There has been a lot of talk lately about impact investing “maturing”, even becoming “its own asset class” People talk about pension funds moving into impact investments, creating pools of tens of billions of impact investing dollars to fund new projects. At the same time mutual fund managers are staffing up to create impact investment products for their retail clients. Implicit or explicit in these discussions is the thought that an individual or institution can make a market-rate of return while also creating positive impact with their investments, that they can “Do well while doing good.”
The idea that you can provide market rate returns while also creating real impact is a myth, and it is a myth with real negative consequences.
I have written this post a couple of times and flushed it. I shared one version with a friend of mine who told me I sounded like the word police. If you ever want to really hurt my feelings, call me the word police. Anyone who has spent time in philanthropy or social justice knows that we waste a lot of time defining, redefining, parsing, defending and then reinventing terminology, often at the expense of actually, you know, doing stuff. So, it’s on me today not only to say why I think people are misunderstanding or misappropriating the term “impact investor” but also to explain why it matters.
Last week I wrote a couple of set-up pieces trying to define what I mean by impact investments (investments that demonstrate additionality) and market rate investors (investors who generate a rate of return across a portfolio of investments equal to an equivalent non-impact portfolio). To summarize the key point from each post:
Now, to combine those ideas:
I am going to repeat this last point because it is important and is often lost on smart people. You can invest in a bunch of projects which each, on its own, has the potential to provide a market rate of return, but if there are additional “uncompensated risks”, you are almost certain to underperform the market on a portfolio basis. So, there is such a thing as an individual market rate impact investment, but as you build a portfolio of them, the portfolio will underperform. As such, the market rate impact investor is a myth.
OK, now I'll describe three archetypical investors, each of whom professes to be doing well by doing good, and show you what goes wrong because they claimed to not have to make a trade off between returns and impact. I even made this handy graph to show you I have an MBA!
Archetype 1: The Symbolist
The symbolist wants to build a portfolio of investments in companies that are, broadly speaking, doing good things but have given their investment people strict instructions to “stay commercial”. (This is often a sofa bed solution to having one board member who is very interested in impact investing and another who is adamantly opposed to doing anything that could compromise returns.) The various fiduciaries understand this directive and, rather than investing in a portfolio of impact investments with additionality, they (rationally, given their mandate and professional ethics) invest in well-understood products that plenty of other institutions invest in as well: some thematic public equity funds, some muni and corporate bonds that fund solar installations, the fourth fund of a respected clean tech VC, maybe a timber manager they’ve used forever who happens to have a sustainability strategy.
What they build is a portfolio of fully commercial investments in some neat sectors with ZERO additionality. Because they have stayed in the part of the capital markets where capital is functionally infinite, their decision to enter “impact investing” has in no way effected the amount of capital available to businesses or the terms on which it is available. They have made a symbolic gesture. 95% of the new pension and retail “impact investments” fall into the Symbolist camp.
The easy compromise of the symbolist approach provides a way that the Board or family considering impact investing can stop arguing. But it is a compromise in which nothing meaningful is accomplished. No meaningful impact happens, something that pro-impact investing board member usually realizes 3 or 4 years into the new strategy, so they’re not happy. The board member who didn’t want to do something in the first place, they're not happy either. The real damage is that, in some sub-set of cases, had the Symbolic compromise not been offered, the board would have made the hard decision to actually consider investments with real additionality and accept whatever additional risk, diminished returns or higher investment management burden (more on this in a future post) that strategy required. So, my argument is, the Symbolic compromise deprives us of investment capital that could have been used to make real, additional impact.
Archetype 2: Rapunzel
Rapunzels are those who are serious about creating real impact and equally serious about meeting or beating the market. They set a high bar on each, they allocate some money, they assemble their team, they meet with everyone they possibly can over a 6 month period and declare . . . that nothing meets their standard. For two or three years after that, they are a fixture on whatever the relevant conference scene is, declaring their dismay that no one can scale their tower to claim the prize of their investment. The market is failing them!
Say what you want about Rapunzels, unlike the Symbolists they often dedicate real resources to searching for and evaluating investments. Unfortunately this means they waste a lot of other people’s time (mostly people trying to get funds or enterprises funded) trying to find investments that, if you buy my definitions above, don’t exist. They also, and this might just be the Rapunzels I have met, seem to always find a way to spin the fact that they weren’t able to build the magical unicorn portfolio that they invented in their heads as a failure of ingenuity of the people actually doing, you know, real work. For most of us, Rapunzels are a minor annoyance. For people raising money and building investment products, Rapunzels are major time and resource sinks and even more major . . . well . . . bummers.
