Impact Investing: How to Invest for Market-Rate Return and Measurable Impact at Large Scale
By Professor Feng Li, Chair of Information Management at Cass Business School,
Gianandrea Giochetta, Senior Research Fellow at Cass Business School
and Dr Luigi Mosca, Research Fellow at Imperial College.
Impact investing is a specific approach of “investing for the common good” alongside ethical investing, sustainable investing, socially responsible investing (SRI), and environmental, social and governance (ESG) investing.
Although they are often grouped together in everyday conversation and media coverage, there are different methodologies associated with each of these approaches.
The Global Impact Investors Network (GIIN) defines Impact Investing as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return”. The term was first coined by the Rockefeller Foundation in 2008.
In an early study, JP Morgan identified it as an emerging new asset class but today, impact investing is increasingly viewed as a lens through which investors identify, analyse and evaluate investments. The scope of impact investing has also been extended to including “both emerging and developed markets as well as across all asset classes … target a range of financial returns from below market to market rate, depending on their strategic goals”.
Unlike SRI or ESG investing, impact investing is not just about avoiding “sin stocks” or “do-no-harm”, but also actively deploying capital to address specific social and environmental objectives while generating financial returns for investors. Different from other approaches, impact investing funds not only use ESG and SRI methodologies to filter opportunities, but also require intentionality: portfolio companies must track, measure and report on their social and environmental impact.
It is already an industry with $502 billion US in assets under management and over 1300 organizations actively involved worldwide. Its ability to generate (market-rate) financial returns alongside measurable impacts can potentially attract substantial new assets from mainstream investors.
Why Is It Necessary to Invest for Impact and Profit?
The need for impact investing has arisen from the persistence of grand societal challenges (e.g. ageing, inequality, social exclusion, and unsustainable development) and the inability of existing institutions (including governments, NGOs, charities, and philanthropy) to eradicate them.
In 2016, the United Nations identified 17 Sustainable Development Goals (SDGs), but achieving these SDGs in 2030 will require $5 to $7 trillion each year, with an annual investment shortfall of $2.5 trillion in developing countries.
The OECD DAC report highlighted that in 2016, the total official development assistance reached a peak of $142.6 billion,6 which is one order of magnitude smaller than what is needed. By addressing social and environmental challenges while generating market rate returns, impact investing can unlock substantial capital from mainstream investors to complement philanthropy and government in addressing some grand societal challenges.
Different from government funding or philanthropy, the financial returns can be re-invested, thereby, creating sustainable, long lasting, and scaled-up impact.
Challenges for Impact Investing: Is It Possible to Invest for Both Return and Impact?
Investing for returns and impacts is easier said than done, as many activities aimed at social and environmental challenges are costly but without immediate or direct financial returns for the investors, and a comprise is often expected between returns and impacts.
Many such activities belong primarily to the realms of philanthropies, governments, charities, NGOs, and CSR, and will remain so. Only selected opportunities exist in social and environmental challenges that offer the potential for both market-rate financial returns and measurable social and environmental impacts.
According to Confucius, "he who chases two rabbits catches neither." The challenge for impact investing is first to demonstrate that it is indeed possible to catch two rabbits at the same time, and then develop robust methodologies to help investors identify such opportunities.
Although sector studies largely support the notion that investing in ESG delivers better, or at least similar, returns as non-screened investments – often also with the added potential for lower volatility, it remains inconclusive, or lack of consistent proof, that investing in ESG automatically leads to increases in the bottom line.
An often cited meta-analysis of 2,200 studies concluded that “the business case for ESG investing is empirically very well-founded”, with 90 per cent of the studies indicating that ESG investing did not negatively impact financial performance.
Many other studies have reached similar conclusions. However, such findings are often questioned – even if subconsciously or secretly - when the ESG strategy of the $1.1 Trillion Norwegian Sovereign Wealth Fund returned 1.6% less on an annualised basis over 12 years because it excluded some stocks on ethical grounds.
