“Impact” investing is the hot topic among the elite crowds at institutional and family office investment conferences spanning the developed world. Make money while doing good is the most noble interpretation of current impact investment theory. Nobility and human nature do not always walk hand-in-hand.
Impact investing is already corrupted despite its recent arrival to the global stage. “Greenwashing” – the act of misleading the public about the impact of a company’s environmental practices – is prevalent when “green” companies look to raise capital or sell their products. Accusations of investment funds and investment managers mis-selling “impact-focused” financial products that have no actual impact are readily abundant.
Who deserves the blame?
The Current Corruption of Impact Investing
One of the most acute criticisms of the current impact investing ecosystem is that of Tariq Fancy, a man who shared with the world his eloquent diatribe against his former employer as the ex-CIO of Sustainable Investing at BlackRock. In short, Fancy concluded that most “impact” initiatives pushed by companies and the funds, like BlackRock, that invest in those companies, result in zero or negative impact value.
This story is a big deal, BlackRock is the largest asset manager on earth. As of Q2 2021, Blackrock managed $9.5 trillion dollars. For reference, the GDP of Japan is only $5.1 trillion dollars. BlackRock is literally managing the wealth of nations.
Fancy claimed in his piece that the products BlackRock sells to its investors are not conducive to any actual “impact” to be made now or in the future. Key players doing the selling are completely aware of this blatant contradiction and go along as if nothing is wrong. The popularity of “impact investing” has given institutions like BlackRock a whole new product line so long as the name of it includes “impact”.
Fancy fears for the world as a whole – a world he sees as running into a brick wall. That brick wall of course is the end of civilization as we know it due to impending climate change. He sees the need for dire changes in financial markets, in regulation and in how we respond to global risks. But, in the end, his writing provides an astute peephole into the world of impact investing at the highest levels. He provides an understanding of how “impact” is really marketed today, in most cases, even in the absence of results.
In sharp contrast to Fancy’s allegations, BlackRock’s current CEO, Larry Fink, has repeatedly been in the news appearing to be in stark support of global impact initiatives. He has consistently written Letters to CEOs since 2016 detailing the importance of impact within the business world. He has pledged BlackRock´s absolute support and has recommended that other CEOs join him in focusing on impact investments.
Recently, he has stated that climate change is invariably the top issue that clients around the world raise and that there is no company whose business model will not be profoundly affected by the transition to a net zero economy. He has openly shared his decision to migrate BlackRock’s core business to respond to these impact movements and embrace them: “We believe that sustainable investing is the strongest foundation for client portfolios going forward” and that “the impact of sustainability on investment returns is increasing.”
The wealthy public seems to agree with Mr. Fink. Just over three-quarters of limited partners of varying private equity funds surveyed by private equity secondaries said that they ranked climate change and sustainability as the market’s most influential mega-trend when deciding where they will invest in the next five years.
So therein lies a contradiction. BlackRock’s top leader is fully aware of the impact trend sweeping the world and is openly voicing his support for the movement. He is not only providing his own support, but that of his entire firm. Along with BlackRock’s support, he is personally writing letters to CEOs of the largest companies in the world to get them on board the impact train. But Fancy, BlackRock´s former top officer in charge of actually spearheading the firm’s impact mission, freely states that BlackRock’s actions and product line not only do not support the impact movement, they damage the movement and the world at-large.
Beyond solely product mis-selling, there are numerous complaints of companies merely greenwashing their business models (i.e., lying about their actual impact) to impact fund managers, who in turn invest in these companies and then continue the spin of this misshapen narrative down the line to their investment audiences who dearly wish to believe it. A recent example is that of Oatly, which is being hammered by activist short seller Spruce Point Capital Management for accusations of both shady accounting practices and misleading consumers and investors about their impact practices. Oatly is being accused of selectively using impact related information for their own beneficial purposes, not presenting their impact picture completely and blatantly disregarding any potentially negative environmental operating information from reporting to investors.
Is this all a matter of laziness and greed among businesses and funds who claim to be “green”, or is actual impact investing too at odds with a business´ primary obligation of generating profit and maximizing shareholder returns to be a sustainable model?
What should we do – how do we fix how impact investing is done so that capital is allocated to businesses that can actually both (a) have a positive social and environmental impact and (b) generate a great financial return that exceeds those of non-impact businesses?
The Root Cause – How Impact Investing Should Actually Be Defined
The definition of impact investing per The Global Impact Investing Network (“GIIN”), a frequently cited authority in this space, is:
“Impact investments are investments made with the intent to generate positive, measurable social and environmental impact alongside a financial return. Impact investments . . . target a range of returns from below market to market rate.”