Archetype 3: The Closet Case
The Closet Case declared at the outset that they were going to achieve impact and a market rate return on their portfolio, just like Rapunzel. But when they started looking at investment opportunities and saw that the impact deals had some extra hair, they (unlike Rapunzel) decided to invest in a few of them. They made some "market-rate" loans to impact enterprises that were having trouble getting financed elsewhere. They invested in a couple of first-time venture capital managers with an interesting thesis around serving unbanked and underbanked people. They found a couple of ecosystem services opportunities that, once a couple of state and federal agencies line up, could provide a nice return. None of the investments are explicitly concessionary, but they each have an extra wrinkle or two. The great news is, if they pick carefully most of these investments should be fine AND there is real additional impact! The bad news is that, over time, those uncompensated risks will effect portfolio return negatively (and the more investments they make and the longer they carry on, the more certain this is). And, they told everyone going into this that they were not going to compromise on returns. They are now a closeted impact investor.
The problem with being in the closet is that:
Seriously, you are beautiful just as you are. If they don’t like you, go get new friends.
But Pat, I thought nirvana was when impact companies could access the “regular” capital markets to fund their activity?
It is! The fact that a commercial wind project can now raise billions of dollars from investors who could care less that it is clean energy is a great thing. And all of the early investors (and rate payers) and developers of wind projects who spent decades standardizing and de-risking those projects should take a bow. But, having a separate pool of money in the capital markets that is now investing in commercial wind projects at the same terms as everyone else and calling itself “impact” helps no one (except maybe the investment bank that is taking some extra fees from their wealth management clients who want an “impact product”) It doesn’t make more projects happen. It doesn’t make them better or faster or cheaper or help them on any other meaningful metric!
I guess my main point, in case you TLDR’d yourself through most of this, is that, if all of these faux impact investors would think long and hard about what they wanted to do and how much risk they can legitimately take AND they were not being offered the “Have your cake and eat it too” solution of market rate impact investing, one of two things would happen:
Because some people actually doing something is better than lots of people just pretending to do something. More on that next time.
(p.s. I updated this a day after posting to fix an egregious number of typos. Apologies to those who read the first draft, I can't spell when I'm mad)
Welcome back to the second of two definitional sections of that will lay the groundwork on my upcoming post on the corrosive myth of market rate impact investing. Thursday I took on additionality. Today I want to talk a little about “market rate investors.”
This is a term that should sound silly to most of you. After all, in most of the world we call these people, you know, “investors.” But in our little corner of the world where people are granting money or lending at a discount or seeding new ventures with only the haziest notion of when the money is coming back, it is important to define “market rate investor”, by which I mean each of the institutions and individuals who are looking to meet or exceed the “market rate of return” across a portfolio of investments. This is tougher to define than you might think, as every portfolio has a different mix of assets that reflect different mandates, plus the projecting expected “market rate return” for a particular asset is a mix of art and science. I am not going to rehash any of that here as a) you probably know this and b) there are places you can go read about that which don't have silly pictures at the top.
Instead I want to focus on a few key elements of the investment world that are not always appreciated by outsiders (it is sometimes not even fully realized by people on the inside):
If it’s not clear already, I am telling this one from the perspective of someone trying to raise money for a new impact investment that offers a market rate of return. (The picture above is Cheap Trick, who wrote “I Want You to Want Me,” one of the ten best rock songs ever. Get it? Get it? I remind you that this blog is free)
OK, here we go.
You probably already know this, so I’ll make it quick. Almost all professional investors, be they individual fund managers, pension/endowment managers or consultants, are managing someone else’s money. They are fiduciaries (as opposed to principals.) Here is a fun drinking game: google the term “fiduciary”, click on any link and then take a drink every time you see the words “prudent” or “prudence”. Fun, huh? Ok, now go sober up. I’ll wait here.
So, we have a couple centuries of professional ethics telling finance professionals that their fundamental duty to clients and investors is to be careful. There is a ton of interesting debate about what it means to be a fiduciary, but for now let’s just leave it at this: finance professionals are generally amoral, anti-social libertarians with a confidence in their own opinions that has been scientifically proven to have no basis in fact. You want their professional ethics to generally be telling them to knock it off rather than egging them on.
