Capital enables companies to expand, innovate, and take risks, which gives them the unique ability to address some of the world’s most pressing challenges. Investors looking to generate a financial profit while also contributing to socially-conscious companies and entrepreneurs have turned in recent years to impact investing. How exactly does impact investing work? What challenges exist in this sector? How do these investments perform, both in terms of social impact and financial returns?
View the Executive Summary for this brief.
In southern California, the city of Compton is considered a food desert. Roughly 20% of residents live below the poverty line, which limits their access to affordable, good-quality fresh food. In most of the city, restaurants are almost exclusively fast food and food stores sell almost exclusively packaged goods.
This is why many residents take advantage of Everytable, a grocery store offering healthy food options at affordable prices. Sam Polk, founder of Everytable, grew up in Los Angeles and knew the problems his city faced. After spending some time on Wall Street, he came back home “to address the vastly unequal access to wholesome food that creates troubling health consequences across Southern California’s lower income communities.” Polk’s business model “placed his underlying goals of community health and healthy food access on equal footing with the need to generate financial profit that would allow him to expand.” Everytable has expanded to 9 locations across the Los Angeles area, thanks in part to impact investments.
Everytable is one of the start-ups supported by Acumen, a nonprofit global venture fund that invests “philanthropically-backed investment capital” in early social enterprises. Founder and CEO Jacqueline Novogratz says the goal of impact investing is “to bridge the gap between the efficiency and scale of market-based approaches and the social impact of pure philanthropy.”
She describes it this way (1 min):
Read more on the story of Acumen and Everytable here.
What is Impact Investing?
Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit.” Common types of investments include stocks, bonds, and exchange traded funds (traded on stock exchanges). Generating a profit is a central component of investing. The Foundation for Economic Education explains that profit is the reward for taking economic risks, such as investing in entrepreneurs’ ideas. Without the potential for profit, there is little investment; without investment, there is little innovation and economic growth, two key components of social transformation that increase societal well-being.
Impact investments focus on the combination of profits and social transformation. These investments are “made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” This type of investing – also related to socially responsible investing (SRI) and environment, social and governance (ESG) investing – uses capital “to address the world’s most pressing challenges” in areas from renewable energy and sustainable agriculture to affordable housing and education.
Kevin Peterson explains, and exemplifies how impact investing is working at the local level across the country through community foundations. Kevin Peterson encourages people to invest their money locally, work with local banks, and talk to financial advisors about impact investing options (9 min):
Investments depend on the strength of the economy, but the economy cannot prosper “if vast swaths of the country are physically or digitally unmoored from the opportunity to participate in growth.” By making “measurable social and environmental impact” just as important as financial return and risk in every investment decision, impact investing opens the door to establish “a new set of economic systems” that address these critical gaps and create a more competitive economy.
Putting it in Context
How Does Impact Investing Work?
There are three key components of impact investing:
- Having the intention to make positive social or environmental impact through investing;
- Gaining financial return on capital, or at least a return of capital;
- Measuring impact by tracking the social and environmental performance of investments through transparency and accountability metrics and targets.
This spectrum of investing from Sonen Capital breaks down these components:
Portfolio managers hold about $15 trillion in assets based on ESG criteria; ESG investing accounts for about one-third of total U.S. assets under management. Bloomberg puts the global total at $35.3 trillion (differences in categorizing ESG funds also affect estimates of total investments).
Avenues for Impact Investing
There are a number of players in the world of impact investing, from financial institutions and private foundations to individual investors and family offices. Depending on the type of impact an individual or an organization wants to have, there are different avenues of investing. Sopact breaks down the social impact ecosystem:
- Governments, individual investors, and even pension funds that supply capital are “impact funders.” In the case of individual investors, for example, banks, financial advisors, and wealth managers can provide their clients with investment opportunities.
- “Impact managers” leverage assets to advance ESG goals, such as what Acumen does. Another example could be community development financial institutions (CDFIs), private financial institutions such as banks, credit unions, loan funds, and venture capital funds that are “dedicated to delivering responsible lending to help low-income, low-wealth, and other disadvantaged people and communities join the economic mainstream.” Hedge Funds such as Impactive or venture capital companies such as Impact Engine also manage funds, although these investments tend to be longer term.
- This capital flows down to the “impact makers,” such as social enterprises like Everytable or B Corporations that “are legally required to consider the impact of their decisions on their workers, customers, suppliers, community, and the environment.”
The Role of Government
The government can play a role by supporting the market through policymaking. One early attempt was the Community Reinvestment Act (CRA), which Congress passed in 1977 with the intention “to encourage depository institutions to help meet the credit needs of the communities in which they operate.” The Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board (FRB) and Office of the Comptroller of the Currency (OCC) are responsible for checking depository institutions’ records. In this way, the government can foster exchange between local business and investors.
