By definition, impact investing means doing something different. Traditional investors focus on financial returns; impact investors must make an intentional ‘contribution’ to measurable social and environmental outcomes. We should therefore expect to see a distinction between their respective investing behaviour.
There are strong and weak versions of this. The strong is that impact investors should make a distinct contribution – financial or otherwise – that traditional investors would not (sometimes called additionality).[1] The weak is a building a portfolio with a distinct impact theme. The investment market offers funds that follow different themes or styles. Some try to exploit “global megatrends”, others pick stocks with high dividend yields. These are varieties of traditional investing – all trying to make money, just in different ways. Impact could be just another theme.[2]
A recent academic paper by Cole et al. (2022) looks into both of these distinctions. It finds support for “most of the prevailing positive narratives about impact investors,” but at the same time finds that only 12 per cent of impact investors are additional. Given the importance of additionality to the distinctive purpose (and positive narratives) of the impact investing industry, how can we reconcile these findings?
Cole et al. construct a dataset of 275 self-described impact investors (excluding development finance institutions) – defined as investors with the explicit dual objective of generating social good and financial returns – and 20,000 traditional investors. They test four core mechanisms by which impact investors might create impact:
- prioritise poor or disadvantaged regions;
- are pioneers in new industries and mobilise capital;
- have a higher risk tolerance and are more patient; and
- prioritise companies that have trouble attracting traditional financing (i.e. additionality).
Taking each of these in turn, the authors find that impact investors differ from traditional investors as they are significantly more likely to invest in developing regions. They are also more likely to invest in pioneering firms and have catalytic effects on markets, with the latter indicated by the way they “step aside” as investees move away from impact financing and towards traditional financing in subsequent funding rounds. There is also evidence that impact investors assume more risk and are more patient than traditional investors. ‘Impact-only’ investee companies – those that at some stage experienced a financing round comprised only of impact investors – are 38 per cent less likely to have a successful exit and those that do exit take nearly 15 more months to do so.
All of these patterns could be found without impact investors being additional – impact investors might crowd-out mainstream investors but with a bias towards certain types of investment (those that appear more impactful). But Cole et al. have come up with a way of identifying additionality, and they do find evidence for it. And it turns out that additionality helps explain the differences they find between impact investors. It should not come as a surprise that investors who fall under the broad umbrella of ‘impact’ do not all act alike, and while some self-described impact investors appear to behave in a way that could justify the name, others do not. The investors Cole et al identify as additional are more “socially-oriented” than other impact and traditional investors, meaning they are more likely to invest in poorer places, take more risk, be more patient, and be more catalytic.
The method Cole et al. have devised to identify additionality is clever and simple: they search for impact investors who very rarely co-invest with commercial investors, and also rarely co-invest with impact investors who regularly co-invest with traditional investors.
The logic behind this approach is that the presence of a traditional investor signals that the deal must have been able to attract investment on its financial merits alone. While some drawbacks of this approach are acknowledged in footnotes – specifically that it does not allow for non-financial additionality, nor the possibility that the actions of truly additional impact investors may have mobilized the co-investment from mainstream investors – there are others.
The presence of a traditional investor in a deal does not demonstrate the impact investors were not additional, in the sense of making something happen that would not have otherwise. There may be cases where firms or funds set out to raise capital and are only able to partially find the sums they require from traditional investors. Without additional funds from impact investors the deal would fail. This is more likely to happen in thin markets where a small number of traditional investors look at each prospective deal and reach different conclusions about its risk return profile. In that way a few may say yes while most say no. BII sometimes enters deals after it has become clear that not enough commercial investors are willing to participate to reach the fund-raising target. And some impact investors may follow something of a mixed strategy and be additional most of the time, but also want some more commercial investments in their portfolio. It is not obvious those investors should be classified as not additional.
The finding that there is no statistically significant difference in additionality between those investors that self-describe as concessionary and those that do not also raises questions. It is hard to understand how an investor can be concessionary and yet also be investing in the same things on the same terms as traditional investors. Yet if they are investing on different terms, that could suggest they are bringing something additional to the table. Perhaps some impact investors self-describe as concessionary but are not. However, Jeffers et al. (2021) find that the often reported poor financial performance of impact funds (see Barber et al., 2021; Kovner and Lerner, 2015) is not evident once you exclude concessionary funds (defined in the same way as Cole et al.). That would suggest self-declared concessionary funds are genuinely concessional.
Having said their definition of additional could be excluding some impact investors with a genuine claim to additionality, despite the occasional co-investment with mainstream investors, there is one argument in the other direction. A paper by Carter et al. (2021) shows that, in theory, if impact investors are attracted to certain types of project (those with certain “impact” characteristics) and they offer finance on more attractive terms that traditional investors, then they could completely crowd out traditional investors from all projects of that type. The result is a world in which impact and traditional investors do indeed separate into two distinct groups, even if there is zero additionality.
Another approach to the “what do impact investors do differently?” question is being pursued by the Wharton ESG Initiative by asking whether impact investing is “hard”. What hard means is more difficult to source investments, to meet financial targets, to exit from investments successfully, and so forth. Intuitively, we might think that impact investors who seek ‘market-rate’ returns would have the toughest job. Not only are they expected to yield annual returns of 20%+, but also to meet an additional impact hurdle. However, the Wharton research shows the opposite. It considers different types of impact investors with different expected rates of return – ‘market-rate’, ‘below but close to market-rate’, and ‘at or near capital preservation’. Across origination, due diligence, meeting financial targets, exiting successfully and more, ‘market-rate’ investors are least likely to report that impact investing is harder than traditional investing, while those investors ‘at or near capital preservation’ are most likely to report it is (investment officers at DFIs might empathise with that!).
The researchers’ explanation is that market rate impact investors are more likely to simplify their work by equating impact and business performance, which might further call into question how some impact investors think about impact.
Industry initiatives such as the Operating Principles on Impact Management (OPIM) are helping to further define what impact investors look like. And the ongoing public consultation on contribution led by Impact Frontiers demonstrates the appetite to tackle the difficult question of additionality. Research like this helps the market sort the impact investing wheat from the chaff, even if we do not yet have definitive answers, and we look forward to more of it.
This blog was written by Steven Ayres, Research and Policy Executive, with contributions by Paddy Carter, Research and Policy Director.
[1] ‘Additionality’ and ‘contribution’ are overlapping terms. At BII, we use the term ‘contribution’ to refer to the difference that our additional inputs make to development outcomes. This goes beyond additionality, which is only concerned with inputs.
[2] Thematic impact investors could make a contribution to outcomes by signalling to companies that impact matters in their investment decisions.
