I've recently written a report on impact investing in collaboration with John Halstead at Founders Pledge. We find that effective impact investing is very hard and, to maximize social impact, it is usually much more effective to donate. You can read the Executive Summary below. You can download the full report on the Founders Pledge research page as well as Lets-Fund.org.
[Edit: 09/01: We have made some minor adjustments to the framing of our findings in the Executive Summary and Section 4.3 of this report following the publication of a piece on impact investing by Vox that mentioned this report. We believe the Vox piece took a more critical stance on impact investing than was warranted from the arguments here, and have made changes to our report to avoid misunderstanding. ]
Impact investing – investing in, or divesting from, for-profits for the purpose of social impact – is an increasingly popular approach to doing good. It seems to offer the promise of a double bottom line: direct social impact and profits that you can keep or reinvest in other socially beneficial businesses. A donation to charity, in contrast, yields no monetary returns and can only be spent once. In this report, we discuss whether impact investing is indeed a promising approach for people who want to have social impact.
Impact investors face two distinct challenges:
- Investors must find companies with enterprise impact – companies that make a positive difference to the world.
- Investors must have additionality – they need to make a difference to the performance of those companies, either through providing additional capital (known as investment impact) or through providing non-monetary support, such as advice or access to networks.
For both of these challenges, it is crucial to consider the counterfactual. That is, we have to ask: what would have happened had we not invested? Will a given solar power company merely displace another near-identical solar power company? Will my capital merely displace another investor? This marks a crucial difference between investing for profit and investing for impact. When investing for profit, we do not need to consider these kinds of questions. If the solar power company I invested in is making a $100 million profit, it doesn’t matter whether an identical solar power company would have sprung up one week later if the company did not exist. And if I made a substantial profit from my investment in the company, the fact that someone else would have acquired those profits had I not done so is irrelevant. When aiming for social impact, however, these questions are fundamental.
When we are deciding whether to impact invest, we must also consider the opportunity cost of impact investing. In the same way, if we want to make a profit, we wouldn’t compare the return on our investment to what we would have got if we had done nothing. Instead, we would compare our ROI to what we could have done otherwise with the money: if I chose an investment with a 3% return, but another available investment had an 8% return, then I would have made a mistake. The same is true if our aim is to have social impact.
If our aim is to do the most good, there are two alternatives to impact investing:
- Investing to give – Investing for profit to donate later to effective charities
- Donating now – Donating the money to effective charities now
Having social impact through donations is much more difficult than many people imagine, and it is easy to miss out on huge impact multipliers in philanthropy. However, if done carefully, the social benefits of these alternative approaches can be substantial. Reviews of our recommended high-impact charities are available on our research page.
The key findings of this report are:
1. Finding an impactful company is hard
The most promising companies will produce positive externalities or benefit consumers in poor countries, and focus on high-impact cause areas, such as global poverty and health, animal welfare, or climate change. However, evidence suggests that it is difficult to identify in advance which social programmes will work: the path from action to social impact is usually not as you would expect. Socially beneficial businesses have to solve two very difficult optimisation problems simultaneously – turning a profit and having impact. Consequently, finding viable companies with enterprise impact will not be straightforward. Our research suggests that many impact investors seem not to carry out rigorous or analytical impact evaluations.
2. It is hard to have additionality in large public stock markets
Many impact investors try to affect the stock price of companies in public stock markets, either by boosting the stock price of beneficial companies or by damaging the stock price of harmful companies. These efforts are complicated by socially neutral investors (who only seek profit), who can potentially offset any effects on the stock price. For example, if impact investors divest from an industry, socially neutral investors can move in to buy up the underpriced stock. There is clear evidence of short-term market inefficiency such that impact investors can affect stock prices on the timescale of around 3 months. There is expert disagreement about whether socially responsible investing is likely to have an effect after 6 months and beyond: some economists hold that the effect will be completely offset, some that more than half will be offset, and some that a substantial fraction of the effect might persist beyond 6 months.
Given the size of the market cap of firms targeted by socially responsible investing, it will also be difficult for most investors to have any substantial effect on stock prices in the first place. Moreover, if you invest in a socially beneficial company offering market-rate returns, then you will likely merely displace a socially neutral investor. This means the counterfactual impact of your investment is merely to provide additional capital to the stock market as a whole. For all of these reasons, the direct impact of any single socially responsible investor in large public stock markets is likely to be modest at best. All this being said, genuine strict socially responsible investing is undoubtedly more socially impactful than investing solely for personal profit. Even if the direct effects on stock prices are modest, the indirect effects appear to be more substantial. Thus, the arguments here do not give license to ignoring divestment movements solely in order to make money.
3. There is more scope for additionality in VC and angel investing
In inefficient markets with fewer investors and with imperfect information, there is more scope for your investment to make a difference to the company’s cost of capital. However, finding and exploiting market inefficiency is difficult. Even in VC and angel investing, the risk that your investment merely displaces someone else’s remains a fundamental consideration.
