I would be willing to bet that the most common sentiment that an investor looking to participate in impact-focused investing would be feeling upon delving into the sea of “opportunities” would be frustration.
I have written numerous articles about some of the current faults of the impact investing market and the corrupted product offerings in impact investing available from large asset managers and others. But, I have not yet provided you with the process that individual investors can use to actually select an appropriate, meaningful impact-focused investment(s) for their portfolio. This article will do just that.
I will aim to educate on the thought process each and every impact-focused investor must go through to strategically select the impact investment that is right for them. Although much of the calculation of impact can be qualitative in nature and highly dependent on the investor’s personal global perspective, the process to which to analyze and assess value should be similar for all investors. As usual, we have focused here on the individual accredited investor building their own investment portfolio rather than institutional investors or money managers.
Step One: Understand where impact is possible and assess your goals
Most impact-focused investors want to be passive investors. They intend to invest in a company or a fund with an expectation of receiving both positive financial returns and driving social value with their investment capital. As such, we will focus on the majority for this analysis. These passive impact investors face an initial three-step process for finding the right investment:
- Investors must find companies that can demonstrate “real” impact: These are the companies that can make a positive difference in the world and prove it. Typically, companies cultivate meaningful impact through their operations, known as operational impact, or through their product line, known as product impact. Operational impact has more of an effect on the company’s employees and the community around them, whereas product impact typically focuses on the creation of social value from their goods or services being present in the market.
- Investors must believe that their capital investment is necessary to achieve the impact goals of the company: In other words, this capital investment must provide “investment impact” to the company itself in the achievement of its performance goals. This must be needed capital.
- Investors must make a determination of what kind of investor they are:
- Socially-neutral: These investors make decisions solely based on their expected financial returns. Therefore, these accredited investors would only invest in an impact-focused company if it earns at-market, or above-market, returns as compared to traditional companies. These investors are largely looking for arbitrage. They will only invest in impact companies if they believe that impact-focused companies will outperform traditional companies in the long-run. But they will never sacrifice returns.
- Socially-motivated: These investors factor social value creation into their investing decision as a potential offset to any decreases in expected financial returns. These investors are willing to earn at-market, and sometimes below market returns, if the social value creation by the company is attractive enough. This investor class has a much more in-depth analysis to be performed than the investor class above, who solely chase financial returns. This investor class must fully understand which social value is most important to them, understand how important financial returns are to them in return for achieving these social value objectives and undergo this analysis on each and every portfolio investment they make to determine whether the company they are investing in can actually achieve the social impact that they want.
Step Two: Understand how to define and assess the value of impact
There are thousands of companies that focus on providing impact-focused returns to investors. Each has their own social value(s) that they are looking to promote within their corporate DNA. No impact-focused company can solve all the world’s issues alone. Each company has to clearly identify which social issues mean the most to them, assess which problems they believe they can reasonably solve and execute a plan to move the train forward. Impact-focused investors must be able to use a reasonable qualitative framework approach to understand how to assess which company’s value proposition means the most to them.
- Impact-focused companies should benefit under-priviledged consumers or produce positive externalities: This is fairly self-explanatory, but the theory is that citizens of wealthier, developed countries are likely in less need of social value creation than that of poorer, less developed nations. The second major grouping of impact-focus would revolve around the creation of positive externalities. This would encompass areas like climate change initiatives and global wellness initiatives. Note that this second classification of impact – that positive externalities result – could involve all citizens around the globe, not only citizens recognized as in need of the most support.
- The specific impact made can actually be quantified by the investor through evaluation of the following three impact attributes:
- Importance: How many people are affected by the problem? What is the significance and gravity of the problem that affects them?
- Tractability: Relative to how large the problem is, how easy is the problem to solve? Can this company realistically make meaningful progress at this time?
- Neglectedness: How much attention does the problem get now, and what resources are currently spent on solving it? Is it a crowded space?
- Impact-focused companies in uncrowded geographic markets can potentially generate greater amounts of social value: The theme here largely is an add-on point to the “neglectedness” theme mentioned above. If no one is currently working on the certain social value creation areas, a company who does so is likely to have more success than a company in a more crowded market.
- Impact-focused companies have the ability to create enhanced social value and financial return if they are to operate in inefficient markets: Within inefficient markets, largely classified as developing economies, there will be fewer competitors engaging in similar business as the stated company. This will most likely create less competition in generating a specific social value. Many of the most attractive opportunities to investors will be from impact-focused companies operating in developing economies.
- Impact-focused companies that work on problems that are traditionally neglected can have enhanced value to investors: Let’s assume the reader is an impact-focused investor and is interested in only one specific area of impact. There exists only one investment opportunity in the entire world that focuses on this exact same area. This company inherently will have a near monopoly on these impact-focused investment dollars due to the scarcity of other investment products that exist on the market. That consolidation of capital could lead to real change and value creation.
