Why profit matters in the impact space
Impact investing takes into consideration both financial return and social or environmental impact. Profit matters as much in the impact world as it does in the core economy because it ensures sustainability and without it, any long-term mission fails. Sustainability and financial sustainability are synonymous. Yet, in many impact investing circles, profit is a dirty word. How can you be doing good if you also seek a profit?
The total amount of impact dollars, including self-defined impact funds and philanthropic sources, is estimated at US$230bn. The aggregate Official Development Assistance (ODA) budgets of OECD (Organisation for Economic Co-operation and Development) countries were US$146.6bn in 2017. Combined, this may seem like an enormous pool of capital. Yet the world’s development problems, such as universal health coverage or the alleviation of poverty, require trillions of dollars. According to the United Nations, the 2015 Sustainable Development Goals – widely viewed as a full menu of this generation’s development challenges – will require some US$5-7tn of capital investment. Other studies identify an annual investment requirement of as much as US$2.5tn in order to meet the goals.
How then to bridge the gap between what is needed and what capital is mandated for developmental outcomes? The answer is to mobilize funds that come with the requirement of a profit or market rate of return on investment. The largest sources of capital on the planet – the savings of private citizens in advanced economies, in the form of public and private pension plans and wealth management funds – can and should be allocated in greater amounts towards developmental challenges. Yet such funds require market returns; after all, the primary purpose of that capital is to provide retirement benefits to its beneficiaries, not do good in the world. Even a small reduction in investment returns can have a significant negative impact on those benefits. So how can such funds deliver the right returns and help solve our development challenges?
Two things must happen. First, the fiduciaries of such funds need to recognize that it is possible to blend market returns with societally beneficial outcomes. Many simply do not. And secondly, there needs to be a revolution within the asset management world as to how to deploy the funds to achieve these outcomes.
Regarding the first challenge, progress is being made in some parts. Not all private capital fiduciaries are constrained by legacy thinking. The wealth management platforms of the world’s largest banks in particular are offering an increasing number of ‘impact products’ to their clients, based on increasing demand. The issue there is more about how to deploy the funds.
On the public pension side, however, the response to date has been muted. Either for legal constitutional reasons, or through adherence to a strict fiduciary model for discretionary allocations, trustees of large public pension plans tend to avoid any fund that has an impact element to it. They fear being held to account for reductions in returns when returns are already under pressure from increasing pension liabilities. The fundamental issue is the perceived wisdom that impact outcomes inevitably come at a financial cost (a trade-off). Is that not why philanthropic capital and government aid budgets occupy that territory? This shows a lack of imagination and a misunderstanding of how the world of impact investing has progressed over the last two decades.
A few observations need to be made. First, the term ‘impact investing’ is misleading and out of date. It is too easily associated with philanthropic investing, whereas the majority of self-defined impact funds in today’s world have some level of financial return built in to them, and many, a true market return.
Secondly, over the last twenty years, the development finance institutions (DFIs) set up by national governments and multi-lateral organizations like the World Bank, have actually proven that strong financial returns can go hand in hand with avowedly impact outcomes. They do this by providing debt and equity to good companies in the developing world at market rates, thereby increasing economic activity or building critical infrastructure for the benefit of the societies that depend on it.
And thirdly, what counts as a developmental impact outcome has been way too narrowly defined. For too long it has been defined by ‘impact evangelists’ who dismiss profit-related metrics, such as economic growth, as qualifying outcomes. Under that thinking, it is not enough to create employment even though there are so many data points linking increased employment and economic activity generally with improved health, education and other social benefits. The asset management industry must adopt a much broader perspective on impact. For those willing to invest in the developing world, there is the entire scope of the UN’s 17 Sustainable Development Goals to consider. Even a cursory analysis shows that there is almost unlimited opportunity to identify and address these global challenges through smart investment that generates a market return.
But developmental outcomes are not limited to the developing world. Impactful investment opportunities abound ‘at home’ too. For example, we believe that funding advances in the delivery of healthcare outcomes in the advanced economies should be considered. Our societies are far from providing adequate services for the care of the elderly, especially those with dementia-related illness or those at the end of their lives. There is a huge gap in quality between expensive private services and public funded services. We believe that businesses that can increase the quality of services in these sectors whilst reducing price points will be both financially successful and also societally impactful. And for the conservative fiduciaries of public pension plans in the developed world, these opportunities are in their home markets and, given the sectors themselves, highly resonant with their beneficiaries. This is just one area where the revolution in thinking needs to happen.
We do not dispute that an enormous amount of good can be achieved through philanthropic endeavor. Some problems cannot be solved directly and quickly and generate a profit at the same time. Much of the amazing work of the Bill & Melinda Gates Foundation would not have happened if a profit layer were applied to its activities. But none of it would have been possible without profit being generated elsewhere. The great foundations are generally built on the side of an endowment that absolutely requires profitable investment to maintain the programmatic side. Moreover, foundations would not exist at all had the benefactors not created the wealth in the first place. The Bill & Melinda Gates Foundation is so game-changing because Microsoft was so profitable. Profit is an important driver of developmental funding and always has been.
Today’s asset managers have an opportunity to revolutionize how we perceive impact investing. Those who take up the challenge will find growing receptivity from societies increasingly concerned with the developmental challenges of the world, both from the poorest economies to our home markets.