The Complete Guide to Social Impact Investing

May 2, 2018 12:20:05 PM / by Peter Heijen, Founder | 13 minute read

This article is about the absolute necessity of a broader vision when investing. A form of investing that not only takes into account financial returns, but also social returns. For example, the impact on the environment and humanity.

Politicians often confuse improved welfare with improved wellbeing. A country’s welfare growth, or the growth in GDP, is seen as a measure of a country’s performance. Politicians use economic variables such as unemployment and inflation to build policy.

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When the economy is growing and unemployment decreases, the country is considered to be doing well. Businesses, investors, and individuals are often driven by economic variables as well, for example, if a company grows its profits, the company is doing well. Likewise, individuals choose the best paying jobs and investors want the highest returns on their investments.

The Dimensions of Money

This way of thinking is outdated and does not help to improve overall wellbeing. Wellbeing is a broader and more useful concept to understand a country’s, company’s, or individual’s state. The concept not only takes into account economic variables but also personal and societal effects that cause economic growth. If the economy is growing but takes a negative psychical toll on the people or the environmental of the planet, it decreases wellbeing.

Peter Heijen on money

It is not uncommon that economic growth goes hand in hand with deforestation, overfishing, and environmental pollution. Furthermore, well-paid jobs commonly go hand in hand with stress, unhealthy lifestyles, and a skewed work-life balance.

Global wealth inequality

Capitalism can cause extreme individualism, loneliness, and depression. On top of that, the benefits of economic growth are not always distributed evenly and fairly. To illustrate, an extremely small group of mega-rich people owns the majority of the wealth in the world.

Consider this stat about global wealth inequality from Inequality.org:

“The world’s wealthiest individuals, those owning over $100,000 in assets, total only 8.6 percent of the global population but own 85.6 percent of global wealth.”

This does not contribute to their wellbeing or the wellbeing of the masses of poorer people around the world.

Simply said, money does not cause happiness, this has been concluded by ample scientific research. Happiness does not improve after people obtain an income of twice the modal average. However, individuals, politicians, and managers are still moved by economic variables.

 credit suisse world wealth map

(via Credit Suisse)

Financial Returns Come With a Cost

Professional investors, who generally earn more than the average person, are chasing high returns. To make things simpler, they do not take into account the effects their investments have on society, the environment, or the employees of the companies they invest in.

The world is facing monumental problems such as poverty, a shortage of clean drinking water, climate change, environmental pollution, and the already mentioned uneven distribution of wealth. Through impact investments, these problems can be solved. Unfortunately, this is only happening on a limited scale.

The good news is that research shows that people who fight for a better world are happier in general. Social impact investors try to contribute to a better world while earning a healthy return on their investments at the same time. And that is absolutely possible.

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What Are Social Impact Investments?

Investors who use their money to create both a financial return and a positive contribution to society are called impact investors. Another frequently used term is sustainable investors. Defining these terms can be difficult. What is classified as impact investing and what is not? When does something make a positive contribution to society?

When Is Your Investment an Impact Investment?

Example 1: Pharmacy

Is an investment in a pharmaceutical company an “impact investment”? The core activity of these companies is the development of medicines which can have a significant positive impact on people’s lives. You would say that this would be a great impact investment.

However, these companies are earning an incredible amount of money doing this, which is not a bad thing in itself. Should you still consider it an impact investment if the company develops the medicine they can earn the most money from instead of the medicine that can save most lives?

pharmacies develop drugs

Example 2: Public Companies Like Unilever

Another example is investing in public companies that try to integrate social, communal, and environmental aspects into their operations. Companies such as Unilever, Heineken, ING, or Philips. A lot of large institutional investors invest in these companies to call their funds sustainable. After all, these companies are winning prizes for their sustainable activities.

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But is Unilever for example really sustainable, just because their chairman Paul Polman is a forerunner of sustainability? By the way, Polman earns 244 times the salary of an average employee at Unilever. How equal is that? How much CO2 is emitted by Unilever employees flying around the globe for business meetings? Unilever is a company with great intent. It is great that the company is working to become more sustainable, but can it really be considered an impact investment?

Example 3: A Fishing Business in Ghana 

Finally, an example of a (fictitious) Ghanaian entrepreneur who, in order to feed his family, started a fishing business on the lake near his house. His fishery is doing well and growing quickly to become a substantial family business. Many children are able to go to school with the money earned through the company and the family can no longer be considered poor.

ghana fishing village

At the same time, the increased number of fish caught decreases biodiversity in the lake. The water is polluted by the motorized boats, and the people living in the village on the other side of the lake can no longer safely use it to drink or bathe. The polluted water makes children sick. Is this an investment in a fishery or an impact investment?