There is also a simpler math to this risk aversion as well. There are a few corners of finance - early stage VC, certain hedge fund strategies, some kinds of prop trading - where you will see investors taking big risks with other people’s money, but this is always in pursuit of equally outsized returns. In most asset classes and most investments though, you don’t have the possibility of massive upside, so the way you make your money is by not making mistakes - by avoiding the investments that actually lose money. For all of the talk about risk adjusted returns, in my 20 years in and around finance, we spend way more time talking about controlling risks than we do talking about maximizing returns.
Think about it this way. Lets say you have a bunch of potential investments. 70% of them will succeed and each of those will have a return somewhere between 10% and 12%. The other 30% will fail, resulting in a 100% loss. As you are researching and making your picks, will you focus your effort on making sure pick the successes that return 12%, rather than 10%? Or will you focus on making sure you stay away from anything that has a chance of failing? What if I went further and said, “The 10% return investments are easy to identify, but the 12% investments and the ones that fail are indistinguishable at the time of investment?” In that case, the clear optimal strategy is to load up on the sure thing.
So, on one side we have a whole profession of fiduciaries who are bound by ethics and self interest to avoid any additional risk that doesn’t produce commensurate upside. - a rational aversion to novelty, if you will. On the other side you have new impact investments who think they have made it over the hump because they have read about all these new “market rate impact investors” and they have an investment that theoretically provides a “market rate risk adjusted rate of return” (whatever the hell that actually is) Only, there's a fundamental problem: their investment is novel as hell. It usually has a) an unproven market, b) an unproven strategy, c) a first time manage and/or d) a new structure. This means it likely has a higher chance of failure than another comparable investment, but the same potential return.
So to interest a prudent "market rate impact investor", it's not enough to offer a good return. You also need to be "de-risked" in a number of ways, most of which involve executing your strategy for five years and coming back after all the risks have been buffed away. But at that point, if you have actually been successful, any investor would be interested in looking at your fund. So what use was that impact investor in the first place?
Stay tuned . . .
I have spent the past few days working on what is becoming a very long post about the corrosive myth of the market rate impact investor. I hope you will like it. It has become so long that I have decided to carve out a couple of definitional sections as their own posts. So, if you get to the end of this and you think, “So what?” well, just wait. It is in service of what is coming: The greatest blog post in the history of blogs giving profanity laden advice to foundation boards who are interested in impact investing and are not too put off by the aforementioned profanity. That’s right. I am pointing at the fence. Let’s hope I do not disappoint. And with that . . . . additionality.
Additionality is an annoying word. Like most annoying words, it has two fundamental traits:
Additionality is a term that I believe was first widely used in the carbon markets. It describes the concept of specific attributable added benefit of doing something versus not doing that thing. In the carbon markets this is very important as they are assigning monetary value to projects based on the specific calculable carbon impact of the funded activities.
Let's use a simple example. Say you need a fence, and I have some money with which to help that fence get built. Consider three options:
The concept of additionality doesn’t work perfectly for everything: as you can see field building grants do poorly versus direct programmatic support, but it is generally a good way to weigh the relevant merits of different ways of spending your money. High additionality? Good. Hazy additionality? Let’s keep talking. No additionality? Get lost. Simple, right? But there is a point that some people don't get.
You Can Invest Money in a Project that Demonstrates Additionality and Still Have an Investment with ZERO Additionality
Maybe you are rolling your eyes at how obvious this is, but it is a concept that seems to blow past many people, especially with regard to impact investing. Let’s consider another hypothetical, this time an impact investment. Let’s say you care about increasing the supply of affordable housing in your home town of Cheboygan, and you have a million bucks burning a hole in your pocket. You can do one of three things with that money- build, buy or lend.
If you want clear additionality, invest in projects that wouldn’t happen without you and/or provide your investment on better terms than others are willing to provide. Easy peasy Alouisey, as we say in Cheboygan. But what if you have been tasked with producing a “market rate” of return as well? Why didn't anyone else want to lend her the money?
That’s my cliff hanger. And, um, sorry there wasn’t more profanity.
I’m going to try to be contentious today. So, let me start by saying to my friends with whom I serve on boards, you are wonderful people. To those foundation Boards I have reported to over the course of my career, you are smart and fair and attractive and have great taste in music. To the foundation boards who I are kind enough to hire me as a consultant from time to time . . . uh . . . well . . .
Foundation boards are choking the life out of philanthropy. And if we don't fix them, much of the innovation happening around us will die on the vine.
People transitioning from the private sector roll their eyes at various aspects of philanthropy when they first show up. As someone with a foot in each world, I can see both sides. I’m not overly sympathetic to the old “this needs to be run like a business” trope. It’s often something an insecure person says to establish their “serious person” bona fides while they scramble to figure out what specific improvements they can actually suggest. But there is one element of “foundation shock” for which I have full sympathy.
