Why do we need an “impact verification” support industry?

There is problem with the idea that, as the manager of an impact fund, even if you can showcase spectacular financial returns, potential investors in your fund will just hand over the cash and say, “Sure, okay, you guys are making good returns, and it says here you’re a social impact fund, so here’s the money!” You need to actually be able to verify the amount of impact that you’ve achieved.

If you’re skeptical of this idea, consider the following scenario. Let’s say that you decide to tell potential investors that your last fund performed in the top quartile relative to funds of a similar vintage. Your potential investors will then ask you to prove it and supply some form of documentation that has been verified by a third party that shows you have, in fact, made a lot of money relative peer funds. If you can’t prove to potential investors that you have in fact performed so well — regardless of whether you actually performed this well — your potential investors will probably look at you funny and walk away (I don’t know, I haven’t raised my own fund but it seems to be common sense you have to provide evidence for your claims to the people who are potentially going to hand you millions of their dollars for you to manage on their behalf).

So it follows to that if you say to them “we have achieved top quartile IMM returns relative to other impact investors and we are one of the few firms actually changing the world” they will likely ask you to prove it. I suspect that fewer firms actually care about impact than the number that say that they care about impact, so you could argue that if you can prove your financial returns, they’ll be sufficiently satisfied and hand you the money anyway. But my hunch is that it’s more about the principle of the thing: potential investors want you to be able to substantiate your claims, because if you can’t, they will get squeamish about investing with you in general on the grounds that you can’t provide evidence to support your claims. I don’t think that’s a good look.

Another way of putting it: one of my favorite columnists, Matt Levine, covered the subject indirectly in his column Money Stuff, saying that “investors want two things: To be told that they’re investing in environmentally, socially, and governance-conscious [ESG] companies, and; to own the S&P 500.” (I will use ESG and impact interchangeably from here on out for simplicity). I would add that investors also want to believe what they’re being told when someone tells them that they’re investing in ESG/impact companies.

Why add that last part? I’ll concede that it’s semantics but in this case I think semantics are important because there are too many low-quality “ESG/impact investors” that don’t meaningfully pass the ESG/impact sniff test. Consequently the rose-colored glasses of ESG/impact investing no longer have a rosy tint. I remember once reading about an ESG fund where the ESG strategy was to simply not invest in the bottom X% of performers along ESG metrics by each industry. So, the index still included coal stocks; just not the bottom 10% of coal stocks along ESG ratings. Groan — no wonder people will need some convincing going forward.

For there to be reliable “impact-convincing” occurring to nudge capital allocators towards earmarking more money for ESG/impact investments, you need an impact support industry to verify levels of impact achieved. Imagine a third party entity that performs myriad impact verification services — like “impact auditors.” As it happens, there’s actually a company that does this already, called Y Analytics. Y Analytics was spun out of The Rise Fund / Bridgespan and produced the relevant IMM research I have previously covered (in short, IMM is a universal metric to evaluate how impactful an investment in a target company is for just about any target company). Unfortunately Y Analytics can’t possibly provide services for every ESG/impact fund out there. If there are dozens of carbon copies of Y Analytics running around in the world, helping guide capital allocators towards ESG/Impact investors, then it will help grow the impact class by further legitimizing the “impact” half of the returns equation.

Ideally, a virtuous cycle will begin where capital allocators get more comfortable investing in funds that have third party impact verification, and will start to demand verification from more funds who are positioned to provide relevant verification. Then, as capital allocators are able to start reporting aggregate level impact returns to their fund performance, stakeholders in the institutions that capital allocators represent will demand a certain level of impact returns. As that becomes more demanded, capital allocators then preferentially seek funds that can report impact over funds with comparable returns in similar asset classes that cannot report impact. The ultimate result would be more capital allocated towards impact-producing funds, which ultimately means more capital available for companies filling structural gaps of where social impact is needed but currently does not exist.

Not only do I hope that the impact support industry continues to flourish in terms of the number of firms in the market, I also hope that they all do pretty much the exact same thing. In my ideal world, they are all hired by funds to do investment- and fund-level IMM calculations, because capital allocators require certain IMM thresholds to be met for a certain amount of the investment portfolio (an exempt percent of the fund would be a good way to leave room for experimental or discretionary impact as I covered here). Although you do lose some nuance describing the characteristics surrounding an investment or set of investments by using IMM, what you get in exchange is a level of standardization that coverts the nuances of impact into a widely palatable and distributable metric. My hunch is that capital allocators don’t have the time to get into the weeds of impact, but would be willing to pay for some degree of verification that what they’re actually investing in is impactful.

If you manage billions of dollars and have the chance to spend $100K on an impact support firm so that you can pat yourself on the back and feel morally superior to all your investor buddies investing in coal, wouldn’t you take it? Especially if that $100K is a fund expense? I definitely would. Frankly, I think most people would.