Impact Investing: What is it and Why Does it Matter?
Venture Capital & Social Impact: Oxymoron?
Venture Capital gets a bad rap. Right or wrong, the fundamentals of traditional venture investing tend to boil down to hard numbers. Valuations and balance sheets. Sometimes though, such a cold and calculated approach doesn’t feel quite adequate. To solve for those instances, there is a rapidly growing strategy to pursuing venture investments that considers more than purely financial metrics, bringing various types of non-financial impacts into the equation. That strategy is broadly referred to as Impact Investing, and in practice it involves investing with the intention of maximizing social and environmental impact alongside the traditional objective of generating a financial return.
The term Impact Investing covers a relatively broad spectrum of investment styles and vehicles. An equity investment in a for-profit entity pursuing renewable energy technology could be defined as an Impact Investment. A Convertible Note for a non-profit with a mission of building a national network of workforce housing could be too. Donor advised fund? You guessed it – also Impact Investing. As the category is relatively broad, the specific investment parameters are generally less important than the overarching objectives. The defining feature across this investment class is that recipients of Impact Investments generate some type of social or environmental return.
Vetting Impact Investments
In many ways, potential Impact Investments are analyzed and vetted the same way a traditional investment would be. Leadership teams are vetted, market potential is analyzed, and financial projections are examined. Financial returns remain an important factor in these types of investments, but with more factors at play than with traditional venture investments, investors in some instances may elect to accept below market returns in exchange for social or environmental impact. For example, a for-profit entity could choose to pay all employees a “living wage,” purposely operate in an underfunded or less profitable sector, or commit 5% of net proceeds to sustainable initiatives. An entity could simply operate in a sector where higher risk or lower returns were the norm, but where the potential for impact was great (think residential solar 20 years ago).These types of operating practices reduce the profitability of an entity and thus reduce its valuation potential and return, but these are exactly the factors that could make them attractive Impact Investments. Ultimately, the question that needs to be answered above and beyond the standard set raised in traditional venture investing is: What is the social/environmental impact, what is the cost of achieving that impact, and is the “tradeoff” worth it?
Measuring Impact
Measuring Impact is no cakewalk, but it is a critical component to analyzing Impact Investments, both pre and post deal close. When considering an investment, it comes as no surprise that investors prefer hard data. Although this relatively intangible facator is more challenging to measure, and ability to standardize, measure and compare imapct across time and ivnestments is helpful when determining whether to make an investment, and post-investment, whether a firm is meeting it’s impact targets. What strategies are available for measuring impact that doesn’t appear on financial statements? An article in the Harvard Business Review in Jan/Feb of 2019 titled “Calculating the Value of Impact Investing” attempts to answer that exact question. The article suggests a method of measuring what is referred to as Impact Multiple of Money (IMM). The method of measurement is broken down into 6 steps:
- Assess the Relevance and Scale: Similar to assessing the market potential of a traditional venture product or service, what is the market potential of the impact? How scalable is it?
- Identify Target Social or Environmental Outcomes: Generating quantifiable metrics is the goal here. Setting specific and quantifiable targets and measuring them against present values provides an effective method of measuring impact.
- Estimate the Economic Value of Those Outcomes to Society: Now that a quantifiable change has been identified, determine the value of the delta.
- Adjust for Risks: All projections are subject to some degree of variability. This risk should be analyzed, quantified, and built into the model.
- Estimate Terminal Value: All venture investments, Impact Investments included, are made anticipating a future exit and financial return. In this method, the terminal Impact value is calculated based on the Impact value as assessed above projected for the final year prior to exit.
- Calculate Social Return on Every Dollar Spent: Now that an Impact value has been determined, it can be calculated against an investment amount to arrive at a value that can be compared directly across investments.
Similar to many aspects of traditional venture investing, there is no standardized output, or even standard range, of this calculation. No convenient “If >10: Go, If<10: No-Go.” However, this measurement method does quantify impact in a way that provides investors an opportunity to view it from a more analytical perspective. With this data, an investment’s impact can be compared with other internal data points across a time spectrum, against other metrics within the individual investment and against other investment opportunities.
Accessing Impactful Opportunities
As important as understanding Impact Investing itself is understanding how to access investment opportunities. Perhaps the most accessible option is via Impact Funds. Similar in design to any other mutual fund, Impact Funds exclusively invest in opportunities defined by the fund management as Impact Investments. These funds lower the barriers to entry into Impact Investing by providing less capital intensive, risk mitigated, accessible opportunities in which to invest. Pursuing more targeted investments generally requires a little more legwork. There are many investment firms and groups that are either purpose built for Impact Investing or have developed impact specific arms. Investors interested in pursuing these investments would do well to research such organizations and inquire about how to get involved. The minimum requirements for individuals would generally be financial qualification as an Accredited Investor.
On occasion, Impact Investors may be presented with an opportunity to invest not in an entity, but in a specific project. Depending on the investment objectives of the individual investor, this can be an ideal solution where the investor is able to allocate resources in a way that meets very granular social objectives. A realistic example of this situation would be a mission driven organization undertaking a large capital project, a new or upgraded building perhaps, to expand the organization’s capacity. These types of projects often have large and complex capital stacks, and some portion of the stack if often made up of private investment capital. An investor with a specific interest in the organization in question of in the impact that the new or upgraded facility will have could participate in the financing of the project, generating a financial return while contributing to the social impact of the project.