Old Hand: Hey new guy, we are so glad to have you here at XYZ Foundation
New Person: Thanks so much. You know, I have been working in this field for 20 years, and I couldn’t be more excited to put my expertise and networks to work. I want to learn as much as I can and then make some really good grants.
Old Hand: Yeah, we’re excited to have you. You’re the cream of the crop, and your fellow program officers are also experts in their respective fields. Bob over there ran an elementary school out of a yurt for 5 years and speaks seven languages. Susan has two PhDs and invented coffee ice cream. We have great relationships with our grantees - we work hard to treat them with respect and learn as much as we can from them. They are genuinely amazing . . . ahem . . . well, most of them. Anyway, it’s a real privilege to work here. Except maybe those weeks we send out Board Books.
New Person: Board Books?
Old Hand: Yeah, they are these packets of memos our team of experts slave over and then send out to a group of strangers once a quarter. Then after a week or so that group of strangers, most of whom don’t read the packets, come in and make all the actual, you know, decisions. In a day. Four times a year.
New Person: Wait, what?
And . . . scene. (Note: XYZ Foundation is not an actual foundation. Hyperbole added for emphasis)
Most US foundations require board approval for every grant (or impact investment) they make. These boards usually meet 2, 3 or 4 times a year, and are comprised of family members, senior advisors like lawyers or the family office managers, and, most often, people who have been invited on to the board because they head a large company or non-profit in the community. These people are generally smart and take their jobs seriously. Sure, there are a few occurrences of malfeasance - self dealing, blatant patronage or other truly unethical behavior - but those examples are so few and far between that I am going to ignore them entirely for now. The changes I recommend are also good for catching the real bad guys, but I think foundations have much more of a “scared of their own shadows” problem than a bad guy problem. Well, except for LiveStrong.
Foundation boards are by nature conservative bodies (That’s “conservative”, not “Conservative".) Although most are technically structured as “majority rules”, every one I have encountered operates on a consensus-based approach. If one board member is vocally against a grant, it doesn’t happen. In addition, most board members are keenly aware of their role as stewards of capital that isn’t theirs. Their number one objective is to make sure the money isn’t being “wasted” or “misspent.” Those two characteristics taken together - consensus based decision making and a focus on avoiding mistakes - are already a recipe for institutional conservatism. But it gets worse.
Program officers are usually a non-profit’s main point of contact with a foundation. Program officers are judged by by different criteria at different foundations, but almost all of them are judged by whether most or all of the proposals they bring to the board are approved. Even if there is no punishment for failure, it often feels wrong to ask a non-profit or social venture to make the effort to make a proposal if you don’t know whether the Board will respond favorably. So, again, there is a natural incentive to present opportunities that are similar to those the Board has approved in the past. And there is a disincentive to spend time on projects that are new, different or have a high chance of failure.
From the applicant side, there is the double whammy of intermediation and delay. By intermediation I mean that your primary interaction is with a program officer who won’t be the final decision maker. You feed information into the PO hopeful that it will get to the Board members without too much distortion. You get minimal feedback back after a decision, often from a PO who reasonably doesn’t know, or doesn’t want to share, the deliberations of the board. The totality of the feedback is often, “Yeah, they were in favor of making the grant. I'll get the award letter to you by Friday” or “Some liked it, but a couple of board members thought you weren’t ready. Let's talk next year." Couple this communication issue with delay, the fact that often you wait several months for a response and you have a recipe for frustration. Many of the best people raising impact investment capital skip foundations entirely because they can't handle the 3, 6 or even 12 months it takes to get an answer.
Using the board as the primary decision maker doesn’t serve any of the three constituencies:
- Non Profits and Social Ventures - face long delays and black box decision making with minimal constructive feedback on applications. Those trying new, high risk strategies find it hard to get proposals in front of Boards because of the above-mentioned structural conservatism.
- Program Officers - are simultaneously disempowered and not held accountable for their recommendations because, at the end of the day, these are the Board’s decisions. Most POs I know go to great lengths to manage applicant expectations during the long “We’ll see how they respond to your proposal, I’m really hopeful they say yes” period, but it’s hard to not feel like a glorified waiting room attendant. Additionally, part of a PO’s job is usually babysitting a couple of “Board favorites”, long term grantees of the Foundation which Board members like but staff all know are not performing.