A study by Japan’s $1.5 Trillion Government Pension Investment Fund also found that although external asset managers “have taken measures to address ESG issues, in many cases such measures have not been included in actual engagement activities".
A further challenge is our inability to accurately measure something as vague as purpose, which is regarded as “the soft underbelly of the ESG movement”. This can encompass anything from treating suppliers fairly to cutting carbon emissions.
To address such challenges, theoretical guidance is urgently needed to distinguish impact investing from other approaches of investing for the common good.
First, international best practices and exemplars in impact investing need to be identified and examined; and second, based on insights from such exemplars, robust methodologies can then be developed to help investors identify opportunities that can - and those that cannot - generate measurable market rate financial return and social and environmental impact using established international standards; and third, practical lessons can be drawn from such exemplars on how to successfully pursue such opportunities.
How to Invest for Market-Rate Return and Impact at large Scale? Lessons from TGIF
TriLinc Advisors, LLC is a fund management subsidiary of TriLinc Global LLC, an investment holding company established in 2008 by Gloria Nelund and a team of financial service veterans and impact investing specialists.
Since inception, its flagship TriLinc Global Impact Fund, LLC (TGIF) has deployed over $1bn capital, generating a consistent, unlevered net annual return to investors of 7 to 9%+ with zero loan losses. This is a remarkable achievement for any emerging markets investors, notably more so considering the measurable impact that has been delivered at the same time.
Alongside financial returns, TriLinc selects its investment opportunities based on the target company’s potential to generate measurable impact on the people, community or region in which it operates.
As of 12th December 2018, its portfolio companies created over 18,500 jobs, achieved 100% compliance with local environmental, labor, health, safety and business laws, standards and regulations and all have committed to working towards implementing international environmental and health and safety best practices. 77% of portfolio companies also demonstrated positive impact on their local communities through services or donations; and 91% implemented environmentally sustainable practices, including energy savings, waste reduction and water conservation.
How did TGIF manage to consistently generate market rate returns and measurable social and environmental impacts at scale? Over the last two years, we conducted a series of interviews with the senior management team of TriLinc, supplemented by email exchanges and exclusive access to detailed data about some of its portfolio companies.
Our research identified four critical factors:
1. Veterans with proven track record in commercial investing and strong motivation for impact
Throughout her career, TriLinc Founder and CEO Gloria Nelund pioneered social impact initiatives. She believes that “philanthropy and aid alone can’t solve the biggest issues facing our world, but private capital deployed at scale can create systematic, transformative change.” By combining philanthropic values with business principles, impact investing is our best chance to solve some of the biggest social problems. She assembled an experienced and highly motivated team at TriLinc – often describing themselves as "reformed Wall Streeters", many of whom had rewarding careers in commercial investing before moving to TriLinc to do something more than just making money. The team is united by the vision that impact investing represents a realistic alternative only if it delivers financial return in-line with or superior to traditional products. By building on their commercial experiences, they strive to manage the tension between social and environmental motives with financial objectives. This is also important for attracting and retaining experienced investment professionals and talented young research analysts to the firm which are essential for success.
2. Investment strategy engineered to maximise both return and impact
TriLinc’s strategy was engineered from the ground-up to maximize both financial and impact objectives. TGIF focuses on short term financing to small and medium enterprises (SMEs) in selected emerging economies for their expansion projects. Most investments seek to generate employment growth and support local communities, particularly in food, energy, infrastructure and sustainable growth that can be directly aligned with the business objectives. Furthermore, TriLinc supports its portfolio companies to improve their practices towards internationally recognized standards and best practices (e.g. ISO). The IMF estimates that there is a $700bn of unmet credit demand globally in the specific niche targeted by TriLinc.11 The scale of the market allows managers of TGIF to choose only opportunities they find compelling from both financial and impact perspectives; and also offers scope for further AUM (Assets under Management) growth. SME lending can make a significant difference not only to the borrower but also to the local economy as capital trickles down through job creation, taxation and local production of goods and services. The Small Enterprise Assistance Funds (SEAF) estimate that every $1 invested in a SME generates an additional $13 in the local economy.12 The portfolio companies of TGIF increased employment by an average of 25% per year. TGIF focuses on private, US$ denominated short-term notes such as trade finance or term loans. This allows the adoption of company specific ESG targets based on IRIS standardized definitions,13 and enhanced risk management through ad hoc structuring and collateralization. Short-term loans may be held to maturity, pragmatically addressing the Fund's liquidity requirements. TriLinc helps portfolio companies to think about their ESG and impact behaviours and codify their activities via a standardized baseline data-gathering and annual reporting process. The risk-adjusted returns are enhanced through its stringent top-down process for country selection and comprehensive diversification across regions, countries, sectors and investment partners, and bottom-up, company specific analysis to ensure robust cash flow coverage and collateralization.
