Time to invest in tackling social problems

Many economists have tried to win a Nobel Prize by either explaining why or proposing a solution for how markets can be better aligned to serve the greater social good. While it is unlikely that the pioneers of impact investing – an investment approach intentionally seeking to create financial return and positive social impact that is actively measured – will receive an early morning call in October from the Swedish Academy of Royal Sciences, it is clear that impact investing demonstrates a practical solution for reconciling market failures that otherwise result in social costs.

Yet despite its great potential, many people think there is a lot of hype surrounding impact investing. There is sufficient cause for that concern. With less than US$ 40 billion of capital committed cumulatively to impact investments out of the tens of trillions in global capital, impact investing remains a niche market. To be considered mainstream by 2020, it would need to clear the symbolic mark of US$ 1 trillion. While not impossible, the required growth rate would mean significant changes to how investments are made.

The strongest critics assert that impact investing will not grow at even a moderate pace because it does not generate market rate returns. On the contrary, our research has found that 80% of impact investment funds target market rate returns, with an estimated 35% targeting an internal rate of return (IRR) above 20%.

So, if impact investments can and do generate market returns, why has more capital not flown into impact investments and generated a faster pace of growth for the sector?

First, impact investing is nascent compared to what mainstream investors can draw on. It has taken decades for mainstream investments and alternative assets to mature. In contrast, impact investing has had only a few iterations of deal structuring, risk management strategies and supporting intermediaries.

Second, impact investment deals are generally done at earlier stages and therefore smaller than mainstream investments, resulting in higher relative transaction costs. While the average private equity deal is US$ 36 million, the average for an impact investment is US$ 2 million. Considering that big suppliers of capital, such as pension funds and insurance companies, allocate their capital in the billions, the deal size presents significant scaling constraints for the impact investment sector.

Third, impact investing does not readily fit within mainstream asset allocation frameworks as it adds an extra dimension of “social impact”. In our view, impact investing is best thought of as a strategy across asset classes (fixed income, private equity, venture capital) rather than an asset class with its own distinct liquidity, risk and time horizon profile. Given its novelty and limited historic data, mainstream investors struggle to include this strategy in their established frameworks that focus purely on financial metrics.

Fourth, the measurement of social impact is not straightforward. Social impact can be costly, has long time horizons and is often hard to categorize and compare when “theories of change” differ. This multitude of definitions has and will continue to cause friction in the deal-making of impact investments.

However, bringing impact investing from the margins to the mainstream is too important an opportunity not to pursue.  In conversations with Millennials, they make it clear that they want investment money to make a social difference rather than single-mindedly pursue financial returns.

Impact investing itself is not a silver bullet. But, it offers an innovative and multifaceted approach to decision-making on investments, which can bring us closer to having more robust and inclusive financial markets that take into consideration social costs and benefits.

Like most investment approaches, impact investing will evolve over the coming years and decades. Investors can have significant influence over the social, environmental and economic challenges of societies, and the mainstreaming of impact investing can help facilitate this.

Read more blogs on finance and economics.

Author: Michael Drexler is Head of Investors Industries at the World Economic Forum. Abigail Noble, Head of Impact Investing Initiatives at the World Economic Forum, also contributed to this piece.

Image: A man is seen wearing a construction helmet in Tokyo REUTERS/Issei Kato.