4. There is a trade-off between financial returns and social impact
Investors seeking market-rate returns risk merely displacing socially neutral investors. Consequently, impact investors may need to accept lower returns for the sake of additionality. Impact investors also incur additional costs in identifying, evaluating and supporting the businesses they invest in. If you accept lower monetary returns, then you are giving up money that could be donated to effective charities.
5. Your investment might merely displace another impact investor
Even if you accept subpar financial returns, you need to consider the risk that your investment merely displaces another impact investor who is also willing to accept subpar returns.
6. Impact investing has other benefits
Although they appear to have had modest direct effects on stock prices, divestment campaigns might in the past have helped to stigmatise targeted companies and industries, which in turn has helped to change consumer attitudes and encourage restrictive regulation. Owning the stock of a company also gives you some control over how it operates, allowing you to potentially steer it towards socially valuable ends or to prevent mission drift.
This suggests that, for people aiming to have maximal social impact, impact investing is likely to be the best approach only in specific circumstances. Impact investing might be a good option for people who:
- Work on an important problem that is neglected by other investors
- Do VC or angel investing
- Accept financial sacrifice
- Have an informational advantage over other investors that allows them to reliably identify promising opportunities
A good example of a case fitting the above criteria would be an investment in a company producing a revolutionary meat-alternative product that is on the brink of financial viability but is, for some reason, ignored by other socially neutral or impact investors. However, when the conditions above cannot be satisfied, investing to give or donating now are likely to be a better bet, if done carefully.
The decision about whether to pursue for-profit or non-profit solutions to problems depends on a few factors. For-profits have some advantages over non-profits in that for-profits tend to be more efficient and customer-focused. However, for products that are not yet market viable, such as public goods, non-profits will be more promising. Non-profits also tend to be more neglected because the incentives to support them (i.e. profits) are lacking. Research on effective charities is improving all the time, allowing donors to have truly outstanding impact for their dollar.
We briefly try to gain an impression of the impact investing space by examining an impact evaluation by an impact investing platform that is a field leader in impact evaluation. Our investigation showed that donations are likely upwards of 10x more impactful than the impact investing platform, and that there are key gaps in the evaluation carried out by the impact investing platform.
I strong upvoted this. I think it's great to have a reference piece on this, and particularly one which has such a good summary.
Finally a decent report on Impact Investing! Thank you so much Hauke and John. Will be sending this to a fair few people.
Only wish there was a more clear division between ESG ($trillions), socially-minded angel/VC ($hundreds of billions) and those that are technically social enterprises but for all intensive purposes look like charities with business models ($hundreds millions).
I feel like most the donor conversations I have about impact investing are about the latter, even though the vast majority of the market is represented by the former.
Found Bridgespan's 2018 report useful and interesting.
It's super important to be thinking about the actual impact of impact investing. There's a lot of rhetoric out there that's not backed up, and this paper does a good job of pointing out that in public markets, investing doesn't impact stock price. That said, there's a few things related to public market investing that could use some more investigation.
1. I don't think many public equity impact investors see their primary means of impact as shifting stock price. They create impact through your point 6 - signaling and improving portfolio companies. A more thorough exploration of the potential impact of signaling and the direct impact of shareholder advocacy compared to the impact of donations would make your argument more compelling.
In the report, you say that "Thus, the indirect effects of divestment campaigns are likely to be much greater than the direct effects.
This being said, we think that, given the financial opportunity costs of socially responsible investing, for people aiming to have maximal social impact, socially neutral investing to donate to effective charities will usually be more effective."
Could you point out the justification for this claim? It certainly might be true, but I'm wondering what makes you think it is so. Also I think it's really important to consider the wealth of literature supporting the impact of shareholder advocacy. This paper has a nice summary of some of that literature:
2. You note that the assumption of reduction in financial performance from ESG investing isn't backed up by empirical evidence - you note in your report that there is no clear relationship shown in the literature. But it seems like you find the theoretical argument compelling enough to overcome the empirical data - which is not impossible, there could be noise that leads to inconclusive empirical data. But, I am not convinced that the theoretical argument is iron-clad enough to overcome the ambiguity in empirical data.
From your report: "Overall, our view is that screening portfolios will reduce expected financial performance. There is no theoretical explanation for the finding from some studies that screening one’s portfolio improves or does not harm financial performance." The assumption seems to be that ESG performance is orthogonal to financial performance, I may have missed where this is justified.
A possible theoretical explanation of why screening doesn't hurt performance: It could be possible that ESG performance is actually a driver of financial performance (or at least risk reduction)? Every active investor has a funnel. Some screen out companies with low profit margins because of a particular investment thesis. Others screen out companies with poor ESG performance because of a particular investment thesis. This idea is becoming more popular - that ESG investing is a part of good investing. See SASB for some of the case that ESG performance impacts financial performance.
[Speaking for myself here not necessarily Hauke.] Hello thanks for these smart comments.
