Investing in Market Infrastructure to Enable Increased Impact
To scale the value created by the impact investing market, stakeholders across the public, private, and philanthropic sectors need to continue to build market infrastructure around impact investing. Much like traditional financial markets, impact markets need enabling public policies, platforms to share market information, standardized reporting systems, and more transparent data. Many firms and organizations have already committed valuable resources to building infrastructure in these areas for impact investing. But for the movement to reach its full potential, innovations in market building need to occur at a broad level, rather than on an investment-by-investment or fund-by-fund basis.
The following recommendations are separated into two buckets. The first grouping highlights those areas of market-building that could be accomplished by those organizations closely linked to the impact investing movement (i.e., investors, philanthropists, intermediaries, and social enterprises). The second grouping targets public policies that could be implemented or improved nationally to create a more robust impact investing marketplace.
Structural Recommendations for the Impact Investing Field
Impact investment funds and the organizations that are thought leaders in the impact investing space—including GIIN, B Lab, and the Aspen Network of Development Entrepreneurs—are playing a critical role as impact investing begins to filter deeper into the asset allocation philosophy of institutional investors and philanthropic groups. Impact funds—where the majority of impact investment dollars are placed—can begin to pull capital into the market in a more strategic way, and service providers—which are bringing some measure of consolidation to financial and social return data—have an opportunity to form more meaningful and powerful networks.
1. Create Better Segmentation Across Impact Investing Funds
The continued misunderstanding around what actually constitutes impact investing has been in part perpetuated by the many funds that classify themselves as impact investors. In fact, these funds operate across a wide spectrum of investment philosophies. In the JP Morgan/GIIN survey, 55% of respondents targeted market-rate returns, 27% targeted below market-rate returns, and 18% focused on capital preservation. Each of these respondents falls under the impact investment category as it currently stands today—as each combines some aspect of social and financial return. However, the industry could create greater understanding amongst mainstream investors if it segmented itself in a more strategic way, separating those funds and investment opportunities that can generate returns comparable to other traditional investments from those that set out to concede financial return for social return. In any case, clear articulation of investment theses and return expectations should become the norm for impact investment fund managers.
2. Pool Funds with Similar Investment and Impact Objectives
Small deal sizes and due diligence requirements continue to be a factor limiting the growth of the impact investing industry. To entice large institutional investors to make larger capital contributions, funds with overlapping investment philosophies and impact objectives should explore consolidation. Fund collaboration and partnership is not common practice today in the traditional investment space, as it would require fund managers to share some of their investment decision-making authority. What is more likely, however, is the creation of impact “funds of funds,” whereby large investments could be made into a larger fund that then makes many smaller investments into individual impact funds. Funds of funds could have a geographic focus, which could generate demand from institutional investors that do not have a particular type of impact they seek to obtain, but want to invest in impactful social enterprises.
3. Agree to a Common Set of Values and Principles Around Impact Measurement
IRIS serves as the impact investing industry’s taxonomy, governing the way companies, investors, and others define their social and environmental performance. It incorporates sector-specific best practices and produces benchmark reports that capture major trends across the impact investing industry. It also allows impact investors to choose a sector of focus in which to measure impact, including agriculture, education, energy, environment, financial services, health, housing, land conservation, and water. While significant progress has been made through IRIS and GIIRS, a more uniform system for measuring and reporting social and environmental impact is needed; until it is achieved, investors will continue to struggle with the meaning of social impact.
In addition to IRIS metrics, many impact funds calculate their social returns using their own methodologies as a means to market to potential investors. According to the JP Morgan/GIIN survey, only 27% of respondents use the same metrics to measure social returns for all companies across the portfolio, and more than 30% track impacts through proprietary frameworks that are not aligned with external standards, like IRIS.
It may be impossible to boil social impact down into a single number or metric, but there is an opportunity to report on a limited set of common measures for every fund without burdening fund managers with additional costs and duties. In its report, the World Economic Forum cited an opportunity to create an industry association of impact investors that could agree to adhere to common reporting metrics.35 The Community Development Venture Capital Alliance is one such domestic association that seeks to disseminate best practice information among its members.
4. Leverage the Role of Philanthropy in the Impact Investing Space
In many impact investments that seek concessionary returns, the largest providers of capital are philanthropic sources—putting money to work in the space between grants and market-rate investments. These philanthropic investments can be used to help grow social enterprises to a point where their business models and impact philosophies can be proven to traditional investors. They can also provide investment types that will bring greater scale to impact investment products, and they can catalyze more traditional capital to enter the market by providing loan guarantees or first-loss layered investments. For example, the prison recidivism social impact bond in New York was structured in a way that Goldman Sachs’ $9.6 million loan was guaranteed by a $7.2 million grant from Bloomberg Philanthropies, protecting Goldman Sachs’ investment to a certain degree if the program failed.
Foundations making investments into social enterprises also complete extensive due diligence before placing their capital, which could be leveraged to lower due diligence costs for the entire impact investing sector. By using existing impact investing industry networks, such as the GIIN, impact investment data from foundations could be shared with mainstream investors in a way that conveys best practices on deal-structuring, return expectations, and impact measurement.
