Expanding the universe of potential investments and other benefits of assessing and managing impact
A vocal minority of impact investing practitioners have long espoused that impact measurement is a waste of time and resources because it distracts investors from their primary objective: to support the growth of businesses tackling real social and environmental challenges.
That position is no longer defensible.
While impact investors recognize they must strike a careful balance between rigor and practicality in their impact measurement systems, the industry has reached a consensus that impact measurement is essential to the growth — and existence — of our field. Unless we measure the social or environmental impacts associated with investments, there becomes no easy way to differentiate impact investing from traditional investing.
A growing body of evidence suggests the practice of measuring and managing an investment’s social or environmental impact can enhance, not detract from, financial performance.
If the impact investing industry takes the intention to generate positive impact as seriously as financial return, the adoption and formalization of impact due diligence systems are an important next step in the field’s growth and development. Impact due diligence systems will not only enhance individual investors’ capacity to make more informed investment decisions and increase the impact of their portfolios, but safeguard the entire field against “impact dilution” as the market scales.
Impact due diligence tool
Pacific Community Ventures, a community development financial institution and impact investing research and consulting firm, partnered with Northern California Community Loan Fund (NCCLF), to develop a tool called the Social Impact Rating System (SIR). The tool assesses the expected positive impact of NCCLF’s potential loans and the extent to which they align with its mission. The SIR translates each loan’s impact objectives into several dimensions corresponding to key indicators within each dimension. The tool’s four dimensions of impact are:
Impact on Community. Does the community where the borrower or client population is located face barriers to opportunities?
Impact on Borrower. Will the loan improve the borrower’s effectiveness or capacity to serve its target population?
Impact on Beneficiaries. What are the direct impacts of the borrower’s services on beneficiaries supported by NCCLF’s loan?
Impact of Financing. Is there potential to increase the impact of the borrower (and similar organizations) as a result of working with NCCLF specifically, and not another lender?
Having used the SIR for over two years to inform the deployment of over $70 million in loans, NCCLF’s loan officers, senior leadership, and loan committee describe numerous ways that the system has added value to their organization.
First, developing the system forced senior leadership to revisit and scrutinize NCCLF’s mission and priorities, which enhanced staff’s shared understanding of the ways the organization can achieve positive impact with its investments. This, in turn, has informed NCCLF’s strategic plans and investment objectives.
Second, adopting the SIR prompted more structured conversations between loan officers during underwriting, and when loan officers presented credit memos to the loan committee about expected impact and mission alignment of loans. This framework helped loan committee members, especially those with primarily finance backgrounds who typically focus on the financial risks of potential loans, to consider nuances to loans’ expected positive impact they previously had not assessed. More broadly, the tool provided a means by which staff can easily compare their assessments of loans’ expected impacts and better understand where their opinions may differ. Using the tool has catalyzed valuable discussions when a loan officer’s expectations for a loan’s impact differed from the loan’s SIR score.
Third, the SIR has enabled NCCLF to broaden the universe of potential investments it makes: NCCLF now considers loans to some organizations it would historically not have provided loans to, due to a perceived lack of mission fit (e.g. loans to for-profit affordable housing developers), but which received a favorable score.
In addition to the positive results above, impact due diligence systems can benefit impact investors in other important ways. Most crucially, they can provide investors the information they need to make investments they wouldn’t otherwise consider due to high levels of financial risk, but which are expected to generate significant positive impact. In some cases, investors may use these systems to determine under what circumstances they’ll offer better investment terms to high-impact investees, supporting enterprises’ ability to achieve societal and environmental objectives with flexible, patient, or lower-cost financing.
Impact due diligence gap
Impact measurement is not generally being used to improve investors’ social or environmental performance. This is despite the industry’s agreement that measurement is essential, and the adoption by amajority of impact investors to adopt impact measurement systems guided by the IRIS catalog of performance metrics. At Pacific Community Ventures we’ve identified two primary reasons for this disconcerting finding.
First, the social and environmental performance reported by companies is typically used as proof of investors’ commitment to impact, yet has little to no influence on portfolio management or future investment decisions. It’s difficult for investors to interpret whether impact data reported by investees represents strong or weak results. Benchmarks aren’t readily available or are difficult to choose, impact targets are infrequently agreed upon, and outputs are easier to assess than outcomes.
