Impact Investing: Conscience, impact and abundance

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 30, 2019 - January 05, 2020.

Drought and flooding have led to water being seen as a valuable resource rather than just a commodity

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When it comes to investing, financial returns and social considerations did not always go hand in hand. In fact, businesses went through a phase of prioritising profit maximisation at the expense of everything else, including the environment and community.

However, the pendulum is slowly swinging the other way as impact investments, which support businesses that consciously create a positive impact on the community, environment or both has become on-trend in the 21st century.

The segment has gained significant momentum as both an investment strategy and an approach to addressing pressing social and environmental challenges in the last decade, says the Global Impact Investing Network (GIIN) in its Sizing the Impact Investing Market report in April.

Defined as “investments made with the intention to generate positive, measurable, social and environmental impact alongside a financial return”, the global impact investing market is estimated to be worth US$502 billion, from just US$228 billion under management in 2017, GIIN points out. Impact investing is considered a subset of socially responsible investing.  

The initial impact investing framework began taking shape in the late 1990s and early 2000s when private investors — led prominently by large family-run entities — wanted a clear distinction between investment activities and philanthropic giving.

It was also when investing based on environmental, social and governance (ESG) principles entered the mainstream as assets owners and managers opined that ESG factors were beneficial when it came to risk mitigation. Prior to that, many early strategies that were deemed ethical and virtuous were in accordance with investors’ faith or moral values.

Simultaneously, the world’s financial engines were starting to choke. In 2007, a downturn in the US housing market — caused by innovative structuring of subprime mortgages and novel securitisation strategies — sparked a financial crisis that spread to the rest of the world.

“The global financial crisis served as a wake-up call to many as it brought into focus the huge potential real-life costs of financial decisions that purely chase short-term profits. The timing of this awakening coincided with the establishment of the current ‘impact’ market as we know it,” says Stephanie Choi, a partner at Hong Kong-based Sustainable Finance Initiative (SFi).

The SFi platform is aimed at mobilising private capital for positive impact to accelerate the city’s transition to a sustainable financial hub.

While impact strategies embody the values of ESG and shares similarities with socially responsible investment approaches, asset managers go several steps further to deliver positive outcomes. To investors who are driven by purpose, finance is seen as a powerful tool to enact change and maximise impact.

At US$502 billion, impact assets make up only a fraction of the US$74.3 trillion in assets under management globally, but the growth has almost doubled since 2017.

One of the key inflection points that led to the development of the sector was the launch of the United Nations Principles for Responsible Investment (UN PRI) in 2006, a voluntary and aspirational set of investment principles for incorporating ESG issues into investment practices. Today, the UN PRI has more than 7,000 corporate signatories in 135 countries.

“This served as a locus for companies — large and small, and across industries — to begin to coordinate, collaborate and act around a set of defined principles,” says Rob Kaplan, CEO of Circulate Capital, a Singapore-based venture capital firm that launched a US$106 million fund dedicated to addressing Asia’s plastic crisis.

The Rockefeller Foundation subsequently introduced the term “impact investing”, which ignited a global conversation on investments that look for both financial returns and social or environmental impact, says Kaplan.

In 2010, the UK government put the concept to the test by initiating the Peterborough Social Impact Bond. The first-of-its-kind initiative funded rehabilitative interventions for 1,000 prisoners with short sentences for a year after their release from Peterborough prison.

A total of 17 impact investors footed the £5 million bond and by 2017, it had resulted in a 9% reduction in the reoffending rate. Investors received their initial capital plus a return of just over 3% per annum for the period of investment. “[The bond] was focused on dealing with recidivism, but it spawned a whole new wave of innovation and investment,” says Kaplan.

To further harness the power of impact capital, the UN adopted the Sustainable Development Goals (SDGs) in 2015 and outlined 17 development challenges, including poverty, health, education and climate change. The SDGs not only identify these challenges but also present 17 unique investment opportunities, says En Lee, managing director and head of sustainable and impact investments (Asia) at LGT,  a leading private banking and asset management group owned by the Princely Family of Liechtenstein.

“Impact investors are looking at similar sectors and countries as other commercial investors but they are looking to invest in solutions that address certain gaps in the market and specific business models that have the dual mandate of driving positive impact alongside financial and operational scale,” says Lee.

Choi says the traction is driven by an increase in stakeholders at public and private companies demanding sustainable practices from businesses, the diversification of non-profit organisation and charity revenue sources away from traditional sources such as donations and grants, and investors seeking to align investments with their personal values. “From the demand side, greater consciousness of social and environmental issues, especially among millennials, who are embracing a more holistic life view (less distinct lines between work and other commitments, for example), allows for easier adoption,” he says.

In addition, the reduction of yields following the quantitative easing measures means that investors have a greater appetite for alternatives than they did a decade ago. “But it also has a lot to do with improving disclosures, more attractive investment products and the development of coherent analytical frameworks, all of which have made impact investing more accountable and approachable,” says Choi.

Moreover, in a reality where climate change, rising inequality, poverty and environmental degradation are pressing global challenges,  investors realise that sustainability is no longer an option but an imperative, says Lee. “In a defensive market environment both private and institutional investors are looking to ensure that their investment portfolios are future-relevant and future-proof.

“Sustainable investment strategies including impact investing are forward-looking strategies based on how the world will look like in the future.”

While the case for impact investing is compelling, there is no shortage of challenges in the nascent industry. For starters, there is still a lot of hesitation when it comes to deploying from page 9

capital because investors are concerned that the returns do not justify the perceived risk, says Kaplan. And the track records of such investments should be monitored better because potential investors want to see that those who have already invested are “making a lot of money”, he adds.

“There also needs to be a pipeline where there is visibility to a lot of deals. If you are looking to deploy US$100 million, you want to see US$1 billion worth of opportunities,” says Kaplan.

“And there needs to be more investment products and easy ways for different investors to participate. We need more funds, larger funds, funds of funds and more.”

Another obstacle is effective impact pricing, says Choi. Existing tools to measure impact quantitatively are less sophisticated than traditional financial analytical methods, she points out.

“So, it remains a challenge to incorporate impact into overall financial portfolios, both from an asset allocation perspective and a bottom-up valuation approach. At the same time, the newness of impact accounting means that products have not achieved scale, thereby limiting accessibility. Most investors, therefore, pursue sustainable investing through a carve-out or separate allocation of assets,” she adds.

On the other hand, there is the problem of “impact washing”. This is where a business or fund misrepresents its claims to generate positive and measurable social or environmental impact, impact washing may happen, Lee points out.

One recent effort to counter the risk of impact washing comes from the International Finance Corporation (IFC) via its Investing for Impact: Operating Principles for Impact Management report, he says. This principles advocate a common discipline and greater transparency in terms of the management of impact investments.

Despite the teething issues, Lee is optimistic about the growth and performance of sustainable and impact investing assets. “Looking at the macro environment, we can see there will be a stronger impetus and investor interest from institutional and private investors,” he says.

One of the founding family offices of SFi, Hong Kong-based RS Group, for example, has built and managed a fully sustainability-aligned portfolio, achieving an average net annual return of 5% over 10 years — slightly above custom benchmarks based on the MSCI ACWI Barclays Global Aggregate and other customised reference figures.

“But like any maturing asset class, there will be greater bifurcation as larger and more established private equity managers enter the space promising attractive risk-adjusted market returns,” says Lee.

“Private investors and family offices that see this as an extension of their philanthropy may be willing to come in at a lower return because they really like the impact.”