Leveraging Impact Investment for Global Development?
December 19, 2016
The term “impact investing” was first coined in 2007 at a gathering hosted by the Rockefeller Foundation, and it refers to investments into companies, organizations, or funds with the intention of generating social or environmental impact alongside a financial return. While there were organizations doing what we would now call impact investing well before 2007—including public institutions such as the International Finance Corporation (IFC) and the Overseas Private Investment Corporation (OPIC), as well as private groups such as the Small Enterprise Assistance Fund (SEAF)—the “field” has only recently achieved formal recognition and is only now achieving breadth of sources of funds and variety of investors.
So far, impact investment’s promise exceeds its current application. There remains a series of hurdles that keep the sector from expanding to the point where it can be considered a significant tool for addressing global challenges. Overcoming these hurdles could unlock impact investment’s full potential as a driver for social good.
There are many challenges that must be overcome before impact investment becomes a mainstream instrument of global development, but it has world-changing potential. Last winter CSIS hosted a conference to explore how impact investment might be relevant in developing countries. The reality is that foreign aid dollars, government resources in developing countries, and philanthropic efforts fall far short when it comes to addressing the world’s most pressing social, environmental, and economic challenges.
A look at the recently announced Sustainable Development Goals (SDGs) clearly displays the need for significant levels of additional development financing. The UN Conference on Trade and Development (UNCTAD) estimates that meeting the objectives outlined in the SDGs will cost $3.3–$4.5 trillion annually, but global development finance totals roughly $1.4 trillion per year, leaving an annual shortfall of $2–$3 trillion. Even as foreign direct investment has expanded in scale and breadth in the past 20 years, the private sector is going to be called on to scale up its engagement and investment to fill this gap. Impact investment is one way private investment and for-profit approaches could be brought to bear to take on big global challenges. The recent downturn in global stock markets will likely temporarily limit private-sector interest, but the long-term prospects in this field should not be overlooked.
A Growing Field
Impact investment’s roots can be traced back to the Socially Responsible Investing (SRI) movement that came to prominence beginning in the late 1990s and early 2000s. Typically, SRI funds seek to deliver social good by avoiding, or screening out, investments in businesses or industries that are deemed socially harmful (e.g., alcohol and tobacco, military and weapons production, and fossil fuels). In this regard, SRI practices represent an earlier and less-proactive form of impact investment. Many large investors have adopted SRI standards—in 2015 SRI assets exceed $7 trillion in the United States alone, having nearly doubled since 2012.
The modern form of impact investment emerged as an ambitious outgrowth of the traditional SRI movement—rather than just seeking to avoid harm, investors wanted to actively deliver positive social outcomes through their investment. In many regards, this expanded social ambition was the product of twin anxieties emerging in the wake of the 2008 financial crisis. Financial dysfunction eroded public confidence in capitalism while simultaneously people began to question the efficacy of government in addressing social challenges. While for many impact investing was simply a way to generate positive outcomes without foregoing returns, for others it also provided an opportunity to respond to critiques of capitalism by leveraging market tools to address the problems government could not solve.
One of the trends driving interest in impact investing is generational—30 percent of millennials believe that the #1 priority of business should be to improve society. Traditionally, thinking around profit vs. social good has been bifurcated, but this generation has a different view on social and corporate interests. U.S. millennials are set to inherit approximately $41 trillion from baby boomers over the next four decades—amounting to the greatest transfer of wealth in history—and many are eager for investment strategies that meet their financial needs while also delivering some broader positive contribution to society. A study by Morgan Stanley in 2015 found millennials to be “twice as likely to both invest in companies or funds that target specific social/environmental outcomes and divest because of objectionable corporate activity.”
A related trend is the 50 percent increase in the number of millionaires and the 200 percent increase in the number of billionaires from 2008 to 2014. This latest generation of high net worth individuals includes entrepreneurs like Mark Zuckerberg, Pierre Omidyar, and Jean and Steve Case, who are intent on transforming the world. For these individuals, impact investment represents a new way to leverage their massive wealth and innovative thinking to deliver social good.
In reaction to these trends, many of the largest private institutional investors in the world have recently acquired or established dedicated impact investing teams. In 2015, Goldman Sachs purchased the impact investment firm Imprint Capital. Morgan Stanley, BlackRock, and UBS have also recently established impact investment units. Earlier this year, former Massachusetts governor Deval Patrick was named managing director of Bain Capital’s social impact investment platform.
Challenges to Broader Impact Investment
The assets dedicated to impact investing represent only a tiny fraction of the nearly $300 trillion global financial sector. So far, impact investing remains a niche investment option for a relatively small market of investors. There are huge margins for growth, but a number of challenges must be overcome before impact investment enters the mainstream in the financial world.
Perhaps the most significant challenge facing impact investment is the difficulty of establishing clear and consistent metrics that measure both financial performance and social impact. An individual impact investor might prefer an investment that delivers high social impact with a modest financial return, moderate social impact with a market competitive financial return, or minimal social impact with a strong financial return. There needs to be a way to benchmark investment performance so that there are clear and realistic expectations on social and financial return, regardless of the investor’s specific preferences. While there have been some efforts—from the U.S. Agency for International Development (USAID), the Rockefeller Foundation, and others—targeted toward creating performance indexes, investors still lack clear expectations on how a given impact investment will perform in terms of social and financial return.
The second challenge to impact investing lies in market liquidity. Many impact investments have time horizons beyond what a typical investor would be willing to tolerate before any returns can be realized. Until the impact investment field becomes larger, investors have limited opportunity to buy or sell assets after an initial investment. Potential investors will be scared off by this lack of liquidity.
Finally, there is a need for greater collaboration among public actors, philanthropy, and private investors to create this more liquid marketplace to grow impact investing. Traditional development agencies and international nongovernmental organizations are well equipped to share on-the-ground knowledge, provide catalytic funding through grants or concessional finance, and create vehicles to connect potential investors with suitable investment opportunities. Many believe that official aid donors like USAID could play a bigger role in enabling collaboration, sharing financial risk, and accelerating the creation of vehicles to intermediate between projects and investors. Official aid donors can take on some of these roles, but sharing financial risk remains difficult because of concerns about “picking winners” or creating “moral hazard.”
Official aid donors could have a role to play in socializing the idea of impact investing. Official aid donors can reduce the inefficiency of the capital raising process by financing impact investing “merchant bankers.” They can provide more grant capital at the very bottom of the pyramid, as there is a shortage, and the risk profile stretches too wide right now to accommodate this gap. Aid donors should continue to improve banking and legal systems in developing countries to create an enabling environment for “normal” investing as well as impact investing.
So far, impact investment has grown at a rate of roughly $10 billion a year. This is impressive, but dealing with the largest global challenges, such as feeding 9 billion people, financing the global infrastructure for water and sanitation, or educating and training the world’s youth bulge, will require trillions, not billions. Many of the solutions to the world’s biggest problems will require private investment capital and capable governments.
For impact investment to play a meaningful role, the industry must grow at a geometric rate. It is possible for impact investment to grow on this scale, but it is not yet a new asset class.
Daniel F. Runde holds the Schreyer Chair in Global Analysis and is director of the Project on Prosperity and Development at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Charles Rice is a research associate with the CSIS Project on Prosperity and Development.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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