Who gets to wear the impact label?

There is not yet consensus about what constitutes a true impact strategy; debate about definitions could get in the way of much needed progress.

Impact investing is fast becoming private markets’ strategy du jour. But do investors know what they are getting?

“Definitions of impact investing vary from fund to fund,” said Adam Rein, COO and president of CapShift, which helps families and charitable institutions develop impact investment portfolios. “There are high level standards and frameworks, but they are not uniformly applied.”

Global Impact Investing Network describes impact investments as those with “the intention to generate positive, measurable social and environmental impact alongside financial returns”. And while it is clear there is a need for intentionality around impact and a requirement to measure it, the waters are occasionally muddied by an overlap with environmental, social and governance strategies.

Helge Tveit

“We do see a lot of confusion between these terms,” said Helge Tveit, managing partner of EV Private Equity, an energy technology-focused impact firm. “The difference is that ESG is about sensible investment and proper stewardship of companies – you have to look at areas such as diversity, governance and the environmental impact of your investments. We see this as a hygiene factor. Everyone should be doing this. Impact, however, is about your intentions and the specific targets you set to achieve certain outcomes.”

Shami Nissan, head of responsible investment at Actis, agreed. “Not everyone is on the same page, although we are seeing a broader consensus emerge,” she said.

“ESG is now largely referred to as a risk mitigation approach: as an investor you’d look at where the E, S or G aspects are that represent material risk and then determine how you would use your time as an owner to plug gaps and elevate company practice.” Impact is distinct but related, she added. “This is about generating positive outcomes, about being intentional in achieving these and being able to measure and verify them to demonstrate what you have done.”

Grey areas?

Yet with measurement frameworks and methodology still relatively early in their development, it can be hard for potential investors to get their arms around which impact offerings are genuine. Respondents to GIIN’s 2020 survey highlighted impact-washing as the greatest challenge facing the market over the next five years, cited by 66 percent. “There are some areas where there is alignment,” said Rein. “There are standard reporting metrics around climate change and carbon footprint and diversity and inclusion, for example. But there are shades of grey in others.”

“Historically, we have seen some firms imply they are impact investors on the back of positive outcomes that they hadn’t originally envisaged”

Shami Nissan

It is a steadily improving picture, but LPs do need to be on their guard. As Nissan noted: “Historically, we have seen some firms imply they are impact investors on the back of positive outcomes that they hadn’t originally envisaged or driven from the outset, although it is becoming more difficult to do this as asset owners are becoming more knowledgeable and discerning.”

Other issues can crop up, too, at the nexus between impact and ESG. “There have been cases where excellent impact investors have been let down by their approach to ESG,” said Clarisa De Franco, managing director and head of private equity funds at CDC. “An example might be an investment in an agriculture business that seeks to derive impact by sourcing products from smallholder farmers to help improve their incomes, but there may be poor working conditions for labourers there; another would be a strategy focused on social housing where buildings don’t comply with safety standards or where climate risks aren’t appropriately managed. As an impact investor, you have to make sure you are looking at both impact and ESG standards.”

Beyond the obvious

Added to the mix is the question of what type of investments impact-focused funds should – and could – be making. There are clearly certain sectors that, by their nature, generate impact. Improving access to healthcare and education, creating renewable energy capacity and building social housing, for example, can all have obvious positive social and/or environmental outcomes. Yet many institutional investors are looking beyond this low-hanging fruit. “This is not just about targeting ‘green’ sectors or those that offer evident social benefit,” said Andrew Lee, head of sustainable and impact investing at UBS. “There are opportunities to generate positive impact across many parts of the economy. As an investor, you need to be looking at whether a fund has a clearly articulated strategy for why certain investments have impact, what their impact thesis is and how the investment will enable the stated impact objective.”

“Impact investing goes far beyond targeting areas such as renewables,” added De Franco. “You could invest in a soap manufacturer, for example. If you are intending to make the business more sustainable by improving energy efficiency, installing new wastewater plants, creating good-quality jobs and perhaps improving the diversity of the workforce, this could all be impactful. Ultimately, it comes down to the question: what do you intend to achieve when you invest in that business?”

