Impact investing – Let’s face the music and dance

As a famous music agent (whose clients have included no other than my all-time favourite band Led Zeppelin) once told me, “Consciousness is the new Rock’n’Roll”. Aside from the fundamentally different industries and backgrounds we came from, the phrase struck a chord.  To me, it resonated as a shift in in mentalities in which the environmental, social and governance (ESG) agenda has infiltrated corporate mindsets and encouraged an increasingly important shift in business and the economy.

Impact investing supports companies and organisations that create a positive impact on society and the environment, whilst generating financial returns. It is not philanthropy, as profitability is a must.  Sacrificing financial results for generating impact is not a condition either because market or above market returns are expected.

Whilst ESG concerns in the investment sphere have been on the table for some time (the UN-backed Principles for Responsible Investment were launched in 2006, and now adhered to by nine of the ten of the world’s largest fund managers), the concept of impact investing is a relative novelty.  However, it’s not completely straightforward.  A recent behavioural analysis on impact investing from Barclays pointed to one fundamental issue: an impact investment can touch upon many different practices of investing – ranging from responsible (i.e. mitigating ESG), sustainable, or outcome-focused.  “Some impact investors are impact-first; they are willing to accept a lower financial return (compared to a conventional financial product) for a greater impact. For finance-first impact investors, the return on investment is higher priority” argues Diane-Laure Arjaliès from the Network for Business Sustainability-it’s not apples-to-apples.  Until there is a consensus on the way the products are described, fund managers need to “be more objective about the levels of risk and the expected returns, both financial and nonfinancial, of their funds. Just as a mature impact-investing market needs shared standards for measuring impact, it will also need a common language for profiling impact funds”, note McKinsey consultants Jonathan Godsall and Aditya Sanghvi.

Investors also need to look beyond short-term gains or risk divestment – and although there is evidence of superior financial returns when an impact investment is mixed, breaches of ESG can affect performance gravely.  The key is to build more solid platforms containing consistent ESG data per sector and build targeted financial products around them – an R&D space for finance, of sorts.

Is this “New World” of investing only for the adventurous?  McKinsey’s 2017 study posits: “these investments can’t be scaled adequately to create attractive returns, carry higher risk overall, and are less liquid and thus tougher to exit. Impact investing may be forecast to grow to more than $300 billion by 2020, but even that would be a small fraction of the $2.9 trillion or so that will likely be managed by private-equity (PE) firms worldwide in 2020.” “Conventional” investors question impact investments – lower returns, longer holding periods and unclear social impact. But today it’s not necessarily clear-cut.  Regarding longer holding periods, the McKinsey study underlines: “the mean and the median holding periods when investors exit have been about five years, no different than the holding periods for conventional PE and venture-capital (VC) firms. […] Social enterprises with strong business models do not need long holding periods to generate value for shareholders”.  The key to success is importantly down to how the due diligence is performed.

Institutional investors have made strides on it, driven by client interest. BlackRock, Goldman Sachs, Bain Capital, and TPG are just a few that have taken significant steps to integrate impact investing into their asset management offerings. More generally, the number of SRI (socially responsible investing) mutual fund and ETF offerings has grown rapidly over the past few years. MSCI and Morningstar—leading providers of independent investment research—have also released ESG indices and ratings to inform investment decisions.

Definition and consistency of ESG data and ratings is a concern. At the moment it is still more of an art rather than an exact science. There needs to be more clarity in standards and terminology. Let’s take the example of ESG rating firms. The research they produce isn’t necessarily consistent due to the way data is collected and analysed-and all ESG specialists will know the variety in methodologies to calculate offset that still abound across the globe. So the ratings will vary significantly from one firm to the other for a same given company until there is a better established, globally agreed methodology.

Impact investing has been most prevalent in equities and specialist activity such as green bonds. Other asset classes are catching up though, but not without their own challenges: a recent World Bank research paper looked at integrating ESG data into their fixed income portfolio. “In fixed income, there are additional issues such as how to pursue engagement with issuers (particularly sovereigns), the role ESG plays in credit ratings, the lack of choice of indices compared to the equity space, as well as a dearth of specific ESG-focused products. […] Conceptual work on ESG and fixed income also needs to go beyond credit risk.”

So, what’s next?  ESG data is improving fast, thus allowing investors to customise their approach on sturdier grounds (specific to the sector they want to invest in for example). The more this improves, the more ESG data and impact investment products will help reduce risk and drive higher financial returns – making it a core investment process. And finally, it would shed some light on where the investment’s value actually comes from — and thus can restore the purpose of financial markets and connect them to the real economy. There’s no reason why impact investing couldn’t merge into a mainstream investment practice, especially as the millennial generation engages to call the shots, with a set of values firmly and rightly entrenched in sustainability matters.

Let’s tune back in the phrase that struck a chord: if consciousness is the new Rock’n’Roll, investors will no doubt soon have to face the music and dance.