1. Although there is some evidence that the indirect effects of campaigns are more substantial, the evidence isn't all that good as divestment campaigns were often combined with boycotts and other campaigns. Secondly, take the example of Norway's sovereign wealth fund, where tobacco divestment cost them $2bn. I would be very surprised if the indirect effects of this gesture would have been more damaging for the tobacco industry than spending the money directly on campaigns against tobacco, which looks a highly cost-effective approach. The aim of the divestment campaign would be to raise awareness among governments presumably, but if that is your aim, it seems to make sense to try to do that directly through ordinary advocacy approaches. I agree that the report could have been clearer on this.
2. The argument in that section was that genuinely strict socially responsible investing would involve financial sacrifice, and ESG-focused screening is not strict. Many socially responsible today don't exclude all companies in harmful industries. Generally, there is a dilemma for proponents of SRI. SRI is supposed to affect the cost of capital of harmful industries. If it succeeds, then the stock price of these companies will be higher than otherwise and people who invest in them will be able to make excess returns.
Great to have something written down on this -- thanks very much guys!
I too have worried about some of the issues highlighted here and ended up not doing any impact investing for this reason. However a benefit of impact investing is that you get the money back and can invest it a new venture (or donate it) later. So to accept your conclusion that impact investing is (usually) less good than donating, you would have to believe that the problems with impact investing (e.g. crowdedness) are bigger than the benefit of getting your money back. I actually suspect that they are (so I'm in agreement with you) but I don't think I saw this comparison done in the report. (Although admittedly I read it fairly quickly, so sorry if it's in there and I didn't spot it)
I think all of this makes complete since if you look at this from the perspective of the marginal individual investor. However, when you think about the push that institutions are making towards esg, and the rise of impact investors in private equity, I think there's significant impact to be had, and as an individual, if you choose to be part of that industry, I think that's broadly impactful things to do.
As a venture builder, I've worked with quite a few impact investors. I recently recorded a conversation with an impact investor (working with Leapfrog Investments) to address some of these points, so feel free to give this a listen if this debate is of interest to you.
Will summarise some of the key arguments here:
1. In public markets, big institutions (like Blackrock and Fidelity) taking ESG screening more seriously is a huge positive. These institutions often have a seat at the board and represent a large enough capital base that they can threaten to pull out if ESG targets are not met. It is not true in this case that "socially neutral" capital will flow in and replace these investors due to the market power they have. So pushing for more esg focus in big asset managers can be a very impactful career. However, this does mean in the short term, some return goes off the table, as the company might have to stray from doing the most profitable thing in the short term, if that's in conflict with esg standards.
2. In the private equity, venture capital space - you have to look at the effects of changing the supply of capital. If more capital , on average, is socially conscious and more geared towards renewable energy ,for example, rather than consumer internet, that's a great thing. Because availability of capital partially determines where entrepreneurship is incentivised. For example, it took risky venture capital bets for decades in the consumer internet space to help companies figure out which business models work and which don't. The availability of capital helped entreperneurs iterate on good business models. If this is done in broadly more productive industries and sectors that actually improve well-being, that's something we should welcome.
3. Having said the above, the impact investing space has serious issues to deal with - standards of impact measurement are pretty low, feedback loops aren't working properly and yes, people need to be more mindful of the opportunity cost of donating to a more effective charity. However, the assumption behind impact investing is that you at least get to recycle capital while spurring growth in an developing country and improving living standards. So comparing it to one time donations is not an apples to apples comparison. One has to prove that donating to the effective charities now is better than waiting to recycle capital, and then donating to charity, accounting for time value of money.
Hi there, I’m assuming this is written for everyday investor, but not as a critique to the whole sector?
I think some of the nuances and innovation in impact investing are overlooked in this article, though I would agree it is harder for everyday investors to tap into the sector (at least for now). However, I don’t think the solution is necessarily to just opt for donation:
(1) Simply by demanding more ethical or impact-led investment products, this will change the behaviours of fund managers and businesses. Already, there are more and more ethical products on offer, because millennials are more socially conscious. Of course, we don’t want to encourage “impact-washing” but that’s a whole different topic.
(2) There is no mention of innovative financial models used by the impact investing sector. An example is blended finance. As opposed to just giving out philanthropic donation, you can leverage that to draw out private capital. These are private capitals that would otherwise not be accessible, so I would argue this is additionality. Impact bond is another model, where you know for sure the investment is used to achieve the outcomes defined (i.e. no payment for investor if outcomes not achieved). If you were going to donate that money anyway, an impact bond gives you the chance of receiving a return + interest. If done right, impact investing can do good at scale where pure philanthropy cannot.
(3) I think a more subtle and contentious point is, by introducing market mechanism, you are forcing NGOs and social enterprises to step up their game. They need to have accountability, and are forced to be more resourceful. Effective charities stay, less effective ones die out.
Of course, impact investing is by no means a silver bullet. As of now, its financial models are more geared towards larger charities, so small/new charities would still rely primarily on donations. Philanthropy still plays an important role, but I would argue it is insufficient to solve problems at scale.