The definition seems simple: do good things in your business, treat people with respect, pay your employees what they’re worth, don’t pollute your environment and follow the Golden Rule – Sounds easy.
But wait . . . does this mean that companies must generate these positive impacts while potentially producing less financial return than that of their competitors or markets as a whole and shareholders must bear the cost, per the definition? Would this not affect an impact-focused company’s ability to compete for business and capital? Is this legally viable given fiduciary duties boards of directors owe to shareholders?
There are two glaring differences between modern impact investing and traditional capitalism that require review and analysis:
- “All Stakeholders”: The concept that to be an impact company a business’s board of directors and management team should consider “all stakeholders” (not solely shareholders) when making all material business decisions.
- Reduced Importance of Financial Returns: The concept that value provided by the generation of a positive social return in an impact company can justifiably offset any potential deficit of the financial returns that company produces.
The definition of impact investing per the GIIN and those similar does not work in modern day capitalism. The incentive structure of capitalism is simply misaligned to expect that shareholders and investors will sacrifice profit for the sake of social good on any grand scale. Impact investing is only sustainable if impact companies can meet or exceed financial returns of traditional companies, in addition to their good works. This misalignment of purpose is leading to a lot of the corruptive practices described earlier.
Where to Begin – Impact Must Support Traditional Capitalism to Survive, Not Replace It
While the terms: “sustainability”, “impact” and “ESG” may seem new for many of us, the idea of socially conscious business has actually been around for quite a while. Within the United States alone, it’s existed at least since Milton Friedman published his legendary 1970 essay, “The Social Responsibility of Business Is To Increase Its Profits.” This paper debated the very theme
of a business’s duty to their shareholders vs. that of alternate “stakeholders” like community, employees and the public at-large. As the title clearly lays out, Milton’s mind rested firmly on the side of businesses only being accountable to their shareholders. His ideas are consistent with much of the logic that makes up modern corporate law.
In Friedman’s view:
“In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires . . . the key point is that, in his capacity as a corporate executive, the manager is the agent of the individuals who own the corporation . . . and his primary responsibility is to them”
In regards to an executive spending company money on “social causes,” the theme is that executives are essentially spending somebody else’s money for their own purposes:
“Insofar as [a business executive’s] actions in accord with his “social responsibility” reduce returns to stockholders, he is spending their money.”
This is an incredibly important concept of how directors and management should view the capital of a company and how to allocate such capital amongst the various stakeholder priorities.
For instance in a hypothetical scenario: if management of a shoe manufacturer intends to plant trees in an effort to achieve a net-zero carbon footprint, which stakeholder has the most weight when it comes to capital allocation decisions? Which party does the directorship owe the highest duty of care? Is it the shareholder who actually owns the company and therefore owns the capital, is it the employee who favors tree plantings over a year-end bonus, or is it the innocent bystander who lives in town and could potentially be affected by a non-zero carbon footprint business? Long story short, the money cannot be spent under traditional capitalism or given current legal duties unless doing so is a net benefit to the company’s profits.
Investors won’t mind if they make less money if they feel good about the investment . . .
“Do good while doing well” is the motto of nearly every impact asset manager when soliciting capital for their funds. But if the Global Impact Investing Network’s definition of impact investing holds true, shouldn’t impact fund managers be more transparent and state that they are “targeting a range of returns from below market to market rate?” Are these impact fund managers actually presenting their products with this incredibly difficult selling point attached to their pitch decks? Should a more appropriate depiction of their fund’s return profile be: “Do good while doing average at best?”
In my own experience, I have seen exactly zero impact funds that promote their investment returns as being lower than those of a non-impact focused fund competitor. In fact, I have seen
the exact opposite. Nearly all the fund managers I have come in contact with have views in line with Larry Fink’s assertion that impact focused funds will actually outperform the market and make more money than that of “traditional” portfolio investment allocations. This assertion of course is the exact opposite of what the Global Impact Investing Network says. Fund managers as a whole tend to agree. In fact, in a recent study of impact within the private equity industry, 47% of limited partners thought that a robust impact policy will improve their long-term private equity returns. Only 1 in 10 limited partners thought that adopting a strong impact policy would lead to a reduction in returns.
I myself am not an ultra-high-net-worth-individual who has opportunities machine gunned at him every day. Larry Fink and Tariq Fancy are not personally calling me with a request for my capital commitment in their newest impact fund. Rather, I work boots-on-the-ground within emerging markets as a builder of impact-focused businesses, focusing on capital deployment rather than capital allocation. So what is my first hand experience in this realm when it relates to capital raising from these differing groups of investors?
