Wealth Management

Impact Investing and Institutional Investments

The stated goal of impact investing is to simultaneously create strong financial returns and measurable environmental, social, or governance (ESG) outcomes from the investments that generate those returns. Perhaps not surprisingly, institutional investors are often at odds over the asset classes that deliver the best impact investing performance, the corporate targets that can best deliver desired performance, and economic and other constraints on their asset selections. As a result, individual investors who entrust their portfolios to professional wealth managers and institutions frequently face a disconnect between what impact investing promises and the extent to which it fulfills those promises.

The professional investment community has recognized that disconnect and is seeking better strategies to assess the best impact investment targets and to accelerate the flow of portfolio capital into those targets. This community realized that at present, impact investing is largely confined to development finance institutions, family offices, and high-net-worth individuals. These groups of investors represent only a small fraction of the available capital that can be allocated to impact investing.

One estimate perceives that impact investing has grown by 11% over the past 20 years and comprises an aggregate allocation of approximately US$25 billion. This is a fraction of the total market potential for ESG-themed wealth management, which experts believe can be between US$500 billion and US$1 trillion. To achieve that potential, impact investing needs to draw a critical mass of institutional investors with investment allocations that validate the importance of ESG goals and strategies.

One way to accomplish this is to form a better definition that highlights the differences between traditional and impact investing. Specifically, this strategy is an investment approach that establishes criteria by which investment decisions are made across asset classes. Unlike asset classes that are usually defined in terms of similar behaviors under varying market conditions, impact investing offers a lens through which investment decisions are made. Further, the investor’s intentions take precedence over profit motivations. A specific investment decision might serve ESG goals, but if the investor is not motivated by impact considerations, that decision is not an impact investment. Last, the ESG effects of the investment should be as objectively measurable as its financial returns. Measurability will necessarily be a specific function of the substantive business of the investment target.

Funds and other institutional investors that are looking to expand their ESG operations have a few examples that can serve as models for an expanded impact investing program. Many of those examples are individuals and family offices that have more flexibility and discretion in asset allocation and fewer stakeholder management challenges. Several large investment banks, including Credit Suisse and JP Morgan, have established targeted funds that enable investment autonomy similar to that available to family offices.

One group of institutional investors that may be a match for impact investing comprises pension funds, insurance companies, and other liability-constrained institutions that can comply with their fiduciary obligations with careful management of ESG-driven investments. TIAA-CREF, for example, is reported to be an active investor in corporate social real estate that delivers affordable housing and sustainable development initiatives. University and other educational endowments are another group of institutional investors that would have a natural affinity for portfolio management driven by ESG factors.

Certain challenges to institutional impact investing will remain even for those institutions that can overcome flexibility and discretionary asset allocation issues. First, many institutions perceive impact investing to be a niche strategy that is mired in its early stages without showing signs of growth or maturity. Early ESG efforts have reflected a disparity between projected and actual returns. As a consequence of this, the track records of impact investing funds are limited, and fund returns have varied significantly. This may be the result of early-stage limitations in the creative and innovative investment products that reflect ESG factors. Those limitations will naturally fall off as more institutions adopt impact investing strategies.

Another challenge is that many ESG investments are small, and fall below the threshold that a pension fund might consider as a stakeholder. A hard truth in the institutional investment industry is that a US$10 million and US$100 million investment each requires the same amount of due diligence. Many funds will not look at an investment of US$50 million or less. Institutional investors that are constrained by this limitation might have to look deeper for large-scale real estate, infrastructure, or fixed income transactions.

Overcoming all of these challenges will require different actions from different institutional participants. The first of those participants, impact investment funds, can draw more interest and attention by being clear and transparent about anticipated returns and by reporting results to independent third parties for verification. They can also create systems to measure and disclose actual ESG impacts that have been achieved. They might also pool funds that have similar investment and impact objectives in order to overcome challenges based on the size of a deal.

Next, impact investment enterprises should look to build capabilities that simplify an institutional investor’s efforts to allocate capital to ESG-themed investments. Those enterprises can distinguish themselves with strong and innovative management and objective financial reporting.

Philanthropists, foundations, and endowments can lead the way to lower ESG investment risk by offering grants to early-stage impact enterprises and anchor or angel investments to products and services that serve ESG goals. This institutional investment class can also champion collaboration among foundations to reduce due diligence costs.

Governments and political subdivisions should consider offering tax relief for high-risk early-stage investments that offer a tangible public benefit, but lower initial returns. Governments might also audit their regulatory environments to remove barriers that lower the desirability of impact investing.

Last, the intermediaries that serve the financial and wealth management industries can begin to aggregate and report data on impact investment deals. More information will generate more inquiries into impact investments, and intermediaries can use those inquiries to promote common investment platforms that align capital and asset allocations. These entities are also well-positioned to create a baseline set of principles to measure results.

As impact investing grows, these problems will fade as new challenges emerge. Institutions can lead that evolution by making a commitment to impact investing now and by establishing themselves as key ESG opinion leaders as impact investing moves from a niche strategy and into the mainstream of asset allocation.