Unleashing the Power of Impact Investing: The Intersection of Profit and Purpose
In this article, we explore the transformative power of impact investing, a rapidly growing approach that balances financial returns with social and environmental good. We will delve into how it compares with traditional investing, its rising significance, the current market size, strategies for risk mitigation, and what the future holds for this purpose-driven form of investment strategy.
Comparing Traditional and Impact Investing
In an evolving investment landscape, impact investing has emerged as an attractive investment strategy that offers both financial returns and positive impact. Despite this, many investors still incline towards making finance-focused investments, often referred to as “traditional” investments, and this preference is not without its rationale. Finance-focused investments often demonstrate a tendency to generate higher short-term returns due to a variety of factors, including the market's familiarity with well-established industries and companies, historical performance trends that facilitate relatively quick investment decisions and the attractive liquidity of publicly traded assets that allow investors to swiftly buy and sell shares.
In contrast, impact investments, which pursue a dual mission of financial and social/environmental returns, are often made in emerging markets or sectors, thus leading to higher risks and volatility, compared to traditional investments. Moreover, a large number of impact investments have private equity or debt structures, potentially complicating asset sale or transfer. Impact investing may require longer periods to realize returns, thus requiring patience from investors.
Nevertheless, impact investing is gaining momentum as an approach that aims to achieve a triple bottom line, pursuing not only financial gains but also the purpose of promoting positive environmental and social change. To fully appreciate the significance of impact investing, it is important to delve into its underlying goals, the wide variety of benefits it presents, and the transformative power it possesses to shape both the investing landscape and the world in which we live.
The Rising Significance of Impact Investing
The business world is currently undergoing a shift with a renewed focus on sustainability and societal good. The conventional understanding of “returns” has been steadily evolving to encompass a more comprehensive view that includes social and environmental outcomes in the equation.
This transition comes at a time when global challenges such as climate change, social inequality, and biodiversity loss demand urgent attention and innovative solutions. Investors are increasingly acknowledging the significance of integrating environmental, social, and governance considerations into their investment strategies. This shift in mindset is contributing to the growing traction of impact investing, which aligns investments with the broader needs of the planet and society. One of the key features that sets impact investing apart from other forms of sustainable investing, such as ESG investing, is intentionality, which refers to the investor’s deliberate aim to generate positive and measurable social or environmental impact through their investments.
Impact investing responds to the needs and interests of all stakeholders of the business - i.e. their employees, local communities and local environmental ecosystems. These interests are increasingly recognized and protected by global governments committed to meeting the objectives of the Paris Agreement—such as achieving the 1.5-degree Celsius goal through decarbonization —and the Sustainable Development Goals (SDGs), which target a wide spectrum of most pressing global challenges, including poverty alleviation, improvement of healthcare, and the preservation of global ecosystems.
But what is the significance of impact investing in a broader sense and can it drive a systemic change? Indeed it can! This can be illustrated through the Multi-Level Perspective (MLP) theory, which describes socio-technical transitions, including sustainability shifts.
The landscape embodies the broader context (such as climate change), the regime represents the established paradigm or way of working, and niches include radical alternatives that challenge the current regime.
The Multi-Level Perspective (MLP)
Impact investing can be linked to the Multi-Level Perspective (MLP) by financing niche innovations involved in sustainability that disrupt existing norms and practices. Impact investing plays a key role by providing funding and support to these early-stage ventures, accelerating their experimentation and development.
As these innovations demonstrate their positive impact and feasibility, they attract more investment and attention, leading to scaling-up – a critical phase in the interaction between the niche and regime levels of the MLP. The success of niche innovations in attracting resources can eventually lead to a regime-level transformation. Impact investing has the potential to create a positive feedback loop, accelerating the growth of sustainability-focused ventures and encouraging a broader shift towards investment practices that prioritize social and environmental impact.
With the landscape factors, such as climate change, resource depletion and social inequality, coupled with evolving sustainability regulations (including transparency regulations such as SFDR and CSRD in the EU), it is only a matter of time when sustainability-oriented companies will reshape the current regime. The question here is: will you contribute to this change?