3. Local partner networks for opportunity identification and monitoring
TriLinc selects target countries using a proprietary macroeconomic analysis platform that takes into consideration a number of variables, including growth, stability and access. For each target country, TriLinc teams up with an institutional-class investment partner supporting through local knowledge and presence on the ground throughout the entire life cycle. No investment is made without the involvement of a local partner. This approach is seen as an efficient and cost effective way to build a global presence. Local agents are carefully vetted and they support TriLinc with origination, structuring, servicing and risk management. TriLinc remains involved in all key decisions and activities, including regulatory compliance and impact assessment, to help manage possible conflicts, which ensures the fiduciary responsibility of the portfolio companies to TGIF.
4. Investment process attributing equal weighting to impact and financial considerations
Once an investment opportunity is originated by a local partner, the team in California follows a bottom up approach to evaluate the deal, structure the transaction and manage the investment. Deals are appraised through an intertwined process by the impact team and investment team within the Credit Committee, assessing the merits from both financial and impact perspectives. A loan is only made when both sets of conditions are met. A stringent methodology to vet opportunities at every step of the process enables the minimization of rejections and concentration of resources on high potential deals. TriLinc has identified five core impact metrics, tracked by every investment across the portfolio, which measure progress toward TGIF’s economic development impact objectives of job creation, wage increase, increased revenue, profitability improvement and increased company taxes paid. Additionally, each portfolio company selects, and is held accountable through KPIs, of its own impact objectives, be they food security, access to financial services, or improvements in energy efficiency. There are two ways to look at impact investing, “positive” impacts by actively doing something, and “absence of negatives” such as preventing an environmental disaster. In both instances, TriLinc can influence actions through its financing at the portfolio company level, e.g. equipment upgrades resulting in less pollution, energy savings or use of solar energy. TriLinc uses the Impact Reporting and Investment Standards (IRIS) to track and report impact activities at both the fund and borrower levels. Additionally, TriLinc aligns its activities with the UN’s SDGs, supporting 14 of the 17 goals.
Our research of TGIF and its portfolio companies has shown that it is indeed possible to achieve measurable social and environmental impact alongside market-rate financial returns at large scale. This, however, requires a robust methodology to identify opportunities where others often see constraints.
The ability to innovate is needed to define and execute a strategy that satisfies investors’ risk tolerance, target returns, liquidity requirements and other constraints. It must also absorb capital at scale and deliver intentional, transparent and reportable impact results.
From a financial perspective, it pays to focus on less efficient markets where greater arbitrage opportunities may be found. Although the overall demand for capital by SMEs in emerging economies is estimated by the IFC and World Bank (as of March, 2018) to be $1.3 trillion, reduced market size at the country level and transactional complexity are likely trade-offs. A pragmatic approach is needed to get the best of both worlds. TriLinc successfully mitigates these risks by pursuing comprehensive diversification across companies, sectors, countries, regions and investment partners.
From an impact perspective, the challenge is to identify targets that are both realistic and measurable using established international standards. Being overly ambitious may be counterproductive. Rather than pursuing complex objectives that require years and a controlling equity stake to achieve, it may be preferable to aim for goals with a high probability of success and that may be achieved over a relatively short time span. Communication is all important and this is why targeting impact objectives that can be attested and audited by third parties (such as IRIS or compliance with ISO standards) is also critical.