Work in progress

Given the scope for confusion and concerns around impact-washing, and as more firms enter the impact space, the need to clarify and standardise definitions and measurement systems will only grow. There is certainly a lot of effort currently going into this. Some GPs have devised impact methodologies that are widely available for others to use. Y Analytics, for example, is an independent organisation established by TPG that helps investors and companies understand impact potential and how to generate it, while the Actis impact measurement scoring system, designed by the firm to compare impact across investments – and potentially managers – is open source.

Broader initiatives are also underway. The Impact Management Project is a network of practitioners aiming to build a global consensus around measuring, managing and reporting impact and the International Finance Corporation released its set of Operating Principles for Impact Measurement in 2019. In Europe, the EU’s Sustainable Finance Disclosure Regulation, which came into effect in March 2020, may help provide some clarity around funds marketing with an ESG or impact strategy – Article 9, for instance, mandates additional disclosure for any fund manager that markets to EU LPs and claims sustainable investment as its “objective”. And in the US, the Securities and Exchange Commission has just announced the creation of a taskforce that will target misstatements and disclosure gaps in fund managers’ ESG strategies.

Shami Nissan

So how much does it matter that there is, as yet, no firm consensus on what constitutes an impact investment?

The impact investment space has come a long way in a short space of time. When GIIN conducted its first annual impact investor survey in 2010, it contained the views of just 24 investors; in 2020, the survey garnered responses from nearly 300 institutions that collectively manage more than $400 billion in impact investments. GIIN estimates the size of the impact investing market at over $700 billion today.

We have seen a flurry of private markets firms launching impact funds. Large, mainstream players such as Bain Capital, TPG and KKR have now joined smaller, long-standing specialist firms in pursuing positive social and/or environmental impact outcomes as well as financial returns.

“Our industry has wasted too much time and energy arguing about definitions and how to apply them. Too often, those disputes have enabled inaction”

Gretchen Postula

Although there are clearly concerns about the potential for firms to make marketing claims that don’t quite stack up, many seasoned investors in the space – both at LP and GP level – remain sanguine. “Taking action to solve problems is what is necessary, regardless of how one wants to define ESG, impact or any of the myriad related concepts and terms,” said Gretchen Postula, head of investor relations at North Sky Capital, a firm that invests in sustainable infrastructure as well as impact secondaries. “Our industry has wasted too much time and energy arguing about definitions and how to apply them. Too often, those disputes have enabled inaction. We have urgent challenges to address and we can’t let perfect be the enemy of the good.”

Many welcome the arrival of more mainstream players, particularly those able to raise substantial funds. They are both directly and indirectly mobilising capital towards impact. “The entry of the larger private markets firms is positive overall,” said Nissan. “The sheer brand weight they bring means that more column inches have been dedicated to this space over the past two years. Even if it is found that some impact strategies could be more rigorous, we have to recognise that we have to walk before we can run. If the serious heavyweights of the industry are iterating in the wings, at least the momentum is building behind impact. We need to get started and then we can build greater consensus around measurements and standards.”

For now at least, investors in impact funds will need to rely at least partly on judgment as to whether impact claims are genuine. At the same time, those raising impact vehicles alongside more conventional funds may find that LPs want to scrutinise the firm’s entire portfolio; after all, do they really want to be committing impact capital to a firm that has a positive impact in one strategy, but whose investments in other areas are detrimental to the environment or society?

Further out, they may also increasingly demand that compensation is linked to impact outcomes. “You have to be authentic – this can’t be a box-ticking exercise,” said Tveit. “The consequences of not delivering financial returns is clear in private markets; the consequences of not delivering impact objectives less so in many instances. We tie our financial compensation to the impact we achieve. That’s more straightforward for us because we are sector specialists and we have one specific target: to reduce greenhouse emissions.”

“The IFC principles already suggest that incentives should be aligned with impact achievement and I would expect to see this develop concretely,” added Lee. As methodologies and measurement systems improve and it becomes easier to compare impact performance across sectors and managers, this will come. And at that stage, it will become much easier to determine which strategies are genuinely focused on achieving impact.