How Investors Can Integrate Social Impact With Financial Performance to Improve Both

(Photo by iStock/Natali_Mis)

After years of framework development, metric definition, and data collection, many investors are increasingly able to anticipate, measure, and manage the social and environmental results of their investments. Many of these practices are now codified in frameworks such as the Operating Principles for Impact Management. But for investors to play an even greater role in solving social problems, impact management must leave its silo and integrate with financial management.

The challenge is that financial and impact management methodologies are not designed to be interoperable. Impact specialists at investment funds typically have their own teams with their own vernacular, frameworks, and datasets, all of which exist in varying degrees of isolation from their financial counterparts. These siloed approaches leave impact, money, or both on the table.

Integrating impact with financial management enables investors to consider the financial, social, and environmental dimensions of their investments in a comprehensive way; to optimize investment performance across those dimensions; and to communicate all dimensions of their investments’ performance clearly and transparently.

The benefit of greater impact-financial integration for the world at large transcends the benefits for individual investors. Asset managers and owners—including those who seek market rates of financial return and those who are comfortable with less—can use integrated impact and financial data to allocate capital to address urgent social and environmental challenges while achieving their financial goals.

Towards this end, our organizations have participated for the past two years in the Impact Frontiers Collaboration, an initiative of the Impact Management Project. The collaborative project, inspired in part by the article "Toward the Efficient Impact Frontier,” pioneered new ways to integrate impact management with financial management across participants' portfolios cumulatively totaling more than $15 billion. The effort joins GIIN's Roadmap for the Future of Impact Investing and the Operating Principles for Impact Management in highlighting the importance of integrating impact with financial risk and return.

Each of us in the Impact Frontiers Collaboration developed unique approaches that were customized to our organizations’ specific contexts, goals, and investment strategies. From these thirteen approaches we synthesized four overarching elements of impact-financial integration that we believe are relevant for a wide range of investors. These elements do not prescribe any approach to impact or financial management. Rather, they provide a method for integrating whatever approach to impact and financial management that asset managers or owners may choose.

Four Elements of Integrated Practice

A common practice among impact investors is to choose their investments through negative and positive screening. A negative impact screen filters out companies with socially or environmentally harmful practices. A positive impact screen allows in companies that are expected to have a positive impact on people and planet. Once prospective investments have passed both impact screens, investors often make decisions purely based on financial considerations. Beyond screening, relatively few investors actively optimize impact and financial performance simultaneously in their portfolio construction.

 

Like other investors, the organizations involved with the Impact Frontiers Collaboration apply negative and positive impact screens. But to move beyond screening, we undertook four other steps to enable us to continuously improve our portfolios’ impact and financial performance. Once implemented, these elements are inter-locking, not sequential. But in developing our organizations’ approaches, we followed the sequence below.

1. Create an impact rating to distinguish the prospective investments, which can include loans, that offer more or less expected impact. An impact rating is a weighted sum of indicators that collectively cover multiple dimensions of impact, such as the number of people reached, how underserved those people are, and how much each individual is affected. The weights applied to each indicator reflect the importance of the impacts to stakeholders, such as consumers, employees, and community members of investees. The weights also reflect investors’ impact priorities, such as increased income for low-income populations, gender inclusion, or reduced carbon emissions. Importantly, our organizations’ impact ratings encompass two factors. The first is the expected social and environmental impacts of the enterprises we support. The second is the expected contribution of our investments toward those impacts, which Paul Brest, Ronald Gilson, and Mark Wolfson describe in "How Investors Can (and Can’t) Create Social Value."

Impact ratings make it easier for investors to obtain a more complex understanding of impact that goes beyond simple scale metrics such as "number of people reached." Even among a set of possible investments already screened for positive impact, the ratings can identify the highest-impact investments. They can increase the clarity of organizations’ impact goals and the quality and consistency of decision-making.

Like any predictive tool, impact ratings are imperfect and subject to the availability and quality of data. They work best as part of a larger approach that includes secondary research and direct feedback from stakeholders. Investors should monitor and evaluate the investments that the ratings help select to verify whether the expected impact occurs.

Though all of us developed impact ratings, other approaches could work, such as impact monetization, which strives to accurately calculate the monetary value of the impact of an investment. Whatever approach investors employ, it should tell them to what extent they should prioritize a transaction based on its expected impact.

2. Select a financial valuation metric to estimate which prospective investments offer more or less expected risk-adjusted financial return. This metric should quantify the expected financial value of a prospective investment to the investor, adjusted for risk, cost of capital, and other costs. This number can then be compared to the expected impact rating.

