Solution-Driven Finance: The New Way of “Impact First”

Why serving organic lobster on Titanic won’t do the trick

Brought to life by family offices, foundations and philanthropists more than a decade ago, even mainstream institutional investors seemingly have now discovered the virtues of impact investing. Or at least so they claim. 

The impact industry has become a “mainstream” investment theme and is filling the agendas of conference organisers. Newspapers are full of lively debate on the size of the “impact investing industry” and the further growth that can be expected. The jargon used meanwhile is not very different to that previously used to describe the rise of new investment fields such as cleantech, or certain investment themes in the life sciences space or, more recently, the fintech industries.

Indeed, impact investing has been struggling with scaling challenges since its inception, both on the capital supply side as well as on the side of capital deployment.

On the capital supply side, scaling was hindered by the still widespread perception that any societal benefit generated by an activity would have an unavoidable negative impact on the financial returns to investors.

On the deployment side, the most prominent barrier to scale is undoubtedly the high granularity of investment opportunities with limited size.

It therefore is no surprise that tracking the size of impact investment volumes has been the focus for quite some time. It is, however, astonishing that the success of impact investing meanwhile appears to be measured exclusively via the amount of capital raised for and deployed in impact investing.

Impact investors claim an intention to seek tangible impact as a result of their investment activity. Their aim is to go beyond the negative screening approaches applied in sustainable and responsible investment strategies, which merely seek to eliminate harmful sectors and business models from their investment focus.

In the light of this claim, the debate amongst the impact investing community about reaching scale feels odd.

Certainly, dealing with the massive humanitarian challenges outlined in the widely quoted United Nations Development Programme’s Sustainable Development Goals (SGDs) requires significant amounts of capital. Reason enough to celebrate ever-increasing amounts raised for impact investing: The annual survey conducted by the Global Impact Investing Network and JP Morgan claims that the impact investing market grew beyond USD 15bn of annual investment volume in 2015 and is projected to have reached a value above USD 17bn in 2016. These figures are praised as signs of a breakthrough in the impact investing industry.

Surprisingly though, these resounding successes have never calmed the critics who maintain that much of this capital has nothing in common with an impact investing approach. These critics say that behind the figures is hidden a disguised form of return-driven investment strategies. How come the supposedly noble objectives of directing massive capital towards impact investing have not overcome the divide between the true features of impact investing and its perception in the eyes of its stakeholder community?

It is not so much the question of what qualifies as impact investing in the eyes of different actors and stakeholders in the market that causes worries: what is of concern is the disconnect between, on one side, the impact investment capital raised and on the other, the impact that is needed to overcome the societal challenges we are currently facing.

Whilst we are celebrating the ever-growing amount of capital going into so-called impact investing, we tend to overlook the limited impact this capital is actually having. Yes, we look for investments that create impact here and there. Yes, we require thorough impact reporting from our investees. Yes, we are having sophisticated debates about all forms of definitions of outputs, outcomes and impact indicators and how they interact.

But is our focus really impact? Or are we merely applying, yet again, another form of negative screening that selects from a universe of impact investing opportunities in the market those which happen to coincide with the risk/return profiles of our underlying asset strategies? What purpose does it serve if we raise USD 15bn of annual impact investing capital if such capital can only be spent on achieving impact in the very narrow spectrum of risk-sterilised investment strategies in mainstream markets?  

Isn’t it like travelling on Titanic and, in order to show responsibility for a better world, deciding that it would be better if we all ate organic and ethically sourced lobster? And while we congratulate ourselves on our impact conscious behaviour with a fine Martini, Titanic stays the course…and hits the iceberg.

We may very well raise an amount of USD 13 to 20 trillion USD, equivalent to what is needed to meet the SDGs. But before getting too enthusiastic about the successful raising of these funds, we need to be aware of the strings that are attached: Most of these funds will seek risk/return profiles that can only be found in mainstream instruments targeted at some 40 countries which show political stability, functioning capital markets, high credit ratings and economic prosperity.

The bulk of challenges (actually some 90%) to be met in order to reach the SDGs, however, lie in the 140 remaining countries, with high political end economic volatility, low safety standards, often unreliable legal systems etc. How are we to get SDG initiatives funded if they are not “eligible” under the risk/return criteria put forward by self-declared impact investors who actually are prepared to invest only in a socially responsible sub-segment of the mainstream markets?

The need for a new “Impact First”:  Solution-Driven Finance

Does our ambition and responsibility as impact investing community not go beyond applying screening filters in the impact investing market in order to select from all opportunities on offer those that happen to meet our risk/return objectives and randomly funding the impact that these opportunities happen to generate?

If we want to be serious about meeting the SDGs defined at the COP 21 meeting in 2015, we need to shift our approach and put impact at the heart of our investment strategies. The subject of “impact first” (or not) is less a debate about the trade-off between impact and an investment’s financial return: rather, what we need is a solution driven investment approach that puts the much needed societal impact at the heart of the design of investment instruments.

