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:
- Additionality - Key take away: An investment that could be easily replaced by another investor without any impact on the company is not an impact investment, even if the company itself creates significant impact.
- Market Rate Investors - Key takeaway: Fiduciaries are rationally averse to novel markets, models, teams and structures unless there is a corresponding chance of return above and beyond “the market rate” Novelty creates risk that, without that corresponding upside, will drag returns down across a portfolio.
Now, to combine those ideas:
- an investment with additionality is one for which, by definition, an oversupply of willing investors are not available, and
- usually it is not because of an explicitly low rate of return, it is because commercial investors have options to earn the same projected return elsewhere without the added risk that comes from novelty, and
- unless you are operating in the rare and temporary instance where the market is seeing added risk where none exists, over time your portfolio of “market rate impact investments” will underperform an equivalent non-impact portfolio because occasionally one of those risks chickens comes home to roost
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!
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:
- all your friends probably already know,
- you have to expend extra energy keeping up the illusion of what you said you were in the first place and
- you are going to have to come out sooner or later.
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:
- 70-80% of them would decide to do nothing, and that's OK because they're already doing nothing and patting themselves on the back for how awesome they are
- 20-30% of them would decide to dome something, and that's awesome
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)