Impact Investing: A Game-Changer for Development?

By Sean Hicks
posted on April 15, 2014 in Economics and Finance, Global Development

Since the term was coined seven years ago, the concept of “impact investing” has gained considerable traction among investors and philanthropists alike. Impact investments, made with the intent of generating measurable social and environmental impact as well as financial return, have been met with both skepticism from those who doubt the feasibility of their dual nature and enthusiasm from those who herald them as a welcome trend in foreign investment.

Indeed, over the last year, impact investment has demonstrated the potential to reshape international development. In June 2013, U.K. Prime Minister David Cameron touted its ability to “tackle the world’s most difficult social problems” at a G8 social impact investing conference in London. Earlier that year, Sir Ronald Cohen and Harvard Business School Professor William A. Sahlman declared impact investing “the new venture capital.”

Many market analysts share these sentiments: according to a September 2013 report from Deliotte, there is approximately $25 billion in impact investment worldwide. Analysts at J.P. Morgan and the Rockefeller Foundation expect this figure to jump up to somewhere between $400 billion and $1 trillion by 2020.

Still, despite the recent surge in this particular investment strategy, there is still a fair amount of confusion over what impact investing represents, and how it works. Here is a quick breakdown:

  • Impact investing is an investment vehicle that can be made across multiple asset classes (debt, fixed income, private equity/venture capital, etc.)
  • Impact investments can be made in developing and emerging markets
  • Leading contributors to impact investments are high-net-worth individuals and development finance institutions; however, banks, pension funds, foundations, and endowments also adopt impact investing strategies
  • Investors can target a range of returns from below market rate – sometimes called “concessionary investments”(for investors who primarily care about impact) – to market rate (for investors with more balanced objectives)

The central assumption of impact investment is that the creation of economic value and social value are not mutually exclusive. This assumption stands in contrast to economic neoliberalism, which stresses privatization, deregulation, and the ability of the free market to directly or indirectly solve the vast majority of societal inefficiencies.

In many respects, the underlying principles of impact investment align with the ways in which millennial Americans view the role of business in society. Figure 1 illustrates that the percentage of millennials – 36% of respondents – who think the primary purpose of business is to improve society is higher than any other category surveyed. With the millennial generation’s impact-oriented mindset at its back, it’s quite possible that impact investing could penetrate mainstream investing by the end of the decade.

To graduate from this either-or fallacy, perhaps impact investment should be thought of as a pipeline of supplementary capital to developing markets. Social entrepreneurs abroad do not have the same resources as their counterparts in the United States. In the U.S. and other developed nations, entrepreneurs have access to much more developed networks of angel investors and venture capital firms. Indeed, the biggest obstacle for scaling a social enterprise is lack of funding. This is despite hundreds of millions of dollars in assets held by foundations and non-profits, which indicates a massive inefficiency in capital allocation, in large part due to donors’ resistance to fund overhead costs of startup nonprofits and social enterprises.

Enter impact investment. Investors understand that their returns are directly related to a firm’s ability to scale, and are thus incentivized to provide adequate capital to drive the innovation and growth social entrepreneurs need to obtain their desired outcomes.    

Before impact investing can reach its full potential, though, there are a few flaws in the model that need to be addressed:

  1. Gaps between social entrepreneurs and investors. Many impact investors only invest in social enterprises that can show on-the-ground production. How, then, does a startup social enterprise get to that point without funding? Silicon Valley may have a mature network of angel investors inclined to provide seed funding; impact investing does not.
  2. Deal sizes are relatively small. The average direct impact investment is twenty times smaller than the average private equity investment. This makes it all the more difficult for startup social enterprises to acquire the necessary funding to scale.
  3. Hard time breaking into traditional portfolios. Impact investing makes sense to many with an interest in or basic knowledge of international development, but it is less intuitive to the average investor.
  4. Measurement of social return is not easy. Although measurement of financial return is fairly straightforward, measurement of social impact is challenging.  In addition to the challenge of quantifying social outcomes, investors and entrepreneurs must be in agreement on the approach and method of measurement when it is applicable.

The bottom line is that while impact investing is nascent, its potential is legitimate. As millennials continue to redefine the role of business in society to be more socially cognizant, impact investing has a natural foothold for years to come. Furthermore, by marrying traditional investing and philanthropic aid, impact investing can unlock waves of capital to the hands of eager social entrepreneurs who will use it to develop effective ways to improve the lives of millions of people across the globe.