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Published on: Nov 26, 2024
Modified on: Nov 26, 2024
#Financial Markets
#Trading 101
Impact investing aims to reduce social or environmental harm caused by business activities, interconnected with philanthropy.
The world today is witnessing a somewhat uncertain environment between society and business. Most companies and financial institutions are desperately seeking investments that can make their businesses profitable and have a positive social impact. This search has increased the need for impact investing – investing in companies that aim to create social or environmental returns.
The global impact investing performance grew from $420.91 billion in 2022 to $495.82 billion in 2023, representing a compound annual growth rate (CAGR) of 17.8%. Such an investment may vary from funding for low-income housing to investing in timber operations and eye-care facilities that are unavailable under traditional business approaches. While impact investing has positive features, it has yet to attract traditional investors. The space is dominated by risk-taking venture capitalists and non-governmental organisations (NGOs) acting as ‘first institutional investors’.
These investors understand the opportunities to enter new markets and improve employee morale and identifying potential risks. However, some argue that such investments may struggle to scale to a level that delivers good returns, are riskier than traditional options, and lack liquidity, complicating exit strategies.
A study from the GIIN research suggests that investors managing over $500 million in assets control 92% of impact investment holdings. The study dispelled several myths discouraging conventional investors and pointed out a growing recognition among firms and big investors of the real potential of impact investing.
The term ‘impact investing’ was coined in 2007, while its practice began much earlier. In essence, impact investing is an attempt to reduce social or environmental harm caused by business activities. It is interconnected with philanthropy.
Investors looking to invest in impactful causes normally consider a firm’s commitment to CSR or responsibility to society before investing. The effects of impact investing can be identified in specific industries and companies; however, it is possible to list such measures as social relations and environmental responsibility.
Institutional investors including hedge funds, private foundations, banks, pension funds, and fund managers mainly apply impact investing. Nevertheless, many socially responsible finance companies, online investment platforms, and investor networks have recently enabled individual investors to engage in impact investing. Microlending, for instance, provides businesspeople in the developing world with assistance and start-up or growth capital.
The goal of impact investing is to enable individuals and businesses to generate financial returns while contributing positively to society and the environment.
Impact investment funds can be divided into public equity, public debt, private equity, and debt funds. Every kind of investment – you own a share of stock, a bond, a stake in a private equity firm, or a private loan – and the resulting relationship with the issuer, including the level of control, is distinct, and each yields a unique level of impact.
Equity investments in the public market are probably the most complex to track the performance of impact investing. For example, when a fund invests in Apple’s stock through the stock exchange, the money is transferred to the previous shareholder of the share. Hence, the investment is not directly linked to activities considered impactful. At most, it can be said that investors have a share in the positive outcomes that Tesla generates from its business operations, such as decreasing the use of fossil fuels and improving battery technology.
However, Tesla would have probably generated this impact irrespective of the fund’s investment; therefore, the marginal impact of the investment is modest. Equity fund managers can get involved in the companies directly through discussions with management, voting on proposals during shareholder meetings, or coalitions with other investors. These engagement exercises are good tools to bring about change and can be quite powerful, but they demand a certain level of shareholding and can be quite costly to manage several of them simultaneously.
Plus, the results of such campaigns are often qualitative and, when positive, will likely be changes in governance or strategy. These will be further discussed at an annual general meeting and may interest many investors.
Bonds and other fixed-income securities have several embedded characteristics that make them useful in impact investing. Bond agreements can be quite flexible when measuring the impact of impact investing, and lenders can define certain goals for the borrowers with the help of covenants and sanctions. Such financing can be associated with assets and the corresponding activities that generate impacts, called ‘use of proceeds’.
Since bonds are usually issued with a specified term, investors can manage impact requirements on a bond-by-bond basis with every new issue or refinancing. This is because green bonds used in environmental-friendly projects have been highly considered. Another relatively new form is sustainability-linked bonds (SLBs) – bonds whose coupons are priced to rise if the issuer fails to achieve certain environmental or social goals in a specified period.
