Impact Investment

A Practical Guide to Investment Process and Social Impact Analysis

Keith A. Allman

• Publisher: Wiley
• Year: 2015
• ISBN:
  9781119009818
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

Apply a rigorous investment process and integrate social impact analyses to successfully select and invest in social impact investments

Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis is a must-read guide for investors and wealth managers entering the social finance investment space known as "impact investing." This book walks readers through the demanding task of properly executing an impact investment strategy, providing solutions to some of the most vexing challenges that arise when investing for both financial return and social impact. Readers will learn how impact investing is different from other strategies, how the organization's mission affects investment decisions and structures, and what to look for in an organization prior to investing. A running example of a village distribution company illustrates the methods and concepts in action, and a full-fledged case study utilizing downloadable professional level analytical tools consolidates all examples into a real-world setting.

Impact investing is generating significant momentum, but many individuals operating in this space come from alternative backgrounds and lack the knowledge to form a rigorous investment process. Disparate funding sources, immature markets, variations in fund economics, and the need to generate and report social impact all complicate the industry even further, creating a barrier for curious investors. This book is a guide to applying standard investment processes and social impact analyses to impact investing, helping readers:

• Adjust standard analysis techniques to suit the particularities of impact investing
• Discover how social mission influences the entire investment from entry to exit
• Plan and execute a robust custom impact investment strategy
• Understand social impact entities and the management of impact investments

Investing with the goal of social impact doesn't remove the need for rigorous investment techniques and diligent processes. Impact Investment: A Practical Guide to Investment Process and Social Impact Analysis is a guide to putting it all together, for a more targeted approach to impact investing.

Chapter 1
Introduction to Impact Investing

It is an extremely tempting proposition: Invest money in a business whose product or service offers financial return and at the same time generates positive social impact. All parties seem to win, with an investor making a return and society benefiting. A charity could direct money into an organization that accomplishes the same social mission as one it grants to, but instead is able to receive back and reinvest the granted funds. What could hinder such a paradigm?

This idealistic form of capitalism has surged in the last few years. As of 2014, over USD12.7 billion has been committed to impact investing, representing a growth of 19 percent from the prior year.¹ Numerous investors are active ranging from lone high net worth individuals to a multitude of private equity funds. Even larger-scale financial institutions and investment firms have dedicated funds and resources to impact investing. Ancillary services have emerged to support these investors and further develop the industry including secondary market platforms, capital advisers who specialize in impact investments, and services to validate and rate social performance.

With such fervor, why does it still seem like the impact investing market is constrained? The simple answer is that it is not easy to both create a profitable business that has a significant social impact and also scale that business so that it generates commercial returns for investors and continues to progress its social mission. It comes as no shock, then, that for a number of years in a row, J.P. Morgan's impact investing survey cites “a shortage of high quality investment opportunities with track records” and a “lack of appropriate capital across the risk/return spectrum” as primary hindrances to the growth of impact investing.²

Part of the issue is that impact investing appeals to our senses and consciences through innovative solutions to pressing social problems. This thought should not be misinterpreted though, as many of the entities and businesses an investor encounters when reviewing social enterprises legitimately intend to or are actively creating significant positive social value. The problem is that a majority of these businesses are not commercially viable and will not generate the return that many investors require. Our morality wants to support these investments, so the industry has grown considerably to encourage social enterprises, but as investors, we must maintain a fiduciary responsibility and invest at the appropriate risk-return level.

However, as we seek to increase the scope of suitable investments, we run the risk of going over an inflexion point, where social impact has been compromised so much that the investment can no longer be considered an impact investment. This can either occur by investing in businesses that actually do not have significant social impact or by investing in a social enterprise that alters itself to become a traditional company. At that point, we have become traditional investors and the paradigm is lost.

We now find ourselves in a delicate situation, balancing financial viability, monetary return expectations, and social impact. How do we achieve the correct balance? As with most industries, the solution is basically hard work and being equipped with the right resources and knowledge. We must know how to look for the right investments and how to screen out ones that are not financially sustainable or demonstrating the right level of social impact. Once found, we must adhere to a rigorous investment process and vet a company to establish its financial and social value. The investment structures created need to properly balance risk and reward. Documentation needs to be done professionally to accurately reflect the structure created and the intentions of all parties. We have to endure far beyond the investment phase, helping businesses scale and exit positions with financial and social success.

