Reimagining Impact Investing: The Second Decade

At least $700 billion of capital―as well as considerable talent―have flocked to impact investing over the past decade. Pre-COVID, its promise was hard to disagree with: a better world, plus competitive financial returns. An exciting proposition for millennials. The rise of impact investing coincided with the longest bull market in recent history, and COVID will keep fueling investors’ hunger for purpose.

But there is some adjustment ahead. Impact investing focuses primarily on private markets. A new study suggests that in May 2020, only 51% of family offices were convinced that private equity can deliver alpha, down from 73% in March. Funds sitting on dry powder and deal multiples becoming more expensive do little to counter that perception. Another study even argues that net of fees, private equity funds have returned only roughly the same as public equity indices since at least 2006.

A New Deck of Cards on Purpose and Impact

Post-COVID, we still have a major transition to an inclusive, low-carbon economy ahead of us, and COVID is now dealing out new cards on purpose and private initiative. After the pandemic, the mix between state and private initiative may not automatically favor entrepreneurship and market-led solutions to social and environmental challenges. After the U.S. unemployment rate recorded a 50-year low of 3.5% in September 2019, it reached its highest level in 80 years at 14.7% only months later in April 2020―inviting reflection whether the nation’s super-flexible labor market is still timely.

Mobilizing millions in over 500 major protests in cities and towns across the U.S. and three continents in a matter of weeks in response to the killing of George Floyd by a white police officer, the Black Lives Matter movement’s protests have raised additional profound questions: on what scale is reform now needed if we are serious about an inclusive society with opportunity for all? And how can we come up with a holistic change agenda that appropriately considers both social and environmental sustainability?

Moreover, the tectonic plates are jostling about in fits and starts. The Economist Intelligence Unit currently expects global output to contract 4.2% year on year in 2020, trade to be down 24.8%, and global GDP to recover to pre-COVID levels in 2022 the earliest, with a contraction of 4% in the U.S. and 8% in the Eurozone this year. For some nations, the current crisis may ‘merely’ end up looking like two to three times the adverse impact of the financial crisis―tragic and expensive, but ultimately manageable. In others, the institutional landscape that governs markets will itself undergo profound changes. We will find out over time if and where an economic-institutional collapse reminiscent of the Soviet bloc in 1991 will take place.

To remain relevant for what’s ahead, impact investing now needs to get impact themes right, keep climate on the radar, and update the narrative of progress.

Reconsider Impact Themes

First, impact investors need to factor in changing behavior among market participants, policy makers and regulators. The current crisis comes after a decade of expansion at peak corporate margins and peak corporate leverage, with global debt of $255 trillion: even before the onset of COVID-19 global debt was over 322% of GDP, or 40% higher than at the onset of the 2008 financial crisis.

COVID’s initially health-driven implications for supply and demand affect the attractiveness of investment themes. We are already witnessing the acceleration of retail becoming e-commerce. Another implication of coronavirus is the growing importance of our immediate surroundings to our well-being. “Nesting”―or the tendency to turn one’s immediate surroundings into a place of comfort, control and security―is becoming a driver of social impact. So is the acceleration of digitally transmitted services in fields such as education, health, leisure, and wellness. Add to this a much wider application of product and service safety considerations in fields such as logistics, nutrition, and healthcare. And of course, managing the security downside associated with increased data flows, or cybersecurity.

These are all fields where money will be made. The purpose question is, who can impact investors back so that the resulting products and services are inclusive and―important for the transition to a low-carbon economy―environmentally sound, while earning their cost of capital? As they review their investee portfolios, assess the fundamental viability of ventures, and the efficiency of their capital structures in a post-COVID world, impact investors need to take a fresh view. What are the investable themes of a post-COVID inclusive, sustainable economy? What role can impact investing play in tackling longstanding patterns of exclusion in developing countries and advanced economies? From an impact-first perspective, where is it more effective to bring about change via the democratic political process and public sector action rather than through the market mechanism? And from a finance-first perspective, how does one meet private equity relative to public market performance expectations?

Keep Climate on the Radar

Second, the implications of the coronavirus pandemic look like a sneak peek preview of what it means not to solve the climate crisis, environmental destruction, and overpopulation. This matters for millennials who will be around to witness the outcome. A recent panel analysis of the United States by the Richmond Fed finds that a 1°F increase in average summer temperature is associated with a reduction of the annual growth rate of output of 0.15% to 0.25%. Rising temperatures could depress economic growth in the U.S. alone by one third over the next 100 years.

The potential future risks of climate change are hard to quantify, still largely underestimated, or even omitted. COVID looks like the preliminaries inviting impact investors to develop alternative scenarios, devise defensive as well as offensive investment strategies, and boost resilience, to address the next powerful triggers of conflict, displacement, mass migration, and loss of life, including the destabilization of ice sheets, extreme heat impacts, more frequent droughts and floods, ecosystem collapse and destruction of biodiversity.

Update the Progress Narrative

Third, impact investing needs to update its narrative of progress. The United Nations (UN) have failed to shape the coronavirus response around the globe. The UN’s yardstick for impact, the Sustainable Development Goals, are one of the casualties. With a total pre-crisis financing gap of at least $2.5 trillion per year for all goals, targets such as universal health coverage or sanitation for all had already looked unattainable before COVID. The pandemic has now put goal #1, eradicating poverty, at the back of the line. To move forward, it is time to graduate from a mechanistic “big development” approach toward more pragmatic, hybrid propositions that use public and private capital where they add the greatest value. Capacity building, partnerships, and effective governance that render global challenges investable are what enables value creation. Impact measurement frameworks need to reflect this.

In the Second Decade, Get Ready to Switch Gears

Post-COVID, many aspects of the U.S. and the global economy will be reorganized. Functioning capital markets that adequately price risk remain indispensable―channeling capital toward activities that result in products and services that consumers want to buy, generating employment as well as tax revenue. Aligning with the resource scarcity conditions of sustainable development moreover requires internalizing environmental externalities, including via signals such as carbon pricing and removal of public subsidies for fossil fuels. Striking the right balance is key for present and future generations.

The second decade of impact investing will be judged by its value add in the new post-COVID context. Talent is not a constraint, millennials want impact. Nor is it capital that is looking for purpose. Now is the time to take a hard look at the implications of the new operating environment and reimagine the strategic agenda for impact investing.

Maximilian Martin, Ph.D. is an impact investing veteran who wrote the primer “Status of the Social Impact Investing Market” for the first ever G8 conference on impact investing hosted by the United Kingdom in 2013.

The opinions expressed in this article are the those of the author and do not necessarily reflect the views of the organizations whom he serves in an executive or board of directors’ capacity.