Impact = Alpha

Family Office Alpha Report

By Phoebe Outerbridge

June 14, 2018

Impact. Responsible investing. ESG. SRI. UNPRI. There’s been a flock to impact/ESG (environmental, social, governance focused) investing and a flurry of acronyms in the investment landscape of late, and perhaps even a misappropriation and overuse of impact nomenclature (after all, traditional private equity and hedge funds can be impactful). Impact investing is getting top billing at conferences along with cannabis and cryptocurrencies. The big-name shops are creating funds and even identities around ESG: Partners Group, TPG Rise Fund, Bain Capital, KKR to name a few.

In short, impact is the investing theme du jour. But isn’t some form of impact really embedded in all investment decisions? If not, shouldn’t it be?

The New Normal

The main pillars of impact investing typically comprise of agriculture, financial inclusion, education, healthcare, and clean energy. More specifically this can translate to affordable housing, sustainable timberland, microfinance, and solutions to intractable environmental and social problems in the clean energy, waste, water and food spaces.

Some estimates put the amount of impact investing at $300B by 2020 (though that’s still a drop in the recycling bin compared to the $2.9T that will be managed in the mainstream PE sector).

Regardless of impact level, optimal investing still is and will always be investing where there are returns. Public pension plans for example need to fulfill their duty to meet their IRR targets and to make sure their beneficiaries are paid. Ontario Teachers’ CEO and interim CIO Ron Mock, on a panel at a recent conference, noted, “We’re investing if we can get the return we need, whether in electric utilities, battery technology, micro grids. All of this is critically important, not just because it’s a feel-good. But these are new opportunities going forward and we want to be there.”

We would concur with Mock and argue that strong returns will be concentrated in revenue-generating companies in essential industries that are addressing societal, environmental and other challenges and providing cost-effective solutions. Not only is this from where growth is likely to stem, but it is also from where it needs to stem. It can be argued that impact is a facet of most or all investment decisions. Especially given the intractable global challenges we face today, making impact a more overtly pronounced priority should be, and likely will be, the new normal.

Impact’s Coming of Age

ESG has evolved and we are now working with a more refined impact investment dialect than ever before. The ESG process has moved from implementing negative screens (no ‘sin’ stocks, for example) to actively seeking companies that possess positive sustainability goals and products; phrased in another way, from “thou shalt not” to “thou shall.”

The convergence of social and financial good is a positive development, but as implied above, there are varying levels and definitions of impact investing. ESG investing is simply making an investment, whether in a publicly listed stock or a private placement, that takes into consideration environmental, social and/or governance criteria.  Environmental criteria consider impact on our natural environment; social criteria consider how well a company handles relationships with its constituents; governance considers its leadership, management, shareholder rights, and more.

Socially responsible investing is one step beyond ESG: actively eliminating or screening out investments while adhering to designated ethical guidelines.  Impact investing is the most proactive genre of investing, with measurable positive impact and strong returns as part of the objective. Some issuers, financial firms and investors have gone a step further and become UNPRI (United Nations Principles for Responsible Investment) signatories. The UNPRI is an international network advocating for responsible investment, currently with about 2,000 signatories worldwide.

Mapping the Misperceptions and Speed Bumps

The UNPRI and the Global Impact Investing Network or GIIN (a global nonprofit that champions impact investing and serves as a resource and knowledge exchange for impact investors) would argue that investors should be evaluating on risk, reward, and impact equally. The GIIN published a “roadmap for the future.” In it they posit that government and philanthropy are insufficient to create solutions to the most critical societal and environmental issues. Rather, impact investing will drive capital to solutions needed in the world today and create long term value.

Impact investing presents a few challenges, one being how to quantify and measure impact. Another is the lack of curb appeal: There is a misperception among investors that one needs to sacrifice returns for an impact investment, that the risk is higher, and/or that the illiquidity of the investment makes it too onerous, with a timely exit unlikely. One investor we spoke with referred to this image problem as “the stench of nonprofit.”

These myths are generally unfounded. Research by McKinsey shows that the mean and median holding period for ESG or impact funds are no different than conventional PE and VC firms—about five years—implying that these enterprises don’t require longer holding periods to generate value for their shareholders, simply a strong and sustainable business model. As with any PE investment, investors who enter earlier in the process may be exposed to more risk as angel investors, their expertise often needed to help establish the business model and operations; later stage investors can expect a more de-risked investment and a balance of social and financial returns. Those who seek market rates of return from impact investments can achieve them.

Ultimately, that which is not profitable is not sustainable.  One always invests with a purpose: not just to make money but to somehow positively affect the well-being of people and planet. In this sense, impact is part and parcel of almost any investment. The most attractive returns, however, can be found in innovative solutions and cutting-edge companies addressing societal needs: the big picture. Aligning private capital with this mission will produce maximum alpha.