Step Three: Understand the inherent limitations and potential opportunities that exist in the impact market today
Many investors may soon come to the conclusion that it is incredibly difficult to assess impact within the pool of companies or funds readily available to them for investment. Finding companies that can prove that they make or will make a lasting impact on the world around us seems to be scarce when reviewing investment options. There’s a reason for this. To save time, I have laid out some key limitations to, and opportunities in, the impact-focused investment market:
- The majority of public market activity is not conducive to achieving “investment impact” via new capital placements: This theme surrounds the inherent contradiction of trading in public company secondary markets and actually having your capital investment influence the “impact” of the company. Even if an investor were to identify a public company they believe to be impact-focused, the mechanics of the secondary market is that of buying a security from another individual or institution who is a pre-existing holder of such security. The company itself is not actually involved in the buy-sell transaction and receives no additional capital. Therefore, if you invest via a secondary market transaction, the ability to determine whether your capital actually went into achieving any future impact would essentially be impossible. Only in the issuance of an initial, or additional, public offering to which proceeds of your purchase are being directly used by the company, could this goal be achieved.
- Public companies are large organizations that are not structured to place purpose over profit: Traditional companies are structured with a governance regime that pledges absolute loyalty to the shareholder, and only the shareholder. A company’s goal is the attainment of profit on behalf of its shareholders, period. In the absence of benefit corporations, which make up an immaterial number of public companies, every company is set up and managed per the description above. Therefore there is no company on this list that would be interested in achieving social good unless it also had a corresponding positive effect on profitability. I have stated in previous articles and I will restate again, that I find it highly unlikely that any public company will prove to have significant social impact value additions to society as a whole given the existing legal framework and duties of profit-first.
- There is typically more opportunity for financial returns and creation of social value in the venture capital and angel funding space: Venture capital and angel funding inherently deal in similar types of companies: primarily earlier stage, private companies. By investing in earlier stage companies, the ability for heightened total returns increases exponentially. Portfolio companies within this space also tend to focus on more inefficient markets, which is the rationale for the founders and management team to have started the business in the first place. Both financial returns and social value creation can benefit from this early-stage, private company ecosystem.
- There can be a trade-off between financial returns and social value creation: Not all social value creation will have a positive effect on financial returns. While we believe that companies who are able to balance financial returns and the creation of recognizable social value will earn the benefit of increased capital available for investment, not all impact-focused companies will aim to engage in social value creation only when the financial effect is neutral or positive in nature. Certain management teams will allow for the creation of certain social values that are most important to them, to the detriment of financial returns. Potential investors must make their own decision as to if this behavior is both acceptable and valuable to them as investors.
Step Four: Select which impact areas mean the most to you and review the outstanding pool of available impact-focused investment opportunities
A passive impact-focused investor is likely to determine after engaging in the filter above that many aspects of the social value assessment process are qualitative in nature. Some social value measurements can be easily reviewed and compared side-by-side company-by-company, such as that of potential global CO2 emission reductions. In a simplified example where company A and B are exactly the same except for their social value creation: If company A can lower CO2 emissions by 100 tonnes and company B can lower CO2 by 200 tonnes, company B is more likely to receive investment funding.
But even if a hypothetical impact goal is quantitative in nature, certain qualitative assessments must often be made by the investor. For instance, let’s assume the investor is focused on global poverty elimination. Company A operates in Liberia (ranked #176 in global nominal GDP) and Company B operates in Aruba (ranked #177 in global nominal GDP). The countries are essentially the same in their stage of economic development for the purposes of this analysis. Both hypothetical companies have the ability to provide $5 extra per month of wages to the exact same amount of people. Quantitatively these companies are the same, but qualitatively there will be differences such as: which people specifically are benefiting within the country of operation, are there other similar impact companies overlapping in the country, what is the nature of the business itself, as examples. The investor would need to select which company’s ethos and initiatives have the most intrinsic value to them. Not every impact-focused investor will view the assessment of social value equivalently.
The most promising impact-focused companies will likely produce positive externalities or benefit consumers in developing countries. In our opinion, they will also most likely focus on high-impact cause areas, such as poverty, health, agriculture or climate change to be attractive to the highest number of accredited impact-focused investors.
Identifying viable companies with enterprise impact, but that also aim to earn at least “at-market” financial returns, will not always be straightforward. In our opinion at Legacy Group, the financial forecast expectations are usually much easier to analyze and assess than the social value creation forecasts. The financial expectations are essentially the same for all investors, while the social value calculations can drastically differ from investor to investor. Although frustration can occur, I believe investors will agree with me that earning the additional bonus of the creation of social value is worth the additional diligence involved in finding appropriate impact investments for their portfolios.
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*This publication/newsletter is for informational purposes and does not contain or convey legal or financial advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer and your financial advisor. Any views expressed herein are those of the author(s) and not necessarily those of our clients.