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December 19, 2022

How to make the most of impact investing

Investors increasingly want to use their capital to achieve an environmental and social impact while generating a return. Impact investing offers a solution to these twin goals, representing a fast-growing asset class that both facilitates positive change and resonates with a growing investor base.

By Matt Christensen

impact investing
Impact investing: the challenge of “doing good” and “earning a return” in a single investment. (Photo by amasterphotographer/Shutterstock)
  • Impact investing, which seeks a measurable social or environmental benefit as well as an investment return, is among the fastest-growing asset classes; interest has accelerated due to the Covid-19 pandemic.
  • Investors shouldn’t need to trade financial returns for impact – in fact, greater quantification of impact returns could help support financial returns.
  • An emerging body of industry standards for impact investing is enabling more accurate reporting while growing numbers of investment options – across both public and private markets – are making impact investing more accessible.

With the rising frequency of major environmental events and social movements – from floods to wildfires, and #MeToo to Black Lives Matter – the objective of making the world a better place has gone from personal choice to global necessity. Last year’s UN Intergovernmental Panel on Climate Change report issuing a “code red for humanity” represented another urgent wake-up call. 

Moreover, the Covid-19 pandemic revealed some profound social inequalities, and many investors have become increasingly aware of the role their capital can and should play in addressing these imbalances. The pandemic and events since, such as the war in Ukraine, have magnified the existing funding shortfall needed to meet the UN Sustainable Development Goals (SDGs) by 2030. 

According to Force for Good’s latest annual report, the total cost of achieving the SDGs has increased by up to 25% in the last year alone, from $116–142trn to $134–176trn. This has been driven by systemic underfunding, high inflation, increasingly urgent requirements for hitting net zero, and an ever-shortening window in which to get this all done. 

While investors have become increasingly aware of the role their capital should play in addressing environmental and social concerns, the challenge has been to combine the twin goals of “doing good” and “earning a return” in a single investment. 

Impact investing offers an answer by providing a credible and scalable pathway to balancing a targeted, measurable and beneficial environmental or social impact on the one hand, with a financial return on the other. As a result, it has transitioned from the realm of direct private-market investments into a significant and expanding market segment. Where investors previously thought only in terms of risk and reward, they can now add a third dimension of oversight to their portfolios: impact.

More opportunities are driving growth in impact investing

The Global Impact Investing Network (GIIN) values the worldwide investing market at $1.164trn. This still represents a very small proportion of global assets, but it is a space that is growing at pace: GIIN valued the market at $715bn as recently as 2020. 

This growth has, in part, been driven by an increase in investment options across the various impact asset classes. Whether through public or private instruments, investors can gain exposure through fixed income, equities, real estate, infrastructure and other real assets, and private equity and venture capital investment vehicles.

How the investment industry makes sure impact investing delivers

The future growth trajectory of impact investing depends on the industry demonstrating where these investments are being directed and why – and how the impact can be measured and reported. Debate continues about what constitutes an acceptable or competitive rate of return from these investments.

Consensus has also emerged that impact investments should contribute to at least one, and preferably several, of the 17 UN SDGs. The involvement of the private sector will be critical to helping achieve these goals, not least because of the increasing shortfall in investment capital needed to finance the SDGs.

To assist with framing impact investments, GIIN has outlined several requirements. As the investment industry coalesces around these standards, an increasing number of private-market participants are developing initiatives around minimum requirements and identifying best practices and audit processes for impact projects and investments. Examples include the Operating Principles for Impact Management and the Impact Management Project.

Raising the bar on transparency and reporting can help the industry deliver on its promise and insulate itself from accusations of “impact washing”, where funds make claims that are not substantiated by any relevant and demonstrable positive impact. In addition, monitoring the progress of investments in achieving impact against expectations helps improve decision-making and delivery.

The breadth and depth of impact are developing very quickly

The notion of “co-investing” with sovereign and corporate entities to support transition strategies can be integral to impact investing. An example is the growth of debt that carries an ESG label. The majority of this debt derives from green, social and sustainability (GSS) bonds, where proceeds are directed towards specific projects with an ongoing audit requirement, but these bonds are complemented by other structures.

Global issuance of GSS and sustainability-linked bonds stood at $992bn in 2021. Moody’s ESG Solutions has forecast that figure will hit a record $1.35trn this year, a 36% year-on-year increase.

