The private sector is likely to play a major role in developing solutions for the challenges presented by the pandemic. These solutions may take different forms, say the authors of this article. The actions fit into the idea of "impact investment".

The following article considers what is called impact investing: putting money to work to bring about a particular result, such as stopping convicted criminals from re-offending, encouraging kids to be more literate, or reducing carbon emissions and creating building spaces for children to play in. These investments can also earn a monetary return. The term “impact investment” should not be conflated with Environmental, Social and Governance (ESG) investment, because with ESG, the prime objective is to earn returns in ways that benefit the environment, society and which uphold high standards of how firms and other organizations are run and held accountable. Impact investing is mainly about the impact – but investment returns are part of the equation. 

As readers can imagine, the COVID-19 pandemic has focused attention on specific impacts – such as helping the afflicted, reducing the chance of getting infected, and pushing research into cures and preventative actions. To explore these ideas are Kunal Shah and Tatiana Esipovich of iCapital, the platform for alternative investments. 

The past decade has seen significant growth in the number of private companies seeking to address social and environmental challenges across diverse areas such as renewable energy, waste processing, education technology, financial services, and healthcare, among many others. At the same time, investor interest in global sustainability has climbed sharply: According to industry research, 80 per cent of global investors say they are more focused on sustainability today than five years ago (1) and 95 per cent of Millennials are interested in sustainable investing strategies. (2)

This combination of an attractive opportunity set and interest from institutional and high net worth investors has helped attract private equity attention and fueled the growth of impact investing, a segment within the sustainable investing universe that seeks to generate a measurable social and environmental impact alongside a market-rate investment return. As it has matured, this once-niche market has entered the mainstream and become a vibrant option for high net worth investors seeking to align their portfolios with their values. 

At the time of writing, it remains to be seen whether sustainable investing will continue to be a near-term priority for investors whose lives and portfolios have been upended by COVID-19. It is clear that the global pandemic directly connects to one of the key UN Sustainable Development Goals: Good Health and Well-Being. The private sector is likely to play a major role in developing solutions to the challenges presented by the pandemic. These solutions may take different forms, for example pharmaceutical companies are looking to develop faster diagnostics tools, treatment options, and vaccines. Opportunities are often borne out of a crisis, and we expect that in the months and years to come, needs will arise that will present attractive opportunities for private capital to address.

Public markets may offer limited potential for direct impact
Compared with sustainable investment strategies offered in the public markets, we believe that private markets are better positioned to deliver positive impact while achieving market-rate financial returns. There are a few reasons for this. First, investors in public market companies typically own a small percentage of shares and, as a result, have limited ability to influence the impact potential of these companies. Rather than actively drive impact, sustainable public market strategies often take a more passive approach by screening out undesirable industries (for example, fossil fuel or firearms) and/or investing in companies that perform well on environmental, social, and governance (ESG) measures.

One of the more common ESG-related approaches, known as ESG integration, is often marketed as “socially responsible,” but a look under the hood of some of these funds reveals a larger focus on risk management related to corporate governance than on achieving positive environmental or social impact. Amid a dramatic rise in ESG assets under management, the SEC is beginning to scrutinize funds’ socially responsible claims to determine whether they are legitimate or amount to marketing spin, a phenomenon known as “greenwashing.” (3)

Leveraging resources helps private equity firms institutionalize ESG across a portfolio
Through the private equity model, managers maintain significant influence over portfolio companies, enabling them to drive improved impact and financial outcomes. The private equity model creates efficiencies by leveraging management, technical expertise, and resources across a portfolio of companies. As PE firms become more focused on impact, they are employing this model to deploy, manage, and measure the success of ESG programs and specific impact initiatives systematically across companies.

Untested ideas and technologies can thrive in private markets
Another reason private markets can better foster impact is that public markets tend to be less hospitable to smaller companies developing untested approaches or that have longer time horizons. Many impact-focused companies are innovative and technology oriented, and need time to prove out their ideas. The vast majority of these companies are located in the private markets. The long-term nature of private equity better enables these companies to thrive: Unencumbered by quarterly reporting requirements, impact-focused private companies and their investors can be flexible and patient in building and following through with longer-term solutions to intractable social and environmental challenges. Public companies seeking to make an impact, meanwhile, must weigh the benefits of such long-term projects against critical near-term financial targets.

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Considerations when adding impact strategies to a portfolio
As with any investment, particularly in private markets, careful due diligence is critical. We believe it’s important to focus on fund managers with a proven track record in achieving a “double bottom line” of both impact and financial returns. Quantifying a fund’s impact goals and key performance indicators can help investors avoid greenwashing and is especially important today as larger, more mainstream fund managers enter the space.

Consistent benchmarks would offer the most effective way to measure impact. Similar to private equity benchmarking, however, there isn’t a single agreed-upon standard. Technology is helping to accelerate the availability of high-quality data and analysis, but it is unlikely that a single industry standard will arise in the near term.

Commonly used and widely accepted metrics for measuring impact include the UN Sustainable Development Goals (SDGs), the Global Impact Investing Network’s IRIS+, GIIRS Ratings, and the CA Impact Investing Benchmark. Today, the UN SDGs seem to be the most widely used: Two years after the ratification of the SDGs by the UN, three out of four investors report that they track their investment performance to the SDGs or plan to do so in the future. (4)

Impact investing and volatility
Is a volatile market the right time to consider impact investing? Given the recency of available impact data, proof points about its performance during a downturn are not yet widely available. However, a review of the performance of the Cambridge Associates U.S. Buyout Index suggests that down markets produce some of private equity’s best-performing vintages. (5) Further, the lack of more frequent reporting and private equity’s illiquid nature can also be an advantage in uncertain times, as they insulate investors from some of the market volatility and prevent panic selling during the depths of a downturn. Meanwhile, PE’s multi-year holding periods also give managers the ability to wait for optimal timing to make investment decisions. 

Impact investing has reached a tipping point
In the early days of impact investing, most strategies focused on environmental issues and invested in companies that often relied on government subsidies or forward-thinking pioneer investors, such as the World Bank, for survival. These strategies could be risky and often delivered disappointing performance. Today, impact investing has entered a more mature, institutionalized sphere that has achieved scale and offers investors opportunities to participate at lower risk levels, with better return potential. As more high-quality, impact-focused private market strategies become accessible at lower investment minimums, we expect to see higher adoption rates among individual investors.

Footnotes

1) Bain & Company, Private Equity Investors Embrace Impact Investing, April 2019.
2) Morgan Stanley Institute for Sustainable Investing, Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice, September 2019.
3) The Wall Street Journal, ESG Funds Draw SEC Scrutiny, December 2019.
4) The Global Impact Investing Network, “Annual Impact Investor Survey: 2018,” June 2018.
5) Source: Cambridge Associates US Buyout Index, as of March 2019. References strong relative performance of the 2001, 2002, and 2009 vintages. See Private Equity Offers Resilience in a Downturn for more information.