Many of our organizations already had asset-class specific methods of financial valuation. For instance, NESsT and other lenders estimate net present value (NPV); Nuveen and WaterEquity use internal rate of return (IRR); and IDB Invest calculates risk-adjusted return on capital.

Some lenders in our group used NPV to quantify the dollar value of financial concession, if any, that was implicit in certain loans. The rationale is that if a loan has a negative NPV to the lender, that loan is economically equivalent in value to a grant in the amount of the negative NPV. It can be thought of as the "price" at which investors are purchasing impact.

Private equity investors such as Bridges Fund Management estimate multiple of invested capital and IRR. Lastly, multi-asset class investors such as Propel Capital compare the rate of return expected of each investment with relevant asset class benchmarks to estimate the value of financial concession implicit in each investment, if any.

3. Conduct integrated analysis of existing portfolios and determine the implications for future investments. Each of us viewed our existing investments on a scatterplot with investments’ impact ratings on the horizontal axis and investments’ financial valuations on the vertical axis. These scatterplots enabled us to simultaneously visualize our portfolios from an impact and financial perspective, and to explore the relationships between impact and financial risk-adjusted return.

We approached integrated decision-making about individual investments in two ways. IDB Invest and Root Capital defined the minimum impact rating they would require of investments with a given financial valuation. These "hurdle rates" are on a sliding scale; proposed investments with lower financial valuations are required to have higher impact ratings. Other investors, such as Calvert Impact Capital and WaterEquity, created new tools that benchmark financial and impact characteristics of proposed transactions against those of similar transactions already in the portfolio.

Both methods enable our organizations to quickly decline proposed transactions that compare unfavorably to the existing portfolio on expected impact or financial performance, and to prioritize the highest-impact transactions for approval if financially prudent.

4. Measure and manage the impact and financial performance of portfolios of investments. One method, practiced by Bridges Fund Management and IDB Invest, is to calculate the average impact rating of the investments in the portfolio. Another method that many of us are experimenting with is to extract three to six high-priority impact indicators from their impact ratings to measure and report on across an entire portfolio.

Many of us are now creating integrated dashboards of the most important impact and financial indicators of portfolio performance. These dashboards will help to ensure that the most important impact and financial indicators remain within acceptable ranges at the portfolio level, while prioritizing one or two measures of impact performance to improve on each year.

These methods are not mutually exclusive. Both go beyond our previous practices of simply reporting on the number, size, and composition of investments by sector or geography, or on the number of people reached by those investments. They paint a more nuanced picture of portfolio impact that can include, for instance, the type and depth of impacts that people experience, the degree to which those people are underserved, and the specific contributions of both the investor and the investee enterprise to those impacts.

Toward a Financial Sector That Better Serves Society

It will take time to demonstrate improved impact and financial performance of our portfolios. The investments that our organizations made using this new approach will not mature for several years. Preliminary results from IDB Invest and Root Capital, both of which implemented the approach independently by 2017, are promising. Each year since then, these organizations have either improved both the expected impact ratings and the financial performance of their portfolios simultaneously, or have improved one while holding the other constant.

In the meantime, the approach has yielded important organizational benefits. It has helped us to articulate more concretely what we mean by "impact," and to align our investment criteria and processes with our desired impacts. It has made us more efficient—we spend less time evaluating unattractive investment opportunities—and more effective in systematically channeling capital to the most attractive investments. Lastly, it has helped us to communicate more clearly with team members, investment committees, and boards of directors about our organizational goals and performance in terms of social impact and financial returns.

We recommend a period of one to two years for development and piloting of these elements of integrated practice, followed by one year of refinement. This is partly because it takes one annual investment cycle to develop an approach and collect and analyze data. It takes another year to refine the methodology based on lessons from the first year. Moreover, the fact that the approach relies on predictive methodologies, combined with the uneven completeness and accuracy of impact data in the investment sector, creates a risk of flawed analysis. To avoid this garbage-in-garbage-out possibility, we built in significant time for piloting, training, quality-checking, and revision of our approaches.

Impact-financial integration requires ongoing attention as it becomes part and parcel of investors' operations. It can always be improved. For investors worried about maintaining another set of practices, it's worth knowing that improvements take less work than the initial start-up.

While much remains to be seen, the integration of financial, social, and environmental data by investors has the potential to help solve urgent problems by changing the way financial markets allocate capital. In an era marked by the coronavirus epidemic, cataclysmic changes in the environment, and ongoing social injustices, smartly wielding investments for good will become more important than ever.

Read more stories by Impact Frontiers Collaboration.