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.