP, a top tier commercial law firm in Nigeria. She graduated with first class honors in law from Nottingham Trent University, England.