Impact Investing by the Numbers
The momentum behind impact investing is significant. According to the Global Impact Investing Network (GIIN), the global impact investing market has been consistently expanding, exceeding USD 1 trillion in 2022 globally, with SDG 8 (Decent work and economic growth), SDG 13 (Climate Action) and SDG 5 (Gender Equality) constituting the majority of impact investments in 2022.
Source: Global Impact Investing Network (GIIN), 2023
The younger generation of investors, especially millennials and Gen Z, is showing growing interest in sustainability and social justice. Their investment decisions are likely to align with these values. For instance, 86% of millennials are attracted to impact investing, and millennials are twice as inclined as the older population to invest in funds that support social or environmental causes, according to the report published by Morgan Stanley. The investment landscape is adapting to accommodate the needs of the sustainability-conscious investors, channeling capital towards businesses that demonstrate a commitment to positive change.
As impact investing grows in size and popularity, a key question remains: can impact investing offer both attractive financial returns and social/environmental impact?
According to the results of the latest Annual Impact Investor Survey by GIIN, the significant majority of respondents reported not only meeting but also exceeding both their impact objectives and financial expectations through impact investing:
Source: Global Impact Investing Network (GIIN), 2020
Transitioning to concrete examples, one noteworthy example is the African Development Partners III private equity fund, which strategically aligns investments with Sustainable Development Goals (SDGs) 5 (Gender Equality) and 10 (Reduced Inequalities). The fund focuses on promoting the growth of businesses led by women as business owners, employees, and consumers, thereby fostering empowerment and contributing to economic development.
Job creation, a key objective of the fund, resulted in 5,000 new jobs for women through the previous ADP Fund I. The fund achieved 4 successful exits, yielding a net internal rate of return of approximately 25%.
Following example is the Indian fund Omnivore, which invests in Indian start-ups engaged in developing technologies for food and agriculture, with the dual mission to make agriculture more profitable and sustainable. As of 2022, the fund supported more than 12 million smallholder farmers, creating for them a total value of USD 1.3 billion, while achieving an above-market rate of return.
Final example includes The Danish Climate Investment Fund (KIF), which provides financing to low-carbon and climate-resilient projects in low- and middle-income countries. KIF’s portfolio companies contribute to reducing greenhouse gasses (GHGs) and to climate change adaptation. Measured outcomes include the creation of 30,000 direct jobs and a comprehensive reduction of GHG emissions from sustainable energy investments based on a conservative estimate of about 4,100 tons CO2 equivalent per DKK 1M invested. Regarding the financial returns, the fund yields a net internal rate of return of 12% per annum.
Strategies for Mitigating Risks in Impact Investing
Now that it was established that impact investing can indeed strike a balance between achieving meaningful societal and environmental change and delivering above-market financial returns, the question could arise: what are the impact and financial risks of impact investing and how to address them?
One of the primary concerns for impact investors is the risk of not achieving the expected financial returns. Just like traditional investments, impact investments can be influenced by market fluctuations and economic conditions, as well as by unquantifiable risks, resulting from a lack of historical performance. De-risking strategies include diversification of portfolios across different asset classes and geographies, spreading the exposure and reducing the impact of any single investment's financial performance. Moreover, investors should carefully evaluate their investment horizon and, depending on the liquidity needs, consider allocating only a portion of their portfolio to illiquid impact investments.
Moreover, impact investors also consider one more set of risks, relating to the accomplishment of impact goals of an investment. Tracking progress in regards to impact involves having strong evidence, including a well-defined impact strategy developed collaboratively with stakeholders. Credibility of evidence can be enhanced when the method of intervention is supported by scientific approaches, such as randomized control studies. However, such studies can be costly, especially for early-stage companies, so credible methodologies can also include case studies and qualitative analysis.
The Future Trajectory of Impact Investing
Impact investing is on an upward trajectory, with experts forecasting its market size to exceed $2 trillion by 2030. Beyond serving as a mere investment strategy, it has the capacity for transformative impact, playing a key role in closing the yearly $4 billion financial gap required to meet the United Nations' Sustainable Development Goals (SDGs). As demonstrated, with sound risk management strategies, impact investors can achieve a portfolio that delivers both solid returns and meaningful impact, so isn’t it time to make impact investing central to the investment approach?
