Does Impact Investing Always Have To Be Higher Risk?

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Impact investments are designed to generate a measurable, beneficial social or environmental impact alongside a financial return. They have become a focal point for a growing number of asset owners when questioning whether they could do more than manage their assets for financial performance alone.

The principles behind impact investing also align with the millennial mindset of making the world a better place while generating profits. Investing in these purpose-driven business initiatives is a great way for family offices to engage the next generation.

Still, many believe that impact investments mean higher risk than other forms. Are the traditionally held beliefs regarding costs, due diligence and extended return timelines a true reflection of modern impact investing? Does investing with your values mean you have to sacrifice on returns?

 

To answer these rather complex questions requires an exploration of their multiple facets.

Impact investment and risk

Traditionally, the central premise of investing revolves around the principle that risk and return are related. When it comes to impact investments, many investment theorists and investors themselves thus believe that there's a trade-off between impact (social and environmental return) and risk-adjusted financial returns. In other words, the more significant the impact focus, the lower the return on investment.

Impact investors may also incur additional costs in identifying and evaluating the organizations in which they're considering investing. Add to this transactional cost, exit, impact and reputational risk factors as well as the degree of uncertainty in entering new markets and it's easy to see why impact investments, at least at face value, are often perceived to be riskier propositions than most other forms of investment.

This, however, does not necessarily always have to be the case. Commenting on the findings of the 2019 Nordic Investment Impact Report compiled by IMPACT X, impact investment advisor Rachel Browning explains, "In terms of risk, institutional perceived impact investments to generally have the same risk as a non-impact investment. They also found diversification benefits through impact exposure. However, this depends deeply on the specific investment.”

For family offices considering impact investment, there is a need to define which risk factors are most important to them. According to Browning, this requires a shift in thinking. "While most investors are accustomed to two-dimensional risk and return assessment when considering investments, there needs to be a transition to a three-dimensional approach that evaluates risk, return and impact. In doing this, family offices must ask themselves the necessary questions to gain insight into their impact objectives and risk appetites."

Browning explains that once a clear definition of risk and impact objectives have been established, risk appetite and impact tolerance will become more apparent. From these, it will be easier to identify investments that would be a good fit as well as those that wouldn't, saving valuable time and resources when choosing between investments.

Impact investment and due diligence

Impact investing is often associated with more expensive, complicated, time-consuming, or incomplete due diligence. As one anonymous institutional investor participating in the Nordic Investors Report survey puts it, "The established benchmark of 1-2 % in management fees should cover all due diligence cost including legal, ESG, impact and monitoring costs. Impact investing implies more costs which are difficult to raise - including an understanding of spending more resources on project preparation and monitoring."

Browning agrees, stating that "There is no doubt that impact due diligence is more complex and expensive, but that will improve over time, as we have seen with the ESG industry. Given the additional insight, however, it is bound to pay off."

How does an investor rise to this challenge? According to Mette Fløe Nielsen a private investor focussed on impact, this should not scare off investors.

"Instead of attempting something entirely new e.g. adding new handles in your due diligence, investors should just broaden what they do already by asking more exploratory questions and emphasizing the Impact related questions. This will start your journey as an Impact investor and ensure that risk assesment is not an obstacle for you to start. - Mette Fløe Nielsen

When pursuing impact investing, family offices are doing far more than just allocating resources to organizations with the most viable financial potential. Instead, based on risk appetite, impact tolerance, values and objectives, family offices are selecting the most feasible market-based solution that addresses a significant environmental or social issue. Investments, regardless of their nature, are still investments. When it comes to due diligence, they need to be treated as such. Keeping these facts in mind can help to focus on getting answers to questions in any area of concern.

The second is by identifying ways in which to measure, manage and report on impact investments. Here, investors can find guidance from The IMP or Impact Management Project – a forum for building global consensus on how to measure, manage and report impact. By consulting with more than 2,000 organisations since 2016, it has reached consensus that any type of impact experienced by people and planet – intended and unintended, positive and negative – needs to be understood across five dimensions of impact. By using this framework, investors have a way to consistently classify the type of impact (or impact class) of each investment in a multimanager, multi-asset class portfolio.

When implemented at the due diligence phase, the framework can help the family office to build a total portfolio view of its impact and set a baseline for managing performance over time.

Impact investments and return timelines

It is generally accepted that impact investments require far longer timelines for returns than other types of investment. The rationale behind this is that impact-orientated businesses take a long time to become financially self-sustainable.

Respondents to the Nordic Investors Report survey confirmed this view, indicating that they expected longer return time horizons with impact initiatives.

However, Browning cautions that this very much depends on the companies involved and the actual investment. Still, overall, she believes that "It is understood that myopic investors and investors demanding short term results are bad for sustainability."

When reviewing impact investment opportunities, family offices need to take return timelines into account, knowing that these have the potential to be extended when it comes to specific causes and organizations. Doing so will help to ascertain whether the proposed timelines are in-line with the organization's overall financial objectives.

Impact investing presents some genuine challenges in the areas of risk management, due diligence and return timelines. Do these mean it always has to be a higher risk? No.

Family offices that have defined risk tolerance and who have clearly set out objectives and instruments of measurement are better positioned to match opportunities to their risk appetites. This helps them to efficiently identify and align themselves with impact organizations that not only share their values but can deliver on the investment requirements.

This post originally appeared on Francois Botha.

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