Are impact investments less risky than non-impact investments? If not, could policy make them less risky?

Some skeptics argue that impact investing will never succeed because any set of goals beyond pure optimization for financial returns will yield sub-optimal returns (assuming again that investors will always prioritize financial returns). Others (including myself) subscribe to the theory that a number of companies exist where there are strong financial and impact returns to be had in this “middle ground” (please conceptualize this middle ground as a set of companies that neither generate solely financial returns nor solely impact returns, but rather generate both).

My professional experience so far in consulting, venture capital, and private equity so far suggests to me that there are many companies in this category. When investing in these companies, impact returns come at no cost because you are still choosing financial returns (and by that logic you are not choosing to forsake financial returns to instead choose impact, as is a common misconception about the cost of buying impact).

Setting that aside for a moment, consider the following: what if impact investments have criteria that make them more attractive to investors even at a lower IRR? I think there are two key questions that, in the condition that certain answers to them become true, have answers that could suggest that impact investments with a lower IRR could be more attractive than comparable investments with a higher IRR:

1. Is there a lower risk profile for impact investments relative to otherwise comparable non-impact investments?
2. What could entice investors to always choose impact investment opportunities when they become marginally less attractive than non-impact investments?

Let’s look at three potential investment tradeoffs that an investor might face in order to illustrate that being able to offer high social impact returns by itself is not enough to convince investors to further allocate to impact investments.

Scenario 1: Consider an investor faced with two possible investments where the only difference is the amount of impact returns generated:

• Investment A: IRR 15%, IMM 15% (I have written about IMM here)
• Investment B: IRR 15%, IMM 14%

The investor is always going to choose Investment A because the financial returns are equal, and the social impact returns are greater. Even if you don’t really care all to much about social returns, you still care about returns in general, and no matter what the return is, if you can have more, you probably want more. Investors want greater returns! I anticipate that nobody will look like the Home Alone poster while reading the above.

Scenario 2: Consider instead an example where the fulcrum of choice rests on IRR rather than IMM:

• Investment A: IRR 15%, IMM 15%
• Investment B: IRR 14%, IMM 15%

In this example, the investor will choose Investment A, because the social impact returns are equal, and the IRR returns are greater. This example is a bit more cut and dry: investors have fiduciary duties to their clients, and this typically manifests as a responsibility to achieve the greatest financial returns possible.

Scenario 3: Lastly, consider a less obvious choice. The previous two have been no brainers because there was no tradeoff; one return profile exceeded that of the other. Consider instead this example:

• Investment A: IRR 14%, IMM 15%
• Investment B: IRR 15%, IMM 14%

In this scenario, Investors will choose Investment B. When given the choice between superior IRR or superior IMM, fund managers and traditional capital allocators will always choose superior IRR (unlike institutional philanthropic capital as I have written about here, who may choose Investment A). That’s the nature of the fiduciary duty at work — most investors have clients that trust them to maximize financial return wherever possible.

Last month I attended a webinar where someone made a comment along the (paraphrased) lines of “It’s unfair for traditional impact investing to be judged against the yardstick of ‘market rate returns.’” When you consider Scenario 3 above, this is a totally unreasonable statement. If you think of Investment A as an “impact investment” and investment B as a “non-impact investment,” and you take the previous statement at face value, then impact investing is doomed to be nothing more than patronage from impact philanthropic capital providers. On to the two key questions:

Is there a lower risk profile for impact investments relative to otherwise comparable non-impact investments?

I had the idea for writing about this while re-reading Marks’ The Most Important Thing. Consider Scenario 4 below:

• Investment A: IRR 15%, IMM 15% (impact), $100M investment required
• Investment B: IRR 15%, IMM not calculated (non-impact), $100M investment required

These investments are entirely identical from the standpoint of traditional capital allocators. While I like to think that investors will always choose A, the reality is that their mandate is to make money — not do social good. So while in a personal decision making capacity they may clearly favor Investment A, in a professional manager capacity, they are neutral.