Through public-private partnerships, the government can be involved and encourage impact investing. The Riegle Community Development and Regulatory Improvement Act of 1994 established the CDFI Fund to promote “economic revitalization and community development through investment in and assistance to Community Development Financial Institutions (CDFIs).” The federal government offers resources and programs that “invest federal dollars alongside private sector capital” through the fund.
The government can also be an investor. In Seattle, for example, the local government’s Regional Equitable Development Fund “used limited public funds to leverage larger private investment by offsetting the high cost of acquiring and constructing affordable housing.” Analysis of the fund indicated it leveraged five private dollars for every one dollar in public spending. Matthew Eldridge and Rayanne Hawkins of Urban Institute suggest state and local governments can be “cooperative partners with impact investing projects,” but add that impact investing is a local endeavor. A large federal role that does not take into account local needs is likely to backfire. Additionally, with government involvement comes the risk for market distortion that could result in less return on investment or even diminished innovation, especially since federal programs are extremely complex and can overlook small grassroots innovators without a localized approach.
Challenges and Considerations
Impact investing is relatively new to the financial sector, and while there have been improvements over the past few years as it has gained momentum and popularity, investors are still searching for ways to access high-quality investment opportunities. They call for more research on market activity, and for professionals with the skill sets to help highlight opportunities and manage investments.
Capital is what allows companies to expand their offerings and take risks, but impact investing is not so simple. In the world of impact investing, businesses need to both turn a profit and make an impact; meanwhile, investors face the difficult challenge of identifying in advance companies that can successfully make a positive difference.
Investment performance, in terms of social and environmental impact and in terms of financial returns, needs more research. Studies investigating financial outcomes of impact investing “found that socially responsible investments yield higher returns than conventional ones, others found the opposite, and most found no statistically significant differences between the two return.”
A 2021 report from the NYU Stern Center for Sustainable Business and Rockefeller Asset Management analyzed over 1,000 studies published between 2015 and 2020 that looked at the relationship between ESG and financial performance. The study found that:
- Sustainability initiatives at corporations appear to drive better financial performance due to mediating factors such as improved risk management and more innovation;
- ESG investing seems to provide downside protection, especially during social or economic crises;
- Improved financial performance due to ESG criteria becomes more apparent over time;
- ESG disclosure alone does not improve financial performance, but rather ESG measures that assess a firm’s performance.
The chart below breaks down the percentage of studies where there was a positive, neutral, or negative relationship between ESG and financial performance. Investor-focused studies analyzed the direct relationship between ESG and financial performance. Corporate-focused studies analyzed mediating factors such as innovation and risk management, and how those affect financial performance.
In the Global Impact Investing Network’s 2020 annual survey, most respondents said their portfolios met their financial and social impact expectations, and about ⅕ of respondents in both cases said their portfolios exceeded their expectations.
It should be noted that exceeded expectations does not necessarily mean the rates of return were exceptionally high. One study from the Centre for Economic & International Studies found companies “that score low on environmental, social, and governance (ESG) indicators exhibit higher than expected returns.” Robert Armstrong of Financial Times agrees, saying most impact investors “have to choose between their values and their pocket books.” They understand that by “providing subsidised capital to projects that are very risky but have a big upside for society,” they accept the trade-off of potentially lower returns in exchange for positive social outcomes. Much more research is needed to help investors understand “how much their investment returns will differ between an impact investing fund and a general index fund” to help them identify opportunity costs. For example, the study from NYU and Rockefeller was based on correlation, not causation, so the exact reasons why ESG was correlated with positive performances is unclear.
- Want to address a problem that is neglected by other investors
- Accept a level of financial sacrifice
- Have “an informational advantage over other investors that allows them to reliably identify promising opportunities.”
Hillebrandt and Halstead also acknowledge that businesses “can sometimes drift from their core values and mission,” which means owning equity in the company can help an investor prevent this from happening. But when this is not the case, they argue investors may be more successful, in terms of profit and impact, if they invest for profit and donate to effective charities.
Many experts have noted that mutual funds and exchange traded funds focusing on ESG have made a lot of money for investment firms, particularly in 2020 and 2021. Whether this amounts to a real-world impact beyond engaging companies is activism still heavily debated.
In 2010, fewer than 20% of companies on the S&P 500 index published sustainability or corporate responsibility reports. By 2021, 92% of S&P 500 companies published these reports. Even so, sustainability reports are not as easy to find as financial reports for companies. Even companies that do report ESG criteria do not do so in a standardized way. The nonprofit B Lab endeavors to provide clarity in this realm by holding companies to transparency and accountability requirements. Its B Impact Assessment is “a rigorous assessment of a company’s impact on its workers, customers, community, and environment.”