- Board Members - let’s not forget these qualified, good hearted people, most of whom are receiving no compensation for their hard work. They are being asked to approve a slate of grants (or impact investments), often many in one meeting, almost always without enough time or information to make a truly informed decision. After all, you spend one or maybe two days a quarter on this. And you have a legal duty to ensure that the foundation funds are being spent in keeping with the foundation’s charitable mission and in compliance with all applicable law. So, of course you are going to be conservative in your decision making, even if you have a nagging sense that the whole organization is ossifying before your eyes.
So if it is so bad, why are almost all foundations run this way?
Short answer, because this is how we’ve always done it. Slightly longer and snarkier answer, foundations at inception are built by lawyers, not by the people who will work there. A lawyer is paid to make sure nothing bad happens, not to maximize the potential for philanthropic innovation. From her perspective, the key question is: “How do I make sure that this new entity meets its legal obligations to spend money in keeping with its charitable purpose and in compliance with state and federal law?” The answer is, she will name five board members who are legally responsible for compliance with the law, and then she will have those five board members approve every pay out the Foundation makes. She will attend every board meeting as well and any time a board member asks her, “Can we do this?” her default answer will be, “It’s technically possible, but to be safe, I’d recommend we pass on doing that for now.” And she’s not wrong!! From her perspective, she has minimized the odds that any of these people will ever go to jail. That’s her job. But I would argue that it is a massive overreaction to a tiny tiny risk (the number of Foundation board members who have ever been charged with something other than knowingly criminal behavior . . . . it’s a short list, it may be a list of zero) It’s as if you decided to manage the risk of being eaten by a shark by never leaving your basement for the rest of your life. I mean, sure, risk managed, but there were easier ways to accomplish the same thing.
OK, smart guy. If you’re so smart, what’s the answer?
Ok, it’s going to hurt me to type this, but here goes . . . Foundations need to be managed more like businesses.
A corporate board of directors, when it is actually doing its job, basically does three things:
Stop laughing, I said “when it is actually doing its job”
The way I see it, foundation boards should get out of the grant approval business and get into the oversight business. They should:
Let’s take those one at a time. First, grantmaking power needs to be put into the hands of people who are closest to the organizations doing the work - whether that is program officers, staff committees, outside experts, peer reviewers or some combination of those. These people need to be given the freedom to take risks and use all of their knowledge and networks to be the most effective grant makers possible. That is step one. Step two: hold them accountable. There are a million ways to define effectiveness: performance metrics, peer reviews, external evaluators, even grantee surveys. The point is, the job of a board should be to hold staff accountable for performance, however it is defined. Evaluating performance is a much better use of a group of outsiders who meet one a quarter than making individual deployment decisions. If you don’t think your staff is capable of making individual grant decisions, or you don’t like the grants they’ve made, go find better staff. Most POs I know would gladly trade job security for more autonomy.
Second, debating and approving multi-year strategy and annual budgets. This gets to the heart of a board’s reason for existing - ensuring that the funds are being spent in keeping with the mission of the foundation. Strategic questions - thinks like “Given our experience over the past 10 years, should we expand our work in affordable housing?” or “Given our grandfather’s wishes when he set up this foundation, should we approve a new program working in developing countries?” - these are the kind of questions that a Board can and should dig in to with help from staff. The fact that they don’t work at the Foundation everyday can help because they have some critical distance. Answers to these questions naturally express themselves in the form of budgets. “We’re going to spend $2 million on affordable housing over the next two years. We’re going to evaluate it in this way, and we’re going to look at that information before we consider another allocation in two years.”
Third, the board should make sure the foundation is meeting all of its legal responsibilities - pay out, charitable purpose, compliance with relevant law. This is serious business but it is easily accomplished through audits and sensible financial oversight. To my earlier point about hiding in your basement, it is silly to build your whole process around it. In addition, in those rare cases of real malfeasance, a Board should be separate enough from day to day operations that it can look at them critically.
That’s it, that’s what a board should do. It gives them plenty of control over the direction of a foundation without disempowering staff and confusing the hell out of prospective grantees.
Why does this matter?
I believe we are entering an era of unprecedented philanthropic innovation. Just in my little corner of the world we have impact investing, benefit corporations, grants to for profits, pay for success programs, ecosystem service contracts, public private partnerships, and in any of these there are opportunities for great impact and a bunch of opportunities to royally step in it. For foundations to play the role we need them to in supporting innovation, they need to be able to actively participate in the iterative process of innovation and take sensible risks quickly, and that means pushing decisions out of the board room. Boards can then focus on the really big question: which of these innovations actually work?
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.