But if you could somehow prove that impact investments have a lower risk profile than non-impact investments, then the investor becomes no longer indifferent to the two investments, and would prefer Investment A. Consider the same two investments, but with additional information (Scenario 5):

• Investment A: IRR 15%, IMM 15% (impact), $100M investment required, 1% possibility of write-down
• Investment B: IRR 15%, IMM not calculated (non-impact), $100M investment required, 2% possibility of write-down

In this case, if you consider outcome values associated with each investment in a simple expected value calculation factoring that factors in the risk of each investment going to zero, then you quickly see that investment A is worth $99M, and investment B is worth $98M. If you can prove there is a reduction in risk associated with impact investing, then you could factor this into your decision making to better understand risk-adjusted return profiles and to thereby be better able to choose between investments. At the margin, this exercise would result in a number of impact investments generating financial returns that are more attractive on a risk-adjusted basis (that is, should it hold that impact investments have characteristics that make them less risky).

I personally am skeptical that all impact investments have lower risk profiles, so for now this is an academic exercise. Research has shown that the ESG risk premium delivers excess returns; it’s not inconceivable that impact investing (ESG or another strategy) eliminates risk at the margins. By doing so, this would categorically make some impact investments more attractive than other options because of comparable risk-adjusted returns, when previous consideration of returns without quantification of risk would show that they deliver a lower risk-adjusted return.

What could entice investors to always choose impact investment opportunities when they become marginally less attractive than non-impact investments?

The Fed is printing trillions of dollars right now (read: Matt Levine). They are doing wacky things like categorically buying credit assets to “stimulate the economy and prop up credit.” Some contend that expansion of the Fed’s operations will distort market prices, sustain numerous zombie companies, and so forth. These may be true; I am at best a monetary policy hobbyist. But I gather that the Fed can do many things now! I don’t expect that the following idea will be implemented but, while the Fed is doing new things, I might as well throw in my suggestion:

I think that someone (probably the Fed because they can print money) should put backstops on the potentially losses of impact investments (specifically impact investments verified by impact auditors, as I have written about here) in order to make the asset class categorically more attractive for investors. Consider Scenario 6:

• Investment A: IRR 15%, IMM 15% (impact), $100M investment required, 1% possibility of write-down, Fed backstops 1% of the investment value
• Investment B: IRR 15%, IMM not calculated (non-impact), $100M investment required, 1% possibility of write-down, Fed does not backstop the investment

In Scenario 6, Investments A and B are entirely comparable in every aspect except one: amount of write-down. If Investment A is written down, the investor loses $99M, because the Fed has backstopped 1% of investment value in order to incentivize investing in impact investments. If Investment B is written down , the investor loses $100M, because the Fed has not backstopped the investment because there are no externally audited impact metrics. Why would the Fed do this? To grow the asset of impact investing — the goal I am perennially strategizing about how to achieve. This could work either by backstopping the investments of capital allocators into impact funds, as well as backstopping the investments of impact managers into specific impact-generating firms.

Please read the following argument carefully. Let’s consider you are an investor that wants both financial and impact returns. However, your mandate as an investor is to maximize financial returns, so you actually are indifferent towards impact levels because you act not on your personal preferences, but on your fiduciary duty as an investor. An investment’s financial profile becomes more attractive when returns are backstopped. As an investor, you would prefer the impact investment because it is backstopped (even if only at a marginal amount).

The reality, however, is that investments don’t often go to zero, so the cost of implementing this program if you are the Fed would be very low. The effect would be that you shift capital towards impact investments at the margin; for every pair of impact and non-impact companies with identical profiles outside of impact returns, the impact company will now receive the investment 100% of the time. This creates a market feedback loop that says impact investments will receive capital more consistently than non-impact investments, all else equal. This market feedback loop would encourage the creation and success of impact-generating firms, which I hypothesize would be better able to withstand the novel forces that have hampered start-up success in the past decade, but that warrants its own paper.