Policy Recommendations for the Public Sector
Government has played a key role in building the impact investing industry into what it is today. Policies such as the Community Reinvestment Act and the institution of tax credit programs, including the Low Income Housing Tax Credit and the New Markets Tax Credit, have created demand and incentives for targeted impact investments. Additionally, domestic governmental organizations such as the Overseas Private Investment Corporation (OPIC) and multilateral development banks on other continents have been making impact investments for years. Going forward, the public sector can continue to implement policies that support the impact investing field, creating synergies and alignment between many of the issues that are important to both impact investors and government.
1. Continue to revise policies that can restrict the flow of capital into impact investments
In two significant announcements in 2015, federal policies have made it easier for capital to flow to impact investments. First, the Internal Revenue Service announced that foundations’ mission-related investments (MRIs) will not automatically be subject to a tax on any investment gains. Previously, foundations were taxed on investment gains when the investment might jeopardize the foundation’s purposes by creating losses. Under the new guidance, foundation managers can exhibit prudent care—thus shielding themselves from taxes—by considering the relationship between the investment and the foundation’s charitable purposes.
Second, the U.S. Department of Labor announced new guidance for private pension funds that will enable fund managers to consider economic, environmental, social, and governance factors in addition to financial return while maintaining their fiduciary duty to fund participants. This move is similar to an announcement made in 1979 that allowed pension fund managers to allocate investments to high-risk sectors, including venture capital. Before that announcement, pension funds supplied just 15% of U.S. venture capital; but by 1988, that percentage had risen to 46% of a $3 billion industry.36
These announcements can push impact capital off the sidelines into investments and bring money in from across the capital spectrum, as foundations may be more willing to accept lower financial returns and pension funds will choose to seek market-rate return potential. National policy should continue to be adjusted to bring more capital to bear on social issues, which could come in two forms:
- Provide greater clarity surrounding the requirements for impact investments to qualify for Community Reinvestment Act (CRA) credit. Currently, CRA investments need to be tied to geography, thereby making it difficult for large banking institutions to invest in impact funds that do not have a focus on a single domestic geographic area.
- Broaden the reach of the Small Business Investment Company (SBIC) Impact Fund. Between 2011 and 2014, the $1 billion SBIC Impact Fund provided capital to private equity funds managing just $176 million invested in 17 companies.37 To qualify as an SBIC Impact Fund, impact funds must target 50% of their invested capital toward a targeted impact sector, within economically distressed areas, in early stage companies that have received federal awards, or toward energy saving investments. This limited menu of options disqualifies many impact funds that have broader impact philosophies.
2. Provide investments alongside impact investors through innovative mechanisms
Though many impact investors have focused their efforts on the venture capital asset class given the need for funding to scale impact, governments have been integral in the creation of entirely new impact products. Innovative investment structures and public-private partnerships have been used most frequently to address domestic housing issues, with two loan funds providing best practices for the use of public funds to spur mainstream impact investment:
- New York City Acquisition Fund: This fund provides loans to developers in exchange for the creation and preservation of affordable housing units in New York. A consortium of banks provides the loans, but the City of New York provides a guarantee (together with philanthropic sources) to cover the banks’ losses up to a certain point if they occur. The guarantee helped to attract capital into the fund and reduced the banks’ exposure to losses.
- Bay Area Transit-Oriented Affordable Housing (TOAH) Fund: This $50 million fund provides loans to developers of affordable housing near transit stations. It was creatively structured by the Metropolitan Transportation Commission (MTC) to leverage $10 million in federal transportation funding. Funding provided by MTC acted as a first loss reserve, meaning MTC will not see any financial returns until senior loans provided by Morgan Stanley and Citi Community Capital are fully repaid with market-rate interest.
These flexible structures utilize funding from government to create market-rate returns for mainstream investors. The public sector can also catalyze investments in early stage impactful businesses through tax incentives for investors. Much in the same way that the Low Income Housing Tax Credit and New Markets Tax Credit have subsidized investments in low-income communities, similar credits could be offered to impact investors that make investments in early-stage companies that are hoping to create public benefit. In the UK, investors that make qualifying investments under the Social Investment Tax Relief program can deduct 30% of the cost of the investment from their income tax liability. Capital gains on these investments are also deferred as long as the gain is invested in another qualifying social investment.
3. Create guidance to bring impact metrics into mainstream financial reporting
The Financial Accounting Standards Board sets the generally accepted accounting principles (GAAP) for traditional companies. While B Corporations certified by B Lab must complete an assessment of their impact performance, there is no national standard-setting body that creates principles that apply to all social enterprises. With social and environmental impacts directly tied to the business models of many impact businesses, measurement of these metrics should be just as important as the measurement of financial indicators.
For the sector to achieve the transparency and accountability it needs to attract mainstream capital, more uniform accounting standards should be set—especially for entities that operate as a benefit corporation. Currently, many impact enterprises willingly enroll in GIIRS impact measurement; however, some form of impact tracking could be mandated through public policy. The Sustainable Accounting Standards Board and the Global Reporting Initiative provide models that are being applied both domestically and internationally, helping large corporations to integrate sustainability metrics within their financial reporting and decision-making processes.