Impact investing can also extend to blended finance, where investment from both institutions and philanthropic funds can be combined to create opportunities for commercial investors. Sovereign nations are also getting in on the act, where impact investing can complement initiatives such as the World Bank’s International Development Association lending to low-income economies. In 2021, Benin issued Africa’s first social bond in the international markets, raising money to broaden access to drinking water for its population of 12 million.

From identifying risks to creating solutions

The best-in-class investment approach is a well-recognised and accepted way of directing capital towards companies with above-peer or better-than-average sustainability profiles. However, this framework is still heavily skewed towards avoiding those with less favourable sustainability profiles, rather than prioritising those geared towards new technologies and services that provide solutions.

Impact investing touches on this notion both in terms of targeting solutions and in terms of the opportunity set. Many “handprint” opportunities, which seek to positively contribute to sustainability objectives, revolve around new technologies and services that seek to shift the mechanics of our daily lives fundamentally. These are often in an early stage of development, an area that has typically been the preserve of venture capital and private equity. 

Nevertheless, there is a trend both to develop these solutions and to scale them for wider applications that can influence sectors and geographies. Impact investing’s reach into both public and private domains means it can cover the full breadth of the opportunity set. Its success is in connecting to the changing nature of client demands by articulating a three-dimensional perspective – incorporating risk, return and impact – and demonstrating how finance can lead to positive societal outcomes.

Impact investing: what constitutes an acceptable return?

As impact investing’s investment options grow, attention is turning to the second goal of impact – “earning a return” – and specifically what constitutes an acceptable or competitive rate of return. Views on this question vary and have arguably become more diverse in recent years. An underlying premise of investing for many is a “risk-adjusted financial return”. But how can the return be adjusted to account for non-financial risks – and can the addition of a non-financial return be quantified to complement a financial return?

The finance industry continues to refine the methodology for integrating ESG or sustainability factors into investment decisions, but formally integrating these into valuation models for investments has presented a challenge. Investors have historically focused on cyclicality and longer-term secular trends, but see an increased focus on structural trends – for example, how a sector or company is aligned to changing expectations in the modern economy. Allianz Global Investors expects structural positioning to be a key factor for valuations.

A company or sector’s positioning in the modern economy, coupled with changing stakeholder expectations, could have a significant impact on assumptions regarding terminal growth rates, terminal margin rates, the weighted average cost of capital and, ultimately, access to liquidity. The term “stakeholder” is used since it better encompasses the full breadth of those assessing behavioural biases. Simply put, if an entity’s potential investor universe is too narrow, its financing options will likely be constrained and the associated cost of capital higher.

The flip side is that those sectors, companies and projects geared to providing solutions will likely benefit from improved perceptions. By providing access to a broader audience, impact investing can help increase their financing options, lower their financing costs and enhance their overall financial viability.

Measuring the return of an impact

Work on calculating the value of a non-financial return has led to metrics such as a social return on investment (SROI) or impact multiple of money (IMM). Once the targeted impact outcome is identified – along with the relevance of a product or project to that outcome – it is possible to estimate the economic value of those outcomes with appropriate risk adjustments, and thereby generate an estimated terminal value. Then, based on the degree of risk associated with the project or product, an appropriate discount rate can be applied to calculate the estimated social or impact return on the investment. This area is expected to develop further.

The case for market – not maximised – returns

Assuming one can accurately calculate and attribute both the financial and the non-financial returns of an investment, there remains the divisive topic of the balance between the two. Allianz Global Investors disagrees that there must be a trade-off between impact and financial returns. In fact, as non-financial returns become an increasingly important factor, they could provide a strong technical tailwind.

However, it may be difficult to target maximised rather than market rates of return. The difference lies in the associated risk attribution and adjustments tied to the expected rate of return. As such, fast-changing perceptions and attribution of sustainability risk factors could swiftly impact expected returns.

We like the notion of sustainability requiring an improving positive “handprint” coupled with the lowering of a “footprint”. The more the impact investment industry can qualify and quantify non-financial returns, the more likely these could not only complement, but also support, financial returns.

Disclaimer: Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Emerging markets may be more volatile, less liquid, less transparent, and subject to less oversight, and values may fluctuate with currency exchange rates. Investments in alternative assets present the opportunity for significant losses including losses which exceed the initial amount invested. Some investments in alternative assets have experienced periods of extreme volatility and in general, are not suitable for all investors. Environmental, social and governance (ESG) strategies consider factors beyond traditional financial information to select securities or eliminate exposure which could result in relative investment performance deviating from other strategies or broad market benchmarks. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

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