It is easy to discuss the beneficial attributes of impact investing and package it in a way that sells a good story. The hard work is in proper investment execution. To get there, this book addresses the following:

• Knowing how to source deals domestically and internationally, while mitigating foreign exchange and business cycle risk
• Properly mapping out the social impact of a company and the metrics that prove it
• Being able to understand, build, and utilize multi-method valuations
• Drafting a term sheet that takes into consideration commercial and social mission risk
• Monitoring and managing an investment to ensure financial and social returns
• Understanding the economics and realities of leveraging other people's money in impact investment funds

Although a shortage of quality investments vis-à-vis investors exists and will most likely be commonplace with the high degree of interest in impact investing, excellent investments can be found that marry profitability and social impact. This book and the online resources that accompany it will assist investors in choosing the right investments, help align risk and reward, and contribute toward investors building financial and social value.

What Is an Impact Investment?

An impact investment can take many forms, but all share the idea that capital can be deployed into an entity making a good or providing a service that offers positive social impact, while also generating some level of financial return. The Global Impact Investing Network (GIIN), one of the major impact investing industry organizations, defines impact investments as “investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.”³ Critical to this definition is the intentionality of the investor to deliver on financial and social returns.

The form of investment can be as straightforward as investing money for shares of equity in a company or much more complicated, such as a convertible debt structure. Core investment funds may not even have to be exchanged, as in the case of credit guarantees. The unifying thought, though, is that an investor is committing capital to a commercial business, which aims to compensate the investor for his or her investment.

Geographically, impact investments can be made anywhere. Impact investments exist in emerging or developed markets, as long as the focus remains on coupling social or environmental impacts with financial returns. Although examples in developed markets are less common, programs such as investment funds that target small businesses in East London could be considered impact investments.

With all of these options, the two primary forms of investment into social enterprises are debt and equity, mostly in emerging markets. Much of the recent enthusiasm over impact investing has been targeted at investments in social enterprises. These are companies that are for-profit, but have created a good or service that provides significant social impact. Given their early stage and venture nature, the more typical form of investment in these companies is equity. Debt does come into play in impact investing, particularly with new debt funds creating specialized products, but equity is still the predominant force in early stage social enterprises.

Debt is also relevant for impact investing when we consider microfinance, which is a specialized sector of impact investing. Microfinance involves lending small amounts of money to individuals or groups of individuals, who then use that money to fund their own businesses. The borrowers agree to pay back the loan, plus interest. Microfinance institutions, which provide the direct borrower funding and collection services, have grown over the years and are recipients of debt and equity investments themselves. All of these would be considered a type of impact investment.

For the most part, what has been described so far are investments. An investor provides capital and expects return. The key differentiator for impact investing is the impact. We will work to define impact later in this chapter, but an impact investment differs from a traditional investment in that the core business product or service provides a positive social impact. A healthcare company that provides high-quality, affordable tiered services for low- to middle-income patients, for profit, would most likely qualify as an impact investment. A healthcare company that builds clinics for wealthy clients and donates 1 percent of profits to charity would most likely not be considered an impact investment. The social impact has to be engrained in the business operations, product, or service.

A specific feature of impact investing is the investor's engagement to measure and report on social and environmental performance and impact. Impact investments should aim to be evidence-based investments. This means the industry needs to build data on the type of interventions that have a positive development impact. Impact investors need to examine and share learnings on the combination of products and services, the type of designs, the pricing and distribution models, and the accompanying services that will result in positive societal impact on the targeted population. Obvious as it is, it may be worth reiterating: Without evidence, we will not make evidence-based investments. In this book, we go through the challenges of defining adequate impact models, identifying appropriate indicators to track, and monitoring and analyzing output, outcome, and impact indicators.

Who Makes Impact Investments?

As we will come to learn later in this book, no other field within finance has a greater disparity of participants than those found to be impact investors. Impact investors differ from traditional investors in a number of ways, but the most important differences relate to return expectations, investment holding periods, and investment motivation. To understand this varied landscape, we should start by looking at some of the oldest impact investors, government institutions.

The International Finance Corporation (IFC), a member of the World Bank Group, is one of the oldest, largest, and best-known impact investors. It invests in a large range of projects, from direct and indirect private equity investments to large-scale infrastructure projects. It would be considered a government institution because it is funded by World Bank member countries. There are a number of other large-scale government funded impact investors, such as IFC, Norway's Norfund, and the UK's CDC Group. The key to these types of investors is that they have a specific mission and seek commercial-style investments, but have a very low cost of capital and longer holding periods than average, which allows them to make investments that strictly traditional investors may not make.

Similar to government-funded investors, in terms of low capital cost and long investment time horizons, are charitabl...