Impact Investing — An Investment Approach That Is Ready for Prime Time
By Neil Gregory
Investors have always known that their investments have social and environmental impacts. But until recently, it was seen more as a side-effect than the goal of investing. For many years, socially concerned investors have screened out certain investments from their portfolios — such as so-called “sin stocks” of companies involved in gambling, alcohol and tobacco. More recently, as environmental concerns have come to the fore, investors have gone beyond simple screening out of certain types of firm towards assessing the ESG (environment, social and governance) risk in all the investments in their portfolio. As they have done so, they have started to appreciate that engagement with these companies not only can reduce risks which may affect financial performance, but also can contribute to better environmental and social outcomes. This has become known as ESG investing, and today up to one third of global assets are managed in alignment with the UN Principles of Responsible Investing.
Beyond ESG Investing
There is a small — but rapidly growing — set of investors that want to go further and ensure that their investment portfolios have positive social and environmental impact, alongside financial returns. This group of investors is not just concerned with ESG risks that may affect the financial performance of the firm (the so-called First Materiality), but also the effects that the firms they invest in may have on wider society and the environment (the so-called Second Materiality). Our IFC research estimates that today, up to $2 trillion is invested with a mandate to achieve positive impact. But we also estimate that the appetite of investors for this approach to investing is much larger — up to $25 trillion, or about 10% of global capital markets. This represents an exciting opportunity. Investments of that scale could make a huge contribution to achieving the United Nations Sustainable Development Goals (SDGs), which require about $2.6bn a year of additional private financing in low- and middle-income countries to complement government spending.
The gap between investor interest and actual investments reflects the state of development of this approach to investing. While development finance institutions (DFIs) like IFC have invested with a mandate for impact for over 60 years, the concept of impact investing by private investors only crystallized after the 2009 global financial crisis. Early adopters of this approach were mostly small specialist funds — like Blue Orchard and responsAbility — often investing money from philanthropic sources (foundations, family offices etc., aid agencies) in social enterprises, microfinance institutions and the like. It was pioneering work, which set the scene for the industry’s growth, but it did not scale easily.
Financing Global Goals
The global agreement in 2015 on the SDGs and the Paris agreement on climate change goals was accompanied by a Financing for Development strategy to mobilize private capital to support the achievement of these goals. This led to growing interest from larger pools of capital — insurance companies, pension funds, sovereign wealth funds, endowments — in finding a way to have positive impact while respecting their fiduciary duty to achieve market level rates of return. At the same time, ultra-low global interest rates following the global financial crisis dramatically lowered the bar of what constituted a market return. This has led to an openness among institutional investors to consider riskier investments in emerging and frontier markets, as well as in underserved regions and communities of home countries — which is where the opportunities for impact are greatest.
To meet this growing interest from institutional investors for investments offering both a market-rate financial return and positive impact on the SDGs and climate change goals, larger asset managers — including the biggest names such as UBS, Blackrock, and Partners Group — have built the capacity to manage funds for impact. And many smaller fund managers have repositioned their funds as sustainable or impact funds. This is very positive for the growth of the industry, but has led to concerns about inconsistent approaches, and ‘impact-washing’ where asset managers claims are not well backed up by a robust impact management system. Of the $2 trillion managed for impact today, only about $500 billion clearly has an impact management system in place.
Defining market standards
To address these concerns, a group of DFIs and private asset managers and asset owners have agreed on a common set of Operating Principles for Impact Management which set a market standard for integrating an impact objective into the management of an investment portfolio. Adopted by 128 institutions managing over $380bn in assets for impact as of early May 2021, the Principles are bringing needed consistency and discipline to impact investing. Among the largest groups of signatories are Swiss-based banks and funds, ranging from large banks like UBS and Credit Suisse to specialist impact fund managers like AlphaMundi and Symbiotics, as well as public institutions like Obviam and SIFEM, and asset owners like Zurich Insurance. Swiss financial institutions — supported by the government — have congregated also on impact and sustainable finance platforms such as the Swiss Sustainable Finance  and the Green Fintech Network, which provides further evidence on the growing importance of Switzerland as a center for sustainable finance.
The Principles also bring transparency and credibility. Signatories are required to disclose annually — and arrange for periodic independent verification — how their impact management system aligns with the Principles. More than 80 disclosures have been published so far. This gives comfort to asset owners to allocate capital to signatories, knowing how their money will be managed for impact.
Beyond consistent management practices, asset owners also want to see consistency in the metrics used to report on impacts. To this end, work is ongoing to develop a common core of impact metrics that all investors can use. The first set of Joint Impact Indicators — covering the key themes of gender, climate, and job creation — have just been published. This work will also feed into ongoing discussions on how firms should report on their social and environmental impacts, including initiatives from the World Economic Forum and International Business Council, IFRS Foundation and others. Over the next few years, we may see the establishment of common impact metrics which firms will routinely report on, and investors can use to report on the impact of their investments in those firms. With these developments, the impact investing industry will be able to provide investors with robust opportunities to have measurable impact.
Today, impact investing mostly happens in private markets — unlisted private equity and debt. But the largest pools of capital are in public markets, so developments there are important to scale up opportunities to invest for impact. On the fixed income side, there has been a rapid growth in green and social bonds, which offer similar returns to standard corporate or government bonds, but with clear tracking of the use of proceeds and the impact they have. This has grown from nothing to a $1 trillion-a-year market in just a few years. This approach has its limitations, as proceeds may be used for positive impact alongside other firm activities with less positive impact. For example, an oil and gas company may issue a green bond to pay for energy efficiency improvements in its offices, but its wider business continues to generate climate emissions. For this reason, there is growing interest in sustainability bonds, where the proceeds can be used for general corporate purposes but are linked to targets for environmental and social improvements across the whole firm. Typically, there is a financial incentive for the issuer to meet those targets. On the public equity side, there is less opportunity for investors to directly influence the environmental and social impacts of the firms that they hold shares in. However, some asset managers are large enough to have influence through shareholder engagement strategies. As large asset managers increase their engagement on impact, expect more activist funds with impact objectives to enter the market.
Finding Investment Opportunities
With all this additional capital seeking impact, the remaining constraint to deploying capital remains the availability of investment opportunities. This is where DFIs like IFC can play an important role. Through our extensive network of field offices and an expanded cadre of staff focused on new project development, IFC — along with other DFIs — plays a key role in originating investment opportunities in hard-to-reach frontier markets which can be co-financed by other investors. IFC typically finances less than 20% of the projects that it engages in, and directly mobilizes more than a dollar of co-investment for every dollar of its own investment. It has also developed platforms which allow institutional investors to invest in a portfolio of projects, which matches their need for transaction sizes of $1 billion or more. IFC’s Asset Management Company (AMC) mobilizes equity co-financing and its MCPP platform mobilizes long-term debt from institutional investors, adding to the long-standing program of syndicating individual project loans with commercial banks.
With these developments, investors of all sizes have more opportunities than ever to find investment which have a credible approach to delivering measurable impact. This makes impact investing an approach that is ready for prime time.
 UNCTAD (2014) World Investment Report: Investing in the SDGs: An Action Plan