- Impact Funds: Personally, I’ve never spoken with an impact fund that had lowered expectations of financial returns vs. a traditional fund manager who has no impact mandate. Every experience I have had resulted in the same grouping of deal sizing requirements, holding timelines and IRR minimums that all traditional funds utilize as a framework to place capital. The only difference was the additional hurdle of placing the investment opportunity into an impact box as an added layer of the capital placement framework.
- High Net Worth Individuals (HNWIs): The majority of our investors at Legacy Group are high net worth individuals. Many of them are current or ex-entrepreneurs themselves. Through our discussions and relationships built, I agree with Larry Fink’s assessment 100% that most investors on an individual basis are concerned with impact, especially as it relates to climate change. We focus on agriculture in our portfolio, so we have it much easier than say an oil extraction company. We do things the right way and we can prove it, so this is a big bonus to investors who come into our ecosystem. But I am also confident that if our business model didn’t demonstrate viability of earning outsized financial returns, the majority of our investors would not have placed capital with us. The financial return expectations have been the minimum requirement to invest with us, and the impact value we provide has been the cherry-on-top.
The financial expectation that impact-focused companies can perform below that of their non-impact focused peers is a mistaken concept. Both shareholders and stakeholders are holding companies to higher standards, but studies have shown that companies with a stronger impact focus in their DNA are more likely to deliver superior financial returns. To be successful in the current environment, impact-focused firms must perform at least as well financially as their non-impact focused peers.
How do we fix the corruption in impact investing?
A light-touch regulatory framework is necessary to move impact-focused companies forward
Much of what Tariq Fancy tried to tell the world is that the corporate profit-first culture, whether it’s an asset manager like BlackRock or an oil company drilling in Alaska, will not change course if they do not have to. Their primary concern is profit, period. His concern that BlackRock was cheaply profiting from the current impact sentiment of the global population as a product “fad” is clear. The repackaging of a string of products claiming to be “green” funds targeting reductions in climate change, but actually resulting in the same net effect on the earth as if they did nothing at all, is a dangerous game. The need for intelligent regulation is at the heart of Fancy’s story.
Modern economic theory regarding the need for regulation spans the spectrum of “all regulation is bad” in an effort to pursue pure “free markets” the likes of libertarian dreams, all the way to “every area of the economy should be regulated” more akin to a socialist agenda. Both of these viewpoints are actively debated in the United States today and have been since securities regulation was first introduced after the stock market crash in October 1929.
Now as a capitalist and entrepreneur, I have a distaste for excessive regulations to the same degree as the rest of my brethren. But, I do recognize that over the history of financial markets there have been significant regulatory gaps that have at least contributed to catastrophic economic bubbles and busts that could have potentially been avoided. Could the mortgage crisis of 2008 have been avoided if banks had more scrupulous lending standards over subprime mortgages? If investment banks had any limits on their credit-default-swap derivative positions?
Many pure capitalist readers will say “no, the market is efficient and will work itself out.” But, remember that within this non-hypothetical scenario above, the market didn’t work itself out. The 2008 financial crisis was remedied only with $498 billion dollars from U.S. taxpayers. While the above is only a singular example, one could easily extrapolate this regulatory gap hypothesis to the savings and loan crisis of the 1980s and 1990s, the fall of Enron in 2001 and numerous other historical financial events. I will not seek to persuade the reader that all regulation is necessary, only that having certain intelligent regulation in place is far better than having none at all.
We are already seeing regulators such as the Securities and Exchange Commission stepping into the impact reporting space. As early as March of this year, the SEC has requested public input on their ideas surrounding climate change disclosure in public company reporting. Articles such as “Can the SEC Make ESG Rules that are Sustainable?” make it clear that the SEC is not only looking at potentially entering the impact reporting space for public reporting entities, but is looking at strategies and is setting up lines of communication asking for advice about how to best execute when they inevitably do step in and regulate.
We see this action by the SEC as a positive step for the impact movements. The largest companies globally will be affected by this and the world will be watching and taking notes. Regulators’ interpretations of how businesses should behave will be a key driver in the adoption of impact themes for all companies globally.
More specifically, I generally agree that consistency around impact and how it is quantified should be put in place, the likes of which the SEC seems to be doing. I expect that impact investors in the future will be more investigative, diligent and selective as they choose their impact investment placements. In the future, there lies the real risk of financial consequence should funds and companies claiming to be impact or ESG being found not to be operating in an impactful manner or are inaccurately quantifying impact to investors.
The creation and implementation of this regulatory framework will be key to avoid the mis-selling and greenwashing issues we see today, and will be a requirement to move the industry forward in the correct direction.
Which companies are going to come out on top?
