Private credit has generated some of the earliest innovations in impact investing – such as microfinance, which helped extend credit to previously unbanked individuals and served nearly 140 million people worldwide as of 2018. The use of community development financial institution notes for investment in affordable housing and community development is another example. More recently, credit has driven innovations in impact investing, such as the invention of green bonds – fixed-income financial instruments that fund projects with positive environmental benefits.

Michael Etzel, Bridgespan Group

Although the launch of private-equity impact investing funds by some of the largest global asset managers has captured headlines over the past five years, private credit is actually the largest impact investing asset class: according to the most recent annual GIIN survey of impact investors, it accounted for 61 percent of impact investments made in 2019, with $17 billion deployed. Yet $2.5 trillion per year is still needed to close the UN Sustainable Development Goals funding gap. Given that private, market-rate credit assets under management have nearly doubled from 2014, and are soon expected to exceed $1 trillion, there is an important opportunity for private credit investors to sharpen their focus on impact.

This opportunity can be approached via two different entry points: impact-focused instruments (across sectors); and a handful of high-impact sectors.

Instruments for credit impact investing

The most familiar impact credit products are green bonds – ‘use of proceeds’ bonds that finance projects with climate or environmental benefits. The first green bond was launched in 2007 by the European Investment Bank to fund renewable energy and energy-efficiency projects. Since then, Toyota, Amazon, Apple and many other companies have launched green bonds; the market is now estimated at $375 billion, with strong growth expected.

The popularity of green bonds has given rise to a variety of other use-of-proceeds bonds. Blue bonds fund water-related projects, such as the Nature Conservancy’s financing for protected marine areas. Forest bonds fund projects to reduce deforestation, such as the World Bank and BHP Billiton bond to protect dryland forest in Kenya. Gender bonds fund female empowerment – for example, through the Inter-American Development Bank’s bond to fund projects that promote gender equality and women’s empowerment in Latin America and the Caribbean.

Recently, sustainability-linked bonds have emerged as a way to link interest rates to the issuer’s ability to achieve a pre-determined social or environmental objective that maps to the SDGs or other sustainability objectives. ENEL launched the first SLB in 2019, whereby the Italian power company promised to increase its installed renewable energy capacity from 46% to at least 55% by 2021; if it does not achieve this objective by the end of the year, its annual interest payment to bondholders will increase by 25 basis points. Less than $10 billion worth of SLBs have been issued to date, primarily by enterprises in Europe. Yet growth is picking up, with some observers predicting a six-fold increase to $60 billion this year.

Targeting sectors

Much of the early impact investing with credit has been focused on a set of sectors with a strong baseline potential for social and environmental impact. Today, some of the most promising sectors include renewables, healthcare, education and affordable housing. Companies in these sectors have business models that are built to make a positive difference on social and environmental issues.

Investment in financial services, which has been a historically popular sector among credit impact investors, requires closer inspection to determine potential impact. Other sectors in which impact is less clear but where opportunities are worth considering on a case-by-case basis are food and agriculture, transport, technology and telecommunications, media, manufacturing and business services.

As should go without saying, not all companies in a given sector make a positive social and environmental impact or have the same level of impact. It is therefore critical to assess the impact of specific prospective investments rather than green-light entire sectors.

Assessing impact

This brings us to a critical question: what are the best ways for new credit impact investors to assess impact? Credit investors looking to have social or environmental impact face a market with challenges similar to those in the broader impact investing market: products are proliferating while standards are just emerging and remain limited. This makes it difficult to assess the ‘impact’ in impact credit investments.

Critics of green bonds have focused on the difficulty of connecting the use of proceeds by issuers to specific environmental outcomes. This has led the International Capital Market Association to develop a set of green bond principles to establish transparency and integrity around the segment. Instruments such as blue bonds, forest bonds and gender bonds still lack clear guidelines for evaluating impact. In the case of SLBs, there is an open debate about how much yield must be on the line to provide a meaningful incentive for impact performance.

Such uncertainties, however, do not mean that private credit investors need to start from scratch when it comes to assessing impact. They can use the tools and standards that private equity impact investors have been sharpening: clearly tying the outcome of each investment to an SDG, assessing the five dimensions of impact outlined by the Impact Management Project (who, what, how much, contribution and risk), and developing fund and investment practices designed to actively manage for impact performance in line with the International Finance Corporation’s nine operating principles for impact management.

Mainstream asset managers are beginning to enter the market, with larger-scale market-rate funds deploying credit. For example, the Tikehau Capital Impact Lending Fund, targeting between €350 million and €400 million, was launched in 2021 to support European small- to medium-size enterprises contributing to an inclusive and sustainable economy through sustainable products and services and improved resource management.

As new funds enter and seek to make sense of the impact credit market, they should ask three questions about any potential investment:

  • Is the debt tied to a specific company or to a derivative or other complex instrument? It can be hard to untangle the underlying mechanics of a derivative, and harder still to evaluate impact when such an instrument is involved. It is much easier to assess the impact of the products and services of a specific company.
  • Is the use of proceeds defined and, if so, is it used to advance SDGs? For example, green, blue, forest and similar bonds earn their ‘colours’ by focusing proceeds on impact-oriented projects. General-obligation bonds, by contrast, require greater scrutiny of both the company and likely use of funds.
  • What evidence is available for assessing whether the investment is producing the impact it claims? As mentioned, some sectors are, by definition, more likely to produce impact than others, thus allowing a lower burden of proof when evaluating for impact. Investments in sectors not traditionally associated with impact will require additional evidence to demonstrate that they will generate impact above and beyond what might otherwise be expected. Identifying a pathway to impact by asking, “Does this investment primarily benefit individual people, society generally or the environment?” is often a useful first step towards establishing evidence of impact.

Answers to these questions will inform the level of due diligence required to establish the potential impact of any individual investments. However, given limited partners’ increasing demand for rigour and transparency around impact measurement, investors would do well to establish and document a due-diligence approach that appropriately applies available data and evidence and sets high thresholds for what constitutes impact.

Michael Etzel is a partner and co-head of impact investing at the Bridgespan Group and a board member of Bridgespan Social Impact