While social and blue bonds are similar in structure to green bonds, they are used for social purposes and ocean or marine protection. They enable investors to provide new funds for a particular project; hence, the link between the investment and its outcome is well-defined. However, the impact of investing in a sustainability-linked bond is less clear, since SLBs are not associated with results.
In private markets, investors are ready to accept the challenge of liquidity and focus risk, which are the most efficient ways to achieve the impact investing performance goals through private equity and private debt. These private market strategies enable the investor to engage directly with the recipient, often one-to-one.
Given that funds generally have a life of ten years, private strategies contribute long-term capital associated with developing and achieving impact goals and plans. In addition, private investors usually get a high level of transparency from the data provided by their investments. They can thus observe the results and make potential corrections to improve their performance.
The Bill & Melinda Gates Foundation is a private foundation established by Bill Gates, founder of Microsoft, and his wife, Melinda. It is one of the biggest impact investors in the world, holding over $40 billion in assets. Although mainly focused on philanthropy, it also manages a strategic investment fund, which showcases the impact of impact investing to improve people’s health, education, and gender equity. The strategic investment fund seeks to invest in ‘organisations or projects that benefit the world’s poorest and are often overlooked by traditional investors’.
The Soros Economic Development Fund is an impact investment part of the Open Society Foundations, founded in 1997 by billionaire and philanthropist George Soros. It works in many areas, including democracy, the rule of law, education, media, and more, showcasing its focus on creating meaningful social change.
The Ford Foundation was founded in 1936 by Edsel and Henry Ford with a capital of $25,000. It has grown to be one of the largest foundations in the world in terms of endowment, with a net worth of more than $16.6 billion. To date, this fund has been helping programs that are in sync with the principles of the foundation. The Ford Foundation changed direction in 2017 by declaring that it would seek to support $1 billion of its endowment to business activities that align with the foundation’s mission, which suggests a deep commitment to mission-related investing.
Danone’s mission is to improve health through food and nourishment using the slogan ‘One Planet, One Health’. The company’s investments are directed to various social programs, such as the Danone Ecosystem Fund and Livelihoods. These social responsibilities have been implemented to address some of the major global challenges, including environmental issues and the provision of water supply.
In 2013, the company decided to set up a $20-million venture capital fund to invest in start-up companies founded by people who were passionate and wanted to create useful, sustainable products. First known as the ‘$20 Million & Change’, the fund changed its name to Tin Shed Ventures and has invested in 12 companies focused on environmental innovation.
Social and environmentally responsible firms are often noticed by impact investors, who have the potential to benefit these businesses financially. The performance of impact investing holds more significance with the younger generation, like Millennials and Gen Z, who are eager to make a positive change. As these groups gain financial influence, the trend of impact investing is expected to rise.
Impact investing also allows individuals and stakeholders to exhibit their support for the values and missions of the companies they invest in. The overall goal is to encourage more businesses to practice impact investing, as many investors are now realising these investments’ social and financial benefits.
Private market investors have been active in impact investing longer than those in other asset classes, mainly because they originated in the investment offices of high-net-worth individuals and foundations.
The rise of new impact investment firms and the creation of dedicated departments in existing investment companies have further fuelled the growth of impact investing. Private capital can target many impact opportunities, with common areas of interest including technology innovation, energy transition, healthcare, and social causes such as education, financial inclusion, and affordable housing.
Understand how capital allocated to impact investments generates returns and meaningful outcomes is important. Investors should ensure that a fund’s objectives match their own and verify that fund managers provide accurate and transparent reporting on impact outcomes and associated risks relative to portfolio performance.
What is impact investing?
Impact investing involves investing capital in entities that can create social or environmental impact while offering financial returns.
What has made many mainstream investors shy away from impact investing?
A significant factor is the common misconception among institutional investors that impact investments do not generate good returns, are riskier, and offer low liquidity, leading to increased uncertainty.
What kind of assets are most common in impact investing?
Impact investments can be made through public equity, bonds, private equity, debt, and other instruments. These instruments have diverse degrees of control over the investing company.
Is it possible for the individual investor to engage in impact investing?
Yes, there are socially aware financial institutions and online intermediaries that enable individual investors to participate in impact investing.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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