After understanding more about the discrepancies that clearly exist in the world of impact investing, a logical reader could reasonably ascertain that the impact world is corrupted and doesn’t deserve their attention. I would argue the exact opposite. Now is exactly the time that investors should be looking into impact-focused investments. They just need to know where to look.
True impact-focused companies do exist. They are out there. But, they are typically smaller than the public market behemoths and funds will have a more difficult time allocating capital to them. Larger asset management companies want an impact-focused fund model as part of their product portfolio for their wealthy clients. They see this as a profitable endeavor and their clients agree. The issue lies not with the demand for investing in impact-focused companies, but rather with the supply of impact-focused companies that can actually make their “impact purpose” value accretive to their businesses. Most public companies that have been trading on public exchanges for 20+ years are not going to scratch the itch that the impact investment public wants to see.
The truth is that many companies that are truly focused on impact and solving the world’s most pressing issues are smaller, private companies. Take for instance the fact that there are currently more than 3,500 companies that are Certified B Corporations, but only 45 are public companies or public company subsidiaries. To participate, an investor can’t simply log onto their Etrade account and instantly access these investments. Investors have to dig a bit deeper, likely into the private placement investment market to find the opportunities that they are looking for.
I believe that there will be more and more capital pouring into smaller impact-focused companies in the future as they aim to truly pair profit and purpose. More sophisticated avenues
of capital raising will be developed to pair these companies with the investors who share the same goals.
As far as impact funds go, impact managers will need to wake up to a new normal as to how to truly differentiate themselves and invest in the “correct” impact portfolio companies that their clients demand. Several things will need to change. Sizing of their capital placements will likely go down as they will have to engage in more small company investing. As such, total fund assets under management (AUM) may decrease as larger AUMs will be more difficult to deploy and manage. Managers will likely have to work harder to find more opportunities to place the amounts of capital they manage and actually diligence the claims of impact that these companies make. The best impact companies are going to be in the private market space, likely smaller and flying somewhat under the radar. There will be a massive opportunity for in-country impact fund managers who truly understand the local markets in which they operate, have the ability to adapt, be flexible and become comfortable placing capital in the early stage private companies they encounter.
Conclusion and Author’s Final Words:
- There are great impact-focused companies: If investors are willing to dig a bit deeper and walk outside their comfort zone of larger, bluechip public equity markets, they will find smaller companies that are merging impact and enhanced profitability together. Look to the private placement world, there’s some truly amazing entrepreneurs out there, and they are going to change the world and earn enhanced profits for their investors.
- Investors will continue to seek profits over social good if taken on a 1:1 comparison. Human behavior related to how we make investments has not and will not materially change as a result of current impact trends. Investors will not accept any significant decrease to their expected financial returns for the sake of social good on any material scale. Don’t expect that modern businesses will become NGOs. CEOs will still drive for profit and investors will push them to do so.
- Investment fundamentals haven’t changed. Investors will always want to invest in great businesses: End-clients and consumers are going to want businesses that are “doing the right thing”. I don’t think that this is necessarily different from what the same investor group wanted 100 years ago. The world has become more transparent. The ability to transmit both useful and non-useful information has become nearly instantaneous. Humans themselves have not fundamentally changed though. The best businesses still are those that operate ethically, have best-in-class products and services, support their employees and contribute to their communities and drive great profits.
- Climate change is the current focus and will continue to be the primary focus of large scale impact investing in the near-term: We believe that the impact industry will largely focus on the subject of climate change and capitalism’s correlating effect. While we do see regulators such as the SEC reviewing other best practices of governance and social inclusion, we believe that at a product level the largest global problem at-hand requiring resolution will revolve around this climate change theme. Companies that have meaningful solutions in this space will receive the most attention and receive the correlating capital infusions that come with that attention.
- Governments, with the input of experienced private citizens, will need to lead the charge to create a viable regulatory framework: Without meaningful changes in regulation (i.e. carbon credits, pollution controls, etc.) relating to material global issues to the future of the planet (global warming, overpopulation), capitalism will not, within itself, accomplish what the majority of world leaders wish to achieve. The incentive structure is simply misaligned. Governments must use effective regulation to guide the end goal of modern day capitalism and create the sandbox for us capitalist kids to play in.
- Capitalism will be capitalism: Capitalism – impact-based or not – must have a set framework to which all players have the exact same score card (i.e. profit) that is readily measurable and identifiable. An ever-expanding scorecard, with an ever-expanding number of stakeholder measurements, has the potential to create confusion. We expect that investors will continue to use the expectation of future profits as the baseline “must-have” for their investment decisions. Impact value will remain important, but secondary.
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*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.