Can multi-strategy impact investment firms grow impact investing as an asset class?

Loosely put, impact investing is investing for both a financial return and specific, measurable, and beneficial social and environmental effects. I think it’s a morally sound goal to want to grow impact investing as an asset class. A lot of people have issues with capitalism these days; while I wouldn’t touch the subject of “changing the system” with a twenty-foot science pole, I do want to suggest that within the system we have, it’s important to steer towards providing positive social benefits alongside healthy returns. It’s a good way to keep the system inclusive — the more people that benefit from it, the better.

Right now, however, there is not that much attention paid to impact investing. The questions explored in this article include: Who pays for impact (e.g., who are the people financing impact investors)? Why do they do it? What institutions does the group of people who pay for impact need to consist of in order for the asset class to become more than a cottage industry? How do you get that to happen?

Who pays for impact?

Right now, philanthropic capital (endowments, foundations, and high net worth individuals) pays for a majority of impact investing. This constellation of philanthropic-minded institutions and “people with money” generally give impact investment funds most of their money (they are referred to as the limited partners or impact investment funds, or LPs, although this is not specific to impact investing). Impact investors then use that money given to them by philanthropic capital sources to go about their day job of impact investing.

The focus here is on institutional philanthropic capital, or more specifically, endowments and foundations. An example that just about everyone has heard of is the Bill & Melinda Gates Foundation. For now, please keep a hypothetical foundation or endowment in mind. Institutions such as these have two objectives that are relevant to this article: to make enough money to increase in size (“growing”), and to give away enough money to create a positive social impact (“giving”). One of the central characteristics about institutional philanthropic capital operations is that entities must give away 5% of their assets every year in the form of grants and operating charitable activities; the “giving” part of the business mentioned above. On the growing side, investment activities are the same as any capital allocator: generate as much money as possible.

Growing the foundation is important because as the foundation grows, so does the amount of distributable “giving” capital. Consider the example below:

Year 1

— Foundation size = $100M

— “Giving” amount = giving 5% of $100M = $5M

— “Growing” amount = assuming 25% returns on $100M = $25M

— Net foundation size = $100M + $25M — $5M = $120M

Year 2

— Foundation size = $120M

— “Giving” amount = 5% of $120M = $6M

— “Growing” amount = assuming 25% returns on $120M = $30M

— Net foundation size = $120M + $30M — $6M = $144M

And so on. As you grow the fund from which you are able to draw upon for funding charitable initiatives, you grow your impact footprint as you are able to fund more on the “giving” side (although it is still considerably lower than the overall “growing” amount, or the total foundation size).

Within institutional philanthropic capital, where does impact money come from?

Right now, impact investors largely rely on institutions providing capital under a category of investment called program related investments (PRI). PRI investing standards are set by the IRS as investments that are relevant to the charitable mission of the philanthropic capital institution; meeting PRI standards is crucial for tax purposes (PRI investments receive favorable tax treatment). Most importantly, PRI investments come from the “giving” side of the institutional philanthropic capital allocator, which means that they are unfortunately constrained in size (recall the math above). You may wonder: why does PRI exist? The answer is actually quite clever: PRIs allow an institutional philanthropic capital allocator to provide money to serve an impactful purpose, and then later re-distribute that same money again to another cause once the original investment has been recouped.

One of the bottlenecks to growing impact investing as an asset class is that institutional philanthropic capital is tiny. To date, the largest institutional philanthropic capital entity is the Gates Foundation, with an endowment of $47B. Saying this amount is tiny may sound crazy, but in the grand scheme of things, that is only a small percentage of all institutional capital: sovereign wealth funds, asset managers, insurance companies, pension plans, etc. For example, CalPERS alone, the pension plan of just one state, has assets in in excess of $400B. If I had to guess, I would say institutional capital is somewhere in the realm of $50-$100T worldwide.

While the PRI investment mechanism may seem sufficient, the point I want to impress upon you is that the currently limited amount of PRI money is not enough to grow the asset class to a desirable size. Think of it like kindling and logs to a bonfire (we are trying to grow the fire like we are trying to grow impact investing as an asset class). Every bonfire starts with kindling, but if you want a big, hot fire, you eventually need big logs with some real mass to them. PRI money from institutional philanthropic capital is nothing more than kindling (it works for now while the fire is small), while real, substantive logs are the checks written by big funds like CalPERS.

To put the above more succinctly: (a) the LPs of impact investing are primarily institutional philanthropic capital, (b) institutional philanthropic capital is tiny, and © to grow the asset class, you need to attract capital from large institutional investors. How do you do that?

The first thing is to make money. PRI investments don’t have to make money, they just have to not lose money (recall that they are on the giving side). If you want to attract large sums of money, you should be good at making money for investors who are investing out of their “growing” side. Investors are expecting market returns within a given asset class, full stop. Whether or not that’s fair to expect of impact investments is beyond the scope of this article. Beyond achieving market returns, I argue here that the development of large, multi-strategy impact investment firms would help grow the asset class.

The world is awash with capital right now. Fundraising may be shaky because of the pandemic but I don’t expect that changes that truism of the current character of what Howard Marks calls “the supply/demand [im]balance for investable funds and the eagerness to spend them”. Frankly, capital allocators highly covet two things: places to put lots of money, and ways to achieve growth (there are always people who will pay for growth at any cost). The most well-known example of the former is Warren Buffett. Buffett is sitting on tremendous amounts of cash because it’s not easy to deploy over $100B and make attractive returns. I have a hunch that there are many people out there who are constantly scratching their heads thinking, “Boy what am I going to do with all this money today? There are just not enough good managers to give my money to. What to do, what to do…” I would wager that in the long run, we are going to continue into an environment where this supply/demand imbalance of investible funds and ways to deploy them to achieve certain returns thresholds, but if it’s true, then it means that there’s ample room for large multi-asset impact investment managers to step up to the plate and get a slice of the pie.