UN Sustainable Development Goals Framework

How should an impact investor look at this? A framework that is useful to assess impact investments in a broader context is the 17 United Nations Sustainable Development Goals, launched in 2015. These goals are aimed at fighting poverty, protecting the planet, and ensuring wellbeing for everyone. See the 17 goals below: Source: United Nations

 

social impact united nations sustainable development goals

 

This list of goals can be seen as a global wishlist with the primary goal of wellbeing. A world in which people are happy and the planet is not being destroyed. To achieve this globally, we need to reach these goals. If an investment contributes to these goals, does not impact the other goals negatively, and has a positive expected financial return, it seems natural to consider this investment a social impact investment.

How Large is the Social Impact Investing Market?

Although social impact investing is growing rapidly, it is still relatively small. For example, in the Netherlands, there is approximately 1,400 billion euros in institutional capital. Based on the data published by these institutional investors, 24 billion euros can be considered impact investments. That contributes to 1.7% of the entire market. Half of this is invested in public companies like those mentioned above. See the Public Markets figure below for an overview. Source: VBDO

 

social impact investing industry

 

50% of the 12-billion-euro investment in the private market consists of real estate and infrastructure investments. These investments are aimed at reducing CO2 emissions and related to SDG number 13. This, of course, is an important impact to be had.

But another important conclusion is that “merely” 6 billion euros, out of the 1,400 billion-euros of institutional investments, is invested in private companies that contribute to the other 16 SDGs. The majority of impact investing flows into American and European companies while problems such as access to clean energy, poverty, access to clean drinking water, healthcare, and education, primarily occur in Africa, Asia, and South America. Is this fair?

Thousands of Billions Needed

Institutional investors are not the only ones who could invest more in social impact investing, individual retail investors can as well. In the Netherlands, retail investors have savings of about 340 billion euros and investments of about 140 billion euros. This group also invests just a fraction in social impact investments, of which the majority again goes towards renewable energy.

That is a fundamental problem. Impact investments are crucial to reach the SDGs. According to United Nations data, thousands of billions are needed in the coming years to finance the transition to renewable energy, banish poverty, and provide clean drinking water, good healthcare, and access to education for everyone.

social impact investing raising cattle

No one knows exactly how much money is invested in impact investments. A survey among GIIN (the world’s largest network for institutional impact investors) shows that their members manage around 105 billion euros in social impact investments. The total market is bigger, but my guess is that it is less than twice this number, and definitely less than three times. However, even if the total market were 5 times larger, it would still fall far short of raising the trillions necessary to achieve the SDGs.

Why is Social Impact Investing Not a Larger Industry?

The good news is that the necessary money is available. According to McKinsey estimates, there are some 118 trillion dollars of capital available worldwide. Just in the Netherlands, institutional and private investors own capital worth some 2 trillion euro. The question remains how we can move a significant part of this capital into impact investments. And why do impact investments currently only account for such a small part of this total capital? There are various reasons, some of which are discussed below:

1. A faulty perception of the risk and return of impact investments

Research shows that many professional fund managers, who manage the capital of large institutional investors, think that there is no strong business case for investments that take into account social factors and the environment

Sustainable Investments Don't Have Lower Returns

It remains questionable if this perception is correct. Plenty of academic reports show that investments with a more sustainable character do not have lower returns than traditional investments. The renowned Journal of Sustainable Finance and Investment published a paper that looked at 2,200 research reports from the last 30 years. This paper clearly demonstrates that a business case for impact investing can be built, and that this form of investing does not have lesser returns.

GIIN also conducted research on the question whether investors who solely chase market returns can achieve these returns through impact investing. Their research showed that this is possible, as you can read in the conclusion. Another GIIN survey showed that the majority of those 209 institutional investors experienced greater than expected financial and social return on their impact investments.

A third group that did research on the returns of investments with a sustainable character is Robeco. In their report, they even talk about the myth of low returns from social impact investing.

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Don't Just Look At Returns

Of course, we should not only look at the returns but take the risks into account as well. Good returns are important, but to make a fair comparison risks should be measured as well. In other words, we need to take a look at the risk-weighted returns, a variable that measures these risk-weighted returns is the Sharpe ratio.