We cannot leave it to the random outcome of individual asset allocation strategies to determine which measures in pursuit of which SDGs will get funding and which will not. Finding funding solutions for meeting the SDGs has become a non-negotiable requirement for the sustainability of our society and therefore has become a non-negotiable factor for economic competitiveness at any level – from the micro-perspective of business owners to the macro-perspective of national economies in a global context.

If the need to achieve the SDGs, however, is non-negotiable, the only way to reach them lies in the intelligence we put into the design of financial instruments so that they link the SDG funding needs to the spectrum of risk profiles available in the financial markets. Only if the impact investing community manages to meet this challenge will it be entitled to claim that it has made a decisive contribution to the sustainability of our society and the planet.

A true new purpose for Development Finance Institutions (DFIs)

Of course the question remains, who will take the lead in looking for solutions for achieving the SDGs? Who will be ready to bear the manifold risks associated with investments in societal solutions in countries that carry sizeable macroeconomic and political risks, or in projects with very low predictability of counterparty risks?

A logical answer to these questions can be found within the role of DFIs. DFIs have the mission, the expertise and the means to lead the design of financial instruments, the objective of which is the fundability of solutions to societal issues both at the level of national economies as well as at a global level.

One prerequisite however, for such a new role for DFIs, would be an increased focus from DFIs on means of intervention that are truly complementary to the private sector. To date, most DFIs have expressed their own impact by reporting their funding volumes deployed in certain target sectors, often in a way that directly competes with funding sources provided by the private sector. Instead, DFIs’ focus should be on the concrete societal solutions they seek to finance in solid individual projects embedded in national and global development plans.

Instead of competing with the private sector or even amongst themselves, DFIs could develop significant and relevant expertise in engineering financial instruments that, through a combination of the different risk/return profiles of various investors, make development-critical projects financeable. Various risk/return profiles would have to include development aid funding of states as well as the funding available from DFIs themselves and catalyse private sector investment money that would otherwise not be available for funding the risks associated with many SDG-critical measures and projects.

Ultimately, DFIs have only two means with which to express their subsidiarity to the private sector and provide true value added in a financial system: expertise and risk-taking. With their capacity for risk-taking being increasingly limited by their own submission to tightening banking regulations, the focus on providing expertise for creating financing solutions to unaddressed shortcomings in areas of social and environmental development appear to be DFIs’ only credible long-term justification for their existence.

Enhanced creativity in combining the resources of investors with different risk appetites

Independently of the role of DFIs, the future of impact investing lies in a greater creativity in the combination of funding sources with different levels of risk-appetite in a number of dimensions. The dividing debate on profit orientation of impact-driven investments causes the impact-investing community to stagnate in isolated for-profit and non-for-profit funding patterns incapable of contributing to the needed societal change. As long as society does not accept the concrete impact objective as the priority in the design of financial instruments beyond the allocation of profit elements that are generated by the funded intervention for impact, a true impact market will never materialise. With (i) philanthropic funding sources being insufficient to tackle mounting societal challenges and (ii) for-profit investing retreating to a very narrow risk spectrum, sustainability-critical solutions to societal issues will continue to be sacrificed in what is a largely ideological debate. 

A focus on solution-driven finance, however, will present opportunities for the rebirth of the financial markets, where expertise in creating funding models put at the service of true impact will not only reshape the ethical substance of financial markets, it will also create an area for growth in a financial services industry that is facing an unprecedented need for restructuring  triggered by the rise of the digital economy.

It is equally the right time for the genuine impact investing community - family offices, foundations, High-net-worth individuals - to deliver proof of their genuine societal concern beyond randomly selected, “feel-good investment opportunities” and create that demand for more sophisticated, solution-focused impact investing instruments which may finally change an obsolete financial market logic.

Solution-driven finance solving the metrics dilemma

Finally, an investment approach targeted at concrete impact solutions, which are not only part of a two-dimensional investment decision but are actually placed at the very heart of the design of the financial instrument itself, would render a large portion of the debate on impact metrics redundant: rather than academically debating the comparability of impact metrics and their relevance for a given business model or impact project, the impact objective would be the starting point for the definition of an investment proposal.

In a second step, such investment proposal, through financial engineering, would then be translated into risk layers suitable for the various risk/return profiles of a diversified investor community, spanning from development aid funds, donations and philanthropic funding to mainstream investment capital with or without an impact agenda.

In doing so, rather than fighting the limitations of the mono-dimensional investment criteria of isolated investor groups, impact projects could access a far vaster investors pool than what is accessible today and may bring us closer to meeting the gigantic funding requirements for the SDGs.  

An intriguing perspective if we imagine that the energy currently wasted on rather futile theoretical arguments over impact metrics could be redirected towards getting the real job done: delivering  concrete action for achieving the SDGs and saving our planet before we run out of time.

 June 2017