This approach is gaining traction; BlackRock CEO Larry Fink has been vocal in how to use the power of investments to specifically address climate change. BlackRock is the world’s largest asset manager and manages $7 trillion in investments. In a letter to investors, Fink asked companies “‘to disclose a plan for how their business model with be compatible with a net-zero economy’” and show “‘how this plan is incorporated into your long-term strategy and reviewed by your board of directors.’” In particular, he is urging companies to make these changes now, rather than wait for regulators to impose standards, to help investors make more informed decisions. Learn more about what Blackrock is doing with iShares, which focuses on exchange traded funds (as in stock exchange) and ESG.
Such certifications and transparency can help people decide if they want to invest in certain companies, but there are also no standardized performance metrics to measure the social and environmental impact of their investments; financial returns in a portfolio are much easier to see than social or environmental impacts. The Sustainability Accounting Standards Board seeks to do for sustainable investing what the Financial Accounting Standards Board has done for accounting by focusing “on sustainability’s financial impact on a company and what that means for investors.” The Global Impact Investing Network (GIIN) also hopes to create a commonly used method with its IRIS rating system to evaluate the impact of investments.
From B Analytics, the Global Impact Investment Rating System (GIIRS) applies “sustainability criteria to private investments made through venture capital and private equity funds.” This system takes into account the overall business model of the company, operations policies related to government, community, workers, and the environment, and also measures the “impact intent” of the fund based on the governance, accountability, and transparency of companies.
Board of Directors’ Responsibility
Governance (the “G” of ESG) refers to corporate governance, “a system of controls and procedures by which individual companies are managed.” A board of directors specifically is seen as “the central pillar of the governance structure, serves as the link between shareholders and managers, and acts as the shareholders’ internal monitoring tool within the company.” A concrete responsibility for boards of directors is to act in the interest of shareholders, those who have invested in the company. This means that if impact is part of shareholder value, it needs to be measured and protected by the board. For example, part of the B Corporation Certification process involves companies amending “their legal governing documents to require their board of directors to balance profit and purpose.”
This is why accountability and transparency measures are necessary for impact investors to consider before investing their capital; without these measures available, companies run the risk of investors passing them by, or of withdrawing support. This also addresses the problem of greenwashing, or “conveying a false impression or promoting misleading information to a potential consumer” about the progress of ESG goals.
An example of boards of directors in action is community foundations, public nonprofit organizations that facilitate or pool donations that are then used to address the needs of communities by providing grants to local charities. A community foundations’ governance chooses how to distribute funds; ultimately, the board is “responsible for ensuring that the funds are managed and dispersed in accordance with all laws and policies.”
All across America, there are “gaps in employment, housing, education, health care, access to banking services,” and these areas usually lack mainstream finance. Impact investing can “fill these gaps and address long-standing issues of disinvestment” and unequal access to opportunity. CDFIs and other “mission-driven banks” that provide opportunities to these underserved areas are small. “Grants, equity investments, the creation of an investment fund, deposits, and technology support are a few direct ways that private companies and philanthropic organizations can partner with these institutions.”
Professor Katherine Klein of the Wharton School at the University of Pennsylvania discusses how impact investing can address gaps created and highlighted by the COVID-19 pandemic (10 min):
Addressing gaps will enable individuals to unleash their creativity and put innovative ideas into action through social entrepreneurship. While entrepreneurial success can be wrapped up in a “franchise model, measuring impact based on the number of people reached and the amount of wealth accrued,” social entrepreneurship shifts the focus to the kinds of projects that “affect laws and policies, and influence mindsets, cultures, and systems” in efforts to correct global problems.
The Ashoka’s Women’s Initiative for Social Entrepreneurship, which offers fellowships for female social entrepreneurs, found that compared to males, female Fellows worked more collaboratively and closely with other community organizations, and were more likely to report that influencing societal and cultural attitudes was a key part of their strategy.
At the same time, women entrepreneurs tend to have a harder time fundraising and networking than their male counterparts, and report they are often not listened to or given decision-making power. According to the World Economic Forum, in terms of economic participation and opportunity, gender parity sits at “a lowly 57.8%, which in terms of time represents a massive 257 years before gender parity can be achieved.”
Investing in social entrepreneurs is one way to fill such gaps in opportunity by providing the capital that allows individuals to use their ideas and creativity not only to lift themselves up, but to solve complex problems affecting communities around the world.
The concept of impact investing prompts us to contemplate how our investments affect the world around us and whether they reflect our values. The value businesses generate by hiring people or producing goods and services for society is not the only consideration; whether it be by fostering a thriving local economy or benefiting the environment, impact investing suggests there is another dimension to consider when evaluating and investing in a project.
The first steps are:
- Understand what your values are and think about what steps you could take to make an impact. The Policy Circle offers briefs to help you further understand the complexity of the challenges that society faces.
- Decide on the vehicles that you will use for impact investing:
- Explore community foundations in your area, or consider starting one yourself;
- Find social enterprises that you can invest in, or start one yourself;
- Consider investment guidelines for your funds.
- Seek out resources that can help you make your decisions: