An Overview of Impact Investing

Investing with an eye toward environmental, social, and governance concerns is a trend that is here to stay. Known as ESG investing, this approach to portfolio management can focus on any number of specific concerns, from greenhouse gas emissions to human rights to executive compensation. And it’s enacted using one of four strategies: portfolio screening, ESG integration, impact investing, or active ownership.

As an ESG-oriented strategy, impact investing focuses strongly on making a quantifiable socially positive impact while still achieving some amount of financial return. This approach is often used in private equity investments, such as venture capital funding for environmental technology innovations.

Read on to learn more about this prosocial investing method and how it differs from other similar strategies.

What is impact investing?

Impact investing is about using one’s financial investments as a lever to push social or environmental improvements or other kinds of change that aligns with the investor’s personal values. As such, the investor may well give up some level of financial return in exchange for the ESG impact they expect the investment to make. These investments can be made across geographic locations and asset types.

Impact investing is the flip side of divestment, which has been shown to have a limited social impact. Instead of pulling investment out of certain businesses in order to positively affect social issues, impact investors put investment in to certain businesses for that same purpose. All methods of ESG investing prioritize active involvement and investment in businesses that are engaging in prosocial activities.

Here are a few possible scenarios that would all fit into this category:

• A venture capital fund invests in a tech startup that’s working on new solutions for solar energy. The goal is to push the solar industry forward and reduce the cost of solar energy generation to help mitigate greenhouse gas emissions.

• A private fund invests in a property developer that focuses on building low-income housing in diverse communities. The goal is to improve the livability of cities and encourage the development of diverse and mixed-income communities.

• An individual invests in companies that taking a critical eye to executive compensation. The goal is to help reduce growing income inequality by supporting companies that are reducing the gap between pay for executives and employees.

• A private fund managed by a church invests in companies that contribute to charitable causes focused on anti-hunger and anti-poverty action. The goal is to reduce hunger and poverty in society and to align with the investors’ religious convictions.

In each of these examples, the investors are not only aiming to change an aspect of society but are seeking some level of financial return from their investments. In fact, they may be likely to accept a return far lower than they would get from an average investment that does not focus on social concerns. But it’s important to note that social impact investing is distinctly different than charitable giving. Financial return is just part of the picture.

How impact investing works

Impact investing must be based on a set of coherent goals unique to each investor. The first step in impact investing is considering one’s aims and motivations. Part of this is thinking about how best to support your goals.

If you would like to impact the operations of a particular industry, you’ll need to consider what aspect of that industry—what element of the supply chain, say—you’ll need to target to have the biggest effect. For example, if you want to improve the practices of the oil industry, you might want to invest in production companies with good safety records, businesses that use particular refining or storage techniques, or those that transport oil in ways that reduce environmental hazard.

Impact investments can be considered “concessionary” or “nonconcessionary.” Concessionary impact investments, often called “impact first,” are assumed to generate returns below those of traditional investments. Some investors prioritize the social impact so highly they are essentially willing to pay for it by getting a lower return.

Nonconcessionary impact investments, often referred to as “finance first” or "double-bottom line,” are intended to generate returns equal to those of traditional investments while simultaneously having the intended social impact. While much more data on potential return from this type of investment is needed, it’s encouraging that some private funds have achieved nonconcessionary returns equal to conventional investments across categories.

One challenge for those looking to do impact investing, as well as other kinds of ESG investing, is that it can be difficult to discern the environmental, social, and governance stances or activities of each potential investment. Quantitative analysis is most likely to apply to environmental concerns, while other issues relating to more subjective areas of social progress are usually harder to assess. Further complicating things, assessments of the environmental- or social-friendliness of a given company may vary widely depending on who is doing the assessing. Some fund managers disillusioned with the variability of third-party assessments have taken to creating their own algorithms to assess companies based on publicly available information on their commitment to relevant ESG priorities.

Even when one can consistently assess companies, however, there is the added difficulty of correctly interpreting the results. Some indicators may rise as others fall—or because others fall. For example, a company that is prioritizing hydropower sources of energy over coal-derived sources may consume far more water than its competitors, which may look on the surface like a liability but is actually an indication of environmental responsibility.

Benefits of impact investing

The potential to have a positive effect on environment sustainability, social issues, and governance concerns in the business sector is the central benefit of impact investing. For many investors, this ability to direct resources to deserving actors is inspiring and empowering—a needed antidote to bottom-line-only thinking that disregards social impact of business actions and positions.

The benefit of impact investing for the companies that find support from socially conscious investors is obvious: They are rewarded for engaging in prosocial activities and are therefore encouraged to do more of them. They are able to thrive in a competitive business arena despite doing things that may not prioritize the bottom line above all else.

Now that ESG-oriented investing is gaining rapidly in popularity, some investors find that engaging in impact investing is a sure way to generate interest in their activities and attract other investors. A fund that invests in retail development in low-income communities may be keen to team up with other like-minded investors who can help make a bigger impact collectively.

Impact Investing vs ESG vs SRI

As socially conscious investing has heated up, there is much confusion about the terms involved, with many being used interchangeably despite subtle differences in meaning. What exactly is the difference among impact investing, ESG, and SRI?

Impact investing is a subset of ESG investing, a strategy that pursues ESG-oriented goals in a particularly assertive way. Impact investment is specifically designed to meet particular goals: The positive impact is of top importance, even more so than financial profit. ESG investing, by contrast, is simply any investing that incorporates environmental, social, and governance concerns in some way.

In contrast to impact investing, socially responsible investing (SRI) is not focused so much on outcomes as process. SRI investors set certain conditions for social responsibility using ESG considerations and then invest in businesses that meet those standards.

SRI might be said to encompass one or both of the ESG strategies called portfolio screening and ESG integration. Portfolio screening involves including or excluding particular companies in investments based on how they measure up on given ESG standards. ESG integration involves using ESG considerations to complement traditional investment management to boost investor outcomes. SRI is a fast-growing approach to investing, showing a ten-fold increase over the past two decades. Some $22 trillion in assets globally are now investing in SRI funds.

What is active ownership?

While SRI and impact investing are focused on investing in companies that are already doing things that will impact the earth and societies in positive ways, another method of using ESG to guide investing involves a bigger focus on shifting company behavior in desirable ways. This ESG-focused investing strategy, called active ownership, stems from the belief that it’s better to be involved in a company whose policies one would like to change instead of walking away from it for failing to measure up.

For example, an investor focused on active ownership may vote against a company’s compensation policy as an expression of interest in reducing the gap between executive and employee pay. The investor may then meet with the company a few times to discuss this issue, resulting in movement: Perhaps the company implements performance standards that makes high executive compensation more difficult to achieve and commits to greater transparency about executive pay.

Active ownership is a strategy that could give rise to the conditions that would attract impact investment. Once the company in the example above has made its positive move on executive compensation, impact investors may reward that development with increased interest and support.

Conclusion

Impact investing is a powerful strategy for social change that is likely to continue garnering solid interest over time. Companies are increasingly attuned to investors’ social consciousness, and investors are increasingly empowered to see social issues as legitimate factors influencing investment decisions.

The willingness to forego some amount of financial return in order to promote social and environmental goals gives social impact investors powerful leverage in a financial landscape where the bottom line usually reigns supreme.