I’ve long had this opinion about the increasing proliferation of large(r) money managers, whether they be single strategy (Sequoia’s $8B Growth vehicle) or multi-strategy (Blackstone), but I’ve only recently begun to think about the application to impact investing. You could conceive of a few ways to attract more institutional capital by “rolling up funds.” I’m not suggesting you somehow start buying majority GP stakes and telling two investment committees they need to hold their meetings in the same room at the same time — in fact, I’m not really suggesting a playbook for anybody — but what I am suggesting is that impact investment managers should start to create scale in order to get larger LP checks from LPs trying to deploy large amounts of capital. What might this look like? I think three ways: you could integrate (1) industry focus, (2) investment strategies, and (3) asset classes.

The idea of industry integration is not new (and is rather commonplace among other investors). Consider a fund like Bain Capital; they have a technology fund, a life sciences fund, etc. I have a suspicion that with impact investing it might make more sense initially to have different industry investments made out of the same fund, because my hunch is that people think of “impact investing” as a singular strategy the way they think of “technology investing” or “life sciences” investing as singular strategies. A good example of an industry-integrated impact investor is The Rise Fund; they cover education, financial inclusion, and myriad other industries within a growth equity mandate.

The idea of investment strategy integration in not that new, either (though probably requires a bit more trust from your LPs). Consider education impact investing. You could take education impact investors at the venture level, the growth level, and the middle market buyout level and combine them (theoretically) so that instead of having a $150M, $300M, and $500M fund, you can call it a $1B fund. Normally, LPs would write checks to different funds, each with their own investment strategy, but I think there’s room to change when you’re at the frontier of an asset class. To start, it’s not like there isn’t precedent for having multiple strategies from within the same fund (I can think of a few), and moreover, there’s a good reason here to set precedent on why investing in this asset class should work like this. Although for illustrative purposes the previous example does the job, in practice, it’s more likely that a fund hires someone to expand their mandate (e.g., a venture fund hires a growth professional and expands scope).

The last point is the idea of integrating your fund across asset class. I’ve mostly stuck to describing “private equity” firms broadly in the above examples (from venture through buyout) but there are impact investors in other asset classes, too. This integration is probably the most difficult to pull off; I can only think of one fund that invests in different asset classes (public equity, private equity, and credit) out of the same fund, and they are only able to because they have a particularly unique evergreen fund structure and set of LPs (maybe they will be a case study for an impact asset manager down the road). Let’s consider public equity: an example of a public equity impact investor is Atlas Impact Partners, a long/short equity fund that takes long positions on firms solving environmental and social issues and takes short positions on companies whose operations have a detrimental effect on the world.

The point of any of these integrations is to make it easier to get larger checks from institutional investors. The following is a hypothetical example of how you could build scale as an impact asset manager. Let’s say you’re a fund manager managing a $100M fund focused on venture capital AgTech investments, and you have enough dry powder to be able to acquire other investment firms.

Putting it together:

1. First, you decide you want to start with industry integration. You spend a year searching for suitable fund acquisitions in the venture capital space and find a $100M EdTech fund and a $100M FinTech fund. You acquire both and now your venture capital fund covers AgTech, EdTech, and FinTech. For now, let’s assume you have really great lawyers and are able to combine the actual funds themselves, rather than have them exist as different funds within the same firm. From here, you can go to CalPERS and say “Hey: I now have a $300M fund and I need you to cut me a $25M check (8% of my fund size).” $25M is still too small for CalPERS (probably), so they say no.
2. Next, you decide you want investment strategy integration. You spend another year searching for other funds with growth equity and buyout mandates. You find (very conveniently) two firms you want to acquire: a $700M growth equity fund that covers AgTech, EdTech, and FinTech, and a $1B middle market buyout fund that covers AgTech, EdTech, and FinTech as well. You make the purchases and now have a fund with $2B. You ask CalPERS for $100M. They say yes! Well done. However, you look at CalPERS’ investment results and see that they are in the business of cutting checks as large as $800M, and you decide you want to keep growing AUM.
3. Lastly, you decide you want asset class integration. You decide you want to keep thing simple and develop a public strategy to complement your private strategy. So, you go out and you look for some public equity investment firms to acquire. You find a $1B actively managed L/S impact fund, and a $1B passive ESG fund (fortuitously for me, Vanguard launched two of the latter during the writing of this essay). In this example, not only do you have asset class integration (you are now in the public equity game), but you also have investment strategy integration (you have an actively managed L/S impact fund and a passive ESG fund). You go back to CalPERS and you say, “Look! I have a very nifty $4B fund that does lots of things! Please write me a $500M check?” And then they say, “Sure! The last time we wrote you a check for $100M things went well. You are growing AUM and we have all this money we need to put somewhere, so you can have it! Bon chance!”

And then comes the actual work of impact investing, or doing the thing you set out to do.

To wrap it up, if you make it easy for capital allocators to become impact capital allocators, then they will! If you are choosing between allocating $500M to either (1) a fund with 15% IRR or (2) a fund with 15% IRR and 15% IMM (a measurement of social impact), I think 99 out of 100 people will choose the latter. Hopefully the practice is as simple as theory. The conclusion then is that the industry needs to further develop ways for people who manage large AUMs to write large checks that are dedicated towards impact investing. It’s feasible to think that one day, there will be someone at CalPERS who covers the asset class of impact investing the same way there’s someone who covers hedge funds or real estate or real assets. To pave the way for large capital allocators to write big checks, the industry need only create well-managed large multi-strategy impact investment funds to which large capital allocators feel comfortable writing large sums.