Recent research, conducted by a large microcredit investor together with GIIN, shows that the Sharpe ratio for microcredit investing is among the best. Besides that, it showed that microcredit investments have little correlations to other investments. This means that microcredit investments help to improve the risk-return ratio of the entire portfolio through diversification.

Plenty of Opportunity

Besides the risks, as an investor, it is important to look at opportunity as well, and the opportunities are plenty in emerging markets. Look at Africa for example, where many households are switching to renewable energy. To do so, billions in investments are necessary, and these investments come with a nice return.

Both solar and financial technology make this possible. This offers great opportunities for investors to earn an attractive financial return, and at the same time improve these poor households’ access to energy, by lowering the costs and improving the quality. This solar energy will replace the current alternatives, which are generated using polluting, odorful, and dangerous kerosene lamps or diesel generators.

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2. Insufficient quality of the offering and novelty of the matter 

In a recent article by Willem Schramade in the Journal of Applied Corporate Finance, the options to invest in the SGDs are definitely limited. An investment in renewable energy in Africa, for example, is difficult to access as a private investor. Investments in microcredit are more accessible but still small in terms of volume.

Micro Credits Perceived as High-Risk

These microcredit investments can be done through Triodos and Oikocredit in the Netherlands. The part of Dutch investors who invest in microcredit is small, especially when considering the strong track record of microcredit. This could be caused by the, often false, perception of microcredit as high-risk. The majority of Dutch private capital is in savings accounts at big banks or invested into funds.

Easily Scalable

For institutional investors there is another hurdle; these investors are looking for investments that are easily scalable at low (administrative) costs. On top of that, the investments must meet liquidity standards and the impact must be measurable. This is not always in line with the offered social impact investment opportunities. Large institutional investors want to invest amounts that are so large that it can not be put to use for microcredit or other impact investments quickly enough.

Although these parties understand that the returns are not lower than the returns on traditional investments, impact investment opportunities are often not scalable enough. On the positive side, this leaves ample opportunity for the smaller investors with a heart for the world. Still, to truly change the world through social  impact investing, the help of the larger institutional investors is necessary. 

5 Reasons for the Limited Growth of Impact Investments 

The above reasons are in line with a paper published by GIIN, which discussed 5 reasons for the limited growth of impact investments. GIIN held a survey of its members and asked what they considered as bottlenecks in the future growth of impact investing. In this survey, only institutional investors who were already active in the impact investing sector were considered.

 

What Have You Learned? 

  1. Impact investments offer both retail and institutional investors the opportunity to earn attractive risk-weighted returns
  2. For large institutional investors, the main barrier to the impact investing market is the scalability. This leaves ample opportunity for impact investments with a healthy financial and social return for the smaller investors with a healthy dose of brainpower and heart for the world.
  3. Due to the low correlation with other investments, impact investments contribute to a stronger investment portfolio.
  4. The benefits of impact investments are not recognized enough by both institutional and private investors.
  5. As a result, the impact investing market is only a fraction of the total investing market.
  6. A substantial proportion of this fraction is invested in public companies in Western countries and focussed on the renewable energy sector.
  7. Only a small fraction of it remains, which is used to face challenges in emerging countries, such as poverty, access to renewable energy, access to clean drinking water, the opportunity for proper healthcare, and schooling.
  8. In order to reach the SDGs, thousands of billions are necessary. This requires a lot of action from investors.

What Needs to Happen?

  • Governments and institutions can make social impact investments more appealing for investors by covering the risks through guarantees of fiscal stimulation. They can also increase the amount they invest in impact investment opportunities.
  • Private and institutional investors need to move (substantially) more of their capital into impact investments.
  • The quality of the demand for impact capital needs to improve through training, coaching, co-operation, and non-financial support to companies with an impact, so-called social enterprises
  • Innovative structures are necessary, in which governments, private investors, and institutional investors can work together to make impact investments.
  • The image of impact investing needs to improve; impact investors are not a bunch of tree-huggers but involved global citizens.
  • There needs to be more information for the investors, through more research into the risks and return of impact investing.

Topics: social impact, impact investing

Peter Heijen, Founder

Written by Peter Heijen, Founder

When I traveled through Nepal, India, and Bangladesh a few years ago, I saw with my own eyes that entrepreneurship and employment are the strongest weapons against poverty. However, many entrepreneurs do not have access to affordable financing. Crowdfunding seemed like a good solution, that's why I founded Lendahand. I've been amazed by the results!

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