A risk-based segmentation for impact investments

‘Impact Investing’. Rarely have two words held so much promise, yet have such a broad scope around what it actually encompasses. For those not familiar, impact investments are generally seen as investments actively targeting social impact alongside financial returns. Depending on the investment, risk-adjusted return expectations can either be market-rate or below market-rate.

While most broadly agree that impact investing is a hybrid between traditional investment ideas and spending by philanthropies & government, there has been little discussion around how to frame these investments based on their risk-return characteristics. Without clear articulation of an impact investment’s risk-return profile, it will be difficult to mobilize the collective capital needed for the sector to grow and scale.
Image Adapted from Sasha Dichter's blog post: Give Impact Investing Time and Space to Develop.

This post serves as an initial attempt to segment impact investments based on their risk-return characteristics. Starting with the GIIN definition of an impact investment — and its distinction between market and below-market rate returns —four general risk-return profiles governing the landscape of impact investments are proposed. It’s worth noting that these classifications are derived looking at impact investments at an individual-level; and not on a portfolio-basis.

1. Luxury (e.g. Patagonia, TOMS, Warby Parker)

These are impact investments in social enterprises that can charge consumers a "social premium" for their goods and services; which would then flow through to the organization’s activities to generate social impact. Whether it’s donating 1% of sales every year, or employing a buy one/give one model (for shoes, glasses, etc), the financing for social impact has to come from somewhere— and because its not from the shareholders, it has to be from the consumers.

The similarity drawn here between these social enterprises and luxury brands are that both rely on the perception of brand value, and the means to afford it. The risks to financial return are clear: limiting mission drift to preserve brand value, and the affordability of the goods/services. To the extent that these social enterprises can successfully keep their core consumers engaged, then: “doing good”, is quite literally “good for business”.

2. Partner (e.g. pay-for-success)

These are investments into specially designed financial vehicles where public, private, and non-profit sector players partner to jointly finance and execute intervention programs addressing social issues.

The private sector (investors) provide upfront capital for the intervention, non-profits execute the intervention program, and the public sector (government) pays a return depending on a minimum level of social impact generated — hence the term "pay for success". The most mature examples of this type of financing are recidivism-reduction social impact bonds (in the UK, NYC, and recently launched in Massachusetts).

From a risk/return standpoint, financial returns are directly linked to the risk of the social impact not being realized. Risks to generating social returns may be a function of factors like: risk of the effectiveness of the intervention methodology, operational risk of the non-profit, credit risk of the government payer etc.

To make the risk/return profile commensurate with investment substitutes, new financial cashflows have to be created (usually by the government), and be sufficient to cover the risks. These vehicles are essentially risk transfer programs from the public sector, with a heavy dose of financial engineering.

3. Venture (e.g. BoP markets, science research)

This is the messiest grouping of impact investments, as the definition of a ‘venture business’ can be broad. The easiest way to recognize these impact investments is by the significant amount of risk associated with individual business investments. Sometimes these risks are not quantifiable.

Just like traditional venture capital, investors are betting on broader macro trends while simultaneously placing lots of bets to get the diversification needed to balance out the portfolio-level risk-return equation. In addition, financial returns may also be disproportionately affected by risks related to a specific geography, political regime, or illiquidity.
Impact investments in the venture category usually target basic societal needs that have historically been the responsibility of the government. Opening this up to “market based solutions” can have advantages in efficiency, but also should be treated with caution. It is imperative here that the mission is preserved — given that many of these organizations will be pseudo-substitutes for government intervention.

4. Catalytic (e.g. philanthropic risk-capital)

Catalytic investments are the use of philanthropic dollars to kick-start opportunities that otherwise wouldn’t exist, or, to balance the risk/return profile for early-stage experimental impact investments.

Given that this capital is “philanthropic”, there are no financial shareholders to report to. As long as social returns are generated in-line with the organization’s mission, then any financial return — be it none, break-even, or even slightly positive, can be seen as a successful outcome.

It will be interesting to see this form of capital deployment evolve as philanthropies experiment with different leverage strategies (vis-a-vis private capital) to maximize “social returns”. Some examples that are worth noting, and their implications, are listed below:
  • Bloomberg Philanthropies —  By taking a first-loss position in the NYC Rikers Island social impact bond deal, Bloomberg has effectively written the first non-profit credit default swap/insurance contract. As more philanthropies start taking these types of exposure, new quantitative risk/capital management expertise will be required.
  • Acumen Fund — By deploying patient capital to catalyze new markets and further investment, Acumen is doing what governments are traditionally expected to do with respect to “infrastructure" investments. With philanthropies not bound to short term cycles (i.e. election cycles), they will perhaps be an increasingly important stakeholder in social impact discussions.
In Conclusion

By framing impact investments in terms of their risk and return characteristics, we can aspire to:
  • Better identify the appropriate funding stakeholders for certain types of risk-return profiles.
  • Better understand stakeholder roles and responsibilities in affecting the numerator or denominator of the risk-return equation.
  • Systematically identify where new data and metrics are required to facilitate the efficient matching of supply (capital) and demand (risks).
Only then can traditional investors comfortably enter into the impact investment space and fulfill the potential that the many of us see in it.