Even if investors determine an investee has achieved significant positive impact, it’s often difficult to apply lessons learned from one investment to decisions regarding other investments. In some cases, the factors that led to the attainment of significant or minimal positive impact are specific to an investee’s business model.
Second, few investors rigorously assess the expected impact or mission alignment of investments before making them, compare the expected impact of prospective investments, or use this analysis to inform investment decisions. This runs in stark contrast to investors’ in-depth evaluations of investments’ expected financial risk and return, which, for obvious reasons, is a key determinant of their investment decisions.
Why do so few investors rigorously assess expected impact in addition to financial risk and return? How can investors adapt their approach to move closer to the efficient impact frontier, maximizing expected impact per level of risk-adjusted financial return? These are questions we plan to answer.
As a place to start, we can look to the investors profiled in Impact Investor 2.0: The Way Forward — Insight from 12 Outstanding Funds, who were selected from a pool of hundreds for their strong social and financial performance. We identified several shared characteristics of these investors, including their commitment to embracing “mission first and last,” meaning they established a clearly-embedded strategy and structure for achieving positive social impact prior to making investments. While no impact due diligence systems were disclosed to our team by these investors, they all clearly defined their impact objectives, employing a “binary” approach to determining whether prospective investments did, or did not, align with their mission.
For example, if a fund’s mission is to improve quality of life in rural communities by financing businesses selling essential products available in urban but not rural areas, then businesses not selling in rural areas wouldn’t be considered. If a potential investee’s model aligned with the fund’s investment thesis, however, the investor wouldn’t quantify the extent to which the prospective investment aligned with its mission, or systematically compare expected impacts of potential investees. This approach to classifying prospective investments as mission-aligned or not, rather than assessing the degree to which investments align with mission, is a widespread practice in the impact investing industry.
Drawing from our experience evaluating the social and environmental impact of billions of dollars across a range of asset classes, sectors, themes and geographies, we’ve seen numerous reasons why investors choose not to rigorously assess the expected impact of investments to inform their decisions:
- Systematic assessment of expected impact is inherently subjective, making it challenging to build consensus around the right inputs for any due diligence model and the weights applied to each input in the model
- Building an easily-implementable tool that assesses expected impact in alignment with a consensus of users’ values can be costly and time-intensive
- Some investors believe certain aspects of their impact cannot be measured, and therefore they must rely upon their judgement to determine whether a potential investment aligns with their social or environmental objectives. An impact due diligence tool, in their view, could never be accurate.
- Their own investors or key stakeholders haven’t demanded impact data inform investment decisions, and they’ve successfully raised money and deployed capital to impactful organizations without such a system.
Despite these barriers, we believe developing rigorous impact assessment tools for use within due diligence and underwriting represents a critically important — yet underdeveloped — practice within the field of impact measurement.
While NCCLF has realized significant benefits from the SIR, there are several factors which may constrain the adoption of impact due diligence by the field beyond those described above. First, for an impact due diligence tool to be effective it must reflect an investor’s unique objectives and investment approach, and cannot be adapted for use by another organization. For example, because NCCLF’s unique mission, strategic objectives, lending approach, and target geographies and beneficiaries directly informed the tool’s design, it cannot be easily modified for use by others. Second, while there are a wide array of resources devoted to the practice of impact measurement, there are few resources that describe how investors can undertake, and benefit from, impact due diligence.
We, therefore, believe an important next step in supporting the impact investing field is the creation of a free impact due diligence toolkit offering practical guidance and information that could be used by any investor to assess the expected impact of their investments, and thereby better align them with impact objectives. We intend to develop such a toolkit by drawing on what we’ve learned from our work with NCCLF and others, as well as conducting additional research on trends and best practice in impact due diligence.
Daniel Brett is an associate director at Pacific Community Ventures, where he manages research and consulting engagements with institutional, corporate, and philanthropic investors seeking to develop and assess the performance of impact investing portfolios across investment areas and asset classes.
This post was originally published on ImpactAlpha.com
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